Font Size: AAA // Print // Bookmark

2011-27536

  • Federal Register, Volume 76 Issue 216 (Tuesday, November 8, 2011)[Federal Register Volume 76, Number 216 (Tuesday, November 8, 2011)]

    [Rules and Regulations]

    [Pages 69334-69480]

    From the Federal Register Online via the Government Printing Office [www.gpo.gov]

    [FR Doc No: 2011-27536]

    [[Page 69333]]

    Vol. 76

    Tuesday,

    No. 216

    November 8, 2011

    Part II

    Commodity Futures Trading Commission

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

    17 CFR Parts 1, 21, 39 et al.

    Derivatives Clearing Organization General Provisions and Core

    Principles; Final Rule

    Federal Register / Vol. 76 , No. 216 / Tuesday, November 8, 2011 /

    Rules and Regulations

    [[Page 69334]]

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

    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Parts 1, 21, 39, and 140

    RIN 3038-AC98

    Derivatives Clearing Organization General Provisions and Core

    Principles

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Final rule.

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

    SUMMARY: The Commodity Futures Trading Commission (Commission) is

    adopting final regulations to implement certain provisions of Title VII

    and Title VIII of the Dodd-Frank Wall Street Reform and Consumer

    Protection Act (Dodd-Frank Act) governing derivatives clearing

    organization (DCO) activities. More specifically, the regulations

    establish the regulatory standards for compliance with DCO Core

    Principles A (Compliance), B (Financial Resources), C (Participant and

    Product Eligibility), D (Risk Management), E (Settlement Procedures), F

    (Treatment of Funds), G (Default Rules and Procedures), H (Rule

    Enforcement), I (System Safeguards), J (Reporting), K (Recordkeeping),

    L (Public Information), M (Information Sharing), N (Antitrust

    Considerations), and R (Legal Risk) set forth in Section 5b of the

    Commodity Exchange Act (CEA). The Commission also is updating and

    adding related definitions; adopting implementing rules for DCO chief

    compliance officers (CCOs); revising procedures for DCO applications

    including the required use of a new Form DCO; adopting procedural rules

    applicable to the transfer of a DCO registration; and adding

    requirements for approval of DCO rules establishing a portfolio

    margining program for customer accounts carried by a futures commission

    merchant (FCM) that is also registered as a securities broker-dealer

    (FCM/BD). In addition, the Commission is adopting certain technical

    amendments to parts 21 and 39, and is adopting certain delegation

    provisions under part 140.

    DATES: The rules will become effective January 9, 2012. DCOs must

    comply with Sec. Sec. 39.11; 39.12; 39.13 (except for 39.13(g)(8)(i));

    and 39.14 by May 7, 2012; with Sec. Sec. 39.10(c); 39.13(g)(8)(i);

    39.18; 39.19; and 39.20 by November 8, 2012; and all other provisions

    of these rules by January 9, 2012.

    FOR FURTHER INFORMATION CONTACT: Phyllis P. Dietz, Deputy Director,

    (202) 418-5449, pdietz@cftc.gov; John C. Lawton, Deputy Director, (202)

    418-5480, jlawton@cftc.gov; Robert B. Wasserman, Chief Counsel, (202)

    418-5092, rwasserman@cftc.gov; Eileen A. Donovan, Associate Director,

    (202) 418-5096, edonovan@cftc.gov; Jonathan Lave, Special Counsel,

    (202) 418-5983, jlave@cftc.gov, Division of Clearing and Risk; and

    Jacob Preiserowicz, Special Counsel, (202) 418-5432,

    jpreiserowicz@cftc.gov, Division of Swap Dealer and Intermediary

    Oversight, Commodity Futures Trading Commission, Three Lafayette

    Centre, 1155 21st Street NW., Washington, DC 20581; and Julie A. Mohr,

    Deputy Director, (312) 596-0568, jmohr@cftc.gov; and Anne C. Polaski,

    Special Counsel, (312) 596-0575, apolaski@cftc.gov, Division of

    Clearing and Risk, Commodity Futures Trading Commission, 525 West

    Monroe Street, Chicago, Illinois 60661.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Background

    A. Title VII of the Dodd-Frank Act

    B. Title VIII of the Dodd-Frank Act

    C. Regulatory Framework for DCOs

    II. Part 1 Amendments--Definitions

    III. Part 39 Amendments--General Provisions

    A. Scope

    B. Definitions

    C. Procedures for Registration

    D. Procedures for Implementing DCO Rules and Clearing New

    Products

    E. Reorganization of Part 39

    F. Technical Amendments

    IV. Part 39 Amendments--Core Principles

    A. Compliance with Core Principles

    B. Financial Resources

    C. Participant and Product Eligibility

    D. Risk Management

    E. Settlement Procedures

    F. Treatment of Funds

    G. Default Rules and Procedures

    H. Rule Enforcement

    I. System Safeguards

    J. Reporting

    K. Recordkeeping

    L. Public Information

    M. Information Sharing

    N. Antitrust Considerations

    O. Legal Risk Considerations

    P. Special Enforcement Authority for SIDCOs

    V. Part 140 Amendments--Delegations of Authority

    VI. Effective Dates

    VII. Section 4(c)

    VIII. Consideration of Costs and Benefits

    IX. Related Matters

    A. Regulatory Flexibility Act

    B. Paperwork Reduction Act

    I. Background

    A. Title VII of the Dodd-Frank Act

    On July 21, 2010, President Obama signed the Dodd-Frank Act.\1\

    Title VII of the Dodd-Frank Act \2\ amended the CEA \3\ to establish a

    comprehensive statutory framework to reduce risk, increase

    transparency, and promote market integrity within the financial system

    by, among other things: (1) Providing for the registration and

    comprehensive regulation of swap dealers and major swap participants;

    (2) imposing clearing and trade execution requirements on standardized

    derivative products; (3) creating rigorous recordkeeping and real-time

    reporting regimes; and (4) enhancing the Commission's rulemaking and

    enforcement authorities with respect to all registered entities and

    intermediaries subject to the Commission's oversight.

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

    \1\ See Dodd-Frank Wall Street Reform and Consumer Protection

    Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the

    Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

    \2\ Pursuant to Section 701 of the Dodd-Frank Act, Title VII may

    be cited as the ``Wall Street Transparency and Accountability Act of

    2010.''

    \3\ 7 U.S.C. 1 et seq.

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

    Section 725(c) of the Dodd-Frank Act amended Section 5b(c)(2) of

    the CEA, which sets forth core principles with which a DCO must comply

    in order to be registered and to maintain registration as a DCO.

    The core principles were added to the CEA by the Commodity Futures

    Modernization Act of 2000 (CFMA).\4\ The Commission did not adopt

    implementing rules and regulations, but instead promulgated guidance

    for DCOs on compliance with the core principles.\5\ Under Section

    5b(c)(2) of the CEA, as amended by the Dodd-Frank Act, Congress

    expressly confirmed that the Commission may adopt implementing rules

    and regulations pursuant to its rulemaking authority under Section

    8a(5) of the CEA.\6\

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

    \4\ See Commodity Futures Modernization Act of 2000, Public Law

    106-554, 114 Stat. 2763 (2000).

    \5\ See 66 FR 45604 (Aug. 29, 2001) (adopting 17 CFR part 39,

    app. A).

    \6\ Section 8a(5) of the CEA authorizes the Commission to

    promulgate such regulations ``as, in the judgment of the Commission,

    are reasonably necessary to effectuate any of the provisions or to

    accomplish any of the purposes of [the CEA].'' 7 U.S.C. 12a(5).

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

    In light of Congress's explicit affirmation of the Commission's

    authority to adopt regulations to implement the core principles, the

    Commission has chosen to adopt regulations (which have the force of

    law) rather than guidance (which does not have the force of law). By

    issuing regulations, the Commission expects to increase legal certainty

    for DCOs, clearing members, and market participants, and prevent DCOs

    from lowering risk management standards for competitive reasons and

    taking on more risk than is prudent. The imposition of legally

    enforceable standards provides

    [[Page 69335]]

    assurance to market participants and the public that DCOs are meeting

    minimum risk management standards. This can serve to increase market

    confidence which, in turn, can increase open interest and free up

    resources that market participants might otherwise hold in order to

    compensate for weaker DCO risk management practices. Regulatory

    standards also can reduce search costs that market participants would

    otherwise incur in determining that DCOs are managing risk effectively.

    B. Title VIII of the Dodd-Frank Act

    Section 802(b) of the Dodd-Frank Act states that the purpose of

    Title VIII is to mitigate systemic risk in the financial system and

    promote financial stability. Section 804 authorizes the Financial

    Stability Oversight Council (FSOC) to designate entities involved in

    clearing and settlement as systemically important.\7\

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

    \7\ See 76 FR 44763 (July 27, 2011) (FSOC authority to designate

    financial market utilities as systemically important; final rule).

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

    Section 805(a) of the Dodd-Frank Act allows the Commission to

    prescribe regulations for those DCOs that the Council has determined

    are systemically important (SIDCOs). The Commission proposed heightened

    requirements for SIDCO financial resources and system safeguards for

    business continuity and disaster recovery.

    Section 807(c) of the Dodd-Frank Act provides the Commission with

    special enforcement authority over SIDCOs, which the Commission

    proposed to codify in its regulations.

    C. Regulatory Framework for DCOs

    The Commission, now responsible for regulating swaps markets as

    well as futures markets, has undertaken an unprecedented rulemaking

    initiative to implement the Dodd-Frank Act. As part of this initiative,

    the Commission has issued a series of eight proposed rulemakings that,

    together, would establish a comprehensive regulatory framework for the

    clearing and settlement activities of DCOs. Through these proposed

    regulations, the Commission sought to enhance legal certainty for DCOs,

    clearing members, and market participants, to strengthen the risk

    management practices of DCOs, and to promote financial integrity for

    swaps and futures markets.

    In this notice of final rulemaking, the Commission is adopting

    regulations to implement 15 DCO core principles: A (Compliance), B

    (Financial Resources), C (Participant and Product Eligibility),\8\ D

    (Risk Management), E (Settlement Procedures), F (Treatment of Funds), G

    (Default Rules and Procedures), H (Rule Enforcement), I (System

    Safeguards), J (Reporting), K (Recordkeeping), L (Public Information),

    M (Information Sharing), N (Antitrust Considerations), and R (Legal

    Risk).\9\ In addition, the Commission is adopting regulations to

    implement the CCO provisions of Section 725 of the Dodd-Frank Act.\10\

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

    \8\ The Commission is reserving for a future final rulemaking

    certain proposed amendments relating to participant and product

    eligibility. See 76 FR 13101 (Mar. 10, 2011) (requirements for

    processing, clearing, and transfer of customer positions (Straight-

    Through Processing)); and 76 FR 45730 (Aug. 1, 2011) (customer

    clearing documentation and timing of acceptance for clearing

    (Customer Clearing)).

    \9\ The Commission is reserving for a future final rulemaking

    regulations to implement DCO Core Principles O (Governance Fitness

    Standards) and Q (Composition of Governing Boards) (76 FR 722 (Jan.

    6, 2011) (Governance)); and Core Principle P (Conflicts of Interest)

    (75 FR 63732 (Oct. 18, 2010) (Conflicts of Interest)).

    \10\ See Section 5b(i) of the CEA, 7 U.S.C 7a-1(i).

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

    The final rules adopted herein were proposed in five separate

    notices of proposed rulemaking.\11\ Each proposed rulemaking was

    subject to an initial 60-day public comment period and a re-opened

    comment period of 30 days.\12\ After the second comment period ended,

    the Commission informed the public that it would continue to accept and

    consider late comments and did so until August 25, 2011. The Commission

    received a total of approximately 119 comment letters directed

    specifically at the proposed rules, in addition to many other comments

    applicable to the Dodd-Frank Act rulemaking initiative more

    generally.\13\ The Chairman and Commissioners, as well as Commission

    staff, participated in numerous meetings with representatives of DCOs,

    FCMs, trade associations, public interest groups, traders, and other

    interested parties. In addition, the Commission has consulted with

    other U.S. financial regulators including the Board of Governors of the

    Federal Reserve System and Securities and Exchange Commission (SEC).

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

    \11\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through

    Processing); 76 FR 3698 (Jan. 20, 2011) (Core Principles C, D, E, F,

    G, and I (Risk Management)); 75 FR 78185 (Dec. 15, 2010) (Core

    Principles J, K, L, and M (Information Management)); 75 FR 77576

    (Dec. 13, 2010) (Core Principles A, H, N, and R (General

    Regulations)); and 75 FR 63113 (Oct. 14, 2010) (Core Principle B

    (Financial Resources)).

    \12\ See 76 FR 25274 (May 4, 2011) (extending or re-opening

    comment periods for multiple Dodd-Frank proposed rulemakings); see

    also 76 FR 16587 (Mar. 24, 2011) (re-opening 30-day comment period

    for reporting requirement with clause omitted in the notice of

    proposed rulemaking).

    \13\ Comment files for each proposed rulemaking can be found on

    the Commission Web site, www.cftc.gov.

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

    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 proposed and final regulations for DCOs.

    The Commission is of the view that each DCO should be afforded an

    appropriate level of discretion in determining how to operate its

    business within the legal framework established by the CEA, as amended

    by the Dodd-Frank Act. At the same time, the Commission recognizes that

    specific, bright-line regulations may be necessary to facilitate DCO

    compliance with a given core principle and, ultimately, to protect the

    integrity of the U.S. derivatives clearing system. Accordingly, in

    developing the proposed regulations and in finalizing the regulations

    adopted herein, taking into consideration public comments and views

    expressed by U.S. and foreign regulators, the Commission has endeavored

    to strike an appropriate balance between establishing general

    prudential standards and specific requirements.

    In determining the scope and content of the final rules, the

    Commission has taken into account concerns raised by commenters

    regarding the implications of specific rules for smaller versus larger

    DCOs, DCOs that do not clear customer positions versus those with a

    traditional customer model, clearinghouses that are registered as both

    a DCO and a securities clearing agency, and clearinghouses that operate

    in foreign jurisdictions as well as in the United States. The

    Commission addresses these issues in its discussion of specific rule

    provisions, below.

    The Commission has carefully considered the costs and benefits

    associated with each proposed rule, with particular attention to public

    comments. For the reasons discussed in this notice of final rulemaking,

    in the analyses of specific rule provisions as well as in the formal

    cost-benefit analysis, the Commission has determined that the final

    rules appropriately balance the costs and benefits associated with

    oversight and supervision of DCOs pursuant to the CEA, as amended by

    the Dodd-Frank Act.

    The Commission is herein adopting regulations to implement the core

    principles applicable to DCOs, to implement CCO requirements

    established under the Dodd-Frank Act, and to update the regulatory

    framework for DCOs to reflect standards and practices that have evolved

    over the past decade since the enactment of the

    [[Page 69336]]

    CFMA. The Commission is largely adopting final rules as proposed,

    although there are a number of proposed provisions that, upon further

    consideration in light of comments received, the Commission has

    determined to either revise or decline to adopt. In the discussion

    below, the Commission highlights topics of particular interest to

    commenters and discusses comment letters that are representative of the

    views expressed on those topics. The discussion does not explicitly

    respond to every comment submitted; rather, it addresses the most

    significant issues raised by the proposed rulemakings and it analyzes

    those issues in the context of specific comments.

    The final rules include a number of technical revisions to the

    proposed rule text, intended variously to clarify certain provisions,

    standardize terminology within part 39, conform terminology to that

    used in other parts of the Commission's rules, and more precisely state

    regulatory standards and requirements. These are non-substantive

    changes. For example, the proposed DCO rules used the terms

    ``contract'' and ``product'' interchangeably, and some provisions used

    the statutory language ``contracts, agreements and transactions'' to

    refer to the products subject to Commission regulation. In the final

    rules adopted herein, the Commission has revised the terminology to

    uniformly refer to ``products,'' which encompasses contracts,

    agreements, and transactions, except where the language of the rule

    codifies statutory language. In those cases, the rule text is

    unchanged.

    For easy reference and for purposes of clarification, in this

    notice of final rulemaking the Commission is publishing the complete

    part 39 as currently adopted. This means that certain longstanding

    rules that are not being amended (e.g., Sec. 39.8 (formerly designated

    as Sec. 39.7, fraud in connection with the clearing of transactions of

    a DCO), and rules recently adopted (Sec. 39.5, review of swaps for

    Commission determination on clearing requirement) are being re-

    published along with the newly-adopted rules. Rules that have been

    proposed but not yet adopted in final form are identified in part 39 as

    ``reserved.''

    II. Part 1 Amendments--Definitions

    The Commission proposed to amend the definitions of ``clearing

    member,'' ``clearing organization,'' and ``customer'' found in Sec.

    1.3 of its regulations to conform the definitions with the terminology

    and substantive provisions of the CEA, as amended by the Dodd-Frank

    Act. The Commission also proposed to add to Sec. 1.3, definitions for

    ``clearing initial margin,'' ``customer initial margin,'' ``initial

    margin,'' ``margin call,'' ``spread margin,'' and ``variation margin.''

    ISDA commented that the margin definitions are appropriate for

    futures and cleared derivatives, but less readily applicable in the

    uncleared OTC derivatives context. It suggested that the definitions

    should expressly provide that they apply only to cleared transactions.

