Clearing Requirement Determination Under Section 2(h) of the CEA, 74283-74339 [2012-29211]

Download as PDF Vol. 77 Thursday, No. 240 December 13, 2012 Part II Commodity Futures Trading Commission sroberts on DSK5SPTVN1PROD with 17 CFR Parts 39 and 50 Clearing Requirement Determination Under Section 2(h) of the CEA; Final Rule VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 PO 00000 Frm 00001 Fmt 4717 Sfmt 4717 E:\FR\FM\13DER2.SGM 13DER2 74284 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations COMMODITY FUTURES TRADING COMMISSION 17 CFR Parts 39 and 50 RIN 3038–AD86 Clearing Requirement Determination Under Section 2(h) of the CEA Commodity Futures Trading Commission. ACTION: Final rule. AGENCY: The Commodity Futures Trading Commission (Commission or CFTC) is adopting regulations to establish a clearing requirement under new section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted under Title VII of the DoddFrank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The regulations require that certain classes of credit default swaps (CDS) and interest rate swaps, described herein, be cleared by a derivatives clearing organization (DCO) registered with the Commission. The Commission also is adopting regulations to prevent evasion of the clearing requirement and related provisions. DATES: The rules will become effective February 11, 2013. Specific compliance dates are discussed in the supplementary information. FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director, 202–418–5684, sjosephson@cftc.gov; Brian O’Keefe, Associate Director, 202– 418–5658, bokeefe@cftc.gov; or Erik Remmler, Associate Director, 202–418– 7630, eremmler@cftc.gov, Division of Clearing and Risk, Camden Nunery, Economist, 202–418–5723, cnunery@cftc.gov, Office of the Chief Economist, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581. SUPPLEMENTARY INFORMATION: SUMMARY: sroberts on DSK5SPTVN1PROD with Table of Contents I. Background A. Clearing Requirement Proposal B. Financial Crisis C. Central Role of Clearing in the DoddFrank Act D. G–20 and International Commitments on Clearing E. Overview of Section 2(h) and § 39.5 F. Submissions From DCOs II. Comments on the Notice of Proposed Rulemaking A. Overview of Comments Received B. Generally Applicable Comments C. Credit Default Swaps D. Determination Analysis for Credit Default Swaps E. Interest Rate Swaps F. Determination Analysis for Interest Rate Swaps VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 III. Final Rule A. Regulation 50.1: Definitions B. Regulation 50.2: Treatment of Swaps Subject to a Clearing Requirement C. Regulation 50.3: Notice to the Public D. Regulation 50.4: Classes of Swaps Required To Be Cleared E. Regulation 50.5: Clearing Transition Rules F. Regulation 50.6: Delegation of Authority G. Regulation 50.10: Prevention of Evasion of the Clearing Requirement and Abuse of an Exception or Exemption to the Clearing Requirement IV. Implementation V. Cost Benefit Considerations A. Statutory and Regulatory Background B. Overview of Swap Clearing C. Consideration of the Costs and Benefits of the Commission’s Action D. Consideration of Alternative Swap Classes for Clearing Determination E. Section 15(a) Factors VI. Related Matters A. Regulatory Flexibility Act B. Paperwork Reduction Act These failures revealed the vulnerability of the U.S. financial system and economy to widespread systemic risk resulting from, among other things, poor risk management practices of financial firms and the lack of supervisory oversight for a financial institution as a whole.3 The financial crisis also illustrated the significant risks that an uncleared, overthe-counter (OTC) derivatives market can pose to the financial system. As the Financial Crisis Inquiry Commission explained: I. Background Certain OTC derivatives, such as CDS, played a prominent role during the crisis. According to a white paper by the U.S. Department of the Treasury, ‘‘the sheer volume of these [CDS] contracts overwhelmed some firms that had promised to provide payment of the CDS and left institutions with losses that they believed they had been protected against.’’ 5 In particular, AIG reportedly issued uncleared CDS transactions covering more than $440 billion in bonds, leaving it with obligations that it could not cover as a result of changed market conditions.6 As a result of AIG’s CDS exposure, the Federal government bailed out the firm with over $180 billion of taxpayer money in order to prevent AIG’s failure and a possible contagion event in the broader economy.7 More broadly, the President’s Working Group (PWG) on Financial Markets noted shortcomings in the OTC A. Clearing Requirement Proposal On August 7, 2012, the Commission published a notice of proposed rulemaking (NPRM) to establish a clearing requirement under new section 2(h)(1)(A) of the CEA, as provided for under section 723 of Title VII of the Dodd-Frank Act.1 The Commission proposed that swaps meeting the specifications identified in two classes of CDS and four classes of interest rate swaps, and available for clearing by an eligible DCO, would be required to be cleared. The Commission also proposed rules related to the prevention of evasion of the clearing requirement and prevention of abuse of an exception or exemption to the clearing requirement. The Commission is hereby adopting §§ 50.1–50.6 and § 50.10, subject to the changes discussed below. B. Financial Crisis In the fall of 2008, a series of large financial institution failures triggered a financial and economic crisis that threatened to freeze U.S. and global credit markets. As a result of these failures, unprecedented governmental intervention was required to ensure the stability of the U.S. financial system.2 1 Clearing Requirement Determination Under Section 2(h) of the CEA; Proposed Rule, 77 FR 47170 (Aug. 7, 2012). 2 On October 3, 2008, President Bush signed the Emergency Economic Stabilization Act of 2008, which was principally designed to allow the U.S. Department of the Treasury and other government agencies to take action to restore liquidity and stability to the U.S. financial system (e.g., the Troubled Asset Relief Program—also known as TARP—under which the U.S. Department of the Treasury was authorized to purchase up to $700 billion of troubled assets that weighed down the PO 00000 Frm 00002 Fmt 4701 Sfmt 4700 The scale and nature of the [OTC] derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008: millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults.4 balance sheets of U.S. financial institutions). See Public Law 110–343, 122 Stat. 3765 (2008). 3 See Financial Crisis Inquiry Commission, ‘‘The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,’’ Jan. 2011, at xxviii, available at http:// www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPOFCIC.pdf. 4 See id. at 386. 5 Financial Regulatory Reform: A New Foundation, June 2009, available at http:// www.treasury.gov/initiatives/Documents/Final Report_web.pdf and cited in S. Rep. 111–176 at 29– 30 (Apr. 30, 2010). 6 Adam Davidson, ‘‘How AIG fell apart,’’ Reuters, Sept. 18, 2008, available at http://www.reuters.com/ article/2008/09/18/us-how-aig-fell-apart-idUS MAR85972720080918. 7 Hugh Son, ‘‘AIG’s Trustees Shun ‘Shadow Board,’ Seek Directors,’’ Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/ news?pid=newsarchive&sid=aaog3i4yUopo& refer=us. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with derivative markets as a whole during the crisis. The PWG identified the need for an improved integrated operational structure supporting OTC derivatives, specifically highlighting the need for an enhanced ability to manage counterparty risk through ‘‘netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.’’ 8 These issues were exposed in part by the surge in collateral required between counterparties during 2008, when the International Swaps and Derivatives Association (ISDA) reported an 86% increase in the collateral in use for OTC derivatives, indicating not only the increase in risk, but also circumstances in which positions may not have been collateralized.9 With only limited checks on the amount of risk that a market participant could incur, great uncertainty was created among market participants. A market participant did not know the extent of its counterparty’s exposure, whether its counterparty was appropriately hedged, or if its counterparty was dangerously exposed to adverse market movements. Without central clearing, a market participant bore the risk that its counterparty would not fulfill its payment obligations pursuant to a swap’s terms (counterparty credit risk). As the financial crisis deepened, this risk made market participants wary of trading with each other. As a result, markets quickly became illiquid and trading volumes plummeted. The dramatic increase in ‘‘TED spreads’’ evidenced this mistrust.10 These spreads increased from a long-term average of approximately 30 basis points to 464 basis points.11 The failure to adequately collateralize the risk exposures posed by OTC derivatives, along with the contagion effects of the vast web of counterparty credit risk, led many to conclude that 8 The President’s Working Group on Financial Markets, ‘‘Policy Statements on Financial Market Developments,’’ Mar. 2008, available at http:// www.treasury.gov/resource-center/fin-mkts/ Documents/pwgpolicystatemktturmoil_ 03122008.pdf. 9 ISDA, ISDA Margin Survey, 2009, available at http://www.isda.org/c_and_a/pdf/ISDA-MarginSurvey-2009.pdf. 10 The TED spread measures the difference in yield between three-month Eurodollars as represented by London Interbank Offered Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit risk while T-bills do not. As the spread got larger, it meant that lenders demanded more return to compensate for credit risk than they would need if they loaned the money to the U.S. Department of the Treasury without any credit risk. 11 The U.S. Financial Crisis: Credit Crunch and Yield Spreads, by James R. Barth et al., page 5, available at http://apeaweb.org/confer/bei08/ papers/blp.pdf. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 OTC derivatives should be centrally cleared. For instance, in 2008, the Federal Reserve Bank of New York (FRBNY) began encouraging market participants to establish a central counterparty to clear CDS.12 For several years prior, the FRBNY had led a targeted effort to enhance operational efficiency and performance in the OTC derivatives market by increasing automation in processing and by promoting sound back office practices, such as timely confirmation of trades and portfolio reconciliation. Beginning with CDS in 2008, the FRBNY and other primary supervisors of OTC derivatives dealers increasingly focused on central clearing as a means of mitigating counterparty credit risk and lowering systemic risk to the markets as a whole. Both regulators and market participants alike recognized that risk exposures would have been monitored, measured, and collateralized through the process of central clearing. C. Central Role of Clearing in the DoddFrank Act Recognizing the peril that the U.S. financial system faced during the financial crisis, Congress and the President came together to pass the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes a comprehensive new regulatory framework for swaps, and the requirement that swaps be cleared by DCOs is one of the cornerstones of that reform. The CEA, as amended by Title VII, now requires a swap: (1) To be cleared through a DCO if the Commission has determined that the swap, or group, category, type, or class of swap, is required to be cleared, unless an exception to the clearing requirement applies; (2) to be reported to a swap data repository (SDR) or the Commission; and (3) if the swap is subject to a clearing requirement, to be executed on a designated contract market (DCM) or swap execution facility (SEF), unless no DCM or SEF has made the swap available to trade.13 12 See Federal Reserve Bank of New York, Press Release, ‘‘New York Fed Welcomes Further Industry Commitments on Over-the-Counter Derivatives,’’ Oct. 31, 2008, available at http:// www.newyorkfed.org/newsevents/news/markets/ 2008/an081031.html, which references documents prepared by market participants describing the importance of clearing. See also Ciara Linnane and Karen Brettell, ‘‘NY Federal Reserve pushes for central CDS counterparty,’’ Reuters, Oct. 6, 2008, available at http://www.reuters.com/article/2008/ 10/06/cds-regulation-idUSN0655208920081006. 13 The Commission has proposed rules that would establish a separate process for determining whether a swap has been made ‘‘available to trade’’ by a DCM or SEF. Those rules, and any determinations made under those rules, will be finalized separately from the clearing requirements PO 00000 Frm 00003 Fmt 4701 Sfmt 4700 74285 Clearing is at the heart of the DoddFrank financial reform. According to the Senate Report: 14 As a key element of reducing systemic risk and protecting taxpayers in the future, protections must include comprehensive regulation and rules for how the OTC derivatives market operates. Increasing the use of central clearinghouses, exchanges, appropriate margining, capital requirements, and reporting will provide safeguards for American taxpayers and the financial system as a whole. The Commission believes that a clearing requirement will reduce counterparty credit risk and provide an organized mechanism for collateralizing the risk exposures posed by swaps. According to the Senate Report: 15 With appropriate collateral and margin requirements, a central clearing organization can substantially reduce counterparty risk and provide an organized mechanism for clearing transactions. * * * While large losses are to be expected in derivatives trading, if those positions are fully margined there will be no loss to counterparties and the overall financial system and none of the uncertainty about potential exposures that contributed to the panic in 2008. Notably, Congress did not focus on just one asset class, such as CDS; rather, Congress determined that all swaps that a DCO plans to accept for clearing must be submitted to the Commission for a determination as to whether or not those swaps are required to be cleared pursuant to section 2(h)(2)(D) of the CEA. D. G–20 and International Commitments on Clearing The financial crisis generated international consensus on the need to strengthen financial regulation by improving transparency, mitigating systemic risk, and protecting against market abuse. As a result of the widespread recognition that transactions in the OTC derivatives market increased risk and uncertainty in the global economy and became a significant contributor to the financial crisis, a series of policy initiatives were undertaken to better regulate the financial markets. discussed herein. See Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade Under Section 2(h)(8) of the Commodity Exchange Act, 76 FR 77728 (Dec. 14, 2011). 14 S. Rep. 111–176, at 32 (April 30, 2010). See also Letter from Senators Christopher Dodd and Blanche Lincoln to Congressmen Barney Frank and Collin Peterson (June 30, 2010) (‘‘Congress determined that clearing is at the heart of reform— bringing transactions and counterparties into a robust, conservative, and transparent risk management framework.’’). 15 S. Rep. 111–176, at 33. E:\FR\FM\13DER2.SGM 13DER2 74286 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with In September 2009, leaders of the Group of 20 (G–20)—whose membership includes the United States, the European Union, and 18 other countries—agreed that: (1) OTC derivatives contracts should be reported to trade repositories; (2) all standardized OTC derivatives contracts should be cleared through central counterparties and traded on exchanges or electronic trading platforms, where appropriate, by the end of 2012; and (3) non-centrally cleared contracts should be subject to higher capital requirements. In June 2010, the G–20 leaders reaffirmed their commitment to achieve these goals. In its October 2010 report on Implementing OTC Derivatives Market Reforms (the October 2010 Report), the Financial Stability Board (FSB) made 21 recommendations addressing practical issues that authorities may encounter in implementing the G–20 leaders’ commitments.16 The G–20 leaders again reaffirmed their commitments at the November 2011 Summit, including the end-2012 deadline. The FSB has issued three implementation progress reports. The most recent report urged jurisdictions to push forward aggressively to meet the G–20 end-2012 deadline in as many reform areas as possible. On mandatory clearing, the report observed that ‘‘[j]urisdictions now have much of the information they requested in order to make informed decisions on the appropriate legislation and regulations to achieve the end-2012 commitment to centrally clear all standardised OTC derivatives.’’ 17 Specifically with regard to required clearing, the Technical Committee of the International Organization of Securities Commissions (IOSCO) has published a final report, Requirements for Mandatory Clearing, outlining recommendations that regulators should follow to carry out the G–20’s goal of requiring standardized swaps to be cleared.18 Nations around the world have been preparing for the move to mandatory clearing. For example, the Japanese Financial Services Authority (JFSA) has proposed requiring certain financial institutions to clear yen-denominated 16 See ‘‘Implementing OTC Derivatives Market Reforms,’’ Financial Stability Board, Oct. 25, 2010, available at http://www.financialstabilityboard.org/ publications/r_101025.pdf. 17 OTC Derivatives Working Group, ‘‘OTC Derivatives Market Reforms: Third Progress Report on Implementation,’’ Financial Stability Board, June 15, 2012, available at http:// www.financialstabilityboard.org/publications/ r_120615.pdf. 18 IOSCO’s report, published in February 2012, is available at https://www.iosco.org/library/pubdocs/ pdf/IOSCOPD374.pdf. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 interest rate swaps that reference LIBOR and CDS that reference the Japanese iTraxx indices by the end of 2012. After that, the requirement will be expanded to other entities engaging in these swaps. In addition, the JFSA is considering expanding its mandatory clearing coverage to include U.S. dollarand euro-denominated interest rate swaps, as well as yen-denominated interest rate swaps referencing TIBOR. The JFSA also will consider mandating single-name CDS referencing Japanese reference entities, and index and singlename CDS on North American and European reference entities. The Monetary Authority of Singapore (MAS) released a consultation paper addressing mandatory clearing on February 13, 2012. Based on a preliminary review MAS expects Singapore dollar interest rate swaps, U.S. dollar interest rate swaps, and Asian currency non-deliverable forwards to meet its proposed mandatory clearing criteria. Additional swaps will be considered for mandatory clearing via clearinghouse submission or upon the review of MAS. The Securities and Futures Commission and Hong Kong Monetary Authority jointly released a consultation paper addressing mandatory clearing on October 17, 2011. This consultation plan described a phased implementation approach where clearing requirements will initially cover standardized interest rate swaps and non-deliverable forwards. Hong Kong regulators have said they will consider extending the mandatory clearing requirements in subsequent phases. In July, the Hong Kong regulators published consultation conclusions and stated that the precise mandatory clearing obligations would be set out in subsidiary legislation which they will be consulting on in the fourth quarter of 2012. On April 18, 2012, the Australian Council of Financial Regulators published a consultation on a number of OTC derivatives, including mandatory clearing. The Council of Financial Regulators is developing advice for the government which is expected to adopt legislation by end-2012. Finally, in the European Union, specific clearing determinations have yet to be made. However, the European Markets Infrastructure Regulation (EMIR) provides that contracts become subject to the clearing obligation through either a ‘‘bottom up’’ approach or a ‘‘top down’’ approach. The ‘‘bottom up’’ approach is where a national authority authorizes a central counterparty (CCP) to clear certain classes of OTC derivatives. The ‘‘top PO 00000 Frm 00004 Fmt 4701 Sfmt 4700 down’’ approach is where the European Securities and Markets Authority (ESMA) identifies classes of OTC derivatives which should be subject to the clearing obligation but for which no CCP is authorized to clear. Based on this framework, ESMA has the authority to make clearing determinations for classes of OTC derivative contracts. With the adoption of these final rules, the Commission is taking a critical step toward meeting the G–20 commitment and fulfilling the requirements of the Dodd-Frank Act. The Commission has consulted with authorities from around the globe to ensure that our efforts are as coordinated as possible. E. Overview of Section 2(h) and § 39.5 The Commission promulgated § 39.5 of its regulations to implement procedural aspects of section 2(h) of the CEA.19 Regulation 39.5 establishes procedures for: (1) Determining the eligibility of a DCO to clear swaps; (2) the submission of swaps by a DCO to the Commission for a clearing requirement determination; (3) Commission initiated reviews of swaps; and (4) the staying of a clearing requirement. The determinations and rules adopted in this release implement the clearing requirement under section 2(h) of the CEA for certain swaps and require that those swaps must be submitted for clearing to Commission-registered DCOs. Under section 2(h)(1)(A), ‘‘it shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a [DCO] that is registered under [the CEA] or a [DCO] that is exempt from registration under [the CEA] if the swap is required to be cleared.’’ 20 A clearing requirement determination may be initiated by a swap submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to ‘‘submit to the Commission each swap, or any group, category, type or class of swaps that it plans to accept for clearing, and provide notice to its members of the submission.’’ In addition under section 2(h)(2)(B)(ii) of the CEA, ‘‘[a]ny swap or group, category, type, or class of swaps listed for clearing by a [DCO] as of the date of enactment shall be considered submitted to the Commission.’’ 19 See 76 FR 44464 (July 26, 2011); 17 CFR 39.5. section 2(h) of the CEA. The Commission also may conduct a Commission-initiated review of swaps for required clearing. Section 2(h)(2)(A)(i) of the CEA requires the Commission on an ongoing basis to ‘‘review each swap, or any group, category, type, or class of swaps to make a determination as to whether the swap, category, type or class of swaps should be required to be cleared.’’ 20 See E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations F. Submissions from DCOs On February 1, 2012, Commission staff sent a letter requesting that DCOs submit all swaps that they were accepting for clearing as of that date, pursuant to § 39.5 of the Commission’s regulations.21 The Commission received submissions relating to CDS and interest rate swaps from: The International Derivatives Clearinghouse Group (IDCH) 22 on February 17, 2012; the CME Group (CME), ICE Clear Credit, and ICE Clear Europe, each dated February 22, 2012; and a submission from LCH.Clearnet Limited (LCH) on February 24, 2012.23 The clearing requirement determinations and rules adopted in this release cover certain CDS and interest rate swaps currently being cleared by a DCO. The Commission intends subsequently to consider other swaps submitted by DCOs, such as agricultural, energy, and equity indices. As stated in the NPRM, the decision to focus on CDS and interest rate swaps in the initial clearing requirement determinations is a function of both the market importance of these swaps and the fact that they already are widely cleared. In order to move the largest number of swaps to required clearing in its initial determinations, the Commission believes that it is prudent to focus on those swaps that have the highest market shares and, accordingly, the biggest market impact. Further, for these swaps there is already a blueprint for clearing and appropriate risk management. CDS and interest rate swaps fit these considerations and therefore are well suited for required clearing consideration.24 Notably, market participants recommended that the Commission take this approach, and comments received on the NPRM supported this approach as well.25 In addition, interest rate sroberts on DSK5SPTVN1PROD with 21 The letter made it clear that DCOs should submit both pre-enactment swaps and swaps for which DCOs have initiated clearing since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to those swaps that DCOs were accepting for clearing as of July 21, 2010, the date of enactment of the Dodd-Frank Act. 22 As discussed in detail below, IDCH has been purchased by LCH.Clearnet Group. 23 Other swaps submissions were received from Kansas City Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and NGX do not accept any CDS or interest rate swaps for clearing. 24 The Commission will consider all other swaps submitted under § 39.5(b) as soon as possible after this determination is published. These other swaps include certain CDS that were submitted to the Commission after the initial February 2012 submissions discussed above. If the Commission determines that additional swaps should be required to be cleared, such determination likely will be proposed as a new class under § 50.4. 25 See, e.g., letters from the CME Group (CME), the Futures Industry Association (FIA), the VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 swaps account for about $500 trillion of the $650 trillion global OTC swaps market, in notional dollars—the highest market share of any class of swaps.26 LCH claims to clear about $302 trillion of those—meaning that, in notional terms, LCH clears approximately 60% of the interest rate swap market.27 While CDS indices do not have as prominent a market share as interest rate swaps, CDS indices are capable of having a sizeable market impact, as they did during the 2008 financial crisis. Overall, the CDS marketplace has almost $29 trillion in notional outstanding across both single and multi-name products.28 CDS on standardized indices accounts for about $10 trillion of the global OTC market in notional dollar amount outstanding.29 Since March 2009, the ICE Clear Credit and ICE Clear Europe have combined to clear over $30 trillion in gross notional for all CDS.30 Because of the market shares and market impacts of these swaps, and because these swaps are currently being cleared, the Commission decided to review CDS and interest rate swaps in its initial clearing requirement determinations. The Commission recognizes that while this is an appropriate basis for the initial determinations, swap clearing is likely to evolve and clearing requirement determinations made at later times may be based on a variety of other factors beyond the extent to which the swaps in question are already being cleared. II. Comments on the Notice of Proposed Rulemaking The Commission received 29 comments during the 30-day public comment period following publication of the NPRM, and four additional comments after the comment period closed. The Commission considered each of these 33 comments in formulating the final regulations.31 The Chairman and Commissioners, as well as Commission staff, participated in numerous meetings with clearinghouses, market participants, trade associations, public interest groups, and other interested parties. In addition, the Commission has consulted Managed Funds Association (MFA), and Americans for Financial Reform (AFR). 26 Bank of International Settlements (BIS) data, December 2011, available at http://www.bis.org/ statistics/otcder/dt1920a.pdf. 27 Id.; LCH data. 28 BIS data, December 2011, available at http:// www.bis.org/statistics/otcder/dt1920a.pdf. 29 Id. 30 ICE Clear Credit data, as of the April 26, 2012 clearing cycle. 31 Comment letters received in response to the NPRM may be found on the Commission’s Web site at http://comments.cftc.gov/PublicComments/ CommentList.aspx?id=1252. PO 00000 Frm 00005 Fmt 4701 Sfmt 4700 74287 with other U.S. financial regulators including: (i) The Securities and Exchange Commission (SEC); (ii) the Board of Governors of the Federal Reserve System; (iii) the Office of the Comptroller of the Currency; and (iv) the Federal Deposit Insurance Corporation (FDIC). Staff from each of these agencies has had the opportunity to provide oral and/or written comments to this adopting release, and the final regulations incorporate elements of the comments provided. The Commission is mindful of the benefits of harmonizing its regulatory framework with that of its counterparts in foreign countries. The Commission has therefore monitored global advisory, legislative, and regulatory proposals, and has consulted with foreign regulators in developing the final regulations. A. Overview of Comments Received None of the 33 comments received expressed outright opposition to the Commission’s clearing requirement proposal.32 Indeed, 22 of the comment letters strongly supported the Commission’s proposal and urged the Commission to finalize its proposal promptly.33 These comments also supported the Commission’s analysis under the five-factor statutory test, and agreed with the Commission’s conclusion that swaps within the four proposed classes of interest rate swaps and the two proposed classes of CDS were appropriate for required clearing.34 All three DCOs clearing the swaps subject to the final rules expressed strong support for the proposal and agreed with the overall approach taken by the Commission.35 However, a number of commenters requested that the Commission make specific modifications to the proposed 32 An unsigned comment submitted on September 4, 2012, questioned the need for additional regulation as a general matter. 33 See letters from Futures Industry Association Principle Traders Group (FIA PTG), Arbor Research and Trading, LLC, R.J. O’Brien & Associates, Svenokur, LLC, Chris Barnard, CRT Capital Group (Robert Gorham), LLC, DRW Trading Group, Javelin, The Swaps and Derivatives Market Association (SDMA), Knight Capital Americas LLC, Bart Sokol (CRT Capital Group), Jefferies & Company, Inc., MarketAxess, Eris Exchange, Coherence Capital Partners LLC, Citadel, Americans for Financial Reform (AFR), D.E. Shaw Group, AllianceBernstein, LCH.Clearnet Group Limited (LCH), CME Group Inc. (CME), and IntercontinentalExchange, Inc. (ICE). 34 See, e.g., letter from Citadel (reviewing each of the five statutory factors and supporting the Commission’s analysis). 35 CME applauded the Commission’s decision to require classes of swaps be cleared rather than take a product-by-product approach. CME also commended the decision not to propose classes of swaps on a DCO-by-DCO basis. E:\FR\FM\13DER2.SGM 13DER2 74288 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with rules,36 and, in several instances, commenters requested clarification of various points.37 A number of commenters requested that the Commission delay implementation of the clearing requirement until certain milestones are met.38 Each of these comments is discussed in detail below. The Futures Industry Association (FIA) expressed concern about the 30day comment period providing sufficient time to comment on the proposal, and recommended that the Commission provide a longer comment period for future proposals.39 The Commission is cognizant of the importance of affording the public sufficient time to comment on important proposals. However, given the CEA’s requirement that the Commission make its clearing requirement determinations within 90 days, in most instances, providing a 30-day comment period will be appropriate. In fact, some commenters stressed the importance of completing the determination process in an efficient manner. As R.J. O’Brien noted in its comment letter, implementing the clearing mandate as soon as possible ‘‘will improve the financial industry’s credibility and show the rest of the world we are serious about improving the financial safety of our markets.’’ Providing for a longer comment period likely would impede the Commission’s ability to meet the 90-day statutory deadline for completing the determination process. Lastly, two commenters encouraged the Commission to issue proposed determinations for energy, agricultural, and equity swaps as soon as possible.40 As required under the CEA, the Commission will continue to review swap submissions received from DCOs for purposes of the clearing requirement in as timely a manner as possible. 36 See, e.g., letter from ISDA (requesting changes to the delegation provisions of proposed § 50.6). 37 See, e.g., letter from The Financial Services Roundtable (FSR) (requesting that the Commission clarify the meaning of ‘‘conditional notional amount’’). 38 See, e.g., letter from ISDA (requesting that no determination take effect until there is ‘‘a further determination that a product has an adequate clearing history to support a finding of operational readiness to clear by DCOs and market participants’’), and letter from Vanguard (requesting that the Commission delay mandatory clearing until new rules for segregation of customer funds and swap positions are fully operational and capable of being tested for three months). 39 FIA specifically mentioned its inability to respond to questions asked in the NPRM with regard to competitiveness, which it viewed as important to the Commission’s analysis of competitiveness under one of the five statutory factions. See Sections II.D and II.F below. 40 See letters from AFR and Chris Barnard. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 B. Generally Applicable Comments A number of comments are equally applicable to both the CDS and interest rate swap proposals. While most of these issues are discussed in Section III below, certain threshold comments are addressed at the outset. i. Submission of Swaps Required To Be Cleared and Failures to Clear CME sought clarification that market participants do not have to clear those swaps that fall within a class of swaps under § 50.4, but for which no DCO provides clearing or for which the DCO provides clearing to only a limited number of market participants. Other commenters expressed similar concerns about not requiring clearing where no DCO offers customer clearing.41 Freddie Mac requested clarification regarding the legal status of a swap that is submitted for clearing to a DCO, but fails to clear. The Commission confirms that if no DCO clears a swap that falls within a class of swaps under § 50.4, then the clearing requirement does not apply to that swap. In essence, it is a two-step process to determine whether the clearing requirement applies to a particular swap. First, a market participant must determine whether its swap falls within one of the classes under § 50.4. Then, if the swap falls within one of the classes, the market participant must determine if any of the eligible DCOs clear that swap. The second step requires market participants to determine if all the product specifications required under the DCO’s rules are met. If no eligible DCO will accept the swap for clearing because there is a different product specification, then the swap is not required to be cleared. Market participants need not submit swaps to a DCO if they know that the DCO does not clear that particular swap.42 In response to Freddie Mac’s request for clarification, if counterparties submit their swap to a DCO for clearing and the swap fails to clear because it contains a term or terms that prevent any eligible DCO from clearing the swap, then the swap is not subject to the Commission’s clearing requirement. On the other hand, if the swap fails to clear because one or both of the counterparties have not met the DCO’s or their clearing members’ credit requirements,43 then 41 See Section II.D for a discussion of iTraxx and the availability of client clearing. 42 The rule text of § 50.2(a) has been modified to clarify this two-step process. 43 It is the Commission’s understanding that clearing failures generally arise under two circumstances: (1) Failure of the swap to meet the PO 00000 Frm 00006 Fmt 4701 Sfmt 4700 the swap remains subject to the clearing requirement and must be cleared as soon as technologically practicable after the counterparties learn of the credit issue. The Commission notes that section 739 of the Dodd-Frank Act amended section 22(a)(4)(B) of the CEA to provide that, regarding contract enforcement between two eligible counterparties, ‘‘[n]o agreement, contract, or transaction between eligible contract participants or persons reasonably believed to be eligible contract participants shall be void, voidable, or unenforceable * * * under this section or any other provision of Federal or State law, based solely on the failure of the agreement, contract, or transaction * * * to be cleared in accordance with section 2(h)(1).’’ Accordingly, a swap that fails to clear because of credit issues may not be voided by either eligible counterparty solely for the failure of the swap to be cleared in accordance with section 2(h)(1), but the basis for the failure to clear must be addressed by the counterparties and they must promptly resubmit the swap for clearing. With regard to clearing that is not available to all market participants, the Commission will not require a swap to be cleared unless clearing is generally available to all types of market participants.44 ii. Adequacy of DCO Clearing History and Commission Review ISDA raised a general issue regarding whether the clearing requirement determination for CDS and interest rate swaps properly differentiates between swaps that a DCO currently clears and those that are not currently cleared by a DCO. ISDA expressed concern about delegating to the Director of the Division of Clearing and Risk the authority to determine whether newly-cleared swaps fall within a previously-established class. ISDA’s specific comments and recommendations are discussed, and in part adopted, in Section III below. However, ISDA’s general recommendation is that the Commission not impose a clearing requirement until there is ‘‘a further determination that a product has an adequate clearing history to support a finding of operational readiness to clear by DCOs and market participants.’’ Specifically, ISDA requests that each product have been actually cleared by a DCO and exhibit product specifications required by the DCO; or (2) a credit issue with one or both of the counterparties to the swap. Generally speaking, identification of a product specification problem can be identified extremely quickly. 44 See Section II.D for a discussion of iTraxx and the availability of client clearing. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with non-zero open interest (for both interdealer and customer clearing) on each day during a six-month period prior to the effective date of the clearing requirement determination. In contrast with ISDA’s comments, the three DCOs eligible to clear swaps within the classes under proposed § 50.4 praised the Commission for taking the class-based approach rather than a product-by-product approach.45 In addition, CME and ICE both endorsed the Commission’s decision not to limit applicability of the clearing requirement to individual DCOs. The Commission observes that ISDA’s recommendation that each DCO demonstrate non-zero open interest for six months may be inconsistent with section 2(h)(2) of the CEA, which requires each DCO to submit to the Commission all swaps that ‘‘it plans to accept for clearing.’’ The use of the phrase ‘‘plans to accept’’ indicates that Congress intended for the Commission to review swap submissions prior to a DCO’s commencing clearing operations for those swaps. Under these circumstances, the DCO would not be able to demonstrate open interest. In addition, adopting ISDA’s suggestion could pose a significant deterrent to competition among DCOs insofar as DCOs seeking to offer swaps for required clearing would have to wait until they attract open interest and retain it for six months before they would be on a level playing field with incumbent DCOs. The Commission believes that it can address ISDA’s concerns about DCO product expansion and risk management through its ongoing supervision and risk surveillance programs.46 In addition, under § 39.5(a)(1) the Commission can review the presumption of eligibility for any DCO offering new swaps falling into a class that it is already clearing, and under § 39.5(a)(2), the Commission must review the eligibility of any DCO that wishes to clear a swap that is not within a class already being cleared by that DCO.47 The many benefits of a classbased approach are discussed with 45 Many other commenters also agreed with this approach. See, e.g., TriOptima and Citadel. 46 See discussion of the Commission’s DCO examination and risk surveillance programs in the NPRM, 77 FR at 47173–74. 47 In its comment letter, Freddie Mac questioned how the Commission would review a proposal from a DCO to clear swaps that are required to be cleared under § 50.4. In addition to its general authority to ensure compliance with the core principles, the Commission has authority to review a DCO’s eligibility to clear swaps subject to a clearing requirement at any time under § 39.5(a). VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 regard to both CDS and interest rate swaps below. iii. Customer Segregation for Swaps Under section 2(h)(2)(D)(ii)(V) of the CEA, in making a clearing requirement determination, the Commission must take into account the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.48 Several commenters raised general concerns about customer segregation for cleared swaps. Vanguard recommended that the Commission should not implement mandatory clearing for any swaps until the Commission’s final swap customer segregation rules under the legally segregated, operationally commingled (LSOC) model are fully operational and capable of being tested for at least three months prior to mandatory clearing. The Securities Industry and Financial Markets Association’s Asset Management Group (SIFMA AMG) expressed similar concerns about unresolved issues concerning LSOC rules and the operational readiness of futures commission merchants (FCMs) and DCOs to comply with those rules. SIFMA AMG requested clarification of certain matters related to the LSOC model and requests that the Commission issue new rules to require FCMs to issue reports as frequently as technologically feasible, require DCOs to take all steps necessary to ensure reported information is accurate, and require DCOs to complete margin calculations as frequently as technologically feasible. SIFMA AMG recommended that the Commission implement a three-month testing period for LSOC rule implementation after the Commission and the market have completed their ongoing rule clarification efforts. Both Vanguard and SIFMA AMG requested that all customer margin, including excess margin above the amount required by the DCO, be protected from fellow-customer risk. ISDA noted that the commodity broker liquidation provisions under the U.S. bankruptcy code and the Commission’s Part 190 regulations have never been applied to a DCO. In addition, ISDA stated that the Orderly Liquidation Authority under Title II of the Dodd-Frank Act has never been applied to any entity. For clearinghouses located in the United Kingdom, ISDA observed that the 48 This factor is discussed further in Sections II.D and II.F below. PO 00000 Frm 00007 Fmt 4701 Sfmt 4700 74289 Commission is relying on legal opinions, noting the lack of practical experience with DCO insolvency in the United Kingdom. In light of the absence of practical experience with DCO insolvency, ISDA recommended that the Commission study the issue with the goal of documenting uncertainties and proposing solutions. In response to these comments, the Commission observes that the compliance date for LSOC was November 13, 2012. The Commission worked with market participants to ensure that compliance by that date was accomplished 49 For reasons discussed below, the compliance schedule for this first clearing requirement will commence on March 11, 2013.50 Accordingly, as requested by SIFMA AMG, parties in the first compliance category 51 will have more than 3 months of experience under the LSOC rules prior to required clearing taking effect. Those parties in the second and third categories will have over 6 and 9 months of testing prior to required clearing, respectively.52 During this time, the Commission will continue to work with market participants to resolve matters that require clarification regarding LSOC. Moreover, in response to requests for enhanced LSOC protections, the Commission understands that the industry is working toward a February implementation date for DCO rules regarding acceptance of excess collateral. The Commission recognizes 49 The Commission notes that under § 22.13 a DCO may, subject to certain conditions contained therein, accept cleared swaps customer collateral in excess of the amount required by the DCO. Acceptance of this excess collateral is entirely at the election of the DCO. Thus, the timing of resolution of any issues that may arise as a result of the optional acceptance of such collateral is separate and apart from the November 13th compliance date for implementation of the regulatory requirements set forth in the Part 22 rules. 50 See Section IV for a complete discussion of compliance dates. 51 Under the compliance schedule for required clearing, § 50.25, Category 1 Entities are swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds. This category must come in compliance with the clearing requirement by March 11, 2013. 52 Category 2 Entities are commodity pools, private funds, and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature according to section 4(k) of the Bank Holding Company Act, provided that such participants are not third-party subaccounts. Category 2 Entities must comply with the clearing requirement by June 10, 2013, for all swaps entered into on or after that date. Category 3 Entities are all other counterparties not electing an exception for a swap under section 2(h)(7), including third-party subaccounts and ERISA plans. Category 3 Entities must comply with the clearing requirement by September 9, 2013, for all swaps entered into on or after that date. E:\FR\FM\13DER2.SGM 13DER2 74290 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations that this issue is of particular concern to third-party subaccounts that will be required to begin clearing swaps executed on or after September 9, 2013. Given the industry’s February goal, the Commission believes that issues regarding the acceptance of excess collateral will be resolved before the beginning of September. In response to ISDA’s request that the Commission conduct a study regarding insolvencies of DCOs and clearing members, the Commission observes that its staff have actively participated in, and taken leading roles in, a number of international efforts related to clearinghouse and clearing member insolvency, including an important cross-border study regarding insolvency regimes.53 In addition, the Commission and other U.S. authorities, including the FDIC, have been engaged, and continue to engage, in regulatory coordination and cooperation, related to insolvencies under Title II. C. Credit Default Swaps sroberts on DSK5SPTVN1PROD with i. DCO Submissions Pursuant to § 39.5, the Commission received filings with respect to CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe, each a registered DCO.54 The CME and ICE Clear Credit submissions included the CDS that each clears on North American corporate indices, covering various tenors and series.55 The ICE Clear Europe submission included, among other swaps, the CDS contracts on European corporate indices that they clear, with 53 See, e.g., ‘‘Survey of Regimes for the Protection, Distribution, and/or Transfer of Client Assets’’ (Technical Committee of the International Organization of Securities Commissions, March, 2011); ‘‘Consultative Report on the Recovery and Resolution of Financial Market Infrastructures’’ (Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, July, 2012). Staff are also actively participating in further efforts in these contexts by the International Organization of Securities Commissions and the Resolution Steering Group of the Financial Stability Board. 54 In the case of CME and ICE Clear Europe, the submissions also included other swaps beyond those in the CDS and interest rate swap categories. These submissions, including a description of the specific swaps covered, are available on the Commission’s Web site at: http://sirt.cftc.gov/sirt/ sirt.aspx?Topic=ClearingOrganizationProducts. 55 The Commission has received subsequent submissions from CME and ICE Clear Credit relating to CDS. In particular, CME submitted a filing with regard to the current series of each of the CDX.NA.IG and CDX.NA.HY (Series 19). ICE Clear Credit made filings with regard to the clearing of the 3-year tenor of the CDX.HY Series 15 and the clearing of the CDX.EM indices. With the exception of the CDX.EM submission, upon which the Commission has not yet begun the determination process, the substance of each of the other submissions was addressed in both the proposed clearing determination and the final clearing determination set forth herein. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 information on each of the different tenors and series. Each of the submissions contained information relating to the five statutory factors set forth in section 2(h)(2)(D) of the CEA and other information required under § 39.5. CME, ICE Clear Credit, and ICE Clear Europe provided notice of their § 39.5 swap submissions to their members by posting their submissions on their respective Web sites.56 The submissions also are published on the Commission’s Web site.57 Regulation 39.5(b)(3)(viii) also directs a DCO’s submission to include a summary of any views on the submission expressed by members. CME’s submission did not address this. In their submissions, ICE Clear Credit and ICE Clear Europe stated that neither has solicited nor received any comments to date and will notify the Commission of any such comments. The Commission did not receive any additional feedback from DCOs beyond the information included in comment letters posted on the Commission’s Web site. The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that were submitted to the Commission are standardized contracts providing credit protection on an untranched basis, meaning that settlement is not limited to a specific range of losses upon the occurrence of credit events among the reference entities included within an index. Besides single-name CDS, untranched CDS on indices are the only type of CDS being cleared by these DCOs. Other swaps, such as credit index tranches, options, and first- or Nth-todefault baskets on these indices, are not currently cleared. CME and ICE Clear Credit each clear CDS on indices administered by Markit. The Markit CDX family of indices is the standard North American credit default swap family of indices, with the primary corporate indices being the CDX North American Investment Grade (consisting of 125 investment grade corporate reference entities) (CDX.NA.IG) and the CDX North American High Yield (consisting of 100 high yield corporate reference entities) (CDX.NA.HY). The standard currency for CDS on these indices is the U.S. dollar. CME offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for Series 9 and 56 Available at http://www.cmegroup.com/ market-regulation/rule-filings.html and https:// www.theice.com/publicdocs/regulatory_filings/ ICEClearCredit_022212.pdf. ICE Clear Europe did not provide a link to its relevant Web page. 57 See http://sirt.cftc.gov/sirt/ sirt.aspx?Topic=ClearingOrganizationProducts. PO 00000 Frm 00008 Fmt 4701 Sfmt 4700 each subsequent series, to the extent that those contracts that have not reached their termination date.58 CME also offers the CDX.NA.HY at the 5-year tenor for Series 11, and each subsequent series. ICE Clear Credit offers the CDX.NA.IG Series 8, and each subsequent series of that index that is still outstanding, at the 3-, 5-, 7- and 10year tenors.59 ICE Clear Credit also offers the CDX.NA.IG. Series 8 to Series 10, at the 7-year tenor. For the high yield index, ICE Clear Credit clears all series from the current series through the CDX.NA.HY Series 9 at the 5-year tenor.60 Each of these cleared CDX.NA contracts is denominated in U.S. dollars. ICE Clear Europe made a submission covering the index CDS that it clears. As with CME’s and ICE Clear Credit’s submissions, the contracts that ICE Clear Europe clears are based on Markit indices with corporate reference entities, though in this case, the entities are based in Europe. ICE Clear Europe clears euro-denominated contracts referencing the three primary indices: iTraxx Europe (covering 125 European investment grade corporate reference entities); the iTraxx Europe Crossover (covering 50 European high yield reference entities); and the iTraxx Europe High Volatility (a 30-entity subset of the European investment grade index). For the iTraxx Europe and Crossover, ICE Clear Europe clears outstanding contracts in the Series 7 and 8, respectively, through the current series. For the High Volatility index, ICE Clear Europe clears outstanding contracts in the Series 9 through the current series. In terms of tenors, ICE Clear Europe clears the 5-year tenor for all swaps, as well as the 10-year tenor for the iTraxx Europe index. 58 As administrator of these indices, Markit reviews the composition of underlying reference entities in the indices every six months. Once Markit establishes the constituents to be included within the indices, a new series of the respective index is created. The most recent series is identified as the ‘‘on-the-run’’ series, with all older series being identified as ‘‘off-the-run.’’ Additionally, each time one of the reference entities within an index suffers a credit event, a new version of an existing series of the index is created. In addition to the series and version variations that may exist on the index, the parties can choose the tenor of the CDS on a given index. While the 5-year tenor is the most common, and therefore most liquid, other standard tenors may include the 1-, 2-, 3-, 7-, and 10-year. 59 ICE Clear Credit began clearing the 3- and 7year tenors on the CDX.NA.IG after its initial § 39.5 submission of February 22, 2012. 60 ICE Clear Credit also made a § 39.5 submission with regard to the 3-year tenor of CDX.NA.HY, Series 15. The Commission is not including this contract within the clearing determination at this time. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations Based upon those portions of the CME, ICE Clear Credit, and ICE Clear Europe swap submissions relating to the CDS contracts discussed above, as well as the analysis conducted by the Commission pursuant to § 39.5(b) and set forth below, the Commission has reviewed the following classes of swaps for purposes of the clearing requirement determination. ii. Identification of CDS Specifications Under § 39.5, the decision of the Commission to require that a group, category, type, or class of swaps be required to be cleared is informed by a number of factors. As an initial matter, the Commission has looked to the DCOs’ submissions with regard to the swaps they currently clear. After analyzing the key attributes of the swaps submitted, the Commission proposed establishing two classes of CDS to be subject to the clearing requirement and, pursuant to this final rulemaking, is finalizing those classes as proposed. The first class is based on the untranched indices covering North American corporate credits, the CDX.NA.IG and 74291 the CDX.NA.HY. The second class is based on the untranched indices covering European corporate credits, the iTraxx Europe, the iTraxx Europe Crossover, and the iTraxx Europe High Volatility. Given the different markets that the CDS indices cover, the different standard currencies, and other logistical differences in how the CDS markets and documentation work, the Commission believes this is an appropriate basis for creating these two classes. The following table sets forth the specific specifications of each class: TABLE 1 Specification North American Untranched CDS Indices Class 1. Reference Entities ...................... 2. Region ......................................... 3. Indices ......................................... 4. Tenor ........................................... 5. Applicable Series ........................ 6. Tranched ..................................... Corporate. North America. CDX.NA.IG. CDX.NA.HY. CDX.NA.IG: 3Y, 5Y, 7Y, 10Y. CDX.NA.HY: 5Y. CDX.NA.IG 3Y: Series 15 and all subsequent Series, up to and including the current Series. CDX.NA.IG 5Y: Series 11 and all subsequent Series, up to and including the current Series. CDX.NA.IG 7Y: Series 8 and all subsequent Series, up to and including the current Series. CDX.NA.IG 10Y: Series 8 and all subsequent Series, up to and including the current Series. CDX.NA.HY 5Y: Series 11 and all subsequent Series, up to and including the current Series. No. Specification European Untranched CDS Indices Class 1. Reference Entities ...................... 2. Region ......................................... 3. Indices ......................................... Corporate. Europe. iTraxx Europe. iTraxx Europe Crossover. iTraxx Europe HiVol. iTraxx Europe: 5Y, 10Y. iTraxx Europe Crossover: 5Y. iTraxx Europe HiVol: 5Y. iTraxx Europe 5Y: Series 10 and all subsequent Series, up to and including the current Series. iTraxx Europe 10Y: Series 7 and all subsequent Series, up to and including the current Series. iTraxx Europe Crossover 5Y: Series 10 and all subsequent Series, up to and including the current Series. iTraxx Europe HiVol 5Y: Series 10 and all subsequent Series, up to and including the current Series. No. 4. Tenor ........................................... 5. Applicable Series ........................ sroberts on DSK5SPTVN1PROD with 6. Tranched ..................................... The Commission believes that indices based on other types of entities would be viewed as a separate class and would be subject to a separate determination by the Commission. For example, given the differences that exist with regard to volumes and risk management of indices based on sovereign issuers, as opposed to corporate issuers, it is likely that such CDS would represent their own class of swaps. Similarly, to the extent indices from other regions were submitted by a DCO, it is likely that the Commission would take the view that they are part of their own class of swaps as well. The Commission believes it appropriate to define the classes of swaps as untranched CDS contracts referencing Markit’s broad-based corporate indices. These corporate VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 indices have the most net notional outstanding, the most trading volumes, and the best available pricing. The risk management frameworks for the corporate index swaps are the most well-established, and have the most available data in terms of CDS spreads and corporate default studies for analysis of the underlying constituents of the indices. Agreements based on these indices also are widely accepted and use standardized terms.61 Both of the CDS classes presented herein assume that the relevant CDS 61 To the extent other vendors successfully develop similar indices, the Commission would conduct the analysis required by § 39.5, either on its own initiative or based on a DCO submission. If based on that analysis the Commission issued a clearing requirement determination, it is likely that such indices would be considered to be part of an existing class of CDS that are required to be cleared. PO 00000 Frm 00009 Fmt 4701 Sfmt 4700 agreement will use the standardized terms established by Markit/ISDA with regard to the specific index and be denominated in a currency that is accepted for clearing by DCOs. To the extent that a CDS agreement on an index listed within the classification is not accepted for clearing by any DCO because it uses non-standard terms or is denominated in a currency that makes it ineligible for clearing, that CDS is not subject to the requirement that it be cleared, notwithstanding that the CDS is based on such index. Also as proposed, this clearing determination is limited to only those series of the referenced indices that are currently being cleared.62 Further, to the 62 As discussed in further detail below, the clearing requirement does not require existing E:\FR\FM\13DER2.SGM Continued 13DER2 sroberts on DSK5SPTVN1PROD with 74292 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations extent that any swap on a CDS index is of a tenor such that it is scheduled to terminate prior to July 1, 2013, such a swap is not part of this clearing determination. Given the implementation periods provided for under § 50.25, discussed below in Section IV, the Commission does not want to create a situation where certain market participants will be required to clear a contract based upon their status under the implementation provisions, but other parties will never be required to clear that same contract before its scheduled termination. Similarly, the classes only include those tenors of contracts which are currently being cleared. AFR commented that both the 1- and 2-year tenors of the CDX.NA.IG should be included in the clearing requirement determination, citing concerns that if market participants shift to these shorter tenors, that shift would undermine a clearing requirement that included only longer tenors. Because no DCO clears the 1- or 2-year tenor of CDX.NA.IG, the Commission has decided to include within today’s clearing determination only those tenors of the CDX.NA.IG that were proposed. The Commission will monitor the market’s use of shorter tenors. To the extent that the market generates significant volumes of such shorter tenors of CDX.NA.IG, the Commission would expect that one or more DCOs will begin offering those tenors for clearing. If no DCO were to offer these swaps for clearing, the Commission has the authority to commence a Commissioninitiated review under section 2(h)(2)(A)(i) of the CEA to determine whether the swaps should be required to be cleared. Under section 2(h)(4), to the extent that the Commission finds that a particular swap or group, category, type, or class of swaps would otherwise be subject to mandatory clearing but no DCO has listed the swap, group, category, type, or class of swaps for clearing, the Commission shall (i) investigate the relevant facts and circumstances; (ii) issue a public report containing the results of the investigation within 30 days; and (iii) take such actions as the Commissions determines to be necessary and in the public interest, which may include requiring the retaining of adequate margin or capital by parties to the swap. The clearing requirement determination will also cover each new series of these indices that is created every six months. The Commission swaps in the older series to be cleared. The requirement is prospective, only requiring newly executed swaps in these older series to be cleared. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 believes this will provide certainty to the market, as opposed to awaiting a new determination for each new series.63 Recognizing that there may be changes to indices and their constituents,64 the Commission will analyze each new series to ensure that the indices should continue to be included within the existing class of swaps subject to a clearing determination. To the extent that the new series raises issues, such as a DCO’s ability to risk manage the contracts, the Commission can issue a stay of the clearing requirement for that series under § 39.5(d). No commenter raised any questions regarding new series. As proposed, the Commission has decided that the classes be limited to untranched CDS on the aforementioned indices. With these untranched CDS, the contract covers the entire index loss distribution of the index, and settlement is not linked to a specified number of defaults. Tranched swaps, first- or ‘‘Nth’’ to-default, options, or any other product variations on these indices are excluded from these classes. These other swaps based on the indices, such as tranches, have very different profiles in terms of the § 39.5 analysis. Besides very different notional and trading volumes, the risk management processes and operations may be significantly different. The Commission believes it appropriate to exclude tranched swaps, and other variations on the indices, from the classes of swaps set forth herein. Such swaps, if accepted by DCOs and submitted for Commission review, likely would be viewed as a separate class or as separate classes. AFR notes that market participants can use tranched CDS on the indices to replicate contracts and portfolios that would otherwise be subject to a clearing requirement. The Commission recognizes this concern and will continue to monitor activity in tranched CDS indices, as well as how the development of risk management processes at DCOs could allow for the clearing of those products. Today’s clearing determination does not foreclose the possibility that tranched products may be subject to another clearing determination in the future. 63 The timing of announcement of index constituents would make it impossible for the Commission to analyze the index and issue a clearing determination on the roll date, given the timeframes imposed on the Commission by § 39.5. 64 See Financial Times, ‘‘CDS Market—Markit’s Weird Selection,’’ September 27, 2012, discussing the inclusion of constituents (CIT, Calpine, and Charter Communications) in the latest series of the CDX.NA.HY that do not have actively traded CDS contracts. PO 00000 Frm 00010 Fmt 4701 Sfmt 4700 D. Determination Analysis for Credit Default Swaps Section 2(h)(2)(D)(i) of the CEA requires the Commission to review whether a swap submission under section 2(h)(2)(B) is consistent with section 5b(c)(2) of the CEA (DCO core principles). Section 2(h)(2)(D)(ii) of the CEA also requires the Commission to consider five factors in a determination based on swap submission: (1) The existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; (2) the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded; (3) the effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the DCO available to clear the contract; (4) the effect on competition, including appropriate fees and charges applied to clearing; and (5) the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.65 i. Consistency With Core Principles for Derivatives Clearing Organizations Section 2(h)(2)(D)(i) of the CEA requires the Commission to review whether a submission is consistent with the core principles for DCOs. Each of the DCO submissions relating to CDS provided data to support the Commission’s analysis of the five factors under section 2(h)(2)(D) of the CEA. The Commission also was able to call upon independent analysis conducted with regard to the CDS market, as well as its knowledge and reviews of the registered DCOs’ operations and risk management processes, covering topics such as product selection criteria, pricing sources, participant eligibility, and other relevant rules. The discussion of all of these factors is set forth below. 65 ISDA highlighted the possibility that a CDS index subject to a clearing requirement determination could undergo such significant changes to its underlying constituents during its lifecycle that such an index would no longer be considered a broad-based index, subject to the Commission’s jurisdiction. The Commission notes that the indices subject to the clearing requirement determinations discussed herein contain a minimum of 30 constituents of equal weighting, limiting the likelihood of such scenario. Nonetheless, in the event of such a scenario, the Commission could review the determination, and if appropriate, stay the determination under § 39.5(d) with regard to the index and/or series so impacted. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe pursuant to § 39.5(b) are currently being cleared by those organizations. As discussed above, the risk management, rules, and operations used by each DCO to clear these swaps are subject to review by the Commission’s risk management, legal, and examinations staff on an on-going basis. Additionally, each of the DCOs has established procedures to review any new swaps it may consider offering for clearing. Before the indices referenced herein were accepted for clearing by any of the DCOs, they were subject to review by the risk management functions of those organizations. Such analysis generally focuses on the DCO’s ability to risk manage positions in the prospective swaps and on any specific operational issues that may arise from the clearing of such swaps. In the case of the former, this involves ensuring that adequate pricing data is available, both historically and on a ‘‘going forward’’ basis, such that a margining methodology could be established, backtested, and used on an on-going basis. Operational issues may include analysis of additional contract terms for new swaps that may require different settlement procedures. Each of the contracts submitted by CME, ICE Clear Credit, and ICE Clear Europe and discussed herein has undergone an internal review process by the respective DCO and found to be within their product eligibility standards. In their submissions, CME and ICE Clear Credit enclosed their risk management procedures. In its submission, ICE Clear Europe references its risk management procedures, which it had previously submitted to the Commission in connection with its application to register as a DCO. As part of its risk management and examination functions, the Commission reviews each DCO’s risk management procedures, including its margining methodologies. ICE Clear Credit uses a multi-factor model to margin the CDX.NA.IG and CDX.NA.HY indices, as well as the single-name CDS it clears. The margining methodology is designed to capture the risk of movements in credit spreads, liquidation costs, jump-todefault risk for those names on which credit protection has been sold, large position concentration risks, interest rate sensitivity, and basis risk associated with offsetting index derived single names and opposite ‘‘outright’’ single names. These factors are similarly used by ICE Clear Europe to calculate the margining requirements for their iTraxx swap listings and the underlying singlename constituents. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 CME’s CDS model also weighs a number of factors to calculate the initial margin for a portfolio of CDS positions. These include macro-economic risk factors, such as movements associated with systematic risk resulting in large shifts in credit spreads across a portfolio, shifts in credit spreads based on tenors, and changes in relative spreads between investment grade and high yield spreads. Additional factors include specific sector risks, the idiosyncratic risk of extreme moves in particular reference entities, and the liquidity risk associated with unwinding the portfolio. In all cases, the methodologies are designed to protect against any 5-day move in the value of the given CDS portfolio, with a 99% confidence level. In addition to initial margin, each of the DCOs collects variation margin on a daily basis to capture changes in the mark-to-market value of the positions. To do this, the DCOs calculate end-ofday settlement prices using clearing members’ price submissions for cleared swaps. Each of the DCOs maintains processes for ensuring the quality of clearing member price submissions, including the ability to compel trades at quoted prices on a random basis and to enforce fines on incomplete or incorrect submissions. ICE Clear Credit and ICE Clear Europe also use Markit services for CDX and iTraxx price submissions. CME uses other third-party data providers for pricing support as necessary on its cleared CDS products. As part of their rule frameworks, each of these three DCOs also maintains participant eligibility requirements. On April 20, 2012, CME filed its amended rule concerning CDS Clearing Member Obligations and Qualifications (Rule 8H04). Pursuant to the amended rule, published to comply with Commission Regulation 39.12(a)(2), a CDS clearing member would have to maintain at least $50 million of capital. The amended rule would also require a CDS clearing member’s minimum capital requirement to be ‘‘scalable’’ to the risks it poses. Furthermore, CME already has client clearing available for its CDS index contracts. Similarly, on March 23, 2012, ICE Clear Credit filed its amended Rule 201(b) to incorporate the $50 million minimum capital requirement for clearing members. ICE Clear Europe has adopted similar rules to comply with § 39.12(a)(2). ICE Clear Credit also has client clearing available for its CDX index contracts. In addition to the CDS indices discussed above, ICE Clear Credit and ICE Clear Europe offer single-name CDS PO 00000 Frm 00011 Fmt 4701 Sfmt 4700 74293 for clearing.66 As part of their margining methodology, they are seeking approval to offer portfolio margining for the single-name CDS and the CDS indices co-mingled as a single portfolio.67 Given that the single-name reference entities will likely also be constituents of a given index within a portfolio, the Commission generally believes that such portfolio margining initiatives are consistent with the sound risk management policies for DCOs that are required under § 39.13(g)(4). Moreover, DCOs such as ICE Clear Credit already use margining methodologies that provide for appropriate portfolio margining treatment with regard to clearing members’ proprietary positions.68 The Commission is committed to working toward establishing similar portfolio margining programs for DCOs clearing customer positions in CDS indices and singlename CDS.69 Specifically, the Commission anticipates addressing ICE’s portfolio margining petitions for CDS in the near term. Based upon the Commission’s ongoing reviews of DCOs’ risk management frameworks and clearing rules, and its annual examinations of the DCOs, the Commission believes that the submissions of CME, ICE Clear Credit, and ICE Clear Europe are consistent with section 5b(c)(2) of the CEA and the related Commission regulations. In analyzing the CDS products submissions discussed herein, the Commission does not believe that a clearing determination with regard to the specified CDS products would be inconsistent with CME, ICE Clear Credit, or ICE Clear Europe’s continued ability to maintain such compliance with the DCO core principles set forth in Part 39 of the Commission’s regulations. 66 Such single-name CDS are defined as ‘‘securitybased swaps’’ under section 721(a) of the DoddFrank Act. 67 See ICE Clear Credit’s petitions to the Commission and SEC, dated October 4, 2011. The petition to the Commission is available at http:// www.cftc.gov/stellent/groups/public/ @rulesandproducts/documents/ifdocs/ice clearcredit100411public.pdf. See also ICE Clear Europe’s petition available at http://www.cftc.gov/ stellent/groups/public/@requestsandactions/ documents/ifdocs/icecleareurope4dfrequest.pdf. 68 See ICE Clear Credit’s certification to the Commission, dated as of November 25, 2011. The certification is available at http://www.cftc.gov/ stellent/groups/public/@rulesandproducts/ documents/ifdocs/rul112511icecc001.pdf. 69 A discussion of comments concerning portfolio margining is included below. E:\FR\FM\13DER2.SGM 13DER2 74294 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations ii. Consideration of the Five Statutory Factors for Clearing Requirement Determinations a. Outstanding Notional Exposures, Trading Liquidity, and Adequate Pricing Data Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to take into account the existence of outstanding notional exposures, trading liquidity, and adequate pricing data. The most recent BIS study 70 found that, as of December 2011, the size of the overall CDS marketplace exceeded $28.6 trillion in notional amount outstanding. Of that amount, $11.8 trillion was in multi-name CDS agreements. Within this sub-category of CDS, CDS on indices accounted for more than 89% of the total notional amount outstanding, with over $10 trillion in notional outstanding. Overall, CDS on index products account for 37% of all notional amounts of CDS contracts outstanding. The predominant provider of CDS indices is Markit. Markit offers indices covering corporate and sovereign entities, among others, in the United States, Europe, and Asia. Recent Markit data shows daily transaction volumes of sroberts on DSK5SPTVN1PROD with 70 See BIS data, available at http://www.bis.org/ statistics/otcder/dt1920a.pdf. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 1,559 transactions using its licensed family of CDX indices, and 1,828 daily transactions in its European iTraxx indices.71 Further, it shows a rolling month gross notional amount of $745 billion in gross notional amount for the CDX family of indices and Ö680 billion for the iTraxx family. Nearly all of the CDX contracts and volumes come from indices that are subject to the clearing requirement determination. With regard to the European iTraxx, more than 80% of those daily contract volumes and 84% of the daily gross notional volumes come from the iTraxx investment grade and high yield indices contemplated by the clearing requirement determination. One point highlighted by this data, however, is the declining trading liquidity in the off-the-run series that can occur. Of the volumes noted by Markit, nearly 60% was in the current on-the-run series, as compared to all other outstanding series combined.72 The submissions of ICE Clear Credit, ICE Clear Europe, and CME also note the decline in average weekly gross 71 Based on data published on www.markit.com as of September 27, 2012. 72 The term ‘‘on-the-run’’ refers to current series of an index, while older series are referred to ‘‘offthe-run.’’ Each six months when a new series is created (or ‘‘rolls’’ using market terminology), the new series is considered the ‘‘on-the-run’’ index, and all others are considered ‘‘off-the-run.’’ PO 00000 Frm 00012 Fmt 4701 Sfmt 4700 notional amounts and contracts for benchmark tenors for off-the-run indices. The decline however can be more precipitous among older off-therun indices. While many market factors can contribute to the actual volumes for a specific off-the-run contract, subject to certain exceptions, the trend is generally toward lower volumes.73 Set forth below is a table of data taken from DTCC as of November 7, 2012, highlighting the net notional amounts and outstanding CDS index contracts, across all tenors, for each index and series included in this clearing determination.74 73 The current ‘‘on-the-run’’ series tend to have the most liquidity, while the older ‘‘off-the-run’’ series tend to have less liquidity, as many investors exit positions in an existing series and enter new positions in the new series when it becomes available (i.e., they ‘‘roll’’ their positions to the new series) thereby increasing liquidity in the ‘‘on-therun’’ series. 74 Data from November 7, 2012, available at www.dtcc.com. In 2006, DTCC began providing warehouse services for confirmed CDS trades through its Trade Information Warehouse (TIW). With the commitment of global market participants in 2009 to ensure that all OTC derivatives trades are recorded by a central repository, TIW has become a global repository for all CDS trades. With all major market participants submitting their trades to the TIW, it is estimated that 98% of all CDS trades are included within the warehouse, making it the primary source of CDS transaction data. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Notwithstanding the declining volumes that occur when an index is no longer on-the-run, the Commission does not believe that is sufficient reason to exclude the older series from the classes of CDS that are subject to the clearing requirement. As the DTCC data indicates, there are still significant volumes and outstanding notional amounts in each of these series.75 From the perspective of the DCO, the risk management of the older series of swaps should not provide significant additional challenges. With the significant notional and contract volumes still outstanding according to DTCC, many clearing members already have these positions on their books and are meeting their risk management requirements, even in the face of 75 The Commission is monitoring volumes in the on-the-run iTraxx Europe HiVol. With the newest roll of the indices occurring on September 20, 2012, this index has yet to show significant volumes in the latest series based on DTCC data. The Commission will continue to monitor these volumes and take action as appropriate. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 declining trading volumes. While the volumes may decline, the data included in the submissions indicates that volume still does exist, and parties should be able to trade these CDS indices as necessary. Additionally, as discussed further below, the clearing requirement would apply only to new swaps executed in the off-the-run indices. Both AFR and ISDA specifically supported the inclusion of ‘‘off-the-run’’ CDS indices in the clearing determination. AFR noted that without including those indices, the market might enter into such swaps so as to avoid the clearing requirement. In addition, ISDA expressed concern about the potential negative impact on the relative liquidity between cleared and uncleared CDS swaps should a clearing requirement cease to apply during the lifecycle of the CDS. Given the contract and notional volumes listed above, there is adequate data available on pricing. The pricing PO 00000 Frm 00013 Fmt 4701 Sfmt 4700 74295 for the CDS on these indices is fairly consistent across clearinghouses. The DCOs generally require a clearing member with open interest in a particular index to provide a price on that index for end-of-day settlement purposes. After applying a process to remove clear outliers, a composite price is calculated using the remaining prices. To ensure the integrity of the submissions, clearing members’ prices may be ‘‘actionable,’’ meaning that they may form the basis of an actual trade that the member will be forced to enter. DCOs also have compliance programs that may result in fines for clearing members that fail to submit accurate pricing data. Beyond clearing member submissions, there are a number of third-party vendors that provide pricing services on these swaps. Third-party vendors typically source their data from a broader range of dealers. The data includes both direct contributions as well as feeds to automated trading E:\FR\FM\13DER2.SGM 13DER2 ER13DE12.000</GPH> Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations 74296 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations systems. This data is reviewed for outliers and aggregated for distribution. sroberts on DSK5SPTVN1PROD with b. Availability of Rule Framework, Capacity, Operational Expertise and Resources, and Credit Support Infrastructure Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to take into account the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded. The Commission has determined that this factor is satisfied by each of CME, ICE Clear Credit, and ICE Clear Europe. CME, ICE Clear Credit, and ICE Clear Europe, respectively, currently are clearing the swaps each submitted under § 39.5. They have developed respective rule frameworks, capacity, operational expertise and resources, and credit support infrastructure to clear the contracts on terms that are consistent with the material terms and trading conventions on which the contracts currently are trading. The Commission believes that these are scalable and that CME, ICE Clear Credit, and ICE Clear Europe would be able to risk manage the additional swaps that might be submitted due to the clearing requirement determination. Following the financial crisis, the major market participants committed in 2009 to the substantial reforms to the OTC derivatives markets.76 Among the commitments from CDS dealers and buy side participants was to actively engage with central counterparties to broaden the range of cleared swaps and market participants. These changes were in addition to those generated through organizations like ISDA and their protocols standardizing CDS. For broadly traded swaps like the CDS indices, the ultimate impact of these initiatives was operational platforms,77 rule frameworks, and other infrastructure initiatives that replicated the uncleared market and supported the move of these CDS to a centrally cleared environment. In this way, the CDS clearing services offered by DCOs, 76 See the June 2, 2009 letter to The Honorable William C. Dudley, President of the Federal Reserve Bank of New York, available at http:// www.newyorkfed.org/newsevents/news/markets/ 2009/060209letter.pdf. 77 In its comment letter supporting the NPRM, MarketAxess Holdings Inc. (MarketAxess) noted that the electronic trading platform it operates supports the trading of CDX and iTraxx products. MarketAxess stated that it intends to apply for registration as a SEF once the Commission issues related final rules. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 including CME, ICE Clear Credit, and ICE Clear Europe, were designed to be cleared in a manner that is consistent with the material terms and trading conventions of a bilateral, uncleared market. In addition, CME, ICE Clear Credit, and ICE Clear Europe are registered DCOs. To be registered as such, CME, ICE Clear Credit, and ICE Clear Europe have, on an on-going basis, demonstrated to the Commission that they are each in compliance with the DCO core principles set forth in the CEA and Commission regulations, as discussed above. As a general matter, any DCO that does not have the rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the swaps that are subject to required clearing is not in compliance with the core principles or the Commission regulations promulgating these principles. Commenters raised issues with regard to the operational capabilities of clearinghouses to manage the clearing of iTraxx for customers. Commenters such as ISDA, FIA, MFA, and D.E. Shaw all highlighted the fact that no registered DCO currently offers customer clearing for iTraxx. Besides the lack of approved customer clearing of the iTraxx indices at any DCO, the commenters noted substantive concerns about the ability of clearinghouses to manage the ‘‘restructuring’’ credit event applicable to iTraxx (and certain other CDS indices) in the context of customer clearing. For the CDX.NA.IG and CDX.NA.HY indices, credit events are limited to a ‘‘failure to pay’’ or the bankruptcy of the companies included in the index. A credit event results in the removal of the defaulted constitute from the index, with the protection seller settling the amounts owed to the protection buyer with regard to that individual constituent. The standardized terms of the iTraxx, however, also include ‘‘restructuring’’ as a credit event. When a restructuring event occurs with regard to an index constituent, the impacted company is removed from the index by the creation of a single-name CDS referencing that entity. The protection buyer and seller have the option to continue that singlename CDS or to settle the contract with regard to the restructured credit. ISDA, MFA, and FIA note that this process raises issues for DCOs. Specifically highlighted were those situations where a DCO does not, in fact, already offer clearing of the singlename CDS that is subject to the restructuring event. To the extent that the SEC or foreign regulator prohibits PO 00000 Frm 00014 Fmt 4701 Sfmt 4700 the DCO from clearing a particular single-name CDS, a process would need to be developed to address such circumstances. Similarly, the customer account in which the new single-name CDS would be held, in the absence of portfolio margining, would need to be addressed. MFA comments that the approval of portfolio margining petitions would remove much of the complexity of the ‘‘spin-off’’ of the single-name CDS from the iTraxx indices. Given the inclusion of the iTraxx within the clearing determination, MFA states that the petitions need to be approved so that the new single-name CDS can be held within the cleared swap account and margined with the iTraxx index CDS. Finally, the commenters believe that DCOs need to demonstrate that their customer clearing platforms are technologically viable and sufficiently tested before a clearing determination with regard to the iTraxx indices is finalized. For these reasons, these commenters believe a delay in the implementation of a clearing requirement for the iTraxx indices would be appropriate until such time as customer clearing platforms have been established, the necessary regulatory approvals have been granted and operational testing has been conducted for an appropriate period of time. In MFA’s view the delay should be 60 to 90 days, and in ISDA’s view, the testing period should consist of voluntary client clearing for at least 90 days. On the other hand, ICE supports the Commission’s inclusion of iTraxx CDS indices within its clearing requirement determination. ICE states that ICE Clear Europe has already begun the process of pursuing regulatory approval for client clearing of iTraxx, and indicates that ICE Clear Credit will do the same.78 78 ICE Clear Europe’s submission, pursuant to Commission Regulation 40.6, amending its rulebook to accommodate client clearing is available on the Commission’s Web site at: http://www.cftc.gov/ stellent/groups/public/@rulesandproducts/ documents/ifdocs/rul091312iclreu001.pdf. ICE Clear Europe is registered as a recognized clearing house with the United Kingdom’s Financial Services Authority (U.K. FSA) and requires approval from the U.K. FSA to offer iTraxx clearing to customers. ICE Clear Credit’s submission with regard to iTraxx clearing for both proprietary and customer accounts is available on the Commission’s Web site at http://www.cftc.gov/stellent/groups/ public/@rulesandproducts/documents/ifdocs/ rul092812icc001.pdf. To the extent that ICE Clear Credit successfully launches iTraxx clearing, it would address ISDA’s concern with regard to the Commission issuing a clearing determination for swaps that cannot be cleared at a U.S.-based DCO. It should be noted, however, that the Commission does not believe a DCO clearing a particular swap needs to be based in the U.S. for the Commission to find a swap subject to a clearing determination, to the extent that swap satisfies the factors required E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with While recognizing that the standard credit events under the iTraxx add some complexity relative to the CDX indices, ICE notes that it has worked with market participants and DTCC to develop industry-wide solutions to the ‘‘restructuring’’ event. Further, ICE states that ICE Clear Credit has already implemented applicable parts of this solution with regard to the clearing of the CDX.EM CDS index of emerging market sovereign constituents.79 ICE claims that any additional processes necessary with regard to clearing iTraxx index CDS are being addressed currently by the industry, and will not present any insurmountable challenges. Citadel also commented that they did not believe that there were any substantive reasons why the iTraxx index CDS should not be required to be cleared. The ‘‘restructuring’’ credit event and the spinning out of a newly cleared single-name CDS do not, in Citadel’s view, present any new issues to market participants. Further, because DCOs already offer clearing on the iTraxx on a dealer-to-dealer basis, they have the necessary processes upon which to build out the client clearing platform. Citadel also states that even if the ICE Clear Credit’s and ICE Clear Europe’s petitions to the SEC for portfolio margining were not approved generally,80 limited exemptions may be available for the single names associated with the spun-off single name. Citadel does agree with other commenters that to the extent that client clearing cannot be offered with sufficient lead time to allow for proper operational testing, a delay may be appropriate in implementing a clearing requirement for the iTraxx indices. Citadel believes 60 days voluntary customer clearing should be sufficient for such testing. The Commission believes that the introduction of client clearing must occur before any clearing determination could become effective with regard to the iTraxx indices, or any other CDS indices that the Commission may consider.81 The Commission agrees with by statute and regulation to be included in the Commission’s analysis. 79 It is not clear, however, the extent to which clearing members are in fact offering customer clearing of the CDX.EM indices cleared by ICE Clear Credit. 80 It should be noted that the Commission strongly supports the petitions for the portfolio margining of single-name CDS and CDS indices. The Commission believes that all customers should be able to benefit from the reasonable application of portfolio margining, and that the benefits thereof should not just be available to the proprietary positions in the house accounts of clearing members. 81 The Commission agrees with the comments of MFA that the availability of client clearing should be considered when making clearing VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 all commenters that subject to resolution of all operational issues surrounding client clearing of the iTraxx indices, specifically the iTraxx Europe, Crossover, and High Volatility, these indices are appropriate for inclusion in a clearing requirement. The Commission is encouraged by the work currently being done by the DCOs, by other regulators, and by the market as a whole, to establish client clearing in the near term. The Commission recognizes that additional time may be necessary to allow for the DCOs to obtain the necessary regulatory approvals and design a workable framework for dealing with the issues presented by the client clearing of the iTraxx indices, before the clearing of this class of indices can be required of market participants. As part of this clearing requirement determination, the Commission is including the iTraxx class of CDS, as proposed. The Commission believes that the compliance schedule outlined in Section IV below should provide adequate time for market participants to resolve the outstanding issues with regard to client clearing of the iTraxx indices. Under this schedule, the requirement for market participants to begin clearing would commence on March 11, 2013, for swaps entered into on or after that date between Category 1 Entities. Category 2 Entities would be required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date, and Category 3 Entities would be required to clear swaps beginning on September 9, 2013, for swaps entered into on or after that date. However, if no DCO has begun offering client clearing for iTraxx by February 11, 2013, then compliance with the required clearing of iTraxx will commence sixty days after the date on which iTraxx is first offered for client clearing by an eligible DCO. If an eligible DCO offers client clearing for iTraxx on or before September 9, 2013, the following phased implementation schedule will apply: Category 1 Entities would be required to clear iTraxx indices entered into on or after the date 60 days after the date on which iTraxx is first offered for client clearing by an eligible DCO; Category 2 Entities would be required to clear iTraxx entered into on or after the date 150 days after the date on which iTraxx is first offered for client clearing determinations. Consequently, DCOs accepting, or planning to accept, swaps for clearing should make client clearing available in compliance with Commission regulations. In the absence of such client clearing, the Commission will delay compliance with required clearing of iTraxx indices. PO 00000 Frm 00015 Fmt 4701 Sfmt 4700 74297 by an eligible DCO; and Category 3 Entities would be required to clear iTraxx entered into on or after the date 240 days after the date on which iTraxx is first offered for client clearing by an eligible DCO. There will be no phasing of compliance if an eligible DCO offers client clearing for iTraxx after September 9, 2013. Rather, all three categories of market participants will be expected to come into compliance by 60 days after the date on which iTraxx is first offered for client clearing by an eligible DCO. c. Effect on the Mitigation of Systemic Risk Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to take into account a clearing requirement’s effect on the mitigation of systemic risk, taking into account the size of the market for the contract subject to the clearing requirement and the resources of the DCOs clearing the contract. The Commission agrees with the § 39.5 swap submissions of CME, ICE Clear Credit, and ICE Clear Europe that requiring certain classes of CDS to be cleared would reduce systemic risk in this sector of the swaps market. As CME noted, the 2008 financial crisis demonstrated the potential for systemic risk arising from the interconnectedness of OTC derivatives market participants and the limited transparency of bilateral, i.e., uncleared, counterparty relationships. According to the Quarterly Report (Second Quarter 2012) on Bank Trading and Derivatives Activities of the Office of the Comptroller of the Currency (OCC Report),82 CDS index products account for a significant percentage of the notional value of swaps positions held by financial institutions. According to ICE Clear Credit, the CDS indices it offers for clearing are among the most actively traded swaps with the largest pre-clearing outstanding positions, and ICE Clear Credit’s clearing members are among the most active market participants. ICE Clear Credit also noted that its clearing members clear a significant portion of their clearingeligible portfolio. Clearing the CDS indices subject to this determination will reduce systemic risk in the following ways: mitigating counterparty credit risk because the DCO would become the buyer to every seller of CDS indices subject to this determination and vice-versa; providing counterparties with daily mark-tomarket valuations and exchange of 82 Available at http://occ.treas.gov/topics/capitalmarkets/financial-markets/trading/derivatives/ dq212.pdf. E:\FR\FM\13DER2.SGM 13DER2 74298 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations variation margin pursuant to a risk management framework set by the DCO and reviewed by the Commission’s Division of Clearing and Risk; posting initial margin with the DCO in order to cover potential future exposures in the event of a default; achieving multilateral netting, which substantially reduces the number and notional amount of outstanding bilateral positions; reducing swap counterparties’ operational burden by consolidating collateral management and cash flows; and eliminating the need for novations or tear-ups because clearing members may offset opposing positions. As discussed in the NPRM, the DCOs collect substantial amounts of collateral in the form of initial margin and guaranty fund contributions to cover potential losses on CDS portfolios. The methodologies for calculating these amounts are based on covering 5-day price movements on a portfolio with a 99% confidence level for initial margin, and longer liquidation periods and higher confidence levels under ‘‘extreme but plausible’’ conditions in the case of guaranty fund requirements. Beyond these financial resources, the clearinghouses have in place established risk monitoring processes, system safeguards, and default management procedures, which are subject to testing and review, to address potential systemic shocks to the financial markets. AFR specifically supported the Commission’s analysis on the mitigation of systemic risk with regard to the CDS clearing determination.83 ISDA commented generally that the Commission’s analysis of this factor should have addressed the centralization of risk at DCOs as a result of the determinations, and the new capital, collateral, and disclosure requirements that have decreased risk in uncleared swaps.84 The Commission believes its analysis of other factors did in fact focus on the management of risk at DCOs and their ability to manage the risks associated with the untranched CDS indices included within the determination. In connection with future determinations, the Commission will continue to take those issues raised by ISDA into consideration. sroberts on DSK5SPTVN1PROD with d. Effect on Competition Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to take into account the effect on competition, 83 Other commenters such as Citadel generally agreed with the Commission’s analysis of the reduction of systemic risk for both the interest rates and CDS determinations. 84 See Section II.F for further discussion of this comment. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 including appropriate fees and charges applied to clearing. Of particular concern to the Commission is whether this determination would harm competition by creating, enhancing, or entrenching market power in an affected product or service market, or facilitating the exercise of market power.85 Under U.S. Department of Justice guidelines, market power is viewed as the ability ‘‘to raise price [including clearing fees and charges], reduce output, diminish innovation, or otherwise harm customers as a result of diminished competitive constraints or incentives.’’ 86 In the NPRM, the Commission identified the following putative product and service markets as potentially affected by this clearing determination: a DCO service market encompassing those clearinghouses that currently (or with relative ease in the future could) clear the CDS subject to this determination, and a CDS product market or markets encompassing the CDS that are subject to this determination.87 Without defining the precise contours of these markets at this time,88 the Commission recognizes that, 85 See U.S. Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines [hereinafter ‘‘Horizontal Merger Guidelines’’] at § 1 (Aug. 19, 2010), available at http://www.justice.gov/ atr/public/guidelines/hmg-2010.pdf. 86 Id.; see also U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC), Antitrust Guidelines for Collaborations Among Competitors at § 1.2 (April 2000), available at http:// www.ftc.gov/os/2000/04/ftcdojguidelines.pdf (‘‘The central question is whether the relevant agreement likely harms competition by increasing the ability or incentive profitably to raise price above or reduce output, quality, service, or innovation below what likely would prevail in the absence of the relevant agreement’’). 87 Included among these could be a separate product market for CDS indices licensing. AFR stated that this factor should not focus on Markit as an index provider, but rather on clearing entities. For purposes of its consideration of this factor, the Commission believes its analysis appropriately covers competition as it relates to clearinghouses, as well as to other market participants. 88 The federal antitrust agencies, the DOJ and FTC, use the ‘‘hypothetical monopolist test’’ as a tool for defining antitrust markets for competition analysis purposes. The test ‘‘identif[ies] a set of products that are reasonably interchangeable with a product,’’ and thus deemed to reside in the same relevant antitrust product or service market. ‘‘[T]he test requires that a hypothetical profit-maximizing firm, not subject to price regulation, that was the only present and future seller of those products (‘hypothetical monopolist’) likely would impose at least a small but significant and non-transitory increase in price (‘SSNIP’) on at least one product in the market.’’ In most cases, a SSNIP of five percent is posited. If consumers would respond to the hypothesized SSNIP by substituting alternatives to a significant degree to render it unprofitable, those alternative products/services are included within the relevant market. This methodological exercise is repeated until it has been determined that consumers have no further interchangeable products/services available to them. Horizontal Merger Guidelines at § 4.1. PO 00000 Frm 00016 Fmt 4701 Sfmt 4700 depending on the interplay of several factors, this clearing determination potentially could impact competition within the affected markets. Of particular importance to whether any impact is, overall, positive or negative, is: (1) Whether the demand for these clearing services and swaps is sufficiently elastic that a small but significant increase above competitive levels would prove unprofitable because users of the CDS products and DCO clearing services would substitute other products/clearing services co-existing in the same market(s), and (2) the potential for new entry into these markets. The availability of substitute products/ clearing services to compete with those encompassed by this determination, and the likelihood of timely, sufficient new entry in the event prices do increase above competitive levels, each operate independently to constrain anticompetitive behavior. The Commission recognized in the NPRM that, depending on the interplay of several factors, the clearing requirement potentially could impact competition within the affected market and discussed various factors that could impact that market. In response to the Commission’s recognition of the fact that currently no DCO clears CDS indices licensed by any provider other than Markit, Markit commented that it did not believe the determination would foreclose or materially impact competition in the CDS products, including licensing. Markit noted that its open licensing policy encourages competition among DCOs, SEFs, market makers, and others. Markit further commented that, given the costs associated with clearing, CDS indices that are not subject to a determination may be at a competitive advantage, including those that may be established by other index providers. In support of the NPRM, Citadel stated that the clearing requirement will have a strong positive impact on competition in the swap market and the market for clearing services. Citadel noted that central clearing will remove a significant barrier to entry for alternative swap market liquidity providers and will enable smaller entities to compete on more equal terms because central clearing eliminates the consideration of counterparty credit risk from the selection of execution counterparties. Citadel further commented that buy-side market participants will benefit from a wider range of potential execution counterparties and asserted that this increased competition yields benefits to market participants including narrower bid-ask spreads, improved access to best E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations execution, and increased market depth and liquidity, all of which facilitate the emergence of an all-to-all market with electronic and/or anonymous execution. Citadel also commented that substitution of the DCO for the bilateral counterparty decouples execution from post-trade processing and settlement.89 Finally, Citadel commented that the certainty as to when the first clearing requirement will begin gives DCOs and FCMs the confidence to invest in their client clearing offerings, and to compete actively for buy-side business both on the quality and efficiency of their services as well as on price. While FIA commented that the NPRM included a full discussion of the potential competitive impact of the clearing proposal, as discussed above, FIA indicated that it was unable to conduct the analysis it believes would be necessary to respond to the Commission’s questions in the NPRM within the 30-day comment period provided. In response to FIA’s comment, as discussed above, the Commission notes that the 30-day public comment period was necessary for the Commission to adhere to the CEA’s 90-day determination process. Moreover, while FIA indicated that it would like more time to conduct further analysis of competitive issues for future determinations, FIA did not identify any specific concerns about the competitiveness issue analysis that could materially change the Commission’s determination if such additional information were made available to the Commission. The comments provided by Markit and Citadel are consistent with the NPRM’s conclusion that the clearing requirement potentially could impact competition within the affected market, but both commenters go on to assert that such an impact would not be negative. Accordingly, the Commission believes that its consideration of competitiveness as described in the NPRM is sufficient for purposes of finalizing the clearing requirement rule. sroberts on DSK5SPTVN1PROD with e. Legal Certainty in the Event of the Insolvency Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to take into 89 The Commission observes that issues regarding the bundling of clearing services and execution are beyond the scope of this rulemaking. See generally Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants, 77 FR 20128, 20154–55 (Apr. 3, 2012) (discussing the application of § 1.71(d)(2)). VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 account the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property. The Commission proposed this clearing requirement based on its view that there is reasonable legal certainty with regard to the treatment of customer and swap counterparty positions, funds, and property in connection with cleared swaps, namely the CDS indices subject to this determination, in the event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or ICE Clear Europe) or one or more of the DCO’s clearing members. In the case of a clearing member insolvency at CME or ICE Clear Credit, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11 U.S.C. 761–767) and Part 190 of the Commission’s regulations would govern the treatment of customer positions.90 Pursuant to section 4d(f) of the CEA, a clearing member accepting funds from a customer to margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C. 761–767 and Part 190 of the Commission’s regulations, the customer’s CDS positions, carried by the insolvent FCM, would be deemed ‘‘commodity contracts.’’ 91 As a result, neither a clearing member’s bankruptcy nor any order of a bankruptcy court could prevent either CME or ICE Clear Credit from closing out/liquidating such positions.92 However, customers of clearing members would have priority over all other claimants with respect to customer funds that had been held by the defaulting clearing member to margin swaps, such as the customers’ positions in CDS indices subject to this determination.93 Customer funds would be distributed to swaps customers, including CDS customers, in accordance with Commission regulations and section 766(h) of the Bankruptcy Code. Moreover, the Bankruptcy Code and the Commission’s rules thereunder (in 90 The Commission observes that an FCM or DCO also may be subject to resolution under Title II of the Dodd-Frank Act to the extent it would qualify as covered financial company (as defined in section 201(a)(8) of the Dodd-Frank Act). 91 If an FCM is also registered as a broker-dealer, certain issues related to its insolvency proceeding would also be governed by the Securities Investor Protection Act. 92 See 11 U.S.C. 556 (‘‘The contractual right of a commodity broker [which term would include a DCO or FCM] * * * to cause the liquidation, termination or acceleration of a commodity contract * * * shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Bankruptcy Code] or by order of a court in any proceeding under [the Bankruptcy Code].’’). 93 See 11 U.S.C. 766(h). PO 00000 Frm 00017 Fmt 4701 Sfmt 4700 74299 particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of customer positions and collateral to solvent clearing members. Similarly, 11 U.S.C. 761–767 and Part 190 would govern the bankruptcy of a DCO, in conjunction with DCO rules providing for the termination of outstanding contracts and/or return of remaining clearing member and customer property to clearing members. With regard to ICE Clear Europe, the Commission understands that the default of a clearing member of ICE Clear Europe would be governed by the rules of that DCO. ICE Clear Europe, a DCO based in the United Kingdom, has represented that under English law its rules would supersede English insolvency laws. Under its rules, ICE Clear Europe would be permitted to close out and/or transfer positions of a defaulting clearing member that is an FCM pursuant to the U.S. Bankruptcy Code and Part 190 of the Commission’s regulations. According to ICE Clear Europe’s submission, the insolvency of ICE Clear Europe itself would be governed by both English insolvency law and Part 190. ICE Clear Europe has obtained legal opinions that support the existence of such legal certainty in relation to the protection of customer and swap counterparty positions, funds, and property in the event of the insolvency of one or more of its clearing members. In addition, ICE Clear Europe has obtained a legal opinion from U.S. counsel regarding compliance with the protections afforded to FCM customers under New York law. In response to the NPRM, Citadel commented that it agreed with the Commission’s analysis that reasonable certainty exists in the event of an insolvency of a DCO or one or more DCO members. As discussed above, the Commission received three comments related to customer segregation. In essence, Vanguard and SIFMA AMG recommend that the Commission delay implementation of the clearing requirement until three months after the LSOC model is implemented, clarified, and perhaps supplemented with additional rulemaking. ISDA requests that the Commission further study the issue of insolvency for DCOs. As stated above, the Commission believes that the concerns of Vanguard and SIFMA AMG are largely addressed by the delayed implementation timeframe for this determination. With regard to ISDA’s request, as discussed above, the Commission is actively engaging in efforts to study and prepare for potential scenarios involving E:\FR\FM\13DER2.SGM 13DER2 74300 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations clearinghouse and clearing member insolvency. iii. Conclusions Regarding the Five Statutory Factors and Clearing Requirement Determination Based on the foregoing discussion and analysis, the Commission has taken into account each of the five factors provided for under section 2(h)(2)(D)(ii) of the CEA. Based on these considerations, and having reviewed the relevant DCOs’ submissions for consistency with section 5b(c)(2) of the CEA, the Commission is determining that the two classes of CDS identified in § 50.4(b) are required to be cleared. E. Interest Rate Swaps i. Introduction Interest rate swaps are agreements wherein counterparties agree to exchange payments based on a series of cash flows over a specified period of time typically calculated using two different rates multiplied by a notional amount. The BIS estimated that, as of December 2011, over $500 trillion in notional amount of single currency interest rate swaps were outstanding representing 75% to 80% of the total estimated notional amount of derivatives outstanding.94 Based on these factors and on the swap submissions received under § 39.5(b), the Commission believes that interest rate swaps represent a substantial portion of the swaps market and warrant consideration by the Commission for required clearing. The Commission’s proposal for interest rate swaps was presented in two parts. The first part, Section II.E of the NPRM, discussed the Commission’s rationale for determining how to classify and define the interest rate swaps identified in the DCO submissions (IRS submissions) to be considered for the clearing requirement. The second part, Section II.F, presented the Commission’s consideration of the IRS submissions in accordance with section 2(h)(2)(D) of the CEA. This final release follows the same basic two-part structure. In each part, the discussion in the NPRM preamble for the corresponding part is summarized. Comments received from the public are summarized where appropriate together with the Commission’s consideration of the comments. ii. DCO Submissions The Commission received submissions from three registered DCOs eligible to clear interest rate swaps: LCH.Clearnet Limited (LCH), the clearing division of the Chicago Mercantile Exchange Inc. (CME), and International Derivatives Clearinghouse, LLC (IDCH).95 On August 14, 2012, LCH acquired IDCH and changed the name of IDCH to LCH.Clearnet LLC (LCH.LLC). LCH.LLC has submitted a request to the CFTC for approval of changes to its DCO rules that would result in LCH.LLC clearing the same interest rate swaps that LCH clears. As noted in the NPRM, IDCH had no cleared swap positions. Accordingly, the change in ownership of IDCH would not change the Commission’s proposal in terms of swap class assessments or volume and liquidity considerations. The proposed clearing requirement rule is not DCO specific. Upon approval of LCH.LLC’s application for its DCO rule changes, LCH.LLC would become a U.S.domiciled DCO capable of accepting the full range of interest rate swap products contemplated in the proposal.96 The following table summarizes the interest rate swap classes and relevant specifications that each DCO identified in its IRS submission. TABLE 3—INTEREST RATE SWAP SUBMISSIONS SUMMARY 97 LCH Swap Classes ..... Currencies 99 ....... Rate Indexes ....... Maximum Stated Termination Dates. CME Fixed-to-floating, basis, forward rate agreements (FRAs), overnight index swaps (OIS). USD, EUR, GBP, JPY, AUD, CAD, CHF, SEK, CZK, DKK, HKD, HUF, NOK, NZD, PLN, SGD, ZAR. For Fixed-to-floating, basis, FRAs: LIBOR in seven currencies, BBR–BBSW, BA– CDOR, PRIBOR, CIBOR–DKNA13, CIBOR2–DKNA13, EURIBOR-Telerate, EURIBOR-Reuters, HIBOR–HIBOR, HIBOR–HKAB, HIBOR–ISDC, BUBOR-Reuters, NIBOR, BBR–FRA, BBR-Telerate, PLN–WIBOR, PLZ–WIBOR, STIBOR, SOR-Reuters, JIBAR. For OIS: FEDFUNDS, SONIA, EONIA, TOIS. For Fixed-to-floating and basis: USD, EUR, and GBP out to 50 years, AUD, CAD, CHF, SEK and JPY out to 30 years and the remaining nine currencies out to 10 years.. For OIS and FRAs: USD, EUR, GBP, and CHF out to two years .................................... Fixed-to-floating.98 USD, EUR, GBP, JPY, CAD, and CHF. USD–LIBOR, CAD–BA, CHF– LIBOR, GBP–LIBOR, JPY– LIBOR, and EURIBOR. USD, EUR, and GBP out to 50 years, and CAD, JPY, and CHF out to 30 years. The NPRM described how interest rate swaps present a wide range of variable product classes and product specifications within each class. Notwithstanding the large variety of contracts, there are commonalities that make it possible to categorize interest rate swaps for clearing, pricing, and risk purposes. Firstly, the vast majority of interest rate swaps use the ISDA definitions and contract conventions that allow market participants to agree quickly on common terms for each transaction. In fact, the DCOs clearing interest rate swaps all use ISDA definitions in their product specifications. Secondly, counterparties enter into swaps to achieve particular economic 94 BIS, OTC Derivatives Market Activity as of December 2011, Table 1, available at http:// www.bis.org/statistics/otcder/dt1920a.pdf. The BIS data provides the broadest market-wide estimates of interest rate swap activity available to the Commission. 95 The IRS submissions received by the Commission are available at http://www.cftc.gov/ IndustryOversight/IndustryFilings/index.htm. Submission materials marked by the submitting DCO for confidential treatment pursuant to §§ 39.5(b)(5) and 145.9(d) are not available for public review. 96 IDCH was eligible under § 39.5 to clear interest rate swaps. When LCH.LLC assumed IDCH’s DCO license, LCH.LLC was deemed eligible to clear interest rate swaps as well. 97 LCH.LLC (formerly IDCH) has applied to the Commission for DCO rule change approvals that would effectively implement clearing of the same interest rate swaps that LCH now clears. LCH.LLC is not accepting interest rate swaps for clearing until such time as it launches under its new clearing rules. Accordingly, IDCH’s product list that was included in the NPRM has been removed from the summary. 98 Subsequent to its original submission, CME has added clearing of OIS for USD, EUR, GBP, and JPY. 99 In this final rule, currencies are identified either by their full name or by the three letter ISO currency designation for the currency. sroberts on DSK5SPTVN1PROD with iii. Interest Rate Swap Market Conventions and Risk Management VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 PO 00000 Frm 00018 Fmt 4701 Sfmt 4700 E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations results. While the results desired may differ in small ways depending on each counterparty’s specific circumstances and goals, there are certain common swap conventions that are used to identify and achieve commonly desired economic results when entering into interest rate swaps. For example, a party that is trying to hedge variable interest rate risk may enter into a fixed rate to floating rate swap, or a party that is seeking to fix interest rates for periods in the future may enter into a forward rate agreement. The IRS submissions identified commonly known classes of swaps that they clear including: fixed rate to floating rate swaps, that are sometimes referred to as plain vanilla swaps (fixedto-floating swaps); floating rate to floating rate swaps, also referred to as basis swaps (basis swaps); overnight index swaps (OIS); and forward rate agreements (FRAs).100 These class terms are also being used in industry efforts to develop a taxonomy for interest rate swaps.101 Furthermore, within these general classes, certain specifications are essential for defining the economic result and the value of the swap. Each of the IRS submissions naturally used these common specifications when identifying the swaps that the DCO clears. Within each of those specifications, there are common terms used by the DCOs and markets, which allows for further classification of the full range of interest rate swaps that are executed. Accordingly, as described in the NPRM, while there are a wide variety of interest rate swaps when taking into account all possible contract specifications, certain specifications are commonly used by the DCOs and market participants. This allows for the identification of classes of swaps and primary specifications within each class. The DCOs also risk manage and set margins for interest rate swaps on a portfolio basis rather than on a transaction- or product-specific basis. In other words, the DCOs analyze the cumulative risk of a party’s portfolio. By looking at risk on a portfolio basis, the DCOs effectively take into account how swaps with different attributes, such as underlying currency, stated termination dates, underlying floating rate indexes, swap classes, etc., are correlated and thus can offset risk across attributes. This is possible because, although individual transactions may have unique contract terms, given the commonalities of transactions as discussed above, swap portfolios can be risk managed on a cumulative value basis taking into account correlations among the cleared swaps. Consequently, DCOs can be expected to fairly rapidly, and efficiently manage the risk of portfolios of interest rate swaps within and across classes in a default scenario through a small number of large hedging transactions that hedge large numbers of similarly correlated positions held by the defaulting party.102 As such, liquidity for specific, individual swaps is not the focus of DCOs from a risk management perspective. Rather, liquidity is viewed as a function of whether a portfolio of swaps has common specifications that are determinative of the economics of the swaps in the portfolio such that a DCO can price and risk manage the portfolio 74301 through block hedging and auctions in a default situation.103 iv. Interest Rate Swap Classification for Clearing Requirement Determinations Section 2(h)(2)(A) of the CEA provides that the Commission ‘‘shall review each swap, or any group, category, type, or class of swaps to make a determination as to whether’’ any thereof shall be required to be cleared. In reviewing the IRS submissions, the Commission considered in the NPRM whether its clearing requirement determination should address individual swaps, or categories, types, classes, or other groups of swaps. Based on the market conventions as discussed above, and the DCO recommendations in the IRS submissions, the Commission proposed a clearing requirement for four classes of interest rate swaps: Fixed-to-floating swaps, basis swaps, OIS, and FRAs. At the time the IRS submissions were submitted to the Commission, LCH offered all four classes for clearing, as did IDCH, and CME offered one of them for clearing. Subsequent to the publication of the NPRM, CME has added clearing of OIS, and has stated publicly that it intends to add clearing of basis swaps and FRAs in the near future. In addition, upon launch of LCH.LLC, it is expected that LCH.LLC will begin clearing the same swaps cleared by LCH that are included in the swap classes designated by the Commission. These four classes represent a substantial portion of the interest rate swap market. The following table provides an indication of the outstanding positions in each class. TABLE 4—INTEREST RATE SWAPS NOTIONAL AND TRADE COUNT BY CLASS 104 Notional amount (USD BNs) Swap class sroberts on DSK5SPTVN1PROD with Fixed-to-Floating ...................................................................... FRA .......................................................................................... OIS ........................................................................................... Basis ........................................................................................ Other 105 ................................................................................... 100 These are sometimes also referred to as ‘‘types,’’ ‘‘categories,’’ or ‘‘groups.’’ For purposes of the clearing requirement determination, the Commission uses the term ‘‘class,’’ in order to be consistent with the approach taken by the European Securities and Markets Authority (ESMA) in its Discussion Paper, ‘‘Draft Technical Standards for the Regulation on OTC Derivatives, CCPs, and Trade Repositories,’’ (Feb. 16, 2012), available at http://www.esma.europa.eu/system/files/201295.pdf. It is also noted that other categorizations are sometimes used for certain purposes. However, these four classes are common terms used by the VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 Gross notional percent of total 299,818 67,145 43,634 27,593 65,689 60 13 9 5 13 DCOs and are common terms used in industry taxonomies. 101 See, e.g., ISDA Swap Taxonomies, available at http://www2.isda.org/identifiers-and-otctaxonomies/; Financial Products Markup Language, available at http://www.fpml.org/; and Federal Reserve Bank of New York Staff Reports, ‘‘An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting’’ (March 2012) at 3, available at http:// www.newyorkfed.org/research/staff_reports/ sr557.pdf. 102 After putting on these hedging positions, the DCO has the time needed to address any residual PO 00000 Frm 00019 Fmt 4701 Sfmt 4700 Total trade count 3,239,092 202,888 109,704 119,683 617,637 Total trade count percent of total 75 5 3 3 14 risk of the defaulted portfolio through auctioning off the defaulted portfolio together with the hedging transactions. 103 See 77 FR at 47188 and LCH IRS submission, at 4 (discussing LCH’s management of the Lehman Brothers’ bankruptcy in September 2008, where upon Lehman’s default, LCH needed to risk manage a portfolio of approximately 66,000 interest rate swaps, which it hedged with approximately 100 new swap trades in less than five days and only used approximately 35% of the initial margin Lehman had posted). E:\FR\FM\13DER2.SGM 13DER2 74302 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations TABLE 4—INTEREST RATE SWAPS NOTIONAL AND TRADE COUNT BY CLASS 104—Continued Notional amount (USD BNs) Swap class Total .................................................................................. Gross notional percent of total 503,879 Total trade count 100 4,289,004 Total trade count percent of total 100 104 TriOptima sroberts on DSK5SPTVN1PROD with data, as of March 16, 2012. See Section II.F below for a description of the TriOptima data. The TriOptima data provided information on nine other classes of swaps, none of which is included in the IRS submissions. 105 In the NPRM, the total notional amount for the ‘‘Other’’ category was incorrectly listed as $132,162 billion as a result of inadvertently including the FRA amounts in the ‘‘Other’’ category. Correcting this error also resulted in changes to the ‘‘Gross Notional Percent of Total’’ column. These corrections do not change the Commission’s analysis in the NPRM. The fact that the four classes of interest rate swaps included in the clearing requirement represent a larger proportion of the total notional amount of interest rate swaps outstanding is consistent with Congressional intent to mitigate systemic risk by implementing clearing of swaps as discussed in the NPRM. See 77 FR 47171. For purposes of the clearing requirement determination, the Commission developed the following class definitions based on information provided by the submitting DCOs and market conventions. 1. ‘‘Fixed-to-floating swap’’: A swap in which the payment or payments owed for one leg of the swap is calculated using a fixed rate and the payment or payments owed for the other leg are calculated using a floating rate. 2. ‘‘Floating-to-floating swap’’ or ‘‘basis swap’’: A swap in which the payments for both legs are calculated using floating rates. 3. ‘‘Forward Rate Agreement’’ or ‘‘FRA’’: A swap in which payments are exchanged on a pre-determined date for a single specified period and one leg of the swap is calculated using a fixed rate and the other leg is calculated using a floating rate that is set on a predetermined date. 4. ‘‘Overnight indexed swap’’ or ‘‘OIS’’: A swap for which one leg of the swap is calculated using a fixed rate and the other leg is calculated using a floating rate based on a daily overnight rate. As described in the NPRM, the LCH and CME IRS submissions addressed issues of classification for purposes of the interest rate swap clearing requirement. In its submission, LCH discussed the classification of interest rate swaps and recommended establishing clearing requirements for classes of interest rate swaps. In effect, LCH recommended the use of a set of basic product specifications to identify and describe each class of swaps subject to the clearing requirement. CME recommended a clearing determination for all non-option interest rate swaps denominated in a currency cleared by any qualified DCO. As an alternative, the Commission considered whether to establish clearing requirements on a product-by-product basis. The Commission noted in the NPRM that such a determination would need to identify the multitude of specifications of each product that would be subject to the clearing VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 requirement. In this regard, LCH stated in its IRS submission that the clearing requirement ‘‘would be sub-optimal for the overall market if participants are forced to read pages of rules to decipher whether or not a swap is required to be cleared, or to have to make complex and time consuming decisions at the point of execution.’’ 106 A class-based approach would allow market participants to determine quickly as a threshold matter whether they might need to submit a swap to a DCO for clearing by checking initially whether the swap has the basic specifications that define each class subject to the clearing requirement.107 A product-by-product designation also would be difficult to administer because the Commission would be required to consider each and every product submitted. On the other hand, designating classes of interest rate swaps for the clearing requirement provides a cost effective, workable method for the Commission to review variations in new swap products that DCOs will submit for clearing determinations on a going forward basis without undertaking a full Commission review of each and every swap to determine if those variations are consistent with the five factors the Commission is directed to consider under section 2(h)(2)(D) of the CEA. For such swaps, as described in greater detail below in Section III.F, the Commission proposed delegating to the Director of the Division of Clearing and 106 LCH IRS submission, at 6. addition, as noted by LCH, in its IRS submission, a product-by-product requirement may be evaded more easily because the specifications of a particular swap contract would need to match the specifications of each product subject to a clearing requirement. The clearing requirement could be evaded by adding, deleting, or modifying one or more of the contract’s specifications, including minor specifications that have little or no impact on the economics of the swap. By using a class-based approach that allows for ranges of contract specifications established by the DCOs within each class, the Commission is reducing the potential for evasion in accordance with section 2(h)(4)(A) of the CEA, which directs the Commission to prescribe rules necessary to prevent evasion of the clearing requirements. 107 In PO 00000 Frm 00020 Fmt 4701 Sfmt 4700 Risk, with the consultation of the General Counsel, the authority to confirm whether the swap fits within the identified class and is therefore subject to the clearing requirement. After consideration of the issues summarized above, the Commission proposed in the NPRM to follow the general approach recommended by LCH and CME of establishing the clearing requirement for classes of interest rate swaps, rather than for individual swap products. v. Interest Rate Swap Specifications In the NPRM, after consideration of the appropriateness of classifying interest rate swaps, the Commission analyzed the IRS submissions and proposed to set out the parameters of the four classes of interest rate swaps submitted by using the following affirmative specifications for each class: (i) Currency in which the notional and payment amounts are specified; (ii) rates referenced for each leg of the swap; and (iii) stated termination date of the swap. The Commission further proposed three ‘‘negative’’ or ‘‘limiting’’ specifications for each class: (i) No optionality (as specified by the DCOs); (ii) no dual currencies; and (iii) no conditional notional amounts.108 The Commission proposed the three affirmative specifications because they are fundamental specifications used in the swap market to determine the economic result of a swap transaction. Counterparties enter into swaps to achieve particular economic results. For 108 The term ‘‘conditional notional amount’’ refers to notional amounts that can change over the term of a swap based on a condition established by the parties upon execution such that the notional amount of the swap is not a known number or schedule of numbers, but may change based on the occurrence of some future event. This term does not include what are commonly referred to as ‘‘amortizing’’ or ‘‘roller coaster’’ notional amounts for which the notional amount changes over the term of the swap based on a schedule of notional amounts known at the time the swap is executed. Furthermore, it would not include a swap containing early termination events or other terms that could result in an early termination of the swap if a DCO clears the swap with those terms. The Commission discusses this definition and comments received on it below. