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2012-29211

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Vol. 77 Thursday,No. 240 December 13, 2012Part II
Commodity Futures Trading Commission
17 CFR Parts 39 and 50Clearing Requirement Determination Under Section 2(h) of the CEA;Final Rule
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74284
Federal Register
/Vol. 77, No. 240/Thursday, December 13, 2012/Rules and Regulations
1
Clearing Requirement Determination UnderSection 2(h) of the CEA; Proposed Rule, 77 FR47170 (Aug. 7, 2012).
2
On October 3, 2008, President Bush signed theEmergency Economic Stabilization Act of 2008,which was principally designed to allow the U.S.Department of the Treasury and other governmentagencies to take action to restore liquidity andstability to the U.S. financial system (
e.g.,
theTroubled Asset Relief Program—also known asTARP—under which the U.S. Department of theTreasury 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, ‘‘TheFinancial Crisis Inquiry Report: Final Report of theNational Commission on the Causes of theFinancial and Economic Crisis in the UnitedStates,’’ Jan. 2011, at xxviii, available at 
4
See id.
at 386.
5
Financial Regulatory Reform: A New Foundation,
 June 2009, available at
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
7
Hugh Son, ‘‘AIG’s Trustees Shun ‘ShadowBoard,’ Seek Directors,’’ Bloomberg, May 13, 2009,available at
COMMODITY FUTURES TRADINGCOMMISSION17 CFR Parts 39 and 50
RIN 3038–AD86
Clearing Requirement DeterminationUnder Section 2(h) of the CEA
AGENCY
:
Commodity Futures TradingCommission.
ACTION
:
Final rule.
SUMMARY
:
The Commodity FuturesTrading Commission (Commission orCFTC) is adopting regulations toestablish a clearing requirement undernew section 2(h)(1)(A) of theCommodity Exchange Act (CEA or Act),enacted under Title VII of the Dodd-Frank Wall Street Reform and ConsumerProtection Act (Dodd-Frank Act). Theregulations require that certain classesof credit default swaps (CDS) andinterest rate swaps, described herein, becleared by a derivatives clearingorganization (DCO) registered with theCommission. The Commission also isadopting regulations to prevent evasionof the clearing requirement and relatedprovisions.
DATES
:
The rules will become effectiveFebruary 11, 2013. Specific compliancedates are discussed in thesupplementary information.
FOR FURTHER INFORMATION CONTACT
:
Sarah E. Josephson, Deputy Director,202–418–5684,
Brian O’Keefe, Associate Director, 202–418–5658,
or ErikRemmler, Associate Director, 202–418–7630,
Division of Clearing and Risk, Camden Nunery,Economist, 202–418–5723,
Office of the Chief Economist, Commodity Futures TradingCommission, Three Lafayette Centre,1155 21st Street NW., Washington, DC20581.
SUPPLEMENTARY INFORMATION
:
Table of Contents
I. BackgroundA. Clearing Requirement ProposalB. Financial CrisisC. Central Role of Clearing in the Dodd-Frank ActD. G–20 and International Commitmentson ClearingE. Overview of Section 2(h) and §39.5F. Submissions From DCOsII. Comments on the Notice of ProposedRulemakingA. Overview of Comments ReceivedB. Generally Applicable CommentsC. Credit Default SwapsD. Determination Analysis for CreditDefault SwapsE. Interest Rate SwapsF. Determination Analysis for Interest RateSwapsIII. Final RuleA. Regulation 50.1: DefinitionsB. Regulation 50.2: Treatment of SwapsSubject to a Clearing RequirementC. Regulation 50.3: Notice to the PublicD. Regulation 50.4: Classes of SwapsRequired To Be ClearedE. Regulation 50.5: Clearing TransitionRulesF. Regulation 50.6: Delegation of AuthorityG. Regulation 50.10: Prevention of Evasionof the Clearing Requirement and Abuseof an Exception or Exemption to theClearing RequirementIV. ImplementationV. Cost Benefit ConsiderationsA. Statutory and Regulatory BackgroundB. Overview of Swap ClearingC. Consideration of the Costs and Benefitsof the Commission’s ActionD. Consideration of Alternative SwapClasses for Clearing DeterminationE. Section 15(a) FactorsVI. Related MattersA. Regulatory Flexibility ActB. Paperwork Reduction Act
I. Background
A. Clearing Requirement Proposal 
On August 7, 2012, the Commissionpublished a notice of proposedrulemaking (NPRM) to establish aclearing requirement under new section2(h)(1)(A) of the CEA, as provided forunder section 723 of Title VII of theDodd-Frank Act.
1
The Commissionproposed that swaps meeting thespecifications identified in two classesof CDS and four classes of interest rateswaps, and available for clearing by aneligible DCO, would be required to becleared. The Commission also proposedrules related to the prevention of evasion of the clearing requirement andprevention of abuse of an exception orexemption to the clearing requirement.The Commission is hereby adopting§§50.1–50.6 and §50.10, subject to thechanges discussed below.
B. Financial Crisis
In the fall of 2008, a series of largefinancial institution failures triggered afinancial and economic crisis thatthreatened to freeze U.S. and globalcredit markets. As a result of thesefailures, unprecedented governmentalintervention was required to ensure thestability of the U.S. financial system.
2
 These failures revealed the vulnerabilityof the U.S. financial system andeconomy to widespread systemic riskresulting from, among other things, poorrisk management practices of financialfirms and the lack of supervisoryoversight for a financial institution as awhole.
3
 The financial crisis also illustrated thesignificant risks that an uncleared, over-the-counter (OTC) derivatives marketcan pose to the financial system. As theFinancial Crisis Inquiry Commissionexplained:
The scale and nature of the [OTC]derivatives market created significantsystemic risk throughout the financial systemand helped fuel the panic in the fall of 2008:millions of contracts in this opaque andderegulated market created interconnectionsamong a vast web of financial institutionsthrough counterparty credit risk, thusexposing the system to a contagion of spreading losses and defaults.
4
 
