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  • [Federal Register: June 11, 2007 (Volume 72, Number 111)]


    [Page 32079-32081]

    From the Federal Register Online via GPO Access []





    Order Exempting the Trading and Clearing of Certain Credit

    Default Products Pursuant to the Exemptive Authority in Section 4(c) of

    the Commodity Exchange Act (``CEA'')

    AGENCY: Commodity Futures Trading Commission

    ACTION: Final order.


    SUMMARY: On May 14, 2007, the Commodity Futures Trading Commission

    (``CFTC'' or the ``Commission'') published for pubic comment in the

    Federal Register \1\ a proposal to exempt for the CEA \2\ the trading

    and clearing of certain products called credit default options

    (``CDOs'') and credit default basket options (``CDBOs'') that are

    proposed to be traded on the Chicago Board Options Exchange (``CBOE''),

    a natioal securities exchange registered under Section 6 of the

    Securities Exchange Act of 1934 (``1934 Act''),\3\ and cleared through

    the Options Clearing Corporation (``OCC''), a registered securities

    clearing agency registered under Section 17A of the 1934 Act,\4\ and

    Derivatives Clearing Organization registered under Section 5b of the

    CEA.\5\ The proposed order was preceded by a request from OCC to

    approve rules that would permit it to clear these CDOs and CDBOs in its

    capacity as a registered securities clearing agency. OCC's request

    presented novel and complex issues of jurisdiction and the Commission

    determined that an order exempting the trading and clearing of such

    instruments from pertinent requirements of the CEA may be appropriate.

    The Commission has reviewed the comments made in response to its

    proposal and the entire record in this matter and has determined to

    issue an order exempting the trading and clearing of these contracts

    from the CEA.


    \1\ 72 FR 27091 (May 14, 2007).

    \2\ 7 U.S.C. 1 et seq.

    \3\ 15 U.S.C. 78f.

    \4\ 15 U.S.C. 78q-1.

    \5\ 7 U.S.C. 7a-1.


    Authority for this exemption is found in Section 4(c) of the



    \6\ 7 U.S.C. 6(c).


    DATES: Effective Date: June 5, 2007.

    FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director and

    Chief Counsel, 202-418-5480;, Robert B. Wasserman,

    Associate Director, 202-418-7719, lgregory*, Division of

    Clearing and Intermediary Oversight, Commodity Futures Trading

    Commission, Three

    [[Page 32080]]

    Lafayette Centre, 1151 21st, NW., Washington, DC 20581.



    The OCC is both a Derivatives Clearing Organization (``DCO'')

    registered pursuant to Section 5b of the CEA,\7\ and a securities

    clearing agency registered pursuant to Section 17A of the 1934 Act.\8\

    The CBOE is a national securities exchange registered as such under

    Section 6 of the 1934 Act.\9\


    \7\ 7 U.S.C. 7a-1.

    \8\ 15 U.S.C. 78q-1.

    \9\ 15 U.S.C. 78f.


    CBOE has filed with the Securities and Exchange Commission

    (``SEC'') proposed rule changes to provide for the listing and trading

    on CBOE of cash-settled products characterized by CBOE as options based

    on credit events in one or more debt securities of specified

    ``Reference Entities.'' \10\ These products are referred to as Credit

    Default Options (``CDOs''), and would pay the holder a specified amount

    upon the occurrence, as determined by CBOE, of a ``Credit Event,''

    defined to mean an ``Event of Default'' on any debt security issued or

    guaranteed by a specified ``Reference Entity.''


    \10\ See Release No. 34-55251, 72 FR 7091 (Feb. 14, 2007).


    CBOE has also filed with the SEC proposed rule changes to provide

    for the listing and trading on CBOE of products called Credit Default

    Basket Options (``CDBOs'').\11\ These are similar in concept to CDOs,

    except that a CDBO covers more than one Reference Entity. For each

    individual Reference Entity, a notional value (a fraction of the

    aggregate Notional Face Value of the basket) and a recovery rate is

    specified. CDBOs may be of the multiple-payout variety, or of the

    single-payout variety, where a payout occurs only the first time a

    Credit Event is confirmed with respect to a Reference Entity prior to



    \11\ See SR-CBOE-2007-026.


    OCC has filed with the CFTC, pursuant to Section 5c(c) of the CEA

    and Commission Regulations 39.4(a) and 40.5 thereunder,\12\ requests

    for approval of rules and rule amendments that would enable OCC to

    clear and settle these CDOs and CDBOs in its capacity as a registered

    securities clearing agency (and not in its capacity as a DCO).\13\

    Section 5c(c)(3) provides that the CFTC must approve any such rules and

    rule amendments submitted for approval unless it finds that the rules

    or rule amendments would violate the CEA.


    \12\ 7 U.S.C. 7a-2(c), 17 CFR Sec. Sec. 39.4(a), 40.5.

    \13\ See SR-OCC-2007-01 A-1; SR-OCC-2007-06. OCC has filed

    identical proposed rule changes with the SEC.