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with example, counterparties may enter into interest rate swaps to hedge an economic risk, to facilitate a purchase, or to take a view on the future direction of an interest rate. The counterparties enter into a swap that they believe will best achieve their desired economic result at a reasonable cost. As noted in the NPRM, the IRS submissions identified four different classes of swap contracts that are being cleared at this time: fixed-to-floating swaps, basis swaps, OIS, and FRAs. These classes of interest rate swaps reflect industry categorization and allow counterparties to achieve a particular economic result. For example, a fixedto-floating swap may be used by a counterparty to hedge interest rate risk related to bonds it has issued or which it owns. All three DCO submitters identified currency as a specification for distinguishing swaps that are subject to clearing. A swap that requires calculation or payment in a currency different than the currency of the related underlying purposes of the swap would introduce currency risk.109 Thus, the currency designated for the swap is a basic factor in pricing the swap and achieving the economic results of the swap desired by each party. Furthermore, the swaps listed by all three DCOs in their IRS submissions all identified the interest rates used for each leg of the swap as a basic term that defines the swap. The rates are basic determinants of the economic value of each stream of payments of an interest rate swap. Finally, the stated termination date, or maturity, of a swap is a basic specification for establishing the value of a swap transaction because interest rate swaps are based on an exchange of payments over a specified period of time ending on the stated termination date. The value of a swap at any one point in time depends in part on the value of each payment stream over the remaining life of the swap. For example, if a party wants to hedge variable interest rate risk for bonds it has issued that mature in ten years, it will generally enter into a swap with a stated termination date that matches the final maturity date of the bonds being hedged.110 To terminate the swap prior 109 For example, parties seeking to hedge interest rate risk in connection with bonds or to invest funds using swaps are more likely to enter into swaps that designate the same currency in which the bonds are payable or that the funds to be invested are held. 110 Although hedging an economic risk expected to remain outstanding for, say, ten years with a matching ten year swap may generally be the most efficient and precise approach, the Commission VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 to such date would result in only a partial hedge and to execute a swap with a stated termination date that is later than the final bond maturity date would simply create exposed rate risk during the extended period beyond the final maturity date of the bonds. As noted above, the Commission also considered in the NPRM whether there are product specifications that the Commission should explicitly exclude from the initial clearing requirement determination. In this regard, the Commission considered swaps with optionality, multiple currency swaps, and swaps with conditional notional amounts. The Commission proposed that these three specifications should be included as so-called ‘‘negative’’ or ‘‘limiting’’ specifications. By using the three affirmative specifications and three limiting specifications to further identify the swaps within each class that are subject to the clearing requirement, counterparties contemplating entering into a swap can determine quickly as a threshold matter whether the particular swap may be subject to a clearing requirement. If the swap is in a specified class and has the six specifications, the parties will know that they need to verify whether a DCO will clear that particular swap. This will reduce the burden on swap counterparties related to determining whether a particular swap may be subject to the clearing requirement. The Commission also considered in the NPRM whether to define classes of swaps on the basis of other product specifications. Other potential specifications are numerous because of the nearly limitless alternative interest rate swaps that are theoretically possible. In the NPRM, the Commission summarized its consideration by breaking down alternative specifications into two general categories: Specifications that are commonly used to address mechanical issues for most swaps, and specifications that are less common and address idiosyncratic issues related to the particular needs of a counterparty. The Commission noted that certain specifications are specifically identified for most swap transactions, but asserted that many such specifications are not, generally speaking, fundamental to determining the economic result the parties are trying to achieve. For example, the day count fraction selected affects calculation periods and therefore the recognizes that parties may achieve a similar result by using swaps with different stated termination dates. However, such substitution generally provides a less precise hedge. PO 00000 Frm 00021 Fmt 4701 Sfmt 4700 74303 amounts payable for each payment period. The parties, and the DCOs, can make mechanical adjustments to period pricing at the time a swap is cleared based on the day count fraction alternative selected by the parties and the day count fraction does not drive the overall economic result the parties are trying to achieve or substantially differentiate the pricing and risk management of the swap relative to other swaps in the same class and having the same basic class defining specifications. Furthermore, as noted in the NPRM, DCOs can provide clearing for the standard alternatives of each of these specifications without affecting risk management. Using the same day count fraction example, LCH will accept U.S. dollar-LIBOR trades for clearing with nine alternative day count fractions based on the common day count fractions used in the market.111 While this specification, and other specifications of this kind, may affect the amounts owed on a swap, they can be accounted for mechanically in the payment amount calculations and do not change the basic substantive economic result the parties want to achieve. Regarding the latter, idiosyncratic specifications, examples include special representations added to address particular legal issues, unique termination events, special fees, and conditions tied to events specific to the parties. None of the DCOs clear interest rate swaps with terms in the second group. Accordingly, such specifications are not included in the classes of swaps subject to the clearing requirement proposed by this rule, and the Commission considered only the first group of more common specifications that are identified by the submitting DCOs in their product specifications. In short, the Commission recognizes that these other specifications may have an effect on the economic result to be 111 Each DCO identifies the standard term or range of terms it will accept for each specification. Accordingly, swap counterparties can review the DCO’s product specifications to determine whether a swap will satisfy the DCO’s requirements for these specifications. Additionally, CME has developed, and LCH has committed to developing by the time the clearing requirement must be complied with in accordance with the Commission’s implementation schedule, product screening mechanisms by which parties can determine whether the DCO will clear a particular swap. As discussed in greater detail throughout this release, if counterparties want to enter into a swap that is in a class subject to required clearing and no DCO will clear the swap because it has other specifications that no DCO will accept, then the parties can still enter into that transaction on an uncleared basis. E:\FR\FM\13DER2.SGM 13DER2 74304 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations achieved with the swap.112 However, counterparties and DCOs may account for the effects of such specifications with adjustments to other specifications or in the price of the swap. Furthermore, DCOs account for various alternatives or range of alternatives for these terms without impairing risk management. Finally, as described above in more detail, including these specifications in the description of the swaps subject to a clearing requirement could increase the burden on counterparties when checking whether a swap may be subject to required clearing. Accordingly, the Commission has determined not to include other, non-class defining specifications in the swap class definition. sroberts on DSK5SPTVN1PROD with vi. General Comments Received Regarding the Specifications Determination Numerous commenters expressed support for including the Commission’s four interest rate swap classes and six class specifications in the clearing requirement and were of the view that the classes satisfy the five statutory factors the Commission is required to consider for the clearing requirement determination.113 CME expressed support for the class-based approach in the rulemaking rather than swap-byswap and stated that the Commission ‘‘struck an appropriate balance for the initial slate of classes subject to the requirement.’’ LCH commented that the six swap specifications selected are consistent with its recommendation in its IRS submission and reaffirmed the reasons cited in the NPRM for using these specifications. Citadel agreed with the Commission’s class-based approach rather than a product-by-product based approach. Citadel stated that the class designation approach ‘‘reflects the risk management approach utilized across the industry, and most importantly by DCOs’’ to determine margin levels and other safeguards and is therefore the starting point for the approved classes. Citadel 112 LCH recommended in its submission that floating rate tenor (also known as frequency) also be a class level specification and the Commission acknowledges that floating rate tenor can, in some cases, be a fundamental specification for achieving the economic benefits of an interest rate swap. However, it is the Commission’s view that floating rate tenor is more akin to the other non-class specifications in that it is not fundamental to all economic results that may be considered by parties when contemplating a swap and it is a specification for which the DCOs can fairly easily offer all of the standard tenors that parties may consider. 113 AllianceBernstein, R.J. O’Brien, Citadel, Eris Exchange, CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies, Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris Barnard, and Svenokur. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 further noted that different tenors or series of the same instruments, while displaying different characteristics, can be priced both based on market activity and by reference to more liquid contracts of the same instruments and are risk managed with the same risk management frameworks. Finally, Citadel expressed concern that not including products that otherwise share essential characteristics as swaps that are otherwise required to be cleared and that can be priced with reference to cleared swaps could risk the development of separate markets that avoid the clearing requirement. AFR noted that the interest rate swap classes selected properly reflect the risk profile of the interest rate swap market and will avoid uncertainty and complexity for the Commission and market participants. AFR also noted that details of product specifications such as slightly different tenors, are largely irrelevant, especially in the interest rate market and stated that any suggestion of a product-by-product approach should be interpreted as a tactic to delay implementation. Furthermore, AFR encouraged the Commission to designate swap classes to include low volume swaps that can be risk managed in ways that high-volume swaps in the class are risk managed. AFR’s concern is that if the low-volume swaps are not included, they could be used to avoid the clearing requirement by replicating the swaps that are required to be cleared with the low-volume swaps. Citadel’s and AFR’s comments are consistent with the Commission’s rationale for establishing the four classes of swaps and the six specifications for each class on which the Commission based its consideration of the five factors set forth in section 2(h)(2)(D)(ii) of the CEA. As noted in the NPRM, the Commission is directed under the CEA to make its determination for ‘‘each swap, or any group, category, type, or class of swaps.’’ The Commission first needed to establish the classes and class-defining specifications to which would then consider using the five statutory factors. ISDA commented that the Commission should not use what ISDA characterized as a newly-articulated standard for choosing the swap classdefining specifications based on whether they are ‘‘fundamental to determining the economic result that parties are trying to achieve.’’ ISDA expressed concern with what it characterized as a standard that it is not grounded in the five statutory factors of section 2(h)(2)(D)(ii) of the CEA and will fail to discriminate between swaps that may differ in terms of the five factors. Furthermore, in ISDA’s view, the PO 00000 Frm 00022 Fmt 4701 Sfmt 4700 fundamental economic result depends on facts and circumstances of each transaction and the parties. The phrase ‘‘fundamental to determining the economic result that parties are trying to achieve’’ used by the Commission in the NPRM does not establish a new standard or replace the statutory five factor determination required by the CEA. Rather, the Commission used this phrase to describe one of several reasons for establishing which product specifications to use in defining each class to which the statutory five factor analysis was then applied. The phrase was used in the context of identifying the primary product specifications the submitting DCOs and the market use to value or price swaps within a class. As described at length in Section II.D of the NPRM, in establishing the swap classes to be considered, the Commission looked at how DCOs grouped the cleared interest rate swaps by certain defining types and specifications, how markets trade and view the products as classes, and how swaps that share certain common specifications can be priced and risk managed together as a class. The Commission’s analysis for establishing the classes to be considered was not based on any new standard. Rather, the aforementioned phrase summarizes one element of the Commission’s analysis of how to define the classes to be considered under the five factors established in the CEA. Furthermore, the five factor statutory analysis was separately undertaken for each class. For the reasons stated in defining the classes and class specifications, the Commission believes that the swaps within each class are sufficiently similar to apply the statutory analysis to each class. As noted above, many commenters agreed with this conclusion. Finally, regarding ISDA’s view that the fundamental economic result depends on facts and circumstances of each transaction and the parties, the Commission recognizes that individual swap counterparties may have highly specific economic results they are trying to achieve with a swap and accordingly set the terms of the swap to achieve those specific results. However, the Commission’s use of the phrase in the NPRM can be more clearly understood in context. The Commission was addressing whether certain specifications, other than the six specifications used to define each class, should be considered to be classdefining specifications. The Commission noted that certain specifications ‘‘affect the value of the swap in a mechanical way, they are not, E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations generally speaking, fundamental to determining the economic result.’’ The Commission provided an example of how other specifications may affect the amounts payable on a swap on each payment date, but when valuing a swap for pricing and risk management purposes, together with other swaps within a class, these other specifications can be accounted for by making price adjustments off a standard price curve and therefore do not change the basic pricing economics of the swap to an extent that would necessitate classifying the swap separately from other swaps defined by the six specifications identified by the Commission. ISDA further commented that, although an overly intricate set of product specifications would impose burdens on the market, broad class designations impose greater burdens by creating the need for filtering products that a DCO will accept for clearing from the designated class. In ISDA’s view, the Commission’s statement in the NPRM that DCOs and vendors are ‘‘likely’’ to develop screening tools acknowledges the issue, but does not provide a solution. ISDA recommended that limiting clearing to swaps with prior clearing history supplemented by an advance DCO notice process would strike a reasonable balance. In response, the Commission notes that the identification of the four interest rate swap classes and the parameters for the six specifications within each class provides a fairly detailed and easy to use initial screening mechanism for market participants to determine whether a particular swap needs to be submitted for clearing. If a market participant determines that a swap falls into a class under § 50.4, then the party will need to take reasonable efforts to determine whether any eligible DCO will accept the swap for clearing.114 The Commission noted in the NPRM that the DCOs or other vendors would likely develop screening tools for this purpose. The Commission further notes that each DCO and its members and the FCMs who clear through the DCO, in effect, already have the capability through their own onboarding processes and transaction affirmation platforms to screen swap transactions nearly instantaneously to determine whether the transactions will be accepted by the DCO. While those systems alone should be able to serve as a screening mechanism sufficient to allow for compliance with the clearing requirement, the Commission 114 See Section III.B for a discussion of the reasonable efforts standard in this context. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 encourages the DCOs to create a tool to provide all market participants with the ability to independently screen potential swap transactions quickly and easily. CME commented that it already has a tool to screen particular swaps for eligibility. LCH stated in its comments that while the current information on its Web site is designed for dealer use, LCH is committed to revising the information to be easily understandable by all counterparties. Furthermore, the Commission does not agree that ISDA’s proposal to limit the determination to swaps with prior clearing history would ease the screening process. DCOs, particularly LCH, already have prior clearing history for swaps with tens of thousands of different product specification combinations.115 Accordingly, even if the Commission adopted such an approach, the result would have the problems that a product-by-product approach would have, as acknowledged by ISDA. Also, the Commission agrees that an appropriate DCO notice framework will facilitate product screening and addresses this comment in Section III below. In addition, ISDA expressed concern that the discussion of specifications that are not included in the six class-specific specifications identified by the Commission could be read as a directive to abandon such other specifications to the extent they are not included in the swaps DCOs will accept for clearing. ISDA requested confirmation that footnote 97 of the NPRM (revised as footnote 111 in this final release) establishes that if a DCO does not accept a swap because the swap contains terms that the DCO does not clear, then entering into the swap as an uncleared transaction is permissible. ISDA further requested that the Commission state that entering into a swap that is not accepted for clearing does not raise a presumption of evasion. Similarly, Freddie Mac also expressed concern that the discussion of fundamental specifications and ‘‘mechanical specifications’’ may signal the Commission’s judgment that parties are required to clear swaps that have sufficiently close substitutes. Freddie Mac requested that the Commission clarify the treatment of swaps that no DCO will clear and that parties may enter into uncleared swaps within a designated class if a DCO will not accept the swap provided that the variation in specifications is for a 115 See, e.g., http://www.swapclear.com/why/ (stating that since 1999, LCH has cleared more than 2.2 million OTC interest rate swaps, $329 trillion notional, and compressed more than $145 trillion (as of September 2012)). PO 00000 Frm 00023 Fmt 4701 Sfmt 4700 74305 legitimate business purpose. Freddie Mac noted that section 2(h)(1)(A) of the CEA refers to an obligation to ‘‘submit’’ the swap for clearing rather than requiring that a swap must be successfully cleared. Freddie Mac expressed concern that failure to clarify this issue would lead to uncertainty as to the legality of uncleared swaps and that executing swap dealers or other market participants could use that uncertainty to insist on contractual rights to have the option to terminate a swap that fails to clear. The Commission confirms that the discussion of the class-defining swap specifications and other specifications served only to explain the Commission’s differentiation between the class specifications and other specifications market participants use. The Commission is not requiring parties to take affirmative steps to substitute a clearable swap for an unclearable swap within a designated class.116 Regarding issues of what constitutes evasion of the clearing requirement when using a close substitute swap that is not cleared by a DCO and ISDA’s request regarding a presumption regarding evasion of the clearing requirement, this issue, along with other evasion and abuse issues, are addressed in Section III.G of this release. With respect to the ‘‘negative specifications,’’ AFR commented that some of these specifications, such as dual currency and optionality, are composites of two derivatives including a basic interest rate swap that may be subject to the clearing requirement and that market participants should be required to clear components of such swaps that can be cleared to prevent evasion. This initial determination is based on the IRS submissions and because none of them include swaps that have the negative specifications, the Commission believes it is beneficial for swap market participants to expressly exclude those specifications so that parties that execute swaps with those specifications will know definitively that they are not subject to the clearing requirement. While the Commission is sensitive to concerns that the clearing requirement could be evaded by adding negative specifications to a swap to make it nonclearable, no data or other information is available at this time to indicate that compound swaps are being used for evasion. If the Commission observes such behavior or otherwise becomes aware that is occurring, it will consider 116 See Sections II and III for further discussion of this issue. E:\FR\FM\13DER2.SGM 13DER2 74306 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with taking appropriate action under its authority provided in the CEA. The FSR requested clarification regarding the conditional notional amount specification. The FSR interpreted footnote 93 of the NPRM (footnote 108 of this adopting release) to mean that interest rate swaps entered into in connection with loans to hedge interest rate risk (the notional amounts of which are tied at all times to the outstanding principal amount of the loan) would not be subject to the clearing requirement if the principal amount of the loan would foreseeably vary over its term in an unscheduled or unpredictable manner.117 The FSR used the examples of a swap used to hedge a construction loan, where the loan would be drawn over time based on the needs of the construction project, and without a fixed draw schedule, or a swap entered into in connection with a revolving credit agreement or a credit agreement that permits voluntary prepayments. The FSR noted that such adjustment may be implemented through a partial termination event, permitting or requiring the lender/swap provider to reduce the outstanding notional amount of the swap so as to protect both the customer and the lender/swap provider from overhedging. In response to the FSR, the Commission clarifies that a ‘‘conditional notional amount’’ is a specification included in the swap at the time of execution that provides that the notional amount will change during the stated term of the swap in an unscheduled manner upon the occurrence of defined events or conditions. There are two elements to such a specification: First, the change in notional amount must be triggered by a defined event or condition, and second, the change must not be clearly predictable at the time the swap is executed. Accordingly, the two examples provided by the FSR might be swaps that have a conditional notional amount if the swaps include specifications or terms that provide for a change in notional amount triggered by an event tied to the hedged loan or credit line and the specific timing of that event is not sufficiently foreseeable or predictable when the swap is entered 117 In a similar vein, ISDA commented that exclusions from the clearing requirements should be available if a party enters into one swap to hedge another swap and the hedge would no longer be functional if one trade of the pair would be cleared and the other not. Section 2(h)(7) of the CEA is clear with respect to this issue, and provides that only certain non-financial entities may elect not to clear certain swaps that hedge or mitigate commercial risk of the entity. The CEA does not extend this election to financial entities. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 into such that the swap notional amount change could have been scheduled in advance. For example, a swap in which the parties agree that the notional amount will automatically be reduced upon a draw on a related construction loan identified in the swap or a prepayment of a loan identified in the swap would qualify as a swap with a conditional notional amount. However, the Commission notes that such a specification would not qualify if the reduction in the notional amount is voluntary. In this regard, a voluntary partial or full termination right is not an indication of a conditional notional amount. A party to a cleared swap can affect the same result as exercising a voluntary termination right at any time by entering into an equal and offsetting cleared swap. Clearing eliminates bilateral counterparty credit risk and therefore entering into an offsetting swap that is cleared with any party has the same effect as terminating the original swap. Accordingly, including a voluntary termination right in a swap that otherwise would be clearable and is subject to the clearing requirement serves no economic purpose that would distinguish the swap from other swaps in the class that are required to be cleared. As noted in the beginning of this Section II.E, the preceding analysis identified the classes of interest rate swaps and specifications within the classes to be considered by the Commission in the clearing requirement determination. In the following section in the NPRM, as summarized in this final release, the Commission took into account the statutory provisions under section 2(h)(2)(D) of the CEA with respect to the four classes of interest rate swaps and, within each class, the six identified product specifications. F. Proposed Determination Analysis for Interest Rate Swaps i. Consistency With Core Principles for Derivatives Clearing Organizations As noted above, section 2(h)(2)(D)(i) of the CEA requires the Commission to review whether a swap submission is consistent with the core principles for DCOs in making a clearing determination. As discussed in the NPRM, LCH and CME already clear all swaps identified in their respective IRS submissions and therefore each is subject to the Commission’s review and surveillance procedures summarized in the NPRM. Accordingly, LCH and CME already are required to comply with the core principles set forth in section 5b(c)(2) of the CEA with respect to the swaps being considered by the PO 00000 Frm 00024 Fmt 4701 Sfmt 4700 Commission for the clearing requirement. The Commission further described in the NPRM its activities as a regulator to monitor and effect ongoing compliance with the core principles applicable to DCOs including periodic examinations and daily risk surveillance. Further, the Commission stated that the Commission does not believe that subjecting any of the interest rate swaps identified in the IRS submissions to a clearing requirement would alter compliance by the respective DCOs with the core principles. Based upon the Commission’s ongoing reviews of DCOs’ risk management frameworks and clearing rules, and its annual examinations of the DCOs, the Commission believes that the submissions of LCH and CME are consistent with section 5b(c)(2) if the CEA and the related Commission regulations. In analyzing the IRS submissions discussed herein, the Commission does not believe that a clearing requirement with regard to the specified interest rate swap classes would be inconsistent with LCH or CME’s continued ability to maintain such compliance with the DCO core principles set forth in part 39 of the Commission’s regulations. ii. Consideration of the Five Statutory Factors for Clearing Requirement Determinations Section 2(h)(2)(D)(ii) of the CEA identifies five factors the Commission shall consider in making a clearing requirement determination. The process for submission and review of swaps for a clearing requirement determination is further detailed in § 39.5 of the Commission’s regulations. This section summarizes the Commission’s consideration the four classes of swaps identified in the preceding section under the statutory five factors in the context of the process established by regulation. a. Outstanding Notional Exposures, Trading Liquidity, and Adequate Pricing Data Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to take into account the existence of outstanding notional exposures, trading liquidity, and adequate pricing data. In the NPRM, the Commission considered available market data and LCH cleared swap information. Unlike CDS for which substantially all of the trading data has been collected in one place, there is no single data source for notional exposures and trading liquidity for the E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with entire interest rate swap market.118 However, the Commission considered several sources of data on the interest rate swap market that collectively provides the information the Commission needs to make a clearing requirement determination. As described in the NPRM, the data sources that the Commission considered include: general estimates published by the Bank for International Settlements (BIS data); market data published weekly by TriOptima (TriOptima data) covering swap trade information submitted voluntarily by 14 large derivatives dealers (G14 Dealers); tradeby-trade data provided voluntarily by the G14 Dealers to the OTC Derivatives Supervisors Group for a three month period between June and August 2010 (ODSG data); and trade-by-trade data for swaps cleared by LCH for the first calendar quarter of 2012 (LCH data).119 The NPRM explained in detail that each data source used has a number of limitations that are important to understand when considering the data. The Commission incorporates the discussion of those limitations found in the NPRM into this final release. For this determination, the Commission only considered the swaps identified in the IRS submissions. Accordingly, where possible, the Commission presented and discussed only the data for swaps identified in the submissions. The analysis of interest rate swap data in the NPRM was presented based on the four swap classes and the class specifications. This information was used by the Commission to determine whether there exists significant outstanding notional amounts, trading liquidity, and pricing data to include each class and specification identified in the IRS submissions. For purposes of this final release, the Commission is incorporating the data 118 See Bank of England, ‘‘Thoughts on Determining Central Clearing Eligibility of OTC Derivatives,’’ Financial Stability Paper No. 14, March 2012, at 11, available at http:// www.bankofengland.co.uk/publications/ Documents/fsr/fs_paper14.pdf. 119 All DCOs were required to begin providing daily position data to the Commission as of November 8, 2012. CME’s available data was considered too limited to provide any indication of the complete interest rate swap market. Because LCH clears a large portion of the swap products it offers clearing for (based on available information, LCH claims to have cleared approximately 50 to 90 percent of the dealer open interest in the different interest rate swap products that it clears), its data provides some indication of the possible notional exposures and liquidity in the products submitted by LCH that the Commission considered. Given the limitations on other available data, the Commission believes it is useful to consider the LCH data along with the market-wide BIS data, ODSG data, and TriOptima data. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 tables in the NPRM by reference and the considerations and conclusions drawn by the Commission following review of the data is summarized below.120 Readers are encouraged to refer to the NPRM to review the data presented. None of the comments received in response to the NPRM raised issues with the data analyzed in the NPRM. 1. Interest Rate Swap Class In the NPRM, the Commission considered data relevant to the different interest rate swap classes included in the IRS submissions. The BIS data provided certain big picture information. It indicated that interest rate swaps in total constituted nearly 80% of the derivatives market and interest rate swap notional amounts generally increased for all three kinds of swaps between 2008 and 2011 with total interest rate swap notional amounts reported growing by about 15% during that period. Additionally, all three classes of swaps identified by the BIS data have substantial notional amounts outstanding. As of December 2011, FRAs had about $50.5 trillion outstanding, optional swaps had about $51 trillion outstanding, and other interest rate swaps had about $403 trillion outstanding. Given this information, the Commission concluded that none of the kinds of swaps identified by the BIS should be eliminated from consideration by the Commission for a clearing requirement based on the BIS data alone. However, the BIS data did not provide enough detail to reach further conclusions regarding the swaps identified in the IRS submissions. The TriOptima data and the ODSG data sets were used to identify notional amounts and trade counts for all four classes of swaps identified in the IRS submissions. Trading liquidity as an indication of how effectively DCOs can risk manage a portfolio of swaps can be evidenced in several ways. The data available for this purpose included total notional amount outstanding, total number of swaps outstanding, and the 120 The ODSG data has not been updated since 2010. The BIS data that was available when the NPRM was published was from the second half of 2011 and the TriOptima and LCH data used was from the first quarter of 2012. The BIS has not published updated data as of this writing. TriOptima stopped publishing the interest rate swap data in April, 2012. DTCC began collecting similar data at that time and is now provisionally registered by the Commission as a SDR. The Commission has reviewed data from DTCC and LCH and confirmed that the recent data available is consistent with the data used in the NPRM to develop the interest rate swap clearing requirement rule, taking into consideration normal changes in market activity. PO 00000 Frm 00025 Fmt 4701 Sfmt 4700 74307 average number of transactions over a given period of time. The TriOptima data showed that all four classes have significant outstanding notional amounts with basis swaps being the lowest at about $27.6 trillion and the highest being fixed-to-floating swaps at $288.8 trillion. Total trade counts for each type were also significant with the lowest being 109,704 for OIS and the highest being fixed-to-floating swaps at 3,239,092. The average number of swap trades per week for each class of swaps was evidenced by the ODSG data. According to the ODSG data set, basis swaps were traded at the lowest frequency compared to the other three classes at 240 times on average each week during the ODSG data period. Because the ODSG data is from the summer of 2010 and gross notional amounts and trading activity in interest rate swaps have both increased generally, the Commission believes that trading activity has likely increased for all classes since the ODSG data was collected. The LCH data generally confirmed the assessment of market-wide data. There is substantial outstanding notional volumes and trade liquidity for each of the four classes already being cleared at LCH. LCH cleared the following percentage of each class of swap as reported by TriOptima: 121 • 75% of the Fixed-to-Floating swaps, • 41% of FRAs,122 • 84% of OIS, and • 41% of Basis Swaps. Accordingly, a substantial portion of each class is already being cleared voluntarily. Swap Class Conclusion The Commission concluded in the NPRM that the four classes of swaps currently being cleared have significant outstanding notional amounts and trading liquidity. The Commission further noted that a substantial percentage of each of the four classes was already being cleared. A number of commenters commented that the four interest rate swap classes are cleared in material volumes at this 121 Percentages are calculated based on total notional amount cleared by LCH divided by total notional outstanding as reported by TriOptima. The TriOptima data is used because it is the most current data set that provides data broken out according to the classes being cleared. 122 LCH started clearing FRAs in December 2011 and cleared volumes have increased significantly each month since the start date. As of March 31, 2012, the date for which the data was presented in the NPRM, LCH had a total notional amount outstanding of cleared FRAs of $27.7 trillion. As of October 15, 2012, that amount had increased to $58.6 trillion. E:\FR\FM\13DER2.SGM 13DER2 74308 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations time and expressed support for including the four interest rate swap classes in the clearing requirement designation based on the data available.123 Citadel agreed with the Commission’s conclusion that the data presented in the NPRM demonstrate substantial outstanding notional exposures and a high level of trading liquidity in the relevant classes of swaps. Citadel commented that liquidity, for purposes of the clearing requirement, should be determined on grounds other than trading activity alone. Specifically, market depth can be evidenced by the number of dealers quoting two-way markets in a product, and the notional sizes of the quoted bids and offers, is also a liquidity indicator. Citadel noted that multiple dealers regularly quote two-way markets in the swaps covered by the proposed rule in meaningful sizes through a variety of mediums, including in periods of market stress, and therefore it believes there is ample trading liquidity to support a clearing requirement for the classes designated. For the reasons described above, the Commission reaffirms the aforementioned conclusions provided in the NRPM regarding the classes of interest rate swaps proposed in the NPRM for required clearing. 2. Currency sroberts on DSK5SPTVN1PROD with As discussed above in Section II.E, the currency in which the notional and payment amounts are specified is a primary product specification and all four data sources provide interest rate swap data by currency. The BIS data addressed seven of the seventeen currencies identified in the submissions individually. All seven currencies had substantial outstanding notional amounts as of December 2011, ranging from nearly $5.4 trillion for the Swiss franc to about $185 trillion in euro. For all currencies, the outstanding notional amounts were higher at the end of the most recent three-year period as compared to the beginning of the period. The Commission believes that the BIS data supports the conclusion that there exists significant outstanding notional amounts in each currency identified in the BIS data and that there is no indication that notional amounts in 123 See letters from FIA PTG, Arbor Research and Trading, LLC, R.J. O’Brien, Svenokur, LLC, Chris Barnard, CRT Capital Group (Robert Gorham), LLC, DRW Trading Group, Javelin, SDMA, Knight Capital Americas LLC, Bart Sokol (CRT Capital Group), Jefferies & Company, Inc., MarketAxess, Eris Exchange, Coherence Capital Partners LLC, Citadel, AFR, D.E. Shaw Group, AllianceBernstein, LCH, CME, and ICE. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 those currencies are decreasing at a rate that would warrant elimination of those currencies from consideration for a clearing requirement. The TriOptima data showed that total outstanding notional amounts as of March 16, 2012, ranged from $400 billion for Czech koruna to over $176 trillion notional amount for euro.124 While there may be sufficient outstanding notional amounts in all seventeen currencies, the Commission noted in the NPRM that there is a clear demarcation between the four currencies with the highest outstanding notional amounts: euro, U.S. dollar, British pound, and yen, and all other currencies. The four top currencies ranged from about 9% to 36% of the total notional amount of all interest rate swaps outstanding and 11% to 33% of the total number of swap trades. The remaining currencies ranged from about 2% down to 0.1% of the total notional amount traded and 3% down to 0.2% of total number of trades. In fact, the four major currencies accounted for about 93% of the total notional amount outstanding in the TriOptima data set. The ODSG data provided an indication of trading liquidity in terms of average weekly notional amount traded and number of new trades completed during the period covered by the data set. Of the four major currencies, Japanese yen had the lowest weekly average notional at $323 billion and the British pound had the lowest average number of trades each week at 1,233. The TriOptima data provided an overall, more current view of trades outstanding, which provides a broader picture of the trading potential for each currency for purposes of DCO risk management. As of March 16, 2012, all but one of the seventeen currencies had outstanding trade counts in excess of 14,000 with the exception being the Danish krone at 6,849. Again, the four highest currencies by trade count: euro, U.S. dollar, British pound, and yen, accounted for about 85% of the total number of trades recorded and outstanding at the time the data was collected. The LCH data showed that the relative notional amount and number of swaps in each currency cleared is generally correlated with the notional amount and number of swaps of each currency reported by the more general market data sets. As a percentage of the total notional amount outstanding as 124 TriOptima PO 00000 Frm 00026 data, as of March 16, 2012. Fmt 4701 Sfmt 4700 reported by TriOptima, LCH cleared the following percentages: 125 • 66% of euro, • 61% of U.S. dollars, • 58% of British pounds, • 59% of Japanese yen, and • 42% of other currencies. Of the interest rate swaps identifying U.S. dollars, euro, British pounds or yen as the applicable currency, significantly more than half were already being cleared by LCH. While the level of clearing of other currencies was, on a combined basis reasonably high at 42%, the Commission noted the level is noticeably lower than the percentage of swaps being cleared for the top four currencies. Currency Specification Conclusion The Commission concluded in the NPRM that all of the data sets demonstrate the existence of significant outstanding notional amounts and trading liquidity in the seventeen currencies identified in the IRS submissions. However, the Commission noted that swaps using the four currencies with the highest outstanding notional amounts and trade frequency: euro, U.S. dollar, British pound, and yen, account for an outsized portion of both notional amounts outstanding and trading volumes. Furthermore, the Commission noted that these four currencies are already being cleared more than the other currencies generally. While it is important that this determination include a substantial portion of the interest rate swaps traded to have a substantive, beneficial impact on systemic risk, the Commission also recognized that the final rule is the Commission’s first swap clearing requirement determination. As noted in the phased implementation rules for the clearing requirement, the Commission believes that introducing too much required clearing too quickly could unnecessarily increase the burden of the clearing requirement on market participants. In recognition of these considerations, the Commission determined in the NPRM to focus the remainder of this initial clearing requirement determination analysis on swaps referencing the four most heavily traded currencies. The Commission noted that the decision not to include the other thirteen currencies at this time does not limit the Commission’s authority to reconsider required clearing of those currencies in the future. 125 The TriOptima data is used for this calculation because it is the most current data set that provides data broken out according to the classes currently being cleared. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with LCH commented that it supports the Commission’s decision to initially limit the interest rate swap clearing determination to swaps with USD, EUR, GBP, and JPY as the underlying currency, and recommended that the Commission propose mandatory clearing of swaps in the other 13 currencies identified in the IRS submission after the initial phase of the clearing requirement is well-established. LCH stated that there is ample volume and liquidity in swaps denominated in those currencies to support a clearing requirement determination and that it would be beneficial for the market if the Commission would clarify whether and/ or when it plans to make clearing of swaps denominated in other currencies mandatory. The Commission reaffirms the conclusions in its proposed determination to limit the interest rate swap clearing determination to interest rate swaps with USD, EUR, GBP, and JPY as the underlying currency, at this time. In response to LCH, the Commission reiterates that not including interest rate swaps in the other 13 currencies in this determination in no way forestalls the Commission from initiating a new clearing requirement determination for interest rate swaps in those currencies. The decision not to include them at this time was based on the fact that this is the initial clearing requirement determination and the Commission is mindful that market participants will be undertaking significant activity to implement compliance for the first time. Accordingly, the Commission has effectively delayed consideration of these currencies so that the market will have time to adapt to mandatory clearing of interest rate swaps in the four primary currencies, with the expectation that thereafter, the additional currencies can be added fairly easily. The Commission expects to initiate a clearing determination for interest rate swaps in the 13 currencies at some time in 2013. 3. Floating Rate Index Referenced The ODSG data and LCH data provided an indication of the rate indices used on a transaction-bytransaction basis. Rate indexes are currency specific. The ODSG data showed minimal activity for the EUR– LIBOR index with about $1 billion of notional amount and five trades made for the three month period in 2010 that the ODSG data covers. EUR–LIBOR does not appear on the LCH data table because, although swaps referencing that index can be cleared at LCH, LCH had no open interest for that index as of VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 March 31, 2012. Given the minimal notional amounts and trade liquidity for the EUR–LIBOR index, the Commission determined in the NPRM not to include EUR–LIBOR under the clearing requirement. The other rate indexes all showed significant notional amounts and trading liquidity. The rates with the least activity, the U.S. dollar Fedfund index and British pound–LIBOR index, each have over one trillion dollars in notional outstanding already cleared at LCH and $93 billion and $82 billion in notional amount, respectively, were cleared per week on average. In terms of number of trades cleared at LCH, swaps referencing Fedfunds were cleared on average 116 times per week and swaps referencing British pound–LIBOR were cleared 888 times per week on average. All of the other indices cleared have similar or substantially higher numbers of trades and notional amounts cleared. In the NPRM, the Commission noted that the rate indexes used for over-thecounter interest rate swaps reference not only the generic index, but a reference definition for the index such as the ISDA definition or Reuters definition. While the Commission recognized the importance of these reference definitions for each swap contract, the Commission concluded that such definitions are not relevant for purposes of the clearing requirement determination. Furthermore, if the parties to a swap identify a specific reference definition for an index, they need only confirm whether any eligible DCO accepts that reference definition. If none do, then the swap in question is not accepted for clearing and it is not subject to the clearing requirement. Rate Index Specification Conclusion The Commission concluded in the NPRM that with the exception of the EURO–LIBOR index, swaps using all of the rate indexes identified in the IRS submissions have significant outstanding notional amounts and trading liquidity and that significant notional amounts of swaps using these rate indexes are already cleared by DCOs. The Commission received no comments on the rate index specification determination, and confirming its conclusions regarding the rate index specifications identified in the NPRM. 4. Stated Termination Dates Stated termination date (sometimes referred to as ‘‘maturities’’) data is often presented by aggregating stated termination dates for swaps into specified term periods or ‘‘buckets.’’ PO 00000 Frm 00027 Fmt 4701 Sfmt 4700 74309 The IRS submissions showed that the DCOs have been clearing interest rate swaps with final termination dates out to at least ten years for all seventeen currencies noted above and out to 50 years for some classes and currencies. Stated termination dates can fall on any day of the year. Given this continuum of termination dates, the DCOs have indicated that they manage the cleared swap portfolio risk using a swap curve.126 Swap curves are also used by market participants to price interest rate swaps. By pricing swaps in this way, the economic results of an interest rate swap can be fairly closely approximated, and therefore hedged, using two or more other swaps with different maturities principally by matching the weighted average duration of those swaps with the duration of the swap being hedged.127 In the same manner, a large portfolio of interest rate swaps can be hedged fairly closely with a small number of hedging swaps that have the same duration as the entire portfolio or subsets of related swaps within the portfolio. In effect, for DCO risk management purposes, the termination dates of interest rate swaps are assessed based on how they affect the overall duration aspects of the portfolio of swaps cleared.128 Accordingly, the primary determination with respect to the stated termination date specification is, for each class and currency, at what point, if any, along the continuum of swap maturities does the notional outstanding and trading liquidity become insufficient to structure the swap curve effectively for DCO risk management purposes. The TriOptima data provided sufficient detail to discern notional amounts and trade counts only for each swap class. The ODSG data provided sufficient detail to discern notional amounts and trade counts only for each currency. The LCH data provided enough detail for both swap class and currency. The TriOptima data and LCH data summarized in the NPRM showed that for fixed-to-floating swaps and basis swaps, there was significant outstanding notional amounts and number of trades for all maturity buckets being cleared. 126 The ‘‘swap curve’’ is the term generally used by market participants for interest rate swap pricing and is similar to, and is sometimes established, in part, based on, ‘‘yield curves’’ used for pricing bonds. 127 Other factors, such as convexity, may also be taken into account in determining the appropriate hedge ratio between the initial swap and the other swaps used to hedge its exposure. 128 For further discussion of the use of portfolio risk management by DCOs, see the discussion of interest rate swap market conventions and risk management in Section II.E above. E:\FR\FM\13DER2.SGM 13DER2 74310 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations For FRAs, the TriOptima data showed a steep drop off after two years, although in the two to five year bucket, there is still over $1 trillion dollars of outstanding notional amount and 1,646 trades. The LCH data showed substantial outstanding notional amounts of FRAs out to two years and none thereafter. The IRS submissions provide that the DCOs do not clear FRAs with payment dates beyond three years. Accordingly, the Commission need not consider FRAs with maturities beyond three years until such time as a DCO submits such swaps for clearing. For OIS, the TriOptima data showed notional amounts for all maturity buckets, but the drop off was steep beyond two years. After ten years, outstanding notional amounts drop below $100 billion for each maturity bucket. The LCH data showed no outstanding notional amounts cleared beyond two years. The IRS submissions provide that the DCOs do not accept for clearing OIS swaps beyond two years. Accordingly, the Commission did not consider OIS swaps beyond two years in this clearing requirement determination. The ODSG data and LCH data presented in the NPRM showed notional amounts traded for maturity buckets by currency. There were traded and cleared notional amounts for euro, U.S. dollars, and British pounds out to the 30 to 50 year bucket and for yen out to the twenty to thirty year bucket. The LCH data confirms that substantial notional amounts of swaps in euro, U.S. dollars, and British pounds are being cleared out to 50 years and yen out to 30 years. Stated Termination Date Specification Conclusion For the classes of swaps considered by the Commission in the NPRM, the TriOptima data showed that there were significant outstanding notional amounts and number of trades out to 50 years for fixed-to-floating swaps and basis swaps, out to 10 years or more for OIS, and out to 2 years for FRAs. With respect to currencies, the ODSG data and LCH data show significant outstanding notional amounts and number of trades in swaps out to 50 years for U.S. dollars, euro, and British pounds and out to 30 years for yen. Citadel noted that different tenors of the same instruments, while displaying incrementally different characteristics, are priceable both based on market activity and also with reference to more liquid or on-the-run (or, as the case may be, already cleared) transactions of the same instruments, and are risk managed using the same risk management frameworks. Accordingly, swaps within a designated class with incrementally different tenors do not require a new review that would incur excessive delay. For the aforementioned reasons, the Commission confirming its conclusions regarding required clearing for interest rate swaps with the stated termination date specifications as proposed in the NPRM. 5. Adequate Pricing Data In the NPRM, the Commission took into account the adequacy of the pricing data for the four classes of interest rate swaps. LCH stated in its IRS submission that there is adequate pricing data for risk and default management. It explained that its risk and default management is based on the following factors under normal and stressed conditions: • Outstanding notional, by maturity bucket and currency; • Number of participants with live open positions, by maturity bucket and currency; • Notional throughput of the market, by maturity bucket and currency; • Size tradable that would not adjust the market price, by maturity bucket; • Number of potential direct clearing members clearing the products that are part of the mutualized default fund and default management process; • Interplay between on-the-run and off-the-run contracts; and • Product messaging components and structure. LCH carries out a fire drill of its default management procedures and readiness twice a year. According to LCH, the fire drill presents an opportunity to further benchmark market liquidity and behavior and for models and assumptions to be recalibrated based on practitioner input. LCH also tests liquidity assumptions from the outset when developing clearing capabilities for a new product and thereafter, on a daily basis. This testing informs how LCH develops and modifies its risk management framework to provide adequate risk coverage in compliance with the core principles applicable to DCOs. Based on this framework, LCH contends that there is adequate pricing data for the swaps offered for clearing. CME represented in its IRS submission that its interest rate swap valuations are fully transparent and rely on pricing inputs obtained from wire service feeds. Further, CME uses conventional pricing methodologies, including OIS discounting, to produce its zero coupon curve off of which cleared swaps of all stated termination dates are priced. In addition, customers are provided with direct access to daily reports showing curve inputs, daily discount factors, and valuations for each cleared swap position. It is also worth noting that those interest rate swaps that are the subject of this proposal are capable of being priced off of deep and liquid debt markets. Because of the stability of access to pricing data from these markets, the pricing data for non-exotic interest rate swaps that are currently being cleared is generally viewed as non-controversial. In response to the NPRM, Citadel commented that its experience regarding trading liquidity further lead it to conclude that there is sufficient data in the market for DCOs to perform required pricing and risk management of the classes of swaps included in the proposed rule. Finally, Citadel commented that access to reliable pricing data will only improve over time as the Dodd-Frank rules promoting transparency are implemented. No other comments were received on this factor. Based on consideration of the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data, as described in the NPRM, the Commission is reaffirming in this release its decision to include interest rate swaps with the following specifications in the clearing requirement rule and to consider the other four factors identified in section 2(h)(2)(D) of the CEA with respect to these swaps. TABLE 5—INTEREST RATE SWAP DETERMINATION sroberts on DSK5SPTVN1PROD with Specification 1. 2. 3. 4. 5. Fixed-to-floating swap class Currency ..................................................... Floating Rate Indexes ................................ Stated Termination Date Range ................ Optionality .................................................. Dual Currencies ......................................... VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 U.S. Dollar (USD) ...... LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. PO 00000 Frm 00028 Fmt 4701 Euro (EUR) ................ EURIBOR ................... 28 days to 50 years ... No .............................. No .............................. Sfmt 4700 Sterling (GBP) ............ LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. E:\FR\FM\13DER2.SGM 13DER2 Yen (JPY). LIBOR. 28 days to 30 years. No. No. Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations 74311 TABLE 5—INTEREST RATE SWAP DETERMINATION—Continued 6. Conditional Notional Amounts ................... No .............................. No .............................. Specification 1. 2. 3. 4. 5. 6. Currency ..................................................... Floating Rate Indexes ................................ Stated Termination Date Range ................ Optionality .................................................. Dual Currencies ......................................... Conditional Notional Amounts ................... U.S. Dollar (USD) ...... LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Currency ..................................................... Floating Rate Indexes ................................ Stated Termination Date Range ................ Optionality .................................................. Dual Currencies ......................................... Conditional Notional Amounts ................... sroberts on DSK5SPTVN1PROD with b. Availability of Rule Framework, Capacity, Operational Expertise and Resources, and Credit Support Infrastructure Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to take into account the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the proposed classes of swaps on terms that are consistent with the material terms and trading conventions on which they are now traded. The Commission stated in the NPRM that it believed that LCH and CME,129 have developed rule frameworks, capacity, operational expertise and resources, and credit support infrastructure to clear the interest rate swaps they currently clear on terms that are consistent with the material terms and trading conventions on which those swaps are being traded. The Commission noted that LCH already clears more than half the global interest rate swaps in the four proposed classes of the clearing requirement and that CME also already cleared the more commonly traded swaps under this 129 IDCH was also included in this discussion in the NPRM. However, as discussed above, IDCH has been acquired by LCH and is now LCH.LLC and its rules and product offering are being revised to be substantially the same as LCH’s. Accordingly, the rule frameworks, capacity, operational expertise and resources, and credit support infrastructure for IDCH is not discussed in this final release, but is being assessed by the Commission as part of LCH.LLC’s request for approval of its rulebook and risk management framework revisions. 20:43 Dec 12, 2012 Sterling (GBP) ............ LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Yen (JPY). LIBOR. 28 days to 30 years. No. No. No. U.S. Dollar (USD) ...... LIBOR ........................ 3 days to 3 years ....... No .............................. No .............................. No .............................. Euro (EUR) ................ EURIBOR ................... 3 days to 3 years ....... No .............................. No .............................. No .............................. Sterling (GBP) ............ LIBOR ........................ 3 days to 3 years ....... No .............................. No .............................. No .............................. Yen (JPY). LIBOR. 3 days to 3 years. No. No. No. Overnight Index Swap Class Currency ..................................................... Floating Rate Indexes ................................ Stated Termination Date Range ................ Optionality .................................................. Dual Currencies ......................................... Conditional Notional Amounts ................... VerDate Mar<15>2010 Euro (EUR) ................ EURIBOR ................... 28 days to 50 years ... No .............................. No .............................. No .............................. Forward Rate Agreement Class Specification 1. 2. 3. 4. 5. 6. No. Basis Swap Class Specification 1. 2. 3. 4. 5. 6. No .............................. Jkt 229001 U.S. Dollar (USD) ...... FedFunds ................... 7 days to 2 years ....... No .............................. No .............................. No .............................. Euro (EUR) ................ EONIA ........................ 7 days to 2 years ....... No .............................. No .............................. No .............................. clearing requirement proposal. The Commission further notes that CME has recently added, or has stated publicly that it intends to add by the end of 2012, swaps in all four classes and at least the four currencies included in the final rule. The Commission also noted that the DCOs each developed their interest rate swap clearing offerings in conjunction with market participants and in response to the specific needs of the marketplace. In this manner, the clearing services of each DCO are designed to be consistent with the material terms and trading conventions of a bilateral, uncleared market. LCH submitted that it has the capability and expertise to manage the risks inherent in the current book of interest rate swaps cleared and the increased volume that the clearing requirement could generate for all of its currently clearable products. LCH has developed operational models, controls, and risk algorithms to ensure that it can process trades, and is capable of calculating the level of risk it has with any counterparty—both direct clearing members and their customers. CME’s IRS submission cited to its rule books to demonstrate the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear qualified, interest rate swap contracts on terms that are consistent with the material terms and trading conventions on which the contracts are then traded. PO 00000 Frm 00029 Fmt 4701 Sfmt 4700 Sterling (GBP). SONIA. 7 days to 2 years. No. No. No. After considering the information provided by the DCOs in the IRS submissions and the nature and extent of clearing already undertaken by the DCOs of existing bilateral swaps, the Commission concluded in the NPRM that there is available rule framework, capacity, operations expertise and resources, and credit support infrastructure consistent with the material terms and trading conventions on which the swaps included in the four interest rate swap classes are designated. Citadel commented that the fact that all swaps included in the four interest rate swap classes are being cleared in material volumes provides clear evidence that there is the rule framework, capacity, operational expertise and resources, and credit support infrastructure necessary to clear each of the swaps that are included in the Commission’s determination. Further, Citadel stated that because registered DCOs are required to be in compliance on an on-going basis with the DCO core principles in the CEA, they ‘‘by definition’’ have demonstrated that they satisfy this factor. In addition, Citadel noted that the DCOs have been preparing for and anticipating increased volumes as a result of the clearing requirement since the enactment of the Dodd-Frank Act, if not earlier. Also, under the Commission’s implementation rule,130 there is a 270130 77 E:\FR\FM\13DER2.SGM FR at 44441–44456. 13DER2 74312 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with day period provided to allow DCOs, customers, FCMs, and all others engaged in the clearing process to test and ramp up customer clearing volumes voluntarily, and be in position to manage full production clearing volumes during the phase-in of the clearing requirement. Citadel stated that it believed the DCOs and FCMs are well prepared for a surge in clearing volumes and have the framework, capacity, expertise, resources and infrastructure to support it in a safe and sound manner and that Citadel’s own experience in commencing voluntary clearing of swaps confirms its observations. For the reasons described above, and as discussed in the NPRM, the Commission reaffirms that there is available rule framework, capacity, operations expertise and resources, and credit support infrastructure consistent with the material terms and trading conventions on which the swaps included in the four interest rate swap classes are designated. c. Effect on the Mitigation of Systemic Risk Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to consider the effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the DCO available to clear the contract. CME, LCH, and IDCH stated in their IRS submissions that subjecting interest rate swaps to central clearing would help mitigate systemic risk. As stated above in the analysis of interest rate swap market data, the Commission believes that the market for these swaps is significant and mitigating counterparty risk through clearing likely would reduce systemic risk in the swap market and the financial system as a whole. According to LCH’s IRS submission, if all clearable swaps are required to be cleared, the inevitable result will be a less disparate marketplace from a systemic risk perspective. CME submits that the 2008 financial crisis demonstrated the potential for systemic risk arising from the interconnectedness of OTC derivatives market participants and that centralized clearing will reduce systemic risk. IDCH stated in its IRS submission that, given the tremendous size of the interest rate derivatives market, the potential mitigation of systemic risk through centralized clearing of interest rate swaps is significant. IDCH asserted that clearing such swaps brings the risk mitigation and collateral and operational efficiency afforded to cleared and exchange-traded futures contracts to bilaterally negotiated OTC VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 interest rate derivatives. The submission of interest rate swaps for clearing affords the parties the credit, risk management, capital, and operational benefits of central counterparty clearing of such transactions, and facilitates collateral efficiency. Cleared swaps allow market participants to free up counterparty credit lines that would otherwise be committed to open bilateral contracts. Additionally, according to IDCH, an efficient system for centralized clearing allows parties to mitigate the risk of a bilateral OTC derivative. Instead of holding offsetting positions with different counterparties and being exposed to the risk of each counterparty, a party may enter into an economically offsetting position that is cleared. Although the positions are not offset, the initial margin requirement will be reduced to close to zero. To eliminate risk without using centralized clearing, the party must enter into a tear-up agreement with the counterparty, or enter into a novation. While the clearing requirement would remove a large portion of the interconnectedness of current OTC markets that leads to systemic risk, the Commission noted in the NPRM that central clearing concentrates risk in a handful of entities. However, the Commission observed that central clearing was developed and designed to handle such concentration of risk. LCH has extensive experience risk managing very large volumes of interest rate swaps. Based on available data, it is believed that about half of all interest rate swaps transacted are cleared by LCH. CME submitted that it has the necessary resources available to clear the swaps that are the subject of its submission. The Commission notes that CME or its predecessors have cleared futures since 1898 and is the largest futures clearinghouse in the world. CME has not defaulted during that time. Accordingly, the Commission stated in the NPRM, and reaffirms in this release that it believes that LCH and CME have the resources needed to clear the interest rate swaps included in its determination and to manage the risk posed by clearing interest rate swaps that are required to be cleared. In addition, the Commission believes that the central clearing of the interest rate swaps that are the subject of this determination and final rule would serve to mitigate counterparty credit risk thereby having a positive effect on reducing systemic risk. In support of the Commission’s determination regarding systemic risk, Citadel commented that the transition from an interconnected network of bilateral derivatives exposures to central PO 00000 Frm 00030 Fmt 4701 Sfmt 4700 clearing in regulated clearing houses will mitigate systemic risk. In support of this assertion, Citadel cited a New York Federal Reserve Board staff paper 131 and noted that central clearing stands as a pillar of the Dodd-Frank Act. Citadel explained that central clearing eliminates the prospect of firms becoming too interconnected to fail by virtue of their bilateral swap positions and ensures that sufficient margin is reserved against each side of each swap, while further mitigating any default event through mutualization funds, clearing member obligations, and the additional financial safeguards of the regulated DCO. Citadel further asserted that the Commission’s determination takes the decisive step, long anticipated and prepared for by the market, of making mandatory central clearing of the most liquid and standardized swaps a reality. Citadel went on to express confidence that the transition to required clearing of liquid swaps will support and incentivize the expansion of the cleared product set, because it will be more economically efficient for market participants to hold as much of their portfolios as possible in a single margined basket at a DCO. Citadel concluded that the Commission’s clearing requirement rule thus provides the certainty needed for market participants to transition more of their swap portfolios from bilateral to cleared trades, thereby reducing or eliminating bilateral counterparty credit risk, and by extension, systemic risk. By contrast, ISDA commented on how mandatory clearing may centralize risk in DCOs and questioned the riskmitigating aspects of central clearing as contrasted with the new regulatory regime for uncleared swaps. ISDA also questioned the Commission’s assertion that central clearing was designed to address the concentration of risk. In response to ISDA’s comment, the Commission observes that while the regime for bilateral, uncleared swaps will be greatly improved after full implementation of the Dodd-Frank Act reforms, central clearing provides for certain risk management features that cannot be replicated on a bilateral basis. To name just one critical distinction, a clearinghouse addresses the tail risk of open positions through mutualization. Each clearing member must contribute to a default fund that protects the system as a whole. 131 See, e.g., Policy Perspectives on OTC Derivatives Market Infrastructure by Duffie, Li, and Lubke (March 2010), available at http:// www.newyorkfed.org/research/staff_reports/ sr424.pdf. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations d. Effect on Competition Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to take into account the effect on competition, including appropriate fees and charges applied to clearing. Of particular concern to the Commission is whether the determination would harm competition by creating, enhancing, or entrenching market power in an affected product or service market, or facilitating the exercise of market power. Market power is viewed as the ability to raise price, including clearing fees and charges, reduce output, diminish innovation, or otherwise harm customers as a result of diminished competitive constraints or incentives.132 In the NPRM, the Commission identified one putative service market as potentially affected by this proposed clearing determination: a DCO service market encompassing those clearinghouses that currently (or with relative ease in the future could) clear the interest rate swaps subject to this proposal. The Commission recognized that, depending on the interplay of several factors, the clearing requirement potentially could impact competition within the affected market and discussed various factors that could impact that market. As discussed above, in support of the NPRM, Citadel stated that the clearing requirement will have a strong positive impact on competition in the swap market and the market for clearing services. Citadel noted that central clearing will remove a significant barrier to entry for alternative swap market liquidity providers and will enable smaller entities to compete on more equal terms because central clearing eliminates the consideration of counterparty credit risk from the selection of execution counterparties. Citadel further commented that buy-side market participants will benefit from a wider range of potential execution counterparties and asserted that this increased competition yields benefits to market participants including narrower bid-ask spreads, improved access to best execution, and increased market depth and liquidity, all of which establish a prerequisite for the emergence of an allto-all market with electronic and/or anonymous execution. Citadel also commented that substitution of the DCO for the bilateral counterparty decouples execution from post-trade processing and settlement. Finally, Citadel commented that the certainty as to when the first clearing requirement will begin gives DCOs and FCMs the 132 See Section II.D above for a more detailed discussion of these issues. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 confidence to invest in their client clearing offerings, and to compete actively for buy-side business both on the quality and efficiency of their services as well as on price. FIA commented that the NPRM included a full discussion of the potential competitive impact of the clearing proposal. However, as discussed above, FIA indicated that it was unable to conduct the analysis it believes would be necessary to respond to the Commission’s questions in the NPRM within the 30-day comment period provided. In response to FIA’s comment, the Commission notes that the 30-day public comment period was necessary for the Commission to adhere to the CEA’s 90-day determination process. Moreover, while FIA indicated that it would like more time to conduct further analysis of competitive issues for future determinations, FIA did not identify any specific concerns about the competitiveness issue analysis that could materially change the Commission’s determination if such additional information were made available to the Commission. The comments provided by Citadel are consistent with the NPRM’s conclusion that the clearing requirement potentially could impact competition within the affected market, but go on to assert that such an impact would not be negative. Accordingly, the Commission believes that its consideration of competitiveness as described in the NPRM is sufficient for purposes of finalizing the clearing requirement rule. e. Legal Certainty in the Event of the Insolvency Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to take into account the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property. The Commission’s proposal was based on its view that there is reasonable legal certainty with regard to the treatment of customer and swap counterparty positions, funds, and property in connection with cleared swaps, namely the interest rate swaps subject to the proposal, in the event of the insolvency of the relevant DCO or one or more of the DCO’s clearing members. In the case of a clearing member insolvency at CME or IDCH (now, LCH.LLC), i.e., DCOs subject to the bankruptcy laws of the United States, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11 U.S.C. 761–767) PO 00000 Frm 00031 Fmt 4701 Sfmt 4700 74313 and Part 190 of the Commission’s regulations would govern the treatment of customer positions.133 Pursuant to section 4d(f) of the CEA, a clearing member accepting funds from a customer to margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C. 761–767 and Part 190 of the Commission’s regulations, the customer’s interest rate swap positions, carried by the insolvent FCM, would be deemed ‘‘commodity contracts.’’ 134 As a result, neither a clearing member’s bankruptcy nor any order of a bankruptcy court could prevent a United States domiciled DCO from closing out/liquidating such positions.135 However, customers of clearing members would have priority over all other claimants with respect to customer funds that had been held by the defaulting clearing member to margin swaps, such as the interest rate swaps included in the clearing determination.136 Customer funds would be distributed to swap customers, including interest rate swap customers, in accordance with Commission regulations and section 766(h) of the Bankruptcy Code. Moreover, the Bankruptcy Code and the Commission’s rules thereunder (in particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of customer positions and collateral to solvent clearing members. Similarly, 11 U.S.C. 761–767 and Part 190 would govern the bankruptcy of a DCO, in conjunction with DCO rules providing for the termination of outstanding contracts and/or return of remaining clearing member and customer property to clearing members. With regard to LCH, the Commission understands that the default of a clearing member of LCH would be governed by the rules of that DCO. LCH, a DCO based in the United Kingdom, has represented that under English law its rules would supersede English insolvency laws. Under its rules, LCH would be permitted to close out and/or transfer positions of a defaulting clearing member that is an FCM 133 The Commission observes that an FCM or DCO also may be subject to resolution under Title II of the Dodd-Frank Act to the extent it would qualify as covered financial company (as defined in section 201(a)(8) of the Dodd-Frank Act). 134 If an FCM is also registered as a broker-dealer, certain issues related to its insolvency proceeding would also be governed by the Securities Investor Protection Act. 135 See 11 U.S.C. 556 (‘‘The contractual right of a commodity broker [which term would include a DCO or FCM] * * * to cause the liquidation, termination or acceleration of a commodity contract * * * shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Bankruptcy Code] or by order of a court in any proceeding under [the Bankruptcy Code]’’). 136 See 11 U.S.C. 766(h). E:\FR\FM\13DER2.SGM 13DER2 74314 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations pursuant to the U.S. Bankruptcy Code and Part 190 of the Commission’s regulations. According to LCH’s submission, the insolvency of LCH itself would be governed by both English insolvency law and Part 190. LCH has obtained legal opinions that support the existence of such legal certainty in relation to the protection of customer and swap counterparty positions, funds, and property in the event of the insolvency of one or more of its clearing members. In addition, LCH has obtained a legal opinion from U.S. counsel regarding compliance with the protections afforded to FCM customers under New York law. In response to the NPRM, Citadel commented that it agreed with the Commission’s analysis that reasonable certainty exists in the event of an insolvency of a DCO or one or more DCO members. As discussed above, the Commission received three comments related to customer segregation. In essence, Vanguard and SIFMA AMG recommend that the Commission delay implementation of the clearing requirement until three months after the LSOC model is implemented, clarified, and perhaps supplemented with additional rulemaking. ISDA requests that the Commission further study the issue of insolvency for DCOs. As stated above, the Commission believes that the concerns of Vanguard and SIFMA AMG are largely addressed by the delayed implementation timeframe for this determination. With regard to ISDA’s request, as discussed above, the Commission is actively engaging in efforts to study and prepare for potential scenarios involving clearinghouse and clearing member insolvency. sroberts on DSK5SPTVN1PROD with iii. Conclusions Regarding the Five Statutory Factors and Clearing Requirement Determination In the foregoing discussion and analysis, the Commission has taken into account each of the five factors provided for under section 2(h)(2)(D)(ii) of the CEA for the interest rate swap classes that are the subject of this determination. Based on these considerations, and having reviewed the relevant DCOs’ submissions for consistency with section 5b(c)(2) of the CEA, the Commission is determining that the four classes of interest rate swaps identified in § 50.4(a) are required to be cleared. III. Final Rules The Commission is adopting the following rules under section 2(h)(2), as well as its authority under sections 5b(c)(2)(L) and 8a(5) of the CEA. In VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 issuing a determination regarding whether a swap or class of swaps is required to be cleared, ‘‘the Commission may require such terms and conditions to the requirement as the Commission determines to be appropriate.’’ 137 A. Regulation 50.1: Definitions As proposed, § 50.1 set forth two defined terms: ‘‘business day’’ and ‘‘day of execution.’’ The definition of business day excluded Saturdays, Sundays, and legal holidays. The definition of ‘‘day of execution’’ served as a means of addressing situations where executing counterparties are located in different time zones. It was intended to avoid difficulties associated with end-of-day trading by deeming swaps executed after 4:00 p.m., or on a day other than a business day, to have been executed on the immediately succeeding business day. The Commission recognized that market participants should not be required to maintain back-office operations 24 hours a day or 7 days a week in order to meet the proposed deadline for submitting swaps that are required to be cleared to a DCO. The Commission also was attempting to be sensitive to possible concerns about timeframes that may discourage trade execution late in the day. To account for time-zone issues, the ‘‘day of execution’’ was defined to be the calendar day of the party to the swap that ends latest, giving the parties the maximum amount of time to submit their swaps to a DCO while still requiring such submission on a same-day basis. The Commission received two comments on these definitions. LCH commended the Commission for including flexibility on the timing of swap submission for those swaps executed late in the day, but requested that the Commission clarify that DCOs can continue to accept swaps for clearing late in the day. In response to this request, the Commission confirms that the 4:00 p.m. cut off for same-day submission to a DCO is intended to give market participants flexibility and respond to concerns about counterparties in different time zones. This definition should not be interpreted as a prohibition on late-day submission of swaps to DCOs or as impeding DCO’s ability to accept such swaps. FIA observed an apparent conflict between the proposed definitions of ‘‘business day’’ and ‘‘day of execution’’ and regulation 23.506(b).138 As with 137 Section 2(h)(2)(D)(iii) of the CEA. regulation directs swap dealers and major swap participants to submit swaps subject to the 138 This PO 00000 Frm 00032 Fmt 4701 Sfmt 4700 LCH, FIA’s concern focused on the ability of DCOs to expand their business hours. As explained above, the definitions do not proscribe a DCO’s ability to set business hours. Accordingly, the Commission is adopting the definitions as proposed. B. Regulation 50.2: Treatment of Swaps Subject to a Clearing Requirement As proposed, § 50.2(a) required all persons, other than those who elect the exception in accordance with § 39.6 (now § 50.50),139 to submit a swap that is part of the class described in § 50.4 for clearing by a DCO as soon as technologically practicable and no later than the end of the day of execution. The objective of this provision was to ensure that swaps subject to a clearing requirement are submitted to DCOs for clearing in a timely manner. ISDA recommended that the Commission clarify the rule text to recognize that non-clearing members are deemed to have met the requirements of § 50.2 once they submit the swap to their FCM clearing member. ISDA also requested that the Commission recognize that in some cross-border transactions clearing members will not necessarily be FCMs. Similarly, ISDA asked that there be an exclusion for foreign governments and governmental entities as set forth in the end-user exception final rulemaking. Lastly, ISDA asked that there be an exception in the rule for system outages and force majeure events. In response to ISDA’s first comment, the Commission is modifying the rule text by adding new paragraph (c) to clarify that submission of a swap to an FCM or a DCO clearing member is sufficient to meet the timeliness requirements of the rule. For U.S. customers, this will mean submission to a registered FCM. For cross-border transactions, the Commission recognizes that submission of the swap may be to a non-FCM clearing member when the customer is not a U.S. person.140 clearing requirement to a DCO as soon as technologically practicable after execution, but no later than the close of business on the day of execution. See 17 CFR 23.506(b), 77 FR 21278, 21307 (Apr. 9, 2012). To the extent that a swap dealer or major swap participant is subject to both § 23.506(b) and § 50.2(a), the entity should comply with § 23.506(b) when its counterparty is another swap dealer or major swap participant, but if the swap is between a swap dealer and a non-swap dealer, then the non-swap dealer counterparty can elect to follow the timing requirements of § 50.2(a) or § 23.506(b). 139 The Commission is recodifying § 39.6 as § 50.50 so that market participants are able to locate all rules related to the clearing requirement in one part of the Code of Federal Regulations. 140 If the person submitting the swap is a customer, as § 1.3(k) defines that term, then only a E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with With regard to foreign governments and governmental entities, the Commission reiterates the position taken in the end-user exception rulemaking that ‘‘foreign governments, foreign central banks, and international financial institutions should not be subject to Section 2(h)(1) of the CEA.’’ 141 Finally, the Commission declines to include an explicit exception for unforeseen outages and other events. The Commission recognizes that these situations may occur and has adopted rules relating to system safeguards and disaster recovery for market infrastructures 142 and market participants.143 However, none of the straight-through-processing rules adopted by the Commission included carve-outs for system outages or force majeure events,144 and the Commission does not believe it is necessary to include such provisions in this rule. In the case of serious market-wide disruptions, the Commission would take this mitigating fact into account in reviewing compliance with § 50.2. Additionally, in an effort to clarify that a market participant does not have to submit a swap that falls within the § 50.4 classes, but that the entity knows are not offered for clearing by any DCO because the swap contains specifications that are not accepted for clearing, the Commission is modifying the text of § 50.2 to include a reference to ‘‘eligible’’ DCOs that offer such swaps for clearing. Proposed § 50.2(b) would require persons subject to § 50.2(a) to undertake reasonable efforts to determine whether a swap is required to be cleared. In the NPRM, the Commission indicated that it would consider such reasonable efforts to include checking the Commission’s Web site or the DCO’s Web site for verification of whether a swap is required to be cleared, or consulting third-party service providers for such verification. CME commented on the Commission’s observation in the NPRM that DCOs could design and develop registered FCM may accept that swap for clearing, even if the customer seeks to clear the swap on a DCO located outside of the U.S. 141 See End-User Exception to the Clearing Requirement for Swaps, 77 FR 42560, 42562 (July 19, 2012). 142 See, e.g., Derivatives Clearing Organization General Provisions and Core Principles, 76 FR 69334, 69443–69444 (Nov. 8, 2011) (adopting § 39.18 relating to system safeguards). 143 See Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules, 77 FR 20128, 20208–20209 (Apr. 3, 2012) (adopting § 23.603 relating to business continuity and disaster recovery). 144 Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management, 77 FR 21278, 21307 (Apr. 9, 2012). VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 systems that will enable market participants and trading platforms to check whether or not their swap is subject to a clearing requirement and be provided with an answer within seconds (or faster). CME stated that its platform already provides market participants with a tool to screen a particular swap for eligibility for clearing upon submission to CME. The Commission recognizes that this technological capability will be beneficial to market participants, particularly pre-execution, and is necessary to ensure timely clearing of swaps subject to the clearing requirement. Freddie Mac observed that § 50.2(a) and (b) could be interpreted to require two different standards of care: strict liability for the former and a reasonable inquiry standard for the latter. In response to Freddie Mac’s comment, the Commission clarifies that § 50.2(a) establishes a requirement regarding the timely submission of swaps to DCOs. It is a bright-line standard, but it is not intended to introduce a new scienter requirement regarding submission for clearing beyond that provided for in the statute.145 With regard to § 50.2(b), the Commission’s objective was to afford market participants clarity about what efforts they must expend in determining whether their swaps are required to be cleared. In the absence of some central screening mechanism available to all market participants for the purpose of immediately determining whether any eligible DCO offers a particular swap for clearing,146 the Commission believes it appropriate to provide clarity regarding what constitutes reasonable search or verification efforts.147 C. Regulation 50.3: Notice to the Public The Commission proposed § 50.3(a) to require each DCO to post on its Web site a list of all swaps that it will accept for clearing and clearly indicate which of those swaps the Commission has determined are required to be cleared pursuant to part 50 of the Commission’s regulations and section 2(h)(1) of the CEA. ISDA commented that DCOs should provide swap information, including product specifications, in a manner that is easy to access and use. ISDA also called upon DCOs to provide at least 145 See Section III.G for further discussion regarding scienter. 146 See discussion in Section II.E regarding LCH’s and CME’s efforts to provide such a screening mechanism. 147 The Commission notes that it will consider whether verification efforts are reasonable in light of all the facts and circumstances of a market participant’s particular situation. PO 00000 Frm 00033 Fmt 4701 Sfmt 4700 74315 one-month’s advance notice for new swaps that they plan to accept for clearing and to provide a description of the margin methodology used in clearing the swap. The Commission agrees that DCOs should provide information in a manner that is easy to use and accessible to the public. Regulation § 50.3(b) builds upon the requirements of § 39.21(c)(1), which requires each DCO to disclose publicly information concerning the terms and conditions of each contract, agreement, and transaction cleared and settled by the DCO. The Commission also welcomes ISDA’s suggestion that DCOs voluntarily provide advance notice of new swaps that they plan to clear and make relevant information regarding their margining methodologies available.148 LCH commented that it is committed to revising the information on its Web site so that it is provided in a format that is easily understandable by all swaps counterparties, including customers. Regulation § 50.3(b) requires the Commission to post on its Web site a list of those swaps it has determined are required to be cleared and all DCOs that are eligible to clear such classes of swaps. No comments were received on this provision. The Commission is adopting the rule as proposed in order to provide market participants with sufficient notice regarding which swaps are subject to a clearing requirement. For clarification, the Commission will include on its Web site any swaps that it has determined through delegated authority under § 50.6 fall within a class of swaps described in § 50.4. D. Regulation 50.4: Classes of Swaps Required To Be Cleared As discussed at length above, proposed § 50.4 set forth the classes of interest rate swaps and CDS that the Commission proposed for required clearing. Proposed § 50.4(a) included a table listing those types of interest rate swaps the Commission would require to be cleared, and proposed § 50.4(b) included a table listing those types of CDS indices the Commission would require to be cleared. ISDA recommended that the Commission clarify that the stated termination date ranges in § 50.4(a) be applied only at trade inception for purposes of determining whether the swap is required to be cleared. The Commission confirms ISDA’s 148 17 CFR 39.21 requires that DCOs provide market participants with ‘‘sufficient information to enable the market participants to identify and evaluate accurately the risks and costs associated with using the services’’ of the DCO. E:\FR\FM\13DER2.SGM 13DER2 74316 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations understanding of the stated termination date range applying only at trade inception or upon an ownership event change, as discussed in detail below. As discussed above, the Commission is adopting § 50.4(a) and (b). The Commission believes that this format provides market participants with a clear understanding of which swaps are required to be cleared. By using basic specifications to identify the swaps subject to the clearing requirement, counterparties contemplating entering into a swap can determine quickly as a threshold matter whether or not the particular swap may be subject to a clearing requirement. If the swap has the basic specifications of a class of swaps determined to be subject to a clearing requirement, the parties will know that they need to verify whether an eligible DCO will clear that particular swap. This will reduce the burden on swap counterparties related to determining whether a particular swap may be subject to the clearing requirement. sroberts on DSK5SPTVN1PROD with i. Disentangling Complex Swaps TriOptima commented that the complete swap must be assessed against the clearing requirement and parties should not be required to disentangle non-clearable swaps in order to clear the clearable components. The Commission confirms TriOptima’s view regarding those swaps that may have components that can be cleared, but would require disentangling the clearable part of the swap. Adherence to the clearing requirement does not require market participants to structure their swaps in a particular manner or disentangle swaps that serve legitimate business purposes.149 ii. Swaptions and Extendible Swaps In response to the Commission’s inquiry in the NPRM regarding how to treat a swap that becomes effective upon the exercise of a swaption, ISDA suggested that the resulting swap should only be required to be cleared if the underlying swap and the counterparties to the swap were subject to a clearing requirement at the time that the swaption was executed. ISDA also commented that the same approach should apply to extendible swaps, i.e., a swap for which a party has the option to extend the term of the swap. ISDA reasoned that the parties to a swaption or an extendible swap would not have taken into account the cost of clearing the resultant swap if they negotiated the price of the option before a clearing 149 See discussion below regarding § 50.10 and the evasion and abuse standards. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 requirement was applicable to the underlying swap or extended swap. LCH similarly commented that a swaption entered into before a clearing requirement is applicable to the underlying swap would not have been priced with an expectation that the swap created on exercise would be cleared. For this reason, LCH also stated that an underlying swap of a swaption should be subject to an applicable clearing requirement only if the swaption was entered into after the clearing requirement applicable to the underlying swap becomes effective. The Commission agrees that the cost of clearing may not be reflected in the pricing of the swaption or extendible swap if the clearing requirement for the underlying swap or the extendable swap arises after the execution of the swaption or extendible swap. The Commission is thus clarifying that the clearing requirement only applies to swaps resulting from the exercise of a swaption or extendible swap extension if the clearing requirement would have been applicable to the underlying swap or the extended swap at the time the counterparties executed the swaption or extendible swap. iii. Ownership Event Changes In the NPRM, the Commission asked whether it should clarify that the clearing requirement applies to all new swaps and changes in the ownership of a swap, including assignment, novation, exchange, transfer, or conveyance. ISDA responded that a swap that is not subject to the clearing requirement at the time it is executed should not become subject to it upon an ownership event change unless the parties can agree on pricing and other terms necessary to reflect the costs of clearing and until the swap can be transitioned from uncleared to cleared with accuracy.150 As the Commission acknowledged above, the cost of clearing may not be reflected in the pricing of a swap if the clearing requirement arises after the execution of that swap. However, unlike with the exercise of a swaption, typically, the original counterparties to a swap that is assigned, novated, exchanged, transferred, or conveyed, along with the new party in ownership, each have an opportunity to revisit the terms of the original swap and account 150 Aside from a general assertion about the challenges of selecting a DCO for clearing, ISDA did not elaborate on its implied assertion that swaps subject to ownership changes may be difficult to transition to clearing accurately. PO 00000 Frm 00034 Fmt 4701 Sfmt 4700 for new costs.151 While there may be cost implications for the remaining party when its counterparty changes, these cost implications can arise for any number of foreseeable or unforeseeable reasons,152 and if the remaining party is concerned about potential cost implications resulting from a change of its counterparty, it would be able to protect itself through the terms of the swap, such as including consent rights or required price adjustments upon such an event.153 The Commission is concerned that if such swaps are not treated as new swaps for the purposes of the clearing requirement, it could be creating incentives to ‘‘trade’’ historical swaps through the assignment, novation, exchange, transfer, or conveyance processes to avoid required clearing. Accordingly, for purposes of this rule, a change in ownership of a swap would subject the swap to required clearing under section 2(h)(1) of the CEA in the same manner and to the same extent as a newly executed swap. Furthermore, for swaps executed after the clearing requirement is in place, the Commission also believes it is important to clarify that a change in ownership may result in a requirement to clear. For example, a financial entity and an end user under section 2(h)(7) of the CEA enter into a swap that is not required to be cleared, and later if the end user transfers its ownership interest in the swap to another party that is a financial entity not eligible to claim an exception under section 2(h)(7), then the swap would be required to be cleared if the other prerequisites to the requirement exist. E. Regulation 50.5: Clearing Transition Rules As proposed, § 50.5 would codify section 2(h)(6) of the CEA. Under proposed § 50.5(a), swaps that are part of a class described in § 50.4 but were entered into before the enactment of the Dodd-Frank Act would be exempt from clearing so long as the swap is reported to an SDR pursuant to § 44.02 and section 2(h)(5)(A) of the CEA. Similarly, under proposed § 50.5(b), swaps entered 151 Going forward, prior to or at the time of ownership change, parties will have to account for any additional costs of clearing. 152 For example, an ownership change for a bilateral swap may have foreseeable or unforeseeable credit or tax implications for the remaining party. 153 The Commission observes that the ISDA Master Agreement used for most bilateral swaps requires the prior written consent of the remaining party for any transfer of the agreement other than for certain limited transfers of payments upon default or upon a merger, acquisition, or transfer of all assets. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with into after the enactment of the DoddFrank Act but before the application of the clearing requirement would be exempt from the clearing requirement if reported pursuant to § 44.03 and section 2(h)(5)(B) of the Act. LCH suggested that the Commission change the citations in § 50.5(a) from § 44.02 to § 46.3, and in § 50.5(b) from § 44.03 to § 45.3 for swaps entered after the enactment of the Dodd-Frank Act but prior to the compliance date for reporting to an SDR and to § 45.3 for swaps entered into after the compliance date for SDR reporting but prior to the application of a clearing requirement. The Commission agrees with LCH and is modifying the rule to provide more accurate cross references to parts 45 and 46. In addition, under § 50.5(b), the Commission cross references § 46.3 or § 45.3, as appropriate, because until April 2013, certain market participants may properly rely on § 46.3 for reporting swaps executed after the enactment of the Dodd-Frank Act. F. Regulation 50.6: Delegation of Authority Under proposed § 50.6(a), the Commission would delegate to the Director of the Division of Clearing and Risk, or the Director’s designee, with the consultation of the General Counsel or the General Counsel’s designee, the authority to determine whether a swap falls within a class of swaps described in § 50.4 and to communicate such a determination to the relevant DCOs. ICE supported the Commission’s proposal and agreed that this approach would allow DCOs to add new swaps in a timely and efficient manner and rely on the DCOs’ risk management processes and governance for adding new products to an existing class. Citadel also supported the proposed delegation provision based on the view that the Commission carefully oversees DCO risk management and it is beneficial to move products into clearing without excessive delay. LCH generally supported the Commission’s proposal, but requested confirmation that if the DCO makes a material change to an existing type of swap, the Commission would follow the full clearing requirement determination process. By contrast, ISDA objected to proposed § 50.6 based on a concern that the Commission would be delegating the clearing determination for DCO product expansions to the DCOs themselves, which would contradict the requirement that the Commission review each DCO submission under section 2(h)(2)(B)(iii)(II) of the CEA. Based on the breadth of the swaps VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 classes under § 50.4, ISDA commented that DCOs will be able to add new swaps under the clearing requirement without review by the Commission under the five statutory factors. ISDA recommended that the delegation provision be supplemented to include (1) a requirement that new DCO product offerings raise no materially different considerations regarding the Commission’s determination; (2) a public comment period; and (3) a compliance phase-in period of 90 days. In response to LCH’s request for clarification, the Commission confirms that if a DCO makes a material change to an existing type of swap, the Commission would follow the full clearing requirement determination process. Under the example provided by LCH—extending the tenor of swaps clearing—the DCO’s change would require a change to the rule text under § 50.4, which would require Commission action. In response to ISDA’s comments, the Commission observes that the proposed delegation provision was not intended to displace Commission review under section 2(h)(2)(B)(iii)(II) of the CEA. With respect to swaps within the classes identified in § 50.4 that are already being cleared by at least one DCO, the delegation provision will facilitate other DCOs’ ability to offer new swaps for required clearing so long as those swaps fall within one of the classes previously established by the Commission. With respect to swaps that meet the specifications identified in § 50.4, but have not been previously offered for clearing by any DCO, the Commission agrees with ISDA that the delegation is limited to those swaps that are consistent with the prior determination. For instance, if a new swap falls within a class under § 50.4, but clearing the swap requires that DCOs adopt a new margining methodology or pricing methodology, the Commission would subject that swap to a new clearing requirement determination process.154 Accordingly, the Commission is modifying the rule to limit the delegation authority to those instances where the newly submitted swap falls within the class under § 50.4 and is consistent with the Commission’s clearing requirement determination for that class of swaps. In addition, the Commission is modifying the rule to require that the Director of the Division of Clearing and Risk notify the 154 Without this delegation process a new swap that falls within a class under § 50.4 could have automatically been included in the clearing requirement without review. The delegation provision provides a check on that process. PO 00000 Frm 00035 Fmt 4701 Sfmt 4700 74317 Commission prior to exercising any authority delegated under § 50.6. The Commission declines to adopt ISDA’s other recommendations. Provided that inclusion of the new swaps under § 50.4 is consistent with the Commission’s previous clearing requirement determination, there is no need for an additional public comment period beyond that provided for as part of the initial clearing requirement determination process. Moreover, under the CEA and Commission regulation, any counterparty to a swap can apply for a stay of the clearing requirement.155 This stay provision would serve to notify the Commission of objections to inclusion of a particular swap in a previously-defined class. In addition, the Commission does not believe that an additional phase-in period is necessary. Provided that including the new swap is consistent with the prior determination, the compliance phasing for the original class will afford sufficient time for operational and systems implementation. If such time had not been sufficient, the Director of the Division of Clearing and Risk could submit the matter to the Commission for its consideration, or the Commission could itself exercise the delegated authority, under § 50.6(b). G. Regulation 50.10: Prevention of Evasion of the Clearing Requirement and Abuse of an Exception or Exemption to the Clearing Requirement The Commission proposed § 50.10 under the rulemaking authority in sections 2(h)(4)(A), 2(h)(7)(F), and 8a(5) of the CEA. Proposed § 50.10 would prohibit evasions of the requirements of section 2(h) of the CEA and abuse of any exemption or exception to the requirements of section 2(h), including the end-user exception or any other exception or exemption that the Commission may provide by rule, regulation, or order.156 Proposed § 50.10(a) would make it unlawful for any person to knowingly or recklessly evade, participate in, or facilitate an evasion of any of the requirements of section 2(h).157 This 155 See section 2(h)(3) of the CEA and regulation 39.5(d). 156 As noted in the proposing release, the Commission preliminarily viewed evasion of the clearing requirement and abuse of an exemption or exception to the clearing requirement, including the end-user exception, to be related concepts and are informed by new enforcement authority under the Dodd-Frank Act, which added new sections 6(e)(4)– (5), and 9(a)(6), to the CEA. See Proposed Clearing Requirement Determination, 77 FR 47170, 47207 (Aug. 7, 2012). 157 Proposed § 50.10(a) was informed by and consistent with section 6(e)(4) and (5) of the CEA, E:\FR\FM\13DER2.SGM Continued 13DER2 74318 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with would apply to any requirement under section 2(h) of the CEA or any Commission rule or regulation promulgated thereunder.158 In the proposing release, the Commission noted, however, that section 2(h)(1)(A) of the CEA provides that it ‘‘shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing’’ to a DCO if the swap is required to be cleared. Unlike the knowing or reckless standard under proposed § 50.10(a), section 2(h)(1)(A) imposes a non-scienter standard on swap market participants.159 Proposed § 50.10(b) would make it unlawful for any person to abuse the end-user exception to the clearing requirement as provided under section 2(h)(7) of the CEA and § 39.6 (now § 50.50).160 The proposing release stated that an abuse of the end-user exception to the clearing requirement may also, depending on the facts and circumstances, be an evasion of the requirements of section 2(h). The Commission’s preliminary view was informed by section 9(a)(6) of the CEA, which cross-references both the prevention of evasion authority in section 2(h)(4) and prevention of abuse to the exception to the clearing requirement in section 2(h)(7)(F).161 Thus, the Commission proposed to interpret a violation of section 9(a)(6) of the CEA to also be a violation of proposed § 50.10(b). Proposed § 50.10(c) would make it unlawful for any person to abuse any exemption or exception to the requirements of section 2(h) of the CEA, including any exemption or exception, which states that any DCO, swap dealer, or major swap participant that ‘‘knowingly or recklessly evades or participates in or facilitates an evasion of the requirements of section 2(h) shall be liable for a civil monetary penalty in twice the amount otherwise available for a violation of section 2(h).’’ 158 These requirements include the clearing requirement under section 2(h)(1), reporting of data under section 2(h)(5), and the trade execution requirement under section 2(h)(8), among other requirements. For example, it would be a violation of proposed § 50.10(a) for a SEF to knowingly or recklessly evade or participate in or facilitate an evasion of the trade execution requirement under section 2(h)(8). 159 Any person engaged in a swap that would be required to be cleared under section 2(h) and Part 50 of the Commission’s Regulations, and such person did not submit the swap for clearing, absent an exemption or exception, would be subject to a Commission enforcement action regardless of whether the person knowingly or recklessly failed to submit the swap for clearing. 160 See End-User Exception to the Clearing Requirement for Swaps, 77 FR 42560 (July 19, 2012). 161 Proposed § 50.10(b) is adopted under the authority in both section 2(h)(4)(A) and section 2(h)(7)(F). VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 as the Commission may provide by rule, regulation, or order.162 In the preamble to the NPRM, the Commission proposed to adopt a ‘‘principles-based’’ approach to applying proposed § 50.10 and declined to provide a bright-line test of nonevasive or abusive conduct, because such an approach may be a roadmap for engaging in evasive or abusive conduct or activities. The Commission, however, did propose additional guidance to provide clarity to market participants. The Commission proposed to determine on a case-by-case basis in light of all the relevant facts and circumstances, whether particular transactions or other activities constitute a violation of § 50.10. Similar to its approach in the final rules further defining the term ‘‘swap’’ (the ‘‘Product Definition Rules’’), the Commission proposed that it would not consider transactions or other activities structured in a manner solely motivated by a legitimate business purpose to constitute evasion or abuse.163 i. In General Four commenters discussed different aspects of proposed § 50.10, including the standard of intent that proposed § 50.10 requires and the proposed legitimate business purpose guidance. After considering the comments as discussed more fully below, the Commission has determined that § 50.10 is necessary to prevent evasion of the requirements of section 2(h) and abuses of any exemption or exception to the requirements of section 2(h). Therefore, the Commission is adopting § 50.10 as proposed, but the Commission is providing additional interpretive guidance regarding § 50.10 as set out below. ii. Standard of Intent Two commenters discussed the relevant standard of intent for proposed § 50.10. ISDA commented that § 50.10(a), (b), and (c) should be 162 This provision was informed by the DoddFrank Act amendments in section 2(h)(4)(A) to prescribe rules necessary to prevent evasions of the clearing requirements; section 2(h)(7)(F) to prescribe rules necessary to prevent abuse of the exceptions to the clearing requirements; and the Commission’s general rulemaking authority in section 8a(5) to promulgate rules that, in the judgment of the Commission, are reasonably necessary to accomplish any purposes of the CEA. 163 The Commission’s discussion of § 50.10 is similar to its approach for the anti-evasion rules §§ 1.3(xxx)(6) and 1.6 that it recently adopted in a joint final rulemaking with the Securities and Exchange Commission. See Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘SecurityBased Swap Agreement’’; Mixed Swaps; SecurityBased Swap Agreement Recordkeeping, 77 FR 48208, 48350–48354 (Aug. 13, 2012). PO 00000 Frm 00036 Fmt 4701 Sfmt 4700 governed by a single standard of intent. ISDA noted that proposed § 50.10(a) would make it unlawful for any person to ‘‘knowingly or recklessly’’ evade the requirements of section 2(h); whereas, proposed § 50.10(b) and (c) would make it unlawful to ‘‘abuse’’ exceptions or exemptions to the requirements of section 2(h). ISDA requested the Commission clarify that all three provisions are subject to a scienter standard. FreddieMac commented that the statutory ‘‘knowing or reckless’’ standard for evasion indicates that Congress intended that parties to a swap should be deemed in compliance with the clearing requirement at least where they have submitted a swap for clearing in good faith and have a reasonable expectation of clearing. In consideration of the comments, the Commission clarifies that it interprets the ‘‘knowingly or recklessly’’ standard in § 50.10(a) to be the same as the ‘‘abuse’’ standard in § 50.10(b) and (c). The Commission believes that a ‘‘knowingly or recklessly’’ standard is consistent with and an appropriate standard of intent for any ‘‘abuse’’ of any exemption or exception to the requirements of section 2(h). Additionally, the purpose of § 50.10 is to prevent evasion of the requirements under section 2(h) or to prevent an abuse of an exception or exemption to the requirements under section 2(h). Therefore, the Commission confirms that it would not constitute a violation of § 50.10 where a party submits a swap for clearing in good faith and the party has a reasonable expectation of clearing. iii. Legitimate Business Purpose Four commenters discussed the proposed guidance on what constitutes a legitimate business purpose. TriOptima supported the proposed principles-based approach to prevent evasion and the proposed guidance. TriOptima also requested the Commission clarify that activities and transactions carried out for the purpose of reducing counterparty credit risk constitute a legitimate business purpose. FreddieMac commented that the proposing release creates ambiguity as to the circumstances in which a swap is required to be submitted for clearing. In particular, FreddieMac commented that the NPRM appears to represent the Commission’s view that swaps that differ in regard to ‘‘mechanical’’ terms may be sufficiently close substitutes such that parties may be required to use such a ‘‘substitute swap’’ (where one is available) that is subject to a clearing E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with requirement.164 FreddieMac asserted that the Commission should not prejudge when a swap that is required to be cleared is a close substitute for a swap that is not subject to a clearing requirement. Furthermore, FreddieMac commented that the Commission should clarify that a swap that would otherwise be required to be cleared but for a variation in one or more material contract terms should not also be required to be submitted for clearing, provided that such variation of the terms is for legitimate business purposes. In response to the proposed guidance, ISDA asserted that the Commission did not clearly respond to its comment to the Product Definition Rules that variations based on considerations of the costs and burdens of regulation should be considered to have a legitimate business purpose.165 ISDA requested the Commission clarify that if a business has a choice, in the absence of fraud, deceit, or unlawful activity, of entering into an uncleared swap, rather than a cleared swap, ‘‘because [the uncleared swap] is cheaper, or free of unwanted aspects of clearing or trading, then that choice should be identified by the Commission as legitimate.’’ ISDA also asserted that presence of fraud, deceit, or unlawful activity is a proper prerequisite to evasion or abuse violations. Furthermore, ISDA argued that market participants will be subject to constant uncertainty when structuring and transacting in markets that offer legitimate alternatives if the proposal were adopted. The Commission is guided by the central role that clearing plays under the Dodd-Frank Act. As noted in the proposing release, ‘‘the requirement that swaps be cleared by DCOs is one of the cornerstones of that reform.’’ 166 But even given the importance of central clearing as a means to mitigate counterparty credit risk, reduce systemic risk, and protect U.S. taxpayers, the Commission accepts that a person may have legitimate business purposes for entering into swaps that are not subject to the clearing requirement. In that regard, commenters requested that the Commission confirm that considering the costs and burdens of regulation, or reduction of counterparty credit risk, are legitimate business purposes. As stated in the proposing release, the Commission will not 164 See NRPM at 47191, fn. 97 (discussing a category of interest rate swap specifications ‘‘that are commonly used to address mechanical issues’’). 165 See Product Definition Rules, 77 FR at 48302, fn. 1052. 166 NPRM at 47171. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 provide a bright-line test of non-evasive or abusive conduct because such an approach may be a roadmap for engaging in evasive or abusive conduct or activities.167 The Commission expects, however, that a person acting for legitimate business purposes will naturally weigh many costs and benefits associated with different transactions, including different swap classes and swap specifications that may or may not be subject to the clearing requirement. Therefore, the Commission clarifies that a person’s specific consideration of, for example, costs or regulatory burdens, including the avoidance thereof, is not, in and of itself, dispositive that the person is acting without a legitimate business purpose in a particular case.168 The Commission will view legitimate business purpose considerations on a case-by-case basis in conjunction with all other relevant facts and circumstances. In the context of the clearing requirement and § 50.10(a), however, the Commission does not believe it would be sufficient to satisfy the legitimate business purpose test where a person’s principal purpose of entering into a swap that is not subject to the clearing requirement is to circumvent the costs of clearing.169 Circumventing the costs of clearing may be a consideration, but cannot be the principal consideration in order to satisfy the legitimate business purpose test. The Commission notes ISDA’s comment regarding evasion, and the Commission has determined that to permit such an outcome would create an exception that would swallow the rule and could render the central clearing objectives and benefits under the Dodd-Frank Act meaningless. Moreover, section 2(h)(4)(A) requires the Commission prescribe the rules that the Commission determines ‘‘to be necessary to prevent evasions of the mandatory clearing requirements,’’ 170 which evinces Congress’s concern that evasion of the clearing requirement 167 NPRM at 47207. described in the guidance are illustrative and not exhaustive of the conduct or activities that could be considered evasive or abusive. In considering whether conduct or activities is evasive or abusive, the Commission will consider the facts and circumstances of each situation. 169 ISDA also requested clarification that avoiding ‘‘unwanted aspects of clearing or trading’’ should be considered to be a legitimate business purpose. ISDA did not specify what it means by ‘‘unwanted aspects,’’ nor did it explain how avoiding aspects of clearing or trading could be distinguished from evasion. Accordingly, the Commission is declining to include this concept as part of its guidance regarding legitimate business purposes. 170 Section 2(h)(4)(A) of the CEA, 7 U.S.C. 2(h)(4)(A). 168 Examples PO 00000 Frm 00037 Fmt 4701 Sfmt 4700 74319 would undermine a central purpose of the Dodd-Frank Act. As noted above, the Commission determines that the proposed rules are necessary to prevent evasions of the mandatory clearing requirements, and is therefore adopting them. Furthermore, the Commission believes that this standard will not subject market participants to significant uncertainty, and the benefits of central clearing will outweigh the costs and burdens of any such uncertainty. In response to Freddie Mac’s comment regarding the Commission discussion of ‘‘mechanical’’ specifications in the NPRM, that discussion served only to explain the Commission’s decision not to include those specifications in the set of class-defining specifications identified by the Commission for its class-based clearing requirement determination. The Commission is not pre-judging whether a swap that contains non class-defining specifications that are not accepted by a DCO would constitute evasion. The Commission recognizes that including such specifications in a swap could serve a legitimate business purpose if, for example, such specifications would legitimately result in a more accurate hedge of a business risk. In keeping with the Commission’s guidance that it will use a principles-based approach, assessing whether any particular swap that includes such terms would constitute evasion will be done on a case-by-case basis in light of all the relevant facts and circumstances. Finally, the Commission declines to adopt ISDA’s suggestion that the presence of fraud, deceit, or other unlawful activity is a prerequisite to establishing a violation of evasion or abuse under § 50.10. Although it is likely that fraud, deceit, or unlawful activity will be present where knowing or reckless evasion or abuse has occurred, the Commission does not believe that these factors are prerequisites to a violation of § 50.10. Rather, the presence or absence of fraud, deceit, or unlawful activity is one circumstance the Commission will consider when evaluating a person’s conduct or activities. IV. Implementation The Commission proposed to require compliance with the clearing requirement for the classes of swaps identified in proposed § 50.4 according to the compliance schedule contained in E:\FR\FM\13DER2.SGM 13DER2 74320 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with § 50.25.171 Under this schedule, compliance with the clearing requirement would be phased by type of market participant entering into a swap subject to the clearing requirement. The Commission received no comments specifically addressing the use of § 50.25. Vanguard recommended that the Commission should not implement mandatory clearing for any swaps until market participants have time to negotiate and execute all necessary documentation. Vanguard recommended the Commission delay compliance with the clearing requirement until six months after August 29, 2012, the date on which ISDA and FIA published a standard form of the futures agreement addendum for cleared swaps, i.e., February 28, 2013. SIFMA AMG also expressed concern about legal documentation and negotiations taking many months, and the difficulty buyside clients face in finding FCMs to clear for them. SIFMA AMG also recommended the clearing requirement be delayed for six months. In response to Vanguard’s and SIFMA AMG’s comments and light of the circumstances discussed below, compliance with the clearing requirement will not be required for any swaps until March 11, 2013. This extension of at least 6 months beyond publication of the FIA-ISDA clearing addendum applies to all market participants and addresses Vanguard’s and SIFMA AMG’s concerns about documentation. The Commission accounted for precisely this type of documentation issue in its adoption of § 50.25. Accordingly, Category 2 Entities and Category 3 Entities have 90 and 180 days beyond March 11, 2013, to come into compliance with the new clearing requirement, which is well beyond the six months from August 29, 2012, as requested by Vanguard and SIFMA AMG. The Commission also notes that any market participant may petition for relief under § 140.99 if that entity is unable to find an FCM to clear its swaps or if it needs additional time to complete requisite documentation.172 On September 10, 2012, the Commission clarified the timing of its swap dealer registration rules. The swap dealer registration regulations go into 171 17 CFR 50.25, Swap Transaction Compliance and Implementation Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR 44441 (July 30, 2012). Regulation 50.25 defines the terms Category 1 Entity and Category 2 Entity; this release uses the term Category 3 Entity to refer to counterparties to swaps falling under § 50.25(b)(3). 172 17 CFR 140.99 sets for the process for addressing requests for exemptive, no-action, and interpretative letters. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 effect on October 12, 2012, and entities that have more than the de minimis level of dealing (swaps entered into after October 12) must register by no later than two months after the end of the month in which they surpass the de minimis level. By way of example, if an entity reaches $8 billion in swap dealing the day after October 12, then the entity would have to register within two months after the end of October, or by December 31, 2012. Given that swap dealers will not be required to register until the end of the year, and in light of requests for clarification regarding the application of § 50.25, the Commission is clarifying that swaps executed prior to specific compliance dates set forth below are not subject to the clearing requirement. To promote certainty for market participants, the Commission is setting specific dates for compliance. Accordingly, the requirement for Category 1 Entities to begin clearing will commence on Monday, March 11, 2013, for swaps they enter into on or after that date. Category 2 Entities are required to clear swaps beginning on Monday, June 10, 2013, for swaps entered into on or after that date, and Category 3 Entities would be required to clear swaps beginning on Monday, September 9, 2013, for swaps entered into on or after that date. For example, no swap executed between two Category 1 Entities prior to March 11, 2013, is required to be cleared. In other words, Category 1 Entities entering into swaps falling within one of the classes identified in § 50.4 on or after March 11, 2013, are required to clear those swaps. Category 2 Entities must begin clearing swaps pursuant to the new clearing requirement on or after June 10, 2013, and Category 3 Entities must begin clearing such swaps if they are entered into on or after the September 9, 2013. The above schedule will apply to compliance with required clearing for iTraxx. However, if no DCO has begun offering client clearing for iTraxx by February 11, 2013, then compliance with the required clearing of iTraxx will commence sixty days after the date on which iTraxx is first offered for client clearing by an eligible DCO. If an eligible DCO offers client clearing for iTraxx on or before September 9, 2013, the following phased implementation schedule will apply: Category 1 Entities are required to clear iTraxx indices entered into on or after the date 60 days after the date on which iTraxx is first offered for client clearing by an eligible DCO; Category 2 Entities are required to clear iTraxx entered into on or after the date 150 days after the date on which PO 00000 Frm 00038 Fmt 4701 Sfmt 4700 iTraxx is first offered for client clearing by an eligible DCO; and Category 3 Entities are required to clear iTraxx entered into on or after the date 240 days after the date on which iTraxx is first offered for client clearing by an eligible DCO. There will be no phasing of compliance if an eligible DCO offers client clearing for iTraxx after September 9, 2013. Rather, all three categories of market participants will be expected to come into compliance by 60 days after the date on which iTraxx is first offered for client clearing by an eligible DCO. This clarification avoids the possibility that Active Funds that are included in Category 1 Entities would be required to clear before swap dealers, and provides market participants with certainty as to when they must begin clearing swaps. With regard to Active Funds, in order to promote orderly implementation of part 23 and the part 50 rules, both of which refer to Active Funds, the Commission is harmonizing the annual calculation period for both implementation of part 23’s swap trading relationship documentation requirements under § 23.504 173 and the clearing requirement compliance schedule under § 50.25. For purposes of implementing § 23.504, the Commission defined an Active Fund, as any private fund as defined in section 202(a) of the Investment Advisers Act of 1940, that is a not a third party subaccount and that executes 200 or more swaps per month based on a monthly average over the 12 months preceding the adopting release, i.e., September 11, 2012.174 For purposes of § 50.25, the Commission defined Active Fund in the same manner except that the monthly average over the 12 months would be preceding the date of publication of the clearing requirement determination in the Federal Register, i.e., whatever date this adopting release is published.175 Market participants have asked the Commission to harmonize these two dates so that there will be one self-identified list of Active Funds for purposes of both implementation schedules under parts 23 and 50. The Commission agrees with this approach and is modifying both compliance schedules to require private funds to calculate the number of swaps they enter into as a monthly average 173 Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 FR 55904 (Sept. 11, 2012). 174 See 77 FR at 55940. 175 See Swap Transaction Compliance and Implementation Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR at 44456. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations over the past 12 months preceding November 1, 2012. In addition, the Commission clarifies that for purposes of calculating the number of swaps a fund executes as a monthly average over the 12 months preceding November 1, 2012, for both part 23 and part 50, private funds as defined in section 202(a) of the Investment Advisers Act of 1940 are not required to include foreign exchange swaps, in light of the final determination from the Secretary of the Treasury to exempt such swaps from the CEA.176 Finally, ISDA commented that the inter-affiliate exemption should be finalized prior to requiring compliance with the clearing requirement. The Commission has proposed its interaffiliate exemption rules 177 and anticipates that it will finalize those rules prior to the aforementioned compliance dates for these clearing requirement determinations. V. Cost-Benefit Considerations A. Statutory and Regulatory Background As discussed in the NPRM, and above, certain OTC derivatives, such as credit default swaps (CDS) played a prominent role in the financial crisis in the fall of 2008, highlighting the risk that opaque OTC markets can create for the financial system by linking together financial institutions in ways that are not well-understood.178 The failure to adequately collateralize the risk exposures posed by OTC derivatives, along with the contagion effects of the vast web of uncollateralized counterparty credit risk, led many to conclude that OTC derivatives should be centrally cleared. A fundamental premise of the DoddFrank Act is that the use of properly functioning central clearing can reduce systemic risk. Congress included the statutory clearing requirement in the Dodd-Frank amendments to the CEA to standardize and reduce counterparty risk associated with swaps, and, in turn, mitigate the potential systemic impact of such risks and reduce the likelihood for swaps to cause or exacerbate instability in the financial system. The clearing requirement determinations and regulations contained in this adopting release identify certain classes sroberts on DSK5SPTVN1PROD with 176 See http://www.treasury.gov/press-center/ press-releases/Documents/11-16-2012%20FX% 20Swaps%20Determination%20pdf.pdf (finalizing Determinations of Foreign Exchange Swaps and Forwards, 75 FR 66829 (Oct. 28, 2010)). 177 Clearing Exemption for Swaps Between Certain Affiliated Entities, 77 FR 50425 (Aug. 21, 2012). 178 77 FR 47170 (Aug. 7, 2012). See also Section I.B above. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 of swaps that are required to be cleared pursuant to the Dodd-Frank Act’s 179 clearing requirement incorporated within amended section 2(h)(1)(A) of the CEA.180 The Commission’s regulations establishing the process for the review of swaps that are submitted for a mandatory clearing determination are found in Part 39 of the Commission’s regulations. Regulation 39.5 provides an outline for the Commission’s review of swaps for required clearing.181 Regulation 39.5 requires the Commission to review all swaps submitted by DCOs or those swaps that the Commission opts to review on its own initiative.182 Under section 2(h)(2)(D) of the CEA, in reviewing swaps for required clearing, the Commission must take into account the following factors: (1) Significant outstanding notional exposures, trading liquidity and adequate pricing data, (2) the availability of rule framework, capacity, operational expertise and credit support infrastructure, (3) the effect on the mitigation of systemic risk, (4) the effect on competition and (5) the existence of reasonable legal certainty in the event of the insolvency of the DCO or one or more of its clearing members.183 Regulation 39.5 also directs DCOs to provide to the Commission other information, such as product specifications, participant eligibility standards, pricing sources, risk management procedures, a description of the manner in which the DCO has provided notice of the submission to its members and any additional information requested by the Commission. This information is designed to assist the Commission in identifying those swaps that are required to be cleared. On February 1, 2012, Commission staff sent a letter requesting that registered DCOs submit all swaps that they were accepting for clearing as of that date, pursuant to § 39.5 of the Commission’s regulations. The Commission received submissions relating to CDS and interest rate swaps, 179 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010). 180 This section states: ‘‘It shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the swap is required to be cleared.’’ 181 76 FR 44464 (July 26, 2011). 182 See § 39.5(b), § 39.5(c). Under section 2(h)(2)(B)(ii) of the CEA, ‘‘[a]ny swap or group, category, type, or class of swaps listed for clearing by a [DCO] as of the date of enactment shall be considered submitted to the Commission.’’ 183 Section 2(h)(2)(D) of the CEA and § 39.5(b)(ii). PO 00000 Frm 00039 Fmt 4701 Sfmt 4700 74321 as well as agricultural and energy swaps. This initial Commission determination addresses certain interest rate swaps and CDS, and is the first of a series of determinations that the Commission anticipates making as part of a phased approach to implementing mandatory clearing. The Commission chose to issue its first clearing requirement proposal for interest rate swaps and CDS because those swaps represent a significant share of the market in the case of interest rate swaps, and pose a unique risk profile in the case of CDS. In addition, the market has been clearing both types of swaps for some time, and market participants asked that the Commission begin with interest rate swaps and CDS. The Commission intends subsequently to consider other swaps submitted by DCOs, such as agricultural, energy, and equity indices. As stated in both the NPRM and above, the decision to initially focus on CDS and interest rate swaps from amongst the swaps submitted to the Commission for mandatory clearing determinations pursuant to section 2(h)(2) is a function of both the market importance of these swaps and the fact that they already are widely cleared. In order to move the largest number of swaps to required clearing in its initial determinations, the Commission believes that it is prudent to focus on those swaps that have the highest market shares and market impact. Further, for these swaps there is already a blueprint for clearing and appropriate risk management. CDS and interest rate swaps fit these considerations and therefore are well suited for required clearing consideration.184 In the discussion that follows, the importance of central clearing is explained and highlighted to provide the background for the Commission’s consideration of the costs and benefits in this rulemaking as the Commission exercises its discretion under section 2(h)(2)(D) of the CEA to determine whether swaps that are submitted for a mandatory clearing determination are required to be cleared. B. Overview of Swap Clearing The following background discussion provides context for the Commission’s consideration of the costs and benefits of its clearing determinations in this rulemaking. 184 77 FR 47172 (August 7, 2012). See also Section I.F above. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with 74322 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations i. How Clearing Reduces Risk When a bilateral swap is cleared, the clearinghouse becomes the counterparty to each of the original counterparties to the swap. This standardizes counterparty credit risk for the original swap participants in that they each bear the same risk—i.e., the risk attributable to facing the clearinghouse as counterparty. In addition, clearing mitigates counterparty risk to the extent that the clearinghouse is a more creditworthy counterparty relative to the original swap participants. Clearinghouses have demonstrated resilience in the face of past market stress. Most recently, they remained financially sound and effectively settled positions in the midst of turbulent events in 2007–2008 that threatened the financial health and stability of many other types of entities. Given the variety of effective clearinghouse tools to monitor and manage counterparty credit risk, the Commission believes that DCOs will continue to be some of the most creditworthy counterparties in the swap markets. These tools include the contractual right to: (1) Collect initial and variation margin associated with outstanding swap positions; (2) mark positions to market regularly (usually one or more times per day) and issue margin calls whenever the margin in a customer’s account has dropped below predetermined levels set by the DCO; (3) adjust the amount of margin that is required to be held against swap positions in light of changing market circumstances, such as increased volatility in the underlying; and (4) close out the swap positions of a customer that does not meet margin calls within a specified period of time. Moreover, in the event that a clearing member defaults on their obligations to the DCO, the latter has a number of remedies to manage associated risks, including transferring the swap positions of the defaulted member, and covering any losses that may have accrued with the defaulting member’s margin and other collateral on deposit. In order to transfer the swap positions of a defaulting member and manage the risk of those positions while doing so, the DCO has the ability to: (1) Hedge the portfolio of positions of the defaulting member to limit future losses; (2) partition the portfolio into smaller pieces; (3) auction off the pieces of the portfolio, together with their corresponding hedges, to other members of the DCO; and (4) allocate any remaining positions to members of the DCO. In order to cover the losses associated with such a default, the DCO VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 would typically draw from (in order): (1) The initial margin posted by the defaulting member; (2) the guaranty fund contribution of the defaulting member; (3) the DCO’s own capital contribution; (4) the guaranty fund contribution of non-defaulting members; and (5) an assessment on the nondefaulting members. These mutualized risk mitigation capabilities are largely unique to clearinghouses, and help to ensure that they remain solvent and creditworthy swap counterparties even when dealing with defaults by their members or other challenging market circumstances. ii. Movement of Swaps Into Clearing There is significant evidence that some parts of the OTC swap markets (the interest rate swaps and CDS markets in particular) have been migrating into clearing over the last number of years in response to market incentives as well as in anticipation of the Dodd-Frank Act’s clearing requirement. LCH data, for example, shows that the outstanding volume of interest rate swaps cleared by LCH has grown steadily since at least November 2007, as has the monthly registration of new trade sides.185 Data provided to the Commission shows that the notional amount of cleared interest rate swaps is approximately $72 trillion as of January 2007, and just over $236 trillion in September 2010, an increase of 228% in three and a half years.186 Together, those facts indicate increased demand for LCH clearing services related to interest rate swaps, a portion of which preceded the Dodd-Frank Act.187 Data available through CME and TriOptima indicate similar patterns of growing demand for interest rate swap clearing services, although their publically available data does not provide a picture of demand prior to the passage of the Dodd-Frank Act.188 185 As a measure of volume, LCH accounts for each swap it clears as one trade side, which represents one counterparty to each two-sided trade. 186 Data provided to the Commission by LCH. In the context of interest rate swaps, the notional amount refers to the specified amount on which the exchanged swap payments are calculated. It is a nominal amount that is not exchanged between counterparties. 187 See http://www.lchclearnet.com/swaps/ volumes/. Since the Dodd-Frank Act was passed in July 2010, outstanding trade sides at LCH have increased from approximately 1.6 million to 2.3 million in September of 2012, an increase of approximately 44%. Indeed, the number of new trade sides being submitted for clearing per month increased from approximately 55,000 trade sides per month to 150,000 trade sides per month, an increase of approximately 270%. 188 See http://www.cmegroup.com/trading/ interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical- PO 00000 Frm 00040 Fmt 4701 Sfmt 4700 In addition to interest rate swap clearing, major CDS market participants are clearing their CDS indices and single names in significant volumes. As explained above, in 2008, prior to the enactment of the Dodd-Frank Act, the Federal Reserve Bank of New York (FRBNY) began encouraging market participants to establish a central counterparty to clear CDS.189 In the past four years CDS clearing has grown significantly. As a representation of this growth, CME now has initial margin for CDS in excess of $1.8 billion and a guaranty fund of approximately $629 million,190 and ICE Clear Credit has initial margin on deposit for CDS of $10.8 billion and a guaranty fund equal to $4.4 billion.191 ICE Clear Europe has initial margin for CDS totaling $6.8 billion and a guaranty fund of $2.7 billion.192 iii. The Clearing Requirement and Role of the Commission In the Dodd-Frank Act, Congress directed that clearing shift from a voluntary practice to a mandatory practice for certain swaps and gave the Commission responsibility for determining which swaps would be required to be cleared. Under section 2(h)(2) of the CEA, the Commission is required to review each swap, or group, category, type, or class of swaps that a DCO clears and submits to the Commission in order to determine whether the submitted swaps are required to be cleared. In making these clearing determinations and promulgating the final rules, the Commission has taken its direction from the statutory text and is implementing the statute by determining, in accordance with the five factors set forth in the statute, whether swaps submitted to the Commission for a mandatory reports.html. Notably, CME launched its interest rate swap clearing service in the fall of 2010, after the Dodd-Frank Act was passed. 189 See Federal Reserve Bank of New York, Press Release, ‘‘New York Fed Welcomes Further Industry Commitments on Over-the-Counter Derivatives,’’ Oct. 31, 2008, available at http:// www.newyorkfed.org/newsevents/news/markets/ 2008/an081031.html, which references documents prepared by market participants describing the importance of clearing. See also Ciara Linnane and Karen Brettell, ‘‘NY Federal Reserve pushes for central CDS counterparty,’’ Reuters, Oct. 6, 2008. 190 See http://www.cmegroup.com/clearing/cmeclearing-overview/safeguards.html for data regarding CME’s guaranty fund, posted as of May 10, 2012. 191 See https://www.theice.com/clear_credit.jhtml for data on the size of guaranty fund, posted as of May 10, 2012. 192 Id. The data is not adequate to enable the Commission to determine how much of the movement into clearing is attributable to natural market forces or anticipated requirements under the Dodd-Frank Act. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with clearing determination are required to be cleared. As described above, the Commission has decided to initially focus on interest rate swaps and CDS because of the market importance of these swaps and the fact that they already are widely cleared. In determining pursuant to section 2(h)(2)(D) whether these particular swaps should be required to be cleared, the Commission has taken into account the fact that voluntary clearing of swaps has increased over the past years (perhaps due in part to anticipation of the clearing requirement to be imposed under the Dodd-Frank Act, but perhaps due in part to a realization of the benefits of clearing after the financial crisis). These industry efforts and the extent to which voluntary clearing of swaps has already occurred provide a useful reference point for the Commission’s consideration of the costs and benefits of its actions in determining whether particular swaps should be required to be cleared.193 In the discussion that follows, the Commission summarizes and evaluates the costs and benefits of the new clearing requirements resulting from the Commission’s clearing determinations in this rulemaking. In the context of this relevant statutory provision and ongoing industry initiatives, in the sections that follow, the Commission also has considered its clearing determinations in light of cost-benefit issues raised by commenters and suggested alternatives. In general, the Commission believes that the costs and benefits related to the required clearing of the classes of interest rate swaps and CDS resulting from this rulemaking are attributable, in part to (1) Congress’s stated goal of reducing systemic risk by, among other things, requiring clearing of swaps and the statutory clearing mandate in section 2(h) of the CEA to achieve that objective; and (2) the Commission’s determination under section 2(h)(2)(D) that these particular classes of swaps should be required to be cleared. The 193 The Commission also recognizes that there might not be a linear relationship between the quantity of swaps that are cleared (whether measured by number of swaps, the notional value of swaps, or some other measure of swap quantity, such as the exposure resulting from the swaps) and the costs and benefits resulting from clearing. For example, if the Commission were to assume that the rule would result in a doubling of the quantity of a certain type of swap that is cleared, it would not necessarily be the case that the costs and benefits of clearing that type of swap would double. Rather, the relationship could be non-linear for a variety of reasons (such as variations among the users of that type of swap). In fact, it may be reasonable to assume that where the costs of clearing are relatively low and the benefits are relatively high, market participants already voluntarily clear swaps even in the absence of a clearing requirement. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 Commission will discuss the costs and benefits of the overall move from voluntary clearing to required clearing for the particular swaps subject to this new clearing requirement.194 However, in so doing, the Commission believes that it is not readily ascertainable whether an increased use of clearing following such determinations should be attributed to statutory or regulatory requirements that particular swaps be required to be cleared, as compared to swap market participants’ market-based decisions to increase the use clearing to reduce risks and costs.195 C. Consideration of the Costs and Benefits of the Commission’s Action i. CEA Section 15(a) Section 15(a) of the CEA requires the Commission to consider the costs and benefits of its actions before promulgating a regulation under the CEA or issuing certain orders. Section 15(a) further specifies that the costs and benefits shall be evaluated in light of the following five broad areas of market and public concern: (1) Protection of market participants and the public; (2) efficiency, competitiveness and financial integrity of futures markets; (3) price discovery; (4) sound risk management practices; and (5) other public interest considerations. Accordingly, the Commission considers the costs and benefits resulting from its discretionary determinations with respect to the section 15(a) factors. As stated above, the Commission received a total of 33 comment letters following the publication of the NPRM, many of which strongly supported the proposed regulations. Some commenters generally addressed the cost-and-benefit aspect of the current rule; none of them, however, provided any quantitative data in response to the Commission’s requests for comment. In the sections that follow the Commission considers: (1) Costs and benefits of required 194 Embedded in this approach is the assumption that costs and benefits of increased clearing prior to the determination is not a function of the DoddFrank Act or the clearing determination contained herein. As stated above, the Commission acknowledges that some increases in clearing that have already occurred are likely the result of anticipated clearing requirements. However, it is not possible to estimate how much of the increases in clearing are the result market forces, and how much is a function of expected requirements related to clearing. Both factors have likely contributed to the increases in clearing that have occurred prior to this rule. 195 It is also possible that some market participants would respond to the current rule’s requirement that certain types of swaps be cleared by decreasing their use of such swaps. This possibility contributes to the uncertainty regarding how the current rule will affect the volume of swaps that are cleared. PO 00000 Frm 00041 Fmt 4701 Sfmt 4700 74323 clearing for the classes of swaps identified in this adopting release; (2) alternatives contemplated by the Commission and the costs and benefits relative to the approach adopted herein; (3) the impact of required clearing for swaps under the identified classes of swaps in light of the 15(a) factors. The Commission also discusses the corresponding comments accordingly. ii. Costs and Benefits of Required Clearing Under the Final Rule In order to comply with required clearing under this adopting release, market participants are likely to face certain startup and ongoing costs relating to technology and infrastructure, new or updated legal agreements, ongoing fees from service providers, and costs related to collateralization of their positions. The per-entity costs related to changes in technology, infrastructure, and legal agreements are likely to vary widely, depending on each market participant’s existing technology infrastructure, legal agreements, operations, and anticipated needs in each of these areas. For market participants that already use clearing services, some of these costs may be expected to be lower, while the opposite will likely be true for market participants that must begin to use clearing services only because of the new clearing requirement. The costs of collateralization, on the other hand, are likely to vary depending on a number of factors, including whether an entity is subject to capital requirements or not, and the differential between the cost of capital for the assets the entity uses as collateral, and the returns the entity realizes on those assets. There are also significant benefits associated with increased clearing, including reducing and standardizing counterparty credit risk, increased transparency, and easier access to the swap markets. These effects together will contribute significantly to the stability and efficiency of the financial system. The Commission lacks data to quantify these benefits with any degree of precision. The Commission notes, however, that the extraordinary financial system turbulence of 2008 has had profound and long-lasting adverse effects on the economy, and therefore reducing systemic risk provides significant, if unquantifiable, benefits.196 Also, as is the case for the 196 For example, the PEW Economic Policy Group estimates total costs of the acute stage of the crisis for U.S. interests were approximately $12.04 trillion, including lost GDP, wages, real estate wealth, equity wealth, and fiscal costs. Their estimates include $7.4 trillion in losses in the E:\FR\FM\13DER2.SGM Continued 13DER2 74324 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations costs related to clearing, these benefits would be relatively less to the extent that market participants are already using clearing in the absence of a requirement. sroberts on DSK5SPTVN1PROD with a. Technology, Infrastructure, and Legal Costs With respect to technology and infrastructure, for market participants that already use swap clearing services or trade futures, many of the backend requirements for technology and infrastructure that supports cleared swaps are likely to be quite similar, and therefore necessary changes to those systems are likely to require relatively lower costs. Market participants that are not currently using swap clearing services or trade futures, however, may need to implement appropriate infrastructure and technology to connect with an FCM that will clear swaps on their behalf. Similarly for legal fees, the costs related to clearing the swaps that are subject to this clearing requirement are likely to vary widely depending on whether market participants already use clearing services or trade futures. For those market participants that have not already engaged an FCM, it has been estimated, in response to another rulemaking, that smaller financial institutions will spend between $2,500 and $25,000 reviewing and negotiating legal agreements when establishing a new business relationship with an FCM.197 Commenters on this rulemaking did not provide data that would enable the Commission to determine to what degree these estimates would apply to larger entities establishing a relationship with an FCM or to determine costs associated with equity markets between June 2008 and March 2009, but do not include subsequent gains in equity markets that restored markets to their mid-2008 levels by the end of 2009. In addition, their calculations do not include continued declines in real estate markets subsequent to March 2009. See Pew Economic Policy Group, ‘‘The Cost of the Financial Crisis: The Impact of the September 2008 Economic Collapse,’’ March 2010. The IMF estimated that the cost to the banking sector of the financial crisis through 2010 was approximately $2.2 trillion and reported a range of estimates for total cost to the taxpayer of GSE bailouts that ranged from $160 billion (Office of Management and Budget, February 2010) to $500 billion (Barclays Capital, December 2009). See IMF, ‘‘Global Financial Stability Report: Responding to the Financial Crisis and Measuring Systemic Risks,’’ October 2010. Both studies acknowledge that the estimates are subject to uncertainties. 197 See comments to End-User Exception to Mandatory Clearing of Swaps; Proposed Rule, 75 FR 80747 (Dec. 23, 2011), including Chatham Financial letter at 2, available at http://comments.cftc.gov/ PublicComments/ViewComment.aspx?id=58077, and Webster Bank letter at 3, available at http:// comments.cftc.gov/PublicComments/ ViewComment.aspx?id=58076. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 entities that already have established relationships with one or more FCMs, but need to revise those agreements.198 Even accepting the data provided for smaller financial institutions, the Commission lacks sufficient data to calculate a reasonable estimate of the potential costs that are likely to depend significantly on the specific business needs of each entity and therefore are expected to vary widely among market participants. Citadel commented that the fact that all the interest rate swaps and CDS included in the Commission’s proposal are already being cleared by registered DCOs in material volumes provides clear evidence that there is the rule framework, capacity, operational expertise and resources, and credit support infrastructure necessary to clear each of the swaps that are the subject of the Commission’s determination. SIFMA AMG and Vanguard expressed concern about legal documentation and negotiations taking many months, and recommended the clearing requirement be delayed. They also raised doubt about the readiness of market participants to comply with the Commission’s upcoming swap customer segregation rules. Vanguard further stated that it has ‘‘serious reservations about the potential impact on cost, liquidity, and heightened margin risk which could result from the premature roll-out of the clearing mandate.’’ In light of the ‘‘lack of experience and practical know-how’’ related to DCO insolvency, ISDA recommended that the Commission conduct a study on insolvency. Citadel, on the other hand, stated that reasonable legal certainty exists in the event of an insolvency of a DCO or one or more DCO members with regard to the treatment of customer and swap counterparty positions, funds, and property. Commission Response In response to Vanguard and SIFMA AMG’s concerns about legal documentation and operational readiness, the Commission has clarified that compliance with the clearing requirement will not be required for any swaps until March 11, 2013, which responds to commenters’ recommendation that the clearing requirement by delayed for six months to allow for documentation. Moreover, Category 2 and Category 3 entities will have until June 10, 2013, and September 198 In its letter, FIA stated that it does not collect information from its members concerning fees charged for particular services, and thus is unable to respond to the Commission’s request for date regarding FCM fees. No other commenter responded to the request for information regarding legal fees. PO 00000 Frm 00042 Fmt 4701 Sfmt 4700 9, 2013, respectively, to come into compliance with the new requirement.199 In response to ISDA’s statements regarding insolvency, as explained above, Commission staff actively participates in a number of international efforts related to clearinghouses and clearing member insolvency, as well as in coordination efforts with U.S. authorities.200 Additionally, the Commission is exercising the anti-evasion rulemaking authority granted to it by the DoddFrank Act. In terms of legal costs, market participants will be responsible for complying with the new anti-evasion requirements. Generally, rule § 50.10 states that it is unlawful for any person to knowingly or recklessly evade or participate in or facilitate an evasion of the requirements of section 2(h) of the CEA, to abuse the exception to the clearing requirement as provided under section 2(h)(7) of the CEA and Commission rules, or to abuse any exemption or exception to the requirements of section 2(h) of the CEA, including any exemption or exception as the Commission may provide by rule, regulation, or order. This rule is expected to help ensure that would-be evaders cannot engage in conduct or activities that constitute an evasion of the requirements of section 2(h) or an abuse of any exemption or exception to such requirements. The Commission also sets forth guidance as to how it would determine if such evasion or abuse has occurred, while at the same time preserving the Commission’s ability to determine, on a case-by-case basis, with consideration given to all the facts and circumstances, that other types of transactions or activities constitute an evasion or abuse under § 50.10.201 The Commission believes that participants in the swap markets should have policies and procedures already in place to ensure that their employees, affiliates, and agents will refrain from engaging in activities, including devising transactions, for the purpose of 199 See Section IV above, clarifying that compliance for Category I, II, and III Entities will apply, respectively, to swaps executed on or after March 11, 2013, June 10, 2013, and September 9, 2013. 200 See Section II.B above. 201 The Commission has not adopted a ‘‘brightline’’ standard for evasion in order to avoid providing a ‘‘road-map’’ for evasion. The Commission’s discussion of § 50.10 is similar to its approach for the anti-evasion rules §§ 1.3(xxx)(6) and 1.6 that it recently adopted in a joint final rulemaking with the Securities and Exchange Commission. See Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘Security-Based Swap Agreement’’; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208, 48350– 48354 (Aug. 13, 2012). E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with evading, or in reckless disregard of, the requirements of section 2(h) of the CEA and Commission regulations or to abuse any exemption or exception to such requirements. The Commission believes that it will not be necessary for firms that currently have adequate compliance programs to hire additional staff or significantly upgrade their systems to comply with the proposed rule. Firms may, however, incur some costs, such as costs associated with training staff on the new clearing requirement rules. In addition, market participants may incur costs when determining whether they are properly relying on a legitimate business purpose. The Commission in choosing a principles-based approach rather than a bright-line test, recognizes that there may be direct costs and indirect costs due to perceived uncertainty related to determining what constitutes a legitimate business purpose for entering into swaps that are not subject to the clearing requirement. As stated above, the Commission will not provide a bright-line test of nonevasive or abusive conduct because such an approach may be a roadmap for engaging in evasive or abusive conduct or activities. However, the Commission has provided guidance above regarding what is meant by certain key terms in § 50.10, and the Commission has clarified its belief that where a person’s principal purpose in entering into a swap that is not subject to the clearing requirement is to circumvent the costs of clearing, the legitimate business purpose test would not be satisfied. The Commission anticipates that this guidance will mitigate costs related to determining whether particular conduct or activity could be construed as being an evasion of the requirements of section 2(h) or an abuse of any exemption or exception to the requirements.202 b. Ongoing Costs Related to FCMs and Other Service Providers In the NPRM, the Commission considered ongoing costs associated with fees charged by FCMs that market participants will bear, in addition to costs associated with technological and legal infrastructure. Regarding fees, DCOs typically charge FCMs an initial transaction fee for each of the FCM’s customers’ interest rate swaps that are cleared, as well as an annual maintenance fee for each of their customers’ open positions. Not including customer-specific and volume discounts, the transaction fees for interest rate swaps at the CME range 202 See above at Section III.G. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 from $1 to $24 per million notional amount for interest rate swaps and the maintenance fees are $2 per year per million notional amount for open positions.203 LCH transaction fees for interest rate swaps range from $1-$20 per million notional amount, and the maintenance fee ranges from $5-$20 per swap per month, depending on the number of outstanding swap positions that an entity has with the clearinghouse.204 For CDS, ICE Clear Credit charges an initial transaction fee of $6 per million notional amount. There is no maintenance fee charged by ICE for maintaining open CDS positions.205 FCMs will also bear additional fees with respect to their house accounts at the DCO to the extent that they clear more swaps due to the clearing requirement. For example, for interest rate swaps that they clear through CME, clearing members are charged a transaction fee that ranges from $0.75 to $18.00 per million notional, depending on the transaction maturity.206 Members, however, are not charged annual maintenance fees for their open house positions.207 For CDS, clearing members at ICE Clear Credit are charged $5–6 per transaction per million notional and there is no maintenance fee.208 As discussed above, it is difficult to predict precisely how the requirement to clear the classes of swaps covered by this new requirement will increase the use of swap clearing, as compared to the use of clearing that would occur in the absence of the requirement. However, the Commission expects that application of the clearing requirement to the swaps covered by the new rule will generally increase the use of clearing, leading to the ongoing transaction costs noted above. In addition, the Commission understands that FCM customers that only transact in swaps occasionally are typically required to pay a monthly or 203 See CME pricing charts at: http://www.cme group.com/trading/cds/files/CDS-Fees.pdf; http://www.cmegroup.com/trading/interest-rates/ files/CME-IRS-Customer-Fee.pdf; and http://www.cmegroup.com/trading/interestrates/files/CME-IRS-Self-Clearing-Fee.pdf. 204 See LCH pricing for clearing services related to OTC interest rate swaps at: http://www.lch clearnet.com/swaps/swapclear_for_clearing_ members/fees.asp. 205 See ICE Clear Credit fees for CDS at: https:// www.theice.com/publicdocs/clear_credit/circulars/ ICEClearCredit%20Fee%20Schedule%20Notice_ FINAL.pdf. 206 See CME pricing charts. 207 See id. 208 See ICE Clear Credit fees for CDS at: https:// www.theice.com/publicdocs/clear_credit/circulars/ ICEClearCredit%20Fee%20Schedule%20Notice_ FINAL.pdf. PO 00000 Frm 00043 Fmt 4701 Sfmt 4700 74325 annual fee to each FCM that ranges from $75,000 to $125,000 per year.209 Again, although it is difficult to predict precisely how many FCM customers would be subject to such fees based on the clearing requirement for CDS and interest rate swaps, the Commission expects that some market participants that previously did not use clearing would be subject to the requirements of the current rule. In the NPRM, the Commission asked a series of questions related to FCM fees and invited comment on the fee information presented. No commenter responded to the questions asked or provided any additional information with regard to clearing fees. As noted above, FIA raised the issue only to explain that it does not collect such information from its members. c. Costs Related to Collateralization of Cleared Swap Positions As mentioned above, market participants that enter into swaps with the specifications identified in the classes subject to this adopting release will be required to post collateral with their FCM and/or at the DCO. The incremental cost of collateral resulting from the application of the clearing requirement depends on the extent to which such swaps are already being cleared (even in the absence of the requirement) or otherwise collateralized bilaterally. The incremental cost also depends on whether such swaps are, if not collateralized, priced to include implicit contingent liabilities and counterparty credit risk born by the counterparty to the swap. 1. Quantitative Approach Presented in the NPRM A conservative approach would be to assume that all the swaps that are currently not cleared would be covered by the new clearing requirement, and that they are completely uncollateralized, and not priced to include implicit contingent liabilities and counterparty credit risk born by the counterparty. Under this approach, imposition of the clearing requirement for those types of swaps would create additional costs due to: (1) The difference between cost of capital and returns on that capital for assets posted to meet initial margin for the entire term of the swap; and (2) the difference 209 See letters from Chatham and Webster Bank. The Commission is not aware of similar annual fees charged to larger customers. The Commission believes that FCMs are more likely to charge such fees to smaller customers in order to cover the fixed costs that are not likely covered through fees charged on a per-swap basis to customers that use swaps less frequently. E:\FR\FM\13DER2.SGM 13DER2 74326 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with between cost of capital and returns on that capital for assets paid to meet the cost of capital for variation margin to the extent a party is ‘‘out of the money’’ on each swap. Under the assumptions mentioned above, if every interest rate swap and CDS that is not currently cleared were moved into clearing, the additional initial margin that would need to be posted is approximately $19.2 billion for interest rate swaps and $53 billion for CDS.210 In the NPRM, the Commission calculated its estimated additional initial margin amounts based on the following assumptions. According to representations made to the Commission by LCH, they clear approximately 51% of the interest rate swaps market. The total amount of initial margin on deposit at LCH for interest rate swaps is approximately $20 billion.211 Therefore, if all remaining interest rate swaps were moved into clearing, approximately $19.2 billion ($20B/0.51¥$20B = 19.2B) would have to be posted in initial margin. Similarly, the initial margin related to CDS currently on deposit at CME, ICE Clear Credit, and ICE Clear Europe is approximately $21.4 billion.212 This amount includes initial margin based on both index-based CDS and single-name CDS positions. BIS data indicates that approximately 36.6% of the CDS market comprises index-based CDS.213 In the NPRM, the Commission noted that if it is assumed that approximately 36.6% of the overall portfolio-based CDS margin (i.e., CDS indices and single-name CDS margined together) currently held by DCOs for CDS positions is related to index-based CDS, and then add any 210 The numbers calculated above may either over-estimate or under-estimate the amount of additional initial margin that would need to be posted under the conservative assumptions stated above. For instance, differences in the amount of netting that is possible within portfolios currently being cleared versus those not currently being cleared could have a significant impact on the amount of additional margin that is required to be posted. Other factors such as differences in liquidity among swaps currently being cleared and those not being cleared could also impact the amount of additional margin that is posted. 211 The total amount of initial margin on deposit at CME for interest rate swaps is $5 billion, but for purposes of this estimate, the Commission is not including that amount. 212 The total amount of initial margin on deposit only includes those amounts reported to the Commission by registered DCOs. Other clearinghouses, such as LCH.Clearnet.SA, clear the indices included in the proposed determination, however, the relative size of the open interest in the relevant CDS indices is substantially smaller than each of the DCOs included in this calculation. 213 BIS estimates that the gross notional value of outstanding CDS contracts is $28.6 trillion, and that $10.5 trillion of that is index related CDS. See BIS data, available at http://www.bis.org/statistics/ otcder/dt21.pdf. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 margin held by DCOs attributable solely to index-based CDS, it can be estimated that approximately $9.0 billion in margin currently held by those DCOs is related to index-based CDS. ISDA data indicates that 14.5% of the index-based CDS market is currently cleared.214 Therefore, the Commission noted in the NPRM that if the entire index-based CDS market moved into clearing, $53 billion ($9.0B/0.145¥$9.0 = $53B) in initial margin would have to be posted at DCOs. Both of the above estimates assume that additional interest rate swaps brought into clearing would have similar margin requirements per unit of notional amount to those interest rate swaps that are already in clearing, and assumes that additional CDS brought into clearing would have similar margin requirements per unit of notional amount to those CDS that are already being cleared. These assumptions, in turn, assume similar levels of liquidity, compression, netting, and similar tenors for the swaps that are currently cleared and those that are not. While the Commission recognizes that these factors are unlikely to be identical among both groups of products, adequate information to quantify the impact of each of these possible differences between the two groups of swaps on the amount of additional collateral that would have to be posted is not available. In any case, the Commission noted that it is probable that the estimates in the NPRM significantly overstate the amount of additional capital that would be posted for a number of reasons described below. First, these estimates are based upon the assumption that every interest rate swap and indexbased CDS not currently cleared is brought into clearing as a result of the Commission’s determinations herein. However, in this adopting release the Commission has set forth clearing requirements only for certain classes of interest rate swaps and CDS, and not for 214 In the NPRM, the Commission noted that ISDA has estimated that 14.5% of the index-based CDS market is currently being cleared, whereas the total outstanding notional at CME, ICE Clear Europe, and ICE Credit represents approximately 7.5% of the global index-based CDS market estimated by BIS. Such a discrepancy would be expected if one or more of the following occurred: (1) If ISDA overestimated the percentage of the index-based CDS that is currently being cleared; (2) if BIS overestimated the size of the global indexbased swap market; (3) if a significant amount of compression occurs as index-based CDS are moved into clearing; and/or (4) if a significant portion of the cleared index-based CDS market is held at clearinghouses other than CME, ICE Clear Europe, and ICE Clear Credit. The Commission noted in the NPRM that it believes that the compression of CDS positions moving into clearing is the most likely explanation and therefore used the ISDA estimate. PO 00000 Frm 00044 Fmt 4701 Sfmt 4700 all interest rate swaps and CDS. Therefore, there will still be certain types of interest rate swaps, such as those related to the thirteen additional currencies cleared by LCH, that are not required to be cleared. Moreover, the clearing requirement will apply only to new swap transactions 215 whereas market estimates include legacy transactions. In addition, these estimates assume that no additional voluntary clearing would be taking place in the absence of the Commission’s determinations. The Commission also observes that, to the extent that portfolio margining for products such as CDS is expanded to all market participants, it is likely to reduce the additional margin that is required. In some instances, these margin reductions for well-balanced portfolios could be significant. In addition, non-financial entities entering into swaps for the purpose of hedging or mitigating commercial risk are not required to use clearing under section 2(h)(7) of the CEA. As a consequence, many entities will not be required to clear, even when entering into interest rate swaps or CDS that are otherwise required to be cleared. Third, some interest rate swaps and CDS involve cross border transactions to which the Commission’s clearing requirement will not apply.216 Fourth, collateral is already posted with respect to many non-cleared interest rate swaps and CDS. ISDA conducted a recent survey which reported that 93.4% of all trades involving credit derivatives, and 78.1% of all trades involving fixed income derivatives are subject to collateral agreements.217 Moreover, although the Commission cannot verify the accuracy of the estimate, ISDA estimated that the aggregate amount of collateral in circulation in the noncleared OTC derivatives market at the end of 2011 was approximately $3.6 trillion.218 215 As well as, applying to swaps subject to a change in ownership, as explained above in Section III.D. 216 Cross-Border Application of Certain Swaps Provisions in the Commodity Exchange Act, 77 FR 41214 (July 12, 2012). 217 See ISDA Margin Survey 2012, at 15, available at http://www2.isda.org/functional-areas/research/ surveys/margin-surveys/. Although it is unclear exactly how many of the derivatives covered by this survey are swaps, it is reasonable to assume that a large part of them are. 218 This estimate, however, does not adjust for double counting of collateral assets. The same survey reports that as much as 91.1% of cash used as collateral and 43.8% of securities used as collateral are being reused, and therefore are counted two or more times in the ISDA survey. See ISDA Margin Survey 2012, at 20 and 11, respectively. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations 2. Comments Received in Response to NPRM Consideration of Costs and Benefits In the NPRM, the Commission requested comment regarding the total amount of additional collateral that would be required due to the proposed clearing requirement. In particular, the Commission sought quantifiable data and analysis.219 No commenter addressed the quantitative approach laid out by the Commission in the NPRM. Nor did any commenter provide quantifiable data and analysis to support or refute such analysis. Citadel stated that the Commission’s determination is justified on a costbenefit basis, but did not address the costs of collateral directly. FIA noted that the NPRM’s cost-benefit discussion ‘‘is among the more thoughtful and comprehensive the Commission has ever prepared,’’ but did not address the costs of collateral, fees, or other costs. 3. Additional Research Reviewed by the Commission Despite the lack of feedback from commenters regarding the costs of collateral, the Commission continued to research market and academic literature in the public domain for additional data. The Commission identified and obtained two relevant papers. These papers are presented as additional informative background regarding the costs of mandatory clearing. The Commission has reviewed, but has not been able to verify, the conclusions reached in these papers. In a recent research note, Morgan Stanley estimated the global increase in initial margin for interest rate swaps trades as a result of the swap clearing requirements.220 Its ‘‘bull case’’ figure of $20 billion is largely consistent with the Commission’s estimate of $19.2 billion in the NPRM calculated above, though its methodology is different. Morgan Stanley obtained this figure in several steps. First, it considered two main groups of interest rate swaps traders: dealers and buy-side investors, which Morgan Stanley believes have interest rate swaps with notional values of approximately $339 trillion and $89 trillion, respectively, outstanding. Next, Morgan Stanley projected that the 219 77 FR at 47214. Morgan Stanley, Morgan Stanley Research, ‘‘Swap Central Clearing: What is the Impact on Collateral?’’ (August 2012). sroberts on DSK5SPTVN1PROD with 220 See VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 amount of new interest rate swaps that will be cleared as a percentage of current notional would be 10% for dealers and 80% for buy-side participants, assuming that ‘‘most of the eligible dealer-to-dealer trades are already centrally cleared.’’ Finally, Morgan Stanley multiplied the resulting amount of new interest rate swaps that will be cleared for each group of traders by an initial margin to notional ratio that they estimated.221 Currently, according to Morgan Stanley, ‘‘the aggregate dealer initial margin as a percentage of notional reported by LCH is approximately 0.005%.’’ For dealers, the value of 0.00005 was therefore chosen as their initial margin to notional ratio. For buy-side investors, however, Morgan Stanley scaled up LCH’s benchmark ratio of 0.00005 by a growth factor of 5 to ‘‘[capture] the extent to which buy-side portfolios are less diversified than dealers and may enjoy less netting efficiencies.’’ Overall, the report argued, dealers and buy-side participants should expect their aggregate initial margin to increase by $2 billion ($339,000B × 10% × 0.00005 ≈ $2B) and $18 billion ($89,000B × 80% × 0.00005 × 5 ≈ $18B), respectively, resulting in a total estimate of $20 billion in additional margin for the bull case scenario. By scaling up LCH’s benchmark ratio by a growth factor in the range between 10–20 for each group of investors, Morgan Stanley further obtained a ‘‘base case’’ figure of $480 billion and a ‘‘bear case’’ figure of $1.3 trillion. The difference between the Commission’s estimate and Morgan Stanley’s base case figure or bear case figure can largely be attributed to the following: the Commission used LCH’s current overall initial margin to notional ratio in its calculations, whereas Morgan Stanley used LCH’s current dealer initial margin to notional ratio; more importantly, the Commission made the simplifying assumption that the initial margin to notional ratio will stay more or less constant, whereas Morgan Stanley scaled up its benchmark ratio by a growth factor in a range between 10– 20 based on its ‘‘discussions with clearing and banking industry professionals and estimates made by [BIS]’’ as well as its internal estimates.222 Putting aside the growth 221 This ratio is the initial margin divided by the notional outstanding. 222 In particular, Morgan Stanley assumed that ‘‘dealer [initial margin] may grow over time due to PO 00000 Frm 00045 Fmt 4701 Sfmt 4700 74327 factor effect, it is worth emphasizing that Morgan Stanley’s estimates refer to the global increase in initial margin, which may potentially be much larger than the additional amount of initial margin required for those entities under the Commission’s jurisdiction. Also, the Commission notes that in Morgan Stanley’s calculations, the additional collateral required for buyside swaps represents the vast majority of the additional collateral required in each scenario (approximately 95%, 74%, and 81% of the total additional capital required for the ‘‘bull case,’’ ‘‘base case,’’ and ‘‘bear case,’’ respectively). A critical assumption driving each of these calculations is that swaps with 80% of the total buy-side notional amount are moved into clearing as a result of the mandate. However, the Commission believes this assumption may be high in light of the end-user exception, which includes an exemption for small financial institutions with less than $10 billion in assets.223 Adjusting this assumption downward would result in dramatic reductions in Morgan Stanley’s calculations regarding the amount of additional collateral that may be required as a result of the mandate. TABB Group has also conducted a study recently that estimated the global ‘‘margin shortfall’’ (i.e., the additional amount of initial margin that will be required) for all OTC swaps due to clearing requirements and anticipated margin requirements for uncleared swaps.224 According to their model, the total amount of margin that will be required for both cleared and uncleared swaps is estimated to be between $2.9 trillion to $4.1 trillion, depending on the degree of netting for each type of traders. Further, they estimate that $1.34 trillion of margin is already posted for all OTC swaps, leaving an additional $1.56–2.76 trillion in margin that would need to be posted for all swaps, including both cleared and uncleared positions. The table below summarizes TABB Group’s margin estimates by trader type. higher CCP collateral requirements and counterparty diversification regulations.’’ 223 See End User Exception to the Clearing Requirement for Swaps, 77 FR 42560 (July 19, 2012). 224 See TABB Group, ‘‘The New Global Risk Transfer Market: Transformation and the Status Quo,’’ (Sept. 2012). E:\FR\FM\13DER2.SGM 13DER2 74328 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations TABLE 6—MARGIN ESTIMATES BY TRADER TYPE IN BILLIONS OF U.S. DOLLARS 225 Gross notional Trader type Gross margin (1.5% of notional) Estimated netting benefit Estimated margin posted Dealers with CCP .......................................................................................... Other Dealers ................................................................................................ Financial Institutions ...................................................................................... Non-Financial End Users ............................................................................... Others ............................................................................................................ 248,561 305,624 59,964 33,851 60,000 3,728 4,584 899 508 3,710 (99.5%) 1,605–2,521 (35–55%) 225–405 (25–45%) 76–178 (15–35%) 19 2,063–2,980 495–675 330–432 Total ........................................................................................................ .................... .................... ...................................... 2,906–4,105 As shown in the table, if the amount for non-financial end-users is excluded, then the margin shortfall will be adjusted down to $1.23–2.33 trillion. Like the Commission, the TABB Group considered all the OTC swaps, some of which are not covered by the clearing requirement. The TABB Group estimates are considerably higher than those of the Commission and of Morgan Stanley largely because of different estimates about what amount of netting will be possible for swaps not currently being cleared, and in particular, for the swaps between dealers that do not involve a CCP. sroberts on DSK5SPTVN1PROD with 4. Collateral Costs and Costs of Capital Given the increased collateral demands that required clearing of interest rate swaps and CDS is likely to bring, there will be corresponding demand for capital. To calculate the additional collateral cost to market participants, the Commission in the NPRM estimated the difference between the cost of capital for the additional collateral and the returns on that capital. Although no comments discussed this issue in comments on the NPRM, the Commission notes that in comments regarding other Commission rules, commenters have sometimes taken the view that the difference between the cost and returns on capital for funds that are used as collateral is substantial. The Commission described a comment on behalf of the Working Group of Commercial Energy Firms in the NPRM. In this comment, an economic consulting firm, NERA, used an estimate of 13.08% for the pre-tax weighted average cost of capital for the firm, and an estimate of 3.49% for the pre-tax yield on collateral, for a difference as 9.59% which NERA used as the net pre-tax cost of collateral.226 225 Id. 226 The NERA study is available at http:// comments.cftc.gov/PublicComments/ ViewComment.aspx?id=50037 and their comments defending their cost of capital are available in their VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 However, as noted in the NPRM, these estimates use the borrowing costs for the entire firm, but only consider the returns on capital for one part of the firm, when determining the spread between the two.227 The result is an over-stated difference, and therefore a higher cost associated with collateral than would result if the costs of capital and returns of capital were compared on a consistent basis.228 However, as the Commission noted in the NPRM, this cost is not only likely overstated, for the reasons mentioned above, but it also may not be a new cost. Rather, it is a displacement of a cost that is embedded in uncleared, uncollateralized (or undercollateralized) swaps. Entering into a swap is costly for any market participant because of the default risk posed by its counterparty, whether the counterparty is a DCO, swap dealer, or other market participant. When a market participant faces the DCO, the DCO accounts for that counterparty risk by requiring collateral to be posted, and the cost of capital for the collateral is part of the cost that is necessary in order to maintain the swap position. When a market participant faces a dealer or other counterparty in an uncleared swap, however, the uncleared swap contains an implicit line of credit upon which the market participant effectively draws when its swap position is out of the money. Counterparties charge for this implicit line of credit in the spread they offer on uncollateralized, uncleared swaps. It can be shown that the cash flows of an uncollateralized swap (i.e., a swap with an implicit line of credit) are, over time, substantially equivalent to the cash flows of a collateralized swap with an explicit line of credit.229 Moreover, because the counterparty credit risk created by the implicit line of credit is the same as the counterparty risk that would result from an explicit line of credit provided to the same market participant, to a first order approximation, the charge for each should be the same as well.230 This means that the cost of capital for additional collateral posted as a consequence of requiring uncollateralized swaps to be cleared does not introduce an additional cost, but rather takes a cost that is implicit in an uncleared, uncollateralized swap and makes it explicit. This observation applies to capital costs associated with both initial margin and variation margin. The Commission received no comment regarding the costs of collateral it presented in the NPRM. letter at http://comments.cftc.gov/PublicComments/ ViewComment.aspx?id=57015. 227 Moreover, according to Morgan Stanley’s research note cited above, many dealers and buyside investors currently hold enough unencumbered collateral to meet at least part of the incremental initial margin requirements. In other words, each of these entities will need to raise only a portion of the additional capital required. 228 This aspect of the NERA study has been described in greater detail by MIT professors John Parsons and Antonio Mello, available at http:// bettingthebusiness.com/2012/01/22/phantom-coststo-the-swap-dealer-designation-and-otc-reform/ and http://bettingthebusiness.com/2012/03/19/neradoubles-down/. 229 Antonio S. Mello, and John E. Parsons, ‘‘Margins, Liquidity, and the Cost of Hedging,’’ MIT Center for Energy and Environmental Policy Research, May 2012. 230 See id. at 12; Mello and Parsons state in their paper, ‘‘Hedging is costly. But the real source of the cost is not the margin posted, but the underlying credit risk that motivates counterparties to demand that margin be posted.’’ The paper goes on to demonstrate that, ‘‘To a first approximation, the cost charged for the non-margined swap must be equal to the cost of funding the margin account. This follows from the fact that the non-margined swap just includes funding of the margin account as an embedded feature of the package.’’ Id. at 15– 16. PO 00000 Frm 00046 Fmt 4701 Sfmt 4700 5. Regulatory Capital Implications Another potential impact of the new clearing requirement that the Commission described in the NPRM may result from the fact that financial institutions are required to hold additional capital with respect to their swap positions pursuant to prudential regulatory capital requirements. Basel III standards are designed to incentivize central clearing of derivatives by applying a lower capital weighting to E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations them than for similar uncleared derivatives positions.231 Moreover, bilateral margining regulations are currently being developed by the Commission and U.S. prudential regulators that will subject uncleared swaps entered into by swap dealers and major swap participants to increased margin requirements in the near future.232 Therefore, the Commission expects that, all things being equal, the capital that certain financial institutions are required to hold is likely to be reduced as a consequence of their increased use of swap clearing. The Commission received no comment regarding the regulatory capital discussion it presented in the NPRM. 6. Operational Issues Related to Collateralization sroberts on DSK5SPTVN1PROD with The Commission also discussed in the NPRM the operational costs that may result from the collateral requirements that apply to the clearing requirement. With uncleared swaps, the Commission noted, counterparties may agree not to collect variation margin until certain thresholds of exposure are reached, thus reducing or perhaps entirely eliminating the need to exchange variation margin as exposure changes. DCOs, on the other hand, collect and pay variation margin on a daily basis and sometimes more frequently. As a consequence, more required clearing may increase certain operational costs associated with moving variation margin to and from the DCO. On the other hand, increased clearing is also likely to lead to benefits from reduced operational costs related to valuation disputes, as parties to cleared swaps agree to abide by the DCO’s valuation procedures. To the extent that the requirement to clear the types of swaps covered by the new clearing requirement leads to increased use of clearing, these costs and benefits are likely to result. The Commission received no comment regarding the operational costs of collateral discussion it offered in the NPRM. 231 See Basel Committee on Banking Supervision reforms—Basel III, available at http://www.bis.org/ bcbs/basel3/b3summarytable.pdf (indicating that Basel III reforms will create capital incentives for banks to use central counterparties for derivatives). 232 The Commission’s proposed is Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 FR 23732 (Apr. 28, 2011); and the U.S. prudential regulators proposed a similar requirement, Margin and Capital Requirements for Covered Swap Entities, 76 FR 27564 (May 11, 2011). VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 7. Guaranty Fund Contribution as a Collateral Cost As explained in the NPRM, increases in clearing as a result of the clearing requirement also may result in additional costs for clearing members in the form of guaranty fund contributions. However, the Commission noted, it may be that increased clearing of swaps would decrease guaranty fund contributions for certain clearing members. Market participants that currently transact swaps bilaterally, and do not clear such swaps, must either become clearing members of an eligible DCO or submit such swaps for clearing through an existing clearing member of an eligible DCO, once the clearing requirement applies to such swaps. A party that chooses to become a clearing member of a DCO must make a guaranty fund contribution based on the risk that its positions pose to the DCO. A party that chooses to clear swaps through an existing clearing member may have a share of the clearing member’s guaranty fund contribution passed along to it in the form of fees. While the addition of new clearing members and new customers for existing clearing members may result in existing clearing members experiencing an increase in their guaranty fund requirements, it should be noted that if (1) new clearing members are not among the two clearing members used to calculate the guaranty fund and (2) any new customers trading through a clearing member do not increase the size of uncollateralized risks at either of the two clearing members used to calculate the guaranty fund, all else held constant, existing clearing members may experience a decrease in their guaranty fund requirement. The Commission received no comment regarding the guaranty fund costs discussion it presented in the NPRM. d. Benefits of Clearing In the NPRM, the Commission also described the benefits of swap clearing, which in general, are significant. Thus, to the extent that the new clearing requirement for certain classes of interest rate swaps and CDS leads to increased use of clearing, these benefits are likely to result. As is the case for the costs noted above, it is difficult to predict the precise extent to which the use of clearing will increase as a result of the new requirement, and therefore the benefits of the requirement cannot be precisely quantified. But the Commission believes that the benefits of increased clearing resulting from this requirement will be significant, because PO 00000 Frm 00047 Fmt 4701 Sfmt 4700 74329 the classes of swaps required to be cleared represent a substantial portion of the total swap markets. Currently outstanding interest rate swaps and CDS indices represent about 77.8% and 1.6%, respectively, of the total global swaps market, when measured by notional amount.233 As noted above, the new clearing requirement requires that only certain classes of interest rate swaps and CDS indices be cleared, but such classes likely represent the most common swaps within those overall asset classes, and therefore are likely to comprise a relatively large portion of those asset classes. The Commission reiterates the conclusion stated in the NPRM, which is that by requiring these particular swaps to be cleared, the benefits of clearing are expected to be realized across a relatively large portion of the market. The new clearing requirement that swaps within certain classes be cleared is expected to increase the number of swaps in which market participants will face a DCO, and therefore, will face a highly creditworthy counterparty. DCOs are some of the most creditworthy counterparties in the swap market because, as explained above, they have at their disposal a number of risk management tools that enable them to manage counterparty risk effectively. Those tools include contractual rights that enable them to use margin to manage current and potential future exposure, to close out and transfer defaulting positions while minimizing losses that result from such defaults, and to protect solvency during the default of one or more members through a waterfall of financial resources from which they can draw, as outlined above. Also, clearing protects swap customers from the risk of having to share losses in the event of the default of another clearing member. Under § 50.2(a) of this adopting release, swaps meeting the specifications of the classes of swaps that are required to be cleared must be submitted to clearing ‘‘as soon as technologically practicable after execution, but in any event by the end of the day of execution.’’ 234 This conforms to the requirements established in the recently finalized rule 233 BIS data, December 2011, available at http:// www.bis.org/statistics/derstats.htm. As explained above, the Commission observes that while CDS accounts for a smaller portion of the total swaps market, its unique risk profile involving jump-todefault risk contributed to the Commission’s decision to include it in among the first clearing determinations. 234 See § 50.2(a) (setting for the timeframe for submission of swaps to DCOs). E:\FR\FM\13DER2.SGM 13DER2 74330 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with regarding timing of acceptance for clearing,235 which is designed to promote rapid submission of these swaps for clearing and reduce the unnecessary counterparty risk that can develop between the time of execution and submission to clearing.236 As it noted in the NPRM, the Commission expects that the requirement for rapid submission, processing, and acceptance or rejection of swaps for clearing will be beneficial in several respects. It is important to note that when two parties enter into a bilateral swap with the intention of clearing it, each party bears counterparty risk until the swap is cleared. Once the swap is cleared, the clearinghouse becomes the counterparty to each of the original parties, which minimizes and standardizes counterparty risk. Where swaps of the type covered by the new clearing requirement are not executed on an exchange, the requirements of § 50.2(a) should significantly reduce the amount of time needed to process them. Although costs associated with latency-period counterparty credit risk cannot be completely eliminated in this context, the rules will reduce the need to discriminate among potential counterparties in executing off-exchange swaps, as well as the potential costs associated with swaps that are rejected from clearing. By reducing the counterparty risk that could otherwise develop during the latency period, these rules promote a market in which all eligible market participants have access to counterparties willing to trade on terms that approximate the best available terms in the market. This is likely to improve price discovery and promote market integrity. Another benefit of the new clearing requirement is the mitigation of systemic risk. Counterparty risk readily develops into systemic risk in an interconnected financial system especially in times of financial stress due to various types of contagion effects.237 By ensuring that outstanding 235 See Client Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management, 77 FR 21278 (Apr. 9, 2012). 236 The Commission notes that if a market participant executed a swap that is required to be cleared on a SEF or DCM, then that market participant will be deemed to have met their obligation to submit the swap to a DCO because of the straight-through processing rules previously adopted by the Commission. 237 For a comprehensive discussion of the various types of contagion effects in times of financial stress, see Brunnermeier, M., A. Crocket, C. Goodhart, A. Persaud, and H. Shin: ‘‘The Fundamental Principles of Financial Regulation,’’ (2009), available at http://www.princeton.edu/ ∼markus/research/papers/Geneva11.pdf. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 potential future and current exposures are collateralized in a timely fashion for more swaps, this new clearing requirement contributes to the mitigation of systemic risk. The Commission’s consideration of the effect on the mitigation of systemic risk is generally supported by comments, which provided general observations regarding the mitigation of systemic risk. Citadel and Eris Exchange both stated that implementing the clearing requirement is a significant milestone toward ‘‘achieving the DoddFrank Act’s objectives of reducing interconnectedness, mitigating systemic risk, increasing transparency, and promoting competition in the swaps market.’’ Freddie Mac commented that it ‘‘supports the Commission’s goal to reduce systemic risk through central clearing of swaps where appropriate.’’ On the other hand, ISDA urged the Commission to consider the argument that ‘‘clearing involves a greater centralization of risk than the over-the counter markets ever did.’’ ISDA also questioned the risk-mitigating aspects of central clearing as contrasted with the new regulatory regime for uncleared swaps. In response to ISDA’s comment, the Commission observes that while the regime for bilateral, uncleared swaps will be greatly improved after full implementation of the Dodd-Frank Act reforms, central clearing provides for certain risk management features that cannot be replicated on a bilateral basis. To name just one critical distinction, a clearinghouse addresses the tail risk of open positions through mutualization. Each clearing member must contribute to a default fund that protects the system as a whole. Also, recent experience indicates that all DCOs were able to withstand the 2008 financial crisis in a relatively sound manner.238 Regarding competition, Markit stated that the new clearing requirement might lower barriers to entry in the index provider market ‘‘because new indices would not necessarily be subject to the clearing mandate, which can be costly.’’ Citadel commented that the framework established by the Commission 238 No DCO required government assistance, and all DCOs were able to manage their open positions in both swaps and futures. Even difficult default situations were handled in an orderly fashion. For example, during the Lehman Brothers’ bankruptcy in September 2008, LCH was able to manage the default of Lehman’s significant swap portfolio. See 77 FR at 47188 and LCH IRS submission, at 4 (discussing LCH’s management of the Lehman Brothers’ bankruptcy in September 2008, where upon Lehman’s default, LCH needed to risk manage a portfolio of approximately 66,000 interest rate swaps, which it hedged with approximately 100 new swap trades in less than five days and only used approximately 35% of the initial margin Lehman had posted). PO 00000 Frm 00048 Fmt 4701 Sfmt 4700 promotes competition among swap dealers, as ‘‘counterparty credit risk no longer features as a consideration in the selection of executive counterparties.’’ In addition, § 50.10 and related guidance provides market participants with a useful framework for behavior under the requirements of section 2(h), which will promote the benefits of swap clearing without introducing uncertainty regarding market behavior. Activity conducted principally for a legitimate business purpose, absent other indicia of evasion or abuse, would not constitute a violation of § 50.10 as described in the Commission’s interpretation. D. Consideration of Alternative Swap Classes for Clearing Determinations The Commission’s determination to require initially the clearing of certain CDS and interest rate swaps is a function of both the market importance of these products and the fact that they already are widely cleared. In order to move the largest number of swaps to required clearing in its initial determination, the Commission continues to believe that it is prudent to focus on swaps that are widely used and for which there is already a blueprint for clearing and appropriate risk management. CDS and interest rate swaps that match these factors are therefore well suited for required cleared. As noted in the NPRM and discussed above, interest rate swaps with a notional amount of $504 trillion are currently outstanding—the highest proportion of the $648 trillion global swaps market of any class of swaps.239 CDS indices with a notional amount of about $10.4 trillion are currently outstanding.240 While CDS indices do not have as prominent a share of the entire swaps market as interest rate swaps, uncleared CDS is capable of having a sizeable market impact, as it did during the 2008 financial crisis. In addition, many of the swaps within each of the classes that will now be subject to required clearing are already cleared by one or more clearinghouses. LCH claims to clear interest rate swaps with a notional amount of about $284 trillion—meaning that, in notional terms, LCH represents that they clear just over 50% of the interest rate swap market.241 The swap market has made a smooth transition into clearing CDS on its own initiative. As a result, DCOs, FCMs, and many market participants 239 BIS data, June 2011, available at http:// www.bis.org/publ/otc_hy1111.pdf. 240 See id. 241 See id. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations already have experience clearing the types of swaps that will be subject to required clearing. The Commission expects, therefore, that DCOs and FCMs are equipped to handle the increases in volume and outstanding notional amount in these swaps that is likely to be cleared as the result of this rule. Because of the wide use of these swaps and their importance to the market, and because these swaps are already cleared safely, the Commission continues to believe it is reasonable to initially subject certain types of interest rate swaps and CDS to the clearing requirement. In reviewing the swap submissions provided by DCOs, the Commission decided to classify swaps according to certain key specifications for CDS and interest rate swaps. These specifications inform whether a particular swap falls within one of the classes of swaps that the Commission has determined are required to be cleared. The two classes of CDS that are required to be cleared are (1) U.S. dollar-denominated CDS covering North America corporate credits and (2) euro-denominated CDS referencing European corporate obligations. The four classes of interest rate swaps required to be cleared are (1) fixed-to-floating swaps, (2) basis swaps, (3) OIS, and (4) FRAs. In formulating each of the six classes under this adopting release, the Commission considered a number of alternatives. Regarding CDS, the Commission outlined three key specifications comprising (1) region and nature of reference entity, (2) the nature of the CDS itself, and (3) tenor. Each of these specifications will assist market participants in determining whether a swap falls within the CDS classes of swaps required to be cleared. For the first, a distinguishing characteristic is whether the reference entity is in North American or European and whether it is one of Markit’s CDX.NA.IG, CDX.NA.HY, iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High Volatility indices. The second key specification relates to whether the CDS is tranched or untranched. The classes that are required to be cleared include only untranched CDS where the contract covers the entire index loss distribution of the index and settlement is not linked to a specified number of defaults. Tranched swaps, first- or ‘‘Nth’’ to-default, options, or any other product variations on these indices are excluded from these classes. Finally, the third key specification entails whether a swap falls within a tenor, specific to an index, that is required to be cleared. The Commission has determined that each of the 3-, 5-, 7-, and 10-year tenors be VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 included within the class of swaps subject to the clearing requirement determination for CDX.NA.IG; the 5year tenor be included for CDX.NA.HY; each of the 5- and 10-year for iTraxx Europe; the 5-year for iTraxx Europe Crossover; and, the 5-year for iTraxx Europe High Volatility. In addition, it should be noted that only certain series will be viewed as required to be cleared. The Commission considered a number of possible alternatives. First, the Commission could have used a narrower or broader group of reference entities. For example, the Commission has not included the CDX.NA.IG.HVOL within the North American swap class, but it considered doing so. The Commission concluded that while doing so would have increased the number of swaps required to be cleared, there is not sufficient liquidity to justify required clearing at this time given that the recent series of CDX.NA.IG.HVOL has not been cleared by ICE (and is not offered at all by CME). Several commenters raised issues regarding the operational capabilities of clearinghouses to manage the clearing of iTraxx CDS indices for customers.242 More specifically, they pointed out that no registered DCO currently offers customer clearing for iTraxx and expressed concerns about the ability of clearinghouses to manage restructuring credit events applicable to iTraxx. On the other hand, Citadel and ICE both supported the inclusion of iTraxx CDS indices in the clearing requirement. In particular, ICE stated that ICE Clear Europe has begun the process of pursuing regulatory approval for clearing of iTraxx and that ICE Clear Credit will do the same; moreover, ICE said that it has worked closely with market participants and DTCC to develop an industry wide solution for processing a restructuring credit event. Having considered the different views, the Commission is including the iTraxx class of CDS as proposed. The Commission believes that the uncertainty surrounding the implementation of customer clearing for iTraxx will be resolved within the next few months, which will allow this standard and liquid class of CDS to be cleared. If no eligible DCO offers iTraxx for client clearing, compliance with the required clearing of iTraxx will commence sixty days after the date on which iTraxx is first offered for client clearing by an eligible DCO. The Commission also considered whether it could include tranched CDS in the clearing requirement. The Commission recognized in the NPRM 242 ISDA, PO 00000 FIA, MFA, and D.E. Shaw. Frm 00049 Fmt 4701 Sfmt 4700 74331 that there is a significant market for tranched swaps using the indices. In these transactions, parties to the CDS contract agree to address only a certain range of losses along the entire loss distribution curve. Other swaps such as first or ‘‘Nth’’ to default baskets, and options, also exist on the indices. However, these swaps are not being cleared currently and were not submitted by a DCO for consideration under § 39.5. As a result, including tranched CDS was not a viable alternative for this determination. AFR noted that requiring clearing of only untranched CDS indices may give rise to arbitrage opportunities, as the payoff properties desired from an index can be closely replicated by trading tranches of that index. The Commission recognizes this concern and will take into account the possibility of arbitrage opportunities in its future reviews of tranched CDS for clearing determination. Regarding tenor, the Commission could have included more of those offered within the classes of swaps required to be cleared. For example, the Commission noted in the NPRM that the CDX.NA.IG has 1- and 2-year tenors and the CDX.NA.HY, has 3-, 7-, and 10-year tenors that have not been included among the specified tenors. The iTraxx Europe has 3- and 7-year tenors and the Crossover and High Volatility each have 3-, 7-, and 10-year tenors that have not been included. In addition, the Commission could have included all series of active indices. The Commission’s concern, regarding both tenors and series, is that certain tenors and series have lower liquidity and may be difficult for a DCO to adequately risk manage, which is reflected in the fact that those tenors and series are not currently cleared by any DCO. While including more tenors and series would have increased the volume of swaps required to be cleared to some degree, the Commission concluded that doing so could raise costs for DCOs and other market participants and be less desirable relative to the factors established in § 39.5. AFR commented that both the 1- and 2-year tenors of the CDX.NA.IG should be included in the clearing requirement. It is concerned that ‘‘market participants might shift to those tenors to avoid mandatory clearing [of the longer tenors].’’ The Commission notes that no DCO currently clears the 1- or 2-year tenor of CDX.NA.IG, making the clearing of either swap infeasible. However, the Commission recognizes that requiring mandatory clearing of these shorter tenors may prevent E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with 74332 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations arbitrage opportunities if they generate sufficient trading volumes in the future. With regard to interest rate swaps, as mentioned above, the Commission is finalizing a clearing requirement for four classes of interest rate swaps: Fixed-to-floating swaps, basis swaps, OIS, and FRAs. Within those four classes, there are three affirmative specifications for each class ((i) Currency in which the notional and payment amounts are specified, (ii) rates referenced for each leg of the swap, and (iii) stated termination date of the swap). There are also three ‘‘negative’’ specifications for each class ((i) No optionality (as specified by the DCOs); (ii) no dual currencies; and (iii) no unknown notional amounts). The Commission considered whether to establish clearing requirements on a product-by-product basis. As noted in the NPRM, such a determination would need to identify the multitude of legal specifications of each product that would be subject to the clearing requirement. Although the industry uses standardized definitions and conventions, the product descriptions would be lengthy and require counterparties to compare all of the legal terms of their particular swap against the terms of the many different swaps that would be included in a clearing requirement. The Commission continues to believe that for interest rate swaps, a product-by-product determination would be unnecessarily burdensome for market participants in trying to assess whether each swap transaction is subject to the requirement. A class-based approach allows market participants to determine quickly whether they need to submit their swap to a DCO for clearing by checking initially whether the swap has the basic specifications that define each class subject to the clearing requirement. As an alternative to the classes selected, LCH recommended in its IRS submission that the Commission use the following specifications to classify interest rate swaps for purposes of making a clearing determination: (i) Swap class (i.e., what the two legs of the swap are (fixed-to-floating, basis, OIS, etc.)); (ii) floating rate definitions used; (iii) the currency designated for swap calculations and payments; (iv) stated final term of the swap (also known as maturity); (v) notional structure over the life of the swap (constant, amortizing, roller coaster, etc.); (vi) floating rate frequency; (vii) whether optionality is included; and (viii) whether a single currency or more than one currency is used for denominating payments and notional amount. In its submission, VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 CME recommended a clearing determination for all non-option interest rate swaps denominated in a currency cleared by any qualified DCO. The Commission noted in the NPRM that these alternative specifications fall into two general categories: specifications that are commonly used to address mechanical issues for most swaps, and specifications that are less common and address idiosyncratic issues related to the particular needs of a counterparty. Examples of the latter are special representations added to address particular legal issues, unique termination events, special fees, and conditions tied to events specific to the parties. None of the DCOs clear interest rate swaps with terms in the second group. While such specifications may affect the value of the swap, such specifications are not, generally speaking, fundamental to determining the economic result the parties are trying to achieve.243 The Commission is finalizing the three affirmative specifications described above because it believes that they are fundamental specifications used by counterparties to determine the economic result of a swap transaction for each party.244 The Commission also noted in the NPRM that it could have not included the negative specifications for interest rate swaps, which would have had the potential effect of including more interest rate swaps within the universe of those required to be cleared. However, the Commission continues to believe that swaps with optionality (such as swaptions or swaps with embedded options), multiple currency swaps, and swaps with notional amounts that are not specified at the time of execution raise concerns regarding adequate pricing measures and consistency across swap contracts. Additionally, at this time, no DCO is offering them for clearing. Another alternative considered by the Commission and discussed in the NPRM was that of stating the clearing requirement in terms of a particular type of swap, rather than using broad characteristics to describe the type of swaps for which clearing would be 243 As noted in Section II.E above, mechanical specifications include characteristics such as floating rate reset tenors, reference city for business days, business day convention, and others that have some small impact on valuation but that do not fundamentally alter the economic consequence of the swap for the parties that enter into it. 244 In a comment, ISDA questioned the Commission’s description of mechanical and idiosyncratic factors. In response, the Commission clarified that it is not introducing a new test for interest rate swaps, but was merely setting forth and describing relevant class-defining specifications. See Section II.D above for a full discussion. PO 00000 Frm 00050 Fmt 4701 Sfmt 4700 required. For example, rather than requiring that all interest rate swaps that meet the six specifications in § 50.4(a) be cleared, the Commission noted in the NPRM that the rule could have specified that only certain sub-types of those interest rate swaps—such as all such interest rate swaps with a term of five years—are required to be cleared. Such an approach might permit the Commission to account for variation in liquidity and outstanding notional values among different sub-types of swap, and thereby focus the clearing requirement on very particular swaps to account for these differences within the same general class. Also, generally speaking, limiting the clearing requirement to fewer swaps could reduce some costs associated with clearing. However, this advantage was weighed against an important disadvantage of this approach. A highly focused clearing requirement could increase the ability for market participants to replicate the economic results of a swap that is required to be cleared by substituting a swap not required to be cleared; this greater latitude for clearing avoidance, in turn, could increase systemic risk and dampen the beneficial effects of clearing noted above.245 Under the approach proposed by the Commission, all swaps that fall within identified classes are covered by the clearing requirement, provided an eligible DCO offers the swap for clearing, which reduces the risk of such avoidance and the associated reduction of benefits. Moreover, stating the clearing requirement in more general terms reduces the costs associated with determining whether or not a particular swap is subject to the clearing requirement. Numerous commenters expressed support for the Commission’s specifications determination.246 CME stated that ‘‘the Commission has struck an appropriate balance for the initial slate of classes subject to the requirement.’’ LCH commented that ‘‘the Commission’s decision to classify interest rate swaps based on six principle swap specifications * * * is sound.’’ Citadel stated that the Commission’s class designation approach ‘‘reflects the risk management approach utilized across the industry, and most importantly by DCOs’’ to 245 For instance, in the example noted above, swaps with a term of five years and one day would not be required to be cleared. 246 AllianceBernstein, R.J. O’Brien, Citadel, Eris Exchange, CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies, Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris Barnard, and Svenokur. E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations determine necessary margin and other safeguards. On the other hand, regarding interest rate swaps, ISDA is concerned that the Commission’s class-based approach will impose great burdens and uncertainties in terms of ‘‘the search efforts needed to filter out from among the broad class those specific products that a DCO will accept for clearing.’’ The Commission notes that ISDA’s concern may not be justified, as CME already has a platform in place that ‘‘provides market participants with a tool to screen a particular swap for eligibility for clearing upon submission of the swap to CME.’’ The Commission also considered requiring clearing for all seventeen currencies of interest rate swaps that are currently offered for clearing, but decided instead to require clearing at this time for interest rate swaps in four currencies (EUR, USD, GBP, and JPY). As noted in the NPRM, the Commission recognizes that requiring interest rate swaps in all seventeen currencies submitted by LCH to be cleared would provide the benefit of some incremental reduction in overall counterparty, and thus systemic, risk attendant to clearing a greater portion of interest rate swaps. However, as noted above, the Commission continues to believe that initiating the clearing requirement in a measured manner with respect to interest rate swaps in the four specified currencies familiar to many market participants is the preferable approach at this time because it would give market participants an opportunity to identify and address any operational challenges related to required clearing. Moreover, the currencies included in the required classes constitute approximately 93% of cleared interest rate swaps, which suggests that significant reductions in counterparty risk and gains in systemic protection will be accomplished by limiting the clearing determination to them.247 LCH supported the Commission’s determination, and recommended that the Commission propose mandatory clearing of swaps denominated in the other 13 currencies once the initial phase of mandatory clearing is wellestablished. LCH stated that there is ‘‘ample volume and liquidity in swaps denominated in these currencies to support mandatory clearing.’’ The Commission will evaluate the benefits of this recommendation against the cost burdens in its future determinations. Similarly, the Commission considered requiring clearing of all CDS that are 247 See Section II.F above for more thorough discussion of the data. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 currently being cleared, but did not propose to include, in the initial clearing requirement, certain types of CDS that have a less significant role in the current market.248 AFR and Chris Barnard both urged the Commission to rapidly designate energy, agriculture and equity swaps for mandatory clearing as well. The Commission reiterates that it will continue to review swap submissions received from DCOs and will issue clearing requirement for other classes of swaps so as to realize the benefits of clearing in a timely manner. E. Section 15(a) Factors As noted above, the requirement to clear swaps within the classes of swaps covered by this adopting release is expected to result in increased use of clearing, although it is difficult to quantify the extent of that increase. Thus, this section discusses the expected results from an overall increase in the use of swap clearing in terms of the factors set forth in section 15(a) of the CEA. i. Protection of Market Participants and the Public As described above, required clearing of CDS and interest rate swaps resulting from this clearing determination is expected to reduce counterparty credit risk for market participants that will now be required to clear those swaps because they will face the DCO rather than another market participant that lacks the full array of risk management tools that the DCO has at its disposal. This increase in clearing of CDS and interest rate swaps also reduces uncertainty in times of market stress because market participants facing a DCO are less concerned with the impact of such stress on the solvency of their counterparty for cleared trades. Moreover, by reducing uncertainty about counterparty solvency for market participants facing a DCO, the clearing determinations under this adopting release are likely to reduce the risk of contagion if one or more DCO customers or clearing members fails during a time of market stress, which creates benefits for the public. By requiring clearing of swaps within certain classes, all of which are already available for clearing, the Commission continues to expect, as it stated in the NPRM, that this rule will encourage a 248 For instance, the Commission decided not to include CDX.NA.IG.HiVol from the proposed determination given the lack of volume in the current on-the-run and recent off-the-run series. In addition, CME currently does not clear any HiVol contracts, and ICE Clear Credit no longer clears the most recent series. PO 00000 Frm 00051 Fmt 4701 Sfmt 4700 74333 smooth transition to clearing by creating an opportunity for market participants to work out challenges related to required clearing of swaps while operating in familiar terrain. More specifically, the DCOs will clear an increased volume of swaps that they already understand and have experience managing. Similarly, FCMs likely will realize increased customer and transaction volume as the result of the requirement, but will not have to simultaneously learn how to operationalize clearing for new types of swaps. Additionally, the experience that current FCMs have with these swaps is likely to benefit customers that are new to swap clearing, as the FCM guides them through initial process of clearing swaps.249 In addition, uncleared swaps subject to collateral agreements can be the subject of valuation disputes. These valuation disputes sometimes require several months, or longer, to resolve. Uncollateralized exposure can grow significantly during that time, leaving one of the two parties exposed to counterparty credit risk that was intended to be covered through a collateral agreement. DCOs eliminate, or reduce, valuation disputes for cleared swaps as well as the risk that uncollateralized exposure can develop and accumulate during the time when such a dispute would have otherwise occurred, thus providing additional protection to market participants that transact in swaps subject to required clearing.250 As far as costs are concerned, market participants that do not currently have established clearing relationships with an FCM will have to set up and maintain such a relationship in order to clear swaps that are required to be cleared. As discussed above, market participants that conduct a limited number of swaps per year will likely be required to pay monthly or annual fees that FCMs charge to maintain both the relationship and outstanding swap positions belonging to the customer. In addition, the FCM is likely to pass along fees charged by the DCO for establishing and maintaining open positions. 249 As discussed in Section II.C and II.E above, DCOs offering clearing for CDS and interest rate swaps have established extensive risk management practices, which focus on the protection of market participants. See also Sections II.D and II.F for a discussion of the effect on the mitigation of systemic risk in the CDS market and in the interest rate swaps market, as well as the protection of market participants during insolvency events at either the clearing member or DCO level. 250 See Sections II.D and II.F above for a further discussion of how DCOs obtain adequate pricing data for the CDS and interest rate swaps that they clear. Based on this pricing data, valuation disputes are minimized, if not eliminated for cleared swaps. E:\FR\FM\13DER2.SGM 13DER2 74334 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with ii. Efficiency, Competitiveness, and Financial Integrity of Swap Markets The Commission continues to expect, as it explained in the NPRM, that increased clearing of the CDS and interest rate swaps subject to this adopting release is expected to reduce uncertainty regarding counterparty credit risk in times of market stress and promote liquidity and efficiency during those times. Increased liquidity promotes the ability of market participants to limit losses from exiting positions effectively when necessary in order to manage risk during a time of market stress. In addition, to the extent that positions move from facing multiple counterparties in the bilateral market to being run through a smaller number of clearinghouses, clearing likely facilitates increased netting. This netting effect reduces operational risk and may reduce the amount of collateral that a party must post or pay in terms of initial and variation margin. As discussed in Sections II.D and II.F above, in setting forth this new clearing requirement, the Commission took into account a number of specific factors that relate to the financial integrity of the swap markets. Specifically, the NPRM and the discussion above includes an assessment of whether the DCOs clearing CDS and interest rate swaps have the rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear CDS and interest rate swaps on terms that are consistent with the material terms and trading conventions on which the contract is then traded. The Commission also considered the financial resources of DCOs to handle additional clearing, as well as the existence of reasonable legal certainty in the event of a clearing member or DCO insolvency.251 As discussed above, bilateral swaps create counterparty risk that may lead market participants to discriminate among potential counterparties based on their creditworthiness. Such discrimination is expensive and time consuming insofar as market participants must conduct due diligence in order to evaluate a potential counterparty’s creditworthiness. Requiring the certain types of swaps subject to this clearing determination to be cleared reduces the number of transactions for which such due diligence is necessary, thereby contributing to the efficiency of the swap markets. 251 See Sections II.D and II.F. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 In setting forth a clearing requirement for both CDS and interest rate swaps, the Commission considered the effect on competition, including appropriate fees and charges applied to clearing. As discussed in more detail in Sections II.D and II.F above, there are a number of potential outcomes that may result from required clearing. Some of these outcomes may impose costs, such as if a DCO possessed market power and exercised that power in a anticompetitive manner, and some of the outcomes would be positive, such as if the clearing requirement facilitated a stronger entry-opportunity for competitors. As far as costs are concerned, the markets for some swaps within the classes that are required to be cleared may be less liquid than others. All other things being equal, swaps for which the markets are less liquid have the potential to develop larger current uncollateralized exposures after a default on a cleared position, and therefore will require posting of relatively greater amounts of initial margin. iii. Price Discovery As the Commission noted in the NPRM, clearing of CDS and interest rate swaps subject to this new clearing requirement is likely to encourage better price discovery because it eliminates the importance of counterparty creditworthiness in pricing swaps cleared through a given DCO. That is, by making the counterparty creditworthiness of all swaps of a certain type essentially the same, prices should reflect factors related to the terms of the swap, rather than the idiosyncratic risk posed by the entities trading it.252 As discussed in Sections II.D and II.F above, DCOs obtain adequate pricing data for the CDS and interest rate swaps that they clear. Each DCO establishes a rule framework for its pricing methodology and rigorously tests its pricing models to ensure that the cornerstone of its risk management regime is as sound as possible. iv. Sound Risk Management Practices If a firm enters into swaps to hedge certain positions and then the counterparty to those swaps defaults unexpectedly, the firm could be left with large outstanding exposures and unhedged positions. As explained in the 252 See Chen, K., et al., ‘‘An Analysis of CDS Transactions: Implications for Public Reporting,’’ September 2011, Federal Reserve Bank of New York Staff Reports, at 14, available at http:// www.newyorkfed.org/research/staff_reports/ sr517.pdf. PO 00000 Frm 00052 Fmt 4701 Sfmt 4700 NPRM and stated above, when a swap is cleared, the DCO becomes the counterparty facing each of the two original counterparties to the swap. This standardizes and reduces counterparty credit risk for each of the two original participants. To the extent that a market participant’s hedges comprise swaps that are required to be cleared, the requirement enhances their risk management practices by reducing their counterparty risk. Accordingly, for counterparties required to clear those CDS and interest rate swaps subject to this requirement, risk management will be enhanced. In addition, from systemic perspective, required clearing reduces the complexity of unwinding/ transferring swap positions from large entities that default. Procedures for transfer of swap positions and mutualization of losses among DCO members are already in place, and the Commission continues to anticipate that they are much more likely to function in a manner that enables efficient transfer of positions than legal processes that apply to uncleared, bilateral swaps.253 v. Other Public Interest Considerations In September 2009, the President and the other leaders of the ‘‘G20’’ nations met in Pittsburgh and committed to a program of action that includes, among other things, central clearing of all standardized swaps.254 Together, interest rate swaps and CDS represent more than 75% of the notional amount of outstanding swaps, and therefore, requiring the most active, standardized classes of swaps within those groups to be cleared represents a significant step toward the fulfillment of that commitment. VI. Related Matters A. Regulatory Flexibility Act The Regulatory Flexibility Act (RFA) requires that agencies consider whether the rules they propose will have a 253 As discussed in Sections II.C and II.E above, sound risk management practices are critical for all DCOs, especially those offering clearing for CDS and interest rate swaps. In the discussion above, the Commission considered whether each DCO submission under review was consistent with the core principles for DCOs. In particular, the Commission considered the DCO submissions in light of Core Principle D, which relates to risk management. See also Sections II.D and II.F for a discussion of the effect on the mitigation of systemic risk in the CDS market and in the interest rate swaps market, as well as the protection of market participants during insolvency events at either the clearing member or DCO level. 254 A list of the G20 commitments made in Pittsburgh can be found at: http:// www.g20.utoronto.ca/analysis/commitments-09pittsburgh.html. E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations significant economic impact on a substantial number of small entities and, if so, provide a regulatory flexibility analysis respecting the impact.255 As stated in the NPRM, the clearing requirement determinations and rules proposed by the Commission will affect only eligible contract participants (ECPs) because all persons that are not ECPs are required to execute their swaps on a DCM, and all contracts executed on a DCM must be cleared by a DCO, as required by statute and regulation; not by operation of any clearing requirement.256 Accordingly, the Chairman, on behalf of the Commission, certified pursuant to 5 U.S.C. 605(b) that the proposed rules would not have a significant economic impact on a substantial number of small entities. The Commission then invited public comment on this determination. The Commission received no comments. The Commission has previously determined that ECPs are not small entities for purposes of the RFA.257 However, in its proposed rulemaking to establish a schedule to phase in compliance with certain provisions of the Dodd-Frank Act, including the clearing requirement under section 2(h)(1)(A) of the CEA, the Commission received a joint comment (Electric Associations Letter) from the Edison Electric Institute (EEI), the National Rural Electric Cooperative Association (NRECA) and the Electric Power Supply Association (EPSA) asserting that certain members of NRECA may both be ECPs under the CEA and small businesses under the RFA.258 These members of NRECA, as the Commission understands, have been determined to be small entities by the Small Business Administration (SBA) because they are ‘‘primarily engaged in the generation, transmission, and/or distribution of electric energy for sale and [their] total electric output for the preceding fiscal year did not exceed 4 million megawatt hours.’’ 259 Although the Electric Associations Letter does not provide details on whether or how the NRECA members that have been determined to 255 See 5 U.S.C. 601 et seq. the extent that this rulemaking affects DCMs, DCOs, or FCMs, the Commission has previously determined that DCMs, DCOs, and FCMs are not small entities for purposes of the RFA. See, respectively and as indicated, 47 FR 18618, 18619, Apr. 30, 1982 (DCMs and FCMs); and 66 FR 45604, 45609, Aug. 29, 2001 (DCOs). 257 See 66 F.R. 20740, 20743 (Apr. 25, 2001). 258 See joint letter from EEI, NRECA, and ESPA, dated Nov. 4, 2011, (Electric Associations Letter), commenting on Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011). 259 Small Business Administration, Table of Small Business Size Standards, Nov. 5, 2010. sroberts on DSK5SPTVN1PROD with 256 To VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 be small entities use the interest rate swaps and CDS that are the subject of this rulemaking, the Electric Associations Letter does state that the EEI, NRECA, and EPSA members ‘‘engage in swaps to hedge commercial risk.’’ 260 Because the NRECA members that have been determined to be small entities would be using swaps to hedge commercial risk, the Commission expects that they would be able to use the end-user exception from the clearing requirement and therefore would not be affected to any significant extent by this rulemaking. Thus, because nearly all of the ECPs that may be subject to the proposed clearing requirement are not small entities, and because the few ECPs that have been determined by the SBA to be small entities are unlikely to be subject to the clearing requirement, the Chairman, on behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that the rules herein will not have a significant economic impact on a substantial number of small entities. B. Paperwork Reduction Act The Paperwork Reduction Act (PRA) 261 imposes certain requirements on federal agencies (including the Commission) in connection with conducting or sponsoring any collection of information as defined by the PRA. As stated in the NPRM, § 50.3(a), would require each DCO to post on its Web site a list of all swaps that it will accept for clearing and clearly indicate which of those swaps the Commission has determined are required to be cleared, builds upon the requirements of § 39.21(c)(1), which requires each DCO to disclose publicly information concerning the terms and conditions of each contract, agreement, and transaction cleared and settled by the DCO. The Commission received no comments related to PRA. Thus, this rulemaking will not require a new collection of information from any persons or entities. List of Subjects 17 CFR Part 39 Business and industry, Reporting requirements, Swaps. 17 CFR Part 50 Business and industry, Clearing, Swaps. 260 See Electric Associations Letter, at 2. The letter also suggests that EEI, NRECA, and EPSA members are not financial entities. See id., at note 5, and at 5 (the associations’ members ‘‘are not financial companies’’). 261 44 U.S.C. 3507(d). PO 00000 Frm 00053 Fmt 4701 Sfmt 4700 74335 For the reasons stated in the preamble, amend 17 CFR parts 39 and 50 as follows: PART 39—DERIVATIVES CLEARING ORGANIZATIONS 1. The authority citation for part 39 continues to read as follows: ■ Authority: 7 U.S.C. 2 and 7a–1 as amended by Pub. L. 111–203, 124 Stat. 1376. § 39.6 ■ [Removed and Reserved] 2. Remove and reserve § 39.6. PART 50—CLEARING REQUIREMENT AND RELATED RULES 3. The authority citation to part 50 is revised to read as follows: ■ Authority: 7 U.S.C. 2(h) and 7a–1 as amended by Pub. L. 111–203, 124 Stat. 1376. 4. Add subpart A, consisting of §§ 50.1 through 50.24 to read as follows: ■ Subpart A—Definitions and Clearing Requirement Sec. 50.1 Definitions. 50.2 Treatment of swaps subject to a clearing requirement. 50.3 Notice to the public. 50.4 Classes of swaps required to be cleared. 50.5 Swaps exempt from a clearing requirement. 50.6 Delegation of authority. 50.7–50.9 [Reserved] 50.10 Prevention of evasion of the clearing requirement and abuse of an exception or exemption to the clearing requirement. 50.11–50.24 [Reserved] Subpart A—Definitions and Clearing Requirement § 50.1 Definitions. For the purposes of this part, Business day means any day other than a Saturday, Sunday, or legal holiday. Day of execution means the calendar day of the party to the swap that ends latest, provided that if a swap is: (1) Entered into after 4:00 p.m. in the location of a party; or (2) Entered into on a day that is not a business day in the location of a party, then such swap shall be deemed to have been entered into by that party on the immediately succeeding business day of that party, and the day of execution shall be determined with reference to such business day. § 50.2 Treatment of swaps subject to a clearing requirement. (a) All persons executing a swap that: (1) Is not subject to an exception under section 2(h)(7) of the Act or § 50.50 of this part; and E:\FR\FM\13DER2.SGM 13DER2 74336 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations paragraph (a) of this section upon submission of such swap to a futures commission merchant or clearing member of a derivatives clearing organization, provided that submission occurs as soon as technologically practicable after execution, but in any event by the end of the day of execution. (2) Is included in a class of swaps identified in § 50.4 of this part, shall submit such swap to any eligible derivatives clearing organization that accepts such swap for clearing as soon as technologically practicable after execution, but in any event by the end of the day of execution. (b) Each person subject to the requirements of paragraph (a) of this section shall undertake reasonable efforts to verify whether a swap is required to be cleared. (c) For purposes of paragraph (a) of this section, persons that are not clearing members of an eligible derivatives clearing organization shall be deemed to have complied with § 50.3 Fixed-to-floating swap class U.S. dollar (USD) ....... LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Euro (EUR) ................ EURIBOR ................... 28 days to 50 years ... No .............................. No .............................. No .............................. Specification Sterling (GBP) ............ LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Yen (JPY). LIBOR. 28 days to 30 years. No. No. No. Basis swap class Currency ......................................................... Floating Rate Indexes .................................... Stated Termination Date Range .................... Optionality ...................................................... Dual Currencies ............................................. Conditional Notional Amounts ........................ U.S. dollar (USD) ....... LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Euro (EUR) ................ EURIBOR ................... 28 days to 50 years ... No .............................. No .............................. No .............................. Specification Sterling (GBP) ............ LIBOR ........................ 28 days to 50 years ... No .............................. No .............................. No .............................. Yen (JPY). LIBOR. 28 days to 30 years. No. No. No. Forward rate agreement class Currency ......................................................... Floating Rate Indexes .................................... Stated Termination Date Range .................... Optionality ...................................................... Dual Currencies ............................................. 6. Conditional Notional Amounts ................... U.S. dollar (USD) ....... LIBOR ........................ 3 days to 3 years ....... No .............................. No .............................. No .............................. Specification Euro (EUR) ................ EURIBOR ................... 3 days to 3 years ....... No .............................. No .............................. No .............................. Sterling (GBP) ............ LIBOR ........................ 3 days to 3 years ....... No .............................. No .............................. No .............................. Yen (JPY). LIBOR. 3 days to 3 years. No. No. No. Overnight index swap class Currency ......................................................... Floating Rate Indexes .................................... Stated Termination Date Range .................... Optionality ...................................................... Dual Currencies ............................................. Conditional Notional Amounts ........................ (b) Credit default swaps. Swaps that have the following specifications are required to be cleared under section U.S. dollar (USD) ....... FedFunds ................... 7 days to 2 years ....... No .............................. No .............................. No .............................. Euro (EUR) ................ EONIA ........................ 7 days to 2 years ....... No .............................. No .............................. No .............................. 2(h)(1) of the Act, and shall be cleared pursuant to the rules of any derivatives clearing organization eligible to clear Specification Sterling (GBP). SONIA. 7 days to 2 years. No. No. No. such swaps under § 39.5(a) of this chapter. North American untranched CDS indices class Reference Entities ..................................... Region ........................................................ Indices ........................................................ Tenor .......................................................... Applicable Series ....................................... sroberts on DSK5SPTVN1PROD with (a) Interest rate swaps. Swaps that have the following specifications are required to be cleared under section 2(h)(1) of the Act, and shall be cleared pursuant to the rules of any derivatives clearing organization eligible to clear such swaps under § 39.5(a) of this chapter. (a) In addition to its obligations under § 39.21(c)(1), each derivatives clearing organization shall make publicly available on its Web site a list of all swaps that it will accept for clearing and identify which swaps on the list are required to be cleared under section 2(h)(1) of the Act and this part. Currency ......................................................... Floating Rate Indexes .................................... Stated Termination Date Range .................... Optionality ...................................................... Dual Currencies ............................................. Conditional Notional Amounts ........................ Tranched .................................................... 20:43 Dec 12, 2012 § 50.4 Classes of swaps required to be cleared. Notice to the public. Specification VerDate Mar<15>2010 (b) The Commission shall maintain a current list of all swaps that are required to be cleared and all derivatives clearing organizations that are eligible to clear such swaps on its Web site. Jkt 229001 Corporate. North America. CDX.NA.IG; CDX.NA.HY. CDX.NA.IG: 3Y, 5Y, 7Y, 10Y; CDX.NA.HY: 5Y. CDX.NA.IG 3Y: Series 15 and all subsequent Series, up to and including the current Series. CDX.NA.IG 5Y: Series 11 and all subsequent Series, up to and including the current Series. CDX.NA.IG 7Y: Series 8 and all subsequent Series, up to and including the current Series. CDX.NA.IG 10Y: Series 8 and all subsequent Series, up to and including the current Series. CDX.NA.HY 5Y: Series 11 and all subsequent Series, up to and including the current Series. No. PO 00000 Frm 00054 Fmt 4701 Sfmt 4700 E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations 74337 Specification European untranched CDS indices class Reference Entities ..................................... Region ........................................................ Indices ........................................................ Corporate. Europe. iTraxx Europe. iTraxx Europe Crossover. iTraxx Europe HiVol. iTraxx Europe: 5Y, 10Y. iTraxx Europe Crossover: 5Y. iTraxx Europe HiVol: 5Y. iTraxx Europe 5Y: Series 10 and all subsequent Series, up to and including the current Series. iTraxx Europe 10Y: Series 7 and all subsequent Series, up to and including the current Series. iTraxx Europe Crossover 5Y: Series 10 and all subsequent Series, up to and including the current Series. iTraxx Europe HiVol 5Y: Series 10 and all subsequent Series, up to and including the current Series. No. Tenor .......................................................... Applicable Series ....................................... Tranched .................................................... § 50.5 Swaps exempt from a clearing requirement. § 50.7–50.9 (a) Swaps entered into before July 21, 2010 shall be exempt from the clearing requirement under § 50.2 of this part if reported to a swap data repository pursuant to section 2(h)(5)(A) of the Act and § 46.3(a) of this chapter. (b) Swaps entered into before the application of the clearing requirement for a particular class of swaps under §§ 50.2 and 50.4 of this part shall be exempt from the clearing requirement if reported to a swap data repository pursuant to section 2(h)(5)(B) of the Act and either § 46.3(a) or §§ 45.3 and 45.4 of this chapter, as appropriate. sroberts on DSK5SPTVN1PROD with § 50.6 Delegation of Authority. (a) The Commission hereby delegates to the Director of the Division of Clearing and Risk or such other employee or employees as the Director may designate from time to time, with the consultation of the General Counsel or such other employee or employees as the General Counsel may designate from time to time, the authority: (1) After prior notice to the Commission, to determine whether one or more swaps submitted by a derivatives clearing organization under § 39.5 falls within a class of swaps as described in § 50.4, provided that inclusion of such swaps is consistent with the Commission’s clearing requirement determination for that class of swaps; and (2) To notify all relevant derivatives clearing organizations of that determination. (b) The Director of the Division of Clearing and Risk may submit to the Commission for its consideration any matter which has been delegated in this section. Nothing in this section prohibits the Commission, at its election, from exercising the authority delegated in this section. VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 [Reserved]. § 50.10 Prevention of evasion of the clearing requirement and abuse of an exception or exemption to the clearing requirement. (a) It shall be unlawful for any person to knowingly or recklessly evade or participate in or facilitate an evasion of the requirements of section 2(h) of the Act or any Commission rule or regulation promulgated thereunder. (b) It shall be unlawful for any person to abuse the exception to the clearing requirement as provided under section 2(h)(7) of the Act or an exception or exemption under this chapter. (c) It shall be unlawful for any person to abuse any exemption or exception to the requirements of section 2(h) of the Act, including any exemption or exception as the Commission may provide by rule, regulation, or order. ■ 5. Designate § 50.25 under new subpart B under the following heading and add reserved §§ 50.26 through 50.49. Subpart B—Compliance Schedule Sec. 50.25 Clearing requirement compliance schedule. 50.26–50.49 [Reserved] 6. Add subpart C, consisting of § 50.50, to read as follows: ■ Subpart C—Exceptions and Exemptions to Clearing Requirement § 50.50 Exceptions to the clearing requirement. (a) Non-financial entities. (1) A counterparty to a swap may elect the exception to the clearing requirement under section 2(h)(7)(A) of the Act if the counterparty: (i) Is not a ‘‘financial entity’’ as defined in section 2(h)(7)(C)(i) of the Act; (ii) Is using the swap to hedge or mitigate commercial risk as provided in paragraph (c) of this section; and PO 00000 Frm 00055 Fmt 4701 Sfmt 4700 (iii) Provides, or causes to be provided, the information specified in paragraph (b) of this section to a registered swap data repository or, if no registered swap data repository is available to receive the information from the reporting counterparty, to the Commission. A counterparty that satisfies the criteria in this paragraph (a)(1) and elects the exception is an ‘‘electing counterparty.’’ (2) If there is more than one electing counterparty to a swap, the information specified in paragraph (b) of this section shall be provided with respect to each of the electing counterparties. (b) Reporting. (1) When a counterparty elects the exception to the clearing requirement under section 2(h)(7)(A) of the Act, one of the counterparties to the swap (the ‘‘reporting counterparty,’’ as determined in accordance with § 45.8 of this part) shall provide, or cause to be provided, the following information to a registered swap data repository or, if no registered swap data repository is available to receive the information from the reporting counterparty, to the Commission, in the form and manner specified by the Commission: (i) Notice of the election of the exception; (ii) The identity of the electing counterparty to the swap; and (iii) The following information, unless such information has previously been provided by the electing counterparty in a current annual filing pursuant to paragraph (b)(2) of this section: (A) Whether the electing counterparty is a ‘‘financial entity’’ as defined in section 2(h)(7)(C)(i) of the Act, and if the electing counterparty is a financial entity, whether it is: (1) Electing the exception in accordance with section 2(h)(7)(C)(iii) or section 2(h)(7)(D) of the Act; or (2) Exempt from the definition of ‘‘financial entity’’ as described in paragraph (d) of this section; E:\FR\FM\13DER2.SGM 13DER2 sroberts on DSK5SPTVN1PROD with 74338 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations (B) Whether the swap or swaps for which the electing counterparty is electing the exception are used by the electing counterparty to hedge or mitigate commercial risk as provided in paragraph (c) of this section; (C) How the electing counterparty generally meets its financial obligations associated with entering into noncleared swaps by identifying one or more of the following categories, as applicable: (1) A written credit support agreement; (2) Pledged or segregated assets (including posting or receiving margin pursuant to a credit support agreement or otherwise); (3) A written third-party guarantee; (4) The electing counterparty’s available financial resources; or (5) Means other than those described in paragraphs (b)(1)(iii)(C)(1), (2), (3) or (4) of this section; and (D) Whether the electing counterparty is an entity that is an issuer of securities registered under section 12 of, or is required to file reports under section 15(d) of, the Securities Exchange Act of 1934, and if so: (1) The relevant SEC Central Index Key number for that counterparty; and (2) Whether an appropriate committee of that counterparty’s board of directors (or equivalent body) has reviewed and approved the decision to enter into swaps that are exempt from the requirements of sections 2(h)(1) and 2(h)(8) of the Act. (2) An entity that qualifies for an exception to the clearing requirement under this section may report the information listed in paragraph (b)(1)(iii) of this section annually in anticipation of electing the exception for one or more swaps. Any such reporting under this paragraph shall be effective for purposes of paragraph (b)(1)(iii) of this section for swaps entered into by the entity for 365 days following the date of such reporting. During such period, the entity shall amend such information as necessary to reflect any material changes to the information reported. (3) Each reporting counterparty shall have a reasonable basis to believe that the electing counterparty meets the requirements for an exception to the clearing requirement under this section. (c) Hedging or mitigating commercial risk. For purposes of section 2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, a swap is used to hedge or mitigate commercial risk if: (1) Such swap: (i) Is economically appropriate to the reduction of risks in the conduct and VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 management of a commercial enterprise, where the risks arise from: (A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise; (B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise; (C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise; (D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise; (E) Any potential change in value related to any of the foregoing arising from interest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or (F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or (ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or (iii) Qualifies for hedging treatment under: (A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); or (B) Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative Instruments; and (2) Such swap is: (i) Not used for a purpose that is in the nature of speculation, investing, or trading; and (ii) Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by this rule or § 240.3a67–4 of this title. (d) For purposes of section 2(h)(7)(A) of the Act, a person that is a ‘‘financial entity’’ solely because of section 2(h)(7)(C)(i)(VIII) shall be exempt from PO 00000 Frm 00056 Fmt 4701 Sfmt 4700 the definition of ‘‘financial entity’’ if such person: (1) Is organized as a bank, as defined in section 3(a) of the Federal Deposit Insurance Act, the deposits of which are insured by the Federal Deposit Insurance Corporation; a savings association, as defined in section 3(b) of the Federal Deposit Insurance Act, the deposits of which are insured by the Federal Deposit Insurance Corporation; a farm credit system institution chartered under the Farm Credit Act of 1971; or an insured Federal credit union or State-chartered credit union under the Federal Credit Union Act; and (2) Has total assets of $10,000,000,000 or less on the last day of such person’s most recent fiscal year. Issued in Washington, DC, on November 29, 2012, by the Commission. Sauntia S. Warfield, Assistant Secretary of the Commission. Note: The following appendices will not appear in the Code of Federal Regulations: Appendices to Clearing Requirement Determination Under Section 2(h) of the CEA—Commission Voting Summary and Statement of the Chairman. Note: The following appendices will not appear in the Code of Federal Regulations. Appendix 1—Commission Voting Summary On this matter, Chairman Gensler and Commissioners Sommers, Chilton, O’Malia and Wetjen voted in the affirmative; no Commissioner voted in the negative. Appendix 2—Statement of Chairman Gary Gensler I support the final rule requiring certain interest rate swaps and credit default swap (CDS) indices to be cleared, as provided by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Central clearing is one of the three major building blocks of Dodd-Frank swaps market reform—in addition to promoting market transparency and bringing swap dealers under comprehensive oversight—and this rule completes the clearing building block. Central clearing lowers the risk of the highly interconnected financial system. It also democratizes the market by eliminating the need for market participants to individually determine counterparty credit risk, as now clearinghouses stand between buyers and sellers. In a cleared market, more people have access on a level playing field. Small and medium-sized businesses, banks and asset managers can enter the market and trade anonymously and benefit from the market’s greater competition. Clearinghouses have lowered risk for the public and fostered competition in the futures markets since the late 19th century. Following the 2008 financial crisis, President Obama convened the G–20 leaders in Pittsburgh in 2009, and an international E:\FR\FM\13DER2.SGM 13DER2 Federal Register / Vol. 77, No. 240 / Thursday, December 13, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with consensus formed that standardized swaps should be cleared by the end of 2012. The CFTC has already completed a number of significant Dodd-Frank reforms laying the foundation of risk management for clearinghouses, futures commission merchants and other market participants that participate in clearing. Other reforms paving the way for this rule include straight-through processing for swaps and protections for customer funds. This rule, which fulfills President Obama’s G–20 commitment on clearing, is the last step on the path to required central clearing between financial entities. It benefited from significant domestic and international consultation. Moving forward, we will work VerDate Mar<15>2010 20:43 Dec 12, 2012 Jkt 229001 with market participants on implementation. I would like to thank my fellow Commissioners and the CFTC staff for all of their hard work and dedication so that now clearing will be a reality in the swaps market. For this first set of determinations, the Commission looked to swaps that are currently cleared by four derivatives clearing organizations (DCOs). This set includes standard interest rate swaps in U.S. dollars, euros, British pounds and Japanese yen, as well as five CDS indices on North American and European corporate names. With this rule, swap dealers and the largest hedge funds will be required to clear these swaps in March. Compliance would be PO 00000 Frm 00057 Fmt 4701 Sfmt 9990 74339 phased in for other market participants through the summer of 2013. I believe that the Commission’s determination for each class satisfies the five factors provided for by Congress in the DoddFrank Act, including the first factor that addresses outstanding exposures, liquidity and pricing data. Under the rule, a DCO must post on its Web site a list of all swaps it will accept for clearing and must indicate which swaps the Commission had determined are required to be cleared. In addition, the Commission will post this information on our Web site. [FR Doc. 2012–29211 Filed 12–12–12; 8:45 am] BILLING CODE 6351–01–P E:\FR\FM\13DER2.SGM 13DER2