    The Commission notes that some of the definitions by their terms

    already apply only to cleared trades, e.g., ``clearing initial

    margin.'' Other terms, however, have applicability to both cleared and

    uncleared trades, e.g., ``initial margin.'' \14\

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

    \14\ See Section 4s of the CEA, 7 U.S.C. 6s.

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

    The Commission proposed to define ``spread margin'' as ``reduced

    initial margin that takes into account correlations between certain

    related positions held in a single account.'' Better Markets commented

    that the definition of ``spread margin'' omits key characteristics of

    netting initial margin which are needed to precisely define spread

    margin. Better Markets proposed to define it as ``initial margin

    relating to two positions in a single account that has been reduced

    from the aggregate initial margin otherwise applicable to the two

    positions by application of an algorithm that measures statistical

    correlations between the historic price movements of the two

    positions.'' The Commission is adopting the definition of ``spread

    margin'' as proposed because it believes that Better Markets'

    definition adds unnecessary details that could have the unintended

    effect of imposing substantive margin methodology requirements in a

    definition.

    In light of proposed rulemakings issued after the Commission

    proposed the definition of ``customer; commodity customer; swap

    customer,'' the Commission is making certain technical

    modifications.\15\ First, instead of placing the definition in Sec.

    1.3, which serves as the general definition section for all of the

    Commission's regulations, this definition is being moved to Sec. 39.2,

    which sets forth definitions applicable only to regulations found in

    part 39 or as otherwise explicitly provided. This accommodates the need

    for further consideration of other proposals before a global definition

    is adopted, while satisfying the need for a definition for purposes of

    part 39 as adopted herein. Second, the Commission has made certain

    technical changes to the rule text in connection with the definition's

    redesignation in 39.2 and to conform phraseology when incorporating by

    reference definitions that appear in the CEA and Sec. 1.3. These

    changes include limiting the term to ``customer,'' because the terms

    ``commodity customer'' and ``swap customer'' are not used in Part 39.

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

    \15\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared Swaps

    Customer Contracts and Collateral; Conforming Amendments to the

    Commodity Broker Bankruptcy Provisions); 76 FR 33066 (June 7, 2011)

    (Adaptation of Regulations to Incorporate Swaps).

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

    The Commission is adopting the other definitions as proposed.

    III. Part 39 Amendments--General Provisions

    A. Scope--Sec. 39.1

    As originally proposed, Sec. 39.1 included an updated statement of

    scope and definitions applicable to other provisions in part 39. The

    Commission later revised proposed Sec. 39.1 to include only the

    statement of scope. The Commission did not receive any comments on the

    statement of scope, which was updated to include references to the

    definition of ``derivatives clearing organization'' in newly-renumbered

    Section 1(a)(15) of the CEA and Sec. 1.3(d) of the Commission's

    regulations. The Commission is adopting Sec. 39.1 as proposed.

    B. Definitions--Sec. 39.2

    The Commission proposed definitions of the terms ``back test,''

    ``compliance policies and procedures,'' ``customer account '' or

    ``customer origin,'' ``house account'' or ``house origin,'' ``key

    personnel,'' ``stress test,'' and ``systemically important derivatives

    clearing organization.'' The definitions set forth in proposed Sec.

    39.2 would apply specifically to provisions contained in part 39 and

    such other rules as may explicitly cross-reference these definitions.

    The Commission is adopting the definitions as proposed, with the

    exceptions discussed below.

    CME Group, Inc. (CME) commented that the proposed definition of

    ``compliance policies and procedures'' was too broad. That definition

    was proposed as an adjunct to the proposed rules for a DCO's CCO. The

    Commission is not adopting a definition of ``compliance policies and

    procedures,'' as it has concluded that a DCO's compliance policies and

    procedures will likely encompass a limited, self-evident body of

    documents, and a regulatory definition could invite more scrutiny than

    is necessary or helpful to the DCO or the Commission.

    The Commission proposed to define ``stress test'' as ``a test that

    compares the impact of a potential price move, change

    [[Page 69337]]

    in option volatility, or change in other inputs that affect the value

    of a position, to the financial resources of a [DCO], clearing member,

    or large trader to determine the adequacy of such financial

    resources.'' Better Markets, Inc. (Better Markets) expressed the view

    that a stress test can only be useful if it tests unprecedented

    circumstances of illiquidity, and that basing the test on historic

    price data would make it meaningless. In response to this comment, the

    Commission is modifying the definition in one respect. The word

    ``extreme'' is being inserted after the word ``potential'' to make

    clear that a stress test does not include typical events. The

    Commission further addresses Better Markets' concerns in its discussion

    of stress tests in Sec. 39.13(h)(3).\16\

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

    \16\ See discussion of stress tests in section IV.D.7.c, below.

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

    The Commission proposed to define the term ``systemically important

    derivatives clearing organization'' to mean ``a financial market

    utility that is a derivatives clearing organization registered under

    Section 5b of the Act (7 U.S.C. 7a-1), which has been designated by the

    Financial Stability Oversight Council to be systemically important.''

    The Options Clearing Corporation (OCC) submitted a comment on this

    definition in connection with the Commission's proposed Sec. 40.10

    (special certification procedures for submission of certain risk-

    related rules by SIDCOs).\17\ OCC pointed out that, under this proposed

    definition, a DCO could be a SIDCO even if the Commission were not its

    Supervisory Agency pursuant to Section 803(8) of the Dodd-Frank Act.

    The Commission, recognizing that some DCOs like OCC may be regulated by

    more than one federal agency, is adopting a revised definition to

    clarify that the term ``systemically important derivatives clearing

    organization'' means a ``financial market utility that is a derivatives

    clearing organization registered under Section 5b of the Act, which has

    been designated by the Financial Stability Oversight Council to be

    systemically important and for which the Commission acts as the

    Supervisory Agency pursuant to Section 803(8) of the Dodd-Frank Wall

    Street Reform and Consumer Protection Act.'' \18\

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

    \17\ See 76 FR 44776 at 44783-84 (July 27, 2011) (Provisions

    Common to Registered Entities; final rule).

    \18\ See id. for further discussion of this topic.

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

    The Commission also is making a technical change to the definition

    of ``customer account or customer origin.'' The proposed definition

    would provide, in part, that ``[a] customer account is also a futures

    account, as that term is defined by Sec. 1.3(vv) of this chapter.'' The

    Commission is removing this reference and defining ``customer account

    or customer origin'' to mean ``a clearing member account held on behalf

    of customers, as that term is defined in this section, and which is

    subject to section 4d(a) or section 4d(f) of the Act.'' This clarifies

    that the term encompasses both customer futures accounts and customer

    cleared swaps accounts, respectively.

    Similarly, the Commission is making a technical revision to the

    term ``house account or house origin'' to delete the proposed reference

    to proprietary accounts, which are currently defined in Sec. 1.3(y)

    only in terms of futures and options (not swaps). The term ``house

    account or house origin'' is now defined as a ``clearing member account

    which is not subject to section 4d(a) or 4d(f) of the Act.''

    In connection with the proposal to adopt a definitions section

    designated as Sec. 39.2, the Commission proposed to rescind the

    existing Sec. 39.2, which exempted DCOs from all Commission

    regulations except those explicitly enumerated in the exemption. This

    action would result in clarifying the applicability of Sec. 1.49

    (denomination of customer funds and location of depositories) to DCOs

    and, insofar as the rule exempted DCOs from regulations relating to DCO

    governance and conflicts of interest, those regulations are expected to

    themselves be replaced by rules to implement DCO Core Principles O

    (Governance Fitness Standards), P (Conflicts of Interest), and Q

    (Composition of Governing Boards).\19\ The Commission did not receive

    any comments on the proposed rescission of the exemption provided by

    existing Sec. 39.2 and is herein rescinding that exemption, as

    proposed.

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

    \19\ See 76 FR 722 (Jan. 6, 2011) (Governance); and 75 FR 63732

    (Oct. 18, 2010) (Conflicts of Interest).

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

    C. Procedures for Registration as a DCO--Sec. 39.3

    The Commission proposed several revisions to its procedures for DCO

    registration, including the elimination of the 90-day expedited review

    period and the required use of an application form, proposed Form DCO.

    The Commission is adopting Sec. 39.3 as proposed, and is adopting the

    Form DCO with the revisions discussed below.

    1. Form DCO

    The Commission proposed to revise appendix A to part 39,

    ``Application Guidance and Compliance with Core Principles,'' by

    removing the existing guidance and substituting the Form DCO in its

    place. An application for DCO registration would consist of the

    completed Form DCO, which would include all applicable exhibits, and

    any supplemental information submitted to the Commission.

    CME commented that the proposed Form DCO would require the

    applicant to create and submit to the Commission a large number of

    documents. It questioned why certain documents were necessary and

    whether Commission staff would be able to meaningfully review all of

    the materials within the 180-day timeframe contemplated in the proposed

    regulations.

    The Commission is adopting the Form DCO as proposed, except for the

    modifications discussed below. The Commission notes that the Form DCO

    standardizes and clarifies the information that the Commission has

    required from DCO applicants in the past and the Form DCO Exhibit

    Instructions, in an effort to reduce the burden on applicants, state

    that ``If any Exhibit requires information that is related to, or may

    be duplicative of, information required to be included in another

    Exhibit, Applicant may summarize such information and provide a cross-

    reference to the Exhibit that contains the required information.''

    Based on the Commission's experience with the DCO registration process

    over the past decade, it believes that its staff can meaningfully

    review the required information within the 180-day time frame. In

    addition, the Commission believes that by standardizing informational

    requirements, the Form DCO will allow the Commission to process

    applications more quickly and efficiently. This will benefit applicants

    as well as free Commission staff to handle other regulatory matters.

    CME specifically questioned whether, as part of the Form DCO cover

    sheet, applicants should be required to identify and list ``all outside

    service providers and consultants, including accountants and legal

    counsel.'' This comment mischaracterizes the information required by

    the Form DCO, which requires contact information for enumerated outside

    service providers (Certified Public Accountant, legal counsel, records

    storage or management, business continuity/disaster recovery) and

    ``other'' outside service providers ``such as consultants, providing

    services related to this application.'' Such contact information is

    helpful to the Commission staff in processing the application and

    making a determination as to whether the applicant has obtained the

    services it needs to effectively

    [[Page 69338]]

    operate as a DCO.\20\ Nonetheless, in response to CME's comments and in

    order to clarify the scope of requesting contact information for ``any

    other outside service providers,'' the Commission has decided to revise

    section 12.e. of the Form DCO cover sheet to provide for contact

    information for any ``Professional consultant providing services

    related to this application.''

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

    \20\ This requirement focuses on outside services ``related to

    this application.'' Similarly, if the applicant intends to use the

    services of an outside service provider (including services of its

    clearing members or market participants), to enable it to comply

    with any of the core principles, the applicant must submit as

    exhibit A-10 all agreements entered into or to be entered into

    between the applicant and the outside service provider, and

    identify: (1) The services that will be provided; (2) the staff who

    will provide the services; and (3) the core principles addressed by

    such arrangement. This exhibit does not require that the applicant

    submit information and documentation related to all outside service

    providers. Rather, the requirement is directed at contractual

    arrangements related to compliance with the core principles, i.e.,

    the DCO's core business functions.

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

    CME commented that proposed exhibit A-1, which would require the

    applicant to produce a chart demonstrating in detail how its rules,

    procedures, and policies address each DCO core principle, is not

    necessary. The Commission believes exhibit A-1 is necessary because it

    will provide a clear picture of which rules, procedures, and policies

    address each DCO core principle. The chart will greatly assist

    Commission staff in tracking and evaluating the materials supplied by

    the applicant and should reduce the need for staff to seek follow-up

    clarifications from the applicant. Again, this will also reduce the

    costs to the applicant.

    CME commented that the Commission has not explained its reasons for

    requiring an applicant to supply ``telephone numbers, mobile phone

    numbers and email addresses of all officers, managers, and directors of

    the DCO,'' as provided in proposed exhibit A-6. The Commission notes

    that the exhibit A-6 instructions request contact and other information

    for ``current officers, directors, governors, general partners, LLC

    managers, and members of all standing committees.'' The exhibit is not

    directed at ``all managers'' or ``all directors,'' but rather at those

    persons who are in key decision-making positions (for example, key

    personnel, directors serving on a board of directors and a manager or

    managing member of a DCO organized in the form of a limited liability

    corporation). The purpose of obtaining contact information is to enable

    the Commission to start building an emergency contact database.

    CME commented that proposed exhibit A-7 would require the applicant

    to list all jurisdictions where the applicant and its affiliates are

    doing business, and the registration status of the applicant and its

    affiliates. CME questioned the Commission's need for such information

    with respect to affiliates of the applicant. The Commission believes

    that such information is necessary because it allows the Commission to

    develop a more complete understanding of the applicant's entire

    corporate organizational structure including potential financial

    commitments and regulatory obligations of the applicant's affiliates

    inclusive of its parent organization.

    CME commented that proposed exhibit B-3, which would require the

    applicant to provide proof that each of its physical locations meets

    all building and fire codes, and that it has running water and a

    heating, ventilation and air conditioning system, and adequate office

    technology, is not necessary. The Commission believes that it is

    important for an applicant to demonstrate that it has a physical

    presence capable of supporting clearing and settlement services and is

    not a ``shoestring'' operation. Typically, Commission staff will

    conduct a site visit to an applicant's headquarters and other

    facilities, and one of the purposes of such visits is to evaluate the

    suitability of the applicant's physical facilities. Site visits,

    however, are conducted after a DCO application is deemed to be

    materially complete, and there are instances when it might not be

    feasible to conduct a site visit. Accordingly, at a minimum, a

    narrative statement discussing the applicant's physical facilities and

    office technology must be submitted to the Commission as part of the

    application package so that staff can complete its initial review for

    ``adequate * * * operational resources'' under Core Principle B.

    In response to CME's comments, the Commission has decided to revise

    exhibit B-3 to require the following:

    (3) A narrative statement demonstrating the adequacy of

    Applicant's physical infrastructure to carry out business

    operations, which includes a principal executive office (separate

    from any personal dwelling) with a U.S. street address (not merely a

    post office box number). For its principal executive office and

    other facilities Applicant plans to occupy in carrying out its DCO

    functions, a description of the space (e.g., location and square

    footage), use of the space (e.g., executive office, data center),

    and the basis for Applicant's right to occupy the space (e.g.,

    lease, agreement with parent company to share leased space).

    (4) A narrative statement demonstrating the adequacy of the

    technological systems necessary to carry out Applicant's business

    operations, including a description of Applicant's information

    technology and telecommunications systems and a timetable for full

    operability.

    CME questioned the value of proposed exhibits C-1(9) and C-2(5),

    which would, respectively, require an applicant to provide a list of

    current and prospective clearing members, and to forecast expected

    volumes and open interest at launch date, six months, and one year

    thereafter. The Commission believes that this information is important

    because it would enable the Commission to understand the nature and

    level of the DCO's expected start-up activities and to appropriately

    evaluate whether the applicant has adequate resources to manage the

    expected volume of business.

    CME questioned the benefits of what it termed the ``incredibly

    burdensome'' requirements of proposed exhibit D-2(b)(3), which would

    require an applicant to explain why a particular margin methodology was

    chosen over other potentially suitable methodologies, and to include a

    comparison of margin levels that would have been generated by using

    such other potential methodologies. To address CME's comment, the

    Commission is revising exhibit D-2(b)(3) to require an explanation of

    whether other margining methodologies were considered and, if so,

    explain why they were not chosen. This information will be sufficient

    in the first instance and, when evaluating an applicant's proposed

    margin methodology, Commission staff can request additional information

    if needed to complete its review for compliance with Core Principle D

    and Sec. 39.13 (risk management).

    The Commission proposed to require use of the Form DCO by a

    registered DCO when requesting an amendment to its DCO registration

    order. CME and Minneapolis Grain Exchange, Inc. (MGEX) suggested that

    the Form DCO be modified so that a currently registered DCO would not

    have to expend as much time and resources to complete an amendment

    request as a new applicant for DCO registration, unless there are

    extenuating circumstances. In response to this suggestion, the

    Commission is revising the Form DCO General Instructions to clarify

    that if the Form DCO is being filed as an amendment to a pending

    application for registration or for the purpose of amending an existing

    registration order, the applicant need only submit the information and

    exhibits relevant to the application

    [[Page 69339]]

    amendment or request for an amended registration order.

    CME also noted that a DCO applicant would be required to represent

    that its Form DCO submission is true, correct, and complete. It

    suggested that the Commission modify this language so that the

    applicant is required to certify that, ``to the best of its

    knowledge,'' its Form DCO submission is true, correct, and complete

    ``in all material respects.'' The Commission is revising the language

    as suggested by CME, in recognition of the fact that some of the

    information contained in the exhibits may have been provided by third

    parties and there is a limit to the reach of an applicant's due

    diligence with respect to such information.