    The request for approval concerning the CDO product was filed

    effective March 8, 2007. On April 23, 2007, the review period was

    extended pursuant to Regulation 40.5(c) until June 6, 2007, on the

    ground that the CDOs ``raise novel or complex issues, including the

    nature of the contract, that require additional time for review.'' The

    request for approval concerning the CDBO product was filed effective

    April 23, 2007.

    II. Section 4(c) of the Commodity Exchange Act

    Section 4(c)(1) of the CEA empowers the CFTC to ``promote

    responsible economic or financial innovation and fair competition'' by

    exempting any transaction or class of transactions from any of the

    provisions of the CEA (subject to exceptions not relevant here) where

    the Commission determines that the exemption would be consistent with

    the public interest. The Commission may grant such an exemption by

    rule, regulation or order, after notice and opportunity for hearing,

    and may do so on application of any person or on its own initiative. In

    enacting Section 4(c), Congress noted that the goal of provision ``is

    to give the Commission a means of providing certainty and stability to

    existing and emerging markets so that financial innovation and market

    development can proceed in an effective and competitive manner.'' \14\

    As noted in the proposing release,\15\ In granting an exemption, the

    CFTC need not find that the CDOs and CDBOs are (or are not) subject to

    the CEA.


    \14\ HOUSE CONF. REPORT ON NO. 102-978, 1992 U.S.C.C.A.N. 3179,

    3213 (``4(c) Conf. Report'').

    \15\ 72 FR 27091 (May 14, 2007).


    Section 4(c)(2) provides that the Commission may grant exemptions

    only when it determines that the requirements for which an exemption is

    being provided should not be applied to the agreements, contracts or

    transactions at issue, and the exemption is consistent with the public

    interest and the purposes of the CEA; that the agreements, contracts or

    transactions will be entered into solely between appropriate persons;

    and that the exemption will not have a material adverse effect on the

    ability of the Commission or any contract market to discharge its

    regulatory or self-regulatory responsibilities under the CEA.

    In the May 14, 2007 Federal Register release, the Commission

    requested public comment on the matters discussed above and all issues

    raised by its proposed exemptive order.

    III. Comment Letters

    The Commission received four comment letters. The Chicago

    Mercantile Exchange (``CME'') stated that it ``applauds'' the

    Commission's proposal to promote innovation but that it believed some

    issues should be addressed before a final order is issued. CME argued

    that: (1) It would be unfair for OCC and CBOE to receive exemptive

    relief yet continue to oppose CME's efforts to list competitive

    products; (2) the Commission should not accept OCC's and CBOE's

    characterization of the products as options; (3) there are strong

    arguments that the products are based on commodities, not securities;

    and (4) it is not proper to define ``appropriate persons'' in terms of

    the status of the person's intermediary.

    OCC focused on the ``appropriate persons'' issue. OCC argued that

    in light of the customer suitability rules and the overall federal

    securities regulatory framework, the products would be limited to

    ``appropriate persons.''

    The Chicago Board of Trade ``CBOTS'') suggested that characterizing

    the CDOs and CDBOs as ``novel instruments'' should be repudiated or

    clarified because it could have implications under the patent laws.

    IV. Findings and Conclusions

    After considering the complete record in this matter, including the

    comments received, the Commission has determined that the requirements

    of Section 4(c) have been met.\16\ First, the exemption is consistent

    with the public interest and with the purposes of the CEA. The purposes

    of the CEA include ``promot[ing] responsible innovation and fair

    competition among boards of trade, other markets and market

    participants.'' \17\ With respect to the competitive issue raised by

    CME in its comment letter, the Commission believes that an exemptive

    order in response to OCC's request for rule approval is the best way to

    promote responsibile innovation and fair competition among futures

    markets and securities markets. In cases such as this one where

    innovative products come close to the jurisdictional line between

    commodities and securities, rather than attempting to draw that line

    with precision with regard to the CBOE products and thereby potentially

    [[Page 32081]]

    imposing litigation costs on both the private sector and the public

    sector, it may be more efficient and is a proper use of Section 4(c)

    exemptive authority to permit, without compromising the public

    interest, the products to trade on both sides of the line and let

    competitive forces determine which venue is successful.


    \16\ In this regard, consistent with the legislative history to

    Section 4(c) of the CEA, the Commission is not making a finding that

    CDOs and CDBO are (or are not) subject to the CEA.

    \17\ CEA Section 3(b), 7 U.S.C. 5(b) (emphasis added. See also

    CEA Section 4(c)(1), 7 U.S.C. 6(c)(1) (purpose of exemptions is ``to

    promote responsible economic or financial innovation and fair



    Second, the CDOs and CDBOs would be entered into solely between

    appropriate persons. This issue was discussed by both CME and OCC in

    their respective comment letters. Section 4(c)(3) includes within the

    term ``appropriate persons'' a number of specified categories of

    persons, but also in subparagraph (K), ``such other persons that the

    Commission determines to be appropriate in light of * * * the

    applicability of appropriate regulatory protections.'' (Emphasis

    added.) These products will be traded on a regulated exchange. CBOE,

    OCC, and their members who will intermediate these transactions, are

    subject to extensive and detailed oversight by the SEC and, in the case

    of the intermediaries, the securities self-regulatory organizations. It

    should be noted that CME has listed or will list comparable products

    and has not limited access to its markets to specified categories of

    persons. In light of where the products will be traded, the regulatory

    protections available under the securities laws, and the goal of

    promoting fair competition, these products will be traded by

    appropriate persons.