Agencies

[Federal Register Volume 77, Number 240 (Thursday, December 13, 2012)]
[Rules and Regulations]
[Pages 74283-74339]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-29211]



[[Page 74283]]

Vol. 77

Thursday,

No. 240

December 13, 2012

Part II





Commodity Futures Trading Commission





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17 CFR Parts 39 and 50





Clearing Requirement Determination Under Section 2(h) of the CEA; Final 
Rule

Federal Register / Vol. 77 , No. 240 / Thursday, December 13, 2012 / 
Rules and Regulations

[[Page 74284]]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 39 and 50

RIN 3038-AD86


Clearing Requirement Determination Under Section 2(h) of the CEA

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC) 
is adopting regulations to establish a clearing requirement under new 
section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted 
under Title VII of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (Dodd-Frank Act). The regulations require that certain 
classes of credit default swaps (CDS) and interest rate swaps, 
described herein, be cleared by a derivatives clearing organization 
(DCO) registered with the Commission. The Commission also is adopting 
regulations to prevent evasion of the clearing requirement and related 
provisions.

DATES: The rules will become effective February 11, 2013. Specific 
compliance dates are discussed in the supplementary information.

FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director, 
202-418-5684, sjosephson@cftc.gov; Brian O'Keefe, Associate Director, 
202-418-5658, bokeefe@cftc.gov; or Erik Remmler, Associate Director, 
202-418-7630, eremmler@cftc.gov, Division of Clearing and Risk, Camden 
Nunery, Economist, 202-418-5723, cnunery@cftc.gov, Office of the Chief 
Economist, Commodity Futures Trading Commission, Three Lafayette 
Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background
    A. Clearing Requirement Proposal
    B. Financial Crisis
    C. Central Role of Clearing in the Dodd-Frank Act
    D. G-20 and International Commitments on Clearing
    E. Overview of Section 2(h) and Sec.  39.5
    F. Submissions From DCOs
II. Comments on the Notice of Proposed Rulemaking
    A. Overview of Comments Received
    B. Generally Applicable Comments
    C. Credit Default Swaps
    D. Determination Analysis for Credit Default Swaps
    E. Interest Rate Swaps
    F. Determination Analysis for Interest Rate Swaps
III. Final Rule
    A. Regulation 50.1: Definitions
    B. Regulation 50.2: Treatment of Swaps Subject to a Clearing 
Requirement
    C. Regulation 50.3: Notice to the Public
    D. Regulation 50.4: Classes of Swaps Required To Be Cleared
    E. Regulation 50.5: Clearing Transition Rules
    F. Regulation 50.6: Delegation of Authority
    G. Regulation 50.10: Prevention of Evasion of the Clearing 
Requirement and Abuse of an Exception or Exemption to the Clearing 
Requirement
IV. Implementation
V. Cost Benefit Considerations
    A. Statutory and Regulatory Background
    B. Overview of Swap Clearing
    C. Consideration of the Costs and Benefits of the Commission's 
Action
    D. Consideration of Alternative Swap Classes for Clearing 
Determination
    E. Section 15(a) Factors
VI. Related Matters
    A. Regulatory Flexibility Act
    B. Paperwork Reduction Act

I. Background

A. Clearing Requirement Proposal

    On August 7, 2012, the Commission published a notice of proposed 
rulemaking (NPRM) to establish a clearing requirement under new section 
2(h)(1)(A) of the CEA, as provided for under section 723 of Title VII 
of the Dodd-Frank Act.\1\ The Commission proposed that swaps meeting 
the specifications identified in two classes of CDS and four classes of 
interest rate swaps, and available for clearing by an eligible DCO, 
would be required to be cleared. The Commission also proposed rules 
related to the prevention of evasion of the clearing requirement and 
prevention of abuse of an exception or exemption to the clearing 
requirement. The Commission is hereby adopting Sec. Sec.  50.1-50.6 and 
Sec.  50.10, subject to the changes discussed below.
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    \1\ Clearing Requirement Determination Under Section 2(h) of the 
CEA; Proposed Rule, 77 FR 47170 (Aug. 7, 2012).
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B. Financial Crisis

    In the fall of 2008, a series of large financial institution 
failures triggered a financial and economic crisis that threatened to 
freeze U.S. and global credit markets. As a result of these failures, 
unprecedented governmental intervention was required to ensure the 
stability of the U.S. financial system.\2\ These failures revealed the 
vulnerability of the U.S. financial system and economy to widespread 
systemic risk resulting from, among other things, poor risk management 
practices of financial firms and the lack of supervisory oversight for 
a financial institution as a whole.\3\
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    \2\ On October 3, 2008, President Bush signed the Emergency 
Economic Stabilization Act of 2008, which was principally designed 
to allow the U.S. Department of the Treasury and other government 
agencies to take action to restore liquidity and stability to the 
U.S. financial system (e.g., the Troubled Asset Relief Program--also 
known as TARP--under which the U.S. Department of the Treasury was 
authorized to purchase up to $700 billion of troubled assets that 
weighed down the balance sheets of U.S. financial institutions). See 
Public Law 110-343, 122 Stat. 3765 (2008).
    \3\ See Financial Crisis Inquiry Commission, ``The Financial 
Crisis Inquiry Report: Final Report of the National Commission on 
the Causes of the Financial and Economic Crisis in the United 
States,'' Jan. 2011, at xxviii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
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    The financial crisis also illustrated the significant risks that an 
uncleared, over-the-counter (OTC) derivatives market can pose to the 
financial system. As the Financial Crisis Inquiry Commission explained:

    The scale and nature of the [OTC] derivatives market created 
significant systemic risk throughout the financial system and helped 
fuel the panic in the fall of 2008: millions of contracts in this 
opaque and deregulated market created interconnections among a vast 
web of financial institutions through counterparty credit risk, thus 
exposing the system to a contagion of spreading losses and 
defaults.\4\
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    \4\ See id. at 386.

    Certain OTC derivatives, such as CDS, played a prominent role 
during the crisis. According to a white paper by the U.S. Department of 
the Treasury, ``the sheer volume of these [CDS] contracts overwhelmed 
some firms that had promised to provide payment of the CDS and left 
institutions with losses that they believed they had been protected 
against.'' \5\ In particular, AIG reportedly issued uncleared CDS 
transactions covering more than $440 billion in bonds, leaving it with 
obligations that it could not cover as a result of changed market 
conditions.\6\ As a result of AIG's CDS exposure, the Federal 
government bailed out the firm with over $180 billion of taxpayer money 
in order to prevent AIG's failure and a possible contagion event in the 
broader economy.\7\
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    \5\ Financial Regulatory Reform: A New Foundation, June 2009, 
available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf and cited in S. Rep. 111-176 at 29-30 (Apr. 30, 
2010).
    \6\ Adam Davidson, ``How AIG fell apart,'' Reuters, Sept. 18, 
2008, available at http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918.
    \7\ Hugh Son, ``AIG's Trustees Shun `Shadow Board,' Seek 
Directors,'' Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.
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    More broadly, the President's Working Group (PWG) on Financial 
Markets noted shortcomings in the OTC

[[Page 74285]]

derivative markets as a whole during the crisis. The PWG identified the 
need for an improved integrated operational structure supporting OTC 
derivatives, specifically highlighting the need for an enhanced ability 
to manage counterparty risk through ``netting and collateral agreements 
by promoting portfolio reconciliation and accurate valuation of 
trades.'' \8\ These issues were exposed in part by the surge in 
collateral required between counterparties during 2008, when the 
International Swaps and Derivatives Association (ISDA) reported an 86% 
increase in the collateral in use for OTC derivatives, indicating not 
only the increase in risk, but also circumstances in which positions 
may not have been collateralized.\9\
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    \8\ The President's Working Group on Financial Markets, ``Policy 
Statements on Financial Market Developments,'' Mar. 2008, available 
at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
    \9\ ISDA, ISDA Margin Survey, 2009, available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.
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    With only limited checks on the amount of risk that a market 
participant could incur, great uncertainty was created among market 
participants. A market participant did not know the extent of its 
counterparty's exposure, whether its counterparty was appropriately 
hedged, or if its counterparty was dangerously exposed to adverse 
market movements. Without central clearing, a market participant bore 
the risk that its counterparty would not fulfill its payment 
obligations pursuant to a swap's terms (counterparty credit risk). As 
the financial crisis deepened, this risk made market participants wary 
of trading with each other. As a result, markets quickly became 
illiquid and trading volumes plummeted. The dramatic increase in ``TED 
spreads'' evidenced this mistrust.\10\ These spreads increased from a 
long-term average of approximately 30 basis points to 464 basis 
points.\11\
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    \10\ The TED spread measures the difference in yield between 
three-month Eurodollars as represented by London Interbank Offered 
Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit 
risk while T-bills do not. As the spread got larger, it meant that 
lenders demanded more return to compensate for credit risk than they 
would need if they loaned the money to the U.S. Department of the 
Treasury without any credit risk.
    \11\ The U.S. Financial Crisis: Credit Crunch and Yield Spreads, 
by James R. Barth et al., page 5, available at http://apeaweb.org/confer/bei08/papers/blp.pdf.
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    The failure to adequately collateralize the risk exposures posed by 
OTC derivatives, along with the contagion effects of the vast web of 
counterparty credit risk, led many to conclude that OTC derivatives 
should be centrally cleared. For instance, in 2008, the Federal Reserve 
Bank of New York (FRBNY) began encouraging market participants to 
establish a central counterparty to clear CDS.\12\ For several years 
prior, the FRBNY had led a targeted effort to enhance operational 
efficiency and performance in the OTC derivatives market by increasing 
automation in processing and by promoting sound back office practices, 
such as timely confirmation of trades and portfolio reconciliation. 
Beginning with CDS in 2008, the FRBNY and other primary supervisors of 
OTC derivatives dealers increasingly focused on central clearing as a 
means of mitigating counterparty credit risk and lowering systemic risk 
to the markets as a whole. Both regulators and market participants 
alike recognized that risk exposures would have been monitored, 
measured, and collateralized through the process of central clearing.
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    \12\ See Federal Reserve Bank of New York, Press Release, ``New 
York Fed Welcomes Further Industry Commitments on Over-the-Counter 
Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which 
references documents prepared by market participants describing the 
importance of clearing. See also Ciara Linnane and Karen Brettell, 
``NY Federal Reserve pushes for central CDS counterparty,'' Reuters, 
Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.
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 C. Central Role of Clearing in the Dodd-Frank Act

    Recognizing the peril that the U.S. financial system faced during 
the financial crisis, Congress and the President came together to pass 
the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes 
a comprehensive new regulatory framework for swaps, and the requirement 
that swaps be cleared by DCOs is one of the cornerstones of that 
reform. The CEA, as amended by Title VII, now requires a swap: (1) To 
be cleared through a DCO if the Commission has determined that the 
swap, or group, category, type, or class of swap, is required to be 
cleared, unless an exception to the clearing requirement applies; (2) 
to be reported to a swap data repository (SDR) or the Commission; and 
(3) if the swap is subject to a clearing requirement, to be executed on 
a designated contract market (DCM) or swap execution facility (SEF), 
unless no DCM or SEF has made the swap available to trade.\13\
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    \13\ The Commission has proposed rules that would establish a 
separate process for determining whether a swap has been made 
``available to trade'' by a DCM or SEF. Those rules, and any 
determinations made under those rules, will be finalized separately 
from the clearing requirements discussed herein. See Process for a 
Designated Contract Market or Swap Execution Facility to Make a Swap 
Available to Trade Under Section 2(h)(8) of the Commodity Exchange 
Act, 76 FR 77728 (Dec. 14, 2011).
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    Clearing is at the heart of the Dodd-Frank financial reform. 
According to the Senate Report: \14\
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    \14\ S. Rep. 111-176, at 32 (April 30, 2010). See also Letter 
from Senators Christopher Dodd and Blanche Lincoln to Congressmen 
Barney Frank and Collin Peterson (June 30, 2010) (``Congress 
determined that clearing is at the heart of reform--bringing 
transactions and counterparties into a robust, conservative, and 
transparent risk management framework.'').

    As a key element of reducing systemic risk and protecting 
taxpayers in the future, protections must include comprehensive 
regulation and rules for how the OTC derivatives market operates. 
Increasing the use of central clearinghouses, exchanges, appropriate 
margining, capital requirements, and reporting will provide 
safeguards for American taxpayers and the financial system as a 
---------------------------------------------------------------------------
whole.

    The Commission believes that a clearing requirement will reduce 
counterparty credit risk and provide an organized mechanism for 
collateralizing the risk exposures posed by swaps. According to the 
Senate Report: \15\
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    \15\ S. Rep. 111-176, at 33.

    With appropriate collateral and margin requirements, a central 
clearing organization can substantially reduce counterparty risk and 
provide an organized mechanism for clearing transactions. * * * 
While large losses are to be expected in derivatives trading, if 
those positions are fully margined there will be no loss to 
counterparties and the overall financial system and none of the 
uncertainty about potential exposures that contributed to the panic 
---------------------------------------------------------------------------
in 2008.

Notably, Congress did not focus on just one asset class, such as CDS; 
rather, Congress determined that all swaps that a DCO plans to accept 
for clearing must be submitted to the Commission for a determination as 
to whether or not those swaps are required to be cleared pursuant to 
section 2(h)(2)(D) of the CEA.

D. G-20 and International Commitments on Clearing

    The financial crisis generated international consensus on the need 
to strengthen financial regulation by improving transparency, 
mitigating systemic risk, and protecting against market abuse. As a 
result of the widespread recognition that transactions in the OTC 
derivatives market increased risk and uncertainty in the global economy 
and became a significant contributor to the financial crisis, a series 
of policy initiatives were undertaken to better regulate the financial 
markets.