    In addition to the above changes, the Commission has made non-

    substantive editorial changes to the Form DCO for purposes of internal

    consistency and conformity with the Form SDR for swap data repositories

    (SDRs) and proposed Form DCM and Form SEF for designated contract

    markets (DCMs) and swap execution facilities (SEFs), respectively.\21\

    The Commission also has made changes to Form DCO to remove references

    to proposed regulations that remain pending.\22\

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

    \21\ See 76 FR 54538 (Sept. 1, 2011) (SDRs: Registration

    Standards, Duties and Core Principles; final rule); 75 FR 80572

    (Dec. 22, 2010) (Core Principles and Other Requirements for

    Designated Contract Markets); 76 FR 1214 (Jan. 7, 2011) (Core

    Principles and Other Requirements for Swap Execution Facilities).

    \22\ For example, the Commission has removed the specific cross-

    references located in exhibit P to Form DCO to the proposed

    conflicts of interest rules, 75 FR 63732 (Oct. 18, 2010) (Conflicts

    of Interest), and replaced such references with a description of the

    required information. When the Commission finalizes such proposed

    rules, the Commission intends to make technical changes to the Form

    DCO to include cross-references to such final rules where, in the

    opinion of the Commission, doing so will facilitate compliance with

    the Form DCO, the CEA and/or Commission regulations.

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

    2. Request for Transfer of Registration and Open Interest--Sec.

    39.3(h)

    The Commission proposed Sec. 39.3(h) to clarify the procedures

    that a DCO must follow when requesting the transfer of its DCO

    registration and positions comprising open interest for clearing and

    settlement, in anticipation of a corporation change.\23\ The Commission

    received a comment from OCC suggesting that a request to transfer a

    DCO's registration and open interest should be published in the Federal

    Register for public comment.

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

    \23\ As a technical matter, the Commission is removing proposed

    Sec. 39.3(g)(1) and adopting proposed Sec. 39.3(h) as Sec.

    39.3(f); proposed Sec. 39.3(g)(1) was a typographical error which

    repeats a delegation of authority already provided by Sec.

    39.3(b)(2)(i).

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

    The Commission recognizes the value of public comment, but it has

    determined not to formalize the public comment process through

    publication in the Federal Register. This procedure could unnecessarily

    delay the review process and completion of the transfer, and the

    Commission believes that posting the request on its Web site, which it

    currently does for DCO registration applications, will provide an

    opportunity for public comment without potential delay.

    3. Technical Amendments

    The Commission proposed a set of technical amendments to Sec. 39.3

    to update filing procedures, to conform various provisions to reflect

    the elimination of the 90-day expedited review period for DCO

    applications, and to correct terminology in the delegation provisions

    of Sec. 39.3(g). The Commission did not receive any comments on the

    proposed technical amendments and the Commission is adopting the

    amendments as proposed.

    D. Procedures for Implementing DCO Rules and Clearing New Products--

    Sec. 39.4

    1. Acceptance of Certain New Products for Clearing--Sec. 39.4(c)(2)

    The Commission proposed a technical amendment to existing Sec.

    39.4(c)(2), which would require a DCO to certify to the Commission the

    terms and conditions of new over-the-counter (OTC) products that it

    intended to clear. The Commission proposed removing the reference to

    new products ``not traded on a designated contract market or a

    registered derivatives transaction execution facility'' and inserting a

    reference to new products ``not traded on a designated contract market

    or a registered swap execution facility.'' The proposed provision would

    retain the reference to filing the terms and conditions of the new

    product ``pursuant to the procedures of Sec. 40.2 of this chapter.''

    Since proposing that technical amendment, the Commission has

    adopted a new Sec. 39.5 (review of swaps for Commission determination

    on clearing requirement) \24\ and revisions to Sec. 40.2 (listing

    products for trading by certification).\25\ As a result, a DCO seeking

    to clear new products that are not traded on a designated contract

    market or swap execution facility must submit to the Commission the

    terms and conditions of the product pursuant to the procedures of Sec.

    39.5, not Sec. 40.2. The Commission is therefore adopting a technical

    revision to conform Sec. 39.4(c)(2) to the current procedural

    requirements.

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

    \24\ See 76 FR 44464, at 44473-44474 (July 26, 2011) (Process

    for Review of Swaps for Mandatory Clearing; final rule).

    \25\ See 76 FR 44776 (July 27, 2011) (Provisions Common to

    Registered Entities; final rule).

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

    2. Holding Securities in a Futures Portfolio Margining Account--Sec.

    39.4(e)

    The CEA, as amended by Section 713 of the Dodd-Frank Act, permits,

    pursuant to an exemption, rule or regulation, futures and options on

    futures to be held in a portfolio margining account that is carried as

    a securities account and approved by the SEC.\26\ Reciprocally, the

    Securities Exchange Act of 1934 (SEA), as amended by Section 713 of the

    Dodd-Frank Act, permits, pursuant to an exemption, rule, or regulation,

    cash and securities to be held in a portfolio margining account that is

    carried as a futures account and approved by the Commission.\27\ Those

    provisions of the CEA and SEA further require consultation between the

    Commission and the SEC in drafting implementing regulations. As a first

    step toward meeting this goal, proposed Sec. 39.4(e) would establish

    the procedural requirements applicable to a DCO seeking approval for a

    futures portfolio margining account program.

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

    \26\ Section 4d(h) of the CEA, 7 U.S.C. 6d(h).

    \27\ Section 15(c)(3)(C) of the SEA, 15 U.S.C. 78o(c)(3).

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

    OCC, Newedge USA, LLC (Newedge), New York Portfolio Clearing, LLC

    (NYPC), and MetLife Inc. urged the Commission to propose rules that

    would permit portfolio margining, not just establish procedural

    requirements. The Commission agrees that it should propose substantive

    portfolio margining rules, but it must move forward on proposing

    substantive rules with the SEC's participation.

    Accordingly, the Commission is adopting the procedural requirements

    as proposed and anticipates consulting with the SEC in the future to

    determine the substantive requirements it would impose in approving a

    futures portfolio margining program and, additionally, in granting an

    exemption under Section 4(c) of the CEA to permit futures and options

    on futures to be held in a securities portfolio margining account. The

    Dodd-Frank Act does not set a deadline for these actions, and the

    Commission believes that it is important to give this matter due

    consideration, both in terms of consultation with the SEC and, more

    broadly, in obtaining industry views on the topic before

    [[Page 69340]]

    proposing substantive regulations or other guidance.

    E. Reorganization of Part 39

    With the adoption of regulations relating to implementation of the

    core principles and other provisions of the Dodd-Frank Act, the

    Commission is reorganizing part 39 of its regulations into two

    subparts, with a new appendix.

    Subpart A, ``General Provisions Applicable to Derivatives Clearing

    Organizations'' contains Sec. Sec. 39.1 through 39.8, which are

    general provisions including procedural requirements for DCO

    applications and other activities such as transfer of a DCO

    registration, clearing of new products, and submission of swaps for a

    mandatory clearing determination. Subpart A also includes pre-existing

    provisions regarding enforceability and fraud in connection with

    clearing transactions on a DCO.\28\ Subpart B, ``Compliance with Core

    Principles,'' contains Sec. Sec. 39.9 through 39.27, which are rules

    that implement the core principles under Section 5b of the CEA, as

    amended by the Dodd-Frank Act.

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

    \28\ As part of the reorganization of Part 39, Sec. 39.6

    (Enforceability) is being redesignated as Sec. 39.7 and Sec. 39.7

    (Fraud in connection with the clearing of transactions on a

    derivatives clearing organization) is being redesignated as Sec.

    39.8.

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

    As discussed above, the Commission is replacing appendix A

    ``Application Guidance and Compliance with Core Principles,'' with a

    new appendix to part 39, ``Form DCO Derivatives Clearing Organization

    Application for Registration.''

    F. Technical Amendments

    With the objective of listing all DCO reporting requirements in a

    new Sec. 39.19, the Commission proposed redesignating Sec. 39.5(a)

    and (b) (information relating to DCOs) as proposed Sec. Sec.

    39.19(c)(5)(i) and (ii), respectively, in substantially the same form.

    The Commission also proposed removing Sec. 39.5(c) (large trader

    reporting by DCOs), redesignating Sec. 39.5(d) (special calls) as

    Sec. 21.04 (and current Sec. 21.04 as Sec. 21.05), and adding Sec.

    21.06, which would delegate authority under Sec. 21.04 to the Director

    of the Division of Clearing and Risk.

    The Commission did not receive any comments on these proposals.

    Therefore, the Commission is adopting these revisions as proposed,

    except for non-substantive changes to Sec. Sec. 39.19(c)(5)(i) and

    (c)(5)(ii) to clarify the language.\29\

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

    \29\ After these technical amendments were proposed, the

    Commission adopted a final rule governing the process for review of

    swaps for mandatory clearing. That rule was designated as Sec.

    39.5, and the former Sec. 39.5 was redesignated as Sec. 39.8. See

    76 FR at 44473 (July 26, 2011) (Process for Review of Swaps for

    Mandatory Clearing; final rule). In connection with adoption of the

    technical amendments described above, the provisions regarding fraud

    in connection with the clearing of transactions on a DCO (former

    Sec. 39.7) are now redesignated as Sec. 39.8.

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

    IV. Part 39 Amendments--Compliance With Core Principles

    Proposed Sec. 39.9 would establish the scope of the rules

    contained in subpart B of part 39, stating that all provisions of

    subpart B apply to DCOs. The Commission did not receive any comments on

    the statement of scope, and the Commission is adopting Sec. 39.9 as

    proposed.

    A. Core Principle A--Compliance With Core Principles--Sec. 39.10

    1. Core Principle A

    Core Principle A,\30\ as amended by the Dodd-Frank Act, requires a

    DCO to comply with each core principle set forth in Section 5b(c)(2) of

    the CEA and any requirement that the Commission may impose by rule or

    regulation pursuant to Section 8a(5) of the CEA. Core Principle A also

    provides a DCO with reasonable discretion to establish the manner by

    which it complies with each core principle. Proposed Sec. Sec.

    39.10(a) and 39.10(b) would codify these provisions, respectively. The

    Commission received no comments on these proposed rules and is adopting

    the rules as proposed.

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

    \30\ Section 5b(c)(2)(A) of the CEA, 7 U.S.C. 7a-1(c)(2)(A).

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

    2. Designation of a Chief Compliance Officer--Sec. 39.10(c)(1)

    Section 725(b) of the Dodd-Frank Act added a new paragraph (i) to

    Section 5b of the CEA to require each DCO to designate an individual as

    its CCO, responsible for the DCO's compliance with the CEA and

    Commission regulations and the filing of an annual compliance

    report.\31\ In proposed Sec. 39.10(c), the Commission set forth

    implementing requirements that would largely track the language of

    Section 5b(i).

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

    \31\ See Section 5b(i) of the CEA; 7 U.S.C. 7a-1(b)(i).

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

    Under the introductory provision of proposed Sec. 39.10(c)(1),

    each DCO would be required to appoint a CCO with ``the full

    responsibility and authority to develop and enforce in consultation

    with the board of directors or the senior officer, appropriate

    compliance policies and procedures, as defined in Sec. 39.1(b), to

    fulfill the duties set forth in the Act and Commission regulations.''

    As previously noted, the Commission is not adopting the definition of

    ``compliance policies and procedures'' included in proposed Sec.

    39.1(b).

    CME commented that the text of the Dodd-Frank Act does not require

    a CCO to ``enforce'' compliance policies and procedures and it

    suggested that Sec. 39.10 should not do so. According to CME, it is

    important to separate the functions of monitoring and advising on

    compliance issues from what it considers ``senior management

    functions'' of enforcing and supervising compliance policies.

    The Commission believes that Congress intended that the CCO have

    the full responsibility and authority to enforce compliance in

    consultation with the board of directors or the senior officer. Given

    the specified duties of the CCO set forth in Section 5b(i)(2), the

    Commission finds ample support for this interpretation and is adopting

    the rule as proposed.

    First, one definition of the term ``enforce'' is ``to ensure

    observance of laws and rules,'' \32\ and among the CCO duties set forth

    by the Dodd-Frank Act is the requirement that the CCO ``ensure

    compliance.'' \33\ Second, Section 5b(i)(2)(C) requires a CCO to

    ``resolve any conflicts of interest that may arise'' in consultation

    with the board of the DCO or the senior officer of the DCO. This duty

    clearly indicates that the CCO is more than just an advisor to

    management and must have the ability to enforce compliance with the CEA

    and Commission regulations. The authority to resolve conflicts of

    interest is more an enforcement function than an audit function.

    Finally, Section 5b(i)(2)(D) requires the CCO to ``be responsible for

    administering each policy.''

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

    \32\ See http://www.websters-online-dictionary.org/definitions/enforce.

    \33\ See Section 5b(i)(2)(E) of the CEA, 7 U.S.C. 7a-

    1(b)(i)(2)(E), which requires the CCO to ``ensure compliance with

    this Act (including regulations) relating to agreements, contracts,

    or transactions, including each rule prescribed by the Commission

    under this section.''

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

    While the CEA does not explicitly use the word ``enforce,'' the

    Commission believes that the use of this word in Sec. 39.10(c)(1) is

    appropriate to capture the meaning of Section 5b(i)(2)(C), i.e., that

    CCOs must have the authority to fulfill their statutory and regulatory

    obligations. Moreover, it is consistent with the statutory directive

    for the CCO to ensure compliance with the CEA. These considerations are

    particularly important given that the CCO of a DCO has unique

    responsibilities in connection with the DCO's critical role in

    providing financial integrity to derivatives markets. In particular, a

    CCO must have the ability to effectively address rules and practices

    that could compromise compliance with fair and open access requirements

    (Core Principle C), risk management

    [[Page 69341]]

    requirements (Core Principle D), and financial resource requirements

    (Core Principle B).

    The Commission, however, recognizes that the term ``enforce'' could

    imply that the DCO's CCO must have direct supervisory authority over

    employees not otherwise in his or her direct chain of command, or that

    the CCO has independent authority to discipline employees or terminate

    employment to facilitate compliance with the CEA and the Commission's

    regulations. To avoid confusion, the Commission herein clarifies that

    the term ``enforce,'' as used in Sec. 39.10(c)(1), is not intended to

    include the authority to supervise employees not in the CCO's direct

    chain of command, or the authority to terminate employment or

    discipline employees for conduct that results in noncompliance. The

    Commission notes that a DCO is not precluded from conferring such

    authority on its CCO; however, such action would be at the DCO's

    discretion and is not required by Sec. 39.10(c)(1).\34\

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

    \34\ See further discussion of a CCO's duties in section IV.A.7,

    below.

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

    3. Individuals Qualifying To Serve as a CCO--Sec. 39.10(c)(1)(i)

    Proposed Sec. 39.10(c)(1)(i) would require a DCO to designate an

    individual with the background and skills appropriate for fulfilling

    the responsibilities of the CCO position. The Commission asked whether

    additional qualifications should be imposed and, in particular, whether

    the Commission should restrict the CCO position from being held by an

    attorney who represents the DCO or its board of directors, such as an

    in-house or general counsel. The Commission explained that the

    rationale for such a restriction would be based on concern that the

    interests of representing the DCO's board of directors or management

    could be in conflict with the duties of the CCO. Related to this, the

    Commission specifically sought comment on whether there is a need for a

    regulation requiring the DCO to insulate a CCO from undue pressure and

    coercion. It further asked if it is necessary to adopt rules to address

    the potential conflict between and among compliance interests,

    commercial interests, and ownership interests of a DCO and, if there is

    no need for such rules, requested comment on how such potential

    conflicts would be addressed.

    CME, OCC, MGEX, and the Kansas City Board of Trade Clearing

    Corporation (KCC) commented that additional restrictions should not be

    imposed. MGEX commented that smaller DCOs will need to maximize the

    utility of each employee. It also argued that there is little risk if a

    CCO serves as in-house counsel because attorneys have additional

    ethical duties which can complement the duties and obligations of a

    CCO. According to MGEX, if a conflict arose, the attorney could step

    out of one or both of the roles.

    Better Markets commented that there is potential conflict between a

    CCO and in-house counsel because in-house counsel is an advocate for

    the DCO or its board of directors regarding any controversy that may

    relate to regulatory compliance, while a CCO's duty is to ensure

    compliance. It suggested that the Commission prohibit a CCO from

    serving as in-house counsel.

    The Commission is adopting Sec. 39.10(c)(1)(i) as proposed. The

    Commission has considered prohibiting a CCO from working in the DCO's

    legal department or serving as general counsel, consistent with the

    Commission's approach to the CCO of an SDR.\35\ However, in response to

    public comments and in light of the fact that all currently registered

    DCOs have some form of compliance program already in place, with one or

    more staff members assigned to carry out compliance officer functions,

    the Commission has determined that the potential costs of hiring

    additional staff to satisfy such requirement could result in imposing

    an unnecessary burden on DCOs, particularly smaller ones. The

    Commission recognizes, however, that a conflict of interest could

    compromise a CCO's ability to effectively fulfill his or her

    responsibilities as a CCO. The Commission therefore expects that as

    soon as any conflict of interest becomes apparent, a DCO would

    immediately implement a back-up plan for reassignment or other measures

    to address the conflict and ensure that the CCO's duties can be

    performed without compromise.

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

    \35\ See 76 FR 54538 (Sept. 1, 2011) (SDRs: Registration

    Standards, Duties and Core Principles; final rule).

