/Vol. 77, No. 240/Thursday, December 13, 2012/Rules and Regulations
The President’s Working Group on FinancialMarkets, ‘‘Policy Statements on Financial MarketDevelopments,’’ Mar. 2008, available at
ISDA, ISDA Margin Survey, 2009, available at
The TED spread measures the difference inyield between three-month Eurodollars asrepresented by London Interbank Offered Rate(LIBOR), and three-month Treasury Bills. LIBORcontains credit risk while T-bills do not. As thespread got larger, it meant that lenders demandedmore return to compensate for credit risk than theywould need if they loaned the money to the U.S.Department of the Treasury without any credit risk.
The U.S. Financial Crisis: Credit Crunch andYield Spreads, by James R. Barth et al., page 5,available at
Federal Reserve Bank of New York, PressRelease, ‘‘New York Fed Welcomes FurtherIndustry Commitments on Over-the-CounterDerivatives,’’ Oct. 31, 2008, available at
which references documentsprepared by market participants describing theimportance of clearing.
Ciara Linnane andKaren Brettell, ‘‘NY Federal Reserve pushes forcentral CDS counterparty,’’ Reuters, Oct. 6, 2008,available at
The Commission has proposed rules that wouldestablish a separate process for determiningwhether a swap has been made ‘‘available to trade’’ by a DCM or SEF. Those rules, and anydeterminations made under those rules, will befinalized separately from the clearing requirementsdiscussed herein.
Process for a DesignatedContract Market or Swap Execution Facility toMake a Swap Available to Trade Under Section2(h)(8) of the Commodity Exchange Act, 76 FR77728 (Dec. 14, 2011).
S. Rep. 111–176, at 32 (April 30, 2010).
Letter from Senators Christopher Dodd andBlanche Lincoln to Congressmen Barney Frank andCollin Peterson (June 30, 2010) (‘‘Congressdetermined that clearing is at the heart of reform— bringing transactions and counterparties into arobust, conservative, and transparent riskmanagement framework.’’).
S. Rep. 111–176, at 33.
derivative markets as a whole during thecrisis. The PWG identified the need foran improved integrated operationalstructure supporting OTC derivatives,specifically highlighting the need for anenhanced ability to managecounterparty risk through ‘‘netting andcollateral agreements by promotingportfolio reconciliation and accuratevaluation of trades.’’
These issues wereexposed in part by the surge incollateral required betweencounterparties during 2008, when theInternational Swaps and DerivativesAssociation (ISDA) reported an 86%increase in the collateral in use for OTCderivatives, indicating not only theincrease in risk, but also circumstancesin which positions may not have beencollateralized.
With only limited checks on theamount of risk that a market participantcould incur, great uncertainty wascreated among market participants. Amarket participant did not know theextent of its counterparty’s exposure,whether its counterparty wasappropriately hedged, or if itscounterparty was dangerously exposedto adverse market movements. Withoutcentral clearing, a market participant bore the risk that its counterparty wouldnot fulfill its payment obligationspursuant to a swap’s terms(counterparty credit risk). As thefinancial crisis deepened, this risk mademarket participants wary of trading witheach other. As a result, markets quickly became illiquid and trading volumesplummeted. The dramatic increase in‘‘TED spreads’’ evidenced thismistrust.
These spreads increasedfrom a long-term average of approximately 30 basis points to 464 basis points.
The failure to adequately collateralizethe risk exposures posed by OTCderivatives, along with the contagioneffects of the vast web of counterpartycredit risk, led many to conclude thatOTC derivatives should be centrallycleared. For instance, in 2008, theFederal Reserve Bank of New York(FRBNY) began encouraging marketparticipants to establish a centralcounterparty to clear CDS.
For severalyears prior, the FRBNY had led atargeted effort to enhance operationalefficiency and performance in the OTCderivatives market by increasingautomation in processing and bypromoting sound back office practices,such as timely confirmation of tradesand portfolio reconciliation. Beginningwith CDS in 2008, the FRBNY and otherprimary supervisors of OTC derivativesdealers increasingly focused on centralclearing as a means of mitigatingcounterparty credit risk and loweringsystemic risk to the markets as a whole.Both regulators and market participantsalike recognized that risk exposureswould have been monitored, measured,and collateralized through the processof central clearing.
C. Central Role of Clearing in the Dodd-Frank Act
Recognizing the peril that the U.S.financial system faced during thefinancial crisis, Congress and thePresident came together to pass theDodd-Frank Act in 2010. Title VII of theDodd-Frank Act establishes acomprehensive new regulatoryframework for swaps, and therequirement that swaps be cleared byDCOs is one of the cornerstones of thatreform. The CEA, as amended by TitleVII, now requires a swap: (1) To becleared through a DCO if theCommission has determined that theswap, or group, category, type, or classof swap, is required to be cleared, unlessan exception to the clearing requirementapplies; (2) to be reported to a swap datarepository (SDR) or the Commission;and (3) if the swap is subject to aclearing requirement, to be executed ona designated contract market (DCM) orswap execution facility (SEF), unless noDCM or SEF has made the swapavailable to trade.
Clearing is at the heart of the Dodd-Frank financial reform. According to theSenate Report:
As a key element of reducing systemic riskand protecting taxpayers in the future,protections must include comprehensiveregulation and rules for how the OTCderivatives market operates. Increasing theuse of central clearinghouses, exchanges,appropriate margining, capital requirements,and reporting will provide safeguards forAmerican taxpayers and the financial systemas a whole.
The Commission believes that aclearing requirement will reducecounterparty credit risk and provide anorganized mechanism for collateralizingthe risk exposures posed by swaps.According to the Senate Report:
With appropriate collateral and marginrequirements, a central clearing organizationcan substantially reduce counterparty riskand provide an organized mechanism forclearing transactions. *** While largelosses are to be expected in derivativestrading, if those positions are fully marginedthere will be no loss to counterparties andthe overall financial system and none of theuncertainty about potential exposures thatcontributed to the panic in 2008.
Notably, Congress did not focus on justone asset class, such as CDS; rather,Congress determined that all swaps thata DCO plans to accept for clearing must be submitted to the Commission for adetermination as to whether or not thoseswaps are required to be clearedpursuant to section 2(h)(2)(D) of theCEA.
D. G–20 and International Commitmentson Clearing
The financial crisis generatedinternational consensus on the need tostrengthen financial regulation byimproving transparency, mitigatingsystemic risk, and protecting againstmarket abuse. As a result of thewidespread recognition thattransactions in the OTC derivativesmarket increased risk and uncertainty inthe global economy and became asignificant contributor to the financialcrisis, a series of policy initiatives wereundertaken to better regulate thefinancial markets.
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