[[Page 74286]]

    In September 2009, leaders of the Group of 20 (G-20)--whose 
membership includes the United States, the European Union, and 18 other 
countries--agreed that: (1) OTC derivatives contracts should be 
reported to trade repositories; (2) all standardized OTC derivatives 
contracts should be cleared through central counterparties and traded 
on exchanges or electronic trading platforms, where appropriate, by the 
end of 2012; and (3) non-centrally cleared contracts should be subject 
to higher capital requirements.
    In June 2010, the G-20 leaders reaffirmed their commitment to 
achieve these goals. In its October 2010 report on Implementing OTC 
Derivatives Market Reforms (the October 2010 Report), the Financial 
Stability Board (FSB) made 21 recommendations addressing practical 
issues that authorities may encounter in implementing the G-20 leaders' 
commitments.\16\ The G-20 leaders again reaffirmed their commitments at 
the November 2011 Summit, including the end-2012 deadline. The FSB has 
issued three implementation progress reports. The most recent report 
urged jurisdictions to push forward aggressively to meet the G-20 end-
2012 deadline in as many reform areas as possible. On mandatory 
clearing, the report observed that ``[j]urisdictions now have much of 
the information they requested in order to make informed decisions on 
the appropriate legislation and regulations to achieve the end-2012 
commitment to centrally clear all standardised OTC derivatives.'' \17\
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    \16\ See ``Implementing OTC Derivatives Market Reforms,'' 
Financial Stability Board, Oct. 25, 2010, available at http://www.financialstabilityboard.org/publications/r_101025.pdf.
    \17\ OTC Derivatives Working Group, ``OTC Derivatives Market 
Reforms: Third Progress Report on Implementation,'' Financial 
Stability Board, June 15, 2012, available at http://www.financialstabilityboard.org/publications/r_120615.pdf.
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    Specifically with regard to required clearing, the Technical 
Committee of the International Organization of Securities Commissions 
(IOSCO) has published a final report, Requirements for Mandatory 
Clearing, outlining recommendations that regulators should follow to 
carry out the G-20's goal of requiring standardized swaps to be 
cleared.\18\
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    \18\ IOSCO's report, published in February 2012, is available at 
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf.
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    Nations around the world have been preparing for the move to 
mandatory clearing. For example, the Japanese Financial Services 
Authority (JFSA) has proposed requiring certain financial institutions 
to clear yen-denominated interest rate swaps that reference LIBOR and 
CDS that reference the Japanese iTraxx indices by the end of 2012. 
After that, the requirement will be expanded to other entities engaging 
in these swaps. In addition, the JFSA is considering expanding its 
mandatory clearing coverage to include U.S. dollar- and euro-
denominated interest rate swaps, as well as yen-denominated interest 
rate swaps referencing TIBOR. The JFSA also will consider mandating 
single-name CDS referencing Japanese reference entities, and index and 
single-name CDS on North American and European reference entities.
    The Monetary Authority of Singapore (MAS) released a consultation 
paper addressing mandatory clearing on February 13, 2012. Based on a 
preliminary review MAS expects Singapore dollar interest rate swaps, 
U.S. dollar interest rate swaps, and Asian currency non-deliverable 
forwards to meet its proposed mandatory clearing criteria. Additional 
swaps will be considered for mandatory clearing via clearinghouse 
submission or upon the review of MAS.
    The Securities and Futures Commission and Hong Kong Monetary 
Authority jointly released a consultation paper addressing mandatory 
clearing on October 17, 2011. This consultation plan described a phased 
implementation approach where clearing requirements will initially 
cover standardized interest rate swaps and non-deliverable forwards. 
Hong Kong regulators have said they will consider extending the 
mandatory clearing requirements in subsequent phases. In July, the Hong 
Kong regulators published consultation conclusions and stated that the 
precise mandatory clearing obligations would be set out in subsidiary 
legislation which they will be consulting on in the fourth quarter of 
2012.
    On April 18, 2012, the Australian Council of Financial Regulators 
published a consultation on a number of OTC derivatives, including 
mandatory clearing. The Council of Financial Regulators is developing 
advice for the government which is expected to adopt legislation by 
end-2012.
    Finally, in the European Union, specific clearing determinations 
have yet to be made. However, the European Markets Infrastructure 
Regulation (EMIR) provides that contracts become subject to the 
clearing obligation through either a ``bottom up'' approach or a ``top 
down'' approach. The ``bottom up'' approach is where a national 
authority authorizes a central counterparty (CCP) to clear certain 
classes of OTC derivatives. The ``top down'' approach is where the 
European Securities and Markets Authority (ESMA) identifies classes of 
OTC derivatives which should be subject to the clearing obligation but 
for which no CCP is authorized to clear. Based on this framework, ESMA 
has the authority to make clearing determinations for classes of OTC 
derivative contracts.
    With the adoption of these final rules, the Commission is taking a 
critical step toward meeting the G-20 commitment and fulfilling the 
requirements of the Dodd-Frank Act. The Commission has consulted with 
authorities from around the globe to ensure that our efforts are as 
coordinated as possible.

E. Overview of Section 2(h) and Sec.  39.5

    The Commission promulgated Sec.  39.5 of its regulations to 
implement procedural aspects of section 2(h) of the CEA.\19\ Regulation 
39.5 establishes procedures for: (1) Determining the eligibility of a 
DCO to clear swaps; (2) the submission of swaps by a DCO to the 
Commission for a clearing requirement determination; (3) Commission 
initiated reviews of swaps; and (4) the staying of a clearing 
requirement.
---------------------------------------------------------------------------

    \19\ See 76 FR 44464 (July 26, 2011); 17 CFR 39.5.
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    The determinations and rules adopted in this release implement the 
clearing requirement under section 2(h) of the CEA for certain swaps 
and require that those swaps must be submitted for clearing to 
Commission-registered DCOs. Under section 2(h)(1)(A), ``it shall be 
unlawful for any person to engage in a swap unless that person submits 
such swap for clearing to a [DCO] that is registered under [the CEA] or 
a [DCO] that is exempt from registration under [the CEA] if the swap is 
required to be cleared.'' \20\
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    \20\ See section 2(h) of the CEA. The Commission also may 
conduct a Commission-initiated review of swaps for required 
clearing. Section 2(h)(2)(A)(i) of the CEA requires the Commission 
on an ongoing basis to ``review each swap, or any group, category, 
type, or class of swaps to make a determination as to whether the 
swap, category, type or class of swaps should be required to be 
cleared.''
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    A clearing requirement determination may be initiated by a swap 
submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to ``submit 
to the Commission each swap, or any group, category, type or class of 
swaps that it plans to accept for clearing, and provide notice to its 
members of the submission.'' In addition under section 2(h)(2)(B)(ii) 
of the CEA, ``[a]ny swap or group, category, type, or class of swaps 
listed for clearing by a [DCO] as of the date of enactment shall be 
considered submitted to the Commission.''

[[Page 74287]]

F. Submissions from DCOs

    On February 1, 2012, Commission staff sent a letter requesting that 
DCOs submit all swaps that they were accepting for clearing as of that 
date, pursuant to Sec.  39.5 of the Commission's regulations.\21\ The 
Commission received submissions relating to CDS and interest rate swaps 
from: The International Derivatives Clearinghouse Group (IDCH) \22\ on 
February 17, 2012; the CME Group (CME), ICE Clear Credit, and ICE Clear 
Europe, each dated February 22, 2012; and a submission from 
LCH.Clearnet Limited (LCH) on February 24, 2012.\23\
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    \21\ The letter made it clear that DCOs should submit both pre-
enactment swaps and swaps for which DCOs have initiated clearing 
since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to 
those swaps that DCOs were accepting for clearing as of July 21, 
2010, the date of enactment of the Dodd-Frank Act.
    \22\ As discussed in detail below, IDCH has been purchased by 
LCH.Clearnet Group.
    \23\ Other swaps submissions were received from Kansas City 
Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and 
NGX do not accept any CDS or interest rate swaps for clearing.
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    The clearing requirement determinations and rules adopted in this 
release cover certain CDS and interest rate swaps currently being 
cleared by a DCO. The Commission intends subsequently to consider other 
swaps submitted by DCOs, such as agricultural, energy, and equity 
indices.
    As stated in the NPRM, the decision to focus on CDS and interest 
rate swaps in the initial clearing requirement determinations is a 
function of both the market importance of these swaps and the fact that 
they already are widely cleared. In order to move the largest number of 
swaps to required clearing in its initial determinations, the 
Commission believes that it is prudent to focus on those swaps that 
have the highest market shares and, accordingly, the biggest market 
impact. Further, for these swaps there is already a blueprint for 
clearing and appropriate risk management. CDS and interest rate swaps 
fit these considerations and therefore are well suited for required 
clearing consideration.\24\
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    \24\ The Commission will consider all other swaps submitted 
under Sec.  39.5(b) as soon as possible after this determination is 
published. These other swaps include certain CDS that were submitted 
to the Commission after the initial February 2012 submissions 
discussed above. If the Commission determines that additional swaps 
should be required to be cleared, such determination likely will be 
proposed as a new class under Sec.  50.4.
---------------------------------------------------------------------------

    Notably, market participants recommended that the Commission take 
this approach, and comments received on the NPRM supported this 
approach as well.\25\ In addition, interest rate swaps account for 
about $500 trillion of the $650 trillion global OTC swaps market, in 
notional dollars--the highest market share of any class of swaps.\26\ 
LCH claims to clear about $302 trillion of those--meaning that, in 
notional terms, LCH clears approximately 60% of the interest rate swap 
market.\27\ While CDS indices do not have as prominent a market share 
as interest rate swaps, CDS indices are capable of having a sizeable 
market impact, as they did during the 2008 financial crisis. Overall, 
the CDS marketplace has almost $29 trillion in notional outstanding 
across both single and multi-name products.\28\ CDS on standardized 
indices accounts for about $10 trillion of the global OTC market in 
notional dollar amount outstanding.\29\ Since March 2009, the ICE Clear 
Credit and ICE Clear Europe have combined to clear over $30 trillion in 
gross notional for all CDS.\30\ Because of the market shares and market 
impacts of these swaps, and because these swaps are currently being 
cleared, the Commission decided to review CDS and interest rate swaps 
in its initial clearing requirement determinations. The Commission 
recognizes that while this is an appropriate basis for the initial 
determinations, swap clearing is likely to evolve and clearing 
requirement determinations made at later times may be based on a 
variety of other factors beyond the extent to which the swaps in 
question are already being cleared.
---------------------------------------------------------------------------

    \25\ See, e.g., letters from the CME Group (CME), the Futures 
Industry Association (FIA), the Managed Funds Association (MFA), and 
Americans for Financial Reform (AFR).
    \26\ Bank of International Settlements (BIS) data, December 
2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
    \27\ Id.; LCH data.
    \28\ BIS data, December 2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
    \29\ Id.
    \30\ ICE Clear Credit data, as of the April 26, 2012 clearing 
cycle.
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II. Comments on the Notice of Proposed Rulemaking

    The Commission received 29 comments during the 30-day public 
comment period following publication of the NPRM, and four additional 
comments after the comment period closed. The Commission considered 
each of these 33 comments in formulating the final regulations.\31\
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    \31\ Comment letters received in response to the NPRM may be 
found on the Commission's Web site at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1252.
---------------------------------------------------------------------------

    The Chairman and Commissioners, as well as Commission staff, 
participated in numerous meetings with clearinghouses, market 
participants, trade associations, public interest groups, and other 
interested parties. In addition, the Commission has consulted with 
other U.S. financial regulators including: (i) The Securities and 
Exchange Commission (SEC); (ii) the Board of Governors of the Federal 
Reserve System; (iii) the Office of the Comptroller of the Currency; 
and (iv) the Federal Deposit Insurance Corporation (FDIC). Staff from 
each of these agencies has had the opportunity to provide oral and/or 
written comments to this adopting release, and the final regulations 
incorporate elements of the comments provided.
    The Commission is mindful of the benefits of harmonizing its 
regulatory framework with that of its counterparts in foreign 
countries. The Commission has therefore monitored global advisory, 
legislative, and regulatory proposals, and has consulted with foreign 
regulators in developing the final regulations.

A. Overview of Comments Received

    None of the 33 comments received expressed outright opposition to 
the Commission's clearing requirement proposal.\32\ Indeed, 22 of the 
comment letters strongly supported the Commission's proposal and urged 
the Commission to finalize its proposal promptly.\33\ These comments 
also supported the Commission's analysis under the five-factor 
statutory test, and agreed with the Commission's conclusion that swaps 
within the four proposed classes of interest rate swaps and the two 
proposed classes of CDS were appropriate for required clearing.\34\ All 
three DCOs clearing the swaps subject to the final rules expressed 
strong support for the proposal and agreed with the overall approach 
taken by the Commission.\35\
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    \32\ An unsigned comment submitted on September 4, 2012, 
questioned the need for additional regulation as a general matter.
    \33\ See letters from Futures Industry Association Principle 
Traders Group (FIA PTG), Arbor Research and Trading, LLC, R.J. 
O'Brien & Associates, Svenokur, LLC, Chris Barnard, CRT Capital 
Group (Robert Gorham), LLC, DRW Trading Group, Javelin, The Swaps 
and Derivatives Market Association (SDMA), Knight Capital Americas 
LLC, Bart Sokol (CRT Capital Group), Jefferies & Company, Inc., 
MarketAxess, Eris Exchange, Coherence Capital Partners LLC, Citadel, 
Americans for Financial Reform (AFR), D.E. Shaw Group, 
AllianceBernstein, LCH.Clearnet Group Limited (LCH), CME Group Inc. 
(CME), and IntercontinentalExchange, Inc. (ICE).
    \34\ See, e.g., letter from Citadel (reviewing each of the five 
statutory factors and supporting the Commission's analysis).
    \35\ CME applauded the Commission's decision to require classes 
of swaps be cleared rather than take a product-by-product approach. 
CME also commended the decision not to propose classes of swaps on a 
DCO-by-DCO basis.
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    However, a number of commenters requested that the Commission make 
specific modifications to the proposed

[[Page 74288]]

rules,\36\ and, in several instances, commenters requested 
clarification of various points.\37\ A number of commenters requested 
that the Commission delay implementation of the clearing requirement 
until certain milestones are met.\38\ Each of these comments is 
discussed in detail below.
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    \36\ See, e.g., letter from ISDA (requesting changes to the 
delegation provisions of proposed Sec.  50.6).
    \37\ See, e.g., letter from The Financial Services Roundtable 
(FSR) (requesting that the Commission clarify the meaning of 
``conditional notional amount'').
    \38\ See, e.g., letter from ISDA (requesting that no 
determination take effect until there is ``a further determination 
that a product has an adequate clearing history to support a finding 
of operational readiness to clear by DCOs and market 
participants''), and letter from Vanguard (requesting that the 
Commission delay mandatory clearing until new rules for segregation 
of customer funds and swap positions are fully operational and 
capable of being tested for three months).
---------------------------------------------------------------------------

    The Futures Industry Association (FIA) expressed concern about the 
30-day comment period providing sufficient time to comment on the 
proposal, and recommended that the Commission provide a longer comment 
period for future proposals.\39\ The Commission is cognizant of the 
importance of affording the public sufficient time to comment on 
important proposals. However, given the CEA's requirement that the 
Commission make its clearing requirement determinations within 90 days, 
in most instances, providing a 30-day comment period will be 
appropriate. In fact, some commenters stressed the importance of 
completing the determination process in an efficient manner. As R.J. 
O'Brien noted in its comment letter, implementing the clearing mandate 
as soon as possible ``will improve the financial industry's credibility 
and show the rest of the world we are serious about improving the 
financial safety of our markets.'' Providing for a longer comment 
period likely would impede the Commission's ability to meet the 90-day 
statutory deadline for completing the determination process.
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    \39\ FIA specifically mentioned its inability to respond to 
questions asked in the NPRM with regard to competitiveness, which it 
viewed as important to the Commission's analysis of competitiveness 
under one of the five statutory factions. See Sections II.D and II.F 
below.
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    Lastly, two commenters encouraged the Commission to issue proposed 
determinations for energy, agricultural, and equity swaps as soon as 
possible.\40\ As required under the CEA, the Commission will continue 
to review swap submissions received from DCOs for purposes of the 
clearing requirement in as timely a manner as possible.
---------------------------------------------------------------------------

    \40\ See letters from AFR and Chris Barnard.
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B. Generally Applicable Comments

    A number of comments are equally applicable to both the CDS and 
interest rate swap proposals. While most of these issues are discussed 
in Section III below, certain threshold comments are addressed at the 
outset.
i. Submission of Swaps Required To Be Cleared and Failures to Clear
    CME sought clarification that market participants do not have to 
clear those swaps that fall within a class of swaps under Sec.  50.4, 
but for which no DCO provides clearing or for which the DCO provides 
clearing to only a limited number of market participants. Other 
commenters expressed similar concerns about not requiring clearing 
where no DCO offers customer clearing.\41\ Freddie Mac requested 
clarification regarding the legal status of a swap that is submitted 
for clearing to a DCO, but fails to clear.
---------------------------------------------------------------------------

    \41\ See Section II.D for a discussion of iTraxx and the 
availability of client clearing.
---------------------------------------------------------------------------

    The Commission confirms that if no DCO clears a swap that falls 
within a class of swaps under Sec.  50.4, then the clearing requirement 
does not apply to that swap. In essence, it is a two-step process to 
determine whether the clearing requirement applies to a particular 
swap. First, a market participant must determine whether its swap falls 
within one of the classes under Sec.  50.4. Then, if the swap falls 
within one of the classes, the market participant must determine if any 
of the eligible DCOs clear that swap. The second step requires market 
participants to determine if all the product specifications required 
under the DCO's rules are met. If no eligible DCO will accept the swap 
for clearing because there is a different product specification, then 
the swap is not required to be cleared. Market participants need not 
submit swaps to a DCO if they know that the DCO does not clear that 
particular swap.\42\
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    \42\ The rule text of Sec.  50.2(a) has been modified to clarify 
this two-step process.
---------------------------------------------------------------------------

    In response to Freddie Mac's request for clarification, if 
counterparties submit their swap to a DCO for clearing and the swap 
fails to clear because it contains a term or terms that prevent any 
eligible DCO from clearing the swap, then the swap is not subject to 
the Commission's clearing requirement. On the other hand, if the swap 
fails to clear because one or both of the counterparties have not met 
the DCO's or their clearing members' credit requirements,\43\ then the 
swap remains subject to the clearing requirement and must be cleared as 
soon as technologically practicable after the counterparties learn of 
the credit issue. The Commission notes that section 739 of the Dodd-
Frank Act amended section 22(a)(4)(B) of the CEA to provide that, 
regarding contract enforcement between two eligible counterparties, 
``[n]o agreement, contract, or transaction between eligible contract 
participants or persons reasonably believed to be eligible contract 
participants shall be void, voidable, or unenforceable * * * under this 
section or any other provision of Federal or State law, based solely on 
the failure of the agreement, contract, or transaction * * * to be 
cleared in accordance with section 2(h)(1).'' Accordingly, a swap that 
fails to clear because of credit issues may not be voided by either 
eligible counterparty solely for the failure of the swap to be cleared 
in accordance with section 2(h)(1), but the basis for the failure to 
clear must be addressed by the counterparties and they must promptly 
resubmit the swap for clearing.
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    \43\ It is the Commission's understanding that clearing failures 
generally arise under two circumstances: (1) Failure of the swap to 
meet the product specifications required by the DCO; or (2) a credit 
issue with one or both of the counterparties to the swap. Generally 
speaking, identification of a product specification problem can be 
identified extremely quickly.
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    With regard to clearing that is not available to all market 
participants, the Commission will not require a swap to be cleared 
unless clearing is generally available to all types of market 
participants.\44\
---------------------------------------------------------------------------

    \44\ See Section II.D for a discussion of iTraxx and the 
availability of client clearing.
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ii. Adequacy of DCO Clearing History and Commission Review
    ISDA raised a general issue regarding whether the clearing 
requirement determination for CDS and interest rate swaps properly 
differentiates between swaps that a DCO currently clears and those that 
are not currently cleared by a DCO. ISDA expressed concern about 
delegating to the Director of the Division of Clearing and Risk the 
authority to determine whether newly-cleared swaps fall within a 
previously-established class. ISDA's specific comments and 
recommendations are discussed, and in part adopted, in Section III 
below. However, ISDA's general recommendation is that the Commission 
not impose a clearing requirement until there is ``a further 
determination that a product has an adequate clearing history to 
support a finding of operational readiness to clear by DCOs and market 
participants.'' Specifically, ISDA requests that each product have been 
actually cleared by a DCO and exhibit

[[Page 74289]]

non-zero open interest (for both inter-dealer and customer clearing) on 
each day during a six-month period prior to the effective date of the 
clearing requirement determination.
    In contrast with ISDA's comments, the three DCOs eligible to clear 
swaps within the classes under proposed Sec.  50.4 praised the 
Commission for taking the class-based approach rather than a product-
by-product approach.\45\ In addition, CME and ICE both endorsed the 
Commission's decision not to limit applicability of the clearing 
requirement to individual DCOs.
---------------------------------------------------------------------------

    \45\ Many other commenters also agreed with this approach. See, 
e.g., TriOptima and Citadel.
---------------------------------------------------------------------------

    The Commission observes that ISDA's recommendation that each DCO 
demonstrate non-zero open interest for six months may be inconsistent 
with section 2(h)(2) of the CEA, which requires each DCO to submit to 
the Commission all swaps that ``it plans to accept for clearing.'' The 
use of the phrase ``plans to accept'' indicates that Congress intended 
for the Commission to review swap submissions prior to a DCO's 
commencing clearing operations for those swaps. Under these 
circumstances, the DCO would not be able to demonstrate open interest. 
In addition, adopting ISDA's suggestion could pose a significant 
deterrent to competition among DCOs insofar as DCOs seeking to offer 
swaps for required clearing would have to wait until they attract open 
interest and retain it for six months before they would be on a level 
playing field with incumbent DCOs.
    The Commission believes that it can address ISDA's concerns about 
DCO product expansion and risk management through its ongoing 
supervision and risk surveillance programs.\46\ In addition, under 
Sec.  39.5(a)(1) the Commission can review the presumption of 
eligibility for any DCO offering new swaps falling into a class that it 
is already clearing, and under Sec.  39.5(a)(2), the Commission must 
review the eligibility of any DCO that wishes to clear a swap that is 
not within a class already being cleared by that DCO.\47\ The many 
benefits of a class-based approach are discussed with regard to both 
CDS and interest rate swaps below.
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    \46\ See discussion of the Commission's DCO examination and risk 
surveillance programs in the NPRM, 77 FR at 47173-74.
    \47\ In its comment letter, Freddie Mac questioned how the 
Commission would review a proposal from a DCO to clear swaps that 
are required to be cleared under Sec.  50.4. In addition to its 
general authority to ensure compliance with the core principles, the 
Commission has authority to review a DCO's eligibility to clear 
swaps subject to a clearing requirement at any time under Sec.  
39.5(a).
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iii. Customer Segregation for Swaps
    Under section 2(h)(2)(D)(ii)(V) of the CEA, in making a clearing 
requirement determination, the Commission must take into account the 
existence of reasonable legal certainty in the event of the insolvency 
of the relevant DCO or one or more of its clearing members with regard 
to the treatment of customer and swap counterparty positions, funds, 
and property.\48\ Several commenters raised general concerns about 
customer segregation for cleared swaps.
---------------------------------------------------------------------------

    \48\ This factor is discussed further in Sections II.D and II.F 
below.
---------------------------------------------------------------------------

    Vanguard recommended that the Commission should not implement 
mandatory clearing for any swaps until the Commission's final swap 
customer segregation rules under the legally segregated, operationally 
commingled (LSOC) model are fully operational and capable of being 
tested for at least three months prior to mandatory clearing.
    The Securities Industry and Financial Markets Association's Asset 
Management Group (SIFMA AMG) expressed similar concerns about 
unresolved issues concerning LSOC rules and the operational readiness 
of futures commission merchants (FCMs) and DCOs to comply with those 
rules. SIFMA AMG requested clarification of certain matters related to 
the LSOC model and requests that the Commission issue new rules to 
require FCMs to issue reports as frequently as technologically 
feasible, require DCOs to take all steps necessary to ensure reported 
information is accurate, and require DCOs to complete margin 
calculations as frequently as technologically feasible. SIFMA AMG 
recommended that the Commission implement a three-month testing period 
for LSOC rule implementation after the Commission and the market have 
completed their ongoing rule clarification efforts.
    Both Vanguard and SIFMA AMG requested that all customer margin, 
including excess margin above the amount required by the DCO, be 
protected from fellow-customer risk.
    ISDA noted that the commodity broker liquidation provisions under 
the U.S. bankruptcy code and the Commission's Part 190 regulations have 
never been applied to a DCO. In addition, ISDA stated that the Orderly 
Liquidation Authority under Title II of the Dodd-Frank Act has never 
been applied to any entity. For clearinghouses located in the United 
Kingdom, ISDA observed that the Commission is relying on legal 
opinions, noting the lack of practical experience with DCO insolvency 
in the United Kingdom. In light of the absence of practical experience 
with DCO insolvency, ISDA recommended that the Commission study the 
issue with the goal of documenting uncertainties and proposing 
solutions.
    In response to these comments, the Commission observes that the 
compliance date for LSOC was November 13, 2012. The Commission worked 
with market participants to ensure that compliance by that date was 
accomplished \49\ For reasons discussed below, the compliance schedule 
for this first clearing requirement will commence on March 11, 
2013.\50\ Accordingly, as requested by SIFMA AMG, parties in the first 
compliance category \51\ will have more than 3 months of experience 
under the LSOC rules prior to required clearing taking effect. Those 
parties in the second and third categories will have over 6 and 9 
months of testing prior to required clearing, respectively.\52\ During 
this time, the Commission will continue to work with market 
participants to resolve matters that require clarification regarding 
LSOC.
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    \49\ The Commission notes that under Sec.  22.13 a DCO may, 
subject to certain conditions contained therein, accept cleared 
swaps customer collateral in excess of the amount required by the 
DCO. Acceptance of this excess collateral is entirely at the 
election of the DCO. Thus, the timing of resolution of any issues 
that may arise as a result of the optional acceptance of such 
collateral is separate and apart from the November 13th compliance 
date for implementation of the regulatory requirements set forth in 
the Part 22 rules.
    \50\ See Section IV for a complete discussion of compliance 
dates.
    \51\ Under the compliance schedule for required clearing, Sec.  
50.25, Category 1 Entities are swap dealers, security-based swap 
dealers, major swap participants, major security-based swap 
participants, and active funds. This category must come in 
compliance with the clearing requirement by March 11, 2013.
    \52\ Category 2 Entities are commodity pools, private funds, and 
persons predominantly engaged in activities that are in the business 
of banking, or in activities that are financial in nature according 
to section 4(k) of the Bank Holding Company Act, provided that such 
participants are not third-party subaccounts. Category 2 Entities 
must comply with the clearing requirement by June 10, 2013, for all 
swaps entered into on or after that date. Category 3 Entities are 
all other counterparties not electing an exception for a swap under 
section 2(h)(7), including third-party subaccounts and ERISA plans. 
Category 3 Entities must comply with the clearing requirement by 
September 9, 2013, for all swaps entered into on or after that date.
---------------------------------------------------------------------------

    Moreover, in response to requests for enhanced LSOC protections, 
the Commission understands that the industry is working toward a 
February implementation date for DCO rules regarding acceptance of 
excess collateral. The Commission recognizes

[[Page 74290]]

that this issue is of particular concern to third-party subaccounts 
that will be required to begin clearing swaps executed on or after 
September 9, 2013. Given the industry's February goal, the Commission 
believes that issues regarding the acceptance of excess collateral will 
be resolved before the beginning of September.
    In response to ISDA's request that the Commission conduct a study 
regarding insolvencies of DCOs and clearing members, the Commission 
observes that its staff have actively participated in, and taken 
leading roles in, a number of international efforts related to 
clearinghouse and clearing member insolvency, including an important 
cross-border study regarding insolvency regimes.\53\ In addition, the 
Commission and other U.S. authorities, including the FDIC, have been 
engaged, and continue to engage, in regulatory coordination and 
cooperation, related to insolvencies under Title II.
---------------------------------------------------------------------------

    \53\ See, e.g., ``Survey of Regimes for the Protection, 
Distribution, and/or Transfer of Client Assets'' (Technical 
Committee of the International Organization of Securities 
Commissions, March, 2011); ``Consultative Report on the Recovery and 
Resolution of Financial Market Infrastructures'' (Committee on 
Payment and Settlement Systems and the International Organization of 
Securities Commissions, July, 2012). Staff are also actively 
participating in further efforts in these contexts by the 
International Organization of Securities Commissions and the 
Resolution Steering Group of the Financial Stability Board.
---------------------------------------------------------------------------

C. Credit Default Swaps

i. DCO Submissions
    Pursuant to Sec.  39.5, the Commission received filings with 
respect to CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe, 
each a registered DCO.\54\ The CME and ICE Clear Credit submissions 
included the CDS that each clears on North American corporate indices, 
covering various tenors and series.\55\ The ICE Clear Europe submission 
included, among other swaps, the CDS contracts on European corporate 
indices that they clear, with information on each of the different 
tenors and series. Each of the submissions contained information 
relating to the five statutory factors set forth in section 2(h)(2)(D) 
of the CEA and other information required under Sec.  39.5.
---------------------------------------------------------------------------

    \54\ In the case of CME and ICE Clear Europe, the submissions 
also included other swaps beyond those in the CDS and interest rate 
swap categories. These submissions, including a description of the 
specific swaps covered, are available on the Commission's Web site 
at: http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ClearingOrganizationProducts.
    \55\ The Commission has received subsequent submissions from CME 
and ICE Clear Credit relating to CDS. In particular, CME submitted a 
filing with regard to the current series of each of the CDX.NA.IG 
and CDX.NA.HY (Series 19). ICE Clear Credit made filings with regard 
to the clearing of the 3-year tenor of the CDX.HY Series 15 and the 
clearing of the CDX.EM indices. With the exception of the CDX.EM 
submission, upon which the Commission has not yet begun the 
determination process, the substance of each of the other 
submissions was addressed in both the proposed clearing 
determination and the final clearing determination set forth herein.
---------------------------------------------------------------------------

    CME, ICE Clear Credit, and ICE Clear Europe provided notice of 
their Sec.  39.5 swap submissions to their members by posting their 
submissions on their respective Web sites.\56\ The submissions also are 
published on the Commission's Web site.\57\
---------------------------------------------------------------------------

    \56\ Available at http://www.cmegroup.com/market-regulation/rule-filings.html and https://www.theice.com/publicdocs/regulatory_filings/ICEClearCredit_022212.pdf. ICE Clear Europe did not provide 
a link to its relevant Web page.
    \57\ See http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ClearingOrganizationProducts.
---------------------------------------------------------------------------

    Regulation 39.5(b)(3)(viii) also directs a DCO's submission to 
include a summary of any views on the submission expressed by members. 
CME's submission did not address this. In their submissions, ICE Clear 
Credit and ICE Clear Europe stated that neither has solicited nor 
received any comments to date and will notify the Commission of any 
such comments. The Commission did not receive any additional feedback 
from DCOs beyond the information included in comment letters posted on 
the Commission's Web site.
    The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that 
were submitted to the Commission are standardized contracts providing 
credit protection on an untranched basis, meaning that settlement is 
not limited to a specific range of losses upon the occurrence of credit 
events among the reference entities included within an index. Besides 
single-name CDS, untranched CDS on indices are the only type of CDS 
being cleared by these DCOs. Other swaps, such as credit index 
tranches, options, and first- or Nth-to-default baskets on these 
indices, are not currently cleared.
    CME and ICE Clear Credit each clear CDS on indices administered by 
Markit. The Markit CDX family of indices is the standard North American 
credit default swap family of indices, with the primary corporate 
indices being the CDX North American Investment Grade (consisting of 
125 investment grade corporate reference entities) (CDX.NA.IG) and the 
CDX North American High Yield (consisting of 100 high yield corporate 
reference entities) (CDX.NA.HY). The standard currency for CDS on these 
indices is the U.S. dollar.
    CME offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for 
Series 9 and each subsequent series, to the extent that those contracts 
that have not reached their termination date.\58\ CME also offers the 
CDX.NA.HY at the 5-year tenor for Series 11, and each subsequent 
series. ICE Clear Credit offers the CDX.NA.IG Series 8, and each 
subsequent series of that index that is still outstanding, at the 3-, 
5-, 7- and 10-year tenors.\59\ ICE Clear Credit also offers the 
CDX.NA.IG. Series 8 to Series 10, at the 7-year tenor. For the high 
yield index, ICE Clear Credit clears all series from the current series 
through the CDX.NA.HY Series 9 at the 5-year tenor.\60\ Each of these 
cleared CDX.NA contracts is denominated in U.S. dollars.
---------------------------------------------------------------------------

    \58\ As administrator of these indices, Markit reviews the 
composition of underlying reference entities in the indices every 
six months. Once Markit establishes the constituents to be included 
within the indices, a new series of the respective index is created. 
The most recent series is identified as the ``on-the-run'' series, 
with all older series being identified as ``off-the-run.'' 
Additionally, each time one of the reference entities within an 
index suffers a credit event, a new version of an existing series of 
the index is created. In addition to the series and version 
variations that may exist on the index, the parties can choose the 
tenor of the CDS on a given index. While the 5-year tenor is the 
most common, and therefore most liquid, other standard tenors may 
include the 1-, 2-, 3-, 7-, and 10-year.
    \59\ ICE Clear Credit began clearing the 3- and 7-year tenors on 
the CDX.NA.IG after its initial Sec.  39.5 submission of February 
22, 2012.
    \60\ ICE Clear Credit also made a Sec.  39.5 submission with 
regard to the 3-year tenor of CDX.NA.HY, Series 15. The Commission 
is not including this contract within the clearing determination at 
this time.
---------------------------------------------------------------------------

    ICE Clear Europe made a submission covering the index CDS that it 
clears. As with CME's and ICE Clear Credit's submissions, the contracts 
that ICE Clear Europe clears are based on Markit indices with corporate 
reference entities, though in this case, the entities are based in 
Europe. ICE Clear Europe clears euro-denominated contracts referencing 
the three primary indices: iTraxx Europe (covering 125 European 
investment grade corporate reference entities); the iTraxx Europe 
Crossover (covering 50 European high yield reference entities); and the 
iTraxx Europe High Volatility (a 30-entity subset of the European 
investment grade index).
    For the iTraxx Europe and Crossover, ICE Clear Europe clears 
outstanding contracts in the Series 7 and 8, respectively, through the 
current series. For the High Volatility index, ICE Clear Europe clears 
outstanding contracts in the Series 9 through the current series. In 
terms of tenors, ICE Clear Europe clears the 5-year tenor for all 
swaps, as well as the 10-year tenor for the iTraxx Europe index.

[[Page 74291]]

    Based upon those portions of the CME, ICE Clear Credit, and ICE 
Clear Europe swap submissions relating to the CDS contracts discussed 
above, as well as the analysis conducted by the Commission pursuant to 
Sec.  39.5(b) and set forth below, the Commission has reviewed the 
following classes of swaps for purposes of the clearing requirement 
determination.
ii. Identification of CDS Specifications
    Under Sec.  39.5, the decision of the Commission to require that a 
group, category, type, or class of swaps be required to be cleared is 
informed by a number of factors. As an initial matter, the Commission 
has looked to the DCOs' submissions with regard to the swaps they 
currently clear. After analyzing the key attributes of the swaps 
submitted, the Commission proposed establishing two classes of CDS to 
be subject to the clearing requirement and, pursuant to this final 
rulemaking, is finalizing those classes as proposed. The first class is 
based on the untranched indices covering North American corporate 
credits, the CDX.NA.IG and the CDX.NA.HY. The second class is based on 
the untranched indices covering European corporate credits, the iTraxx 
Europe, the iTraxx Europe Crossover, and the iTraxx Europe High 
Volatility. Given the different markets that the CDS indices cover, the 
different standard currencies, and other logistical differences in how 
the CDS markets and documentation work, the Commission believes this is 
an appropriate basis for creating these two classes.
    The following table sets forth the specific specifications of each 
class:

                                 Table 1
------------------------------------------------------------------------
                                        North American Untranched CDS
           Specification                        Indices Class
------------------------------------------------------------------------
1. Reference Entities.............  Corporate.
2. Region.........................  North America.
3. Indices........................  CDX.NA.IG.
                                    CDX.NA.HY.
4. Tenor..........................  CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.
                                    CDX.NA.HY: 5Y.
5. Applicable Series..............  CDX.NA.IG 3Y: Series 15 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    CDX.NA.IG 5Y: Series 11 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    CDX.NA.IG 7Y: Series 8 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    CDX.NA.IG 10Y: Series 8 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    CDX.NA.HY 5Y: Series 11 and all
                                     subsequent Series, up to and
                                     including the current Series.
6. Tranched.......................  No.
------------------------------------------------------------------------
           Specification               European Untranched CDS Indices
                                                    Class
------------------------------------------------------------------------
1. Reference Entities.............  Corporate.
2. Region.........................  Europe.
3. Indices........................  iTraxx Europe.
                                    iTraxx Europe Crossover.
                                    iTraxx Europe HiVol.
4. Tenor..........................  iTraxx Europe: 5Y, 10Y.
                                    iTraxx Europe Crossover: 5Y.
                                    iTraxx Europe HiVol: 5Y.
5. Applicable Series..............  iTraxx Europe 5Y: Series 10 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    iTraxx Europe 10Y: Series 7 and all
                                     subsequent Series, up to and
                                     including the current Series.
                                    iTraxx Europe Crossover 5Y: Series
                                     10 and all subsequent Series, up to
                                     and including the current Series.
                                    iTraxx Europe HiVol 5Y: Series 10
                                     and all subsequent Series, up to
                                     and including the current Series.
6. Tranched.......................  No.
------------------------------------------------------------------------

    The Commission believes that indices based on other types of 
entities would be viewed as a separate class and would be subject to a 
separate determination by the Commission. For example, given the 
differences that exist with regard to volumes and risk management of 
indices based on sovereign issuers, as opposed to corporate issuers, it 
is likely that such CDS would represent their own class of swaps. 
Similarly, to the extent indices from other regions were submitted by a 
DCO, it is likely that the Commission would take the view that they are 
part of their own class of swaps as well.
    The Commission believes it appropriate to define the classes of 
swaps as untranched CDS contracts referencing Markit's broad-based 
corporate indices. These corporate indices have the most net notional 
outstanding, the most trading volumes, and the best available pricing. 
The risk management frameworks for the corporate index swaps are the 
most well-established, and have the most available data in terms of CDS 
spreads and corporate default studies for analysis of the underlying 
constituents of the indices. Agreements based on these indices also are 
widely accepted and use standardized terms.\61\
---------------------------------------------------------------------------

    \61\ To the extent other vendors successfully develop similar 
indices, the Commission would conduct the analysis required by Sec.  
39.5, either on its own initiative or based on a DCO submission. If 
based on that analysis the Commission issued a clearing requirement 
determination, it is likely that such indices would be considered to 
be part of an existing class of CDS that are required to be cleared.
---------------------------------------------------------------------------

    Both of the CDS classes presented herein assume that the relevant 
CDS agreement will use the standardized terms established by Markit/
ISDA with regard to the specific index and be denominated in a currency 
that is accepted for clearing by DCOs. To the extent that a CDS 
agreement on an index listed within the classification is not accepted 
for clearing by any DCO because it uses non-standard terms or is 
denominated in a currency that makes it ineligible for clearing, that 
CDS is not subject to the requirement that it be cleared, 
notwithstanding that the CDS is based on such index.
    Also as proposed, this clearing determination is limited to only 
those series of the referenced indices that are currently being 
cleared.\62\ Further, to the

[[Page 74292]]

extent that any swap on a CDS index is of a tenor such that it is 
scheduled to terminate prior to July 1, 2013, such a swap is not part 
of this clearing determination. Given the implementation periods 
provided for under Sec.  50.25, discussed below in Section IV, the 
Commission does not want to create a situation where certain market 
participants will be required to clear a contract based upon their 
status under the implementation provisions, but other parties will 
never be required to clear that same contract before its scheduled 
termination.
---------------------------------------------------------------------------

    \62\ As discussed in further detail below, the clearing 
requirement does not require existing swaps in the older series to 
be cleared. The requirement is prospective, only requiring newly 
executed swaps in these older series to be cleared.
---------------------------------------------------------------------------

    Similarly, the classes only include those tenors of contracts which 
are currently being cleared. AFR commented that both the 1- and 2-year 
tenors of the CDX.NA.IG should be included in the clearing requirement 
determination, citing concerns that if market participants shift to 
these shorter tenors, that shift would undermine a clearing requirement 
that included only longer tenors. Because no DCO clears the 1- or 2-
year tenor of CDX.NA.IG, the Commission has decided to include within 
today's clearing determination only those tenors of the CDX.NA.IG that 
were proposed. The Commission will monitor the market's use of shorter 
tenors. To the extent that the market generates significant volumes of 
such shorter tenors of CDX.NA.IG, the Commission would expect that one 
or more DCOs will begin offering those tenors for clearing.
    If no DCO were to offer these swaps for clearing, the Commission 
has the authority to commence a Commission-initiated review under 
section 2(h)(2)(A)(i) of the CEA to determine whether the swaps should 
be required to be cleared. Under section 2(h)(4), to the extent that 
the Commission finds that a particular swap or group, category, type, 
or class of swaps would otherwise be subject to mandatory clearing but 
no DCO has listed the swap, group, category, type, or class of swaps 
for clearing, the Commission shall (i) investigate the relevant facts 
and circumstances; (ii) issue a public report containing the results of 
the investigation within 30 days; and (iii) take such actions as the 
Commissions determines to be necessary and in the public interest, 
which may include requiring the retaining of adequate margin or capital 
by parties to the swap.
    The clearing requirement determination will also cover each new 
series of these indices that is created every six months. The 
Commission believes this will provide certainty to the market, as 
opposed to awaiting a new determination for each new series.\63\ 
Recognizing that there may be changes to indices and their 
constituents,\64\ the Commission will analyze each new series to ensure 
that the indices should continue to be included within the existing 
class of swaps subject to a clearing determination. To the extent that 
the new series raises issues, such as a DCO's ability to risk manage 
the contracts, the Commission can issue a stay of the clearing 
requirement for that series under Sec.  39.5(d). No commenter raised 
any questions regarding new series.
---------------------------------------------------------------------------

    \63\ The timing of announcement of index constituents would make 
it impossible for the Commission to analyze the index and issue a 
clearing determination on the roll date, given the timeframes 
imposed on the Commission by Sec.  39.5.
    \64\ See Financial Times, ``CDS Market--Markit's Weird 
Selection,'' September 27, 2012, discussing the inclusion of 
constituents (CIT, Calpine, and Charter Communications) in the 
latest series of the CDX.NA.HY that do not have actively traded CDS 
contracts.
---------------------------------------------------------------------------

    As proposed, the Commission has decided that the classes be limited 
to untranched CDS on the aforementioned indices. With these untranched 
CDS, the contract covers the entire index loss distribution of the 
index, and settlement is not linked to a specified number of defaults. 
Tranched swaps, first- or ``Nth'' to-default, options, or any other 
product variations on these indices are excluded from these classes. 
These other swaps based on the indices, such as tranches, have very 
different profiles in terms of the Sec.  39.5 analysis. Besides very 
different notional and trading volumes, the risk management processes 
and operations may be significantly different. The Commission believes 
it appropriate to exclude tranched swaps, and other variations on the 
indices, from the classes of swaps set forth herein. Such swaps, if 
accepted by DCOs and submitted for Commission review, likely would be 
viewed as a separate class or as separate classes.
    AFR notes that market participants can use tranched CDS on the 
indices to replicate contracts and portfolios that would otherwise be 
subject to a clearing requirement. The Commission recognizes this 
concern and will continue to monitor activity in tranched CDS indices, 
as well as how the development of risk management processes at DCOs 
could allow for the clearing of those products. Today's clearing 
determination does not foreclose the possibility that tranched products 
may be subject to another clearing determination in the future.

D. Determination Analysis for Credit Default Swaps

    Section 2(h)(2)(D)(i) of the CEA requires the Commission to review 
whether a swap submission under section 2(h)(2)(B) is consistent with 
section 5b(c)(2) of the CEA (DCO core principles). Section 
2(h)(2)(D)(ii) of the CEA also requires the Commission to consider five 
factors in a determination based on swap submission: (1) The existence 
of significant outstanding notional exposures, trading liquidity, and 
adequate pricing data; (2) the availability of rule framework, 
capacity, operational expertise and resources, and credit support 
infrastructure to clear the contract on terms that are consistent with 
the material terms and trading conventions on which the contract is 
then traded; (3) the effect on the mitigation of systemic risk, taking 
into account the size of the market for such contract and the resources 
of the DCO available to clear the contract; (4) the effect on 
competition, including appropriate fees and charges applied to 
clearing; and (5) the existence of reasonable legal certainty in the 
event of the insolvency of the relevant DCO or one or more of its 
clearing members with regard to the treatment of customer and swap 
counterparty positions, funds, and property.\65\
---------------------------------------------------------------------------

    \65\ ISDA highlighted the possibility that a CDS index subject 
to a clearing requirement determination could undergo such 
significant changes to its underlying constituents during its 
lifecycle that such an index would no longer be considered a broad-
based index, subject to the Commission's jurisdiction. The 
Commission notes that the indices subject to the clearing 
requirement determinations discussed herein contain a minimum of 30 
constituents of equal weighting, limiting the likelihood of such 
scenario. Nonetheless, in the event of such a scenario, the 
Commission could review the determination, and if appropriate, stay 
the determination under Sec.  39.5(d) with regard to the index and/
or series so impacted.
---------------------------------------------------------------------------

i. Consistency With Core Principles for Derivatives Clearing 
Organizations
    Section 2(h)(2)(D)(i) of the CEA requires the Commission to review 
whether a submission is consistent with the core principles for DCOs. 
Each of the DCO submissions relating to CDS provided data to support 
the Commission's analysis of the five factors under section 2(h)(2)(D) 
of the CEA. The Commission also was able to call upon independent 
analysis conducted with regard to the CDS market, as well as its 
knowledge and reviews of the registered DCOs' operations and risk 
management processes, covering topics such as product selection 
criteria, pricing sources, participant eligibility, and other relevant 
rules. The discussion of all of these factors is set forth below.

[[Page 74293]]

    The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe 
pursuant to Sec.  39.5(b) are currently being cleared by those 
organizations. As discussed above, the risk management, rules, and 
operations used by each DCO to clear these swaps are subject to review 
by the Commission's risk management, legal, and examinations staff on 
an on-going basis.
    Additionally, each of the DCOs has established procedures to review 
any new swaps it may consider offering for clearing. Before the indices 
referenced herein were accepted for clearing by any of the DCOs, they 
were subject to review by the risk management functions of those 
organizations. Such analysis generally focuses on the DCO's ability to 
risk manage positions in the prospective swaps and on any specific 
operational issues that may arise from the clearing of such swaps. In 
the case of the former, this involves ensuring that adequate pricing 
data is available, both historically and on a ``going forward'' basis, 
such that a margining methodology could be established, back-tested, 
and used on an on-going basis. Operational issues may include analysis 
of additional contract terms for new swaps that may require different 
settlement procedures. Each of the contracts submitted by CME, ICE 
Clear Credit, and ICE Clear Europe and discussed herein has undergone 
an internal review process by the respective DCO and found to be within 
their product eligibility standards.
    In their submissions, CME and ICE Clear Credit enclosed their risk 
management procedures. In its submission, ICE Clear Europe references 
its risk management procedures, which it had previously submitted to 
the Commission in connection with its application to register as a DCO. 
As part of its risk management and examination functions, the 
Commission reviews each DCO's risk management procedures, including its 
margining methodologies.
    ICE Clear Credit uses a multi-factor model to margin the CDX.NA.IG 
and CDX.NA.HY indices, as well as the single-name CDS it clears. The 
margining methodology is designed to capture the risk of movements in 
credit spreads, liquidation costs, jump-to-default risk for those names 
on which credit protection has been sold, large position concentration 
risks, interest rate sensitivity, and basis risk associated with 
offsetting index derived single names and opposite ``outright'' single 
names. These factors are similarly used by ICE Clear Europe to 
calculate the margining requirements for their iTraxx swap listings and 
the underlying single-name constituents.
    CME's CDS model also weighs a number of factors to calculate the 
initial margin for a portfolio of CDS positions. These include macro-
economic risk factors, such as movements associated with systematic 
risk resulting in large shifts in credit spreads across a portfolio, 
shifts in credit spreads based on tenors, and changes in relative 
spreads between investment grade and high yield spreads. Additional 
factors include specific sector risks, the idiosyncratic risk of 
extreme moves in particular reference entities, and the liquidity risk 
associated with unwinding the portfolio. In all cases, the 
methodologies are designed to protect against any 5-day move in the 
value of the given CDS portfolio, with a 99% confidence level.
    In addition to initial margin, each of the DCOs collects variation 
margin on a daily basis to capture changes in the mark-to-market value 
of the positions. To do this, the DCOs calculate end-of-day settlement 
prices using clearing members' price submissions for cleared swaps. 
Each of the DCOs maintains processes for ensuring the quality of 
clearing member price submissions, including the ability to compel 
trades at quoted prices on a random basis and to enforce fines on 
incomplete or incorrect submissions. ICE Clear Credit and ICE Clear 
Europe also use Markit services for CDX and iTraxx price submissions. 
CME uses other third-party data providers for pricing support as 
necessary on its cleared CDS products.
    As part of their rule frameworks, each of these three DCOs also 
maintains participant eligibility requirements. On April 20, 2012, CME 
filed its amended rule concerning CDS Clearing Member Obligations and 
Qualifications (Rule 8H04). Pursuant to the amended rule, published to 
comply with Commission Regulation 39.12(a)(2), a CDS clearing member 
would have to maintain at least $50 million of capital. The amended 
rule would also require a CDS clearing member's minimum capital 
requirement to be ``scalable'' to the risks it poses. Furthermore, CME 
already has client clearing available for its CDS index contracts.
    Similarly, on March 23, 2012, ICE Clear Credit filed its amended 
Rule 201(b) to incorporate the $50 million minimum capital requirement 
for clearing members. ICE Clear Europe has adopted similar rules to 
comply with Sec.  39.12(a)(2). ICE Clear Credit also has client 
clearing available for its CDX index contracts.
    In addition to the CDS indices discussed above, ICE Clear Credit 
and ICE Clear Europe offer single-name CDS for clearing.\66\ As part of 
their margining methodology, they are seeking approval to offer 
portfolio margining for the single-name CDS and the CDS indices co-
mingled as a single portfolio.\67\ Given that the single-name reference 
entities will likely also be constituents of a given index within a 
portfolio, the Commission generally believes that such portfolio 
margining initiatives are consistent with the sound risk management 
policies for DCOs that are required under Sec.  39.13(g)(4). Moreover, 
DCOs such as ICE Clear Credit already use margining methodologies that 
provide for appropriate portfolio margining treatment with regard to 
clearing members' proprietary positions.\68\ The Commission is 
committed to working toward establishing similar portfolio margining 
programs for DCOs clearing customer positions in CDS indices and 
single-name CDS.\69\ Specifically, the Commission anticipates 
addressing ICE's portfolio margining petitions for CDS in the near 
term.
---------------------------------------------------------------------------

    \66\ Such single-name CDS are defined as ``security-based 
swaps'' under section 721(a) of the Dodd-Frank Act.
    \67\ See ICE Clear Credit's petitions to the Commission and SEC, 
dated October 4, 2011. The petition to the Commission is available 
at http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/iceclearcredit100411public.pdf. See also ICE Clear 
Europe's petition available at http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/icecleareurope4dfrequest.pdf.
    \68\ See ICE Clear Credit's certification to the Commission, 
dated as of November 25, 2011. The certification is available at 
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul112511icecc001.pdf.
    \69\ A discussion of comments concerning portfolio margining is 
included below.
---------------------------------------------------------------------------

    Based upon the Commission's on-going reviews of DCOs' risk 
management frameworks and clearing rules, and its annual examinations 
of the DCOs, the Commission believes that the submissions of CME, ICE 
Clear Credit, and ICE Clear Europe are consistent with section 5b(c)(2) 
of the CEA and the related Commission regulations. In analyzing the CDS 
products submissions discussed herein, the Commission does not believe 
that a clearing determination with regard to the specified CDS products 
would be inconsistent with CME, ICE Clear Credit, or ICE Clear Europe's 
continued ability to maintain such compliance with the DCO core 
principles set forth in Part 39 of the Commission's regulations.

[[Page 74294]]

ii. Consideration of the Five Statutory Factors for Clearing 
Requirement Determinations
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate 
Pricing Data
    Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to 
take into account the existence of outstanding notional exposures, 
trading liquidity, and adequate pricing data.
    The most recent BIS study \70\ found that, as of December 2011, the 
size of the overall CDS marketplace exceeded $28.6 trillion in notional 
amount outstanding. Of that amount, $11.8 trillion was in multi-name 
CDS agreements. Within this sub-category of CDS, CDS on indices 
accounted for more than 89% of the total notional amount outstanding, 
with over $10 trillion in notional outstanding. Overall, CDS on index 
products account for 37% of all notional amounts of CDS contracts 
outstanding.
---------------------------------------------------------------------------

    \70\ See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
---------------------------------------------------------------------------

    The predominant provider of CDS indices is Markit. Markit offers 
indices covering corporate and sovereign entities, among others, in the 
United States, Europe, and Asia. Recent Markit data shows daily 
transaction volumes of 1,559 transactions using its licensed family of 
CDX indices, and 1,828 daily transactions in its European iTraxx 
indices.\71\ Further, it shows a rolling month gross notional amount of 
$745 billion in gross notional amount for the CDX family of indices and 
[euro]680 billion for the iTraxx family. Nearly all of the CDX 
contracts and volumes come from indices that are subject to the 
clearing requirement determination. With regard to the European iTraxx, 
more than 80% of those daily contract volumes and 84% of the daily 
gross notional volumes come from the iTraxx investment grade and high 
yield indices contemplated by the clearing requirement determination.
---------------------------------------------------------------------------

    \71\ Based on data published on www.markit.com as of September 
27, 2012.
---------------------------------------------------------------------------

    One point highlighted by this data, however, is the declining 
trading liquidity in the off-the-run series that can occur. Of the 
volumes noted by Markit, nearly 60% was in the current on-the-run 
series, as compared to all other outstanding series combined.\72\ The 
submissions of ICE Clear Credit, ICE Clear Europe, and CME also note 
the decline in average weekly gross notional amounts and contracts for 
benchmark tenors for off-the-run indices. The decline however can be 
more precipitous among older off-the-run indices. While many market 
factors can contribute to the actual volumes for a specific off-the-run 
contract, subject to certain exceptions, the trend is generally toward 
lower volumes.\73\
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    \72\ The term ``on-the-run'' refers to current series of an 
index, while older series are referred to ``off-the-run.'' Each six 
months when a new series is created (or ``rolls'' using market 
terminology), the new series is considered the ``on-the-run'' index, 
and all others are considered ``off-the-run.''
    \73\ The current ``on-the-run'' series tend to have the most 
liquidity, while the older ``off-the-run'' series tend to have less 
liquidity, as many investors exit positions in an existing series 
and enter new positions in the new series when it becomes available 
(i.e., they ``roll'' their positions to the new series) thereby 
increasing liquidity in the ``on-the-run'' series.
---------------------------------------------------------------------------

    Set forth below is a table of data taken from DTCC as of November 
7, 2012, highlighting the net notional amounts and outstanding CDS 
index contracts, across all tenors, for each index and series included 
in this clearing determination.\74\
---------------------------------------------------------------------------

    \74\ Data from November 7, 2012, available at www.dtcc.com. In 
2006, DTCC began providing warehouse services for confirmed CDS 
trades through its Trade Information Warehouse (TIW). With the 
commitment of global market participants in 2009 to ensure that all 
OTC derivatives trades are recorded by a central repository, TIW has 
become a global repository for all CDS trades. With all major market 
participants submitting their trades to the TIW, it is estimated 
that 98% of all CDS trades are included within the warehouse, making 
it the primary source of CDS transaction data.

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[[Page 74295]]

[GRAPHIC] [TIFF OMITTED] TR13DE12.000

    Notwithstanding the declining volumes that occur when an index is 
no longer on-the-run, the Commission does not believe that is 
sufficient reason to exclude the older series from the classes of CDS 
that are subject to the clearing requirement. As the DTCC data 
indicates, there are still significant volumes and outstanding notional 
amounts in each of these series.\75\ From the perspective of the DCO, 
the risk management of the older series of swaps should not provide 
significant additional challenges. With the significant notional and 
contract volumes still outstanding according to DTCC, many clearing 
members already have these positions on their books and are meeting 
their risk management requirements, even in the face of declining 
trading volumes. While the volumes may decline, the data included in 
the submissions indicates that volume still does exist, and parties 
should be able to trade these CDS indices as necessary. Additionally, 
as discussed further below, the clearing requirement would apply only 
to new swaps executed in the off-the-run indices.
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    \75\ The Commission is monitoring volumes in the on-the-run 
iTraxx Europe HiVol. With the newest roll of the indices occurring 
on September 20, 2012, this index has yet to show significant 
volumes in the latest series based on DTCC data. The Commission will 
continue to monitor these volumes and take action as appropriate.
---------------------------------------------------------------------------

    Both AFR and ISDA specifically supported the inclusion of ``off-
the-run'' CDS indices in the clearing determination. AFR noted that 
without including those indices, the market might enter into such swaps 
so as to avoid the clearing requirement. In addition, ISDA expressed 
concern about the potential negative impact on the relative liquidity 
between cleared and uncleared CDS swaps should a clearing requirement 
cease to apply during the lifecycle of the CDS.
    Given the contract and notional volumes listed above, there is 
adequate data available on pricing. The pricing for the CDS on these 
indices is fairly consistent across clearinghouses. The DCOs generally 
require a clearing member with open interest in a particular index to 
provide a price on that index for end-of-day settlement purposes. After 
applying a process to remove clear outliers, a composite price is 
calculated using the remaining prices. To ensure the integrity of the 
submissions, clearing members' prices may be ``actionable,'' meaning 
that they may form the basis of an actual trade that the member will be 
forced to enter. DCOs also have compliance programs that may result in 
fines for clearing members that fail to submit accurate pricing data.
    Beyond clearing member submissions, there are a number of third-
party vendors that provide pricing services on these swaps. Third-party 
vendors typically source their data from a broader range of dealers. 
The data includes both direct contributions as well as feeds to 
automated trading

[[Page 74296]]

systems. This data is reviewed for outliers and aggregated for 
distribution.
b. Availability of Rule Framework, Capacity, Operational Expertise and 
Resources, and Credit Support Infrastructure
    Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to 
take into account the availability of rule framework, capacity, 
operational expertise and resources, and credit support infrastructure 
to clear the contract on terms that are consistent with the material 
terms and trading conventions on which the contract is then traded. The 
Commission has determined that this factor is satisfied by each of CME, 
ICE Clear Credit, and ICE Clear Europe.
    CME, ICE Clear Credit, and ICE Clear Europe, respectively, 
currently are clearing the swaps each submitted under Sec.  39.5. They 
have developed respective rule frameworks, capacity, operational 
expertise and resources, and credit support infrastructure to clear the 
contracts on terms that are consistent with the material terms and 
trading conventions on which the contracts currently are trading. The 
Commission believes that these are scalable and that CME, ICE Clear 
Credit, and ICE Clear Europe would be able to risk manage the 
additional swaps that might be submitted due to the clearing 
requirement determination.
    Following the financial crisis, the major market participants 
committed in 2009 to the substantial reforms to the OTC derivatives 
markets.\76\ Among the commitments from CDS dealers and buy side 
participants was to actively engage with central counterparties to 
broaden the range of cleared swaps and market participants. These 
changes were in addition to those generated through organizations like 
ISDA and their protocols standardizing CDS. For broadly traded swaps 
like the CDS indices, the ultimate impact of these initiatives was 
operational platforms,\77\ rule frameworks, and other infrastructure 
initiatives that replicated the uncleared market and supported the move 
of these CDS to a centrally cleared environment. In this way, the CDS 
clearing services offered by DCOs, including CME, ICE Clear Credit, and 
ICE Clear Europe, were designed to be cleared in a manner that is 
consistent with the material terms and trading conventions of a 
bilateral, uncleared market.
---------------------------------------------------------------------------

    \76\ See the June 2, 2009 letter to The Honorable William C. 
Dudley, President of the Federal Reserve Bank of New York, available 
at http://www.newyorkfed.org/newsevents/news/markets/2009/060209letter.pdf.
    \77\ In its comment letter supporting the NPRM, MarketAxess 
Holdings Inc. (MarketAxess) noted that the electronic trading 
platform it operates supports the trading of CDX and iTraxx 
products. MarketAxess stated that it intends to apply for 
registration as a SEF once the Commission issues related final 
rules.
---------------------------------------------------------------------------

    In addition, CME, ICE Clear Credit, and ICE Clear Europe are 
registered DCOs. To be registered as such, CME, ICE Clear Credit, and 
ICE Clear Europe have, on an on-going basis, demonstrated to the 
Commission that they are each in compliance with the DCO core 
principles set forth in the CEA and Commission regulations, as 
discussed above. As a general matter, any DCO that does not have the 
rule framework, capacity, operational expertise and resources, and 
credit support infrastructure to clear the swaps that are subject to 
required clearing is not in compliance with the core principles or the 
Commission regulations promulgating these principles.
    Commenters raised issues with regard to the operational 
capabilities of clearinghouses to manage the clearing of iTraxx for 
customers. Commenters such as ISDA, FIA, MFA, and D.E. Shaw all 
highlighted the fact that no registered DCO currently offers customer 
clearing for iTraxx. Besides the lack of approved customer clearing of 
the iTraxx indices at any DCO, the commenters noted substantive 
concerns about the ability of clearinghouses to manage the 
``restructuring'' credit event applicable to iTraxx (and certain other 
CDS indices) in the context of customer clearing. For the CDX.NA.IG and 
CDX.NA.HY indices, credit events are limited to a ``failure to pay'' or 
the bankruptcy of the companies included in the index. A credit event 
results in the removal of the defaulted constitute from the index, with 
the protection seller settling the amounts owed to the protection buyer 
with regard to that individual constituent. The standardized terms of 
the iTraxx, however, also include ``restructuring'' as a credit event. 
When a restructuring event occurs with regard to an index constituent, 
the impacted company is removed from the index by the creation of a 
single-name CDS referencing that entity. The protection buyer and 
seller have the option to continue that single-name CDS or to settle 
the contract with regard to the restructured credit.
    ISDA, MFA, and FIA note that this process raises issues for DCOs. 
Specifically highlighted were those situations where a DCO does not, in 
fact, already offer clearing of the single-name CDS that is subject to 
the restructuring event. To the extent that the SEC or foreign 
regulator prohibits the DCO from clearing a particular single-name CDS, 
a process would need to be developed to address such circumstances. 
Similarly, the customer account in which the new single-name CDS would 
be held, in the absence of portfolio margining, would need to be 
addressed. MFA comments that the approval of portfolio margining 
petitions would remove much of the complexity of the ``spin-off'' of 
the single-name CDS from the iTraxx indices. Given the inclusion of the 
iTraxx within the clearing determination, MFA states that the petitions 
need to be approved so that the new single-name CDS can be held within 
the cleared swap account and margined with the iTraxx index CDS. 
Finally, the commenters believe that DCOs need to demonstrate that 
their customer clearing platforms are technologically viable and 
sufficiently tested before a clearing determination with regard to the 
iTraxx indices is finalized. For these reasons, these commenters 
believe a delay in the implementation of a clearing requirement for the 
iTraxx indices would be appropriate until such time as customer 
clearing platforms have been established, the necessary regulatory 
approvals have been granted and operational testing has been conducted 
for an appropriate period of time. In MFA's view the delay should be 60 
to 90 days, and in ISDA's view, the testing period should consist of 
voluntary client clearing for at least 90 days.
    On the other hand, ICE supports the Commission's inclusion of 
iTraxx CDS indices within its clearing requirement determination. ICE 
states that ICE Clear Europe has already begun the process of pursuing 
regulatory approval for client clearing of iTraxx, and indicates that 
ICE Clear Credit will do the same.\78\

[[Page 74297]]

While recognizing that the standard credit events under the iTraxx add 
some complexity relative to the CDX indices, ICE notes that it has 
worked with market participants and DTCC to develop industry-wide 
solutions to the ``restructuring'' event. Further, ICE states that ICE 
Clear Credit has already implemented applicable parts of this solution 
with regard to the clearing of the CDX.EM CDS index of emerging market 
sovereign constituents.\79\ ICE claims that any additional processes 
necessary with regard to clearing iTraxx index CDS are being addressed 
currently by the industry, and will not present any insurmountable 
challenges.
---------------------------------------------------------------------------

    \78\ ICE Clear Europe's submission, pursuant to Commission 
Regulation 40.6, amending its rulebook to accommodate client 
clearing is available on the Commission's Web site at: http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul091312iclreu001.pdf. ICE Clear Europe is registered as a 
recognized clearing house with the United Kingdom's Financial 
Services Authority (U.K. FSA) and requires approval from the U.K. 
FSA to offer iTraxx clearing to customers. ICE Clear Credit's 
submission with regard to iTraxx clearing for both proprietary and 
customer accounts is available on the Commission's Web site at 
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul092812icc001.pdf. To the extent that ICE Clear 
Credit successfully launches iTraxx clearing, it would address 
ISDA's concern with regard to the Commission issuing a clearing 
determination for swaps that cannot be cleared at a U.S.-based DCO. 
It should be noted, however, that the Commission does not believe a 
DCO clearing a particular swap needs to be based in the U.S. for the 
Commission to find a swap subject to a clearing determination, to 
the extent that swap satisfies the factors required by statute and 
regulation to be included in the Commission's analysis.
    \79\ It is not clear, however, the extent to which clearing 
members are in fact offering customer clearing of the CDX.EM indices 
cleared by ICE Clear Credit.
---------------------------------------------------------------------------

    Citadel also commented that they did not believe that there were 
any substantive reasons why the iTraxx index CDS should not be required 
to be cleared. The ``restructuring'' credit event and the spinning out 
of a newly cleared single-name CDS do not, in Citadel's view, present 
any new issues to market participants. Further, because DCOs already 
offer clearing on the iTraxx on a dealer-to-dealer basis, they have the 
necessary processes upon which to build out the client clearing 
platform. Citadel also states that even if the ICE Clear Credit's and 
ICE Clear Europe's petitions to the SEC for portfolio margining were 
not approved generally,\80\ limited exemptions may be available for the 
single names associated with the spun-off single name. Citadel does 
agree with other commenters that to the extent that client clearing 
cannot be offered with sufficient lead time to allow for proper 
operational testing, a delay may be appropriate in implementing a 
clearing requirement for the iTraxx indices. Citadel believes 60 days 
voluntary customer clearing should be sufficient for such testing.
---------------------------------------------------------------------------

    \80\ It should be noted that the Commission strongly supports 
the petitions for the portfolio margining of single-name CDS and CDS 
indices. The Commission believes that all customers should be able 
to benefit from the reasonable application of portfolio margining, 
and that the benefits thereof should not just be available to the 
proprietary positions in the house accounts of clearing members.
---------------------------------------------------------------------------

    The Commission believes that the introduction of client clearing 
must occur before any clearing determination could become effective 
with regard to the iTraxx indices, or any other CDS indices that the 
Commission may consider.\81\ The Commission agrees with all commenters 
that subject to resolution of all operational issues surrounding client 
clearing of the iTraxx indices, specifically the iTraxx Europe, 
Crossover, and High Volatility, these indices are appropriate for 
inclusion in a clearing requirement. The Commission is encouraged by 
the work currently being done by the DCOs, by other regulators, and by 
the market as a whole, to establish client clearing in the near term. 
The Commission recognizes that additional time may be necessary to 
allow for the DCOs to obtain the necessary regulatory approvals and 
design a workable framework for dealing with the issues presented by 
the client clearing of the iTraxx indices, before the clearing of this 
class of indices can be required of market participants.
---------------------------------------------------------------------------

    \81\ The Commission agrees with the comments of MFA that the 
availability of client clearing should be considered when making 
clearing determinations. Consequently, DCOs accepting, or planning 
to accept, swaps for clearing should make client clearing available 
in compliance with Commission regulations. In the absence of such 
client clearing, the Commission will delay compliance with required 
clearing of iTraxx indices.
---------------------------------------------------------------------------

    As part of this clearing requirement determination, the Commission 
is including the iTraxx class of CDS, as proposed. The Commission 
believes that the compliance schedule outlined in Section IV below 
should provide adequate time for market participants to resolve the 
outstanding issues with regard to client clearing of the iTraxx 
indices. Under this schedule, the requirement for market participants 
to begin clearing would commence on March 11, 2013, for swaps entered 
into on or after that date between Category 1 Entities. Category 2 
Entities would be required to clear swaps beginning on June 10, 2013, 
for swaps entered into on or after that date, and Category 3 Entities 
would be required to clear swaps beginning on September 9, 2013, for 
swaps entered into on or after that date. However, if no DCO has begun 
offering client clearing for iTraxx by February 11, 2013, then 
compliance with the required clearing of iTraxx will commence sixty 
days after the date on which iTraxx is first offered for client 
clearing by an eligible DCO.
    If an eligible DCO offers client clearing for iTraxx on or before 
September 9, 2013, the following phased implementation schedule will 
apply: Category 1 Entities would be required to clear iTraxx indices 
entered into on or after the date 60 days after the date on which 
iTraxx is first offered for client clearing by an eligible DCO; 
Category 2 Entities would be required to clear iTraxx entered into on 
or after the date 150 days after the date on which iTraxx is first 
offered for client clearing by an eligible DCO; and Category 3 Entities 
would be required to clear iTraxx entered into on or after the date 240 
days after the date on which iTraxx is first offered for client 
clearing by an eligible DCO. There will be no phasing of compliance if 
an eligible DCO offers client clearing for iTraxx after September 9, 
2013. Rather, all three categories of market participants will be 
expected to come into compliance by 60 days after the date on which 
iTraxx is first offered for client clearing by an eligible DCO.
c. Effect on the Mitigation of Systemic Risk
    Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to 
take into account a clearing requirement's effect on the mitigation of 
systemic risk, taking into account the size of the market for the 
contract subject to the clearing requirement and the resources of the 
DCOs clearing the contract. The Commission agrees with the Sec.  39.5 
swap submissions of CME, ICE Clear Credit, and ICE Clear Europe that 
requiring certain classes of CDS to be cleared would reduce systemic 
risk in this sector of the swaps market. As CME noted, the 2008 
financial crisis demonstrated the potential for systemic risk arising 
from the interconnectedness of OTC derivatives market participants and 
the limited transparency of bilateral, i.e., uncleared, counterparty 
relationships. According to the Quarterly Report (Second Quarter 2012) 
on Bank Trading and Derivatives Activities of the Office of the 
Comptroller of the Currency (OCC Report),\82\ CDS index products 
account for a significant percentage of the notional value of swaps 
positions held by financial institutions. According to ICE Clear 
Credit, the CDS indices it offers for clearing are among the most 
actively traded swaps with the largest pre-clearing outstanding 
positions, and ICE Clear Credit's clearing members are among the most 
active market participants. ICE Clear Credit also noted that its 
clearing members clear a significant portion of their clearing-eligible 
portfolio.
---------------------------------------------------------------------------

    \82\ Available at http://occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq212.pdf.
---------------------------------------------------------------------------

    Clearing the CDS indices subject to this determination will reduce 
systemic risk in the following ways: mitigating counterparty credit 
risk because the DCO would become the buyer to every seller of CDS 
indices subject to this determination and vice-versa; providing 
counterparties with daily mark-to-market valuations and exchange of

[[Page 74298]]

variation margin pursuant to a risk management framework set by the DCO 
and reviewed by the Commission's Division of Clearing and Risk; posting 
initial margin with the DCO in order to cover potential future 
exposures in the event of a default; achieving multilateral netting, 
which substantially reduces the number and notional amount of 
outstanding bilateral positions; reducing swap counterparties' 
operational burden by consolidating collateral management and cash 
flows; and eliminating the need for novations or tear-ups because 
clearing members may offset opposing positions.
    As discussed in the NPRM, the DCOs collect substantial amounts of 
collateral in the form of initial margin and guaranty fund 
contributions to cover potential losses on CDS portfolios. The 
methodologies for calculating these amounts are based on covering 5-day 
price movements on a portfolio with a 99% confidence level for initial 
margin, and longer liquidation periods and higher confidence levels 
under ``extreme but plausible'' conditions in the case of guaranty fund 
requirements. Beyond these financial resources, the clearinghouses have 
in place established risk monitoring processes, system safeguards, and 
default management procedures, which are subject to testing and review, 
to address potential systemic shocks to the financial markets.
    AFR specifically supported the Commission's analysis on the 
mitigation of systemic risk with regard to the CDS clearing 
determination.\83\ ISDA commented generally that the Commission's 
analysis of this factor should have addressed the centralization of 
risk at DCOs as a result of the determinations, and the new capital, 
collateral, and disclosure requirements that have decreased risk in 
uncleared swaps.\84\ The Commission believes its analysis of other 
factors did in fact focus on the management of risk at DCOs and their 
ability to manage the risks associated with the untranched CDS indices 
included within the determination. In connection with future 
determinations, the Commission will continue to take those issues 
raised by ISDA into consideration.
---------------------------------------------------------------------------

    \83\ Other commenters such as Citadel generally agreed with the 
Commission's analysis of the reduction of systemic risk for both the 
interest rates and CDS determinations.
    \84\ See Section II.F for further discussion of this comment.
---------------------------------------------------------------------------

d. Effect on Competition
    Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to 
take into account the effect on competition, including appropriate fees 
and charges applied to clearing. Of particular concern to the 
Commission is whether this determination would harm competition by 
creating, enhancing, or entrenching market power in an affected product 
or service market, or facilitating the exercise of market power.\85\ 
Under U.S. Department of Justice guidelines, market power is viewed as 
the ability ``to raise price [including clearing fees and charges], 
reduce output, diminish innovation, or otherwise harm customers as a 
result of diminished competitive constraints or incentives.'' \86\
---------------------------------------------------------------------------

    \85\ See U.S. Department of Justice and the Federal Trade 
Commission, Horizontal Merger Guidelines [hereinafter ``Horizontal 
Merger Guidelines''] at Sec.  1 (Aug. 19, 2010), available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.
    \86\ Id.; see also U.S. Department of Justice (DOJ) and the 
Federal Trade Commission (FTC), Antitrust Guidelines for 
Collaborations Among Competitors at Sec.  1.2 (April 2000), 
available at http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf 
(``The central question is whether the relevant agreement likely 
harms competition by increasing the ability or incentive profitably 
to raise price above or reduce output, quality, service, or 
innovation below what likely would prevail in the absence of the 
relevant agreement'').
---------------------------------------------------------------------------

    In the NPRM, the Commission identified the following putative 
product and service markets as potentially affected by this clearing 
determination: a DCO service market encompassing those clearinghouses 
that currently (or with relative ease in the future could) clear the 
CDS subject to this determination, and a CDS product market or markets 
encompassing the CDS that are subject to this determination.\87\ 
Without defining the precise contours of these markets at this 
time,\88\ the Commission recognizes that, depending on the interplay of 
several factors, this clearing determination potentially could impact 
competition within the affected markets. Of particular importance to 
whether any impact is, overall, positive or negative, is: (1) Whether 
the demand for these clearing services and swaps is sufficiently 
elastic that a small but significant increase above competitive levels 
would prove unprofitable because users of the CDS products and DCO 
clearing services would substitute other products/clearing services co-
existing in the same market(s), and (2) the potential for new entry 
into these markets. The availability of substitute products/clearing 
services to compete with those encompassed by this determination, and 
the likelihood of timely, sufficient new entry in the event prices do 
increase above competitive levels, each operate independently to 
constrain anticompetitive behavior.
---------------------------------------------------------------------------

    \87\ Included among these could be a separate product market for 
CDS indices licensing. AFR stated that this factor should not focus 
on Markit as an index provider, but rather on clearing entities. For 
purposes of its consideration of this factor, the Commission 
believes its analysis appropriately covers competition as it relates 
to clearinghouses, as well as to other market participants.
    \88\ The federal antitrust agencies, the DOJ and FTC, use the 
``hypothetical monopolist test'' as a tool for defining antitrust 
markets for competition analysis purposes. The test ``identif[ies] a 
set of products that are reasonably interchangeable with a 
product,'' and thus deemed to reside in the same relevant antitrust 
product or service market. ``[T]he test requires that a hypothetical 
profit-maximizing firm, not subject to price regulation, that was 
the only present and future seller of those products (`hypothetical 
monopolist') likely would impose at least a small but significant 
and non-transitory increase in price (`SSNIP') on at least one 
product in the market.'' In most cases, a SSNIP of five percent is 
posited. If consumers would respond to the hypothesized SSNIP by 
substituting alternatives to a significant degree to render it 
unprofitable, those alternative products/services are included 
within the relevant market. This methodological exercise is repeated 
until it has been determined that consumers have no further 
interchangeable products/services available to them. Horizontal 
Merger Guidelines at Sec.  4.1.
---------------------------------------------------------------------------

    The Commission recognized in the NPRM that, depending on the 
interplay of several factors, the clearing requirement potentially 
could impact competition within the affected market and discussed 
various factors that could impact that market.
    In response to the Commission's recognition of the fact that 
currently no DCO clears CDS indices licensed by any provider other than 
Markit, Markit commented that it did not believe the determination 
would foreclose or materially impact competition in the CDS products, 
including licensing. Markit noted that its open licensing policy 
encourages competition among DCOs, SEFs, market makers, and others. 
Markit further commented that, given the costs associated with 
clearing, CDS indices that are not subject to a determination may be at 
a competitive advantage, including those that may be established by 
other index providers.
    In support of the NPRM, Citadel stated that the clearing 
requirement will have a strong positive impact on competition in the 
swap market and the market for clearing services. Citadel noted that 
central clearing will remove a significant barrier to entry for 
alternative swap market liquidity providers and will enable smaller 
entities to compete on more equal terms because central clearing 
eliminates the consideration of counterparty credit risk from the 
selection of execution counterparties. Citadel further commented that 
buy-side market participants will benefit from a wider range of 
potential execution counterparties and asserted that this increased 
competition yields benefits to market participants including narrower 
bid-ask spreads, improved access to best

[[Page 74299]]

execution, and increased market depth and liquidity, all of which 
facilitate the emergence of an all-to-all market with electronic and/or 
anonymous execution. Citadel also commented that substitution of the 
DCO for the bilateral counterparty decouples execution from post-trade 
processing and settlement.\89\ Finally, Citadel commented that the 
certainty as to when the first clearing requirement will begin gives 
DCOs and FCMs the confidence to invest in their client clearing 
offerings, and to compete actively for buy-side business both on the 
quality and efficiency of their services as well as on price.
---------------------------------------------------------------------------

    \89\ The Commission observes that issues regarding the bundling 
of clearing services and execution are beyond the scope of this 
rulemaking. See generally Swap Dealer and Major Swap Participant 
Recordkeeping, Reporting, and Duties Rules; Futures Commission 
Merchant and Introducing Broker Conflicts of Interest Rules; and 
Chief Compliance Officer Rules for Swap Dealers, Major Swap 
Participants, and Futures Commission Merchants, 77 FR 20128, 20154-
55 (Apr. 3, 2012) (discussing the application of Sec.  1.71(d)(2)).
---------------------------------------------------------------------------

    While FIA commented that the NPRM included a full discussion of the 
potential competitive impact of the clearing proposal, as discussed 
above, FIA indicated that it was unable to conduct the analysis it 
believes would be necessary to respond to the Commission's questions in 
the NPRM within the 30-day comment period provided.
    In response to FIA's comment, as discussed above, the Commission 
notes that the 30-day public comment period was necessary for the 
Commission to adhere to the CEA's 90-day determination process. 
Moreover, while FIA indicated that it would like more time to conduct 
further analysis of competitive issues for future determinations, FIA 
did not identify any specific concerns about the competitiveness issue 
analysis that could materially change the Commission's determination if 
such additional information were made available to the Commission. The 
comments provided by Markit and Citadel are consistent with the NPRM's 
conclusion that the clearing requirement potentially could impact 
competition within the affected market, but both commenters go on to 
assert that such an impact would not be negative. Accordingly, the 
Commission believes that its consideration of competitiveness as 
described in the NPRM is sufficient for purposes of finalizing the 
clearing requirement rule.
e. Legal Certainty in the Event of the Insolvency
    Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to 
take into account the existence of reasonable legal certainty in the 
event of the insolvency of the relevant DCO or one or more of its 
clearing members with regard to the treatment of customer and swap 
counterparty positions, funds, and property. The Commission proposed 
this clearing requirement based on its view that there is reasonable 
legal certainty with regard to the treatment of customer and swap 
counterparty positions, funds, and property in connection with cleared 
swaps, namely the CDS indices subject to this determination, in the 
event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or 
ICE Clear Europe) or one or more of the DCO's clearing members.
    In the case of a clearing member insolvency at CME or ICE Clear 
Credit, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11 
U.S.C. 761-767) and Part 190 of the Commission's regulations would 
govern the treatment of customer positions.\90\ Pursuant to section 
4d(f) of the CEA, a clearing member accepting funds from a customer to 
margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C. 
761-767 and Part 190 of the Commission's regulations, the customer's 
CDS positions, carried by the insolvent FCM, would be deemed 
``commodity contracts.'' \91\ As a result, neither a clearing member's 
bankruptcy nor any order of a bankruptcy court could prevent either CME 
or ICE Clear Credit from closing out/liquidating such positions.\92\ 
However, customers of clearing members would have priority over all 
other claimants with respect to customer funds that had been held by 
the defaulting clearing member to margin swaps, such as the customers' 
positions in CDS indices subject to this determination.\93\ Customer 
funds would be distributed to swaps customers, including CDS customers, 
in accordance with Commission regulations and section 766(h) of the 
Bankruptcy Code. Moreover, the Bankruptcy Code and the Commission's 
rules thereunder (in particular 11 U.S.C. 764(b) and 17 CFR 190.06) 
permit the transfer of customer positions and collateral to solvent 
clearing members.
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    \90\ The Commission observes that an FCM or DCO also may be 
subject to resolution under Title II of the Dodd-Frank Act to the 
extent it would qualify as covered financial company (as defined in 
section 201(a)(8) of the Dodd-Frank Act).
    \91\ If an FCM is also registered as a broker-dealer, certain 
issues related to its insolvency proceeding would also be governed 
by the Securities Investor Protection Act.
    \92\ See 11 U.S.C. 556 (``The contractual right of a commodity 
broker [which term would include a DCO or FCM] * * * to cause the 
liquidation, termination or acceleration of a commodity contract * * 
* shall not be stayed, avoided, or otherwise limited by operation of 
any provision of [the Bankruptcy Code] or by order of a court in any 
proceeding under [the Bankruptcy Code].'').
    \93\ See 11 U.S.C. 766(h).
---------------------------------------------------------------------------

    Similarly, 11 U.S.C. 761-767 and Part 190 would govern the 
bankruptcy of a DCO, in conjunction with DCO rules providing for the 
termination of outstanding contracts and/or return of remaining 
clearing member and customer property to clearing members.
    With regard to ICE Clear Europe, the Commission understands that 
the default of a clearing member of ICE Clear Europe would be governed 
by the rules of that DCO. ICE Clear Europe, a DCO based in the United 
Kingdom, has represented that under English law its rules would 
supersede English insolvency laws. Under its rules, ICE Clear Europe 
would be permitted to close out and/or transfer positions of a 
defaulting clearing member that is an FCM pursuant to the U.S. 
Bankruptcy Code and Part 190 of the Commission's regulations. According 
to ICE Clear Europe's submission, the insolvency of ICE Clear Europe 
itself would be governed by both English insolvency law and Part 190.
    ICE Clear Europe has obtained legal opinions that support the 
existence of such legal certainty in relation to the protection of 
customer and swap counterparty positions, funds, and property in the 
event of the insolvency of one or more of its clearing members. In 
addition, ICE Clear Europe has obtained a legal opinion from U.S. 
counsel regarding compliance with the protections afforded to FCM 
customers under New York law.
    In response to the NPRM, Citadel commented that it agreed with the 
Commission's analysis that reasonable certainty exists in the event of 
an insolvency of a DCO or one or more DCO members. As discussed above, 
the Commission received three comments related to customer segregation. 
In essence, Vanguard and SIFMA AMG recommend that the Commission delay 
implementation of the clearing requirement until three months after the 
LSOC model is implemented, clarified, and perhaps supplemented with 
additional rulemaking. ISDA requests that the Commission further study 
the issue of insolvency for DCOs.
    As stated above, the Commission believes that the concerns of 
Vanguard and SIFMA AMG are largely addressed by the delayed 
implementation timeframe for this determination. With regard to ISDA's 
request, as discussed above, the Commission is actively engaging in 
efforts to study and prepare for potential scenarios involving

[[Page 74300]]

clearinghouse and clearing member insolvency.
iii. Conclusions Regarding the Five Statutory Factors and Clearing 
Requirement Determination
    Based on the foregoing discussion and analysis, the Commission has 
taken into account each of the five factors provided for under section 
2(h)(2)(D)(ii) of the CEA. Based on these considerations, and having 
reviewed the relevant DCOs' submissions for consistency with section 
5b(c)(2) of the CEA, the Commission is determining that the two classes 
of CDS identified in Sec.  50.4(b) are required to be cleared.