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

    MGEX and KCC also recommended that the Commission should permit the

    Chief Regulatory Officer to function as the CCO. Presumably, the

    commenters are referring to circumstances in which a DCO (which

    typically would not have a Chief Regulatory Officer) is also registered

    as a DCM (which typically would have a Chief Regulatory Officer). The

    Commission notes that the rule does not prohibit the person serving as

    CCO from also serving as the Chief Regulatory Officer.

    4. CCO Reporting Structure--Sec. 39.10(c)(1)(ii)

    Section 5b(i)(2)(A) of the CEA requires that a CCO report directly

    to the board of directors or the senior officer of the DCO.\36\

    Proposed Sec. 39.10(c)(1)(ii) would codify this requirement. The

    proposed rule also would require the board of directors or the senior

    officer to approve the compensation of the CCO.

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

    \36\ 7 U.S.C. 7a-1(i)(2)(A).

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

    In the notice of proposed rulemaking, the Commission sought comment

    as to the degree of flexibility that should be provided in the

    reporting structure of the CCO. Specifically, the Commission requested

    comment on: (i) Whether it would be more appropriate for a CCO to

    report to the senior officer or the board of directors; (ii) as between

    the senior officer or board of directors, which generally is a stronger

    advocate of compliance matters within an organization; and (iii)

    whether the proposed rules allow for sufficient flexibility with regard

    to a DCO's business structure.

    CME, MGEX, and KCC commented that the proposed rules would provide

    DCOs with the appropriate degree of flexibility. CME, however, believes

    it would be ``logical'' for a CCO to report to the senior officer, and

    that the board of directors should oversee implementation of compliance

    policies and ensure that compliance issues are resolved effectively and

    expeditiously by the senior officer with the assistance of the CCO.

    MGEX noted that each DCO may have a different business and reporting

    structure and believes that rigid rules may hinder the effectiveness

    and independence of the CCO.

    Better Markets observed that, in the past, businesses have placed

    financial interests over other considerations like risk management and

    have created a climate where people were unwilling to speak out against

    financial considerations for fear of being fired. Better Markets

    suggested that there should be a strong reporting and working

    relationship between the CCO and independent directors, and suggested

    that independent directors have sole responsibility to designate or

    terminate the CCO and to set compensation levels for the CCO.

    The Commission is adopting Sec. 39.10(c)(1)(ii) as proposed,

    declining to prescribe whether the CCO can only report to the board of

    directors or to the senior officer. The Commission appreciates Better

    Markets' concern that a CCO who reports to the senior officer may be

    swayed by financial

    [[Page 69342]]

    considerations. However, the Dodd-Frank Act permits alternative

    reporting structures and the Commission has not been presented with a

    compelling reason to conclude that the structure and operations of a

    DCO require the imposition of this limitation on the ability of a DCO's

    board and management to establish lines of authority appropriate to the

    particular DCO.

    CME asked the Commission to clarify that the term ``senior

    officer'' may apply to the senior officer of a division that is engaged

    in clearing activities. The Commission notes that Section 5b(i)(2)(A)

    of the CEA requires a CCO to ``report directly to the board or to the

    senior officer of the derivatives clearing organization.'' If the

    division engaged in clearing activities is the registered DCO, then the

    senior officer of that division would be the ``senior officer'' for

    purposes of this provision.

    Finally, Better Markets suggested that compliance should be

    addressed on an entire-group basis by a senior CCO. According to Better

    Markets, a single senior CCO should have overall responsibility for

    each affiliated and controlled entity, even if the individual entities

    within the group have CCOs. The final rules do not require a business

    organization to have a ``senior'' CCO as Better Markets suggested. The

    Commission believes this would be overly prescriptive and that a DCO

    should have the flexibility to manage compliance functions across

    divisions or affiliates to accommodate its particular organizational

    structure.

    5. Annual Compliance Meeting--Sec. 39.10(c)(1)(iii)

    Proposed Sec. 39.10(c)(1)(iii) would require a CCO to meet with

    the board of directors or the senior officer at least once a year to

    discuss the effectiveness of the DCO's compliance policies and

    procedures, as well as the administration of those policies and

    procedures by the CCO. Better Markets suggested that a CCO meet with

    the board of directors at least quarterly. No comments were received on

    the proposed topics to be discussed at the annual meeting.

    The Commission is adopting Sec. 39.10(c)(1)(iii) in modified form.

    The final rule retains the requirement that the CCO meet with the board

    of directors or senior officer annually, but eliminates the required

    topics to be discussed at the meeting. As the Commission noted in the

    notice of proposed rulemaking, the requirement for an annual discussion

    would not preclude the board of directors or the senior officer from

    meeting with the CCO more frequently. While more frequent communication

    between the CCO and the DCO's board or senior officer may be desirable,

    the Commission has concluded that adopting requirements to that effect

    would be overly prescriptive. Similarly, upon further consideration,

    the Commission has concluded that the purpose of the meeting should be

    self-evident (i.e., compliance) and it is not necessary for the

    Commission, by regulation, to prescribe the business that must be

    conducted at that meeting.

    6. Change in the Designation of the CCO--Sec. 39.10(c)(1)(iv)

    Proposed Sec. 39.10(c)(1)(iv) would require that a change in the

    designation of the individual serving as the CCO be reported to the

    Commission, in accordance with the requirements of proposed Sec.

    39.19(c)(4)(xi). The Commission received no comments on the proposed

    rule and is adopting the provision as proposed.\37\

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

    \37\ See discussion in section IV.J.5.h. (The Commission is

    adopting proposed Sec. 39.19(c)(4)(xi) as a renumbered Sec.

    39.19(c)(4)(ix)).

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

    7. Duties of the CCO--Sec. 39.10(c)(2)

    Section 5b(i)(2) of the CEA, added by Section 725(a) of the Dodd-

    Frank Act, sets forth the duties of a CCO,\38\ and proposed Sec.

    39.10(c)(2) would codify those enumerated duties in paragraphs

    (c)(2)(i)-(vii).

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

    \38\ 7 U.S.C. 7a-1(i)(2).

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

    The Commission received comments on the CCO's duties from CME, KCC,

    and OCC. In general, the commenters expressed the view that the

    proposed regulations are too broad because they improperly provide the

    CCO with what CME calls ``senior management functions'' like enforcing

    and supervising compliance policies. Instead, the commenters believe

    that the role of a CCO is only to serve as an auditor who monitors

    compliance and informs senior management of noncompliance. The

    Commission has carefully considered the comments and is adopting the

    rule as proposed, except as discussed below.

    CME acknowledged that proposed Sec. 39.10(c)(2)(ii) mirrors the

    language in the Dodd-Frank Act. However, CME believes that Congress did

    not intend to mean ``resolve'' in the executive or managerial sense

    such that the CCO alone would examine the facts and determine and

    affect the course of action. CME believes that Congress intended the

    CCO to identify, advise, and escalate, as appropriate, and to assist

    senior management in resolving conflicts of interest.

    KCC also believes that the board of directors or senior officer

    should resolve any conflict of interest in consultation with the CCO.

    KCC commented that compliance policies and procedures should be

    administered by DCO staff and not by the CCO. According to KCC, a DCO's

    staff is most familiar with the day-to-day operations of the DCO and is

    in the best position to manage the policies and procedures. KCC

    believes that a CCO's role should be that of oversight of the DCO's

    compliance program and filing an annual report.

    The Commission disagrees with assertions that a CCO should only

    assist senior management in resolving conflicts of interest or that the

    board or senior management should resolve conflicts of interest in

    consultation with the CCO. Section 5b(i)(2)(C) of the CEA states that a

    CCO shall ``in consultation with the board of the derivatives clearing

    organization, a body performing a function similar to the board of the

    derivatives clearing organization, or the senior officer of the

    derivatives clearing organization, resolve any conflicts of interest

    that may arise.'' Given this express statutory direction, the

    Commission is not revising the proposed rule.

    The Commission points out that a CCO's duty to administer

    compliance policies and procedures is set forth in Section 5b(i)(2)(D)

    of the CEA. It requires a CCO to ``be responsible for administering

    each policy and procedure that is required to be established pursuant

    to this section.'' By administering compliance policies and procedures,

    a CCO is not required to perform staff functions that have compliance

    implications. Rather, the CCO is responsible for oversight of such

    functions.

    The Commission is revising Sec. 39.10(c)(2)(iii) to require a CCO

    to have the duty of ``[e]stablishing and administering written policies

    and procedures reasonably designed to prevent violation of the Act.''

    This does not change the substance of the requirement or alter the

    implementation of the statutory standard, as it is consistent with

    Sec. 39.10(c)(1) which requires a CCO to ``develop * * * appropriate

    policies and procedures * * * to fulfill the duties set forth in the

    Act and Commission regulations.'' The Commission believes that the

    revised language eliminates the possibility of ambiguity and prevents

    too narrow a reading of the reference to policies and procedures that

    are ``required'' under the CEA.

    CME described as ``impracticable'' the proposed standard that a CCO

    must ''ensure'' a DCO's compliance and

    [[Page 69343]]

    suggested that an appropriate and ``achievable'' standard would be to

    require a CCO to put in place measures ``reasonably designed to ensure

    compliance'' with the CEA and Commission regulations.

    The Commission is revising Sec. 39.10(c)(2)(iv) in response to

    CME's comment. Although Section 5b(i)(2)(E) of the CEA requires a CCO

    to ``ensure'' compliance, the Commission agrees that a CCO cannot fully

    guarantee compliance because, as a practical matter, he or she will

    have to rely to some extent on information provided by other DCO

    employees or representatives of the DCO's service providers.

    Accordingly, Sec. 39.10(c)(2)(iv) is being modified to include as a

    duty of the CCO, ``[t]aking reasonable steps to ensure compliance with

    the Act and Commission regulations * * * '' (added text in italics).

    The Commission believes that this revision addresses CME's concern

    while retaining the emphasis on the CCO's actions rather than focusing

    on the nature of measures put in place by the CCO.\39\

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

    \39\ See also 76 FR at 54584 (Sept. 1, 2011) (SDRs: Registration

    Standards, Duties and Core Principles; final rule) (adopting Sec.

    49.22(d)(4), which applies this standard to the CCO of an SDR).

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

    CME recommended that the Commission revise proposed Sec.

    39.10(c)(2)(vi) to require a CCO to ``[e]stablish[] appropriate

    procedures [for] the handling, management response, remediation,

    retesting, and closing of noncompliance issues,'' and to eliminate the

    requirement that a CCO ``follow[]'' such procedures. According to CME,

    this is a function of senior management and Congress did not intend for

    a CCO to exercise senior management functions. OCC agrees with CME.

    Specifically, CME suggested that proposed Sec. 39.10(c)(2)(vi) be

    modified to eliminate the requirement that a CCO ``follow'' appropriate

    procedures because following procedures is a function of senior

    management. However, a CCO's performance of this ``senior management''

    function is explicitly set forth in Section 5b(i)(2)(G) of the CEA,

    which states that ``[t]he chief compliance officer shall * * *

    establish and follow appropriate procedures for the handling,

    management response, remediation, retesting, and closing of

    noncompliance issues.'' The Commission does not believe that CME has

    provided a persuasive basis for its suggested modification of Sec.

    39.10(c)(2)(vi), and the Commission is adopting the provision as

    proposed.

    Finally, the Commission, on its own initiative, is revising Sec.

    39.10(c)(2)(vii) to eliminate the requirement that a CCO establish a

    compliance manual. While having a compliance manual is a good practice,

    incorporating this requirement into a regulation may be overly

    prescriptive and the Commission has concluded that a DCO should have

    discretion as to the vehicles through which it will carry out its

    compliance program.

    8. Annual Report--Sec. 39.10(c)(3)

    Section 5b(i)(3) of the CEA, added by Section 725(b) of the Dodd-

    Frank Act, requires a CCO to prepare an annual report that describes

    the DCO's compliance with the CEA, regulations promulgated under the

    CEA, and each policy and procedure of the DCO, including the code of

    ethics and conflicts of interest policies.\40\ Implementation of these

    statutory requirements was addressed at proposed Sec. 39.10(c)(3)(i),

    (c)(3)(ii)(A), and (c)(3)(v) and (v).

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

    \40\ 7 U.S.C. 7a-1(i)(3).

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

    With respect to proposed Sec. 39.10(c)(3)(i), CME suggested that

    the Commission eliminate it and KCC commented that the requirement for

    a DCO to show compliance with respect to the CEA and Commission

    regulations is ambiguous and overreaching. KCC also suggested that the

    scope of the annual report should not go beyond reviewing the DCO core

    principles and identifying the compliance policies and procedures that

    are in place to satisfy the core principles.

    Although paragraph (i) mirrors the language and requirements set

    forth in Section 5b(i)(3)(A)(i) of the CEA, to address CME's and KCC's

    comments, the Commission has decided to revise the language of

    Sec. Sec. 39.10(c)(3)(i) and (ii) to avoid submission of duplicative

    information and to clarify the scope of the annual report content

    requirements without altering the nature of the information that must

    be included in the report pursuant to the CEA. Final Sec. 39.10

    (c)(3)(i) requires that the annual report ``[c]ontain a description of

    the derivatives clearing organization's written policies and

    procedures, including the code of ethics and conflict of interest

    policies.'' Final Sec. 39.10 (c)(3)(ii) requires that the report ''

    [r]eview each core principle and applicable Commission regulations, and

    with respect to each: (A) Identify the compliance policies and

    procedures that are designed to ensure compliance with the core

    principle.'' The Commission notes that by specifying ``written''

    policies and procedures, the rule more precisely establishes the scope

    of Sec. 39.10(c)(3)(i).

    Proposed Sec. Sec. 39.10(c)(3)(iii) and (c)(3)(iv) would require

    that the annual report list any material changes to compliance policies

    and procedures since the last annual report and describe the DCO's

    financial, managerial, and operational resources for compliance with

    the Act and Commission regulations, respectively. The Commission did

    not receive any comments on these provisions and is adopting Sec. Sec.

    39.10(c)(3)(iii) and (c)(3)(iv) as proposed.

    Proposed Sec. 39.10(c)(3)(v) would require that the annual report

    ``[d]escribe any material compliance matters, including incidents of

    noncompliance, since the date of the last annual report and describe

    the corresponding action taken.'' CME suggested that the provision be

    revised to require that the annual report identify only material

    compliance issues that were not properly addressed by the DCO.

    The Commission is adopting Sec. 39.10(c)(3)(v) as proposed because

    receiving such information will enable the Commission to assess whether

    the DCO is addressing compliance matters effectively. It also will

    enable the Commission to become aware of possible future compliance

    issues across DCOs and to proactively identify best practices. An

    annual report that identifies only material compliance issues would not

    provide sufficient information.

    Finally, the Commission on its own initiative is not adopting

    proposed Sec. 39.10(c)(3)(vi) because information of this nature is

    not essential to the Commission's evaluation of the DCO's compliance

    program and, if it is relevant to a material compliance matter, it will

    be provided to the Commission pursuant to Sec. 39.10(c)(3)(v).

    9. Submission of Annual Report to the Commission--Sec. 39.10(c)(4)

    Proposed Sec. 39.10(c)(4) would set forth the requirements for

    submitting an annual report to the Commission. Except as noted below,

    the Commission is adopting the rule as proposed.

    Better Markets suggested that the Commission change proposed Sec.

    39.10(c)(4)(i) to require a CCO to present the finalized annual report

    to the board of directors and executive management prior to its

    submission to the Commission. Better Markets also suggested that the

    independent directors as well as the entire board should be required to

    review and approve the report in its entirety and to detail any

    disagreement with any portion. In

    [[Page 69344]]

    addition, Better Markets commented that a CCO should be required to

    file the report with the Commission, either as approved or with

    statements of disagreement.

    The Commission is not revising proposed Sec. 39.10(c)(4)(i) per

    Better Markets' suggestion. The Commission believes that a DCO should

    have the flexibility to determine whether the annual report will be

    provided to the board of directors, the senior officer, or both. The

    Commission also is not requiring the board of directors to approve or

    submit comments on the report given that the board of directors might

    not have sufficient information to approve or disagree with the report.

    In addition, there is a risk that the board might try to influence the

    CCO to change the report if it were required to express approval. The

    Commission notes that the rules do not prohibit the board, any of its

    members, or the senior officer from approving or disagreeing with

    aspects of the annual report.

    Proposed Sec. 39.10(c)(4)(ii) would require that the annual report

    include a certification by the CCO that, to the best of his or her

    knowledge and reasonable belief, and under penalty of law, the annual

    report is accurate and complete. CME commented that the Commission

    should require the DCO's senior officer, and not the CCO, to make the

    necessary certification in the annual compliance report. According to

    CME, ``the best way to achieve the goal of a robust effective

    compliance program, and to close the loop on creating a culture of

    compliance, is to require the registrant's senior officer--and not the

    CCO--to complete the required certification.''

    KCC commented that a CCO should not have to certify ``under penalty

    of law'' that the annual report is accurate and complete, and a CCO

    should certify instead that to the best of his or her knowledge and

    belief the annual report is accurate and complete.

    The Commission is adopting Sec. 39.10(c)(4)(ii) as proposed. The

    CEA requires (1) the CCO to sign the annual report and (2) that the

    annual report contain a certification that, under penalty of law, the

    compliance report is accurate and complete.\41\ Accordingly, the

    Commission believes the regulation accurately reflects Congressional

    intent.