Certain OTC derivatives, such as CDS,played a prominent role during thecrisis. According to a white paper by theU.S. Department of the Treasury, ‘‘thesheer volume of these [CDS] contractsoverwhelmed some firms that hadpromised to provide payment of theCDS and left institutions with lossesthat they believed they had beenprotected against.’’
5
In particular, AIGreportedly issued uncleared CDStransactions covering more than $440 billion in bonds, leaving it withobligations that it could not cover as aresult of changed market conditions.
6
 As a result of AIG’s CDS exposure, theFederal government bailed out the firmwith over $180 billion of taxpayermoney in order to prevent AIG’s failureand a possible contagion event in the broader economy.
7
 More broadly, the President’sWorking Group (PWG) on FinancialMarkets noted shortcomings in the OTC
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74285
Federal Register
/Vol. 77, No. 240/Thursday, December 13, 2012/Rules and Regulations
8
The President’s Working Group on FinancialMarkets, ‘‘Policy Statements on Financial MarketDevelopments,’’ Mar. 2008, available at
9
ISDA, ISDA Margin Survey, 2009, available at
10
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.
11
The U.S. Financial Crisis: Credit Crunch andYield Spreads, by James R. Barth et al., page 5,available at
12
See
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.
See also
Ciara Linnane andKaren Brettell, ‘‘NY Federal Reserve pushes forcentral CDS counterparty,’’ Reuters, Oct. 6, 2008,available at
13
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.
See
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).
14
S. Rep. 111–176, at 32 (April 30, 2010).
Seealso
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.’’).
15
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.’’
8
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.
9
 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.
10
These spreads increasedfrom a long-term average of approximately 30 basis points to 464 basis points.
11
 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.
12
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.
13
 Clearing is at the heart of the Dodd-Frank financial reform. According to theSenate Report:
14
 
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:
15
 
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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