E. Interest Rate Swaps

i. Introduction
    Interest rate swaps are agreements wherein counterparties agree to 
exchange payments based on a series of cash flows over a specified 
period of time typically calculated using two different rates 
multiplied by a notional amount. The BIS estimated that, as of December 
2011, over $500 trillion in notional amount of single currency interest 
rate swaps were outstanding representing 75% to 80% of the total 
estimated notional amount of derivatives outstanding.\94\ Based on 
these factors and on the swap submissions received under Sec.  39.5(b), 
the Commission believes that interest rate swaps represent a 
substantial portion of the swaps market and warrant consideration by 
the Commission for required clearing.
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    \94\ BIS, OTC Derivatives Market Activity as of December 2011, 
Table 1, available at http://www.bis.org/statistics/otcder/dt1920a.pdf. The BIS data provides the broadest market-wide 
estimates of interest rate swap activity available to the 
Commission.
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    The Commission's proposal for interest rate swaps was presented in 
two parts. The first part, Section II.E of the NPRM, discussed the 
Commission's rationale for determining how to classify and define the 
interest rate swaps identified in the DCO submissions (IRS submissions) 
to be considered for the clearing requirement. The second part, Section 
II.F, presented the Commission's consideration of the IRS submissions 
in accordance with section 2(h)(2)(D) of the CEA. This final release 
follows the same basic two-part structure. In each part, the discussion 
in the NPRM preamble for the corresponding part is summarized. Comments 
received from the public are summarized where appropriate together with 
the Commission's consideration of the comments.
ii. DCO Submissions
    The Commission received submissions from three registered DCOs 
eligible to clear interest rate swaps: LCH.Clearnet Limited (LCH), the 
clearing division of the Chicago Mercantile Exchange Inc. (CME), and 
International Derivatives Clearinghouse, LLC (IDCH).\95\ On August 14, 
2012, LCH acquired IDCH and changed the name of IDCH to LCH.Clearnet 
LLC (LCH.LLC). LCH.LLC has submitted a request to the CFTC for approval 
of changes to its DCO rules that would result in LCH.LLC clearing the 
same interest rate swaps that LCH clears. As noted in the NPRM, IDCH 
had no cleared swap positions. Accordingly, the change in ownership of 
IDCH would not change the Commission's proposal in terms of swap class 
assessments or volume and liquidity considerations. The proposed 
clearing requirement rule is not DCO specific. Upon approval of 
LCH.LLC's application for its DCO rule changes, LCH.LLC would become a 
U.S.-domiciled DCO capable of accepting the full range of interest rate 
swap products contemplated in the proposal.\96\
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    \95\ The IRS submissions received by the Commission are 
available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm. Submission materials marked by the submitting DCO for 
confidential treatment pursuant to Sec. Sec.  39.5(b)(5) and 
145.9(d) are not available for public review.
    \96\ IDCH was eligible under Sec.  39.5 to clear interest rate 
swaps. When LCH.LLC assumed IDCH's DCO license, LCH.LLC was deemed 
eligible to clear interest rate swaps as well.
---------------------------------------------------------------------------

    The following table summarizes the interest rate swap classes and 
relevant specifications that each DCO identified in its IRS submission.
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    \97\ LCH.LLC (formerly IDCH) has applied to the Commission for 
DCO rule change approvals that would effectively implement clearing 
of the same interest rate swaps that LCH now clears. LCH.LLC is not 
accepting interest rate swaps for clearing until such time as it 
launches under its new clearing rules. Accordingly, IDCH's product 
list that was included in the NPRM has been removed from the 
summary.
    \98\ Subsequent to its original submission, CME has added 
clearing of OIS for USD, EUR, GBP, and JPY.
    \99\ In this final rule, currencies are identified either by 
their full name or by the three letter ISO currency designation for 
the currency.

          Table 3--Interest Rate Swap Submissions Summary \97\
------------------------------------------------------------------------
                                         LCH                   CME
------------------------------------------------------------------------
Swap Classes................  Fixed-to-floating, basis,  Fixed-to-
                               forward rate agreements    floating.\98\
                               (FRAs), overnight index
                               swaps (OIS)..
Currencies \99\.............  USD, EUR, GBP, JPY, AUD,   USD, EUR, GBP,
                               CAD, CHF, SEK, CZK, DKK,   JPY, CAD, and
                               HKD, HUF, NOK, NZD, PLN,   CHF.
                               SGD, ZAR.
Rate Indexes................  For Fixed-to-floating,     USD-LIBOR, CAD-
                               basis, FRAs: LIBOR in      BA, CHF-LIBOR,
                               seven currencies, BBR-     GBP-LIBOR, JPY-
                               BBSW, BA-CDOR, PRIBOR,     LIBOR, and
                               CIBOR-DKNA13, CIBOR2-      EURIBOR.
                               DKNA13, EURIBOR-
                               Telerate, EURIBOR-
                               Reuters, HIBOR-HIBOR,
                               HIBOR-HKAB, HIBOR-ISDC,
                               BUBOR-Reuters, NIBOR,
                               BBR-FRA, BBR-Telerate,
                               PLN-WIBOR, PLZ-WIBOR,
                               STIBOR, SOR-Reuters,
                               JIBAR.
                              For OIS: FEDFUNDS, SONIA,
                               EONIA, TOIS.
Maximum Stated Termination    For Fixed-to-floating and  USD, EUR, and
 Dates.                        basis: USD, EUR, and GBP   GBP out to 50
                               out to 50 years, AUD,      years, and
                               CAD, CHF, SEK and JPY      CAD, JPY, and
                               out to 30 years and the    CHF out to 30
                               remaining nine             years.
                               currencies out to 10
                               years..
                              For OIS and FRAs: USD,
                               EUR, GBP, and CHF out to
                               two years.
------------------------------------------------------------------------

 iii. Interest Rate Swap Market Conventions and Risk Management
    The NPRM described how interest rate swaps present a wide range of 
variable product classes and product specifications within each class. 
Notwithstanding the large variety of contracts, there are commonalities 
that make it possible to categorize interest rate swaps for clearing, 
pricing, and risk purposes. Firstly, the vast majority of interest rate 
swaps use the ISDA definitions and contract conventions that allow 
market participants to agree quickly on common terms for each 
transaction. In fact, the DCOs clearing interest rate swaps all use 
ISDA definitions in their product specifications.
    Secondly, counterparties enter into swaps to achieve particular 
economic

[[Page 74301]]

results. While the results desired may differ in small ways depending 
on each counterparty's specific circumstances and goals, there are 
certain common swap conventions that are used to identify and achieve 
commonly desired economic results when entering into interest rate 
swaps. For example, a party that is trying to hedge variable interest 
rate risk may enter into a fixed rate to floating rate swap, or a party 
that is seeking to fix interest rates for periods in the future may 
enter into a forward rate agreement.
    The IRS submissions identified commonly known classes of swaps that 
they clear including: fixed rate to floating rate swaps, that are 
sometimes referred to as plain vanilla swaps (fixed-to-floating swaps); 
floating rate to floating rate swaps, also referred to as basis swaps 
(basis swaps); overnight index swaps (OIS); and forward rate agreements 
(FRAs).\100\ These class terms are also being used in industry efforts 
to develop a taxonomy for interest rate swaps.\101\
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    \100\ These are sometimes also referred to as ``types,'' 
``categories,'' or ``groups.'' For purposes of the clearing 
requirement determination, the Commission uses the term ``class,'' 
in order to be consistent with the approach taken by the European 
Securities and Markets Authority (ESMA) in its Discussion Paper, 
``Draft Technical Standards for the Regulation on OTC Derivatives, 
CCPs, and Trade Repositories,'' (Feb. 16, 2012), available at http://www.esma.europa.eu/system/files/2012-95.pdf. It is also noted that 
other categorizations are sometimes used for certain purposes. 
However, these four classes are common terms used by the DCOs and 
are common terms used in industry taxonomies.
    \101\ See, e.g., ISDA Swap Taxonomies, available at http://www2.isda.org/identifiers-and-otc-taxonomies/; Financial Products 
Markup Language, available at http://www.fpml.org/; and Federal 
Reserve Bank of New York Staff Reports, ``An Analysis of OTC 
Interest Rate Derivatives Transactions: Implications for Public 
Reporting'' (March 2012) at 3, available at http://www.newyorkfed.org/research/staff_reports/sr557.pdf.
---------------------------------------------------------------------------

    Furthermore, within these general classes, certain specifications 
are essential for defining the economic result and the value of the 
swap. Each of the IRS submissions naturally used these common 
specifications when identifying the swaps that the DCO clears. Within 
each of those specifications, there are common terms used by the DCOs 
and markets, which allows for further classification of the full range 
of interest rate swaps that are executed. Accordingly, as described in 
the NPRM, while there are a wide variety of interest rate swaps when 
taking into account all possible contract specifications, certain 
specifications are commonly used by the DCOs and market participants. 
This allows for the identification of classes of swaps and primary 
specifications within each class.
    The DCOs also risk manage and set margins for interest rate swaps 
on a portfolio basis rather than on a transaction- or product-specific 
basis. In other words, the DCOs analyze the cumulative risk of a 
party's portfolio. By looking at risk on a portfolio basis, the DCOs 
effectively take into account how swaps with different attributes, such 
as underlying currency, stated termination dates, underlying floating 
rate indexes, swap classes, etc., are correlated and thus can offset 
risk across attributes. This is possible because, although individual 
transactions may have unique contract terms, given the commonalities of 
transactions as discussed above, swap portfolios can be risk managed on 
a cumulative value basis taking into account correlations among the 
cleared swaps. Consequently, DCOs can be expected to fairly rapidly, 
and efficiently manage the risk of portfolios of interest rate swaps 
within and across classes in a default scenario through a small number 
of large hedging transactions that hedge large numbers of similarly 
correlated positions held by the defaulting party.\102\ As such, 
liquidity for specific, individual swaps is not the focus of DCOs from 
a risk management perspective. Rather, liquidity is viewed as a 
function of whether a portfolio of swaps has common specifications that 
are determinative of the economics of the swaps in the portfolio such 
that a DCO can price and risk manage the portfolio through block 
hedging and auctions in a default situation.\103\
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    \102\ After putting on these hedging positions, the DCO has the 
time needed to address any residual risk of the defaulted portfolio 
through auctioning off the defaulted portfolio together with the 
hedging transactions.
    \103\ See 77 FR at 47188 and LCH IRS submission, at 4 
(discussing LCH's management of the Lehman Brothers' bankruptcy in 
September 2008, where upon Lehman's default, LCH needed to risk 
manage a portfolio of approximately 66,000 interest rate swaps, 
which it hedged with approximately 100 new swap trades in less than 
five days and only used approximately 35% of the initial margin 
Lehman had posted).
---------------------------------------------------------------------------

iv. Interest Rate Swap Classification for Clearing Requirement 
Determinations
    Section 2(h)(2)(A) of the CEA provides that the Commission ``shall 
review each swap, or any group, category, type, or class of swaps to 
make a determination as to whether'' any thereof shall be required to 
be cleared. In reviewing the IRS submissions, the Commission considered 
in the NPRM whether its clearing requirement determination should 
address individual swaps, or categories, types, classes, or other 
groups of swaps.
    Based on the market conventions as discussed above, and the DCO 
recommendations in the IRS submissions, the Commission proposed a 
clearing requirement for four classes of interest rate swaps: Fixed-to-
floating swaps, basis swaps, OIS, and FRAs. At the time the IRS 
submissions were submitted to the Commission, LCH offered all four 
classes for clearing, as did IDCH, and CME offered one of them for 
clearing. Subsequent to the publication of the NPRM, CME has added 
clearing of OIS, and has stated publicly that it intends to add 
clearing of basis swaps and FRAs in the near future. In addition, upon 
launch of LCH.LLC, it is expected that LCH.LLC will begin clearing the 
same swaps cleared by LCH that are included in the swap classes 
designated by the Commission.
    These four classes represent a substantial portion of the interest 
rate swap market. The following table provides an indication of the 
outstanding positions in each class.

                      Table 4--Interest Rate Swaps Notional and Trade Count by Class \104\
----------------------------------------------------------------------------------------------------------------
                                       Notional amount     Gross notional                      Total trade count
             Swap class                   (USD BNs)       percent of total  Total trade count   percent of total
----------------------------------------------------------------------------------------------------------------
Fixed-to-Floating...................            299,818                 60          3,239,092                 75
FRA.................................             67,145                 13            202,888                  5
OIS.................................             43,634                  9            109,704                  3
Basis...............................             27,593                  5            119,683                  3
Other \105\.........................             65,689                 13            617,637                 14
                                     ---------------------------------------------------------------------------

[[Page 74302]]

 
    Total...........................            503,879                100          4,289,004                100
----------------------------------------------------------------------------------------------------------------
\104\ TriOptima data, as of March 16, 2012. See Section II.F below for a description of the TriOptima data. The
  TriOptima data provided information on nine other classes of swaps, none of which is included in the IRS
  submissions.
\105\ In the NPRM, the total notional amount for the ``Other'' category was incorrectly listed as $132,162
  billion as a result of inadvertently including the FRA amounts in the ``Other'' category. Correcting this
  error also resulted in changes to the ``Gross Notional Percent of Total'' column. These corrections do not
  change the Commission's analysis in the NPRM. The fact that the four classes of interest rate swaps included
  in the clearing requirement represent a larger proportion of the total notional amount of interest rate swaps
  outstanding is consistent with Congressional intent to mitigate systemic risk by implementing clearing of
  swaps as discussed in the NPRM. See 77 FR 47171.

    For purposes of the clearing requirement determination, the 
Commission developed the following class definitions based on 
information provided by the submitting DCOs and market conventions.
    1. ``Fixed-to-floating swap'': A swap in which the payment or 
payments owed for one leg of the swap is calculated using a fixed rate 
and the payment or payments owed for the other leg are calculated using 
a floating rate.
    2. ``Floating-to-floating swap'' or ``basis swap'': A swap in which 
the payments for both legs are calculated using floating rates.
    3. ``Forward Rate Agreement'' or ``FRA'': A swap in which payments 
are exchanged on a pre-determined date for a single specified period 
and one leg of the swap is calculated using a fixed rate and the other 
leg is calculated using a floating rate that is set on a pre-determined 
date.
    4. ``Overnight indexed swap'' or ``OIS'': A swap for which one leg 
of the swap is calculated using a fixed rate and the other leg is 
calculated using a floating rate based on a daily overnight rate.
    As described in the NPRM, the LCH and CME IRS submissions addressed 
issues of classification for purposes of the interest rate swap 
clearing requirement. In its submission, LCH discussed the 
classification of interest rate swaps and recommended establishing 
clearing requirements for classes of interest rate swaps. In effect, 
LCH recommended the use of a set of basic product specifications to 
identify and describe each class of swaps subject to the clearing 
requirement. CME recommended a clearing determination for all non-
option interest rate swaps denominated in a currency cleared by any 
qualified DCO.
    As an alternative, the Commission considered whether to establish 
clearing requirements on a product-by-product basis. The Commission 
noted in the NPRM that such a determination would need to identify the 
multitude of specifications of each product that would be subject to 
the clearing requirement. In this regard, LCH stated in its IRS 
submission that the clearing requirement ``would be sub-optimal for the 
overall market if participants are forced to read pages of rules to 
decipher whether or not a swap is required to be cleared, or to have to 
make complex and time consuming decisions at the point of execution.'' 
\106\ A class-based approach would allow market participants to 
determine quickly as a threshold matter whether they might need to 
submit a swap to a DCO for clearing by checking initially whether the 
swap has the basic specifications that define each class subject to the 
clearing requirement.\107\
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    \106\ LCH IRS submission, at 6.
    \107\ In addition, as noted by LCH, in its IRS submission, a 
product-by-product requirement may be evaded more easily because the 
specifications of a particular swap contract would need to match the 
specifications of each product subject to a clearing requirement. 
The clearing requirement could be evaded by adding, deleting, or 
modifying one or more of the contract's specifications, including 
minor specifications that have little or no impact on the economics 
of the swap. By using a class-based approach that allows for ranges 
of contract specifications established by the DCOs within each 
class, the Commission is reducing the potential for evasion in 
accordance with section 2(h)(4)(A) of the CEA, which directs the 
Commission to prescribe rules necessary to prevent evasion of the 
clearing requirements.
---------------------------------------------------------------------------

    A product-by-product designation also would be difficult to 
administer because the Commission would be required to consider each 
and every product submitted. On the other hand, designating classes of 
interest rate swaps for the clearing requirement provides a cost 
effective, workable method for the Commission to review variations in 
new swap products that DCOs will submit for clearing determinations on 
a going forward basis without undertaking a full Commission review of 
each and every swap to determine if those variations are consistent 
with the five factors the Commission is directed to consider under 
section 2(h)(2)(D) of the CEA. For such swaps, as described in greater 
detail below in Section III.F, the Commission proposed delegating to 
the Director of the Division of Clearing and Risk, with the 
consultation of the General Counsel, the authority to confirm whether 
the swap fits within the identified class and is therefore subject to 
the clearing requirement.
    After consideration of the issues summarized above, the Commission 
proposed in the NPRM to follow the general approach recommended by LCH 
and CME of establishing the clearing requirement for classes of 
interest rate swaps, rather than for individual swap products.
v. Interest Rate Swap Specifications
    In the NPRM, after consideration of the appropriateness of 
classifying interest rate swaps, the Commission analyzed the IRS 
submissions and proposed to set out the parameters of the four classes 
of interest rate swaps submitted by using the following affirmative 
specifications for each class: (i) Currency in which the notional and 
payment amounts are specified; (ii) rates referenced for each leg of 
the swap; and (iii) stated termination date of the swap. The Commission 
further proposed three ``negative'' or ``limiting'' specifications for 
each class: (i) No optionality (as specified by the DCOs); (ii) no dual 
currencies; and (iii) no conditional notional amounts.\108\
---------------------------------------------------------------------------

    \108\ The term ``conditional notional amount'' refers to 
notional amounts that can change over the term of a swap based on a 
condition established by the parties upon execution such that the 
notional amount of the swap is not a known number or schedule of 
numbers, but may change based on the occurrence of some future 
event. This term does not include what are commonly referred to as 
``amortizing'' or ``roller coaster'' notional amounts for which the 
notional amount changes over the term of the swap based on a 
schedule of notional amounts known at the time the swap is executed. 
Furthermore, it would not include a swap containing early 
termination events or other terms that could result in an early 
termination of the swap if a DCO clears the swap with those terms. 
The Commission discusses this definition and comments received on it 
below.
---------------------------------------------------------------------------

    The Commission proposed the three affirmative specifications 
because they are fundamental specifications used in the swap market to 
determine the economic result of a swap transaction. Counterparties 
enter into swaps to achieve particular economic results. For

[[Page 74303]]

example, counterparties may enter into interest rate swaps to hedge an 
economic risk, to facilitate a purchase, or to take a view on the 
future direction of an interest rate. The counterparties enter into a 
swap that they believe will best achieve their desired economic result 
at a reasonable cost.
    As noted in the NPRM, the IRS submissions identified four different 
classes of swap contracts that are being cleared at this time: fixed-
to-floating swaps, basis swaps, OIS, and FRAs. These classes of 
interest rate swaps reflect industry categorization and allow 
counterparties to achieve a particular economic result. For example, a 
fixed-to-floating swap may be used by a counterparty to hedge interest 
rate risk related to bonds it has issued or which it owns.
    All three DCO submitters identified currency as a specification for 
distinguishing swaps that are subject to clearing. A swap that requires 
calculation or payment in a currency different than the currency of the 
related underlying purposes of the swap would introduce currency 
risk.\109\ Thus, the currency designated for the swap is a basic factor 
in pricing the swap and achieving the economic results of the swap 
desired by each party.
---------------------------------------------------------------------------

    \109\ For example, parties seeking to hedge interest rate risk 
in connection with bonds or to invest funds using swaps are more 
likely to enter into swaps that designate the same currency in which 
the bonds are payable or that the funds to be invested are held.
---------------------------------------------------------------------------

    Furthermore, the swaps listed by all three DCOs in their IRS 
submissions all identified the interest rates used for each leg of the 
swap as a basic term that defines the swap. The rates are basic 
determinants of the economic value of each stream of payments of an 
interest rate swap.
    Finally, the stated termination date, or maturity, of a swap is a 
basic specification for establishing the value of a swap transaction 
because interest rate swaps are based on an exchange of payments over a 
specified period of time ending on the stated termination date. The 
value of a swap at any one point in time depends in part on the value 
of each payment stream over the remaining life of the swap. For 
example, if a party wants to hedge variable interest rate risk for 
bonds it has issued that mature in ten years, it will generally enter 
into a swap with a stated termination date that matches the final 
maturity date of the bonds being hedged.\110\ To terminate the swap 
prior to such date would result in only a partial hedge and to execute 
a swap with a stated termination date that is later than the final bond 
maturity date would simply create exposed rate risk during the extended 
period beyond the final maturity date of the bonds.
---------------------------------------------------------------------------

    \110\ Although hedging an economic risk expected to remain 
outstanding for, say, ten years with a matching ten year swap may 
generally be the most efficient and precise approach, the Commission 
recognizes that parties may achieve a similar result by using swaps 
with different stated termination dates. However, such substitution 
generally provides a less precise hedge.
---------------------------------------------------------------------------

    As noted above, the Commission also considered in the NPRM whether 
there are product specifications that the Commission should explicitly 
exclude from the initial clearing requirement determination. In this 
regard, the Commission considered swaps with optionality, multiple 
currency swaps, and swaps with conditional notional amounts. The 
Commission proposed that these three specifications should be included 
as so-called ``negative'' or ``limiting'' specifications.
    By using the three affirmative specifications and three limiting 
specifications to further identify the swaps within each class that are 
subject to the clearing requirement, counterparties contemplating 
entering into a swap can determine quickly as a threshold matter 
whether the particular swap may be subject to a clearing requirement. 
If the swap is in a specified class and has the six specifications, the 
parties will know that they need to verify whether a DCO will clear 
that particular swap. This will reduce the burden on swap 
counterparties related to determining whether a particular swap may be 
subject to the clearing requirement.
    The Commission also considered in the NPRM whether to define 
classes of swaps on the basis of other product specifications. Other 
potential specifications are numerous because of the nearly limitless 
alternative interest rate swaps that are theoretically possible. In the 
NPRM, the Commission summarized its consideration by breaking down 
alternative specifications into two general categories: Specifications 
that are commonly used to address mechanical issues for most swaps, and 
specifications that are less common and address idiosyncratic issues 
related to the particular needs of a counterparty. The Commission noted 
that certain specifications are specifically identified for most swap 
transactions, but asserted that many such specifications are not, 
generally speaking, fundamental to determining the economic result the 
parties are trying to achieve. For example, the day count fraction 
selected affects calculation periods and therefore the amounts payable 
for each payment period. The parties, and the DCOs, can make mechanical 
adjustments to period pricing at the time a swap is cleared based on 
the day count fraction alternative selected by the parties and the day 
count fraction does not drive the overall economic result the parties 
are trying to achieve or substantially differentiate the pricing and 
risk management of the swap relative to other swaps in the same class 
and having the same basic class defining specifications.
    Furthermore, as noted in the NPRM, DCOs can provide clearing for 
the standard alternatives of each of these specifications without 
affecting risk management. Using the same day count fraction example, 
LCH will accept U.S. dollar-LIBOR trades for clearing with nine 
alternative day count fractions based on the common day count fractions 
used in the market.\111\ While this specification, and other 
specifications of this kind, may affect the amounts owed on a swap, 
they can be accounted for mechanically in the payment amount 
calculations and do not change the basic substantive economic result 
the parties want to achieve.
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    \111\ Each DCO identifies the standard term or range of terms it 
will accept for each specification. Accordingly, swap counterparties 
can review the DCO's product specifications to determine whether a 
swap will satisfy the DCO's requirements for these specifications. 
Additionally, CME has developed, and LCH has committed to developing 
by the time the clearing requirement must be complied with in 
accordance with the Commission's implementation schedule, product 
screening mechanisms by which parties can determine whether the DCO 
will clear a particular swap. As discussed in greater detail 
throughout this release, if counterparties want to enter into a swap 
that is in a class subject to required clearing and no DCO will 
clear the swap because it has other specifications that no DCO will 
accept, then the parties can still enter into that transaction on an 
uncleared basis.
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    Regarding the latter, idiosyncratic specifications, examples 
include special representations added to address particular legal 
issues, unique termination events, special fees, and conditions tied to 
events specific to the parties. None of the DCOs clear interest rate 
swaps with terms in the second group. Accordingly, such specifications 
are not included in the classes of swaps subject to the clearing 
requirement proposed by this rule, and the Commission considered only 
the first group of more common specifications that are identified by 
the submitting DCOs in their product specifications.
    In short, the Commission recognizes that these other specifications 
may have an effect on the economic result to be

[[Page 74304]]

achieved with the swap.\112\ However, counterparties and DCOs may 
account for the effects of such specifications with adjustments to 
other specifications or in the price of the swap. Furthermore, DCOs 
account for various alternatives or range of alternatives for these 
terms without impairing risk management. Finally, as described above in 
more detail, including these specifications in the description of the 
swaps subject to a clearing requirement could increase the burden on 
counterparties when checking whether a swap may be subject to required 
clearing. Accordingly, the Commission has determined not to include 
other, non-class defining specifications in the swap class definition.
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    \112\ LCH recommended in its submission that floating rate tenor 
(also known as frequency) also be a class level specification and 
the Commission acknowledges that floating rate tenor can, in some 
cases, be a fundamental specification for achieving the economic 
benefits of an interest rate swap. However, it is the Commission's 
view that floating rate tenor is more akin to the other non-class 
specifications in that it is not fundamental to all economic results 
that may be considered by parties when contemplating a swap and it 
is a specification for which the DCOs can fairly easily offer all of 
the standard tenors that parties may consider.
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vi. General Comments Received Regarding the Specifications 
Determination
    Numerous commenters expressed support for including the 
Commission's four interest rate swap classes and six class 
specifications in the clearing requirement and were of the view that 
the classes satisfy the five statutory factors the Commission is 
required to consider for the clearing requirement determination.\113\ 
CME expressed support for the class-based approach in the rulemaking 
rather than swap-by-swap and stated that the Commission ``struck an 
appropriate balance for the initial slate of classes subject to the 
requirement.'' LCH commented that the six swap specifications selected 
are consistent with its recommendation in its IRS submission and 
reaffirmed the reasons cited in the NPRM for using these 
specifications.
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    \113\ AllianceBernstein, R.J. O'Brien, Citadel, Eris Exchange, 
CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies, 
Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris 
Barnard, and Svenokur.
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    Citadel agreed with the Commission's class-based approach rather 
than a product-by-product based approach. Citadel stated that the class 
designation approach ``reflects the risk management approach utilized 
across the industry, and most importantly by DCOs'' to determine margin 
levels and other safeguards and is therefore the starting point for the 
approved classes. Citadel further noted that different tenors or series 
of the same instruments, while displaying different characteristics, 
can be priced both based on market activity and by reference to more 
liquid contracts of the same instruments and are risk managed with the 
same risk management frameworks. Finally, Citadel expressed concern 
that not including products that otherwise share essential 
characteristics as swaps that are otherwise required to be cleared and 
that can be priced with reference to cleared swaps could risk the 
development of separate markets that avoid the clearing requirement.
    AFR noted that the interest rate swap classes selected properly 
reflect the risk profile of the interest rate swap market and will 
avoid uncertainty and complexity for the Commission and market 
participants. AFR also noted that details of product specifications 
such as slightly different tenors, are largely irrelevant, especially 
in the interest rate market and stated that any suggestion of a 
product-by-product approach should be interpreted as a tactic to delay 
implementation. Furthermore, AFR encouraged the Commission to designate 
swap classes to include low volume swaps that can be risk managed in 
ways that high-volume swaps in the class are risk managed. AFR's 
concern is that if the low-volume swaps are not included, they could be 
used to avoid the clearing requirement by replicating the swaps that 
are required to be cleared with the low-volume swaps. Citadel's and 
AFR's comments are consistent with the Commission's rationale for 
establishing the four classes of swaps and the six specifications for 
each class on which the Commission based its consideration of the five 
factors set forth in section 2(h)(2)(D)(ii) of the CEA. As noted in the 
NPRM, the Commission is directed under the CEA to make its 
determination for ``each swap, or any group, category, type, or class 
of swaps.'' The Commission first needed to establish the classes and 
class-defining specifications to which would then consider using the 
five statutory factors.
    ISDA commented that the Commission should not use what ISDA 
characterized as a newly-articulated standard for choosing the swap 
class-defining specifications based on whether they are ``fundamental 
to determining the economic result that parties are trying to 
achieve.'' ISDA expressed concern with what it characterized as a 
standard that it is not grounded in the five statutory factors of 
section 2(h)(2)(D)(ii) of the CEA and will fail to discriminate between 
swaps that may differ in terms of the five factors. Furthermore, in 
ISDA's view, the fundamental economic result depends on facts and 
circumstances of each transaction and the parties.
    The phrase ``fundamental to determining the economic result that 
parties are trying to achieve'' used by the Commission in the NPRM does 
not establish a new standard or replace the statutory five factor 
determination required by the CEA. Rather, the Commission used this 
phrase to describe one of several reasons for establishing which 
product specifications to use in defining each class to which the 
statutory five factor analysis was then applied. The phrase was used in 
the context of identifying the primary product specifications the 
submitting DCOs and the market use to value or price swaps within a 
class. As described at length in Section II.D of the NPRM, in 
establishing the swap classes to be considered, the Commission looked 
at how DCOs grouped the cleared interest rate swaps by certain defining 
types and specifications, how markets trade and view the products as 
classes, and how swaps that share certain common specifications can be 
priced and risk managed together as a class. The Commission's analysis 
for establishing the classes to be considered was not based on any new 
standard. Rather, the aforementioned phrase summarizes one element of 
the Commission's analysis of how to define the classes to be considered 
under the five factors established in the CEA.
    Furthermore, the five factor statutory analysis was separately 
undertaken for each class. For the reasons stated in defining the 
classes and class specifications, the Commission believes that the 
swaps within each class are sufficiently similar to apply the statutory 
analysis to each class. As noted above, many commenters agreed with 
this conclusion.
    Finally, regarding ISDA's view that the fundamental economic result 
depends on facts and circumstances of each transaction and the parties, 
the Commission recognizes that individual swap counterparties may have 
highly specific economic results they are trying to achieve with a swap 
and accordingly set the terms of the swap to achieve those specific 
results. However, the Commission's use of the phrase in the NPRM can be 
more clearly understood in context. The Commission was addressing 
whether certain specifications, other than the six specifications used 
to define each class, should be considered to be class-defining 
specifications. The Commission noted that certain specifications 
``affect the value of the swap in a mechanical way, they are not,

[[Page 74305]]

generally speaking, fundamental to determining the economic result.'' 
The Commission provided an example of how other specifications may 
affect the amounts payable on a swap on each payment date, but when 
valuing a swap for pricing and risk management purposes, together with 
other swaps within a class, these other specifications can be accounted 
for by making price adjustments off a standard price curve and 
therefore do not change the basic pricing economics of the swap to an 
extent that would necessitate classifying the swap separately from 
other swaps defined by the six specifications identified by the 
Commission.
    ISDA further commented that, although an overly intricate set of 
product specifications would impose burdens on the market, broad class 
designations impose greater burdens by creating the need for filtering 
products that a DCO will accept for clearing from the designated class. 
In ISDA's view, the Commission's statement in the NPRM that DCOs and 
vendors are ``likely'' to develop screening tools acknowledges the 
issue, but does not provide a solution. ISDA recommended that limiting 
clearing to swaps with prior clearing history supplemented by an 
advance DCO notice process would strike a reasonable balance.
    In response, the Commission notes that the identification of the 
four interest rate swap classes and the parameters for the six 
specifications within each class provides a fairly detailed and easy to 
use initial screening mechanism for market participants to determine 
whether a particular swap needs to be submitted for clearing. If a 
market participant determines that a swap falls into a class under 
Sec.  50.4, then the party will need to take reasonable efforts to 
determine whether any eligible DCO will accept the swap for 
clearing.\114\ The Commission noted in the NPRM that the DCOs or other 
vendors would likely develop screening tools for this purpose. The 
Commission further notes that each DCO and its members and the FCMs who 
clear through the DCO, in effect, already have the capability through 
their own onboarding processes and transaction affirmation platforms to 
screen swap transactions nearly instantaneously to determine whether 
the transactions will be accepted by the DCO. While those systems alone 
should be able to serve as a screening mechanism sufficient to allow 
for compliance with the clearing requirement, the Commission encourages 
the DCOs to create a tool to provide all market participants with the 
ability to independently screen potential swap transactions quickly and 
easily. CME commented that it already has a tool to screen particular 
swaps for eligibility. LCH stated in its comments that while the 
current information on its Web site is designed for dealer use, LCH is 
committed to revising the information to be easily understandable by 
all counterparties.
---------------------------------------------------------------------------

    \114\ See Section III.B for a discussion of the reasonable 
efforts standard in this context.
---------------------------------------------------------------------------

    Furthermore, the Commission does not agree that ISDA's proposal to 
limit the determination to swaps with prior clearing history would ease 
the screening process. DCOs, particularly LCH, already have prior 
clearing history for swaps with tens of thousands of different product 
specification combinations.\115\ Accordingly, even if the Commission 
adopted such an approach, the result would have the problems that a 
product-by-product approach would have, as acknowledged by ISDA. Also, 
the Commission agrees that an appropriate DCO notice framework will 
facilitate product screening and addresses this comment in Section III 
below.
---------------------------------------------------------------------------

    \115\ See, e.g., http://www.swapclear.com/why/ (stating that 
since 1999, LCH has cleared more than 2.2 million OTC interest rate 
swaps, $329 trillion notional, and compressed more than $145 
trillion (as of September 2012)).
---------------------------------------------------------------------------

    In addition, ISDA expressed concern that the discussion of 
specifications that are not included in the six class-specific 
specifications identified by the Commission could be read as a 
directive to abandon such other specifications to the extent they are 
not included in the swaps DCOs will accept for clearing. ISDA requested 
confirmation that footnote 97 of the NPRM (revised as footnote 111 in 
this final release) establishes that if a DCO does not accept a swap 
because the swap contains terms that the DCO does not clear, then 
entering into the swap as an uncleared transaction is permissible. ISDA 
further requested that the Commission state that entering into a swap 
that is not accepted for clearing does not raise a presumption of 
evasion.
    Similarly, Freddie Mac also expressed concern that the discussion 
of fundamental specifications and ``mechanical specifications'' may 
signal the Commission's judgment that parties are required to clear 
swaps that have sufficiently close substitutes. Freddie Mac requested 
that the Commission clarify the treatment of swaps that no DCO will 
clear and that parties may enter into uncleared swaps within a 
designated class if a DCO will not accept the swap provided that the 
variation in specifications is for a legitimate business purpose. 
Freddie Mac noted that section 2(h)(1)(A) of the CEA refers to an 
obligation to ``submit'' the swap for clearing rather than requiring 
that a swap must be successfully cleared. Freddie Mac expressed concern 
that failure to clarify this issue would lead to uncertainty as to the 
legality of uncleared swaps and that executing swap dealers or other 
market participants could use that uncertainty to insist on contractual 
rights to have the option to terminate a swap that fails to clear.
    The Commission confirms that the discussion of the class-defining 
swap specifications and other specifications served only to explain the 
Commission's differentiation between the class specifications and other 
specifications market participants use. The Commission is not requiring 
parties to take affirmative steps to substitute a clearable swap for an 
unclearable swap within a designated class.\116\
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    \116\ See Sections II and III for further discussion of this 
issue.
---------------------------------------------------------------------------

    Regarding issues of what constitutes evasion of the clearing 
requirement when using a close substitute swap that is not cleared by a 
DCO and ISDA's request regarding a presumption regarding evasion of the 
clearing requirement, this issue, along with other evasion and abuse 
issues, are addressed in Section III.G of this release.
    With respect to the ``negative specifications,'' AFR commented that 
some of these specifications, such as dual currency and optionality, 
are composites of two derivatives including a basic interest rate swap 
that may be subject to the clearing requirement and that market 
participants should be required to clear components of such swaps that 
can be cleared to prevent evasion.
    This initial determination is based on the IRS submissions and 
because none of them include swaps that have the negative 
specifications, the Commission believes it is beneficial for swap 
market participants to expressly exclude those specifications so that 
parties that execute swaps with those specifications will know 
definitively that they are not subject to the clearing requirement. 
While the Commission is sensitive to concerns that the clearing 
requirement could be evaded by adding negative specifications to a swap 
to make it non-clearable, no data or other information is available at 
this time to indicate that compound swaps are being used for evasion. 
If the Commission observes such behavior or otherwise becomes aware 
that is occurring, it will consider

[[Page 74306]]

taking appropriate action under its authority provided in the CEA.
    The FSR requested clarification regarding the conditional notional 
amount specification. The FSR interpreted footnote 93 of the NPRM 
(footnote 108 of this adopting release) to mean that interest rate 
swaps entered into in connection with loans to hedge interest rate risk 
(the notional amounts of which are tied at all times to the outstanding 
principal amount of the loan) would not be subject to the clearing 
requirement if the principal amount of the loan would foreseeably vary 
over its term in an unscheduled or unpredictable manner.\117\ The FSR 
used the examples of a swap used to hedge a construction loan, where 
the loan would be drawn over time based on the needs of the 
construction project, and without a fixed draw schedule, or a swap 
entered into in connection with a revolving credit agreement or a 
credit agreement that permits voluntary prepayments. The FSR noted that 
such adjustment may be implemented through a partial termination event, 
permitting or requiring the lender/swap provider to reduce the 
outstanding notional amount of the swap so as to protect both the 
customer and the lender/swap provider from over-hedging.
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    \117\ In a similar vein, ISDA commented that exclusions from the 
clearing requirements should be available if a party enters into one 
swap to hedge another swap and the hedge would no longer be 
functional if one trade of the pair would be cleared and the other 
not. Section 2(h)(7) of the CEA is clear with respect to this issue, 
and provides that only certain non-financial entities may elect not 
to clear certain swaps that hedge or mitigate commercial risk of the 
entity. The CEA does not extend this election to financial entities.
---------------------------------------------------------------------------

    In response to the FSR, the Commission clarifies that a 
``conditional notional amount'' is a specification included in the swap 
at the time of execution that provides that the notional amount will 
change during the stated term of the swap in an unscheduled manner upon 
the occurrence of defined events or conditions. There are two elements 
to such a specification: First, the change in notional amount must be 
triggered by a defined event or condition, and second, the change must 
not be clearly predictable at the time the swap is executed. 
Accordingly, the two examples provided by the FSR might be swaps that 
have a conditional notional amount if the swaps include specifications 
or terms that provide for a change in notional amount triggered by an 
event tied to the hedged loan or credit line and the specific timing of 
that event is not sufficiently foreseeable or predictable when the swap 
is entered into such that the swap notional amount change could have 
been scheduled in advance. For example, a swap in which the parties 
agree that the notional amount will automatically be reduced upon a 
draw on a related construction loan identified in the swap or a 
prepayment of a loan identified in the swap would qualify as a swap 
with a conditional notional amount.
    However, the Commission notes that such a specification would not 
qualify if the reduction in the notional amount is voluntary. In this 
regard, a voluntary partial or full termination right is not an 
indication of a conditional notional amount. A party to a cleared swap 
can affect the same result as exercising a voluntary termination right 
at any time by entering into an equal and offsetting cleared swap. 
Clearing eliminates bilateral counterparty credit risk and therefore 
entering into an offsetting swap that is cleared with any party has the 
same effect as terminating the original swap. Accordingly, including a 
voluntary termination right in a swap that otherwise would be clearable 
and is subject to the clearing requirement serves no economic purpose 
that would distinguish the swap from other swaps in the class that are 
required to be cleared.
    As noted in the beginning of this Section II.E, the preceding 
analysis identified the classes of interest rate swaps and 
specifications within the classes to be considered by the Commission in 
the clearing requirement determination. In the following section in the 
NPRM, as summarized in this final release, the Commission took into 
account the statutory provisions under section 2(h)(2)(D) of the CEA 
with respect to the four classes of interest rate swaps and, within 
each class, the six identified product specifications.

F. Proposed Determination Analysis for Interest Rate Swaps

i. Consistency With Core Principles for Derivatives Clearing 
Organizations
    As noted above, section 2(h)(2)(D)(i) of the CEA requires the 
Commission to review whether a swap submission is consistent with the 
core principles for DCOs in making a clearing determination. As 
discussed in the NPRM, LCH and CME already clear all swaps identified 
in their respective IRS submissions and therefore each is subject to 
the Commission's review and surveillance procedures summarized in the 
NPRM. Accordingly, LCH and CME already are required to comply with the 
core principles set forth in section 5b(c)(2) of the CEA with respect 
to the swaps being considered by the Commission for the clearing 
requirement. The Commission further described in the NPRM its 
activities as a regulator to monitor and effect ongoing compliance with 
the core principles applicable to DCOs including periodic examinations 
and daily risk surveillance. Further, the Commission stated that the 
Commission does not believe that subjecting any of the interest rate 
swaps identified in the IRS submissions to a clearing requirement would 
alter compliance by the respective DCOs with the core principles.
    Based upon the Commission's ongoing reviews of DCOs' risk 
management frameworks and clearing rules, and its annual examinations 
of the DCOs, the Commission believes that the submissions of LCH and 
CME are consistent with section 5b(c)(2) if the CEA and the related 
Commission regulations. In analyzing the IRS submissions discussed 
herein, the Commission does not believe that a clearing requirement 
with regard to the specified interest rate swap classes would be 
inconsistent with LCH or CME's continued ability to maintain such 
compliance with the DCO core principles set forth in part 39 of the 
Commission's regulations.
ii. Consideration of the Five Statutory Factors for Clearing 
Requirement Determinations
    Section 2(h)(2)(D)(ii) of the CEA identifies five factors the 
Commission shall consider in making a clearing requirement 
determination. The process for submission and review of swaps for a 
clearing requirement determination is further detailed in Sec.  39.5 of 
the Commission's regulations. This section summarizes the Commission's 
consideration the four classes of swaps identified in the preceding 
section under the statutory five factors in the context of the process 
established by regulation.
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate 
Pricing Data
    Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to 
take into account the existence of outstanding notional exposures, 
trading liquidity, and adequate pricing data. In the NPRM, the 
Commission considered available market data and LCH cleared swap 
information. Unlike CDS for which substantially all of the trading data 
has been collected in one place, there is no single data source for 
notional exposures and trading liquidity for the

[[Page 74307]]

entire interest rate swap market.\118\ However, the Commission 
considered several sources of data on the interest rate swap market 
that collectively provides the information the Commission needs to make 
a clearing requirement determination. As described in the NPRM, the 
data sources that the Commission considered include: general estimates 
published by the Bank for International Settlements (BIS data); market 
data published weekly by TriOptima (TriOptima data) covering swap trade 
information submitted voluntarily by 14 large derivatives dealers (G14 
Dealers); trade-by-trade data provided voluntarily by the G14 Dealers 
to the OTC Derivatives Supervisors Group for a three month period 
between June and August 2010 (ODSG data); and trade-by-trade data for 
swaps cleared by LCH for the first calendar quarter of 2012 (LCH 
data).\119\
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    \118\ See Bank of England, ``Thoughts on Determining Central 
Clearing Eligibility of OTC Derivatives,'' Financial Stability Paper 
No. 14, March 2012, at 11, available at http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper14.pdf.
    \119\ All DCOs were required to begin providing daily position 
data to the Commission as of November 8, 2012. CME's available data 
was considered too limited to provide any indication of the complete 
interest rate swap market. Because LCH clears a large portion of the 
swap products it offers clearing for (based on available 
information, LCH claims to have cleared approximately 50 to 90 
percent of the dealer open interest in the different interest rate 
swap products that it clears), its data provides some indication of 
the possible notional exposures and liquidity in the products 
submitted by LCH that the Commission considered. Given the 
limitations on other available data, the Commission believes it is 
useful to consider the LCH data along with the market-wide BIS data, 
ODSG data, and TriOptima data.
---------------------------------------------------------------------------

    The NPRM explained in detail that each data source used has a 
number of limitations that are important to understand when considering 
the data. The Commission incorporates the discussion of those 
limitations found in the NPRM into this final release.
    For this determination, the Commission only considered the swaps 
identified in the IRS submissions. Accordingly, where possible, the 
Commission presented and discussed only the data for swaps identified 
in the submissions. The analysis of interest rate swap data in the NPRM 
was presented based on the four swap classes and the class 
specifications. This information was used by the Commission to 
determine whether there exists significant outstanding notional 
amounts, trading liquidity, and pricing data to include each class and 
specification identified in the IRS submissions.
    For purposes of this final release, the Commission is incorporating 
the data tables in the NPRM by reference and the considerations and 
conclusions drawn by the Commission following review of the data is 
summarized below.\120\ Readers are encouraged to refer to the NPRM to 
review the data presented. None of the comments received in response to 
the NPRM raised issues with the data analyzed in the NPRM.
---------------------------------------------------------------------------

    \120\ The ODSG data has not been updated since 2010. The BIS 
data that was available when the NPRM was published was from the 
second half of 2011 and the TriOptima and LCH data used was from the 
first quarter of 2012. The BIS has not published updated data as of 
this writing. TriOptima stopped publishing the interest rate swap 
data in April, 2012. DTCC began collecting similar data at that time 
and is now provisionally registered by the Commission as a SDR. The 
Commission has reviewed data from DTCC and LCH and confirmed that 
the recent data available is consistent with the data used in the 
NPRM to develop the interest rate swap clearing requirement rule, 
taking into consideration normal changes in market activity.
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1. Interest Rate Swap Class
    In the NPRM, the Commission considered data relevant to the 
different interest rate swap classes included in the IRS submissions. 
The BIS data provided certain big picture information. It indicated 
that interest rate swaps in total constituted nearly 80% of the 
derivatives market and interest rate swap notional amounts generally 
increased for all three kinds of swaps between 2008 and 2011 with total 
interest rate swap notional amounts reported growing by about 15% 
during that period. Additionally, all three classes of swaps identified 
by the BIS data have substantial notional amounts outstanding. As of 
December 2011, FRAs had about $50.5 trillion outstanding, optional 
swaps had about $51 trillion outstanding, and other interest rate swaps 
had about $403 trillion outstanding. Given this information, the 
Commission concluded that none of the kinds of swaps identified by the 
BIS should be eliminated from consideration by the Commission for a 
clearing requirement based on the BIS data alone. However, the BIS data 
did not provide enough detail to reach further conclusions regarding 
the swaps identified in the IRS submissions.
    The TriOptima data and the ODSG data sets were used to identify 
notional amounts and trade counts for all four classes of swaps 
identified in the IRS submissions. Trading liquidity as an indication 
of how effectively DCOs can risk manage a portfolio of swaps can be 
evidenced in several ways. The data available for this purpose included 
total notional amount outstanding, total number of swaps outstanding, 
and the average number of transactions over a given period of time.
    The TriOptima data showed that all four classes have significant 
outstanding notional amounts with basis swaps being the lowest at about 
$27.6 trillion and the highest being fixed-to-floating swaps at $288.8 
trillion. Total trade counts for each type were also significant with 
the lowest being 109,704 for OIS and the highest being fixed-to-
floating swaps at 3,239,092.
    The average number of swap trades per week for each class of swaps 
was evidenced by the ODSG data. According to the ODSG data set, basis 
swaps were traded at the lowest frequency compared to the other three 
classes at 240 times on average each week during the ODSG data period. 
Because the ODSG data is from the summer of 2010 and gross notional 
amounts and trading activity in interest rate swaps have both increased 
generally, the Commission believes that trading activity has likely 
increased for all classes since the ODSG data was collected.
    The LCH data generally confirmed the assessment of market-wide 
data. There is substantial outstanding notional volumes and trade 
liquidity for each of the four classes already being cleared at LCH.
    LCH cleared the following percentage of each class of swap as 
reported by TriOptima: \121\
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    \121\ Percentages are calculated based on total notional amount 
cleared by LCH divided by total notional outstanding as reported by 
TriOptima. The TriOptima data is used because it is the most current 
data set that provides data broken out according to the classes 
being cleared.
---------------------------------------------------------------------------

     75% of the Fixed-to-Floating swaps,
     41% of FRAs,\122\
---------------------------------------------------------------------------

    \122\ LCH started clearing FRAs in December 2011 and cleared 
volumes have increased significantly each month since the start 
date. As of March 31, 2012, the date for which the data was 
presented in the NPRM, LCH had a total notional amount outstanding 
of cleared FRAs of $27.7 trillion. As of October 15, 2012, that 
amount had increased to $58.6 trillion.
---------------------------------------------------------------------------

     84% of OIS, and
     41% of Basis Swaps.

Accordingly, a substantial portion of each class is already being 
cleared voluntarily.
Swap Class Conclusion
    The Commission concluded in the NPRM that the four classes of swaps 
currently being cleared have significant outstanding notional amounts 
and trading liquidity. The Commission further noted that a substantial 
percentage of each of the four classes was already being cleared.
    A number of commenters commented that the four interest rate swap 
classes are cleared in material volumes at this

[[Page 74308]]

time and expressed support for including the four interest rate swap 
classes in the clearing requirement designation based on the data 
available.\123\ Citadel agreed with the Commission's conclusion that 
the data presented in the NPRM demonstrate substantial outstanding 
notional exposures and a high level of trading liquidity in the 
relevant classes of swaps. Citadel commented that liquidity, for 
purposes of the clearing requirement, should be determined on grounds 
other than trading activity alone. Specifically, market depth can be 
evidenced by the number of dealers quoting two-way markets in a 
product, and the notional sizes of the quoted bids and offers, is also 
a liquidity indicator. Citadel noted that multiple dealers regularly 
quote two-way markets in the swaps covered by the proposed rule in 
meaningful sizes through a variety of mediums, including in periods of 
market stress, and therefore it believes there is ample trading 
liquidity to support a clearing requirement for the classes designated. 
For the reasons described above, the Commission reaffirms the 
aforementioned conclusions provided in the NRPM regarding the classes 
of interest rate swaps proposed in the NPRM for required clearing.
---------------------------------------------------------------------------

    \123\ See letters from FIA PTG, Arbor Research and Trading, LLC, 
R.J. O'Brien, Svenokur, LLC, Chris Barnard, CRT Capital Group 
(Robert Gorham), LLC, DRW Trading Group, Javelin, SDMA, Knight 
Capital Americas LLC, Bart Sokol (CRT Capital Group), Jefferies & 
Company, Inc., MarketAxess, Eris Exchange, Coherence Capital 
Partners LLC, Citadel, AFR, D.E. Shaw Group, AllianceBernstein, LCH, 
CME, and ICE.
---------------------------------------------------------------------------

2. Currency
    As discussed above in Section II.E, the currency in which the 
notional and payment amounts are specified is a primary product 
specification and all four data sources provide interest rate swap data 
by currency.
    The BIS data addressed seven of the seventeen currencies identified 
in the submissions individually. All seven currencies had substantial 
outstanding notional amounts as of December 2011, ranging from nearly 
$5.4 trillion for the Swiss franc to about $185 trillion in euro. For 
all currencies, the outstanding notional amounts were higher at the end 
of the most recent three-year period as compared to the beginning of 
the period.
    The Commission believes that the BIS data supports the conclusion 
that there exists significant outstanding notional amounts in each 
currency identified in the BIS data and that there is no indication 
that notional amounts in those currencies are decreasing at a rate that 
would warrant elimination of those currencies from consideration for a 
clearing requirement.
    The TriOptima data showed that total outstanding notional amounts 
as of March 16, 2012, ranged from $400 billion for Czech koruna to over 
$176 trillion notional amount for euro.\124\ While there may be 
sufficient outstanding notional amounts in all seventeen currencies, 
the Commission noted in the NPRM that there is a clear demarcation 
between the four currencies with the highest outstanding notional 
amounts: euro, U.S. dollar, British pound, and yen, and all other 
currencies. The four top currencies ranged from about 9% to 36% of the 
total notional amount of all interest rate swaps outstanding and 11% to 
33% of the total number of swap trades. The remaining currencies ranged 
from about 2% down to 0.1% of the total notional amount traded and 3% 
down to 0.2% of total number of trades. In fact, the four major 
currencies accounted for about 93% of the total notional amount 
outstanding in the TriOptima data set.
---------------------------------------------------------------------------

    \124\ TriOptima data, as of March 16, 2012.
---------------------------------------------------------------------------

    The ODSG data provided an indication of trading liquidity in terms 
of average weekly notional amount traded and number of new trades 
completed during the period covered by the data set. Of the four major 
currencies, Japanese yen had the lowest weekly average notional at $323 
billion and the British pound had the lowest average number of trades 
each week at 1,233.
    The TriOptima data provided an overall, more current view of trades 
outstanding, which provides a broader picture of the trading potential 
for each currency for purposes of DCO risk management. As of March 16, 
2012, all but one of the seventeen currencies had outstanding trade 
counts in excess of 14,000 with the exception being the Danish krone at 
6,849. Again, the four highest currencies by trade count: euro, U.S. 
dollar, British pound, and yen, accounted for about 85% of the total 
number of trades recorded and outstanding at the time the data was 
collected.
    The LCH data showed that the relative notional amount and number of 
swaps in each currency cleared is generally correlated with the 
notional amount and number of swaps of each currency reported by the 
more general market data sets. As a percentage of the total notional 
amount outstanding as reported by TriOptima, LCH cleared the following 
percentages: \125\
---------------------------------------------------------------------------

    \125\ The TriOptima data is used for this calculation because it 
is the most current data set that provides data broken out according 
to the classes currently being cleared.
---------------------------------------------------------------------------

     66% of euro,
     61% of U.S. dollars,
     58% of British pounds,
     59% of Japanese yen, and
     42% of other currencies.
    Of the interest rate swaps identifying U.S. dollars, euro, British 
pounds or yen as the applicable currency, significantly more than half 
were already being cleared by LCH. While the level of clearing of other 
currencies was, on a combined basis reasonably high at 42%, the 
Commission noted the level is noticeably lower than the percentage of 
swaps being cleared for the top four currencies.
Currency Specification Conclusion
    The Commission concluded in the NPRM that all of the data sets 
demonstrate the existence of significant outstanding notional amounts 
and trading liquidity in the seventeen currencies identified in the IRS 
submissions. However, the Commission noted that swaps using the four 
currencies with the highest outstanding notional amounts and trade 
frequency: euro, U.S. dollar, British pound, and yen, account for an 
outsized portion of both notional amounts outstanding and trading 
volumes. Furthermore, the Commission noted that these four currencies 
are already being cleared more than the other currencies generally.
    While it is important that this determination include a substantial 
portion of the interest rate swaps traded to have a substantive, 
beneficial impact on systemic risk, the Commission also recognized that 
the final rule is the Commission's first swap clearing requirement 
determination. As noted in the phased implementation rules for the 
clearing requirement, the Commission believes that introducing too much 
required clearing too quickly could unnecessarily increase the burden 
of the clearing requirement on market participants. In recognition of 
these considerations, the Commission determined in the NPRM to focus 
the remainder of this initial clearing requirement determination 
analysis on swaps referencing the four most heavily traded currencies. 
The Commission noted that the decision not to include the other 
thirteen currencies at this time does not limit the Commission's 
authority to reconsider required clearing of those currencies in the 
future.

[[Page 74309]]

    LCH commented that it supports the Commission's decision to 
initially limit the interest rate swap clearing determination to swaps 
with USD, EUR, GBP, and JPY as the underlying currency, and recommended 
that the Commission propose mandatory clearing of swaps in the other 13 
currencies identified in the IRS submission after the initial phase of 
the clearing requirement is well-established. LCH stated that there is 
ample volume and liquidity in swaps denominated in those currencies to 
support a clearing requirement determination and that it would be 
beneficial for the market if the Commission would clarify whether and/
or when it plans to make clearing of swaps denominated in other 
currencies mandatory.
    The Commission reaffirms the conclusions in its proposed 
determination to limit the interest rate swap clearing determination to 
interest rate swaps with USD, EUR, GBP, and JPY as the underlying 
currency, at this time. In response to LCH, the Commission reiterates 
that not including interest rate swaps in the other 13 currencies in 
this determination in no way forestalls the Commission from initiating 
a new clearing requirement determination for interest rate swaps in 
those currencies. The decision not to include them at this time was 
based on the fact that this is the initial clearing requirement 
determination and the Commission is mindful that market participants 
will be undertaking significant activity to implement compliance for 
the first time. Accordingly, the Commission has effectively delayed 
consideration of these currencies so that the market will have time to 
adapt to mandatory clearing of interest rate swaps in the four primary 
currencies, with the expectation that thereafter, the additional 
currencies can be added fairly easily. The Commission expects to 
initiate a clearing determination for interest rate swaps in the 13 
currencies at some time in 2013.
3. Floating Rate Index Referenced
    The ODSG data and LCH data provided an indication of the rate 
indices used on a transaction-by-transaction basis. Rate indexes are 
currency specific. The ODSG data showed minimal activity for the EUR-
LIBOR index with about $1 billion of notional amount and five trades 
made for the three month period in 2010 that the ODSG data covers. EUR-
LIBOR does not appear on the LCH data table because, although swaps 
referencing that index can be cleared at LCH, LCH had no open interest 
for that index as of March 31, 2012. Given the minimal notional amounts 
and trade liquidity for the EUR-LIBOR index, the Commission determined 
in the NPRM not to include EUR-LIBOR under the clearing requirement.
    The other rate indexes all showed significant notional amounts and 
trading liquidity. The rates with the least activity, the U.S. dollar 
Fedfund index and British pound-LIBOR index, each have over one 
trillion dollars in notional outstanding already cleared at LCH and $93 
billion and $82 billion in notional amount, respectively, were cleared 
per week on average. In terms of number of trades cleared at LCH, swaps 
referencing Fedfunds were cleared on average 116 times per week and 
swaps referencing British pound-LIBOR were cleared 888 times per week 
on average. All of the other indices cleared have similar or 
substantially higher numbers of trades and notional amounts cleared.
    In the NPRM, the Commission noted that the rate indexes used for 
over-the-counter interest rate swaps reference not only the generic 
index, but a reference definition for the index such as the ISDA 
definition or Reuters definition. While the Commission recognized the 
importance of these reference definitions for each swap contract, the 
Commission concluded that such definitions are not relevant for 
purposes of the clearing requirement determination. Furthermore, if the 
parties to a swap identify a specific reference definition for an 
index, they need only confirm whether any eligible DCO accepts that 
reference definition. If none do, then the swap in question is not 
accepted for clearing and it is not subject to the clearing 
requirement.
Rate Index Specification Conclusion
    The Commission concluded in the NPRM that with the exception of the 
EURO-LIBOR index, swaps using all of the rate indexes identified in the 
IRS submissions have significant outstanding notional amounts and 
trading liquidity and that significant notional amounts of swaps using 
these rate indexes are already cleared by DCOs.
    The Commission received no comments on the rate index specification 
determination, and confirming its conclusions regarding the rate index 
specifications identified in the NPRM.
4. Stated Termination Dates
    Stated termination date (sometimes referred to as ``maturities'') 
data is often presented by aggregating stated termination dates for 
swaps into specified term periods or ``buckets.'' The IRS submissions 
showed that the DCOs have been clearing interest rate swaps with final 
termination dates out to at least ten years for all seventeen 
currencies noted above and out to 50 years for some classes and 
currencies.
    Stated termination dates can fall on any day of the year. Given 
this continuum of termination dates, the DCOs have indicated that they 
manage the cleared swap portfolio risk using a swap curve.\126\ Swap 
curves are also used by market participants to price interest rate 
swaps. By pricing swaps in this way, the economic results of an 
interest rate swap can be fairly closely approximated, and therefore 
hedged, using two or more other swaps with different maturities 
principally by matching the weighted average duration of those swaps 
with the duration of the swap being hedged.\127\ In the same manner, a 
large portfolio of interest rate swaps can be hedged fairly closely 
with a small number of hedging swaps that have the same duration as the 
entire portfolio or subsets of related swaps within the portfolio. In 
effect, for DCO risk management purposes, the termination dates of 
interest rate swaps are assessed based on how they affect the overall 
duration aspects of the portfolio of swaps cleared.\128\ Accordingly, 
the primary determination with respect to the stated termination date 
specification is, for each class and currency, at what point, if any, 
along the continuum of swap maturities does the notional outstanding 
and trading liquidity become insufficient to structure the swap curve 
effectively for DCO risk management purposes.
---------------------------------------------------------------------------

    \126\ The ``swap curve'' is the term generally used by market 
participants for interest rate swap pricing and is similar to, and 
is sometimes established, in part, based on, ``yield curves'' used 
for pricing bonds.
    \127\ Other factors, such as convexity, may also be taken into 
account in determining the appropriate hedge ratio between the 
initial swap and the other swaps used to hedge its exposure.
    \128\ For further discussion of the use of portfolio risk 
management by DCOs, see the discussion of interest rate swap market 
conventions and risk management in Section II.E above.
---------------------------------------------------------------------------

    The TriOptima data provided sufficient detail to discern notional 
amounts and trade counts only for each swap class. The ODSG data 
provided sufficient detail to discern notional amounts and trade counts 
only for each currency. The LCH data provided enough detail for both 
swap class and currency.
    The TriOptima data and LCH data summarized in the NPRM showed that 
for fixed-to-floating swaps and basis swaps, there was significant 
outstanding notional amounts and number of trades for all maturity 
buckets being cleared.

[[Page 74310]]

    For FRAs, the TriOptima data showed a steep drop off after two 
years, although in the two to five year bucket, there is still over $1 
trillion dollars of outstanding notional amount and 1,646 trades. The 
LCH data showed substantial outstanding notional amounts of FRAs out to 
two years and none thereafter. The IRS submissions provide that the 
DCOs do not clear FRAs with payment dates beyond three years. 
Accordingly, the Commission need not consider FRAs with maturities 
beyond three years until such time as a DCO submits such swaps for 
clearing.
    For OIS, the TriOptima data showed notional amounts for all 
maturity buckets, but the drop off was steep beyond two years. After 
ten years, outstanding notional amounts drop below $100 billion for 
each maturity bucket. The LCH data showed no outstanding notional 
amounts cleared beyond two years. The IRS submissions provide that the 
DCOs do not accept for clearing OIS swaps beyond two years. 
Accordingly, the Commission did not consider OIS swaps beyond two years 
in this clearing requirement determination.
    The ODSG data and LCH data presented in the NPRM showed notional 
amounts traded for maturity buckets by currency. There were traded and 
cleared notional amounts for euro, U.S. dollars, and British pounds out 
to the 30 to 50 year bucket and for yen out to the twenty to thirty 
year bucket. The LCH data confirms that substantial notional amounts of 
swaps in euro, U.S. dollars, and British pounds are being cleared out 
to 50 years and yen out to 30 years.
Stated Termination Date Specification Conclusion
    For the classes of swaps considered by the Commission in the NPRM, 
the TriOptima data showed that there were significant outstanding 
notional amounts and number of trades out to 50 years for fixed-to-
floating swaps and basis swaps, out to 10 years or more for OIS, and 
out to 2 years for FRAs. With respect to currencies, the ODSG data and 
LCH data show significant outstanding notional amounts and number of 
trades in swaps out to 50 years for U.S. dollars, euro, and British 
pounds and out to 30 years for yen.
    Citadel noted that different tenors of the same instruments, while 
displaying incrementally different characteristics, are priceable both 
based on market activity and also with reference to more liquid or on-
the-run (or, as the case may be, already cleared) transactions of the 
same instruments, and are risk managed using the same risk management 
frameworks. Accordingly, swaps within a designated class with 
incrementally different tenors do not require a new review that would 
incur excessive delay. For the aforementioned reasons, the Commission 
confirming its conclusions regarding required clearing for interest 
rate swaps with the stated termination date specifications as proposed 
in the NPRM.
5. Adequate Pricing Data
    In the NPRM, the Commission took into account the adequacy of the 
pricing data for the four classes of interest rate swaps. LCH stated in 
its IRS submission that there is adequate pricing data for risk and 
default management. It explained that its risk and default management 
is based on the following factors under normal and stressed conditions:
     Outstanding notional, by maturity bucket and currency;
     Number of participants with live open positions, by 
maturity bucket and currency;
     Notional throughput of the market, by maturity bucket and 
currency;
     Size tradable that would not adjust the market price, by 
maturity bucket;
     Number of potential direct clearing members clearing the 
products that are part of the mutualized default fund and default 
management process;
     Interplay between on-the-run and off-the-run contracts; 
and
     Product messaging components and structure.
    LCH carries out a fire drill of its default management procedures 
and readiness twice a year. According to LCH, the fire drill presents 
an opportunity to further benchmark market liquidity and behavior and 
for models and assumptions to be recalibrated based on practitioner 
input. LCH also tests liquidity assumptions from the outset when 
developing clearing capabilities for a new product and thereafter, on a 
daily basis. This testing informs how LCH develops and modifies its 
risk management framework to provide adequate risk coverage in 
compliance with the core principles applicable to DCOs. Based on this 
framework, LCH contends that there is adequate pricing data for the 
swaps offered for clearing.
    CME represented in its IRS submission that its interest rate swap 
valuations are fully transparent and rely on pricing inputs obtained 
from wire service feeds. Further, CME uses conventional pricing 
methodologies, including OIS discounting, to produce its zero coupon 
curve off of which cleared swaps of all stated termination dates are 
priced. In addition, customers are provided with direct access to daily 
reports showing curve inputs, daily discount factors, and valuations 
for each cleared swap position.
    It is also worth noting that those interest rate swaps that are the 
subject of this proposal are capable of being priced off of deep and 
liquid debt markets. Because of the stability of access to pricing data 
from these markets, the pricing data for non-exotic interest rate swaps 
that are currently being cleared is generally viewed as non-
controversial.
    In response to the NPRM, Citadel commented that its experience 
regarding trading liquidity further lead it to conclude that there is 
sufficient data in the market for DCOs to perform required pricing and 
risk management of the classes of swaps included in the proposed rule. 
Finally, Citadel commented that access to reliable pricing data will 
only improve over time as the Dodd-Frank rules promoting transparency 
are implemented. No other comments were received on this factor.
    Based on consideration of the existence of significant outstanding 
notional exposures, trading liquidity, and adequate pricing data, as 
described in the NPRM, the Commission is reaffirming in this release 
its decision to include interest rate swaps with the following 
specifications in the clearing requirement rule and to consider the 
other four factors identified in section 2(h)(2)(D) of the CEA with 
respect to these swaps.

                                    Table 5--Interest Rate Swap Determination
----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
          Specification                                    Fixed-to-floating swap class
----------------------------------------------------------------------------------------------------------------
1. Currency.....................  U.S. Dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
2. Floating Rate Indexes........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
3. Stated Termination Date Range  28 days to 50       28 days to 50       28 days to 50       28 days to 30
                                   years.              years.              years.              years.
4. Optionality..................  No................  No................  No................  No.
5. Dual Currencies..............  No................  No................  No................  No.

[[Page 74311]]

 
6. Conditional Notional Amounts.  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                                          Basis Swap Class
----------------------------------------------------------------------------------------------------------------
1. Currency.....................  U.S. Dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
2. Floating Rate Indexes........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
3. Stated Termination Date Range  28 days to 50       28 days to 50       28 days to 50       28 days to 30
                                   years.              years.              years.              years.
4. Optionality..................  No................  No................  No................  No.
5. Dual Currencies..............  No................  No................  No................  No.
6. Conditional Notional Amounts.  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                                    Forward Rate Agreement Class
----------------------------------------------------------------------------------------------------------------
1. Currency.....................  U.S. Dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
2. Floating Rate Indexes........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
3. Stated Termination Date Range  3 days to 3 years.  3 days to 3 years.  3 days to 3 years.  3 days to 3 years.
4. Optionality..................  No................  No................  No................  No.
5. Dual Currencies..............  No................  No................  No................  No.
6. Conditional Notional Amounts.  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                                     Overnight Index Swap Class
----------------------------------------------------------------------------------------------------------------
1. Currency.....................  U.S. Dollar (USD).  Euro (EUR)........  Sterling (GBP).
2. Floating Rate Indexes........  FedFunds..........  EONIA.............  SONIA.
3. Stated Termination Date Range  7 days to 2 years.  7 days to 2 years.  7 days to 2 years.
4. Optionality..................  No................  No................  No.
5. Dual Currencies..............  No................  No................  No.
6. Conditional Notional Amounts.  No................  No................  No.
----------------------------------------------------------------------------------------------------------------

b. Availability of Rule Framework, Capacity, Operational Expertise and 
Resources, and Credit Support Infrastructure
    Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to 
take into account the availability of rule framework, capacity, 
operational expertise and resources, and credit support infrastructure 
to clear the proposed classes of swaps on terms that are consistent 
with the material terms and trading conventions on which they are now 
traded. The Commission stated in the NPRM that it believed that LCH and 
CME,\129\ have developed rule frameworks, capacity, operational 
expertise and resources, and credit support infrastructure to clear the 
interest rate swaps they currently clear on terms that are consistent 
with the material terms and trading conventions on which those swaps 
are being traded. The Commission noted that LCH already clears more 
than half the global interest rate swaps in the four proposed classes 
of the clearing requirement and that CME also already cleared the more 
commonly traded swaps under this clearing requirement proposal. The 
Commission further notes that CME has recently added, or has stated 
publicly that it intends to add by the end of 2012, swaps in all four 
classes and at least the four currencies included in the final rule.
---------------------------------------------------------------------------

    \129\ IDCH was also included in this discussion in the NPRM. 
However, as discussed above, IDCH has been acquired by LCH and is 
now LCH.LLC and its rules and product offering are being revised to 
be substantially the same as LCH's. Accordingly, the rule 
frameworks, capacity, operational expertise and resources, and 
credit support infrastructure for IDCH is not discussed in this 
final release, but is being assessed by the Commission as part of 
LCH.LLC's request for approval of its rulebook and risk management 
framework revisions.
---------------------------------------------------------------------------

    The Commission also noted that the DCOs each developed their 
interest rate swap clearing offerings in conjunction with market 
participants and in response to the specific needs of the marketplace. 
In this manner, the clearing services of each DCO are designed to be 
consistent with the material terms and trading conventions of a 
bilateral, uncleared market.
    LCH submitted that it has the capability and expertise to manage 
the risks inherent in the current book of interest rate swaps cleared 
and the increased volume that the clearing requirement could generate 
for all of its currently clearable products. LCH has developed 
operational models, controls, and risk algorithms to ensure that it can 
process trades, and is capable of calculating the level of risk it has 
with any counterparty--both direct clearing members and their 
customers.
    CME's IRS submission cited to its rule books to demonstrate the 
availability of rule framework, capacity, operational expertise and 
resources, and credit support infrastructure to clear qualified, 
interest rate swap contracts on terms that are consistent with the 
material terms and trading conventions on which the contracts are then 
traded.
    After considering the information provided by the DCOs in the IRS 
submissions and the nature and extent of clearing already undertaken by 
the DCOs of existing bilateral swaps, the Commission concluded in the 
NPRM that there is available rule framework, capacity, operations 
expertise and resources, and credit support infrastructure consistent 
with the material terms and trading conventions on which the swaps 
included in the four interest rate swap classes are designated.
    Citadel commented that the fact that all swaps included in the four 
interest rate swap classes are being cleared in material volumes 
provides clear evidence that there is the rule framework, capacity, 
operational expertise and resources, and credit support infrastructure 
necessary to clear each of the swaps that are included in the 
Commission's determination. Further, Citadel stated that because 
registered DCOs are required to be in compliance on an on-going basis 
with the DCO core principles in the CEA, they ``by definition'' have 
demonstrated that they satisfy this factor. In addition, Citadel noted 
that the DCOs have been preparing for and anticipating increased 
volumes as a result of the clearing requirement since the enactment of 
the Dodd-Frank Act, if not earlier. Also, under the Commission's 
implementation rule,\130\ there is a 270-

[[Page 74312]]

day period provided to allow DCOs, customers, FCMs, and all others 
engaged in the clearing process to test and ramp up customer clearing 
volumes voluntarily, and be in position to manage full production 
clearing volumes during the phase-in of the clearing requirement. 
Citadel stated that it believed the DCOs and FCMs are well prepared for 
a surge in clearing volumes and have the framework, capacity, 
expertise, resources and infrastructure to support it in a safe and 
sound manner and that Citadel's own experience in commencing voluntary 
clearing of swaps confirms its observations.
---------------------------------------------------------------------------

    \130\ 77 FR at 44441-44456.
---------------------------------------------------------------------------

    For the reasons described above, and as discussed in the NPRM, the 
Commission reaffirms that there is available rule framework, capacity, 
operations expertise and resources, and credit support infrastructure 
consistent with the material terms and trading conventions on which the 
swaps included in the four interest rate swap classes are designated.
c. Effect on the Mitigation of Systemic Risk
    Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to 
consider the effect on the mitigation of systemic risk, taking into 
account the size of the market for such contract and the resources of 
the DCO available to clear the contract. CME, LCH, and IDCH stated in 
their IRS submissions that subjecting interest rate swaps to central 
clearing would help mitigate systemic risk. As stated above in the 
analysis of interest rate swap market data, the Commission believes 
that the market for these swaps is significant and mitigating 
counterparty risk through clearing likely would reduce systemic risk in 
the swap market and the financial system as a whole.
    According to LCH's IRS submission, if all clearable swaps are 
required to be cleared, the inevitable result will be a less disparate 
marketplace from a systemic risk perspective. CME submits that the 2008 
financial crisis demonstrated the potential for systemic risk arising 
from the interconnectedness of OTC derivatives market participants and 
that centralized clearing will reduce systemic risk.
    IDCH stated in its IRS submission that, given the tremendous size 
of the interest rate derivatives market, the potential mitigation of 
systemic risk through centralized clearing of interest rate swaps is 
significant. IDCH asserted that clearing such swaps brings the risk 
mitigation and collateral and operational efficiency afforded to 
cleared and exchange-traded futures contracts to bilaterally negotiated 
OTC interest rate derivatives. The submission of interest rate swaps 
for clearing affords the parties the credit, risk management, capital, 
and operational benefits of central counterparty clearing of such 
transactions, and facilitates collateral efficiency. Cleared swaps 
allow market participants to free up counterparty credit lines that 
would otherwise be committed to open bilateral contracts. Additionally, 
according to IDCH, an efficient system for centralized clearing allows 
parties to mitigate the risk of a bilateral OTC derivative. Instead of 
holding offsetting positions with different counterparties and being 
exposed to the risk of each counterparty, a party may enter into an 
economically offsetting position that is cleared. Although the 
positions are not offset, the initial margin requirement will be 
reduced to close to zero. To eliminate risk without using centralized 
clearing, the party must enter into a tear-up agreement with the 
counterparty, or enter into a novation.
    While the clearing requirement would remove a large portion of the 
interconnectedness of current OTC markets that leads to systemic risk, 
the Commission noted in the NPRM that central clearing concentrates 
risk in a handful of entities. However, the Commission observed that 
central clearing was developed and designed to handle such 
concentration of risk. LCH has extensive experience risk managing very 
large volumes of interest rate swaps. Based on available data, it is 
believed that about half of all interest rate swaps transacted are 
cleared by LCH. CME submitted that it has the necessary resources 
available to clear the swaps that are the subject of its submission. 
The Commission notes that CME or its predecessors have cleared futures 
since 1898 and is the largest futures clearinghouse in the world. CME 
has not defaulted during that time.
    Accordingly, the Commission stated in the NPRM, and reaffirms in 
this release that it believes that LCH and CME have the resources 
needed to clear the interest rate swaps included in its determination 
and to manage the risk posed by clearing interest rate swaps that are 
required to be cleared. In addition, the Commission believes that the 
central clearing of the interest rate swaps that are the subject of 
this determination and final rule would serve to mitigate counterparty 
credit risk thereby having a positive effect on reducing systemic risk.
    In support of the Commission's determination regarding systemic 
risk, Citadel commented that the transition from an interconnected 
network of bilateral derivatives exposures to central clearing in 
regulated clearing houses will mitigate systemic risk. In support of 
this assertion, Citadel cited a New York Federal Reserve Board staff 
paper \131\ and noted that central clearing stands as a pillar of the 
Dodd-Frank Act. Citadel explained that central clearing eliminates the 
prospect of firms becoming too interconnected to fail by virtue of 
their bilateral swap positions and ensures that sufficient margin is 
reserved against each side of each swap, while further mitigating any 
default event through mutualization funds, clearing member obligations, 
and the additional financial safeguards of the regulated DCO.
---------------------------------------------------------------------------

    \131\ See, e.g., Policy Perspectives on OTC Derivatives Market 
Infrastructure by Duffie, Li, and Lubke (March 2010), available at 
http://www.newyorkfed.org/research/staff_reports/sr424.pdf.
---------------------------------------------------------------------------

    Citadel further asserted that the Commission's determination takes 
the decisive step, long anticipated and prepared for by the market, of 
making mandatory central clearing of the most liquid and standardized 
swaps a reality. Citadel went on to express confidence that the 
transition to required clearing of liquid swaps will support and 
incentivize the expansion of the cleared product set, because it will 
be more economically efficient for market participants to hold as much 
of their portfolios as possible in a single margined basket at a DCO. 
Citadel concluded that the Commission's clearing requirement rule thus 
provides the certainty needed for market participants to transition 
more of their swap portfolios from bilateral to cleared trades, thereby 
reducing or eliminating bilateral counterparty credit risk, and by 
extension, systemic risk.
    By contrast, ISDA commented on how mandatory clearing may 
centralize risk in DCOs and questioned the risk-mitigating aspects of 
central clearing as contrasted with the new regulatory regime for 
uncleared swaps. ISDA also questioned the Commission's assertion that 
central clearing was designed to address the concentration of risk. In 
response to ISDA's comment, the Commission observes that while the 
regime for bilateral, uncleared swaps will be greatly improved after 
full implementation of the Dodd-Frank Act reforms, central clearing 
provides for certain risk management features that cannot be replicated 
on a bilateral basis. To name just one critical distinction, a 
clearinghouse addresses the tail risk of open positions through 
mutualization. Each clearing member must contribute to a default fund 
that protects the system as a whole.