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

    \41\ See Section 5b(i)(3)(B)(ii) of the CEA, 7 U.S.C. 7a-

    1(i)(3)(B)(ii).

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

    10. Annual Report Confidentiality

    CME suggested that Commission regulations should expressly state

    that annual reports are confidential documents that are not subject to

    public disclosure by listing annual reports as a specifically exempt

    item in part 145 of the Commission's regulations. The Commission has

    not proposed and is not adopting CME's proposal, which would provide

    blanket confidentiality to all annual reports submitted by CCOs of

    DCOs, even though the Commission may determine that there is

    information contained in a report that should be public. Accordingly, a

    DCO must petition for confidential treatment of its annual report under

    Sec. 145.9 if it wants the Commission to determine that a particular

    annual report should be subject to confidentiality.

    11. Insulating the CCO From Undue Influence

    The notice of proposed rulemaking solicited comments as to whether

    the Commission should adopt regulations that require a DCO to insulate

    its CCO from undue pressure and coercion. CME commented that the

    current regulations are sufficient to protect a CCO from undue

    influence and it does not believe additional regulations are necessary.

    The Commission agrees with CME and is not adopting such regulations.

    12. Recordkeeping--Sec. 39.10(c)(5)

    Proposed Sec. 39.10(c)(5) would require a DCO to maintain: (i) A

    copy of the policies and procedures adopted in furtherance of

    compliance with the CEA and Commission regulations; (ii) copies of

    materials, including written reports provided to the board of directors

    or the senior officer in connection with review of the annual report;

    and (iii) any records relevant to the DCO's annual report, including

    work papers and financial data. The DCO would be required to maintain

    these records in accordance with Sec. 1.31 and proposed Sec. 39.20.

    The Commission did not receive any comment letters discussing proposed

    Sec. 39.10(c)(5). The Commission has adopted Sec. 39.10(c)(5) as

    proposed, except that the Commission has modified Sec. 39.10(c)(5)(A)

    to refer to ``all compliance policies and procedures'' rather than

    ``the compliance policies and procedures, as defined in Sec. 39.1(b)''

    in light of the Commission's decision not to adopt a definition of

    compliance policies and procedures, as discussed in section III.B,

    above.

    B. Core Principle B--Financial Resources--Sec. 39.11

    Core Principle B,\42\ as amended by the Dodd-Frank Act, requires a

    DCO to possess financial resources that, at a minimum, exceed the total

    amount that would enable the DCO to meet its financial obligations to

    its clearing members notwithstanding a default by the clearing member

    creating the largest financial exposure for the DCO in extreme but

    plausible market conditions and to cover its operating costs for a

    period one year, as calculated on a rolling basis. Proposed Sec. 39.11

    would codify these requirements. The Commission received a total of 18

    comments on the proposed regulations. The Commission considered each of

    these comments in formulating the final regulations discussed below.

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

    \42\ Section 5b(c)(2)(B) of the CEA, 7 U.S.C. 7a-1(c)(2)(B).

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

    1. Amount of Financial Resources Required--Sec. Sec. 39.11(a) and

    39.11(b)(3)

    Proposed Sec. 39.11(a)(1) would require a DCO to maintain

    sufficient financial resources to meet its financial obligations to its

    clearing members notwithstanding a default by the clearing member

    creating the largest financial exposure for the DCO in extreme but

    plausible market conditions, and proposed Sec. 39.11(a)(2) would

    require a DCO to maintain sufficient financial resources to cover its

    operating costs for at least one year, calculated on a rolling basis.

    Proposed Sec. 39.11(b)(3) would allow a DCO to allocate a financial

    resource, in whole or in part, to satisfy the requirements of either

    proposed Sec. 39.11(a)(1) or proposed Sec. 39.11(a)(2), but not both,

    and only to the extent that use of that financial resource is not

    otherwise limited by the CEA, Commission regulations, the DCO's rules,

    or any contractual arrangements to which the DCO is a party.

    The Futures Industry Association (FIA) recommended that all DCOs be

    required to maintain resources sufficient to withstand the default of

    the two clearing members representing the largest financial exposure to

    the DCO, but that the Commission give DCOs reasonable time to come into

    compliance with the enhanced requirement.

    The International Swaps and Derivatives Association (ISDA) also

    suggested that, in the clearing of certain OTC derivatives such as

    eligible credit default swaps and interest rate swaps, a DCO should

    have sufficient financial resources that, at a minimum, enable it to

    withstand a potential default by two of its largest clearing members,

    as measured by the two clearing members with the largest obligations to

    the DCO in extreme but plausible market conditions. ISDA further

    suggested, however, that this heightened financial resource level may

    not be appropriate for all other OTC or other derivatives products, and

    offered to work with the Commission to determine the

    [[Page 69345]]

    appropriate standard for derivatives in other asset classes.

    Similarly, Mr. Chris Barnard recommended that consideration be

    given to differentiating risk, and therefore resource requirements by

    broad derivative/product class, or at least by exchange-traded and OTC

    derivative types.

    Better Markets suggested that the default rate used in the stress

    test for DCOs should be the larger of (1) the member representing the

    largest exposure to the DCO, and (2) the members constituting at least

    25 percent of the exposures in aggregate to the DCO. Americans for

    Financial Reform (AFR) stated that the calculation in proposed Sec.

    39.11(a)(1) should be based on risk exposure as well as number of

    defaults.

    LCH.Clearnet Group Limited (LCH) concurred with all the provisions

    set forth by the Commission under proposed Sec. 39.11(a). NYPC also

    expressed support for proposed Sec. Sec. 39.11(a)(1) and 39.11(a)(2).

    The Commission is adopting Sec. 39.11(a) as proposed. Section

    39.11(a) is consistent with Core Principle B as amended by the Dodd-

    Frank Act. As the Commission noted in its notice of proposed

    rulemaking, Sec. 39.11(a)(1) is also consistent with the Bank for

    International Settlements' Committee on Payment and Settlement Systems

    and the Technical Committee of the International Organization of

    Securities Commissions (CPSS-IOSCO) Recommendations for Central

    Counterparties (CCPs), issued in 2004 (2004 CPSS-IOSCO

    Recommendations).\43\ The Commission recognizes that those

    recommendations eventually will be replaced by the Principles for

    Financial Market Infrastructures (FMIs), which are currently being

    developed by CPSS and IOSCO and are expected to be finalized in

    2012.\44\ For financial resources requirements for CCPs, CPSS and IOSCO

    are considering three alternatives: (1) A ``cover one'' minimum

    requirement for all CCPs; (2) a ``cover two'' minimum requirement for

    all CCPs; and (3) either a ``cover one'' or a ``cover two'' minimum

    requirement for a particular CCP, depending upon the risk and other

    characteristics of the particular products it clears, the markets it

    serves, and the number and type of participants it has.\45\ The

    Commission may reconsider Sec. 39.11(a)(1) once CPSS and IOSCO have

    finished their work.

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

    \43\ See Bank for International Settlements' Committee on

    Payment and Settlement Systems and Technical Committee of the

    International Organization of Securities Commissions,

    ``Recommendations for Central Counterparties,'' CPSS Publ'n No. 64

    (November 2004), available at http://www.bis.org/publ/cpss64.pdf.

    \44\ See Bank for International Settlements' Committee on

    Payment and Settlement Systems and Technical Committee of the

    International Organization of Securities Commissions, ``Principles

    for financial market infrastructures: Consultative report,'' CPSS

    Publ'n No. 94 (March 2011), available at http://www.bis.org/publ/cpss94.pdf (CPSS-IOSCO Consultative Report).

    \45\ CPSS-IOSCO Consultative Report, Principle 4: Credit Risk,

    at 30.

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

    MGEX noted that proposed Sec. 39.11(b)(3) would prohibit a DCO

    from using a financial resource for both default and operating cost

    purposes. While MGEX agreed this seems a logical approach to take to

    avoid counting an asset's value for two different purposes, MGEX stated

    that there are practical implications to consider. As a DCM and DCO,

    MGEX keeps one basic set of financial records that are compliant with

    various accounting standards. MGEX recommended that the Commission's

    proposal should not be interpreted to require a DCO to formally divide

    some assets and accounts. The Commission confirms that Sec.

    39.11(b)(3) does not require a DCO to formally divide its assets or

    accounts. The Commission is adopting Sec. 39.11(b)(3) as proposed.

    2. Treatment of Affiliated Clearing Members--Sec. 39.11(a)(1)

    Proposed Sec. 39.11(a) would state, in part: ``A [DCO] shall

    maintain financial resources sufficient to cover its exposures with a

    high degree of confidence and to enable it to perform its functions in

    compliance with the core principles set out in Section 5b of the [CEA]

    * * * Financial resources shall be considered sufficient if their

    value, at a minimum, exceeds the total amount that would: (1) Enable

    the [DCO] to meet its financial obligations to its clearing members

    notwithstanding a default by the clearing member creating the largest

    financial exposure for the [DCO] in extreme but plausible market

    conditions; Provided that if a clearing member controls another

    clearing member or is under common control with another clearing

    member, the affiliated clearing members shall be deemed to be a single

    clearing member for purposes of this provision * * * ''

    In the notice of proposed rulemaking, the Commission stated:

    ``There may be some instances in which one clearing member controls

    another clearing member or in which a clearing member is under common

    control with another clearing member. The Commission proposes to treat

    such affiliated clearing members as a single entity for purposes of

    determining the largest financial exposure because the default of one

    affiliate could have an impact on the ability of the other to meet its

    financial obligations to the DCO. However, to the extent that each

    affiliated clearing member is treated as a separate entity by the DCO,

    with separate capital requirements, separate guaranty fund obligations,

    and separate potential assessment liability, the Commission requests

    comment on whether a different approach might be warranted.''

    CME noted that it treats affiliated clearing members as separate

    entities, with separate capital requirements, separate guaranty fund

    obligations, and separate potential assessment liability. While CME

    acknowledged that the default of one affiliate may impact the ability

    of another affiliated clearing member to meet its financial obligations

    to the DCO, CME suggested that circumstances may exist in which a

    clearing member is sufficiently independent to continue operating

    notwithstanding a default by an affiliate. CME rules allow, but do not

    require, emergency action to be taken against a clearing member based

    upon the financial or operational condition of an affiliate (whether or

    not that affiliate is also a clearing member). CME urged the Commission

    to take a similar approach by revising the language of proposed Sec.

    39.11(a) to state that ``if a clearing member controls another clearing

    member or is under common control with another clearing member, the

    affiliated clearing members may be deemed to be a single clearing

    member * * *.''

    LCH agreed with the Commission's proposed requirement that the DCO

    must treat any clearing member, either controlled by another clearing

    member or under common control with another clearing member, as a

    single clearing member for the purposes of Sec. 39.11(a)(1).

    The Commission is adopting Sec. 39.11(a)(1) as proposed. The

    Commission believes this treatment appropriately addresses the

    potential risks of affiliates. The Commission notes that aggregating

    the potential losses of affiliated clearing members for purposes of

    this calculation would provide more coverage in the event of a default.

    3. Operating Costs--Sec. 39.11(a)(2)

    Proposed Sec. 39.11(a)(2) would require a DCO to maintain

    sufficient financial resources to cover its operating costs for at

    least one year, calculated on a rolling basis.

    OCC commented that while the statutory requirement that a DCO have

    one year of operating costs, based on a rolling period, may be a

    reasonable

    [[Page 69346]]

    standard to ensure that a DCO is not forced out of business while there

    is still open interest in the contracts it clears, the requirement

    should be calculated based on essential operating expenses for the

    rolling period. According to OCC, an appropriate wind-down budget would

    include projected revenues during the wind-down and would not include

    expenses associated with activities having value only to a DCO that

    intends to remain in business (e.g., product development, technological

    enhancements, lobbying activities, investor education, etc.).

    ISDA stated that it is appropriate that a DCO hold equity capital

    sufficient to cover its operating costs and likely exit costs during

    any liquidation and this capital should be separate from any DCO equity

    contribution to the required default resources.

    Eurex Clearing AG (Eurex) agreed that having a requirement for

    operating resources is reasonable, especially in view of the

    flexibility implied in the Commission's proposed rules for types of

    financial resources, but cautioned that the one-year time frame may be

    unnecessarily long.

    FIA supported this aspect of the Commission's proposal, including

    the requirement that a DCO not be permitted to ``double-count'' its

    resources to cover both this and the default resources requirement.

    The Commission is adopting Sec. 39.11(a)(2) as proposed. The

    Commission notes that the language in Sec. 39.11(a)(2) is virtually

    identical to that of Core Principle B.

    4. Types of Financial Resources--Sec. 39.11(b)

    Proposed Sec. 39.11(b)(1) lists the types of financial resources

    that would be available to a DCO to satisfy the requirements of

    proposed Sec. 39.11(a)(1): (1) The margin of the defaulting clearing

    member; (2) The DCO's own capital; (3) the guaranty fund deposits of

    the defaulting clearing member and non-defaulting clearing members; (4)

    default insurance; (5) if permitted by the DCO's rules, potential

    assessments for additional guaranty fund contributions on non-

    defaulting clearing members; and (6) any other financial resource

    deemed acceptable by the Commission. Proposed Sec. 39.11(b)(2) lists

    the types of financial resources that would be available to a DCO to

    satisfy the requirements of proposed Sec. 39.11(a)(2): (1) The DCO's

    own capital and (2) any other financial resource deemed acceptable by

    the Commission.

    In the notice of proposed rulemaking, the Commission noted that a

    DCO would be able to request an informal interpretation from Commission

    staff on whether or not a particular financial resource may be

    acceptable to the Commission. The Commission also invited commenters to

    recommend particular financial resources for inclusion in the final

    regulation.

    ISDA encouraged the Commission to give prudent consideration to the

    use of standby letters of credit as an additional financial resource,

    given that many letter-of-credit issuing banks will be an affiliate of

    a clearing member.

    Natural Gas Exchange Inc. (NGX) requested that the Commission

    consider the acceptability of letters of credit as an asset of the

    guaranty fund and clarify in the final rule that letters of credit are

    acceptable as an asset of the guaranty fund if subject to certain

    safeguards. NGX also requested that the Commission make clear in the

    final regulation that it will interpret proposed Sec. Sec.

    39.11(b)(1)(vi) and 39.11(b)(2)(ii) broadly so as to permit a

    demonstration, on a case-by-case basis, that a DCO meets the overall

    policies of the regulation through a specific mix of financial

    resources.

    Mr. Barnard recommended splitting the types of financial resources

    permitted under proposed Sec. 39.11(b)(1) into two classes: Class A

    would consist of the financial resources listed in paragraphs (b)(i)

    through (b)(iii), and would be required to make up the significant part

    of the total financial resources, and class B would consist of the

    financial resources listed in paragraphs (b)(iv) through (b)(vi), on

    which larger prudential haircuts would be required. MGEX suggested that

    proposed Sec. 39.11(b)(2) should retain the ability for a DCO to

    provide its explanation and methodology for including a particular

    financial resource. MGEX further suggested that the list of potential

    financial resources should be broad and not pruned too quickly,

    particularly by initial regulation.

    Eurex commented that the Commission's proposed list of financial

    resources in proposed Sec. 39.11(b)(1) is appropriate.

    The Commission is adopting Sec. 39.11(b) as proposed, except for a

    technical amendment to clarify the scope of the use of margin as a

    financial resource to cover a default. As proposed, the Commission is

    not including letters of credit as an acceptable financial resource

    because they are only a promise by a bank to pay and not an asset that

    can be sold.\46\ However, both Sec. 39.11(b)(1) and Sec. 39.11(b)(2)

    permit ``any other financial resource deemed acceptable by the

    Commission,'' which means that the Commission could evaluate the use of

    letters of credit on a case-by-case basis.\47\

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

    \46\ The Commission recognizes that assessment powers are also a

    promise to pay, but as the Commission noted in the notice of

    proposed rulemaking, a clearing member may have a strong financial

    incentive to pay an assessment. If a clearing member failed to pay

    its assessment obligation, that failure would be treated as a

    default and the clearing member would be subject to liquidation of

    its positions and forfeiture of the margin in its house account.

    Thus, in addition to a potential general interest in maintaining the

    viability of the DCO going forward, a non-defaulting clearing member

    may have a specific incentive to pay an assessment, depending on the

    size and profitability of its positions and the margin on deposit

    relative to the size of the assessment.

    \47\ See discussion of the prohibition on accepting letters of

    credit as initial margin in section IV.F.5, below.

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

    The Commission also received inquiries from a few DCOs as to

    whether the Commission would deem projected revenue an acceptable

    financial resource to satisfy the requirements of Sec. 39.11(a)(2).

    The Commission expects that projected revenue generally would be deemed

    acceptable for established DCOs that can demonstrate a historical

    record of revenue, but not for DCO applicants or relatively new DCOs

    with no such record.

    With respect to any financial resource that is not enumerated in

    Sec. 39.11(b) and for which a DCO seeks a determination as to its

    acceptability based on the DCO's particular circumstances, DCO staff

    should contact Commission staff prior to submitting the DCO's quarterly

    financial resources report.

    The Commission is modifying Sec. 39.11(b)(1)(i) to more precisely

    reflect the fact that the use of margin as a financial resource

    available to satisfy the requirements of paragraph (a)(1) is subject to

    limitations imposed by the Commission and a DCO, e.g., relating to the

    use of customer margin to cover a default. As proposed, Sec.