    Third, the exemption would not have a material adverse effect on

    the ability of the Commission or any designated contract market to

    carry out their regulatory responsibilities under the CEA. There is no

    reason to believe that granting an exemption here would interfere with

    the Commission's or a designated contract market's ability to oversee

    the trading of similar products on a designated contract market or

    otherwise to carry out their duties. None of the comment letters

    received addressed this issue.\18\


    \18\ Under Section 4(c) of the CEA, the Commission need not

    resolve whether, as CME argues in its comment letter, these products

    are based on commodities and not securities, or, as CBOE argues in

    its comment letter, these products are securities subject to the

    securities laws. Nor need the Commission determine, as CME urges,

    whether the products are properly characterized as options. Finally,

    the Commission notes that its references to the novelty of the

    issues raised by these products refer to issues under the CEA and

    were not intended to be applicable in any matter relating to patent

    or intellectual property law.


    Therefore, upon due consideration, pursuant to its authority under

    Section 4(c) of the CEA, the Commission hereby issues this Order and

    exempts the trading and clearing of CDOs and CDBOs to be listed and

    traded on CBOE and cleared through OCC as a securities clearing agency

    from the CEA. This Order is contingent upon the approval by the SEC,

    pursuant to Section 19(b) of the 1934 Act, of CBOE and OCC rules to

    permit the listing and trading of CDOs and CDBOs on CBOE. This Order is

    subject to termination or revision, on a prospective basis, if the

    Commission determines upon further information that this exemption is

    not consistent with the public interest. If the commission believes

    such exemption becomes detrimental to the public interest, the

    Commission may revoke this Order on its own motion.

    V. Related Matters

    A. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \19\ imposes certain

    requirements on federal agencies (including the Commission) in

    connection with their conducting or sponsoring any collection of

    information as defined by the PRA. The order would not require a new

    collection of information from any entities that would be subject to

    the order.


    \19\ 44 U.S.C. 3507(d).


    B. Cost-Benefit Analysis

    Section 15(a) of the CEA, as amended by Section 119 of the

    Commodity Futures Modernization Act of 2000 (``CFMA''),\20\ requires

    the Commission to consider the costs and benefits of its action before

    issuing an order under the CEA. By its terms, Section 15(a) as amended

    does not require the Commission to quantify the costs and benefits of

    an order or to determine whether the benefits of the order outweigh its

    costs. Rather, Section 15(a) simply requires the Commission to

    ``consider the costs and benefits'' of its action.


    \20\ 7 U.S.C. 19(a).


    Section 15(a) of the CEA further specifies that costs and benefits

    shall be evaluated in light of five broad areas of market and public

    concern: protection of market participants and the public; efficiency,

    competitiveness, and financial integrity of futures markets; price

    discovery; sound risk management practices; and other public interest

    considerations. Accordingly, the Commission could in its discretion

    give greater weight to any one of the five enumerated areas and could

    in its discretion determine that, notwithstanding its costs, a

    particular order was necessary or appropriate to protect the public

    interest or to effectuate any of the provisions or to accomplish any of

    the purposes of the CEA.

    The order issued today is expected to facilitate market

    competition. The commission has considered the costs and benefits of

    the order in light of the specific provisions of Section 15(a) of the

    CEA, as follows:

    1. Protection of market participants and the public. Protections

    for market participants and the public exist in that CBOE, OCC and

    their members who will intermediate CDOs and CDBOs are subject to

    extensive oversight by the SEC and, in the case of intermediaries,

    securities self-regulatory organizations.

    2. Efficiency, competition, and financial integrity. The exemptive

    order may enhance market efficiency and competition since it could

    encourage potential trading of CDOs and CDBOs on markets other than

    designated contract markets. Financial integrity will not be impaired

    since the CDOs and CDBOs will be cleared by OCC, a DCO and SEC-

    registered clearing agency, and intermediated by SEC-registered broker-


    3. Price discovery. Price discovery may be enhanced through market


    4. Sound risk management practices. OCC has described appropriate

    risk-management practices that it will follow in connection with the

    clearing of CDOs and CDBOs.

    5. Other public interest considerations. The exemptive order may

    encourage development of credit derivative products through market

    competition without unnecessary regulatory burden.

    The Commission requested comment on its application of these

    factors in the proposing release. No comments were received.

    After considering these factors, the Commission has determined to

    issue this Order.

    * * * * *

    Issued in Washington, DC, on June 5, 2007 by the Commission.

    Eileen A. Donovan,

    Acting Secretary of the Commission.

    [FR Doc. 07-2878 Filed 6-8-07; 8:45 am]

    BILLING CODE 6351-01-M

    Last Updated: June 29, 2007