[[Page 74313]]

d. Effect on Competition
    Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to 
take into account the effect on competition, including appropriate fees 
and charges applied to clearing. Of particular concern to the 
Commission is whether the determination would harm competition by 
creating, enhancing, or entrenching market power in an affected product 
or service market, or facilitating the exercise of market power. Market 
power is viewed as the ability to raise price, including clearing fees 
and charges, reduce output, diminish innovation, or otherwise harm 
customers as a result of diminished competitive constraints or 
incentives.\132\
---------------------------------------------------------------------------

    \132\ See Section II.D above for a more detailed discussion of 
these issues.
---------------------------------------------------------------------------

    In the NPRM, the Commission identified one putative service market 
as potentially affected by this proposed clearing determination: a DCO 
service market encompassing those clearinghouses that currently (or 
with relative ease in the future could) clear the interest rate swaps 
subject to this proposal. The Commission recognized that, depending on 
the interplay of several factors, the clearing requirement potentially 
could impact competition within the affected market and discussed 
various factors that could impact that market.
    As discussed above, in support of the NPRM, Citadel stated that the 
clearing requirement will have a strong positive impact on competition 
in the swap market and the market for clearing services. Citadel noted 
that central clearing will remove a significant barrier to entry for 
alternative swap market liquidity providers and will enable smaller 
entities to compete on more equal terms because central clearing 
eliminates the consideration of counterparty credit risk from the 
selection of execution counterparties. Citadel further commented that 
buy-side market participants will benefit from a wider range of 
potential execution counterparties and asserted that this increased 
competition yields benefits to market participants including narrower 
bid-ask spreads, improved access to best execution, and increased 
market depth and liquidity, all of which establish a prerequisite for 
the emergence of an all-to-all market with electronic and/or anonymous 
execution. Citadel also commented that substitution of the DCO for the 
bilateral counterparty decouples execution from post-trade processing 
and settlement. Finally, Citadel commented that the certainty as to 
when the first clearing requirement will begin gives DCOs and FCMs the 
confidence to invest in their client clearing offerings, and to compete 
actively for buy-side business both on the quality and efficiency of 
their services as well as on price.
    FIA commented that the NPRM included a full discussion of the 
potential competitive impact of the clearing proposal. However, as 
discussed above, FIA indicated that it was unable to conduct the 
analysis it believes would be necessary to respond to the Commission's 
questions in the NPRM within the 30-day comment period provided.
    In response to FIA's comment, the Commission notes that the 30-day 
public comment period was necessary for the Commission to adhere to the 
CEA's 90-day determination process. Moreover, while FIA indicated that 
it would like more time to conduct further analysis of competitive 
issues for future determinations, FIA did not identify any specific 
concerns about the competitiveness issue analysis that could materially 
change the Commission's determination if such additional information 
were made available to the Commission. The comments provided by Citadel 
are consistent with the NPRM's conclusion that the clearing requirement 
potentially could impact competition within the affected market, but go 
on to assert that such an impact would not be negative. Accordingly, 
the Commission believes that its consideration of competitiveness as 
described in the NPRM is sufficient for purposes of finalizing the 
clearing requirement rule.
e. Legal Certainty in the Event of the Insolvency
    Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to 
take into account the existence of reasonable legal certainty in the 
event of the insolvency of the relevant DCO or one or more of its 
clearing members with regard to the treatment of customer and swap 
counterparty positions, funds, and property. The Commission's proposal 
was based on its view that there is reasonable legal certainty with 
regard to the treatment of customer and swap counterparty positions, 
funds, and property in connection with cleared swaps, namely the 
interest rate swaps subject to the proposal, in the event of the 
insolvency of the relevant DCO or one or more of the DCO's clearing 
members.
    In the case of a clearing member insolvency at CME or IDCH (now, 
LCH.LLC), i.e., DCOs subject to the bankruptcy laws of the United 
States, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11 
U.S.C. 761-767) and Part 190 of the Commission's regulations would 
govern the treatment of customer positions.\133\ Pursuant to section 
4d(f) of the CEA, a clearing member accepting funds from a customer to 
margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C. 
761-767 and Part 190 of the Commission's regulations, the customer's 
interest rate swap positions, carried by the insolvent FCM, would be 
deemed ``commodity contracts.'' \134\ As a result, neither a clearing 
member's bankruptcy nor any order of a bankruptcy court could prevent a 
United States domiciled DCO from closing out/liquidating such 
positions.\135\ However, customers of clearing members would have 
priority over all other claimants with respect to customer funds that 
had been held by the defaulting clearing member to margin swaps, such 
as the interest rate swaps included in the clearing determination.\136\ 
Customer funds would be distributed to swap customers, including 
interest rate swap customers, in accordance with Commission regulations 
and section 766(h) of the Bankruptcy Code. Moreover, the Bankruptcy 
Code and the Commission's rules thereunder (in particular 11 U.S.C. 
764(b) and 17 CFR 190.06) permit the transfer of customer positions and 
collateral to solvent clearing members.
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    \133\ The Commission observes that an FCM or DCO also may be 
subject to resolution under Title II of the Dodd-Frank Act to the 
extent it would qualify as covered financial company (as defined in 
section 201(a)(8) of the Dodd-Frank Act).
    \134\ If an FCM is also registered as a broker-dealer, certain 
issues related to its insolvency proceeding would also be governed 
by the Securities Investor Protection Act.
    \135\ See 11 U.S.C. 556 (``The contractual right of a commodity 
broker [which term would include a DCO or FCM] * * * to cause the 
liquidation, termination or acceleration of a commodity contract * * 
* shall not be stayed, avoided, or otherwise limited by operation of 
any provision of [the Bankruptcy Code] or by order of a court in any 
proceeding under [the Bankruptcy Code]'').
    \136\ See 11 U.S.C. 766(h).
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    Similarly, 11 U.S.C. 761-767 and Part 190 would govern the 
bankruptcy of a DCO, in conjunction with DCO rules providing for the 
termination of outstanding contracts and/or return of remaining 
clearing member and customer property to clearing members.
    With regard to LCH, the Commission understands that the default of 
a clearing member of LCH would be governed by the rules of that DCO. 
LCH, a DCO based in the United Kingdom, has represented that under 
English law its rules would supersede English insolvency laws. Under 
its rules, LCH would be permitted to close out and/or transfer 
positions of a defaulting clearing member that is an FCM

[[Page 74314]]

pursuant to the U.S. Bankruptcy Code and Part 190 of the Commission's 
regulations. According to LCH's submission, the insolvency of LCH 
itself would be governed by both English insolvency law and Part 190.
    LCH has obtained legal opinions that support the existence of such 
legal certainty in relation to the protection of customer and swap 
counterparty positions, funds, and property in the event of the 
insolvency of one or more of its clearing members. In addition, LCH has 
obtained a legal opinion from U.S. counsel regarding compliance with 
the protections afforded to FCM customers under New York law.
    In response to the NPRM, Citadel commented that it agreed with the 
Commission's analysis that reasonable certainty exists in the event of 
an insolvency of a DCO or one or more DCO members. As discussed above, 
the Commission received three comments related to customer segregation. 
In essence, Vanguard and SIFMA AMG recommend that the Commission delay 
implementation of the clearing requirement until three months after the 
LSOC model is implemented, clarified, and perhaps supplemented with 
additional rulemaking. ISDA requests that the Commission further study 
the issue of insolvency for DCOs.
    As stated above, the Commission believes that the concerns of 
Vanguard and SIFMA AMG are largely addressed by the delayed 
implementation timeframe for this determination. With regard to ISDA's 
request, as discussed above, the Commission is actively engaging in 
efforts to study and prepare for potential scenarios involving 
clearinghouse and clearing member insolvency.
iii. Conclusions Regarding the Five Statutory Factors and Clearing 
Requirement Determination
    In the foregoing discussion and analysis, the Commission has taken 
into account each of the five factors provided for under section 
2(h)(2)(D)(ii) of the CEA for the interest rate swap classes that are 
the subject of this determination. Based on these considerations, and 
having reviewed the relevant DCOs' submissions for consistency with 
section 5b(c)(2) of the CEA, the Commission is determining that the 
four classes of interest rate swaps identified in Sec.  50.4(a) are 
required to be cleared.

III. Final Rules

    The Commission is adopting the following rules under section 
2(h)(2), as well as its authority under sections 5b(c)(2)(L) and 8a(5) 
of the CEA. In issuing a determination regarding whether a swap or 
class of swaps is required to be cleared, ``the Commission may require 
such terms and conditions to the requirement as the Commission 
determines to be appropriate.'' \137\
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    \137\ Section 2(h)(2)(D)(iii) of the CEA.
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A. Regulation 50.1: Definitions

    As proposed, Sec.  50.1 set forth two defined terms: ``business 
day'' and ``day of execution.'' The definition of business day excluded 
Saturdays, Sundays, and legal holidays. The definition of ``day of 
execution'' served as a means of addressing situations where executing 
counterparties are located in different time zones. It was intended to 
avoid difficulties associated with end-of-day trading by deeming swaps 
executed after 4:00 p.m., or on a day other than a business day, to 
have been executed on the immediately succeeding business day. The 
Commission recognized that market participants should not be required 
to maintain back-office operations 24 hours a day or 7 days a week in 
order to meet the proposed deadline for submitting swaps that are 
required to be cleared to a DCO. The Commission also was attempting to 
be sensitive to possible concerns about timeframes that may discourage 
trade execution late in the day. To account for time-zone issues, the 
``day of execution'' was defined to be the calendar day of the party to 
the swap that ends latest, giving the parties the maximum amount of 
time to submit their swaps to a DCO while still requiring such 
submission on a same-day basis.
    The Commission received two comments on these definitions. LCH 
commended the Commission for including flexibility on the timing of 
swap submission for those swaps executed late in the day, but requested 
that the Commission clarify that DCOs can continue to accept swaps for 
clearing late in the day. In response to this request, the Commission 
confirms that the 4:00 p.m. cut off for same-day submission to a DCO is 
intended to give market participants flexibility and respond to 
concerns about counterparties in different time zones. This definition 
should not be interpreted as a prohibition on late-day submission of 
swaps to DCOs or as impeding DCO's ability to accept such swaps.
    FIA observed an apparent conflict between the proposed definitions 
of ``business day'' and ``day of execution'' and regulation 
23.506(b).\138\ As with LCH, FIA's concern focused on the ability of 
DCOs to expand their business hours. As explained above, the 
definitions do not proscribe a DCO's ability to set business hours. 
Accordingly, the Commission is adopting the definitions as proposed.
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    \138\ This regulation directs swap dealers and major swap 
participants to submit swaps subject to the clearing requirement to 
a DCO as soon as technologically practicable after execution, but no 
later than the close of business on the day of execution. See 17 CFR 
23.506(b), 77 FR 21278, 21307 (Apr. 9, 2012). To the extent that a 
swap dealer or major swap participant is subject to both Sec.  
23.506(b) and Sec.  50.2(a), the entity should comply with Sec.  
23.506(b) when its counterparty is another swap dealer or major swap 
participant, but if the swap is between a swap dealer and a non-swap 
dealer, then the non-swap dealer counterparty can elect to follow 
the timing requirements of Sec.  50.2(a) or Sec.  23.506(b).
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B. Regulation 50.2: Treatment of Swaps Subject to a Clearing 
Requirement

    As proposed, Sec.  50.2(a) required all persons, other than those 
who elect the exception in accordance with Sec.  39.6 (now Sec.  
50.50),\139\ to submit a swap that is part of the class described in 
Sec.  50.4 for clearing by a DCO as soon as technologically practicable 
and no later than the end of the day of execution. The objective of 
this provision was to ensure that swaps subject to a clearing 
requirement are submitted to DCOs for clearing in a timely manner.
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    \139\ The Commission is recodifying Sec.  39.6 as Sec.  50.50 so 
that market participants are able to locate all rules related to the 
clearing requirement in one part of the Code of Federal Regulations.
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    ISDA recommended that the Commission clarify the rule text to 
recognize that non-clearing members are deemed to have met the 
requirements of Sec.  50.2 once they submit the swap to their FCM 
clearing member. ISDA also requested that the Commission recognize that 
in some cross-border transactions clearing members will not necessarily 
be FCMs. Similarly, ISDA asked that there be an exclusion for foreign 
governments and governmental entities as set forth in the end-user 
exception final rulemaking. Lastly, ISDA asked that there be an 
exception in the rule for system outages and force majeure events.
    In response to ISDA's first comment, the Commission is modifying 
the rule text by adding new paragraph (c) to clarify that submission of 
a swap to an FCM or a DCO clearing member is sufficient to meet the 
timeliness requirements of the rule. For U.S. customers, this will mean 
submission to a registered FCM. For cross-border transactions, the 
Commission recognizes that submission of the swap may be to a non-FCM 
clearing member when the customer is not a U.S. person.\140\
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    \140\ If the person submitting the swap is a customer, as Sec.  
1.3(k) defines that term, then only a registered FCM may accept that 
swap for clearing, even if the customer seeks to clear the swap on a 
DCO located outside of the U.S.

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[[Page 74315]]

    With regard to foreign governments and governmental entities, the 
Commission reiterates the position taken in the end-user exception 
rulemaking that ``foreign governments, foreign central banks, and 
international financial institutions should not be subject to Section 
2(h)(1) of the CEA.'' \141\ Finally, the Commission declines to include 
an explicit exception for unforeseen outages and other events. The 
Commission recognizes that these situations may occur and has adopted 
rules relating to system safeguards and disaster recovery for market 
infrastructures \142\ and market participants.\143\ However, none of 
the straight-through-processing rules adopted by the Commission 
included carve-outs for system outages or force majeure events,\144\ 
and the Commission does not believe it is necessary to include such 
provisions in this rule. In the case of serious market-wide 
disruptions, the Commission would take this mitigating fact into 
account in reviewing compliance with Sec.  50.2.
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    \141\ See End-User Exception to the Clearing Requirement for 
Swaps, 77 FR 42560, 42562 (July 19, 2012).
    \142\ See, e.g., Derivatives Clearing Organization General 
Provisions and Core Principles, 76 FR 69334, 69443-69444 (Nov. 8, 
2011) (adopting Sec.  39.18 relating to system safeguards).
    \143\ See Swap Dealer and Major Swap Participant Recordkeeping, 
Reporting, and Duties Rules, 77 FR 20128, 20208-20209 (Apr. 3, 2012) 
(adopting Sec.  23.603 relating to business continuity and disaster 
recovery).
    \144\ Customer Clearing Documentation, Timing of Acceptance for 
Clearing, and Clearing Member Risk Management, 77 FR 21278, 21307 
(Apr. 9, 2012).
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    Additionally, in an effort to clarify that a market participant 
does not have to submit a swap that falls within the Sec.  50.4 
classes, but that the entity knows are not offered for clearing by any 
DCO because the swap contains specifications that are not accepted for 
clearing, the Commission is modifying the text of Sec.  50.2 to include 
a reference to ``eligible'' DCOs that offer such swaps for clearing.
    Proposed Sec.  50.2(b) would require persons subject to Sec.  
50.2(a) to undertake reasonable efforts to determine whether a swap is 
required to be cleared. In the NPRM, the Commission indicated that it 
would consider such reasonable efforts to include checking the 
Commission's Web site or the DCO's Web site for verification of whether 
a swap is required to be cleared, or consulting third-party service 
providers for such verification.
    CME commented on the Commission's observation in the NPRM that DCOs 
could design and develop systems that will enable market participants 
and trading platforms to check whether or not their swap is subject to 
a clearing requirement and be provided with an answer within seconds 
(or faster). CME stated that its platform already provides market 
participants with a tool to screen a particular swap for eligibility 
for clearing upon submission to CME. The Commission recognizes that 
this technological capability will be beneficial to market 
participants, particularly pre-execution, and is necessary to ensure 
timely clearing of swaps subject to the clearing requirement.
    Freddie Mac observed that Sec.  50.2(a) and (b) could be 
interpreted to require two different standards of care: strict 
liability for the former and a reasonable inquiry standard for the 
latter. In response to Freddie Mac's comment, the Commission clarifies 
that Sec.  50.2(a) establishes a requirement regarding the timely 
submission of swaps to DCOs. It is a bright-line standard, but it is 
not intended to introduce a new scienter requirement regarding 
submission for clearing beyond that provided for in the statute.\145\ 
With regard to Sec.  50.2(b), the Commission's objective was to afford 
market participants clarity about what efforts they must expend in 
determining whether their swaps are required to be cleared. In the 
absence of some central screening mechanism available to all market 
participants for the purpose of immediately determining whether any 
eligible DCO offers a particular swap for clearing,\146\ the Commission 
believes it appropriate to provide clarity regarding what constitutes 
reasonable search or verification efforts.\147\
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    \145\ See Section III.G for further discussion regarding 
scienter.
    \146\ See discussion in Section II.E regarding LCH's and CME's 
efforts to provide such a screening mechanism.
    \147\ The Commission notes that it will consider whether 
verification efforts are reasonable in light of all the facts and 
circumstances of a market participant's particular situation.
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C. Regulation 50.3: Notice to the Public

    The Commission proposed Sec.  50.3(a) to require each DCO to post 
on its Web site a list of all swaps that it will accept for clearing 
and clearly indicate which of those swaps the Commission has determined 
are required to be cleared pursuant to part 50 of the Commission's 
regulations and section 2(h)(1) of the CEA.
    ISDA commented that DCOs should provide swap information, including 
product specifications, in a manner that is easy to access and use. 
ISDA also called upon DCOs to provide at least one-month's advance 
notice for new swaps that they plan to accept for clearing and to 
provide a description of the margin methodology used in clearing the 
swap. The Commission agrees that DCOs should provide information in a 
manner that is easy to use and accessible to the public. Regulation 
Sec.  50.3(b) builds upon the requirements of Sec.  39.21(c)(1), which 
requires each DCO to disclose publicly information concerning the terms 
and conditions of each contract, agreement, and transaction cleared and 
settled by the DCO. The Commission also welcomes ISDA's suggestion that 
DCOs voluntarily provide advance notice of new swaps that they plan to 
clear and make relevant information regarding their margining 
methodologies available.\148\
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    \148\ 17 CFR 39.21 requires that DCOs provide market 
participants with ``sufficient information to enable the market 
participants to identify and evaluate accurately the risks and costs 
associated with using the services'' of the DCO.
---------------------------------------------------------------------------

    LCH commented that it is committed to revising the information on 
its Web site so that it is provided in a format that is easily 
understandable by all swaps counterparties, including customers.
    Regulation Sec.  50.3(b) requires the Commission to post on its Web 
site a list of those swaps it has determined are required to be cleared 
and all DCOs that are eligible to clear such classes of swaps. No 
comments were received on this provision. The Commission is adopting 
the rule as proposed in order to provide market participants with 
sufficient notice regarding which swaps are subject to a clearing 
requirement. For clarification, the Commission will include on its Web 
site any swaps that it has determined through delegated authority under 
Sec.  50.6 fall within a class of swaps described in Sec.  50.4.

D. Regulation 50.4: Classes of Swaps Required To Be Cleared

    As discussed at length above, proposed Sec.  50.4 set forth the 
classes of interest rate swaps and CDS that the Commission proposed for 
required clearing. Proposed Sec.  50.4(a) included a table listing 
those types of interest rate swaps the Commission would require to be 
cleared, and proposed Sec.  50.4(b) included a table listing those 
types of CDS indices the Commission would require to be cleared.
    ISDA recommended that the Commission clarify that the stated 
termination date ranges in Sec.  50.4(a) be applied only at trade 
inception for purposes of determining whether the swap is required to 
be cleared. The Commission confirms ISDA's

[[Page 74316]]

understanding of the stated termination date range applying only at 
trade inception or upon an ownership event change, as discussed in 
detail below.
    As discussed above, the Commission is adopting Sec.  50.4(a) and 
(b). The Commission believes that this format provides market 
participants with a clear understanding of which swaps are required to 
be cleared. By using basic specifications to identify the swaps subject 
to the clearing requirement, counterparties contemplating entering into 
a swap can determine quickly as a threshold matter whether or not the 
particular swap may be subject to a clearing requirement. If the swap 
has the basic specifications of a class of swaps determined to be 
subject to a clearing requirement, the parties will know that they need 
to verify whether an eligible DCO will clear that particular swap. This 
will reduce the burden on swap counterparties related to determining 
whether a particular swap may be subject to the clearing requirement.
i. Disentangling Complex Swaps
    TriOptima commented that the complete swap must be assessed against 
the clearing requirement and parties should not be required to 
disentangle non-clearable swaps in order to clear the clearable 
components. The Commission confirms TriOptima's view regarding those 
swaps that may have components that can be cleared, but would require 
disentangling the clearable part of the swap. Adherence to the clearing 
requirement does not require market participants to structure their 
swaps in a particular manner or disentangle swaps that serve legitimate 
business purposes.\149\
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    \149\ See discussion below regarding Sec.  50.10 and the evasion 
and abuse standards.
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ii. Swaptions and Extendible Swaps
    In response to the Commission's inquiry in the NPRM regarding how 
to treat a swap that becomes effective upon the exercise of a swaption, 
ISDA suggested that the resulting swap should only be required to be 
cleared if the underlying swap and the counterparties to the swap were 
subject to a clearing requirement at the time that the swaption was 
executed. ISDA also commented that the same approach should apply to 
extendible swaps, i.e., a swap for which a party has the option to 
extend the term of the swap. ISDA reasoned that the parties to a 
swaption or an extendible swap would not have taken into account the 
cost of clearing the resultant swap if they negotiated the price of the 
option before a clearing requirement was applicable to the underlying 
swap or extended swap. LCH similarly commented that a swaption entered 
into before a clearing requirement is applicable to the underlying swap 
would not have been priced with an expectation that the swap created on 
exercise would be cleared. For this reason, LCH also stated that an 
underlying swap of a swaption should be subject to an applicable 
clearing requirement only if the swaption was entered into after the 
clearing requirement applicable to the underlying swap becomes 
effective.
    The Commission agrees that the cost of clearing may not be 
reflected in the pricing of the swaption or extendible swap if the 
clearing requirement for the underlying swap or the extendable swap 
arises after the execution of the swaption or extendible swap. The 
Commission is thus clarifying that the clearing requirement only 
applies to swaps resulting from the exercise of a swaption or 
extendible swap extension if the clearing requirement would have been 
applicable to the underlying swap or the extended swap at the time the 
counterparties executed the swaption or extendible swap.
iii. Ownership Event Changes
    In the NPRM, the Commission asked whether it should clarify that 
the clearing requirement applies to all new swaps and changes in the 
ownership of a swap, including assignment, novation, exchange, 
transfer, or conveyance. ISDA responded that a swap that is not subject 
to the clearing requirement at the time it is executed should not 
become subject to it upon an ownership event change unless the parties 
can agree on pricing and other terms necessary to reflect the costs of 
clearing and until the swap can be transitioned from uncleared to 
cleared with accuracy.\150\
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    \150\ Aside from a general assertion about the challenges of 
selecting a DCO for clearing, ISDA did not elaborate on its implied 
assertion that swaps subject to ownership changes may be difficult 
to transition to clearing accurately.
---------------------------------------------------------------------------

    As the Commission acknowledged above, the cost of clearing may not 
be reflected in the pricing of a swap if the clearing requirement 
arises after the execution of that swap. However, unlike with the 
exercise of a swaption, typically, the original counterparties to a 
swap that is assigned, novated, exchanged, transferred, or conveyed, 
along with the new party in ownership, each have an opportunity to 
revisit the terms of the original swap and account for new costs.\151\ 
While there may be cost implications for the remaining party when its 
counterparty changes, these cost implications can arise for any number 
of foreseeable or unforeseeable reasons,\152\ and if the remaining 
party is concerned about potential cost implications resulting from a 
change of its counterparty, it would be able to protect itself through 
the terms of the swap, such as including consent rights or required 
price adjustments upon such an event.\153\ The Commission is concerned 
that if such swaps are not treated as new swaps for the purposes of the 
clearing requirement, it could be creating incentives to ``trade'' 
historical swaps through the assignment, novation, exchange, transfer, 
or conveyance processes to avoid required clearing. Accordingly, for 
purposes of this rule, a change in ownership of a swap would subject 
the swap to required clearing under section 2(h)(1) of the CEA in the 
same manner and to the same extent as a newly executed swap.
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    \151\ Going forward, prior to or at the time of ownership 
change, parties will have to account for any additional costs of 
clearing.
    \152\ For example, an ownership change for a bilateral swap may 
have foreseeable or unforeseeable credit or tax implications for the 
remaining party.
    \153\ The Commission observes that the ISDA Master Agreement 
used for most bilateral swaps requires the prior written consent of 
the remaining party for any transfer of the agreement other than for 
certain limited transfers of payments upon default or upon a merger, 
acquisition, or transfer of all assets.
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    Furthermore, for swaps executed after the clearing requirement is 
in place, the Commission also believes it is important to clarify that 
a change in ownership may result in a requirement to clear. For 
example, a financial entity and an end user under section 2(h)(7) of 
the CEA enter into a swap that is not required to be cleared, and later 
if the end user transfers its ownership interest in the swap to another 
party that is a financial entity not eligible to claim an exception 
under section 2(h)(7), then the swap would be required to be cleared if 
the other prerequisites to the requirement exist.

E. Regulation 50.5: Clearing Transition Rules

    As proposed, Sec.  50.5 would codify section 2(h)(6) of the CEA. 
Under proposed Sec.  50.5(a), swaps that are part of a class described 
in Sec.  50.4 but were entered into before the enactment of the Dodd-
Frank Act would be exempt from clearing so long as the swap is reported 
to an SDR pursuant to Sec.  44.02 and section 2(h)(5)(A) of the CEA. 
Similarly, under proposed Sec.  50.5(b), swaps entered

[[Page 74317]]

into after the enactment of the Dodd-Frank Act but before the 
application of the clearing requirement would be exempt from the 
clearing requirement if reported pursuant to Sec.  44.03 and section 
2(h)(5)(B) of the Act.
    LCH suggested that the Commission change the citations in Sec.  
50.5(a) from Sec.  44.02 to Sec.  46.3, and in Sec.  50.5(b) from Sec.  
44.03 to Sec.  45.3 for swaps entered after the enactment of the Dodd-
Frank Act but prior to the compliance date for reporting to an SDR and 
to Sec.  45.3 for swaps entered into after the compliance date for SDR 
reporting but prior to the application of a clearing requirement. The 
Commission agrees with LCH and is modifying the rule to provide more 
accurate cross references to parts 45 and 46. In addition, under Sec.  
50.5(b), the Commission cross references Sec.  46.3 or Sec.  45.3, as 
appropriate, because until April 2013, certain market participants may 
properly rely on Sec.  46.3 for reporting swaps executed after the 
enactment of the Dodd-Frank Act.

F. Regulation 50.6: Delegation of Authority

    Under proposed Sec.  50.6(a), the Commission would delegate to the 
Director of the Division of Clearing and Risk, or the Director's 
designee, with the consultation of the General Counsel or the General 
Counsel's designee, the authority to determine whether a swap falls 
within a class of swaps described in Sec.  50.4 and to communicate such 
a determination to the relevant DCOs.
    ICE supported the Commission's proposal and agreed that this 
approach would allow DCOs to add new swaps in a timely and efficient 
manner and rely on the DCOs' risk management processes and governance 
for adding new products to an existing class. Citadel also supported 
the proposed delegation provision based on the view that the Commission 
carefully oversees DCO risk management and it is beneficial to move 
products into clearing without excessive delay. LCH generally supported 
the Commission's proposal, but requested confirmation that if the DCO 
makes a material change to an existing type of swap, the Commission 
would follow the full clearing requirement determination process.
    By contrast, ISDA objected to proposed Sec.  50.6 based on a 
concern that the Commission would be delegating the clearing 
determination for DCO product expansions to the DCOs themselves, which 
would contradict the requirement that the Commission review each DCO 
submission under section 2(h)(2)(B)(iii)(II) of the CEA. Based on the 
breadth of the swaps classes under Sec.  50.4, ISDA commented that DCOs 
will be able to add new swaps under the clearing requirement without 
review by the Commission under the five statutory factors. ISDA 
recommended that the delegation provision be supplemented to include 
(1) a requirement that new DCO product offerings raise no materially 
different considerations regarding the Commission's determination; (2) 
a public comment period; and (3) a compliance phase-in period of 90 
days.
    In response to LCH's request for clarification, the Commission 
confirms that if a DCO makes a material change to an existing type of 
swap, the Commission would follow the full clearing requirement 
determination process. Under the example provided by LCH--extending the 
tenor of swaps clearing--the DCO's change would require a change to the 
rule text under Sec.  50.4, which would require Commission action.
    In response to ISDA's comments, the Commission observes that the 
proposed delegation provision was not intended to displace Commission 
review under section 2(h)(2)(B)(iii)(II) of the CEA. With respect to 
swaps within the classes identified in Sec.  50.4 that are already 
being cleared by at least one DCO, the delegation provision will 
facilitate other DCOs' ability to offer new swaps for required clearing 
so long as those swaps fall within one of the classes previously 
established by the Commission. With respect to swaps that meet the 
specifications identified in Sec.  50.4, but have not been previously 
offered for clearing by any DCO, the Commission agrees with ISDA that 
the delegation is limited to those swaps that are consistent with the 
prior determination. For instance, if a new swap falls within a class 
under Sec.  50.4, but clearing the swap requires that DCOs adopt a new 
margining methodology or pricing methodology, the Commission would 
subject that swap to a new clearing requirement determination 
process.\154\ Accordingly, the Commission is modifying the rule to 
limit the delegation authority to those instances where the newly 
submitted swap falls within the class under Sec.  50.4 and is 
consistent with the Commission's clearing requirement determination for 
that class of swaps. In addition, the Commission is modifying the rule 
to require that the Director of the Division of Clearing and Risk 
notify the Commission prior to exercising any authority delegated under 
Sec.  50.6.
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    \154\ Without this delegation process a new swap that falls 
within a class under Sec.  50.4 could have automatically been 
included in the clearing requirement without review. The delegation 
provision provides a check on that process.
---------------------------------------------------------------------------

    The Commission declines to adopt ISDA's other recommendations. 
Provided that inclusion of the new swaps under Sec.  50.4 is consistent 
with the Commission's previous clearing requirement determination, 
there is no need for an additional public comment period beyond that 
provided for as part of the initial clearing requirement determination 
process. Moreover, under the CEA and Commission regulation, any 
counterparty to a swap can apply for a stay of the clearing 
requirement.\155\ This stay provision would serve to notify the 
Commission of objections to inclusion of a particular swap in a 
previously-defined class. In addition, the Commission does not believe 
that an additional phase-in period is necessary. Provided that 
including the new swap is consistent with the prior determination, the 
compliance phasing for the original class will afford sufficient time 
for operational and systems implementation. If such time had not been 
sufficient, the Director of the Division of Clearing and Risk could 
submit the matter to the Commission for its consideration, or the 
Commission could itself exercise the delegated authority, under Sec.  
50.6(b).
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    \155\ See section 2(h)(3) of the CEA and regulation 39.5(d).
---------------------------------------------------------------------------

G. Regulation 50.10: Prevention of Evasion of the Clearing Requirement 
and Abuse of an Exception or Exemption to the Clearing Requirement

    The Commission proposed Sec.  50.10 under the rulemaking authority 
in sections 2(h)(4)(A), 2(h)(7)(F), and 8a(5) of the CEA. Proposed 
Sec.  50.10 would prohibit evasions of the requirements of section 2(h) 
of the CEA and abuse of any exemption or exception to the requirements 
of section 2(h), including the end-user exception or any other 
exception or exemption that the Commission may provide by rule, 
regulation, or order.\156\
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    \156\ As noted in the proposing release, the Commission 
preliminarily viewed evasion of the clearing requirement and abuse 
of an exemption or exception to the clearing requirement, including 
the end-user exception, to be related concepts and are informed by 
new enforcement authority under the Dodd-Frank Act, which added new 
sections 6(e)(4)-(5), and 9(a)(6), to the CEA. See Proposed Clearing 
Requirement Determination, 77 FR 47170, 47207 (Aug. 7, 2012).
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    Proposed Sec.  50.10(a) would make it unlawful for any person to 
knowingly or recklessly evade, participate in, or facilitate an evasion 
of any of the requirements of section 2(h).\157\ This

[[Page 74318]]

would apply to any requirement under section 2(h) of the CEA or any 
Commission rule or regulation promulgated thereunder.\158\ In the 
proposing release, the Commission noted, however, that section 
2(h)(1)(A) of the CEA provides that it ``shall be unlawful for any 
person to engage in a swap unless that person submits such swap for 
clearing'' to a DCO if the swap is required to be cleared. Unlike the 
knowing or reckless standard under proposed Sec.  50.10(a), section 
2(h)(1)(A) imposes a non-scienter standard on swap market 
participants.\159\
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    \157\ Proposed Sec.  50.10(a) was informed by and consistent 
with section 6(e)(4) and (5) of the CEA, which states that any DCO, 
swap dealer, or major swap participant that ``knowingly or 
recklessly evades or participates in or facilitates an evasion of 
the requirements of section 2(h) shall be liable for a civil 
monetary penalty in twice the amount otherwise available for a 
violation of section 2(h).''
    \158\ These requirements include the clearing requirement under 
section 2(h)(1), reporting of data under section 2(h)(5), and the 
trade execution requirement under section 2(h)(8), among other 
requirements. For example, it would be a violation of proposed Sec.  
50.10(a) for a SEF to knowingly or recklessly evade or participate 
in or facilitate an evasion of the trade execution requirement under 
section 2(h)(8).
    \159\ Any person engaged in a swap that would be required to be 
cleared under section 2(h) and Part 50 of the Commission's 
Regulations, and such person did not submit the swap for clearing, 
absent an exemption or exception, would be subject to a Commission 
enforcement action regardless of whether the person knowingly or 
recklessly failed to submit the swap for clearing.
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    Proposed Sec.  50.10(b) would make it unlawful for any person to 
abuse the end-user exception to the clearing requirement as provided 
under section 2(h)(7) of the CEA and Sec.  39.6 (now Sec.  50.50).\160\ 
The proposing release stated that an abuse of the end-user exception to 
the clearing requirement may also, depending on the facts and 
circumstances, be an evasion of the requirements of section 2(h). The 
Commission's preliminary view was informed by section 9(a)(6) of the 
CEA, which cross-references both the prevention of evasion authority in 
section 2(h)(4) and prevention of abuse to the exception to the 
clearing requirement in section 2(h)(7)(F).\161\ Thus, the Commission 
proposed to interpret a violation of section 9(a)(6) of the CEA to also 
be a violation of proposed Sec.  50.10(b).
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    \160\ See End-User Exception to the Clearing Requirement for 
Swaps, 77 FR 42560 (July 19, 2012).
    \161\ Proposed Sec.  50.10(b) is adopted under the authority in 
both section 2(h)(4)(A) and section 2(h)(7)(F).
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    Proposed Sec.  50.10(c) would make it unlawful for any person to 
abuse any exemption or exception to the requirements of section 2(h) of 
the CEA, including any exemption or exception, as the Commission may 
provide by rule, regulation, or order.\162\
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    \162\ This provision was informed by the Dodd-Frank Act 
amendments in section 2(h)(4)(A) to prescribe rules necessary to 
prevent evasions of the clearing requirements; section 2(h)(7)(F) to 
prescribe rules necessary to prevent abuse of the exceptions to the 
clearing requirements; and the Commission's general rulemaking 
authority in section 8a(5) to promulgate rules that, in the judgment 
of the Commission, are reasonably necessary to accomplish any 
purposes of the CEA.
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    In the preamble to the NPRM, the Commission proposed to adopt a 
``principles-based'' approach to applying proposed Sec.  50.10 and 
declined to provide a bright-line test of non-evasive or abusive 
conduct, because such an approach may be a roadmap for engaging in 
evasive or abusive conduct or activities. The Commission, however, did 
propose additional guidance to provide clarity to market participants. 
The Commission proposed to determine on a case-by-case basis in light 
of all the relevant facts and circumstances, whether particular 
transactions or other activities constitute a violation of Sec.  50.10. 
Similar to its approach in the final rules further defining the term 
``swap'' (the ``Product Definition Rules''), the Commission proposed 
that it would not consider transactions or other activities structured 
in a manner solely motivated by a legitimate business purpose to 
constitute evasion or abuse.\163\
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    \163\ The Commission's discussion of Sec.  50.10 is similar to 
its approach for the anti-evasion rules Sec. Sec.  1.3(xxx)(6) and 
1.6 that it recently adopted in a joint final rulemaking with the 
Securities and Exchange Commission. See Further Definition of 
``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap 
Agreement''; Mixed Swaps; Security-Based Swap Agreement 
Recordkeeping, 77 FR 48208, 48350-48354 (Aug. 13, 2012).
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i. In General
    Four commenters discussed different aspects of proposed Sec.  
50.10, including the standard of intent that proposed Sec.  50.10 
requires and the proposed legitimate business purpose guidance. After 
considering the comments as discussed more fully below, the Commission 
has determined that Sec.  50.10 is necessary to prevent evasion of the 
requirements of section 2(h) and abuses of any exemption or exception 
to the requirements of section 2(h). Therefore, the Commission is 
adopting Sec.  50.10 as proposed, but the Commission is providing 
additional interpretive guidance regarding Sec.  50.10 as set out 
below.
ii. Standard of Intent
    Two commenters discussed the relevant standard of intent for 
proposed Sec.  50.10. ISDA commented that Sec.  50.10(a), (b), and (c) 
should be governed by a single standard of intent. ISDA noted that 
proposed Sec.  50.10(a) would make it unlawful for any person to 
``knowingly or recklessly'' evade the requirements of section 2(h); 
whereas, proposed Sec.  50.10(b) and (c) would make it unlawful to 
``abuse'' exceptions or exemptions to the requirements of section 2(h). 
ISDA requested the Commission clarify that all three provisions are 
subject to a scienter standard.
    FreddieMac commented that the statutory ``knowing or reckless'' 
standard for evasion indicates that Congress intended that parties to a 
swap should be deemed in compliance with the clearing requirement at 
least where they have submitted a swap for clearing in good faith and 
have a reasonable expectation of clearing.
    In consideration of the comments, the Commission clarifies that it 
interprets the ``knowingly or recklessly'' standard in Sec.  50.10(a) 
to be the same as the ``abuse'' standard in Sec.  50.10(b) and (c). The 
Commission believes that a ``knowingly or recklessly'' standard is 
consistent with and an appropriate standard of intent for any ``abuse'' 
of any exemption or exception to the requirements of section 2(h). 
Additionally, the purpose of Sec.  50.10 is to prevent evasion of the 
requirements under section 2(h) or to prevent an abuse of an exception 
or exemption to the requirements under section 2(h). Therefore, the 
Commission confirms that it would not constitute a violation of Sec.  
50.10 where a party submits a swap for clearing in good faith and the 
party has a reasonable expectation of clearing.
iii. Legitimate Business Purpose
    Four commenters discussed the proposed guidance on what constitutes 
a legitimate business purpose. TriOptima supported the proposed 
principles-based approach to prevent evasion and the proposed guidance. 
TriOptima also requested the Commission clarify that activities and 
transactions carried out for the purpose of reducing counterparty 
credit risk constitute a legitimate business purpose.
    FreddieMac commented that the proposing release creates ambiguity 
as to the circumstances in which a swap is required to be submitted for 
clearing. In particular, FreddieMac commented that the NPRM appears to 
represent the Commission's view that swaps that differ in regard to 
``mechanical'' terms may be sufficiently close substitutes such that 
parties may be required to use such a ``substitute swap'' (where one is 
available) that is subject to a clearing

[[Page 74319]]

requirement.\164\ FreddieMac asserted that the Commission should not 
pre-judge when a swap that is required to be cleared is a close 
substitute for a swap that is not subject to a clearing requirement. 
Furthermore, FreddieMac commented that the Commission should clarify 
that a swap that would otherwise be required to be cleared but for a 
variation in one or more material contract terms should not also be 
required to be submitted for clearing, provided that such variation of 
the terms is for legitimate business purposes.
---------------------------------------------------------------------------

    \164\ See NRPM at 47191, fn. 97 (discussing a category of 
interest rate swap specifications ``that are commonly used to 
address mechanical issues'').
---------------------------------------------------------------------------

    In response to the proposed guidance, ISDA asserted that the 
Commission did not clearly respond to its comment to the Product 
Definition Rules that variations based on considerations of the costs 
and burdens of regulation should be considered to have a legitimate 
business purpose.\165\ ISDA requested the Commission clarify that if a 
business has a choice, in the absence of fraud, deceit, or unlawful 
activity, of entering into an uncleared swap, rather than a cleared 
swap, ``because [the uncleared swap] is cheaper, or free of unwanted 
aspects of clearing or trading, then that choice should be identified 
by the Commission as legitimate.'' ISDA also asserted that presence of 
fraud, deceit, or unlawful activity is a proper prerequisite to evasion 
or abuse violations. Furthermore, ISDA argued that market participants 
will be subject to constant uncertainty when structuring and 
transacting in markets that offer legitimate alternatives if the 
proposal were adopted.
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    \165\ See Product Definition Rules, 77 FR at 48302, fn. 1052.
---------------------------------------------------------------------------

    The Commission is guided by the central role that clearing plays 
under the Dodd-Frank Act. As noted in the proposing release, ``the 
requirement that swaps be cleared by DCOs is one of the cornerstones of 
that reform.'' \166\ But even given the importance of central clearing 
as a means to mitigate counterparty credit risk, reduce systemic risk, 
and protect U.S. taxpayers, the Commission accepts that a person may 
have legitimate business purposes for entering into swaps that are not 
subject to the clearing requirement.
---------------------------------------------------------------------------

    \166\ NPRM at 47171.
---------------------------------------------------------------------------

    In that regard, commenters requested that the Commission confirm 
that considering the costs and burdens of regulation, or reduction of 
counterparty credit risk, are legitimate business purposes. As stated 
in the proposing release, the Commission will not provide a bright-line 
test of non-evasive or abusive conduct because such an approach may be 
a roadmap for engaging in evasive or abusive conduct or 
activities.\167\ The Commission expects, however, that a person acting 
for legitimate business purposes will naturally weigh many costs and 
benefits associated with different transactions, including different 
swap classes and swap specifications that may or may not be subject to 
the clearing requirement. Therefore, the Commission clarifies that a 
person's specific consideration of, for example, costs or regulatory 
burdens, including the avoidance thereof, is not, in and of itself, 
dispositive that the person is acting without a legitimate business 
purpose in a particular case.\168\ The Commission will view legitimate 
business purpose considerations on a case-by-case basis in conjunction 
with all other relevant facts and circumstances.
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    \167\ NPRM at 47207.
    \168\ Examples described in the guidance are illustrative and 
not exhaustive of the conduct or activities that could be considered 
evasive or abusive. In considering whether conduct or activities is 
evasive or abusive, the Commission will consider the facts and 
circumstances of each situation.
---------------------------------------------------------------------------

    In the context of the clearing requirement and Sec.  50.10(a), 
however, the Commission does not believe it would be sufficient to 
satisfy the legitimate business purpose test where a person's principal 
purpose of entering into a swap that is not subject to the clearing 
requirement is to circumvent the costs of clearing.\169\ Circumventing 
the costs of clearing may be a consideration, but cannot be the 
principal consideration in order to satisfy the legitimate business 
purpose test. The Commission notes ISDA's comment regarding evasion, 
and the Commission has determined that to permit such an outcome would 
create an exception that would swallow the rule and could render the 
central clearing objectives and benefits under the Dodd-Frank Act 
meaningless. Moreover, section 2(h)(4)(A) requires the Commission 
prescribe the rules that the Commission determines ``to be necessary to 
prevent evasions of the mandatory clearing requirements,'' \170\ which 
evinces Congress's concern that evasion of the clearing requirement 
would undermine a central purpose of the Dodd-Frank Act. As noted 
above, the Commission determines that the proposed rules are necessary 
to prevent evasions of the mandatory clearing requirements, and is 
therefore adopting them.
---------------------------------------------------------------------------

    \169\ ISDA also requested clarification that avoiding ``unwanted 
aspects of clearing or trading'' should be considered to be a 
legitimate business purpose. ISDA did not specify what it means by 
``unwanted aspects,'' nor did it explain how avoiding aspects of 
clearing or trading could be distinguished from evasion. 
Accordingly, the Commission is declining to include this concept as 
part of its guidance regarding legitimate business purposes.
    \170\ Section 2(h)(4)(A) of the CEA, 7 U.S.C. 2(h)(4)(A).
---------------------------------------------------------------------------

    Furthermore, the Commission believes that this standard will not 
subject market participants to significant uncertainty, and the 
benefits of central clearing will outweigh the costs and burdens of any 
such uncertainty. In response to Freddie Mac's comment regarding the 
Commission discussion of ``mechanical'' specifications in the NPRM, 
that discussion served only to explain the Commission's decision not to 
include those specifications in the set of class-defining 
specifications identified by the Commission for its class-based 
clearing requirement determination. The Commission is not pre-judging 
whether a swap that contains non class-defining specifications that are 
not accepted by a DCO would constitute evasion. The Commission 
recognizes that including such specifications in a swap could serve a 
legitimate business purpose if, for example, such specifications would 
legitimately result in a more accurate hedge of a business risk. In 
keeping with the Commission's guidance that it will use a principles-
based approach, assessing whether any particular swap that includes 
such terms would constitute evasion will be done on a case-by-case 
basis in light of all the relevant facts and circumstances.
    Finally, the Commission declines to adopt ISDA's suggestion that 
the presence of fraud, deceit, or other unlawful activity is a 
prerequisite to establishing a violation of evasion or abuse under 
Sec.  50.10. Although it is likely that fraud, deceit, or unlawful 
activity will be present where knowing or reckless evasion or abuse has 
occurred, the Commission does not believe that these factors are 
prerequisites to a violation of Sec.  50.10. Rather, the presence or 
absence of fraud, deceit, or unlawful activity is one circumstance the 
Commission will consider when evaluating a person's conduct or 
activities.

IV. Implementation

    The Commission proposed to require compliance with the clearing 
requirement for the classes of swaps identified in proposed Sec.  50.4 
according to the compliance schedule contained in

[[Page 74320]]

Sec.  50.25.\171\ Under this schedule, compliance with the clearing 
requirement would be phased by type of market participant entering into 
a swap subject to the clearing requirement.
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    \171\ 17 CFR 50.25, Swap Transaction Compliance and 
Implementation Schedule: Clearing Requirement Under Section 2(h) of 
the CEA, 77 FR 44441 (July 30, 2012). Regulation 50.25 defines the 
terms Category 1 Entity and Category 2 Entity; this release uses the 
term Category 3 Entity to refer to counterparties to swaps falling 
under Sec.  50.25(b)(3).
---------------------------------------------------------------------------

    The Commission received no comments specifically addressing the use 
of Sec.  50.25. Vanguard recommended that the Commission should not 
implement mandatory clearing for any swaps until market participants 
have time to negotiate and execute all necessary documentation. 
Vanguard recommended the Commission delay compliance with the clearing 
requirement until six months after August 29, 2012, the date on which 
ISDA and FIA published a standard form of the futures agreement 
addendum for cleared swaps, i.e., February 28, 2013. SIFMA AMG also 
expressed concern about legal documentation and negotiations taking 
many months, and the difficulty buy-side clients face in finding FCMs 
to clear for them. SIFMA AMG also recommended the clearing requirement 
be delayed for six months.
    In response to Vanguard's and SIFMA AMG's comments and light of the 
circumstances discussed below, compliance with the clearing requirement 
will not be required for any swaps until March 11, 2013. This extension 
of at least 6 months beyond publication of the FIA-ISDA clearing 
addendum applies to all market participants and addresses Vanguard's 
and SIFMA AMG's concerns about documentation. The Commission accounted 
for precisely this type of documentation issue in its adoption of Sec.  
50.25. Accordingly, Category 2 Entities and Category 3 Entities have 90 
and 180 days beyond March 11, 2013, to come into compliance with the 
new clearing requirement, which is well beyond the six months from 
August 29, 2012, as requested by Vanguard and SIFMA AMG. The Commission 
also notes that any market participant may petition for relief under 
Sec.  140.99 if that entity is unable to find an FCM to clear its swaps 
or if it needs additional time to complete requisite 
documentation.\172\
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    \172\ 17 CFR 140.99 sets for the process for addressing requests 
for exemptive, no-action, and interpretative letters.
---------------------------------------------------------------------------

    On September 10, 2012, the Commission clarified the timing of its 
swap dealer registration rules. The swap dealer registration 
regulations go into effect on October 12, 2012, and entities that have 
more than the de minimis level of dealing (swaps entered into after 
October 12) must register by no later than two months after the end of 
the month in which they surpass the de minimis level. By way of 
example, if an entity reaches $8 billion in swap dealing the day after 
October 12, then the entity would have to register within two months 
after the end of October, or by December 31, 2012.
    Given that swap dealers will not be required to register until the 
end of the year, and in light of requests for clarification regarding 
the application of Sec.  50.25, the Commission is clarifying that swaps 
executed prior to specific compliance dates set forth below are not 
subject to the clearing requirement.
    To promote certainty for market participants, the Commission is 
setting specific dates for compliance. Accordingly, the requirement for 
Category 1 Entities to begin clearing will commence on Monday, March 
11, 2013, for swaps they enter into on or after that date. Category 2 
Entities are required to clear swaps beginning on Monday, June 10, 
2013, for swaps entered into on or after that date, and Category 3 
Entities would be required to clear swaps beginning on Monday, 
September 9, 2013, for swaps entered into on or after that date.
    For example, no swap executed between two Category 1 Entities prior 
to March 11, 2013, is required to be cleared. In other words, Category 
1 Entities entering into swaps falling within one of the classes 
identified in Sec.  50.4 on or after March 11, 2013, are required to 
clear those swaps. Category 2 Entities must begin clearing swaps 
pursuant to the new clearing requirement on or after June 10, 2013, and 
Category 3 Entities must begin clearing such swaps if they are entered 
into on or after the September 9, 2013.
    The above schedule will apply to compliance with required clearing 
for iTraxx. However, if no DCO has begun offering client clearing for 
iTraxx by February 11, 2013, then compliance with the required clearing 
of iTraxx will commence sixty days after the date on which iTraxx is 
first offered for client clearing by an eligible DCO. If an eligible 
DCO offers client clearing for iTraxx on or before September 9, 2013, 
the following phased implementation schedule will apply: Category 1 
Entities are required to clear iTraxx indices entered into on or after 
the date 60 days after the date on which iTraxx is first offered for 
client clearing by an eligible DCO; Category 2 Entities are required to 
clear iTraxx entered into on or after the date 150 days after the date 
on which iTraxx is first offered for client clearing by an eligible 
DCO; and Category 3 Entities are required to clear iTraxx entered into 
on or after the date 240 days after the date on which iTraxx is first 
offered for client clearing by an eligible DCO. There will be no 
phasing of compliance if an eligible DCO offers client clearing for 
iTraxx after September 9, 2013. Rather, all three categories of market 
participants will be expected to come into compliance by 60 days after 
the date on which iTraxx is first offered for client clearing by an 
eligible DCO.
    This clarification avoids the possibility that Active Funds that 
are included in Category 1 Entities would be required to clear before 
swap dealers, and provides market participants with certainty as to 
when they must begin clearing swaps.
    With regard to Active Funds, in order to promote orderly 
implementation of part 23 and the part 50 rules, both of which refer to 
Active Funds, the Commission is harmonizing the annual calculation 
period for both implementation of part 23's swap trading relationship 
documentation requirements under Sec.  23.504 \173\ and the clearing 
requirement compliance schedule under Sec.  50.25. For purposes of 
implementing Sec.  23.504, the Commission defined an Active Fund, as 
any private fund as defined in section 202(a) of the Investment 
Advisers Act of 1940, that is a not a third party subaccount and that 
executes 200 or more swaps per month based on a monthly average over 
the 12 months preceding the adopting release, i.e., September 11, 
2012.\174\ For purposes of Sec.  50.25, the Commission defined Active 
Fund in the same manner except that the monthly average over the 12 
months would be preceding the date of publication of the clearing 
requirement determination in the Federal Register, i.e., whatever date 
this adopting release is published.\175\ Market participants have asked 
the Commission to harmonize these two dates so that there will be one 
self-identified list of Active Funds for purposes of both 
implementation schedules under parts 23 and 50. The Commission agrees 
with this approach and is modifying both compliance schedules to 
require private funds to calculate the number of swaps they enter into 
as a monthly average

[[Page 74321]]

over the past 12 months preceding November 1, 2012.
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    \173\ Confirmation, Portfolio Reconciliation, Portfolio 
Compression, and Swap Trading Relationship Documentation 
Requirements for Swap Dealers and Major Swap Participants, 77 FR 
55904 (Sept. 11, 2012).
    \174\ See 77 FR at 55940.
    \175\ See Swap Transaction Compliance and Implementation 
Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR 
at 44456.
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    In addition, the Commission clarifies that for purposes of 
calculating the number of swaps a fund executes as a monthly average 
over the 12 months preceding November 1, 2012, for both part 23 and 
part 50, private funds as defined in section 202(a) of the Investment 
Advisers Act of 1940 are not required to include foreign exchange 
swaps, in light of the final determination from the Secretary of the 
Treasury to exempt such swaps from the CEA.\176\
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    \176\ See http://www.treasury.gov/press-center/press-releases/Documents/11-16-2012%20FX%20Swaps%20Determination%20pdf.pdf 
(finalizing Determinations of Foreign Exchange Swaps and Forwards, 
75 FR 66829 (Oct. 28, 2010)).
---------------------------------------------------------------------------

    Finally, ISDA commented that the inter-affiliate exemption should 
be finalized prior to requiring compliance with the clearing 
requirement. The Commission has proposed its inter-affiliate exemption 
rules \177\ and anticipates that it will finalize those rules prior to 
the aforementioned compliance dates for these clearing requirement 
determinations.
---------------------------------------------------------------------------

    \177\ Clearing Exemption for Swaps Between Certain Affiliated 
Entities, 77 FR 50425 (Aug. 21, 2012).
---------------------------------------------------------------------------

V. Cost-Benefit Considerations

A. Statutory and Regulatory Background

    As discussed in the NPRM, and above, certain OTC derivatives, such 
as credit default swaps (CDS) played a prominent role in the financial 
crisis in the fall of 2008, highlighting the risk that opaque OTC 
markets can create for the financial system by linking together 
financial institutions in ways that are not well-understood.\178\ The 
failure to adequately collateralize the risk exposures posed by OTC 
derivatives, along with the contagion effects of the vast web of 
uncollateralized counterparty credit risk, led many to conclude that 
OTC derivatives should be centrally cleared.
---------------------------------------------------------------------------

    \178\ 77 FR 47170 (Aug. 7, 2012). See also Section I.B above.
---------------------------------------------------------------------------

    A fundamental premise of the Dodd-Frank Act is that the use of 
properly functioning central clearing can reduce systemic risk. 
Congress included the statutory clearing requirement in the Dodd-Frank 
amendments to the CEA to standardize and reduce counterparty risk 
associated with swaps, and, in turn, mitigate the potential systemic 
impact of such risks and reduce the likelihood for swaps to cause or 
exacerbate instability in the financial system. The clearing 
requirement determinations and regulations contained in this adopting 
release identify certain classes of swaps that are required to be 
cleared pursuant to the Dodd-Frank Act's \179\ clearing requirement 
incorporated within amended section 2(h)(1)(A) of the CEA.\180\
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    \179\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, 124 Stat. 1376 (2010).
    \180\ This section states: ``It shall be unlawful for any person 
to engage in a swap unless that person submits such swap for 
clearing to a derivatives clearing organization that is registered 
under this Act or a derivatives clearing organization that is exempt 
from registration under this Act if the swap is required to be 
cleared.''
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    The Commission's regulations establishing the process for the 
review of swaps that are submitted for a mandatory clearing 
determination are found in Part 39 of the Commission's regulations. 
Regulation 39.5 provides an outline for the Commission's review of 
swaps for required clearing.\181\ Regulation 39.5 requires the 
Commission to review all swaps submitted by DCOs or those swaps that 
the Commission opts to review on its own initiative.\182\ Under section 
2(h)(2)(D) of the CEA, in reviewing swaps for required clearing, the 
Commission must take into account the following factors: (1) 
Significant outstanding notional exposures, trading liquidity and 
adequate pricing data, (2) the availability of rule framework, 
capacity, operational expertise and credit support infrastructure, (3) 
the effect on the mitigation of systemic risk, (4) the effect on 
competition and (5) the existence of reasonable legal certainty in the 
event of the insolvency of the DCO or one or more of its clearing 
members.\183\ Regulation 39.5 also directs DCOs to provide to the 
Commission other information, such as product specifications, 
participant eligibility standards, pricing sources, risk management 
procedures, a description of the manner in which the DCO has provided 
notice of the submission to its members and any additional information 
requested by the Commission. This information is designed to assist the 
Commission in identifying those swaps that are required to be cleared.
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    \181\ 76 FR 44464 (July 26, 2011).
    \182\ See Sec.  39.5(b), Sec.  39.5(c). Under section 
2(h)(2)(B)(ii) of the CEA, ``[a]ny swap or group, category, type, or 
class of swaps listed for clearing by a [DCO] as of the date of 
enactment shall be considered submitted to the Commission.''
    \183\ Section 2(h)(2)(D) of the CEA and Sec.  39.5(b)(ii).
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    On February 1, 2012, Commission staff sent a letter requesting that 
registered DCOs submit all swaps that they were accepting for clearing 
as of that date, pursuant to Sec.  39.5 of the Commission's 
regulations. The Commission received submissions relating to CDS and 
interest rate swaps, as well as agricultural and energy swaps.
    This initial Commission determination addresses certain interest 
rate swaps and CDS, and is the first of a series of determinations that 
the Commission anticipates making as part of a phased approach to 
implementing mandatory clearing. The Commission chose to issue its 
first clearing requirement proposal for interest rate swaps and CDS 
because those swaps represent a significant share of the market in the 
case of interest rate swaps, and pose a unique risk profile in the case 
of CDS. In addition, the market has been clearing both types of swaps 
for some time, and market participants asked that the Commission begin 
with interest rate swaps and CDS. The Commission intends subsequently 
to consider other swaps submitted by DCOs, such as agricultural, 
energy, and equity indices.
    As stated in both the NPRM and above, the decision to initially 
focus on CDS and interest rate swaps from amongst the swaps submitted 
to the Commission for mandatory clearing determinations pursuant to 
section 2(h)(2) is a function of both the market importance of these 
swaps and the fact that they already are widely cleared. In order to 
move the largest number of swaps to required clearing in its initial 
determinations, the Commission believes that it is prudent to focus on 
those swaps that have the highest market shares and market impact. 
Further, for these swaps there is already a blueprint for clearing and 
appropriate risk management. CDS and interest rate swaps fit these 
considerations and therefore are well suited for required clearing 
consideration.\184\ In the discussion that follows, the importance of 
central clearing is explained and highlighted to provide the background 
for the Commission's consideration of the costs and benefits in this 
rulemaking as the Commission exercises its discretion under section 
2(h)(2)(D) of the CEA to determine whether swaps that are submitted for 
a mandatory clearing determination are required to be cleared.
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    \184\ 77 FR 47172 (August 7, 2012). See also Section I.F above.
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B. Overview of Swap Clearing

    The following background discussion provides context for the 
Commission's consideration of the costs and benefits of its clearing 
determinations in this rulemaking.

[[Page 74322]]

i. How Clearing Reduces Risk
    When a bilateral swap is cleared, the clearinghouse becomes the 
counterparty to each of the original counterparties to the swap. This 
standardizes counterparty credit risk for the original swap 
participants in that they each bear the same risk--i.e., the risk 
attributable to facing the clearinghouse as counterparty. In addition, 
clearing mitigates counterparty risk to the extent that the 
clearinghouse is a more creditworthy counterparty relative to the 
original swap participants. Clearinghouses have demonstrated resilience 
in the face of past market stress. Most recently, they remained 
financially sound and effectively settled positions in the midst of 
turbulent events in 2007-2008 that threatened the financial health and 
stability of many other types of entities.
    Given the variety of effective clearinghouse tools to monitor and 
manage counterparty credit risk, the Commission believes that DCOs will 
continue to be some of the most creditworthy counterparties in the swap 
markets. These tools include the contractual right to: (1) Collect 
initial and variation margin associated with outstanding swap 
positions; (2) mark positions to market regularly (usually one or more 
times per day) and issue margin calls whenever the margin in a 
customer's account has dropped below predetermined levels set by the 
DCO; (3) adjust the amount of margin that is required to be held 
against swap positions in light of changing market circumstances, such 
as increased volatility in the underlying; and (4) close out the swap 
positions of a customer that does not meet margin calls within a 
specified period of time.
    Moreover, in the event that a clearing member defaults on their 
obligations to the DCO, the latter has a number of remedies to manage 
associated risks, including transferring the swap positions of the 
defaulted member, and covering any losses that may have accrued with 
the defaulting member's margin and other collateral on deposit. In 
order to transfer the swap positions of a defaulting member and manage 
the risk of those positions while doing so, the DCO has the ability to: 
(1) Hedge the portfolio of positions of the defaulting member to limit 
future losses; (2) partition the portfolio into smaller pieces; (3) 
auction off the pieces of the portfolio, together with their 
corresponding hedges, to other members of the DCO; and (4) allocate any 
remaining positions to members of the DCO. In order to cover the losses 
associated with such a default, the DCO would typically draw from (in 
order): (1) The initial margin posted by the defaulting member; (2) the 
guaranty fund contribution of the defaulting member; (3) the DCO's own 
capital contribution; (4) the guaranty fund contribution of non-
defaulting members; and (5) an assessment on the non-defaulting 
members. These mutualized risk mitigation capabilities are largely 
unique to clearinghouses, and help to ensure that they remain solvent 
and creditworthy swap counterparties even when dealing with defaults by 
their members or other challenging market circumstances.
ii. Movement of Swaps Into Clearing
    There is significant evidence that some parts of the OTC swap 
markets (the interest rate swaps and CDS markets in particular) have 
been migrating into clearing over the last number of years in response 
to market incentives as well as in anticipation of the Dodd-Frank Act's 
clearing requirement. LCH data, for example, shows that the outstanding 
volume of interest rate swaps cleared by LCH has grown steadily since 
at least November 2007, as has the monthly registration of new trade 
sides.\185\ Data provided to the Commission shows that the notional 
amount of cleared interest rate swaps is approximately $72 trillion as 
of January 2007, and just over $236 trillion in September 2010, an 
increase of 228% in three and a half years.\186\ Together, those facts 
indicate increased demand for LCH clearing services related to interest 
rate swaps, a portion of which preceded the Dodd-Frank Act.\187\ Data 
available through CME and TriOptima indicate similar patterns of 
growing demand for interest rate swap clearing services, although their 
publically available data does not provide a picture of demand prior to 
the passage of the Dodd-Frank Act.\188\
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    \185\ As a measure of volume, LCH accounts for each swap it 
clears as one trade side, which represents one counterparty to each 
two-sided trade.
    \186\ Data provided to the Commission by LCH. In the context of 
interest rate swaps, the notional amount refers to the specified 
amount on which the exchanged swap payments are calculated. It is a 
nominal amount that is not exchanged between counterparties.
    \187\ See http://www.lchclearnet.com/swaps/volumes/. Since the 
Dodd-Frank Act was passed in July 2010, outstanding trade sides at 
LCH have increased from approximately 1.6 million to 2.3 million in 
September of 2012, an increase of approximately 44%. Indeed, the 
number of new trade sides being submitted for clearing per month 
increased from approximately 55,000 trade sides per month to 150,000 
trade sides per month, an increase of approximately 270%.
    \188\ See http://www.cmegroup.com/trading/interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical-reports.html. Notably, CME launched its interest rate 
swap clearing service in the fall of 2010, after the Dodd-Frank Act 
was passed.
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    In addition to interest rate swap clearing, major CDS market 
participants are clearing their CDS indices and single names in 
significant volumes. As explained above, in 2008, prior to the 
enactment of the Dodd-Frank Act, the Federal Reserve Bank of New York 
(FRBNY) began encouraging market participants to establish a central 
counterparty to clear CDS.\189\ In the past four years CDS clearing has 
grown significantly. As a representation of this growth, CME now has 
initial margin for CDS in excess of $1.8 billion and a guaranty fund of 
approximately $629 million,\190\ and ICE Clear Credit has initial 
margin on deposit for CDS of $10.8 billion and a guaranty fund equal to 
$4.4 billion.\191\ ICE Clear Europe has initial margin for CDS totaling 
$6.8 billion and a guaranty fund of $2.7 billion.\192\
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    \189\ See Federal Reserve Bank of New York, Press Release, ``New 
York Fed Welcomes Further Industry Commitments on Over-the-Counter 
Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which 
references documents prepared by market participants describing the 
importance of clearing. See also Ciara Linnane and Karen Brettell, 
``NY Federal Reserve pushes for central CDS counterparty,'' Reuters, 
Oct. 6, 2008.
    \190\ See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME's guaranty fund, 
posted as of May 10, 2012.
    \191\ See https://www.theice.com/clear_credit.jhtml for data on 
the size of guaranty fund, posted as of May 10, 2012.
    \192\ Id. The data is not adequate to enable the Commission to 
determine how much of the movement into clearing is attributable to 
natural market forces or anticipated requirements under the Dodd-
Frank Act.
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iii. The Clearing Requirement and Role of the Commission
    In the Dodd-Frank Act, Congress directed that clearing shift from a 
voluntary practice to a mandatory practice for certain swaps and gave 
the Commission responsibility for determining which swaps would be 
required to be cleared. Under section 2(h)(2) of the CEA, the 
Commission is required to review each swap, or group, category, type, 
or class of swaps that a DCO clears and submits to the Commission in 
order to determine whether the submitted swaps are required to be 
cleared. In making these clearing determinations and promulgating the 
final rules, the Commission has taken its direction from the statutory 
text and is implementing the statute by determining, in accordance with 
the five factors set forth in the statute, whether swaps submitted to 
the Commission for a mandatory

[[Page 74323]]

clearing determination are required to be cleared. As described above, 
the Commission has decided to initially focus on interest rate swaps 
and CDS because of the market importance of these swaps and the fact 
that they already are widely cleared.
    In determining pursuant to section 2(h)(2)(D) whether these 
particular swaps should be required to be cleared, the Commission has 
taken into account the fact that voluntary clearing of swaps has 
increased over the past years (perhaps due in part to anticipation of 
the clearing requirement to be imposed under the Dodd-Frank Act, but 
perhaps due in part to a realization of the benefits of clearing after 
the financial crisis). These industry efforts and the extent to which 
voluntary clearing of swaps has already occurred provide a useful 
reference point for the Commission's consideration of the costs and 
benefits of its actions in determining whether particular swaps should 
be required to be cleared.\193\
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    \193\ The Commission also recognizes that there might not be a 
linear relationship between the quantity of swaps that are cleared 
(whether measured by number of swaps, the notional value of swaps, 
or some other measure of swap quantity, such as the exposure 
resulting from the swaps) and the costs and benefits resulting from 
clearing. For example, if the Commission were to assume that the 
rule would result in a doubling of the quantity of a certain type of 
swap that is cleared, it would not necessarily be the case that the 
costs and benefits of clearing that type of swap would double. 
Rather, the relationship could be non-linear for a variety of 
reasons (such as variations among the users of that type of swap). 
In fact, it may be reasonable to assume that where the costs of 
clearing are relatively low and the benefits are relatively high, 
market participants already voluntarily clear swaps even in the 
absence of a clearing requirement.
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    In the discussion that follows, the Commission summarizes and 
evaluates the costs and benefits of the new clearing requirements 
resulting from the Commission's clearing determinations in this 
rulemaking. In the context of this relevant statutory provision and 
ongoing industry initiatives, in the sections that follow, the 
Commission also has considered its clearing determinations in light of 
cost-benefit issues raised by commenters and suggested alternatives.
    In general, the Commission believes that the costs and benefits 
related to the required clearing of the classes of interest rate swaps 
and CDS resulting from this rulemaking are attributable, in part to (1) 
Congress's stated goal of reducing systemic risk by, among other 
things, requiring clearing of swaps and the statutory clearing mandate 
in section 2(h) of the CEA to achieve that objective; and (2) the 
Commission's determination under section 2(h)(2)(D) that these 
particular classes of swaps should be required to be cleared. The 
Commission will discuss the costs and benefits of the overall move from 
voluntary clearing to required clearing for the particular swaps 
subject to this new clearing requirement.\194\ However, in so doing, 
the Commission believes that it is not readily ascertainable whether an 
increased use of clearing following such determinations should be 
attributed to statutory or regulatory requirements that particular 
swaps be required to be cleared, as compared to swap market 
participants' market-based decisions to increase the use clearing to 
reduce risks and costs.\195\
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    \194\ Embedded in this approach is the assumption that costs and 
benefits of increased clearing prior to the determination is not a 
function of the Dodd-Frank Act or the clearing determination 
contained herein. As stated above, the Commission acknowledges that 
some increases in clearing that have already occurred are likely the 
result of anticipated clearing requirements. However, it is not 
possible to estimate how much of the increases in clearing are the 
result market forces, and how much is a function of expected 
requirements related to clearing. Both factors have likely 
contributed to the increases in clearing that have occurred prior to 
this rule.
    \195\ It is also possible that some market participants would 
respond to the current rule's requirement that certain types of 
swaps be cleared by decreasing their use of such swaps. This 
possibility contributes to the uncertainty regarding how the current 
rule will affect the volume of swaps that are cleared.
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C. Consideration of the Costs and Benefits of the Commission's Action

i. CEA Section 15(a)
    Section 15(a) of the CEA requires the Commission to consider the 
costs and benefits of its actions before promulgating a regulation 
under the CEA or issuing certain orders. Section 15(a) further 
specifies that the costs and benefits shall be evaluated in light of 
the following five broad areas of market and public concern: (1) 
Protection of market participants and the public; (2) efficiency, 
competitiveness and financial integrity of futures markets; (3) price 
discovery; (4) sound risk management practices; and (5) other public 
interest considerations. Accordingly, the Commission considers the 
costs and benefits resulting from its discretionary determinations with 
respect to the section 15(a) factors.
    As stated above, the Commission received a total of 33 comment 
letters following the publication of the NPRM, many of which strongly 
supported the proposed regulations. Some commenters generally addressed 
the cost-and-benefit aspect of the current rule; none of them, however, 
provided any quantitative data in response to the Commission's requests 
for comment. In the sections that follow the Commission considers: (1) 
Costs and benefits of required clearing for the classes of swaps 
identified in this adopting release; (2) alternatives contemplated by 
the Commission and the costs and benefits relative to the approach 
adopted herein; (3) the impact of required clearing for swaps under the 
identified classes of swaps in light of the 15(a) factors. The 
Commission also discusses the corresponding comments accordingly.
ii. Costs and Benefits of Required Clearing Under the Final Rule
    In order to comply with required clearing under this adopting 
release, market participants are likely to face certain startup and 
ongoing costs relating to technology and infrastructure, new or updated 
legal agreements, ongoing fees from service providers, and costs 
related to collateralization of their positions. The per-entity costs 
related to changes in technology, infrastructure, and legal agreements 
are likely to vary widely, depending on each market participant's 
existing technology infrastructure, legal agreements, operations, and 
anticipated needs in each of these areas. For market participants that 
already use clearing services, some of these costs may be expected to 
be lower, while the opposite will likely be true for market 
participants that must begin to use clearing services only because of 
the new clearing requirement. The costs of collateralization, on the 
other hand, are likely to vary depending on a number of factors, 
including whether an entity is subject to capital requirements or not, 
and the differential between the cost of capital for the assets the 
entity uses as collateral, and the returns the entity realizes on those 
assets.
    There are also significant benefits associated with increased 
clearing, including reducing and standardizing counterparty credit 
risk, increased transparency, and easier access to the swap markets. 
These effects together will contribute significantly to the stability 
and efficiency of the financial system. The Commission lacks data to 
quantify these benefits with any degree of precision. The Commission 
notes, however, that the extraordinary financial system turbulence of 
2008 has had profound and long-lasting adverse effects on the economy, 
and therefore reducing systemic risk provides significant, if 
unquantifiable, benefits.\196\ Also, as is the case for the

[[Page 74324]]

costs related to clearing, these benefits would be relatively less to 
the extent that market participants are already using clearing in the 
absence of a requirement.
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    \196\ For example, the PEW Economic Policy Group estimates total 
costs of the acute stage of the crisis for U.S. interests were 
approximately $12.04 trillion, including lost GDP, wages, real 
estate wealth, equity wealth, and fiscal costs. Their estimates 
include $7.4 trillion in losses in the equity markets between June 
2008 and March 2009, but do not include subsequent gains in equity 
markets that restored markets to their mid-2008 levels by the end of 
2009. In addition, their calculations do not include continued 
declines in real estate markets subsequent to March 2009. See Pew 
Economic Policy Group, ``The Cost of the Financial Crisis: The 
Impact of the September 2008 Economic Collapse,'' March 2010. The 
IMF estimated that the cost to the banking sector of the financial 
crisis through 2010 was approximately $2.2 trillion and reported a 
range of estimates for total cost to the taxpayer of GSE bailouts 
that ranged from $160 billion (Office of Management and Budget, 
February 2010) to $500 billion (Barclays Capital, December 2009). 
See IMF, ``Global Financial Stability Report: Responding to the 
Financial Crisis and Measuring Systemic Risks,'' October 2010. Both 
studies acknowledge that the estimates are subject to uncertainties.
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a. Technology, Infrastructure, and Legal Costs
    With respect to technology and infrastructure, for market 
participants that already use swap clearing services or trade futures, 
many of the backend requirements for technology and infrastructure that 
supports cleared swaps are likely to be quite similar, and therefore 
necessary changes to those systems are likely to require relatively 
lower costs. Market participants that are not currently using swap 
clearing services or trade futures, however, may need to implement 
appropriate infrastructure and technology to connect with an FCM that 
will clear swaps on their behalf.
    Similarly for legal fees, the costs related to clearing the swaps 
that are subject to this clearing requirement are likely to vary widely 
depending on whether market participants already use clearing services 
or trade futures. For those market participants that have not already 
engaged an FCM, it has been estimated, in response to another 
rulemaking, that smaller financial institutions will spend between 
$2,500 and $25,000 reviewing and negotiating legal agreements when 
establishing a new business relationship with an FCM.\197\ Commenters 
on this rulemaking did not provide data that would enable the 
Commission to determine to what degree these estimates would apply to 
larger entities establishing a relationship with an FCM or to determine 
costs associated with entities that already have established 
relationships with one or more FCMs, but need to revise those 
agreements.\198\ Even accepting the data provided for smaller financial 
institutions, the Commission lacks sufficient data to calculate a 
reasonable estimate of the potential costs that are likely to depend 
significantly on the specific business needs of each entity and 
therefore are expected to vary widely among market participants.
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    \197\ See comments to End-User Exception to Mandatory Clearing 
of Swaps; Proposed Rule, 75 FR 80747 (Dec. 23, 2011), including 
Chatham Financial letter at 2, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58077, and 
Webster Bank letter at 3, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58076.
    \198\ In its letter, FIA stated that it does not collect 
information from its members concerning fees charged for particular 
services, and thus is unable to respond to the Commission's request 
for date regarding FCM fees. No other commenter responded to the 
request for information regarding legal fees.
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    Citadel commented that the fact that all the interest rate swaps 
and CDS included in the Commission's proposal are already being cleared 
by registered DCOs in material volumes provides clear evidence that 
there is the rule framework, capacity, operational expertise and 
resources, and credit support infrastructure necessary to clear each of 
the swaps that are the subject of the Commission's determination.
    SIFMA AMG and Vanguard expressed concern about legal documentation 
and negotiations taking many months, and recommended the clearing 
requirement be delayed. They also raised doubt about the readiness of 
market participants to comply with the Commission's upcoming swap 
customer segregation rules. Vanguard further stated that it has 
``serious reservations about the potential impact on cost, liquidity, 
and heightened margin risk which could result from the premature roll-
out of the clearing mandate.''
    In light of the ``lack of experience and practical know-how'' 
related to DCO insolvency, ISDA recommended that the Commission conduct 
a study on insolvency. Citadel, on the other hand, stated that 
reasonable legal certainty exists in the event of an insolvency of a 
DCO or one or more DCO members with regard to the treatment of customer 
and swap counterparty positions, funds, and property.
Commission Response
    In response to Vanguard and SIFMA AMG's concerns about legal 
documentation and operational readiness, the Commission has clarified 
that compliance with the clearing requirement will not be required for 
any swaps until March 11, 2013, which responds to commenters' 
recommendation that the clearing requirement by delayed for six months 
to allow for documentation. Moreover, Category 2 and Category 3 
entities will have until June 10, 2013, and September 9, 2013, 
respectively, to come into compliance with the new requirement.\199\ In 
response to ISDA's statements regarding insolvency, as explained above, 
Commission staff actively participates in a number of international 
efforts related to clearinghouses and clearing member insolvency, as 
well as in coordination efforts with U.S. authorities.\200\
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    \199\ See Section IV above, clarifying that compliance for 
Category I, II, and III Entities will apply, respectively, to swaps 
executed on or after March 11, 2013, June 10, 2013, and September 9, 
2013.
    \200\ See Section II.B above.
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    Additionally, the Commission is exercising the anti-evasion 
rulemaking authority granted to it by the Dodd-Frank Act. In terms of 
legal costs, market participants will be responsible for complying with 
the new anti-evasion requirements. Generally, rule Sec.  50.10 states 
that it is unlawful for any person to knowingly or recklessly evade or 
participate in or facilitate an evasion of the requirements of section 
2(h) of the CEA, to abuse the exception to the clearing requirement as 
provided under section 2(h)(7) of the CEA and Commission rules, or to 
abuse any exemption or exception to the requirements of section 2(h) of 
the CEA, including any exemption or exception as the Commission may 
provide by rule, regulation, or order.
    This rule is expected to help ensure that would-be evaders cannot 
engage in conduct or activities that constitute an evasion of the 
requirements of section 2(h) or an abuse of any exemption or exception 
to such requirements. The Commission also sets forth guidance as to how 
it would determine if such evasion or abuse has occurred, while at the 
same time preserving the Commission's ability to determine, on a case-
by-case basis, with consideration given to all the facts and 
circumstances, that other types of transactions or activities 
constitute an evasion or abuse under Sec.  50.10.\201\
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    \201\ The Commission has not adopted a ``bright-line'' standard 
for evasion in order to avoid providing a ``road-map'' for evasion. 
The Commission's discussion of Sec.  50.10 is similar to its 
approach for the anti-evasion rules Sec. Sec.  1.3(xxx)(6) and 1.6 
that it recently adopted in a joint final rulemaking with the 
Securities and Exchange Commission. See Further Definition of 
``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap 
Agreement''; Mixed Swaps; Security-Based Swap Agreement 
Recordkeeping, 77 FR 48208, 48350-48354 (Aug. 13, 2012).
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    The Commission believes that participants in the swap markets 
should have policies and procedures already in place to ensure that 
their employees, affiliates, and agents will refrain from engaging in 
activities, including devising transactions, for the purpose of

[[Page 74325]]

evading, or in reckless disregard of, the requirements of section 2(h) 
of the CEA and Commission regulations or to abuse any exemption or 
exception to such requirements. The Commission believes that it will 
not be necessary for firms that currently have adequate compliance 
programs to hire additional staff or significantly upgrade their 
systems to comply with the proposed rule. Firms may, however, incur 
some costs, such as costs associated with training staff on the new 
clearing requirement rules.
    In addition, market participants may incur costs when determining 
whether they are properly relying on a legitimate business purpose. The 
Commission in choosing a principles-based approach rather than a 
bright-line test, recognizes that there may be direct costs and 
indirect costs due to perceived uncertainty related to determining what 
constitutes a legitimate business purpose for entering into swaps that 
are not subject to the clearing requirement. As stated above, the 
Commission will not provide a bright-line test of non-evasive or 
abusive conduct because such an approach may be a roadmap for engaging 
in evasive or abusive conduct or activities. However, the Commission 
has provided guidance above regarding what is meant by certain key 
terms in Sec.  50.10, and the Commission has clarified its belief that 
where a person's principal purpose in entering into a swap that is not 
subject to the clearing requirement is to circumvent the costs of 
clearing, the legitimate business purpose test would not be satisfied. 
The Commission anticipates that this guidance will mitigate costs 
related to determining whether particular conduct or activity could be 
construed as being an evasion of the requirements of section 2(h) or an 
abuse of any exemption or exception to the requirements.\202\
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    \202\ See above at Section III.G.
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b. Ongoing Costs Related to FCMs and Other Service Providers
    In the NPRM, the Commission considered ongoing costs associated 
with fees charged by FCMs that market participants will bear, in 
addition to costs associated with technological and legal 
infrastructure. Regarding fees, DCOs typically charge FCMs an initial 
transaction fee for each of the FCM's customers' interest rate swaps 
that are cleared, as well as an annual maintenance fee for each of 
their customers' open positions. Not including customer-specific and 
volume discounts, the transaction fees for interest rate swaps at the 
CME range from $1 to $24 per million notional amount for interest rate 
swaps and the maintenance fees are $2 per year per million notional 
amount for open positions.\203\ LCH transaction fees for interest rate 
swaps range from $1-$20 per million notional amount, and the 
maintenance fee ranges from $5-$20 per swap per month, depending on the 
number of outstanding swap positions that an entity has with the 
clearinghouse.\204\ For CDS, ICE Clear Credit charges an initial 
transaction fee of $6 per million notional amount. There is no 
maintenance fee charged by ICE for maintaining open CDS positions.\205\
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    \203\ See CME pricing charts at: http://www.cmegroup.com/trading/cds/files/CDS-Fees.pdf;
     http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Customer-Fee.pdf;
     and http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Self-Clearing-Fee.pdf.
    \204\ See LCH pricing for clearing services related to OTC 
interest rate swaps at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.
    \205\ See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.
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    FCMs will also bear additional fees with respect to their house 
accounts at the DCO to the extent that they clear more swaps due to the 
clearing requirement. For example, for interest rate swaps that they 
clear through CME, clearing members are charged a transaction fee that 
ranges from $0.75 to $18.00 per million notional, depending on the 
transaction maturity.\206\ Members, however, are not charged annual 
maintenance fees for their open house positions.\207\ For CDS, clearing 
members at ICE Clear Credit are charged $5-6 per transaction per 
million notional and there is no maintenance fee.\208\
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    \206\ See CME pricing charts.
    \207\ See id.
    \208\ See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.
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    As discussed above, it is difficult to predict precisely how the 
requirement to clear the classes of swaps covered by this new 
requirement will increase the use of swap clearing, as compared to the 
use of clearing that would occur in the absence of the requirement. 
However, the Commission expects that application of the clearing 
requirement to the swaps covered by the new rule will generally 
increase the use of clearing, leading to the ongoing transaction costs 
noted above.
    In addition, the Commission understands that FCM customers that 
only transact in swaps occasionally are typically required to pay a 
monthly or annual fee to each FCM that ranges from $75,000 to $125,000 
per year.\209\ Again, although it is difficult to predict precisely how 
many FCM customers would be subject to such fees based on the clearing 
requirement for CDS and interest rate swaps, the Commission expects 
that some market participants that previously did not use clearing 
would be subject to the requirements of the current rule.
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    \209\ See letters from Chatham and Webster Bank. The Commission 
is not aware of similar annual fees charged to larger customers. The 
Commission believes that FCMs are more likely to charge such fees to 
smaller customers in order to cover the fixed costs that are not 
likely covered through fees charged on a per-swap basis to customers 
that use swaps less frequently.
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    In the NPRM, the Commission asked a series of questions related to 
FCM fees and invited comment on the fee information presented. No 
commenter responded to the questions asked or provided any additional 
information with regard to clearing fees. As noted above, FIA raised 
the issue only to explain that it does not collect such information 
from its members.
c. Costs Related to Collateralization of Cleared Swap Positions
    As mentioned above, market participants that enter into swaps with 
the specifications identified in the classes subject to this adopting 
release will be required to post collateral with their FCM and/or at 
the DCO. The incremental cost of collateral resulting from the 
application of the clearing requirement depends on the extent to which 
such swaps are already being cleared (even in the absence of the 
requirement) or otherwise collateralized bilaterally. The incremental 
cost also depends on whether such swaps are, if not collateralized, 
priced to include implicit contingent liabilities and counterparty 
credit risk born by the counterparty to the swap.
1. Quantitative Approach Presented in the NPRM
    A conservative approach would be to assume that all the swaps that 
are currently not cleared would be covered by the new clearing 
requirement, and that they are completely uncollateralized, and not 
priced to include implicit contingent liabilities and counterparty 
credit risk born by the counterparty. Under this approach, imposition 
of the clearing requirement for those types of swaps would create 
additional costs due to: (1) The difference between cost of capital and 
returns on that capital for assets posted to meet initial margin for 
the entire term of the swap; and (2) the difference

[[Page 74326]]

between cost of capital and returns on that capital for assets paid to 
meet the cost of capital for variation margin to the extent a party is 
``out of the money'' on each swap. Under the assumptions mentioned 
above, if every interest rate swap and CDS that is not currently 
cleared were moved into clearing, the additional initial margin that 
would need to be posted is approximately $19.2 billion for interest 
rate swaps and $53 billion for CDS.\210\
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    \210\ The numbers calculated above may either over-estimate or 
under-estimate the amount of additional initial margin that would 
need to be posted under the conservative assumptions stated above. 
For instance, differences in the amount of netting that is possible 
within portfolios currently being cleared versus those not currently 
being cleared could have a significant impact on the amount of 
additional margin that is required to be posted. Other factors such 
as differences in liquidity among swaps currently being cleared and 
those not being cleared could also impact the amount of additional 
margin that is posted.
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    In the NPRM, the Commission calculated its estimated additional 
initial margin amounts based on the following assumptions. According to 
representations made to the Commission by LCH, they clear approximately 
51% of the interest rate swaps market. The total amount of initial 
margin on deposit at LCH for interest rate swaps is approximately $20 
billion.\211\ Therefore, if all remaining interest rate swaps were 
moved into clearing, approximately $19.2 billion ($20B/0.51-$20B = 
19.2B) would have to be posted in initial margin.
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    \211\ The total amount of initial margin on deposit at CME for 
interest rate swaps is $5 billion, but for purposes of this 
estimate, the Commission is not including that amount.
---------------------------------------------------------------------------

    Similarly, the initial margin related to CDS currently on deposit 
at CME, ICE Clear Credit, and ICE Clear Europe is approximately $21.4 
billion.\212\ This amount includes initial margin based on both index-
based CDS and single-name CDS positions. BIS data indicates that 
approximately 36.6% of the CDS market comprises index-based CDS.\213\ 
In the NPRM, the Commission noted that if it is assumed that 
approximately 36.6% of the overall portfolio-based CDS margin (i.e., 
CDS indices and single-name CDS margined together) currently held by 
DCOs for CDS positions is related to index-based CDS, and then add any 
margin held by DCOs attributable solely to index-based CDS, it can be 
estimated that approximately $9.0 billion in margin currently held by 
those DCOs is related to index-based CDS. ISDA data indicates that 
14.5% of the index-based CDS market is currently cleared.\214\ 
Therefore, the Commission noted in the NPRM that if the entire index-
based CDS market moved into clearing, $53 billion ($9.0B/0.145-$9.0 = 
$53B) in initial margin would have to be posted at DCOs.
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    \212\ The total amount of initial margin on deposit only 
includes those amounts reported to the Commission by registered 
DCOs. Other clearinghouses, such as LCH.Clearnet.SA, clear the 
indices included in the proposed determination, however, the 
relative size of the open interest in the relevant CDS indices is 
substantially smaller than each of the DCOs included in this 
calculation.
    \213\ BIS estimates that the gross notional value of outstanding 
CDS contracts is $28.6 trillion, and that $10.5 trillion of that is 
index related CDS. See BIS data, available at http://www.bis.org/statistics/otcder/dt21.pdf.
    \214\ In the NPRM, the Commission noted that ISDA has estimated 
that 14.5% of the index-based CDS market is currently being cleared, 
whereas the total outstanding notional at CME, ICE Clear Europe, and 
ICE Credit represents approximately 7.5% of the global index-based 
CDS market estimated by BIS. Such a discrepancy would be expected if 
one or more of the following occurred: (1) If ISDA overestimated the 
percentage of the index-based CDS that is currently being cleared; 
(2) if BIS overestimated the size of the global index-based swap 
market; (3) if a significant amount of compression occurs as index-
based CDS are moved into clearing; and/or (4) if a significant 
portion of the cleared index-based CDS market is held at 
clearinghouses other than CME, ICE Clear Europe, and ICE Clear 
Credit. The Commission noted in the NPRM that it believes that the 
compression of CDS positions moving into clearing is the most likely 
explanation and therefore used the ISDA estimate.
---------------------------------------------------------------------------

    Both of the above estimates assume that additional interest rate 
swaps brought into clearing would have similar margin requirements per 
unit of notional amount to those interest rate swaps that are already 
in clearing, and assumes that additional CDS brought into clearing 
would have similar margin requirements per unit of notional amount to 
those CDS that are already being cleared. These assumptions, in turn, 
assume similar levels of liquidity, compression, netting, and similar 
tenors for the swaps that are currently cleared and those that are not. 
While the Commission recognizes that these factors are unlikely to be 
identical among both groups of products, adequate information to 
quantify the impact of each of these possible differences between the 
two groups of swaps on the amount of additional collateral that would 
have to be posted is not available.
    In any case, the Commission noted that it is probable that the 
estimates in the NPRM significantly overstate the amount of additional 
capital that would be posted for a number of reasons described below. 
First, these estimates are based upon the assumption that every 
interest rate swap and index-based CDS not currently cleared is brought 
into clearing as a result of the Commission's determinations herein. 
However, in this adopting release the Commission has set forth clearing 
requirements only for certain classes of interest rate swaps and CDS, 
and not for all interest rate swaps and CDS. Therefore, there will 
still be certain types of interest rate swaps, such as those related to 
the thirteen additional currencies cleared by LCH, that are not 
required to be cleared. Moreover, the clearing requirement will apply 
only to new swap transactions \215\ whereas market estimates include 
legacy transactions. In addition, these estimates assume that no 
additional voluntary clearing would be taking place in the absence of 
the Commission's determinations. The Commission also observes that, to 
the extent that portfolio margining for products such as CDS is 
expanded to all market participants, it is likely to reduce the 
additional margin that is required. In some instances, these margin 
reductions for well-balanced portfolios could be significant.
---------------------------------------------------------------------------

    \215\ As well as, applying to swaps subject to a change in 
ownership, as explained above in Section III.D.
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    In addition, non-financial entities entering into swaps for the 
purpose of hedging or mitigating commercial risk are not required to 
use clearing under section 2(h)(7) of the CEA. As a consequence, many 
entities will not be required to clear, even when entering into 
interest rate swaps or CDS that are otherwise required to be cleared. 
Third, some interest rate swaps and CDS involve cross border 
transactions to which the Commission's clearing requirement will not 
apply.\216\ Fourth, collateral is already posted with respect to many 
non-cleared interest rate swaps and CDS. ISDA conducted a recent survey 
which reported that 93.4% of all trades involving credit derivatives, 
and 78.1% of all trades involving fixed income derivatives are subject 
to collateral agreements.\217\ Moreover, although the Commission cannot 
verify the accuracy of the estimate, ISDA estimated that the aggregate 
amount of collateral in circulation in the non-cleared OTC derivatives 
market at the end of 2011 was approximately $3.6 trillion.\218\
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    \216\ Cross-Border Application of Certain Swaps Provisions in 
the Commodity Exchange Act, 77 FR 41214 (July 12, 2012).
    \217\ See ISDA Margin Survey 2012, at 15, available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. 
Although it is unclear exactly how many of the derivatives covered 
by this survey are swaps, it is reasonable to assume that a large 
part of them are.
    \218\ This estimate, however, does not adjust for double 
counting of collateral assets. The same survey reports that as much 
as 91.1% of cash used as collateral and 43.8% of securities used as 
collateral are being reused, and therefore are counted two or more 
times in the ISDA survey. See ISDA Margin Survey 2012, at 20 and 11, 
respectively.