    39.11(b)(1)(i) would permit the use of ``[m]argin of a defaulting

    clearing member.'' The provision now refers to ``[m]argin to the extent

    permitted under parts 1, 22, and 190 of this chapter and under the

    rules of the derivatives clearing organization.''

    5. Capital Requirement

    Proposed Sec. Sec. 39.11(b)(1) and (b)(2) list the DCO's own

    capital as a type of financial resource that would be available to a

    DCO to satisfy the requirements of proposed Sec. Sec. 39.11(a)(1) and

    (a)(2), respectively. In the notice of proposed rulemaking, the

    Commission noted that Commission regulations do not prescribe capital

    requirements for DCOs. The Commission invited

    [[Page 69347]]

    comment on whether it should consider adopting such requirements and if

    so, what those requirements should be.

    J.P. Morgan Chase & Co. (J.P. Morgan) commented that if a DCO

    enumerates its own capital as part of its waterfall, that DCO should be

    required to provide sufficient assurances that the capital will be

    available to meet those obligations and will not be reallocated to

    serve other purposes at the DCO's discretion. In a separate comment

    letter on the proposed risk management requirements for DCOs, J.P.

    Morgan offered its support for regulations that would require a DCO to

    retain in a segregated deposit account, on a rolling basis, 50 percent

    of its earnings from the previous 4 years. In addition, J.P. Morgan

    stated that it would be appropriate for at least 50 percent of the

    retained earnings to have a first loss position. J.P. Morgan also

    recommended that the DCO contribution be subject to a minimum floor of

    $50 million.

    Mr. Michael Greenberger recommended that the Commission require

    DCOs to set aside a reasonable amount of capital, equal to an average

    size of one contract for that DCO, so that a DCO would have sufficient

    financial resources to absorb a default. In addition, Mr. Greenberger

    suggested that capital requirements for DCOs must require that the

    DCOs' capital be highly liquid so that a DCO can cure a default in a

    timely manner.

    Eurex noted that clearing organizations exhibit a variety of

    organizational and capital structures and suggested the Commission

    should allow DCOs to determine their own mixes of protective measures,

    which might include the DCO's own capital. Nevertheless, Eurex

    expressed support for an initial capital requirement of $25 million for

    DCOs.

    OCC commented that an equity capital requirement for DCOs is not

    appropriate because DCOs rely primarily on member-supplied resources,

    such as clearing fund deposits and margin, to meet their obligations.

    According to OCC, most, if not all, DCOs have little capital in

    relation to their obligations. OCC suggested that the critical question

    from a safeness and soundness standpoint is whether DCOs have adequate

    financial resources, not the form in which such resources are held.

    CME stated that the financial resources requirements contained in

    Core Principle B are better suited to achieve the goal of ensuring

    adequate capitalization of DCOs, and that further capital requirements

    would be unnecessary and essentially duplicative.

    KCC commented that, with proposed Sec. 39.11(a)(1) requiring a DCO

    to maintain sufficient financial resources to meets its financial

    obligations, a separate capital requirement would be redundant. KCC

    also stated that onerous capital requirements placed on DCOs could have

    an anti-competitive effect.

    NYPC cautioned that mandating that DCOs hold specific forms or

    amounts of capital could have a chilling effect on competition, at odds

    with the principles of the CEA by potentially shutting out various

    forms of organizational structures for DCOs. NYPC noted that Core

    Principle B requires that DCOs maintain sufficient financial resources

    to perform their functions as central counterparties in compliance with

    the CEA. NYPC suggested that whether such financial resources are

    derived from a DCO's own capital or other financial resources deemed

    acceptable to the Commission should be inconsequential to the extent

    such statutorily prescribed functions are fulfilled.

    MGEX stated that it does not support adopting specific capital

    requirements for DCOs. MGEX noted that the proposed regulation already

    requires a DCO to be able to withstand the default of its largest

    clearing member in extreme but plausible market conditions. MGEX

    further noted that a DCO's capital is only one element of the financial

    resources necessary to cover that risk, and suggested that a DCO should

    be able to determine how it best needs to allocate that risk among its

    various financial resources.

    The Commission is not adopting a capital requirement for DCOs at

    this time. The Commission believes that it is appropriate to provide

    flexibility to DCOs in designing their financial resources structure so

    long as the aggregate amount is sufficient. The Commission notes,

    however, that one of the principles in the CPSS-IOSCO Consultative

    Report would require an FMI to ``hold sufficiently liquid net assets

    funded by equity to cover potential general business losses so that it

    can continue providing services as a going concern.'' \48\ CPSS and

    IOSCO are considering, and requesting comment on, the establishment of

    a specific minimum quantitative requirement for liquid net assets

    funded by equity. If such a requirement is established, the Commission

    may consider a similar requirement for DCOs at that time.

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

    \48\ See CPSS-IOSCO Consultative Report, Principle 15: General

    Business Risk, at 70.

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

    6. Assessments--Sec. Sec. 39.11(b)(1)(v) and 39.11(d)(2)

    Proposed Sec. 39.11(b)(1)(v) would list ``potential assessments

    for additional guaranty fund contributions, if permitted by the [DCO]'s

    rules'' as a type of financial resource that would be available to a

    DCO to satisfy the requirements of proposed Sec. 39.11(a)(1). Proposed

    Sec. 39.11(d)(2) would require a DCO: (i) To have rules requiring that

    its clearing members have the ability to meet an assessment within the

    time frame of a normal variation settlement cycle; (ii) to monitor, on

    a continual basis, the financial and operational capacity of its

    clearing members to meet potential assessments; (iii) to apply a 30

    percent haircut to the value of potential assessments; and (iv) to only

    count the value of assessments, after the haircut, to meet up to 20

    percent of its default resources requirement. The Commission requested

    comment on whether these limits and requirements are appropriate and,

    more generally, whether assessment powers should be considered to be a

    financial resource available to satisfy the requirements of proposed

    Sec. 39.11(a)(1).

    With regard to proposed Sec. Sec. 39.11(d)(2)(i) and (ii), OCC

    commented that the requirement that clearing members be able to meet an

    assessment within the time frame of a normal variation settlement cycle

    is an aggressive but appropriate standard that its clearing members

    would be able to meet in most circumstances, but that DCOs should have

    discretion to extend this deadline on a case-by-case basis where

    appropriate to avoid severe strains on clearing member liquidity in

    unusual circumstances. OCC objected to the requirement that DCOs must

    monitor ``on a continual basis'' a clearing member's ability to meet

    potential assessments, which OCC claimed is overly burdensome and

    difficult to administer. OCC suggested that a monthly review is

    reasonable and adequate.

    NYPC requested that the Commission clarify how the requirement of

    proposed Sec. 39.11(d)(2)(i) would be imposed on DCOs that conduct

    both end-of-day and intraday settlements each business day. In order to

    ensure that a uniform standard is applied across clearing members of

    all DCOs, whether the DCO conducts one or two settlements per business

    day, NYPC recommended that the Commission clarify that a DCO's rules

    should require clearing members to have the ability to meet an

    assessment within one business day.

    With regard to proposed Sec. 39.11(d)(2)(ii), NYPC requested that

    [[Page 69348]]

    the Commission provide guidance as to how it expects DCOs to determine

    whether a clearing member has the capacity to meet a potential

    assessment. In addition, NYPC expressed concern that the ``continual''

    monitoring of clearing members' ability to meet potential assessments,

    which NYPC believes implies daily or even real-time monitoring, would

    be extremely difficult, if not impossible, to administer. NYPC

    suggested that it would be reasonable and more practicable for the

    Commission to require that monitoring of clearing members' ability to

    meet potential assessments be included as a mandatory component of the

    periodic financial reviews of clearing members that DCOs already

    conduct in the ordinary course of business.

    In response to these comments, the Commission is revising Sec.

    39.11(d)(2)(i) to read as follows (added text in italics): ``The

    derivatives clearing organization shall have rules requiring that its

    clearing members have the ability to meet an assessment within the time

    frame of a normal end-of-day variation settlement cycle.'' In response

    to OCC's comment, the Commission notes that Sec. 39.11(d)(2)(i)

    requires a DCO to have rules requiring that its clearing members have

    the ability to meet an assessment within the time frame of a normal

    end-of-day variation settlement cycle, but would permit a DCO, in its

    discretion, to provide some flexibility to clearing members as to

    timing.

    In addition, the requirement in Sec. 39.11(d)(2)(ii) that a DCO

    must monitor the financial and operational capacity of its clearing

    members to meet potential assessments ``on a continual basis'' was

    intended to mean only that the DCO must perform such monitoring often

    enough to enable it to become aware of any potential problems in a

    timely manner. To eliminate possible ambiguity, the Commission is

    revising the final rule by removing the phrase ``on a continual

    basis.'' Thus, Sec. 39.11(d)(2)(ii) establishes a standard whereby a

    DCO must monitor its clearing members, but the DCO can meet the

    standard through the exercise of its judgment in response to particular

    circumstances, e.g., a DCO might have reason to evaluate certain

    clearing members on a daily basis and evaluate others only as part of

    routine, periodic financial reviews.

    With regard to proposed Sec. Sec. 39.11(d)(2)(iii), FIA commented

    that the 30 percent haircut and 20 percent cap are reasonable and

    prudent safeguards, sufficient to ensure that a DCO does not unduly

    rely on its assessment power. J.P. Morgan supported the proposal and

    also recommended that regulators adopt a risk-based analysis to

    determine the likelihood that a clearing member will be able to meet

    its assessment obligations across all DCOs. Mr. Greenberger, citing

    J.P. Morgan's comments, agreed that it is absolutely critical that the

    Commission promulgate rules that would determine a clearing member's

    risk of default and its availability of financial resources across all

    clearinghouses. Similarly, ISDA suggested that the Commission evaluate

    the potential impact of multiple assessments from different DCOs on the

    same clearing member or affiliate group in a short time-frame.

    CME suggested that a DCO should be required to completely exclude

    the potential defaulting firm's assessment liability in calculating its

    available assessment resources. CME also commented that, in light of

    the requirements of proposed Sec. Sec. 39.11(d)(2)(i) and (ii), and

    the fact that a clearing member that failed to pay an assessment would

    itself be in default to the DCO, it does not believe that a further

    haircut on assessments is necessary, and it is aware of no valid reason

    to cap the use of assessments at 20 percent as proposed.

    KCC noted that the inclusion of assessment powers as financial

    resources is necessary for it to meet its obligations in the unlikely

    event of a default. KCC agreed that a reasonable haircut on the value

    of a DCO's assessment power may be a prudent measure, but stated that

    the proposed limits are unreasonable and excessive and seem arbitrary.

    KCC suggested that a better approach would be for the DCO to be allowed

    the latitude to determine clearing member assessment haircuts on an

    individual basis, based on each clearing member's financial

    capabilities.

    MGEX recommended that the Commission allow each DCO to provide its

    methodology and support for why any assessment might be considered a

    financial resource and how much. MGEX stated that the 30 percent

    haircut and 20 percent cap seem arbitrary and prescriptive. MGEX stated

    that the DCO should have the discretion to determine an appropriate

    haircut based on the clearing member's liquidity.

    Better Markets commented that the proposed haircuts for assessments

    are inadequate. According to Better Markets, it would be far more

    prudent to require funding of risk that can be anticipated in stress

    tests and rely on assessments as a financial resource only for

    conditions that are not anticipated in stress tests.

    LCH recommended that potential assessments not be allowed to

    satisfy the requirements of proposed Sec. 39.11(a)(1) because, in

    LCH's view, it is of the utmost importance that a DCO's resources

    following a clearing member default be immediately and unconditionally

    available. LCH suggested that assessments should be allowed as part of

    the DCO's ``waterfall'' of protections, but should not be taken into

    account to meet the specific test outlined under proposed Sec.

    39.11(a)(1).

    AFR urged the Commission to prohibit DCOs from including assessment

    powers in their calculation of financial resources because it is

    unclear, in a time of broad market distress, whether a DCO's members

    would be willing and able to pay their assessments.

    The Commission is adopting Sec. 39.11(d)(2)(iii) as proposed. In

    view of the wide range of comments on this issue, the Commission

    believes the rule strikes an appropriate balance. The 30 percent

    haircut recognizes that the defaulting firm, which by definition will

    not be paying an assessment, might represent a significant segment of

    the DCO's total risk. The 20 percent cap recognizes that given the

    contingent nature of assessments, they should only be relied upon as a

    last resort. In response to ISDA's comment, the Commission expects that

    as part of the evaluation of a clearing member's risk profile, a DCO

    would take into consideration the potential exposure of the clearing

    member at other DCOs, to the extent that it is able to obtain such

    information, including the possibility of assessments. The Commission

    notes, in response to MGEX's and KCC's comments, that a DCO may

    determine clearing member assessment haircuts on an individual basis

    because Sec. 39.11(d)(2)(iii) only requires a 30 percent haircut on an

    aggregate basis.

    7. Computation of the Financial Resources Requirement--Sec.

    39.11(c)(1)

    Proposed Sec. 39.11(c)(1) would require a DCO to perform stress

    testing on a monthly basis in order to make a reasonable calculation of

    the financial resources it needs to meet the requirements of proposed

    Sec. 39.11(a)(1). The DCO would have reasonable discretion in

    determining the methodology used to make the calculation, but would be

    required to take into account both historical data and hypothetical

    situations. In the notice of proposed rulemaking, the Commission

    requested comment on whether monthly tests are appropriate.

    MGEX commented that monthly reporting seems reasonable as it

    already

    [[Page 69349]]

    performs stress tests on a routine basis. MGEX further commented that

    allowing DCOs discretion in selecting stress test scenarios is

    appropriate.

    CME suggested that annual stress testing would suffice for

    operating costs because operating costs are generally static. With

    regard to default coverage, CME suggested that stress testing should be

    done no less than monthly.

    LCH expressed concern over the requirement that the DCO perform

    stress testing only on a monthly basis. In LCH's view, stress testing

    should be carried out by the DCO on at least a daily basis, and LCH

    strongly urged the Commission to amend its proposal accordingly. LCH

    suggested that monthly stress testing is inadequate, as experience has

    shown that market conditions and member positions can change rapidly

    during periods of market turmoil.

    ISDA suggested that reverse stress tests \49\ should be required

    for determining the size of the financial resources package and that

    there should be public disclosure of the stress tests and their

    results.

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

    \49\ Reverse stress tests are stress tests that require a firm

    to assess scenarios and circumstances that would render its business

    model unviable, thereby identifying potential business

    vulnerabilities. Reverse stress testing starts from an outcome of

    business failure and identifies circumstances where this might

    occur. This is different from general stress testing, which tests

    for outcomes arising from changes in circumstances. See http://www.fsa.gov.uk/pages/About/What/International/stress_testing/firm_s/reverse_stress_testing/index.shtml.

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

    Mr. Barnard agreed that stress testing should be carried out at

    least monthly, and suggested that back testing should be carried out

    daily. Mr. Barnard also suggested that the Commission specifically

    refer to reverse stress testing in proposed Sec. 39.11(c)(1) because,

    in his view, it is a useful tool for managing expectations and for

    helping the DCO to anticipate financial resources requirements in

    extreme conditions.

    FIA recommended that the Commission make clear its expectation that

    the DCOs will, at a minimum: (1) Conduct a range of stress tests that

    reflect the DCO's product mix; (2) include the most volatile periods

    that have been experienced by the markets for which the DCO provides

    clearing services; (3) take into account the distribution of cleared

    positions between clearing members and their customers; and (4) test

    for unanticipated levels of volatility and for breakdowns in

    correlations within and across product classes.

    Mr. Greenberger recommended that historical market data that led up

    to the passage of the Dodd-Frank Act be taken into account in

    determining market conditions that could be defined as extreme but

    plausible.

    Better Markets commented that the passive role of the Commission in

    measuring the financial requirements for a DCO is inappropriate in

    light of the importance of this function. Better Markets proposed that

    the methodology, the historical data set, and the hypothetical

    scenarios be: (1) Jointly developed by the DCO and the Commission and

    (2) reviewed whenever ordered by the Commission, but no less frequently

    than quarterly. Better Markets also recommended that the Commission

    explicitly recognize the importance of illiquidity in developing

    hypothetical scenarios.

    AFR stated that it is critical that the Commission play a central

    role in establishing the standards by which DCOs will measure their

    exposure to future risks. AFR urged the Commission to define minimal

    standards that will ensure that DCO stress tests are stringent and

    incorporate realistic metrics of worst-case scenarios that DCOs may

    experience.

    The Commission is adopting Sec. 39.11(c)(1) as proposed. The

    Commission believes it is appropriate to allow the DCO discretion in

    designing stress tests because stress testing is an exercise that

    inherently entails the exercise of judgment at various stages.

    Furthermore, Sec. 39.11(c)(1) allows the Commission to evaluate the

    testing and require changes as appropriate. In response to the LCH

    comment, the Commission notes that there is a distinction between the

    type of stress testing carried out under this rule for the purpose of

    sizing the overall financial resource package and the type of stress

    testing carried out under Sec. 39.13(h)(3) for the purpose of

    ascertaining the risks that may be posed to the DCO by individual

    traders and clearing members. The former is a comprehensive test across

    all clearing members and all products with the goal of identifying the

    firms posing the greatest risk to the DCO and quantifying that risk.

    The regulations would require such testing to be completed monthly. The

    latter is targeted testing addressing the specific risks of specific

    positions at specific firms. The regulations would require such testing

    to be completed on either a daily or weekly basis, as described in

    Sec. 39.13(h)(3).\50\

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

    \50\ See discussion of Sec. 39.13(h)(3) in section IV.D.7.c,

    below.

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

    8. Valuation of Financial Resources--Sec. 39.11(d)(1)

    Proposed Sec. 39.11(d)(1) would require a DCO, no less frequently

    than monthly, to calculate the current market value of each financial

    resource used to meet its obligations under proposed Sec. 39.11(a).

    When valuing a financial resource, a DCO would be required to reduce

    the value, as appropriate, to reflect any market or credit risk

    specific to that particular resource, i.e., apply a haircut. The

    Commission would permit each DCO to exercise its discretion in

    determining the applicable haircuts. However, the haircuts would have

    to be evaluated on a monthly basis, would be subject to Commission

    review, and would have to be acceptable to the Commission.

    OCC suggested that the proposed regulations should be modified or

    interpreted to accommodate the use of a true portfolio margining model

    that values collateral based on its relationship to an overall

    portfolio in lieu of applying fixed haircuts on margin collateral.

    ISDA stated that it would support an appropriate haircut for

    default insurance, potential assessments, and possibly other financial

    resources deemed acceptable by the Commission, as determined by the

    Commission upon review of the relevant DCO.

    FIA expressed reservations about the ability of a DCO to be paid

    promptly under the terms of a default insurance policy. FIA therefore

    recommended that default insurance coverage be subjected to a 30

    percent haircut and a 20 percent cap, similar to the policies that the

    Commission has proposed to apply to a DCO's assessment power.

    In discussions with Commission staff, Federal Reserve and Federal

    Reserve Bank of New York staff suggested that the liquidity of a

    financial resource should be an additional factor in determining an

    appropriate haircut. Considerations should include whether it is easy

    to value the financial resource (e.g., whether the pricing is

    transparent) and whether the financial resource could be divested in a

    short time period under normal market conditions. The Commission agrees

    that liquidity is an important factor in valuing financial resources.

    Accordingly, the Commission is revising Sec. 39.11(d)(1) to read

    as follows (added text in italics): ``At appropriate intervals, but not

    less than monthly, a derivatives clearing organization shall compute

    the current market value of each financial resource used to meet its

    obligations under paragraph (a) of this section. Reductions in value to

    reflect

    [[Page 69350]]

    credit, market, and liquidity risks (haircuts) shall be applied as

    appropriate and evaluated on a monthly basis.'' In response to OCC's

    comments, the Commission notes that Sec. 39.11(d)(1) does not prohibit

    the valuation method described by OCC in its comment letter.

    The Commission believes Sec. 39.11(d)(1) takes a balanced approach

    by permitting a DCO to exercise its discretion in determining

    applicable haircuts for each of its financial resources but making

    those haircuts subject to Commission review and approval. Section

    39.11(d)(1) requires a DCO to perform such valuations no less

    frequently than monthly, which means the Commission would expect a DCO

    to perform such valuations more frequently when appropriate, such as

    during periods of market volatility.

    9. Liquidity of Financial Resources--Sec. 39.11(e)

    Proposed Sec. 39.11(e)(1) would require a DCO to have financial

    resources sufficiently liquid to enable the DCO to fulfill its

    obligations as a central counterparty during a one-day settlement

    cycle, including sufficient capital in the form of cash to meet the

    average daily settlement variation pay per clearing member over the

    last fiscal quarter. The DCO would be permitted to take into account a

    committed line of credit or similar facility for the purpose of meeting

    the remainder of the liquidity requirement. In the notice of proposed

    rulemaking, the Commission requested comment on whether the liquidity

    requirement should cover more than a one-day cycle. The Commission also

    requested comment on what standards might be applicable to lines of

    credit--e.g., should the Commission require that there be a diversified

    set of providers, or that a line of credit have same-day drawing

    rights?

    Proposed Sec. 39.11(e)(2) would require a DCO to maintain

    unencumbered liquid financial assets in the form of cash or highly

    liquid securities, equal to six months' operating costs. The DCO would

    be permitted to take into account a committed line of credit or similar

    facility to satisfy this requirement.

    Proposed Sec. 39.11(e)(3) would require that: (i) Assets in a

    guaranty fund have minimal credit, market, and liquidity risks and be

    readily accessible on a same-day basis, (ii) cash balances be invested

    or placed in safekeeping in a manner that bears little or no principal

    risk, and (iii) letters of credit not be a permissible asset for a

    guaranty fund.

    OCC recommended that the proposed regulations be modified or

    interpreted to provide DCOs some flexibility in determining the means

    of managing their ``cash'' liquidity needs by allowing DCOs to use

    secured credit facilities and tri-party repo facilities in addition to

    cash held in demand deposit accounts to satisfy the cash requirement.

    OCC observed that permitting these alternatives would allow a DCO to

    hold a significant portion of its financial resources in the form of

    U.S. Treasuries, with the ability to convert the Treasuries to cash as

    needed. According to OCC, cash must generally be held at banks, which

    presents a credit risk.

    NGX suggested that immediately accessible bank lines of credit

    should be acceptable to cover the cash requirement where the underlying

    commodity is itself traded in a liquid market.

    CME suggested the phrase ``average daily settlement variation pay

    per clearing member over the last fiscal quarter'' in proposed Sec.

    39.11(e)(1) is somewhat ambiguous. CME assumed that the Commission

    intended to refer to the average daily variation pay for a single

    clearing member, not the average daily settlement variation pay for all

    clearing members.

    CME also commented that the Commission's approach is not warranted

    given the potential amount of cash at issue and the reliability of

    liquidity facilities for short-term cash needs. CME suggested that the

    Commission revise the last sentence of proposed Sec. 39.11(e)(1) to

    read as follows: ``If any portion of such financial resources is not

    sufficiently liquid, the derivatives clearing organization may take

    into account a committed line of credit or similar facility for

    purposes of meeting these requirements.''

    In response to the Commission's request for comment on what

    standards might be applicable to a liquidity facility, CME stated that

    reviews and evaluations by Commission staff during regular DCO audits

    are a sufficient check on the adequacy and soundness of a committed

    line of credit, and that the Commission should not attempt to prescribe

    the terms and conditions of a DCO's liquidity facility.

    KCC found the language in proposed Sec. 39.11(e) to be ambiguous.

    KCC interpreted the average daily settlement variation pay per clearing

    member over the last fiscal quarter to mean the cumulative average of

    the pay-ins per each clearing member divided by the number of clearing

    members. In KCC's view, a line of credit with same-day drawing rights

    should be considered as liquid as cash and therefore should be allowed

    to be used by the DCO to fulfill its financial obligations during a

    one-day settlement cycle. KCC commented that the liquidity requirement

    should cover no more than one day of market price movement.

    LCH was unclear on what the Commission intends to mean in proposed

    Sec. 39.11(e)(1) by requiring that the DCO should allocate financial

    resources to meet the requirements of Sec. 39.11(a)(1) and fulfill its

    arising obligations during a ``one-day settlement cycle.'' LCH

    suggested that the requirement instead should be that the DCO is

    obliged to fulfill its arising obligations ``as they fall due.''

    Additionally, LCH suggested that the requirement that the DCO must have

    ``sufficient capital in the form of cash to meet the average daily

    settlement variation pay per clearing member over the last fiscal

    quarter'' is insufficient. LCH recommended that this requirement be

    replaced by a test that the DCO can meet its liquidity requirements

    ``following the default of the clearing member(s) creating the largest

    liquidity requirement under stressed market conditions over the

    quarter.''

    Mr. Greenberger suggested that the standards for a committed line

    of credit or similar facility must be narrowly and strictly defined, so

    that the party can easily use such highly liquid line of credit or

    similar facility. Mr. Greenberger further suggested that greater

    participation by clearing members in a committed line of credit or a

    similar instrument at times of market distress would not provide

    necessary liquidity but rather would increase systemic risk.

    Eurex noted that proposed Sec. 39.11(e) requires DCOs to monitor

    the liquidity of assets and agreed that low-credit risk, highly liquid

    assets should comprise guaranty funds and that this rule would serve

    important purposes.

    FIA recommended that the Commission clarify that the cash

    requirement is intended to measure the average (and not the aggregate)

    clearing member variation margin requirement. FIA further recommended

    that the Commission permit a DCO to satisfy this requirement through

    the use of cash or cash equivalents, including U.S. government

    securities and repurchase agreements involving highly liquid securities

    if such repurchase agreement matures within one business day or is

    reversible upon demand. FIA additionally recommended that this aspect

    of the Commission's proposal be modified to clarify that DCOs are

    permitted to satisfy the liquidity requirement through the

    establishment of committed repo facilities. FIA supported allowing a

    DCO to obtain a

    [[Page 69351]]

    committed line of credit or similar credit facility to cover the

    remainder of its default resources requirement, but recommended that

    this proposal be strengthened by the diversification of credit

    providers, with concentration limits of 25 percent per provider.

    MGEX commented that proposed Sec. 39.11(e)(1) requires some

    clarity. MGEX interpreted it to mean that a DCO must have cash that

    will cover the average of all the clearing members' average daily

    settlement variation pays, which to MGEX would seem a logical and

    practical application. Rather than adopting multiple liquidity

    requirements (i.e., cash, clearing member default coverage, six months'

    worth of operating expenses), MGEX suggested the process could be

    simplified to address the most relevant, which appeared to MGEX to be

    the clearing member default coverage. In addition, MGEX recommended

    that proposed Sec. 39.11(e) should permit combining and then totaling

    its liquidity of financial resources as a single-entity DCO/DCM.

    AFR stated that DCOs should be required to have sufficient cash to

    fulfill their obligations for 10 business days and that lines of credit

    should not count toward liquidity requirements.

    NYPC commented that, to the extent the proposed requirement is

    intended to exclude cash equivalents, such as U.S. Treasury securities,

    the standard is inappropriate. NYPC recommended that the Commission

    allow DCOs to satisfy their liquidity needs through the use of any

    combination of cash held in demand deposit accounts, bank accounts

    meeting the requirements of CFTC Interpretative Letter 03-31,\51\ and

    secured credit facilities and repurchase agreements that allow DCOs to

    convert U.S. Treasury securities and other high quality collateral into

    cash on a same-day basis.

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

    \51\ CFTC Interpretative Letter 03-31 concerned a bank that

    requested an interpretation that a trust deposit account product it

    developed would be acceptable for the deposit of customer segregated

    funds in accordance with Commission Regulation 1.20. Based on an

    analysis of the account, staff of the Commission's Division of

    Clearing and Intermediary Oversight issued an interpretation that

    the account would be acceptable as a deposit location because the

    account would be properly titled and covered by appropriate

    acknowledgements by the bank, and the funds in the account would at

    all times be immediately available for withdrawal on demand.

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

    In response to the comments, the Commission is revising Sec.

    39.11(e)(1) to provide greater clarity. In addition, the Commission is

    modifying the ``cash'' requirement to include ``U.S. Treasury

    obligations and high quality, liquid, general obligations of a

    sovereign nation.'' This conforms the requirement to existing liquidity

    practices and, in particular, it accommodates acceptable practices of

    foreign-based DCOs. However, the Commission is not including bank lines

    of credit as an acceptable financial resource for meeting the ``cash''

    requirement because they are only a promise by the bank to pay and not

    an asset that can be sold. The Commission is revising Sec. 39.11(e)(1)

    by deleting the following language: ``The derivatives clearing

    organization shall have sufficient capital in the form of cash to meet

    the average daily settlement pay per clearing member over the last

    fiscal quarter. If any portion of the remainder of the financial

    resources is not sufficiently liquid, the derivatives clearing

    organization may take into account a committed line of credit or

    similar facility for the purpose of meeting this requirement.''

    The Commission is replacing the deleted language with the

    following: ``[(ii)] The derivatives clearing organization shall

    maintain cash, U.S. Treasury obligations, or high quality, liquid,

    general obligations of a sovereign nation, in an amount greater than or

    equal to an amount calculated as follows: (A) Calculate the average

    daily settlement pay for each clearing member over the last fiscal

    quarter; (B) Calculate the sum of those average daily settlement pays;

    and (C) Using that sum, calculate the average of its clearing members'

    average pays. (iii) The derivatives clearing organization may take into

    account a committed line of credit or similar facility for the purpose

    of meeting the remainder of the requirement under paragraph (e)(1)(ii)

    of this section.''

    The Commission notes that, in the CPSS-IOSCO Consultative Report,

    CPSS and IOSCO are considering a minimum liquidity requirement for CCPs

    that would be either: (1) A ``cover one'' minimum requirement for all

    CCPs; (2) a ``cover two'' minimum requirement for all CCPs; or (3) a

    ``cover one'' or ``cover two'' minimum requirement for an individual

    CCP, depending on the particular risk and other characteristics of the

    particular products that it clears, the markets it serves, and the

    number and type of participants it has.\52\ The Commission might

    revisit the issue after CPSS and IOSCO determine what standard they

    will adopt.

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

    \52\ See CPSS-IOSCO Consultative Report, Principle 7: Liquidity

    Risk, at 46.

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

    10. Reporting Requirements--Sec. 39.11(f)

    Proposed Sec. 39.11(f) would require a DCO to report to the

    Commission, at the end of each fiscal quarter or at any time upon

    Commission request: (i) The amount of financial resources necessary to

    meet the requirements set forth in the regulation; and (ii) the value

    of each financial resource available to meet those requirements. The

    DCO would be required to include with its report a financial statement

    (including the balance sheet, income statement, and statement of cash

    flows) of the DCO or its parent company. A DCO would have 17 business

    days from the end of the fiscal quarter to file its report, but would

    also be able to request an extension of time from the Commission.

    NYPC suggested that, in light of the scope of information required

    to be submitted in the quarterly report (i.e., information regarding

    default risk financial resources and operating financial resources),

    the Commission should require that such reports be filed not later than

    30 calendar days, rather than 17 business days, following the end of

    the DCO's fiscal quarter.

    ISDA suggested that a DCO seeking an extension of the 17-day

    reporting deadline should be required to request the extension at least

    seven business days before the deadline.

    KCC noted that it does not prepare a statement of cash flows on a

    monthly basis, only on an annual basis as part of its audited financial

    statements. KCC commented that a monthly profit/loss statement is

    sufficient for determining its financial operating needs.

    MGEX suggested the Commission should consider a DCO's privacy

    concerns when permitting reasonable discretion in the data the DCO

    provides in the monthly reports required by the proposed regulations.

    MGEX stated that some detail as to projected revenue and expenses must

    remain proprietary if it involves potential business opportunities or

    other strategic business decisions, and that DCOs have a legitimate

    concern that confidential financial information could be subject to

    Freedom of Information Act requests.

    The Commission is adopting Sec. 39.11(f) as proposed. The

    Commission notes that the 17-business-day filing deadline is consistent

    with the deadline imposed on FCMs for the filing of monthly financial

    reports under Sec. 1.10(b). Moreover, a DCO may request an extension

    if it is unable to meet the deadline. The Commission does not believe

    it is appropriate to require a DCO to request an extension at least

    seven business days before the deadline, because a DCO may not know

    that far in advance that it will be unable to meet the deadline. With

    regard to the confidentiality of the information contained in the

    reports, the Commission notes that Core Principle L

    [[Page 69352]]

    and Sec. 39.21(c)(4) require a DCO to publicly disclose the size and

    composition of the financial resources package available in the event

    of a clearing member default. A DCO may request confidential treatment

    under Sec. 145.9 for other information submitted to the Commission

    under these regulations.

    11. SIDCOs--Sec. 39.29

    Proposed Sec. 39.29(a) would require a SIDCO to maintain

    sufficient financial resources to meet its financial obligations to its

    clearing members notwithstanding a default by the two clearing members

    creating the largest combined financial exposure for the SIDCO in

    extreme but plausible market conditions. Proposed Sec. 39.29(b) would

    require that a SIDCO not count the value of assessments to meet the

    obligations arising from a default by the clearing member creating the

    single largest financial exposure and only count the value of

    assessments, after a 30 percent haircut, to meet up to 20 percent of

    the obligations arising from a default by the clearing member creating

    the second largest financial exposure. The Commission believes that it

    would be premature to take action regarding Sec. 39.29 at this time.

    The FSOC has not yet designated any DCOs as systemically important. As

    previously noted, the CPSS-IOSCO Principles for Financial Market

    Infrastructures, which are expected to be finalized in 2012, will

    address minimum financial resources requirements for CCPs. Similarly,

    certain foreign regulators, including the European Union, are also

    considering requirements in this area for the CCPs they regulate. The

    Commission is concerned that SIDCOs would be put at a competitive

    disadvantage if they are forced to comply with these requirements

    before non-U.S. CCPs are subject to comparable standards. The

    Commission is closely monitoring developments on this issue and is

    prepared to revisit the issue if the European Union or other foreign

    regulators move closer to implementation. Moreover, because it may be

    some time before any DCO is designated a SIDCO, the Commission believes

    it would be prudent to reconsider the regulation of SIDCOs in light of

    developments that may occur in the interim. The Commission expects to

    consider all the proposed rules relating to SIDCOs together.