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[[Page 74327]]

2. Comments Received in Response to NPRM Consideration of Costs and 
Benefits
    In the NPRM, the Commission requested comment regarding the total 
amount of additional collateral that would be required due to the 
proposed clearing requirement. In particular, the Commission sought 
quantifiable data and analysis.\219\ No commenter addressed the 
quantitative approach laid out by the Commission in the NPRM. Nor did 
any commenter provide quantifiable data and analysis to support or 
refute such analysis. Citadel stated that the Commission's 
determination is justified on a cost-benefit basis, but did not address 
the costs of collateral directly. FIA noted that the NPRM's cost-
benefit discussion ``is among the more thoughtful and comprehensive the 
Commission has ever prepared,'' but did not address the costs of 
collateral, fees, or other costs.
---------------------------------------------------------------------------

    \219\ 77 FR at 47214.
---------------------------------------------------------------------------

3. Additional Research Reviewed by the Commission
    Despite the lack of feedback from commenters regarding the costs of 
collateral, the Commission continued to research market and academic 
literature in the public domain for additional data. The Commission 
identified and obtained two relevant papers. These papers are presented 
as additional informative background regarding the costs of mandatory 
clearing. The Commission has reviewed, but has not been able to verify, 
the conclusions reached in these papers.
    In a recent research note, Morgan Stanley estimated the global 
increase in initial margin for interest rate swaps trades as a result 
of the swap clearing requirements.\220\ Its ``bull case'' figure of $20 
billion is largely consistent with the Commission's estimate of $19.2 
billion in the NPRM calculated above, though its methodology is 
different. Morgan Stanley obtained this figure in several steps. First, 
it considered two main groups of interest rate swaps traders: dealers 
and buy-side investors, which Morgan Stanley believes have interest 
rate swaps with notional values of approximately $339 trillion and $89 
trillion, respectively, outstanding. Next, Morgan Stanley projected 
that the amount of new interest rate swaps that will be cleared as a 
percentage of current notional would be 10% for dealers and 80% for 
buy-side participants, assuming that ``most of the eligible dealer-to-
dealer trades are already centrally cleared.'' Finally, Morgan Stanley 
multiplied the resulting amount of new interest rate swaps that will be 
cleared for each group of traders by an initial margin to notional 
ratio that they estimated.\221\ Currently, according to Morgan Stanley, 
``the aggregate dealer initial margin as a percentage of notional 
reported by LCH is approximately 0.005%.'' For dealers, the value of 
0.00005 was therefore chosen as their initial margin to notional ratio. 
For buy-side investors, however, Morgan Stanley scaled up LCH's 
benchmark ratio of 0.00005 by a growth factor of 5 to ``[capture] the 
extent to which buy-side portfolios are less diversified than dealers 
and may enjoy less netting efficiencies.'' Overall, the report argued, 
dealers and buy-side participants should expect their aggregate initial 
margin to increase by $2 billion ($339,000B x 10% x 0.00005 [ap] $2B) 
and $18 billion ($89,000B x 80% x 0.00005 x 5 [ap] $18B), respectively, 
resulting in a total estimate of $20 billion in additional margin for 
the bull case scenario. By scaling up LCH's benchmark ratio by a growth 
factor in the range between 10-20 for each group of investors, Morgan 
Stanley further obtained a ``base case'' figure of $480 billion and a 
``bear case'' figure of $1.3 trillion. The difference between the 
Commission's estimate and Morgan Stanley's base case figure or bear 
case figure can largely be attributed to the following: the Commission 
used LCH's current overall initial margin to notional ratio in its 
calculations, whereas Morgan Stanley used LCH's current dealer initial 
margin to notional ratio; more importantly, the Commission made the 
simplifying assumption that the initial margin to notional ratio will 
stay more or less constant, whereas Morgan Stanley scaled up its 
benchmark ratio by a growth factor in a range between 10-20 based on 
its ``discussions with clearing and banking industry professionals and 
estimates made by [BIS]'' as well as its internal estimates.\222\ 
Putting aside the growth factor effect, it is worth emphasizing that 
Morgan Stanley's estimates refer to the global increase in initial 
margin, which may potentially be much larger than the additional amount 
of initial margin required for those entities under the Commission's 
jurisdiction.
---------------------------------------------------------------------------

    \220\ See Morgan Stanley, Morgan Stanley Research, ``Swap 
Central Clearing: What is the Impact on Collateral?'' (August 2012).
    \221\ This ratio is the initial margin divided by the notional 
outstanding.
    \222\ In particular, Morgan Stanley assumed that ``dealer 
[initial margin] may grow over time due to higher CCP collateral 
requirements and counterparty diversification regulations.''
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    Also, the Commission notes that in Morgan Stanley's calculations, 
the additional collateral required for buy-side swaps represents the 
vast majority of the additional collateral required in each scenario 
(approximately 95%, 74%, and 81% of the total additional capital 
required for the ``bull case,'' ``base case,'' and ``bear case,'' 
respectively). A critical assumption driving each of these calculations 
is that swaps with 80% of the total buy-side notional amount are moved 
into clearing as a result of the mandate. However, the Commission 
believes this assumption may be high in light of the end-user 
exception, which includes an exemption for small financial institutions 
with less than $10 billion in assets.\223\ Adjusting this assumption 
downward would result in dramatic reductions in Morgan Stanley's 
calculations regarding the amount of additional collateral that may be 
required as a result of the mandate.
---------------------------------------------------------------------------

    \223\ See End User Exception to the Clearing Requirement for 
Swaps, 77 FR 42560 (July 19, 2012).
---------------------------------------------------------------------------

    TABB Group has also conducted a study recently that estimated the 
global ``margin shortfall'' (i.e., the additional amount of initial 
margin that will be required) for all OTC swaps due to clearing 
requirements and anticipated margin requirements for uncleared 
swaps.\224\ According to their model, the total amount of margin that 
will be required for both cleared and uncleared swaps is estimated to 
be between $2.9 trillion to $4.1 trillion, depending on the degree of 
netting for each type of traders. Further, they estimate that $1.34 
trillion of margin is already posted for all OTC swaps, leaving an 
additional $1.56-2.76 trillion in margin that would need to be posted 
for all swaps, including both cleared and uncleared positions. The 
table below summarizes TABB Group's margin estimates by trader type.
---------------------------------------------------------------------------

    \224\ See TABB Group, ``The New Global Risk Transfer Market: 
Transformation and the Status Quo,'' (Sept. 2012).

[[Page 74328]]



                   Table 6--Margin Estimates by Trader Type in Billions of U.S. Dollars \225\
----------------------------------------------------------------------------------------------------------------
                                                                    Gross
                                                       Gross        margin      Estimated netting     Estimated
                    Trader type                       notional     (1.5% of          benefit            margin
                                                                  notional)                             posted
----------------------------------------------------------------------------------------------------------------
Dealers with CCP..................................      248,561        3,728          3,710 (99.5%)           19
Other Dealers.....................................      305,624        4,584   1,605-2,521 (35-55%)  2,063-2,980
Financial Institutions............................       59,964          899       225-405 (25-45%)      495-675
Non-Financial End Users...........................       33,851          508        76-178 (15-35%)      330-432
Others............................................       60,000
                                                   -------------------------------------------------------------
    Total.........................................  ...........  ...........  .....................  2,906-4,105
----------------------------------------------------------------------------------------------------------------

    As  shown in the table, if the amount for non-financial end-users 
is excluded, then the margin shortfall will be adjusted down to $1.23-
2.33 trillion. Like the Commission, the TABB Group considered all the 
OTC swaps, some of which are not covered by the clearing requirement.
---------------------------------------------------------------------------

    \225\ Id.
---------------------------------------------------------------------------

    The TABB Group estimates are considerably higher than those of the 
Commission and of Morgan Stanley largely because of different estimates 
about what amount of netting will be possible for swaps not currently 
being cleared, and in particular, for the swaps between dealers that do 
not involve a CCP.
4. Collateral Costs and Costs of Capital
    Given the increased collateral demands that required clearing of 
interest rate swaps and CDS is likely to bring, there will be 
corresponding demand for capital. To calculate the additional 
collateral cost to market participants, the Commission in the NPRM 
estimated the difference between the cost of capital for the additional 
collateral and the returns on that capital. Although no comments 
discussed this issue in comments on the NPRM, the Commission notes that 
in comments regarding other Commission rules, commenters have sometimes 
taken the view that the difference between the cost and returns on 
capital for funds that are used as collateral is substantial.
    The Commission described a comment on behalf of the Working Group 
of Commercial Energy Firms in the NPRM. In this comment, an economic 
consulting firm, NERA, used an estimate of 13.08% for the pre-tax 
weighted average cost of capital for the firm, and an estimate of 3.49% 
for the pre-tax yield on collateral, for a difference as 9.59% which 
NERA used as the net pre-tax cost of collateral.\226\ However, as noted 
in the NPRM, these estimates use the borrowing costs for the entire 
firm, but only consider the returns on capital for one part of the 
firm, when determining the spread between the two.\227\ The result is 
an over-stated difference, and therefore a higher cost associated with 
collateral than would result if the costs of capital and returns of 
capital were compared on a consistent basis.\228\
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    \226\ The NERA study is available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=50037 and their comments 
defending their cost of capital are available in their letter at 
http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=57015.
    \227\ Moreover, according to Morgan Stanley's research note 
cited above, many dealers and buy-side investors currently hold 
enough unencumbered collateral to meet at least part of the 
incremental initial margin requirements. In other words, each of 
these entities will need to raise only a portion of the additional 
capital required.
    \228\ This aspect of the NERA study has been described in 
greater detail by MIT professors John Parsons and Antonio Mello, 
available at http://bettingthebusiness.com/2012/01/22/phantom-costs-to-the-swap-dealer-designation-and-otc-reform/ and http://bettingthebusiness.com/2012/03/19/nera-doubles-down/.
---------------------------------------------------------------------------

    However, as the Commission noted in the NPRM, this cost is not only 
likely overstated, for the reasons mentioned above, but it also may not 
be a new cost. Rather, it is a displacement of a cost that is embedded 
in uncleared, uncollateralized (or under-collateralized) swaps. 
Entering into a swap is costly for any market participant because of 
the default risk posed by its counterparty, whether the counterparty is 
a DCO, swap dealer, or other market participant. When a market 
participant faces the DCO, the DCO accounts for that counterparty risk 
by requiring collateral to be posted, and the cost of capital for the 
collateral is part of the cost that is necessary in order to maintain 
the swap position. When a market participant faces a dealer or other 
counterparty in an uncleared swap, however, the uncleared swap contains 
an implicit line of credit upon which the market participant 
effectively draws when its swap position is out of the money. 
Counterparties charge for this implicit line of credit in the spread 
they offer on uncollateralized, uncleared swaps. It can be shown that 
the cash flows of an uncollateralized swap (i.e., a swap with an 
implicit line of credit) are, over time, substantially equivalent to 
the cash flows of a collateralized swap with an explicit line of 
credit.\229\ Moreover, because the counterparty credit risk created by 
the implicit line of credit is the same as the counterparty risk that 
would result from an explicit line of credit provided to the same 
market participant, to a first order approximation, the charge for each 
should be the same as well.\230\ This means that the cost of capital 
for additional collateral posted as a consequence of requiring 
uncollateralized swaps to be cleared does not introduce an additional 
cost, but rather takes a cost that is implicit in an uncleared, 
uncollateralized swap and makes it explicit. This observation applies 
to capital costs associated with both initial margin and variation 
margin.
---------------------------------------------------------------------------

    \229\ Antonio S. Mello, and John E. Parsons, ``Margins, 
Liquidity, and the Cost of Hedging,'' MIT Center for Energy and 
Environmental Policy Research, May 2012.
    \230\ See id. at 12; Mello and Parsons state in their paper, 
``Hedging is costly. But the real source of the cost is not the 
margin posted, but the underlying credit risk that motivates 
counterparties to demand that margin be posted.'' The paper goes on 
to demonstrate that, ``To a first approximation, the cost charged 
for the non-margined swap must be equal to the cost of funding the 
margin account. This follows from the fact that the non-margined 
swap just includes funding of the margin account as an embedded 
feature of the package.'' Id. at 15-16.
---------------------------------------------------------------------------

    The Commission received no comment regarding the costs of 
collateral it presented in the NPRM.
5. Regulatory Capital Implications
    Another potential impact of the new clearing requirement that the 
Commission described in the NPRM may result from the fact that 
financial institutions are required to hold additional capital with 
respect to their swap positions pursuant to prudential regulatory 
capital requirements. Basel III standards are designed to incentivize 
central clearing of derivatives by applying a lower capital weighting 
to

[[Page 74329]]

them than for similar uncleared derivatives positions.\231\ Moreover, 
bilateral margining regulations are currently being developed by the 
Commission and U.S. prudential regulators that will subject uncleared 
swaps entered into by swap dealers and major swap participants to 
increased margin requirements in the near future.\232\ Therefore, the 
Commission expects that, all things being equal, the capital that 
certain financial institutions are required to hold is likely to be 
reduced as a consequence of their increased use of swap clearing.
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    \231\ See Basel Committee on Banking Supervision reforms--Basel 
III, available at http://www.bis.org/bcbs/basel3/b3summarytable.pdf 
(indicating that Basel III reforms will create capital incentives 
for banks to use central counterparties for derivatives).
    \232\ The Commission's proposed is Margin Requirements for 
Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 FR 
23732 (Apr. 28, 2011); and the U.S. prudential regulators proposed a 
similar requirement, Margin and Capital Requirements for Covered 
Swap Entities, 76 FR 27564 (May 11, 2011).
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    The Commission received no comment regarding the regulatory capital 
discussion it presented in the NPRM.
6. Operational Issues Related to Collateralization
    The Commission also discussed in the NPRM the operational costs 
that may result from the collateral requirements that apply to the 
clearing requirement. With uncleared swaps, the Commission noted, 
counterparties may agree not to collect variation margin until certain 
thresholds of exposure are reached, thus reducing or perhaps entirely 
eliminating the need to exchange variation margin as exposure changes. 
DCOs, on the other hand, collect and pay variation margin on a daily 
basis and sometimes more frequently. As a consequence, more required 
clearing may increase certain operational costs associated with moving 
variation margin to and from the DCO. On the other hand, increased 
clearing is also likely to lead to benefits from reduced operational 
costs related to valuation disputes, as parties to cleared swaps agree 
to abide by the DCO's valuation procedures. To the extent that the 
requirement to clear the types of swaps covered by the new clearing 
requirement leads to increased use of clearing, these costs and 
benefits are likely to result.
    The Commission received no comment regarding the operational costs 
of collateral discussion it offered in the NPRM.
7. Guaranty Fund Contribution as a Collateral Cost
    As explained in the NPRM, increases in clearing as a result of the 
clearing requirement also may result in additional costs for clearing 
members in the form of guaranty fund contributions. However, the 
Commission noted, it may be that increased clearing of swaps would 
decrease guaranty fund contributions for certain clearing members. 
Market participants that currently transact swaps bilaterally, and do 
not clear such swaps, must either become clearing members of an 
eligible DCO or submit such swaps for clearing through an existing 
clearing member of an eligible DCO, once the clearing requirement 
applies to such swaps. A party that chooses to become a clearing member 
of a DCO must make a guaranty fund contribution based on the risk that 
its positions pose to the DCO. A party that chooses to clear swaps 
through an existing clearing member may have a share of the clearing 
member's guaranty fund contribution passed along to it in the form of 
fees. While the addition of new clearing members and new customers for 
existing clearing members may result in existing clearing members 
experiencing an increase in their guaranty fund requirements, it should 
be noted that if (1) new clearing members are not among the two 
clearing members used to calculate the guaranty fund and (2) any new 
customers trading through a clearing member do not increase the size of 
uncollateralized risks at either of the two clearing members used to 
calculate the guaranty fund, all else held constant, existing clearing 
members may experience a decrease in their guaranty fund requirement.
    The Commission received no comment regarding the guaranty fund 
costs discussion it presented in the NPRM.
d. Benefits of Clearing
    In the NPRM, the Commission also described the benefits of swap 
clearing, which in general, are significant. Thus, to the extent that 
the new clearing requirement for certain classes of interest rate swaps 
and CDS leads to increased use of clearing, these benefits are likely 
to result. As is the case for the costs noted above, it is difficult to 
predict the precise extent to which the use of clearing will increase 
as a result of the new requirement, and therefore the benefits of the 
requirement cannot be precisely quantified. But the Commission believes 
that the benefits of increased clearing resulting from this requirement 
will be significant, because the classes of swaps required to be 
cleared represent a substantial portion of the total swap markets.
    Currently outstanding interest rate swaps and CDS indices represent 
about 77.8% and 1.6%, respectively, of the total global swaps market, 
when measured by notional amount.\233\ As noted above, the new clearing 
requirement requires that only certain classes of interest rate swaps 
and CDS indices be cleared, but such classes likely represent the most 
common swaps within those overall asset classes, and therefore are 
likely to comprise a relatively large portion of those asset classes. 
The Commission reiterates the conclusion stated in the NPRM, which is 
that by requiring these particular swaps to be cleared, the benefits of 
clearing are expected to be realized across a relatively large portion 
of the market.
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    \233\ BIS data, December 2011, available at http://www.bis.org/statistics/derstats.htm. As explained above, the Commission observes 
that while CDS accounts for a smaller portion of the total swaps 
market, its unique risk profile involving jump-to-default risk 
contributed to the Commission's decision to include it in among the 
first clearing determinations.
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    The new clearing requirement that swaps within certain classes be 
cleared is expected to increase the number of swaps in which market 
participants will face a DCO, and therefore, will face a highly 
creditworthy counterparty. DCOs are some of the most creditworthy 
counterparties in the swap market because, as explained above, they 
have at their disposal a number of risk management tools that enable 
them to manage counterparty risk effectively. Those tools include 
contractual rights that enable them to use margin to manage current and 
potential future exposure, to close out and transfer defaulting 
positions while minimizing losses that result from such defaults, and 
to protect solvency during the default of one or more members through a 
waterfall of financial resources from which they can draw, as outlined 
above. Also, clearing protects swap customers from the risk of having 
to share losses in the event of the default of another clearing member.
    Under Sec.  50.2(a) of this adopting release, swaps meeting the 
specifications of the classes of swaps that are required to be cleared 
must be submitted to clearing ``as soon as technologically practicable 
after execution, but in any event by the end of the day of execution.'' 
\234\ This conforms to the requirements established in the recently 
finalized rule

[[Page 74330]]

regarding timing of acceptance for clearing,\235\ which is designed to 
promote rapid submission of these swaps for clearing and reduce the 
unnecessary counterparty risk that can develop between the time of 
execution and submission to clearing.\236\
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    \234\ See Sec.  50.2(a) (setting for the timeframe for 
submission of swaps to DCOs).
    \235\ See Client Clearing Documentation, Timing of Acceptance 
for Clearing, and Clearing Member Risk Management, 77 FR 21278 (Apr. 
9, 2012).
    \236\ The Commission notes that if a market participant executed 
a swap that is required to be cleared on a SEF or DCM, then that 
market participant will be deemed to have met their obligation to 
submit the swap to a DCO because of the straight-through processing 
rules previously adopted by the Commission.
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    As it noted in the NPRM, the Commission expects that the 
requirement for rapid submission, processing, and acceptance or 
rejection of swaps for clearing will be beneficial in several respects. 
It is important to note that when two parties enter into a bilateral 
swap with the intention of clearing it, each party bears counterparty 
risk until the swap is cleared. Once the swap is cleared, the 
clearinghouse becomes the counterparty to each of the original parties, 
which minimizes and standardizes counterparty risk.
    Where swaps of the type covered by the new clearing requirement are 
not executed on an exchange, the requirements of Sec.  50.2(a) should 
significantly reduce the amount of time needed to process them. 
Although costs associated with latency-period counterparty credit risk 
cannot be completely eliminated in this context, the rules will reduce 
the need to discriminate among potential counterparties in executing 
off-exchange swaps, as well as the potential costs associated with 
swaps that are rejected from clearing. By reducing the counterparty 
risk that could otherwise develop during the latency period, these 
rules promote a market in which all eligible market participants have 
access to counterparties willing to trade on terms that approximate the 
best available terms in the market. This is likely to improve price 
discovery and promote market integrity.
    Another benefit of the new clearing requirement is the mitigation 
of systemic risk. Counterparty risk readily develops into systemic risk 
in an interconnected financial system especially in times of financial 
stress due to various types of contagion effects.\237\ By ensuring that 
outstanding potential future and current exposures are collateralized 
in a timely fashion for more swaps, this new clearing requirement 
contributes to the mitigation of systemic risk.
---------------------------------------------------------------------------

    \237\ For a comprehensive discussion of the various types of 
contagion effects in times of financial stress, see Brunnermeier, 
M., A. Crocket, C. Goodhart, A. Persaud, and H. Shin: ``The 
Fundamental Principles of Financial Regulation,'' (2009), available 
at http://www.princeton.edu/~markus/research/papers/Geneva11.pdf.
---------------------------------------------------------------------------

    The Commission's consideration of the effect on the mitigation of 
systemic risk is generally supported by comments, which provided 
general observations regarding the mitigation of systemic risk. Citadel 
and Eris Exchange both stated that implementing the clearing 
requirement is a significant milestone toward ``achieving the Dodd-
Frank Act's objectives of reducing interconnectedness, mitigating 
systemic risk, increasing transparency, and promoting competition in 
the swaps market.'' Freddie Mac commented that it ``supports the 
Commission's goal to reduce systemic risk through central clearing of 
swaps where appropriate.'' On the other hand, ISDA urged the Commission 
to consider the argument that ``clearing involves a greater 
centralization of risk than the over-the counter markets ever did.'' 
ISDA also questioned the risk-mitigating aspects of central clearing as 
contrasted with the new regulatory regime for uncleared swaps. In 
response to ISDA's comment, the Commission observes that while the 
regime for bilateral, uncleared swaps will be greatly improved after 
full implementation of the Dodd-Frank Act reforms, central clearing 
provides for certain risk management features that cannot be replicated 
on a bilateral basis. To name just one critical distinction, a 
clearinghouse addresses the tail risk of open positions through 
mutualization. Each clearing member must contribute to a default fund 
that protects the system as a whole. Also, recent experience indicates 
that all DCOs were able to withstand the 2008 financial crisis in a 
relatively sound manner.\238\
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    \238\ No DCO required government assistance, and all DCOs were 
able to manage their open positions in both swaps and futures. Even 
difficult default situations were handled in an orderly fashion. For 
example, during the Lehman Brothers' bankruptcy in September 2008, 
LCH was able to manage the default of Lehman's significant swap 
portfolio. See 77 FR at 47188 and LCH IRS submission, at 4 
(discussing LCH's management of the Lehman Brothers' bankruptcy in 
September 2008, where upon Lehman's default, LCH needed to risk 
manage a portfolio of approximately 66,000 interest rate swaps, 
which it hedged with approximately 100 new swap trades in less than 
five days and only used approximately 35% of the initial margin 
Lehman had posted).
---------------------------------------------------------------------------

    Regarding competition, Markit stated that the new clearing 
requirement might lower barriers to entry in the index provider market 
``because new indices would not necessarily be subject to the clearing 
mandate, which can be costly.'' Citadel commented that the framework 
established by the Commission promotes competition among swap dealers, 
as ``counterparty credit risk no longer features as a consideration in 
the selection of executive counterparties.''
    In addition, Sec.  50.10 and related guidance provides market 
participants with a useful framework for behavior under the 
requirements of section 2(h), which will promote the benefits of swap 
clearing without introducing uncertainty regarding market behavior. 
Activity conducted principally for a legitimate business purpose, 
absent other indicia of evasion or abuse, would not constitute a 
violation of Sec.  50.10 as described in the Commission's 
interpretation.

D. Consideration of Alternative Swap Classes for Clearing 
Determinations

    The Commission's determination to require initially the clearing of 
certain CDS and interest rate swaps is a function of both the market 
importance of these products and the fact that they already are widely 
cleared. In order to move the largest number of swaps to required 
clearing in its initial determination, the Commission continues to 
believe that it is prudent to focus on swaps that are widely used and 
for which there is already a blueprint for clearing and appropriate 
risk management. CDS and interest rate swaps that match these factors 
are therefore well suited for required cleared.
    As noted in the NPRM and discussed above, interest rate swaps with 
a notional amount of $504 trillion are currently outstanding--the 
highest proportion of the $648 trillion global swaps market of any 
class of swaps.\239\ CDS indices with a notional amount of about $10.4 
trillion are currently outstanding.\240\ While CDS indices do not have 
as prominent a share of the entire swaps market as interest rate swaps, 
uncleared CDS is capable of having a sizeable market impact, as it did 
during the 2008 financial crisis. In addition, many of the swaps within 
each of the classes that will now be subject to required clearing are 
already cleared by one or more clearinghouses. LCH claims to clear 
interest rate swaps with a notional amount of about $284 trillion--
meaning that, in notional terms, LCH represents that they clear just 
over 50% of the interest rate swap market.\241\ The swap market has 
made a smooth transition into clearing CDS on its own initiative. As a 
result, DCOs, FCMs, and many market participants

[[Page 74331]]

already have experience clearing the types of swaps that will be 
subject to required clearing. The Commission expects, therefore, that 
DCOs and FCMs are equipped to handle the increases in volume and 
outstanding notional amount in these swaps that is likely to be cleared 
as the result of this rule. Because of the wide use of these swaps and 
their importance to the market, and because these swaps are already 
cleared safely, the Commission continues to believe it is reasonable to 
initially subject certain types of interest rate swaps and CDS to the 
clearing requirement.
---------------------------------------------------------------------------

    \239\ BIS data, June 2011, available at http://www.bis.org/publ/otc_hy1111.pdf.
    \240\ See id.
    \241\ See id.
---------------------------------------------------------------------------

    In reviewing the swap submissions provided by DCOs, the Commission 
decided to classify swaps according to certain key specifications for 
CDS and interest rate swaps. These specifications inform whether a 
particular swap falls within one of the classes of swaps that the 
Commission has determined are required to be cleared. The two classes 
of CDS that are required to be cleared are (1) U.S. dollar-denominated 
CDS covering North America corporate credits and (2) euro-denominated 
CDS referencing European corporate obligations. The four classes of 
interest rate swaps required to be cleared are (1) fixed-to-floating 
swaps, (2) basis swaps, (3) OIS, and (4) FRAs. In formulating each of 
the six classes under this adopting release, the Commission considered 
a number of alternatives.
    Regarding CDS, the Commission outlined three key specifications 
comprising (1) region and nature of reference entity, (2) the nature of 
the CDS itself, and (3) tenor. Each of these specifications will assist 
market participants in determining whether a swap falls within the CDS 
classes of swaps required to be cleared. For the first, a 
distinguishing characteristic is whether the reference entity is in 
North American or European and whether it is one of Markit's CDX.NA.IG, 
CDX.NA.HY, iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe 
High Volatility indices. The second key specification relates to 
whether the CDS is tranched or untranched. The classes that are 
required to be cleared include only untranched CDS where the contract 
covers the entire index loss distribution of the index and settlement 
is not linked to a specified number of defaults. Tranched swaps, first- 
or ``Nth'' to-default, options, or any other product variations on 
these indices are excluded from these classes. Finally, the third key 
specification entails whether a swap falls within a tenor, specific to 
an index, that is required to be cleared. The Commission has determined 
that each of the 3-, 5-, 7-, and 10-year tenors be included within the 
class of swaps subject to the clearing requirement determination for 
CDX.NA.IG; the 5-year tenor be included for CDX.NA.HY; each of the 5- 
and 10-year for iTraxx Europe; the 5-year for iTraxx Europe Crossover; 
and, the 5-year for iTraxx Europe High Volatility. In addition, it 
should be noted that only certain series will be viewed as required to 
be cleared.
    The Commission considered a number of possible alternatives. First, 
the Commission could have used a narrower or broader group of reference 
entities. For example, the Commission has not included the 
CDX.NA.IG.HVOL within the North American swap class, but it considered 
doing so. The Commission concluded that while doing so would have 
increased the number of swaps required to be cleared, there is not 
sufficient liquidity to justify required clearing at this time given 
that the recent series of CDX.NA.IG.HVOL has not been cleared by ICE 
(and is not offered at all by CME).
    Several commenters raised issues regarding the operational 
capabilities of clearinghouses to manage the clearing of iTraxx CDS 
indices for customers.\242\ More specifically, they pointed out that no 
registered DCO currently offers customer clearing for iTraxx and 
expressed concerns about the ability of clearinghouses to manage 
restructuring credit events applicable to iTraxx. On the other hand, 
Citadel and ICE both supported the inclusion of iTraxx CDS indices in 
the clearing requirement. In particular, ICE stated that ICE Clear 
Europe has begun the process of pursuing regulatory approval for 
clearing of iTraxx and that ICE Clear Credit will do the same; 
moreover, ICE said that it has worked closely with market participants 
and DTCC to develop an industry wide solution for processing a 
restructuring credit event.
---------------------------------------------------------------------------

    \242\ ISDA, FIA, MFA, and D.E. Shaw.
---------------------------------------------------------------------------

    Having considered the different views, the Commission is including 
the iTraxx class of CDS as proposed. The Commission believes that the 
uncertainty surrounding the implementation of customer clearing for 
iTraxx will be resolved within the next few months, which will allow 
this standard and liquid class of CDS to be cleared. If no eligible DCO 
offers iTraxx for client clearing, compliance with the required 
clearing of iTraxx will commence sixty days after the date on which 
iTraxx is first offered for client clearing by an eligible DCO.
    The Commission also considered whether it could include tranched 
CDS in the clearing requirement. The Commission recognized in the NPRM 
that there is a significant market for tranched swaps using the 
indices. In these transactions, parties to the CDS contract agree to 
address only a certain range of losses along the entire loss 
distribution curve. Other swaps such as first or ``Nth'' to default 
baskets, and options, also exist on the indices. However, these swaps 
are not being cleared currently and were not submitted by a DCO for 
consideration under Sec.  39.5. As a result, including tranched CDS was 
not a viable alternative for this determination.
    AFR noted that requiring clearing of only untranched CDS indices 
may give rise to arbitrage opportunities, as the payoff properties 
desired from an index can be closely replicated by trading tranches of 
that index. The Commission recognizes this concern and will take into 
account the possibility of arbitrage opportunities in its future 
reviews of tranched CDS for clearing determination.
    Regarding tenor, the Commission could have included more of those 
offered within the classes of swaps required to be cleared. For 
example, the Commission noted in the NPRM that the CDX.NA.IG has 1- and 
2-year tenors and the CDX.NA.HY, has 3-, 7-, and 10-year tenors that 
have not been included among the specified tenors. The iTraxx Europe 
has 3- and 7-year tenors and the Crossover and High Volatility each 
have 3-, 7-, and 10-year tenors that have not been included. In 
addition, the Commission could have included all series of active 
indices. The Commission's concern, regarding both tenors and series, is 
that certain tenors and series have lower liquidity and may be 
difficult for a DCO to adequately risk manage, which is reflected in 
the fact that those tenors and series are not currently cleared by any 
DCO. While including more tenors and series would have increased the 
volume of swaps required to be cleared to some degree, the Commission 
concluded that doing so could raise costs for DCOs and other market 
participants and be less desirable relative to the factors established 
in Sec.  39.5.
    AFR commented that both the 1- and 2-year tenors of the CDX.NA.IG 
should be included in the clearing requirement. It is concerned that 
``market participants might shift to those tenors to avoid mandatory 
clearing [of the longer tenors].'' The Commission notes that no DCO 
currently clears the 1- or 2-year tenor of CDX.NA.IG, making the 
clearing of either swap infeasible. However, the Commission recognizes 
that requiring mandatory clearing of these shorter tenors may prevent

[[Page 74332]]

arbitrage opportunities if they generate sufficient trading volumes in 
the future.
    With regard to interest rate swaps, as mentioned above, the 
Commission is finalizing a clearing requirement for four classes of 
interest rate swaps: Fixed-to-floating swaps, basis swaps, OIS, and 
FRAs. Within those four classes, there are three affirmative 
specifications for each class ((i) Currency in which the notional and 
payment amounts are specified, (ii) rates referenced for each leg of 
the swap, and (iii) stated termination date of the swap). There are 
also three ``negative'' specifications for each class ((i) No 
optionality (as specified by the DCOs); (ii) no dual currencies; and 
(iii) no unknown notional amounts). The Commission considered whether 
to establish clearing requirements on a product-by-product basis. As 
noted in the NPRM, such a determination would need to identify the 
multitude of legal specifications of each product that would be subject 
to the clearing requirement. Although the industry uses standardized 
definitions and conventions, the product descriptions would be lengthy 
and require counterparties to compare all of the legal terms of their 
particular swap against the terms of the many different swaps that 
would be included in a clearing requirement. The Commission continues 
to believe that for interest rate swaps, a product-by-product 
determination would be unnecessarily burdensome for market participants 
in trying to assess whether each swap transaction is subject to the 
requirement. A class-based approach allows market participants to 
determine quickly whether they need to submit their swap to a DCO for 
clearing by checking initially whether the swap has the basic 
specifications that define each class subject to the clearing 
requirement.
    As an alternative to the classes selected, LCH recommended in its 
IRS submission that the Commission use the following specifications to 
classify interest rate swaps for purposes of making a clearing 
determination: (i) Swap class (i.e., what the two legs of the swap are 
(fixed-to-floating, basis, OIS, etc.)); (ii) floating rate definitions 
used; (iii) the currency designated for swap calculations and payments; 
(iv) stated final term of the swap (also known as maturity); (v) 
notional structure over the life of the swap (constant, amortizing, 
roller coaster, etc.); (vi) floating rate frequency; (vii) whether 
optionality is included; and (viii) whether a single currency or more 
than one currency is used for denominating payments and notional 
amount. In its submission, CME recommended a clearing determination for 
all non-option interest rate swaps denominated in a currency cleared by 
any qualified DCO.
    The Commission noted in the NPRM that these alternative 
specifications fall into two general categories: specifications that 
are commonly used to address mechanical issues for most swaps, and 
specifications that are less common and address idiosyncratic issues 
related to the particular needs of a counterparty. Examples of the 
latter are special representations added to address particular legal 
issues, unique termination events, special fees, and conditions tied to 
events specific to the parties. None of the DCOs clear interest rate 
swaps with terms in the second group. While such specifications may 
affect the value of the swap, such specifications are not, generally 
speaking, fundamental to determining the economic result the parties 
are trying to achieve.\243\ The Commission is finalizing the three 
affirmative specifications described above because it believes that 
they are fundamental specifications used by counterparties to determine 
the economic result of a swap transaction for each party.\244\
---------------------------------------------------------------------------

    \243\ As noted in Section II.E above, mechanical specifications 
include characteristics such as floating rate reset tenors, 
reference city for business days, business day convention, and 
others that have some small impact on valuation but that do not 
fundamentally alter the economic consequence of the swap for the 
parties that enter into it.
    \244\ In a comment, ISDA questioned the Commission's description 
of mechanical and idiosyncratic factors. In response, the Commission 
clarified that it is not introducing a new test for interest rate 
swaps, but was merely setting forth and describing relevant class-
defining specifications. See Section II.D above for a full 
discussion.
---------------------------------------------------------------------------

    The Commission also noted in the NPRM that it could have not 
included the negative specifications for interest rate swaps, which 
would have had the potential effect of including more interest rate 
swaps within the universe of those required to be cleared. However, the 
Commission continues to believe that swaps with optionality (such as 
swaptions or swaps with embedded options), multiple currency swaps, and 
swaps with notional amounts that are not specified at the time of 
execution raise concerns regarding adequate pricing measures and 
consistency across swap contracts. Additionally, at this time, no DCO 
is offering them for clearing.
    Another alternative considered by the Commission and discussed in 
the NPRM was that of stating the clearing requirement in terms of a 
particular type of swap, rather than using broad characteristics to 
describe the type of swaps for which clearing would be required. For 
example, rather than requiring that all interest rate swaps that meet 
the six specifications in Sec.  50.4(a) be cleared, the Commission 
noted in the NPRM that the rule could have specified that only certain 
sub-types of those interest rate swaps--such as all such interest rate 
swaps with a term of five years--are required to be cleared. Such an 
approach might permit the Commission to account for variation in 
liquidity and outstanding notional values among different sub-types of 
swap, and thereby focus the clearing requirement on very particular 
swaps to account for these differences within the same general class. 
Also, generally speaking, limiting the clearing requirement to fewer 
swaps could reduce some costs associated with clearing.
    However, this advantage was weighed against an important 
disadvantage of this approach. A highly focused clearing requirement 
could increase the ability for market participants to replicate the 
economic results of a swap that is required to be cleared by 
substituting a swap not required to be cleared; this greater latitude 
for clearing avoidance, in turn, could increase systemic risk and 
dampen the beneficial effects of clearing noted above.\245\ Under the 
approach proposed by the Commission, all swaps that fall within 
identified classes are covered by the clearing requirement, provided an 
eligible DCO offers the swap for clearing, which reduces the risk of 
such avoidance and the associated reduction of benefits. Moreover, 
stating the clearing requirement in more general terms reduces the 
costs associated with determining whether or not a particular swap is 
subject to the clearing requirement.
---------------------------------------------------------------------------

    \245\ For instance, in the example noted above, swaps with a 
term of five years and one day would not be required to be cleared.
---------------------------------------------------------------------------

    Numerous commenters expressed support for the Commission's 
specifications determination.\246\ CME stated that ``the Commission has 
struck an appropriate balance for the initial slate of classes subject 
to the requirement.'' LCH commented that ``the Commission's decision to 
classify interest rate swaps based on six principle swap specifications 
* * * is sound.'' Citadel stated that the Commission's class 
designation approach ``reflects the risk management approach utilized 
across the industry, and most importantly by DCOs'' to

[[Page 74333]]

determine necessary margin and other safeguards.
---------------------------------------------------------------------------

    \246\ AllianceBernstein, R.J. O'Brien, Citadel, Eris Exchange, 
CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies, 
Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris 
Barnard, and Svenokur.
---------------------------------------------------------------------------

    On the other hand, regarding interest rate swaps, ISDA is concerned 
that the Commission's class-based approach will impose great burdens 
and uncertainties in terms of ``the search efforts needed to filter out 
from among the broad class those specific products that a DCO will 
accept for clearing.'' The Commission notes that ISDA's concern may not 
be justified, as CME already has a platform in place that ``provides 
market participants with a tool to screen a particular swap for 
eligibility for clearing upon submission of the swap to CME.''
    The Commission also considered requiring clearing for all seventeen 
currencies of interest rate swaps that are currently offered for 
clearing, but decided instead to require clearing at this time for 
interest rate swaps in four currencies (EUR, USD, GBP, and JPY). As 
noted in the NPRM, the Commission recognizes that requiring interest 
rate swaps in all seventeen currencies submitted by LCH to be cleared 
would provide the benefit of some incremental reduction in overall 
counterparty, and thus systemic, risk attendant to clearing a greater 
portion of interest rate swaps. However, as noted above, the Commission 
continues to believe that initiating the clearing requirement in a 
measured manner with respect to interest rate swaps in the four 
specified currencies familiar to many market participants is the 
preferable approach at this time because it would give market 
participants an opportunity to identify and address any operational 
challenges related to required clearing. Moreover, the currencies 
included in the required classes constitute approximately 93% of 
cleared interest rate swaps, which suggests that significant reductions 
in counterparty risk and gains in systemic protection will be 
accomplished by limiting the clearing determination to them.\247\
---------------------------------------------------------------------------

    \247\ See Section II.F above for more thorough discussion of the 
data.
---------------------------------------------------------------------------

    LCH supported the Commission's determination, and recommended that 
the Commission propose mandatory clearing of swaps denominated in the 
other 13 currencies once the initial phase of mandatory clearing is 
well-established. LCH stated that there is ``ample volume and liquidity 
in swaps denominated in these currencies to support mandatory 
clearing.'' The Commission will evaluate the benefits of this 
recommendation against the cost burdens in its future determinations.
    Similarly, the Commission considered requiring clearing of all CDS 
that are currently being cleared, but did not propose to include, in 
the initial clearing requirement, certain types of CDS that have a less 
significant role in the current market.\248\
---------------------------------------------------------------------------

    \248\ For instance, the Commission decided not to include 
CDX.NA.IG.HiVol from the proposed determination given the lack of 
volume in the current on-the-run and recent off-the-run series. In 
addition, CME currently does not clear any HiVol contracts, and ICE 
Clear Credit no longer clears the most recent series.
---------------------------------------------------------------------------

    AFR and Chris Barnard both urged the Commission to rapidly 
designate energy, agriculture and equity swaps for mandatory clearing 
as well. The Commission reiterates that it will continue to review swap 
submissions received from DCOs and will issue clearing requirement for 
other classes of swaps so as to realize the benefits of clearing in a 
timely manner.

E. Section 15(a) Factors

    As noted above, the requirement to clear swaps within the classes 
of swaps covered by this adopting release is expected to result in 
increased use of clearing, although it is difficult to quantify the 
extent of that increase. Thus, this section discusses the expected 
results from an overall increase in the use of swap clearing in terms 
of the factors set forth in section 15(a) of the CEA.
i. Protection of Market Participants and the Public
    As described above, required clearing of CDS and interest rate 
swaps resulting from this clearing determination is expected to reduce 
counterparty credit risk for market participants that will now be 
required to clear those swaps because they will face the DCO rather 
than another market participant that lacks the full array of risk 
management tools that the DCO has at its disposal. This increase in 
clearing of CDS and interest rate swaps also reduces uncertainty in 
times of market stress because market participants facing a DCO are 
less concerned with the impact of such stress on the solvency of their 
counterparty for cleared trades. Moreover, by reducing uncertainty 
about counterparty solvency for market participants facing a DCO, the 
clearing determinations under this adopting release are likely to 
reduce the risk of contagion if one or more DCO customers or clearing 
members fails during a time of market stress, which creates benefits 
for the public.
    By requiring clearing of swaps within certain classes, all of which 
are already available for clearing, the Commission continues to expect, 
as it stated in the NPRM, that this rule will encourage a smooth 
transition to clearing by creating an opportunity for market 
participants to work out challenges related to required clearing of 
swaps while operating in familiar terrain. More specifically, the DCOs 
will clear an increased volume of swaps that they already understand 
and have experience managing. Similarly, FCMs likely will realize 
increased customer and transaction volume as the result of the 
requirement, but will not have to simultaneously learn how to 
operationalize clearing for new types of swaps. Additionally, the 
experience that current FCMs have with these swaps is likely to benefit 
customers that are new to swap clearing, as the FCM guides them through 
initial process of clearing swaps.\249\
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    \249\ As discussed in Section II.C and II.E above, DCOs offering 
clearing for CDS and interest rate swaps have established extensive 
risk management practices, which focus on the protection of market 
participants. See also Sections II.D and II.F for a discussion of 
the effect on the mitigation of systemic risk in the CDS market and 
in the interest rate swaps market, as well as the protection of 
market participants during insolvency events at either the clearing 
member or DCO level.
---------------------------------------------------------------------------

    In addition, uncleared swaps subject to collateral agreements can 
be the subject of valuation disputes. These valuation disputes 
sometimes require several months, or longer, to resolve. 
Uncollateralized exposure can grow significantly during that time, 
leaving one of the two parties exposed to counterparty credit risk that 
was intended to be covered through a collateral agreement. DCOs 
eliminate, or reduce, valuation disputes for cleared swaps as well as 
the risk that uncollateralized exposure can develop and accumulate 
during the time when such a dispute would have otherwise occurred, thus 
providing additional protection to market participants that transact in 
swaps subject to required clearing.\250\
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    \250\ See Sections II.D and II.F above for a further discussion 
of how DCOs obtain adequate pricing data for the CDS and interest 
rate swaps that they clear. Based on this pricing data, valuation 
disputes are minimized, if not eliminated for cleared swaps.
---------------------------------------------------------------------------

    As far as costs are concerned, market participants that do not 
currently have established clearing relationships with an FCM will have 
to set up and maintain such a relationship in order to clear swaps that 
are required to be cleared. As discussed above, market participants 
that conduct a limited number of swaps per year will likely be required 
to pay monthly or annual fees that FCMs charge to maintain both the 
relationship and outstanding swap positions belonging to the customer. 
In addition, the FCM is likely to pass along fees charged by the DCO 
for establishing and maintaining open positions.

[[Page 74334]]

ii. Efficiency, Competitiveness, and Financial Integrity of Swap 
Markets
    The Commission continues to expect, as it explained in the NPRM, 
that increased clearing of the CDS and interest rate swaps subject to 
this adopting release is expected to reduce uncertainty regarding 
counterparty credit risk in times of market stress and promote 
liquidity and efficiency during those times. Increased liquidity 
promotes the ability of market participants to limit losses from 
exiting positions effectively when necessary in order to manage risk 
during a time of market stress.
    In addition, to the extent that positions move from facing multiple 
counterparties in the bilateral market to being run through a smaller 
number of clearinghouses, clearing likely facilitates increased 
netting. This netting effect reduces operational risk and may reduce 
the amount of collateral that a party must post or pay in terms of 
initial and variation margin.
    As discussed in Sections II.D and II.F above, in setting forth this 
new clearing requirement, the Commission took into account a number of 
specific factors that relate to the financial integrity of the swap 
markets. Specifically, the NPRM and the discussion above includes an 
assessment of whether the DCOs clearing CDS and interest rate swaps 
have the rule framework, capacity, operational expertise and resources, 
and credit support infrastructure to clear CDS and interest rate swaps 
on terms that are consistent with the material terms and trading 
conventions on which the contract is then traded. The Commission also 
considered the financial resources of DCOs to handle additional 
clearing, as well as the existence of reasonable legal certainty in the 
event of a clearing member or DCO insolvency.\251\
---------------------------------------------------------------------------

    \251\ See Sections II.D and II.F.
---------------------------------------------------------------------------

    As discussed above, bilateral swaps create counterparty risk that 
may lead market participants to discriminate among potential 
counterparties based on their creditworthiness. Such discrimination is 
expensive and time consuming insofar as market participants must 
conduct due diligence in order to evaluate a potential counterparty's 
creditworthiness. Requiring the certain types of swaps subject to this 
clearing determination to be cleared reduces the number of transactions 
for which such due diligence is necessary, thereby contributing to the 
efficiency of the swap markets.
    In setting forth a clearing requirement for both CDS and interest 
rate swaps, the Commission considered the effect on competition, 
including appropriate fees and charges applied to clearing. As 
discussed in more detail in Sections II.D and II.F above, there are a 
number of potential outcomes that may result from required clearing. 
Some of these outcomes may impose costs, such as if a DCO possessed 
market power and exercised that power in a anticompetitive manner, and 
some of the outcomes would be positive, such as if the clearing 
requirement facilitated a stronger entry-opportunity for competitors.
    As far as costs are concerned, the markets for some swaps within 
the classes that are required to be cleared may be less liquid than 
others. All other things being equal, swaps for which the markets are 
less liquid have the potential to develop larger current 
uncollateralized exposures after a default on a cleared position, and 
therefore will require posting of relatively greater amounts of initial 
margin.
iii. Price Discovery
    As the Commission noted in the NPRM, clearing of CDS and interest 
rate swaps subject to this new clearing requirement is likely to 
encourage better price discovery because it eliminates the importance 
of counterparty creditworthiness in pricing swaps cleared through a 
given DCO. That is, by making the counterparty creditworthiness of all 
swaps of a certain type essentially the same, prices should reflect 
factors related to the terms of the swap, rather than the idiosyncratic 
risk posed by the entities trading it.\252\
---------------------------------------------------------------------------

    \252\ See Chen, K., et al., ``An Analysis of CDS Transactions: 
Implications for Public Reporting,'' September 2011, Federal Reserve 
Bank of New York Staff Reports, at 14, available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf.
---------------------------------------------------------------------------

    As discussed in Sections II.D and II.F above, DCOs obtain adequate 
pricing data for the CDS and interest rate swaps that they clear. Each 
DCO establishes a rule framework for its pricing methodology and 
rigorously tests its pricing models to ensure that the cornerstone of 
its risk management regime is as sound as possible.
iv. Sound Risk Management Practices
    If a firm enters into swaps to hedge certain positions and then the 
counterparty to those swaps defaults unexpectedly, the firm could be 
left with large outstanding exposures and unhedged positions. As 
explained in the NPRM and stated above, when a swap is cleared, the DCO 
becomes the counterparty facing each of the two original counterparties 
to the swap. This standardizes and reduces counterparty credit risk for 
each of the two original participants. To the extent that a market 
participant's hedges comprise swaps that are required to be cleared, 
the requirement enhances their risk management practices by reducing 
their counterparty risk. Accordingly, for counterparties required to 
clear those CDS and interest rate swaps subject to this requirement, 
risk management will be enhanced.
    In addition, from systemic perspective, required clearing reduces 
the complexity of unwinding/transferring swap positions from large 
entities that default. Procedures for transfer of swap positions and 
mutualization of losses among DCO members are already in place, and the 
Commission continues to anticipate that they are much more likely to 
function in a manner that enables efficient transfer of positions than 
legal processes that apply to uncleared, bilateral swaps.\253\
---------------------------------------------------------------------------

    \253\ As discussed in Sections II.C and II.E above, sound risk 
management practices are critical for all DCOs, especially those 
offering clearing for CDS and interest rate swaps. In the discussion 
above, the Commission considered whether each DCO submission under 
review was consistent with the core principles for DCOs. In 
particular, the Commission considered the DCO submissions in light 
of Core Principle D, which relates to risk management. See also 
Sections II.D and II.F for a discussion of the effect on the 
mitigation of systemic risk in the CDS market and in the interest 
rate swaps market, as well as the protection of market participants 
during insolvency events at either the clearing member or DCO level.
---------------------------------------------------------------------------

v. Other Public Interest Considerations
    In September 2009, the President and the other leaders of the 
``G20'' nations met in Pittsburgh and committed to a program of action 
that includes, among other things, central clearing of all standardized 
swaps.\254\ Together, interest rate swaps and CDS represent more than 
75% of the notional amount of outstanding swaps, and therefore, 
requiring the most active, standardized classes of swaps within those 
groups to be cleared represents a significant step toward the 
fulfillment of that commitment.
---------------------------------------------------------------------------

    \254\ A list of the G20 commitments made in Pittsburgh can be 
found at: http://www.g20.utoronto.ca/analysis/commitments-09-pittsburgh.html.
---------------------------------------------------------------------------

VI. Related Matters

A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA) requires that agencies 
consider whether the rules they propose will have a

[[Page 74335]]

significant economic impact on a substantial number of small entities 
and, if so, provide a regulatory flexibility analysis respecting the 
impact.\255\ As stated in the NPRM, the clearing requirement 
determinations and rules proposed by the Commission will affect only 
eligible contract participants (ECPs) because all persons that are not 
ECPs are required to execute their swaps on a DCM, and all contracts 
executed on a DCM must be cleared by a DCO, as required by statute and 
regulation; not by operation of any clearing requirement.\256\ 
Accordingly, the Chairman, on behalf of the Commission, certified 
pursuant to 5 U.S.C. 605(b) that the proposed rules would not have a 
significant economic impact on a substantial number of small entities. 
The Commission then invited public comment on this determination. The 
Commission received no comments.
---------------------------------------------------------------------------

    \255\ See 5 U.S.C. 601 et seq.
    \256\ To the extent that this rulemaking affects DCMs, DCOs, or 
FCMs, the Commission has previously determined that DCMs, DCOs, and 
FCMs are not small entities for purposes of the RFA. See, 
respectively and as indicated, 47 FR 18618, 18619, Apr. 30, 1982 
(DCMs and FCMs); and 66 FR 45604, 45609, Aug. 29, 2001 (DCOs).
---------------------------------------------------------------------------

    The Commission has previously determined that ECPs are not small 
entities for purposes of the RFA.\257\ However, in its proposed 
rulemaking to establish a schedule to phase in compliance with certain 
provisions of the Dodd-Frank Act, including the clearing requirement 
under section 2(h)(1)(A) of the CEA, the Commission received a joint 
comment (Electric Associations Letter) from the Edison Electric 
Institute (EEI), the National Rural Electric Cooperative Association 
(NRECA) and the Electric Power Supply Association (EPSA) asserting that 
certain members of NRECA may both be ECPs under the CEA and small 
businesses under the RFA.\258\ These members of NRECA, as the 
Commission understands, have been determined to be small entities by 
the Small Business Administration (SBA) because they are ``primarily 
engaged in the generation, transmission, and/or distribution of 
electric energy for sale and [their] total electric output for the 
preceding fiscal year did not exceed 4 million megawatt hours.'' \259\ 
Although the Electric Associations Letter does not provide details on 
whether or how the NRECA members that have been determined to be small 
entities use the interest rate swaps and CDS that are the subject of 
this rulemaking, the Electric Associations Letter does state that the 
EEI, NRECA, and EPSA members ``engage in swaps to hedge commercial 
risk.'' \260\ Because the NRECA members that have been determined to be 
small entities would be using swaps to hedge commercial risk, the 
Commission expects that they would be able to use the end-user 
exception from the clearing requirement and therefore would not be 
affected to any significant extent by this rulemaking.
---------------------------------------------------------------------------

    \257\ See 66 F.R. 20740, 20743 (Apr. 25, 2001).
    \258\ See joint letter from EEI, NRECA, and ESPA, dated Nov. 4, 
2011, (Electric Associations Letter), commenting on Swap Transaction 
Compliance and Implementation Schedule: Clearing and Trade Execution 
Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 
2011).
    \259\ Small Business Administration, Table of Small Business 
Size Standards, Nov. 5, 2010.
    \260\ See Electric Associations Letter, at 2. The letter also 
suggests that EEI, NRECA, and EPSA members are not financial 
entities. See id., at note 5, and at 5 (the associations' members 
``are not financial companies'').
---------------------------------------------------------------------------

    Thus, because nearly all of the ECPs that may be subject to the 
proposed clearing requirement are not small entities, and because the 
few ECPs that have been determined by the SBA to be small entities are 
unlikely to be subject to the clearing requirement, the Chairman, on 
behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that 
the rules herein will not have a significant economic impact on a 
substantial number of small entities.

B. Paperwork Reduction Act

    The Paperwork Reduction Act (PRA) \261\ imposes certain 
requirements on federal agencies (including the Commission) in 
connection with conducting or sponsoring any collection of information 
as defined by the PRA. As stated in the NPRM, Sec.  50.3(a), would 
require each DCO to post on its Web site a list of all swaps that it 
will accept for clearing and clearly indicate which of those swaps the 
Commission has determined are required to be cleared, builds upon the 
requirements of Sec.  39.21(c)(1), which requires each DCO to disclose 
publicly information concerning the terms and conditions of each 
contract, agreement, and transaction cleared and settled by the DCO. 
The Commission received no comments related to PRA. Thus, this 
rulemaking will not require a new collection of information from any 
persons or entities.
---------------------------------------------------------------------------

    \261\ 44 U.S.C. 3507(d).
---------------------------------------------------------------------------

List of Subjects

17 CFR Part 39

    Business and industry, Reporting requirements, Swaps.

17 CFR Part 50

    Business and industry, Clearing, Swaps.

    For the reasons stated in the preamble, amend 17 CFR parts 39 and 
50 as follows:

PART 39--DERIVATIVES CLEARING ORGANIZATIONS

0
1. The authority citation for part 39 continues to read as follows:

    Authority: 7 U.S.C. 2 and 7a-1 as amended by Pub. L. 111-203, 
124 Stat. 1376.


Sec.  39.6  [Removed and Reserved]

0
2. Remove and reserve Sec.  39.6.

PART 50--CLEARING REQUIREMENT AND RELATED RULES

0
3. The authority citation to part 50 is revised to read as follows:

    Authority: 7 U.S.C. 2(h) and 7a-1 as amended by Pub. L. 111-203, 
124 Stat. 1376.


0
4. Add subpart A, consisting of Sec. Sec.  50.1 through 50.24 to read 
as follows:
Subpart A--Definitions and Clearing Requirement
Sec.
50.1 Definitions.
50.2 Treatment of swaps subject to a clearing requirement.
50.3 Notice to the public.
50.4 Classes of swaps required to be cleared.
50.5 Swaps exempt from a clearing requirement.
50.6 Delegation of authority.
50.7-50.9 [Reserved]
50.10 Prevention of evasion of the clearing requirement and abuse of 
an exception or exemption to the clearing requirement.
50.11-50.24 [Reserved]

Subpart A--Definitions and Clearing Requirement


Sec.  50.1  Definitions.

    For the purposes of this part,
    Business day means any day other than a Saturday, Sunday, or legal 
holiday.
    Day of execution means the calendar day of the party to the swap 
that ends latest, provided that if a swap is:
    (1) Entered into after 4:00 p.m. in the location of a party; or
    (2) Entered into on a day that is not a business day in the 
location of a party, then such swap shall be deemed to have been 
entered into by that party on the immediately succeeding business day 
of that party, and the day of execution shall be determined with 
reference to such business day.


Sec.  50.2  Treatment of swaps subject to a clearing requirement.

    (a) All persons executing a swap that:
    (1) Is not subject to an exception under section 2(h)(7) of the Act 
or Sec.  50.50 of this part; and

[[Page 74336]]

    (2) Is included in a class of swaps identified in Sec.  50.4 of 
this part, shall submit such swap to any eligible derivatives clearing 
organization that accepts such swap for clearing as soon as 
technologically practicable after execution, but in any event by the 
end of the day of execution.
    (b) Each person subject to the requirements of paragraph (a) of 
this section shall undertake reasonable efforts to verify whether a 
swap is required to be cleared.
    (c) For purposes of paragraph (a) of this section, persons that are 
not clearing members of an eligible derivatives clearing organization 
shall be deemed to have complied with paragraph (a) of this section 
upon submission of such swap to a futures commission merchant or 
clearing member of a derivatives clearing organization, provided that 
submission occurs as soon as technologically practicable after 
execution, but in any event by the end of the day of execution.


Sec.  50.3  Notice to the public.

    (a) In addition to its obligations under Sec.  39.21(c)(1), each 
derivatives clearing organization shall make publicly available on its 
Web site a list of all swaps that it will accept for clearing and 
identify which swaps on the list are required to be cleared under 
section 2(h)(1) of the Act and this part.
    (b) The Commission shall maintain a current list of all swaps that 
are required to be cleared and all derivatives clearing organizations 
that are eligible to clear such swaps on its Web site.


Sec.  50.4  Classes of swaps required to be cleared.

    (a) Interest rate swaps. Swaps that have the following 
specifications are required to be cleared under section 2(h)(1) of the 
Act, and shall be cleared pursuant to the rules of any derivatives 
clearing organization eligible to clear such swaps under Sec.  39.5(a) 
of this chapter.

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
          Specification                                    Fixed-to-floating swap class
----------------------------------------------------------------------------------------------------------------
Currency........................  U.S. dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
Floating Rate Indexes...........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
Stated Termination Date Range...  28 days to 50       28 days to 50       28 days to 50       28 days to 30
                                   years.              years.              years.              years.
Optionality.....................  No................  No................  No................  No.
Dual Currencies.................  No................  No................  No................  No.
Conditional Notional Amounts....  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                                          Basis swap class
----------------------------------------------------------------------------------------------------------------
Currency........................  U.S. dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
Floating Rate Indexes...........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
Stated Termination Date Range...  28 days to 50       28 days to 50       28 days to 50       28 days to 30
                                   years.              years.              years.              years.
Optionality.....................  No................  No................  No................  No.
Dual Currencies.................  No................  No................  No................  No.
Conditional Notional Amounts....  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                                    Forward rate agreement class
----------------------------------------------------------------------------------------------------------------
Currency........................  U.S. dollar (USD).  Euro (EUR)........  Sterling (GBP)....  Yen (JPY).
Floating Rate Indexes...........  LIBOR.............  EURIBOR...........  LIBOR.............  LIBOR.
Stated Termination Date Range...  3 days to 3 years.  3 days to 3 years.  3 days to 3 years.  3 days to 3 years.
Optionality.....................  No................  No................  No................  No.
Dual Currencies.................  No................  No................  No................  No.
6. Conditional Notional Amounts.  No................  No................  No................  No.
----------------------------------------------------------------------------------------------------------------
          Specification                           Overnight index swap class
----------------------------------------------------------------------------------------------------------------
Currency........................  U.S. dollar (USD).  Euro (EUR)........  Sterling (GBP).
Floating Rate Indexes...........  FedFunds..........  EONIA.............  SONIA.
Stated Termination Date Range...  7 days to 2 years.  7 days to 2 years.  7 days to 2 years.
Optionality.....................  No................  No................  No.
Dual Currencies.................  No................  No................  No.
Conditional Notional Amounts....  No................  No................  No.
----------------------------------------------------------------------------------------------------------------

    (b) Credit default swaps. Swaps that have the following 
specifications are required to be cleared under section 2(h)(1) of the 
Act, and shall be cleared pursuant to the rules of any derivatives 
clearing organization eligible to clear such swaps under Sec.  39.5(a) 
of this chapter.

----------------------------------------------------------------------------------------------------------------
                          Specification                             North American untranched CDS indices class
----------------------------------------------------------------------------------------------------------------
Reference Entities...............................................  Corporate.
Region...........................................................  North America.
Indices..........................................................  CDX.NA.IG; CDX.NA.HY.
Tenor............................................................  CDX.NA.IG: 3Y, 5Y, 7Y, 10Y; CDX.NA.HY: 5Y.
Applicable Series................................................  CDX.NA.IG 3Y: Series 15 and all subsequent
                                                                    Series, up to and including the current
                                                                    Series.
                                                                   CDX.NA.IG 5Y: Series 11 and all subsequent
                                                                    Series, up to and including the current
                                                                    Series.
                                                                   CDX.NA.IG 7Y: Series 8 and all subsequent
                                                                    Series, up to and including the current
                                                                    Series.
                                                                   CDX.NA.IG 10Y: Series 8 and all subsequent
                                                                    Series, up to and including the current
                                                                    Series.
                                                                   CDX.NA.HY 5Y: Series 11 and all subsequent
                                                                    Series, up to and including the current
                                                                    Series.
Tranched.........................................................  No.
----------------------------------------------------------------------------------------------------------------


[[Page 74337]]


 
                          Specification                                European untranched CDS indices class
----------------------------------------------------------------------------------------------------------------
Reference Entities...............................................  Corporate.
Region...........................................................  Europe.
Indices..........................................................  iTraxx Europe.
                                                                   iTraxx Europe Crossover.
                                                                   iTraxx Europe HiVol.
Tenor............................................................  iTraxx Europe: 5Y, 10Y.
                                                                   iTraxx Europe Crossover: 5Y.
                                                                   iTraxx Europe HiVol: 5Y.
Applicable Series................................................  iTraxx Europe 5Y: Series 10 and all
                                                                    subsequent Series, up to and including the
                                                                    current Series.
                                                                   iTraxx Europe 10Y: Series 7 and all
                                                                    subsequent Series, up to and including the
                                                                    current Series.
                                                                   iTraxx Europe Crossover 5Y: Series 10 and all
                                                                    subsequent Series, up to and including the
                                                                    current Series.
                                                                   iTraxx Europe HiVol 5Y: Series 10 and all
                                                                    subsequent Series, up to and including the
                                                                    current Series.
Tranched.........................................................  No.
----------------------------------------------------------------------------------------------------------------

Sec.  50.5  Swaps exempt from a clearing requirement.

    (a) Swaps entered into before July 21, 2010 shall be exempt from 
the clearing requirement under Sec.  50.2 of this part if reported to a 
swap data repository pursuant to section 2(h)(5)(A) of the Act and 
Sec.  46.3(a) of this chapter.
    (b) Swaps entered into before the application of the clearing 
requirement for a particular class of swaps under Sec. Sec.  50.2 and 
50.4 of this part shall be exempt from the clearing requirement if 
reported to a swap data repository pursuant to section 2(h)(5)(B) of 
the Act and either Sec.  46.3(a) or Sec. Sec.  45.3 and 45.4 of this 
chapter, as appropriate.


Sec.  50.6  Delegation of Authority.

    (a) The Commission hereby delegates to the Director of the Division 
of Clearing and Risk or such other employee or employees as the 
Director may designate from time to time, with the consultation of the 
General Counsel or such other employee or employees as the General 
Counsel may designate from time to time, the authority:
    (1) After prior notice to the Commission, to determine whether one 
or more swaps submitted by a derivatives clearing organization under 
Sec.  39.5 falls within a class of swaps as described in Sec.  50.4, 
provided that inclusion of such swaps is consistent with the 
Commission's clearing requirement determination for that class of 
swaps; and
    (2) To notify all relevant derivatives clearing organizations of 
that determination.
    (b) The Director of the Division of Clearing and Risk may submit to 
the Commission for its consideration any matter which has been 
delegated in this section. Nothing in this section prohibits the 
Commission, at its election, from exercising the authority delegated in 
this section.


Sec.  50.7-50.9  [Reserved].


Sec.  50.10  Prevention of evasion of the clearing requirement and 
abuse of an exception or exemption to the clearing requirement.

    (a) It shall be unlawful for any person to knowingly or recklessly 
evade or participate in or facilitate an evasion of the requirements of 
section 2(h) of the Act or any Commission rule or regulation 
promulgated thereunder.
    (b) It shall be unlawful for any person to abuse the exception to 
the clearing requirement as provided under section 2(h)(7) of the Act 
or an exception or exemption under this chapter.
    (c) It shall be unlawful for any person to abuse any exemption or 
exception to the requirements of section 2(h) of the Act, including any 
exemption or exception as the Commission may provide by rule, 
regulation, or order.

0
5. Designate Sec.  50.25 under new subpart B under the following 
heading and add reserved Sec. Sec.  50.26 through 50.49.

Subpart B--Compliance Schedule

Sec.
50.25 Clearing requirement compliance schedule.
50.26-50.49 [Reserved]

0
6. Add subpart C, consisting of Sec.  50.50, to read as follows:

Subpart C--Exceptions and Exemptions to Clearing Requirement


Sec.  50.50  Exceptions to the clearing requirement.

    (a) Non-financial entities. (1) A counterparty to a swap may elect 
the exception to the clearing requirement under section 2(h)(7)(A) of 
the Act if the counterparty:
    (i) Is not a ``financial entity'' as defined in section 
2(h)(7)(C)(i) of the Act;
    (ii) Is using the swap to hedge or mitigate commercial risk as 
provided in paragraph (c) of this section; and
    (iii) Provides, or causes to be provided, the information specified 
in paragraph (b) of this section to a registered swap data repository 
or, if no registered swap data repository is available to receive the 
information from the reporting counterparty, to the Commission. A 
counterparty that satisfies the criteria in this paragraph (a)(1) and 
elects the exception is an ``electing counterparty.''
    (2) If there is more than one electing counterparty to a swap, the 
information specified in paragraph (b) of this section shall be 
provided with respect to each of the electing counterparties.
    (b) Reporting. (1) When a counterparty elects the exception to the 
clearing requirement under section 2(h)(7)(A) of the Act, one of the 
counterparties to the swap (the ``reporting counterparty,'' as 
determined in accordance with Sec.  45.8 of this part) shall provide, 
or cause to be provided, the following information to a registered swap 
data repository or, if no registered swap data repository is available 
to receive the information from the reporting counterparty, to the 
Commission, in the form and manner specified by the Commission:
    (i) Notice of the election of the exception;
    (ii) The identity of the electing counterparty to the swap; and
    (iii) The following information, unless such information has 
previously been provided by the electing counterparty in a current 
annual filing pursuant to paragraph (b)(2) of this section:
    (A) Whether the electing counterparty is a ``financial entity'' as 
defined in section 2(h)(7)(C)(i) of the Act, and if the electing 
counterparty is a financial entity, whether it is:
    (1) Electing the exception in accordance with section 
2(h)(7)(C)(iii) or section 2(h)(7)(D) of the Act; or
    (2) Exempt from the definition of ``financial entity'' as described 
in paragraph (d) of this section;

[[Page 74338]]

    (B) Whether the swap or swaps for which the electing counterparty 
is electing the exception are used by the electing counterparty to 
hedge or mitigate commercial risk as provided in paragraph (c) of this 
section;
    (C) How the electing counterparty generally meets its financial 
obligations associated with entering into non-cleared swaps by 
identifying one or more of the following categories, as applicable:
    (1) A written credit support agreement;
    (2) Pledged or segregated assets (including posting or receiving 
margin pursuant to a credit support agreement or otherwise);
    (3) A written third-party guarantee;
    (4) The electing counterparty's available financial resources; or
    (5) Means other than those described in paragraphs 
(b)(1)(iii)(C)(1), (2), (3) or (4) of this section; and
    (D) Whether the electing counterparty is an entity that is an 
issuer of securities registered under section 12 of, or is required to 
file reports under section 15(d) of, the Securities Exchange Act of 
1934, and if so:
    (1) The relevant SEC Central Index Key number for that 
counterparty; and
    (2) Whether an appropriate committee of that counterparty's board 
of directors (or equivalent body) has reviewed and approved the 
decision to enter into swaps that are exempt from the requirements of 
sections 2(h)(1) and 2(h)(8) of the Act.
    (2) An entity that qualifies for an exception to the clearing 
requirement under this section may report the information listed in 
paragraph (b)(1)(iii) of this section annually in anticipation of 
electing the exception for one or more swaps. Any such reporting under 
this paragraph shall be effective for purposes of paragraph (b)(1)(iii) 
of this section for swaps entered into by the entity for 365 days 
following the date of such reporting. During such period, the entity 
shall amend such information as necessary to reflect any material 
changes to the information reported.
    (3) Each reporting counterparty shall have a reasonable basis to 
believe that the electing counterparty meets the requirements for an 
exception to the clearing requirement under this section.
    (c) Hedging or mitigating commercial risk. For purposes of section 
2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section, 
a swap is used to hedge or mitigate commercial risk if:
    (1) Such swap:
    (i) Is economically appropriate to the reduction of risks in the 
conduct and management of a commercial enterprise, where the risks 
arise from:
    (A) The potential change in the value of assets that a person owns, 
produces, manufactures, processes, or merchandises or reasonably 
anticipates owning, producing, manufacturing, processing, or 
merchandising in the ordinary course of business of the enterprise;
    (B) The potential change in the value of liabilities that a person 
has incurred or reasonably anticipates incurring in the ordinary course 
of business of the enterprise;
    (C) The potential change in the value of services that a person 
provides, purchases, or reasonably anticipates providing or purchasing 
in the ordinary course of business of the enterprise;
    (D) The potential change in the value of assets, services, inputs, 
products, or commodities that a person owns, produces, manufactures, 
processes, merchandises, leases, or sells, or reasonably anticipates 
owning, producing, manufacturing, processing, merchandising, leasing, 
or selling in the ordinary course of business of the enterprise;
    (E) Any potential change in value related to any of the foregoing 
arising from interest, currency, or foreign exchange rate movements 
associated with such assets, liabilities, services, inputs, products, 
or commodities; or
    (F) Any fluctuation in interest, currency, or foreign exchange rate 
exposures arising from a person's current or anticipated assets or 
liabilities; or
    (ii) Qualifies as bona fide hedging for purposes of an exemption 
from position limits under the Act; or
    (iii) Qualifies for hedging treatment under:
    (A) Financial Accounting Standards Board Accounting Standards 
Codification Topic 815, Derivatives and Hedging (formerly known as 
Statement No. 133); or
    (B) Governmental Accounting Standards Board Statement 53, 
Accounting and Financial Reporting for Derivative Instruments; and
    (2) Such swap is:
    (i) Not used for a purpose that is in the nature of speculation, 
investing, or trading; and
    (ii) Not used to hedge or mitigate the risk of another swap or 
security-based swap position, unless that other position itself is used 
to hedge or mitigate commercial risk as defined by this rule or Sec.  
240.3a67-4 of this title.
    (d) For purposes of section 2(h)(7)(A) of the Act, a person that is 
a ``financial entity'' solely because of section 2(h)(7)(C)(i)(VIII) 
shall be exempt from the definition of ``financial entity'' if such 
person:
    (1) Is organized as a bank, as defined in section 3(a) of the 
Federal Deposit Insurance Act, the deposits of which are insured by the 
Federal Deposit Insurance Corporation; a savings association, as 
defined in section 3(b) of the Federal Deposit Insurance Act, the 
deposits of which are insured by the Federal Deposit Insurance 
Corporation; a farm credit system institution chartered under the Farm 
Credit Act of 1971; or an insured Federal credit union or State-
chartered credit union under the Federal Credit Union Act; and
    (2) Has total assets of $10,000,000,000 or less on the last day of 
such person's most recent fiscal year.

    Issued in Washington, DC, on November 29, 2012, by the 
Commission.
Sauntia S. Warfield,
Assistant Secretary of the Commission.

    Note: The following appendices will not appear in the Code of 
Federal Regulations: Appendices to Clearing Requirement 
Determination Under Section 2(h) of the CEA--Commission Voting 
Summary and Statement of the Chairman.


    Note: The following appendices will not appear in the Code of 
Federal Regulations.

Appendix 1--Commission Voting Summary

    On this matter, Chairman Gensler and Commissioners Sommers, 
Chilton, O'Malia and Wetjen voted in the affirmative; no 
Commissioner voted in the negative.

Appendix 2--Statement of Chairman Gary Gensler

    I support the final rule requiring certain interest rate swaps 
and credit default swap (CDS) indices to be cleared, as provided by 
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act).
    Central clearing is one of the three major building blocks of 
Dodd-Frank swaps market reform--in addition to promoting market 
transparency and bringing swap dealers under comprehensive 
oversight--and this rule completes the clearing building block.
    Central clearing lowers the risk of the highly interconnected 
financial system. It also democratizes the market by eliminating the 
need for market participants to individually determine counterparty 
credit risk, as now clearinghouses stand between buyers and sellers.
    In a cleared market, more people have access on a level playing 
field.
    Small and medium-sized businesses, banks and asset managers can 
enter the market and trade anonymously and benefit from the market's 
greater competition.
    Clearinghouses have lowered risk for the public and fostered 
competition in the futures markets since the late 19th century. 
Following the 2008 financial crisis, President Obama convened the G-
20 leaders in Pittsburgh in 2009, and an international

[[Page 74339]]

consensus formed that standardized swaps should be cleared by the 
end of 2012.
    The CFTC has already completed a number of significant Dodd-
Frank reforms laying the foundation of risk management for 
clearinghouses, futures commission merchants and other market 
participants that participate in clearing. Other reforms paving the 
way for this rule include straight-through processing for swaps and 
protections for customer funds.
    This rule, which fulfills President Obama's G-20 commitment on 
clearing, is the last step on the path to required central clearing 
between financial entities. It benefited from significant domestic 
and international consultation. Moving forward, we will work with 
market participants on implementation. I would like to thank my 
fellow Commissioners and the CFTC staff for all of their hard work 
and dedication so that now clearing will be a reality in the swaps 
market.
    For this first set of determinations, the Commission looked to 
swaps that are currently cleared by four derivatives clearing 
organizations (DCOs).
    This set includes standard interest rate swaps in U.S. dollars, 
euros, British pounds and Japanese yen, as well as five CDS indices 
on North American and European corporate names.
    With this rule, swap dealers and the largest hedge funds will be 
required to clear these swaps in March. Compliance would be phased 
in for other market participants through the summer of 2013.
    I believe that the Commission's determination for each class 
satisfies the five factors provided for by Congress in the Dodd-
Frank Act, including the first factor that addresses outstanding 
exposures, liquidity and pricing data.
    Under the rule, a DCO must post on its Web site a list of all 
swaps it will accept for clearing and must indicate which swaps the 
Commission had determined are required to be cleared. In addition, 
the Commission will post this information on our Web site.

[FR Doc. 2012-29211 Filed 12-12-12; 8:45 am]
BILLING CODE 6351-01-P