    C. Core Principle C--Participant and Product Eligibility--Sec. 39.12

    1. Participant Eligibility

    Core Principle C,\53\ as amended by the Dodd-Frank Act, requires

    each DCO to establish appropriate admission and continuing eligibility

    standards for members of, and participants in, the DCO,\54\ including

    sufficient financial resources and operational capacity to meet the

    obligations arising from participation. Core Principle C further

    requires that such participation and membership requirements be

    objective, be publicly disclosed, and permit fair and open access. Core

    Principle C also requires that each DCO establish and implement

    procedures to verify compliance with each participation and membership

    requirement, on an ongoing basis. Proposed Sec. 39.12(a) would codify

    these requirements and establish the minimum requirements that a DCO

    would have to meet in order to comply with Core Principle C.

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

    \53\ Section 5b(c)(2)(C) of the CEA, 7 U.S.C. 7a-1(c)(2)(C).

    \54\ Core Principle C, as well as the other core principles that

    are discussed herein, refer to ``members of, and participants in'' a

    DCO. The Commission interprets this phrase to mean persons with

    clearing privileges, and has used the term ``clearing member'' in

    describing the requirements of each core principle and in the text

    of the proposed regulations described herein. The Commission is also

    amending the definition of ``clearing member'' in Sec. 1.3(c),

    adopted herein, to mean ``any person that has clearing privileges

    such that it can process, clear and settle trades through a

    derivatives clearing organization on behalf of itself or others. The

    derivatives clearing organization need not be organized as a

    membership organization.''

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

    Although there is potential tension between the goals of ``fair and

    open access'' and ``sufficient financial resources and operational

    capacity to meet obligations arising from participation in the

    derivatives clearing organization,'' the Commission believes the rules

    that it is adopting herein strike an appropriate balance. The

    Commission has crafted the provisions of Sec. 39.12 and related rules,

    e.g., the risk management requirements, to establish a regulatory

    framework that it believes can ensure that a DCO's participation

    requirements do not unreasonably restrict any entity from becoming a

    clearing member while, at the same time, limiting risk to the DCO and

    its clearing members. The Commission expects that more widespread

    participation will reduce the concentration of clearing member

    portfolios, thereby diversifying risk, increasing market liquidity, and

    increasing competition among clearing members.

    a. Fair and Open Access--Sec. 39.12(a)(1)

    Proposed Sec. 39.12(a) would require a DCO to establish

    appropriate admission and continuing participation requirements for

    clearing members of the DCO, which are objective, publicly disclosed,

    and risk-based. Proposed Sec. 39.12(a)(1) would require a DCO to have

    participation requirements that permit fair and open access, setting

    forth specific standards.

    The Managed Funds Association (MFA), BlackRock, Inc. (BlackRock),

    State Street Corporation (State Street), and the Committee on Capital

    Markets Regulation (CCMR) supported the proposed rules. J.P. Morgan,

    ISDA, and FIA expressed support for the fair and open access provisions

    as long as there is prudent risk management.

    According to MFA, more inclusive DCO participation requirements

    would benefit DCOs and the markets by: (1) Reducing DCO concentration

    risk; (2) increasing diversity of market participants involved in DCO

    governance; (3) enhancing competition in the provision of clearing

    services; and (4) lowering overall costs for non-clearing members.

    State Street agreed that more widespread participation could increase

    competition by allowing more entities to become clearing members.

    Blackrock commented that the proposed rule would allow a diverse group

    of entities to become clearing members, which would increase

    competition, promote more inclusive DCO participation requirements, and

    lower costs to customers of clearing members.

    Each of the provisions of Sec. 39.12(a)(1) are discussed below.

    b. Less Restrictive Standards--Sec. 39.12(a)(1)(i)

    To achieve fair and open access, proposed Sec. 39.12(a)(1)(i)

    would prohibit a DCO from adopting a particular restrictive

    participation requirement if it could adopt a less restrictive

    requirement that would not materially increase risk to the DCO or its

    clearing members. BlackRock, the Swaps & Derivatives Market Association

    (SDMA), CME, LCH, Citadel, and CCMR supported the proposed rule. CCMR

    commented that the proposed rule would help to encourage an open

    marketplace.

    KCC, ICE, and MGEX did not support the proposed rule. According to

    KCC, the test is highly subjective and would be difficult to implement

    in practice. ICE commented that the proposal would require a DCO to

    dilute current prudent risk management practices. MGEX commented that

    the proposed rule

    [[Page 69353]]

    would require DCOs to consider only objective, hard number risk

    factors, which would force DCOs to bear other risks such as financial

    fraud convictions. MGEX suggested that the Commission should provide

    DCOs with latitude when determining the risks to which it will expose

    itself.

    The Commission is adopting Sec. 39.12(a)(1)(i) as proposed, except

    for the addition of clarifying language to provide that a DCO shall not

    adopt restrictive clearing member standards if less restrictive

    requirements ``that achieve the same objective and'' that would not

    materially increase risk to the derivatives clearing organization or

    clearing members could be adopted. The rule balances the dual

    Congressional mandate to provide for fair and open access while

    ensuring that such increased access does not materially increase risk.

    Because the rule does not require a DCO to provide access that

    materially increases risk to the DCO or clearing members, the

    Commission does not agree with ICE that the rule will subject a DCO to

    increased risk.

    The Commission does not agree with KCC that the rule will be highly

    subjective or difficult to implement in practice. The rule provides a

    DCO with discretion to balance restrictions on participation with

    legitimate risk management concerns and, in this regard, a DCO is in

    the best position in the first instance to determine the optimal

    balance. Only in circumstances where there is a question as to the

    impact of the rule would the Commission ask a DCO to justify the

    balance that the DCO has struck.

    In response to MGEX's comment, the Commission notes that the rule

    does not require a DCO to rely solely on objective, hard number risk

    factors. The rule permits a DCO to rely on both qualitative and

    quantitative analyses, providing each DCO with latitude to determine

    how it can facilitate open access while determining the risks to which

    it will expose itself.

    Except for certain bright-line participation requirements (e.g.,

    capital requirements for clearing members), the Commission has not

    provided more specific guidance as to what participant eligibility

    requirements are permissible under Core Principle C. Such a

    clarification would only serve to limit a DCO's flexibility to

    formulate participation requirements.

    The Commission encourages each DCO to conduct a self-assessment to

    make sure that it can provide reasoned support to justify a conclusion

    that its rules do not violate the ``less restrictive'' standard

    contained in Sec. 39.12(a)(1)(i). Such an analysis should take into

    consideration the interaction of this provision with the other

    provisions of Sec. 39.12(a).

    c. Clearing Member Qualification--Sec. 39.12(a)(1)(ii)

    Proposed Sec. 39.12(a)(1)(ii) would require a DCO to permit a

    market participant to become a clearing member if it meets the DCO's

    participation requirements. SDMA, LCH, and CCMR supported the proposed

    rule. According to CCMR, the proposed rule would help to encourage an

    open marketplace.

    KCC commented that the proposed rule is not workable because a DCO

    may not have the operational capacity to admit all applicants that

    satisfy the DCO's membership requirements. KCC proposed that the

    regulation clarify that a DCO may set limits on the number of market

    participants that may be admitted in light of the DCO's own operational

    constraints.

    The Commission is adopting Sec. 39.12(a)(1)(ii) as proposed. The

    Commission is concerned that permitting a DCO to set a limit on the

    number of market participants that may become clearing members could

    enable a DCO to evade the open access requirement imposed by Core

    Principle C. If a DCO were able to demonstrate that operational

    constraints prevented it from admitting additional clearing members,

    the DCO could petition the Commission for an exemption.

    d. Non-Discriminatory Treatment--Sec. 39.12(a)(1)(iii)

    Proposed Sec. 39.12(a)(1)(iii) would prohibit participation

    requirements that have the effect of excluding or limiting clearing

    membership of certain types of market participants unless the DCO can

    demonstrate that the restriction is necessary to address credit risk or

    deficiencies in the participants' operational capabilities that would

    prevent them from fulfilling their obligations as clearing members. LCH

    and SDMA supported the proposed rule. CME commented that in addition to

    credit risk and deficiencies in operational capabilities, legal risk

    should be included in the text of this regulation as a basis upon which

    a DCO may exclude or limit clearing membership of certain types of

    participants.

    KCC did not support the proposed rule, commenting that a DCO's

    right to exclude or place limitation on certain clearing members should

    not be subject to ex-post determinations as to the necessity of such

    restrictions, as the DCO itself is in the best position to monitor the

    risks posed by the activities of its clearing members. According to

    KCC, the proposed rule would limit the risk management capabilities of

    a DCO, and DCOs should be accorded flexibility in their assessments of

    the operational capabilities of potential clearing members.

    The Commission is adopting Sec. 39.12(a)(1)(iii) as proposed.

    CME's concerns regarding heightened legal risk, such as the inability

    to attach property of a foreign clearing member under foreign law, are

    encompassed within the ``credit risk'' consideration. The Commission

    expects that most, if not all, bases for membership exclusion or

    limitation will fall within either financial or operational

    considerations. In addition, the Commission does not believe the rule

    would limit a DCO's risk management capabilities as KCC suggested

    because it would not prevent a DCO from excluding or limiting certain

    types of market participants from clearing if such participation would

    introduce genuine risk that cannot be adequately managed by the DCO.

    The Commission expects that DCOs will review their existing

    participation requirements for compliance with this rule.

    e. Prohibition of Swap Dealer Requirement--Sec. 39.12(a)(1)(iv)

    Proposed Sec. 39.12(a)(1)(iv) would prohibit a DCO from requiring

    that clearing members be swap dealers. LCH commented that, in the event

    of default, it relies on non-defaulting clearing members to hedge the

    defaulting member's swap portfolio; to provide liquidity for such

    hedging; to bid on hedged portfolios; and, in extreme circumstances, to

    accept a forced allocation of swaps, which could be a risky, unhedged

    swaps portfolio. LCH commented that a clearing member who is not a swap

    dealer may not be able to participate in a DCO's default management

    process.

    The Commission is adopting Sec. 39.12(a)(1)(iv) as proposed. It is

    important to note that the regulation would not preclude participation

    by swap dealers (on which LCH currently relies). It simply requires

    that a DCO provide clearing access to other entities that could also

    participate in a DCO's default management process, even if to a lesser

    extent. Broader access is supported by other Commission regulations,

    e.g., Sec. 39.12(a)(3), which mandates that a DCO require its clearing

    members to have adequate operational capacity to participate in default

    management activities; Sec. 39.12(b)(5), which requires a DCO to

    select contract units for clearing purposes that maximize liquidity,

    facilitate

    [[Page 69354]]

    transparency in pricing, promote open access, and allow for effective

    risk management; and Sec. 39.16(c)(2)(iii), which permits a DCO to

    require its clearing members to accept an allocation, provided that any

    allocation must be proportional to the size of the clearing member's

    positions at the DCO. Thus, a DCO should be able to establish

    participation requirements that allow it to rely on non-defaulting

    clearing members to hedge a defaulting member's swap portfolio, to

    provide liquidity for such hedging, to bid on hedged portfolios, and to

    accept a forced allocation of swaps.

    f. Prohibition of Swap Portfolio or Swap Transaction Volume

    Requirements--Sec. 39.12(a)(1)(v)

    Proposed Sec. 39.12(a)(1)(v) would prohibit a DCO from requiring

    clearing members to maintain a swap portfolio of any particular size,

    or that clearing members meet a swap transaction volume threshold.

    According to State Street, such requirements are intended to

    systematically favor membership for financial institutions that are

    also substantial dealers in swaps. They do not take into account the

    risk management capabilities of many DCO members such as State Street,

    which are able to closely monitor risk exposures and effectively

    liquidate exposures through networks of interdealer relationships. The

    Commission believes that such requirements would have the effect of

    permitting only large swap dealers to provide clearing services. This

    would be inconsistent with Core Principle C. Accordingly, the

    Commission is adopting Sec. 39.12(a)(1)(v) as proposed.

    g. Financial Resources--Sec. 39.12(a)(2)(i)

    Core Principle C mandates that each DCO must ensure that its

    clearing members have ``sufficient financial resources and operational

    capacity to meet obligations arising from participation in the [DCO].''

    \55\ Proposed Sec. 39.12(a)(2)(i) would require a DCO to establish

    participation requirements that require clearing members to have access

    to sufficient financial resources to meet obligations arising from

    participation in the DCO in extreme but plausible market conditions.

    The financial resources could include a clearing member's capital, a

    guarantee from a clearing member's parent, or a credit facility funding

    arrangement.

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

    \55\ Section 5b(c)(2)(C)(i)(I) of the CEA; 7 U.S.C. 7a-

    1(c)(2)(C)(i)(I).

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

    CME commented that it supports the inclusion of parent guarantees

    and credit facility funding arrangements as acceptable financial

    resources for clearing members, provided that each DCO retains the

    flexibility to determine the particular terms and conditions of such

    arrangements. LCH, however, commented that credit facilities or funding

    arrangements should not be allowed for the purposes of fulfilling

    financial participation requirements. According to LCH, all clearing

    members' resources should be immediately and unconditionally available.

    ISDA also commented that a credit facility funding arrangement from an

    unaffiliated entity should not be available to satisfy clearing member

    financial resource requirements. ISDA did not believe that such funding

    would be reliable.

    MGEX commented that testing for extreme but plausible market

    conditions would have minimal value because the test would be based on

    historical records or it would be based on future assumptions that are

    based on static conditions. MGEX believes that the proposed rule would

    require a DCO to devise tests for clearing members to use and would

    require a DCO to conduct the tests and provide the results to clearing

    members. MGEX commented that this specific rule seems unnecessary

    because DCOs have other methods to address risk, like increasing and

    decreasing margin. It noted further that it already requires clearing

    members to be in good financial standing, which includes minimum

    capital requirements and a requirement to provide a parent guarantee in

    certain circumstances.

    The Commission is adopting Sec. 39.12(a)(2)(i) with the

    modification described below. Per CME's comment, the rule provides a

    DCO with the flexibility to determine what constitutes sufficient

    financial resources to meet obligations arising from participation in

    the DCO in extreme but plausible market conditions, and to determine

    what financial resources are available to a clearing member to satisfy

    this requirement.

    Regarding the comments of LCH and ISDA, the rule does not require a

    DCO to allow clearing members to use a credit facility funding

    arrangement to meet financial resource requirements. Because such

    arrangements can serve as an important source of liquidity for clearing

    members, the Commission has not prohibited their possible use to

    satisfy clearing member financial resource requirements. The Commission

    is modifying Sec. 39.12(a)(2)(i) to clarify a DCO's discretion, by

    rephrasing the second sentence to read as follows: ``A derivatives

    clearing organization may permit such financial resources to include,

    without limitation, a clearing member's capital, a guarantee from the

    clearing member's parent, or a credit facility funding arrangement.''

    To address concerns about reliability, a DCO can consider requiring

    that a credit facility funding arrangement be supported by multiple

    lenders.

    Finally, the Commission does not believe that MGEX's comment

    provides a basis for revising the proposed rule. As an initial matter,

    Core Principle C requires each DCO to establish participation standards

    that require a clearing member to have sufficient financial resources

    to meet obligations arising from participation in the DCO. Core

    Principle B requires a DCO to maintain financial resources that would

    enable it to meet its financial obligations in ``extreme but

    plausible'' market conditions. The Commission believes that it is

    appropriate for a DCO to subject its clearing members to a comparable

    financial standard to support its own compliance with statutory

    requirements. A DCO would have discretion in setting the terms of any

    tests to determine whether clearing members' financial resources are

    sufficient to meet their obligations in extreme but plausible market

    conditions.

    h. Capital Requirements Must Match Capital to Risk--Sec.

    39.12(a)(2)(ii)

    Proposed Sec. 39.12(a)(2)(ii) would require a DCO to establish

    capital requirements that are based on objective, transparent, and

    commonly accepted standards, which appropriately match capital to risk.

    The capital requirements also would have to be scalable so that they

    are proportional to the risks posed by clearing members.

    J.P. Morgan, MFA, ISDA, State Street, SDMA, Citadel LLC (Citadel),

    Better Markets, and FIA supported the proposed rule. According to

    Better Markets, the proposed rule is an important change of practices

    that will open DCO membership to more market participants while

    protecting the risk management system. FIA commented that a DCO, when

    it sets capital requirements, should take into account a clearing

    member's risk-derived exposures and its potential assessment

    obligations at each clearing organization of which it is a member. FIA

    recommended that a DCO should allow an FCM to clear positions in

    proportion to its capital net of those other risk-derived exposures and

    assessment obligations.

    The Commission is adopting Sec. 39.12(a)(2)(ii) as proposed, with

    one modification. In response to a comment from staff of the Federal

    Reserve and the Federal Reserve Bank of New York, the

    [[Page 69355]]

    Commission is deleting the phrase ``so that they are proportional''

    from the rule. This is to make clear that a DCO should take into

    account nonlinear risk. In response to FIA's comment, the Commission

    notes that in setting scalable requirements, a DCO should take into

    consideration risks that a clearing member carries as a result of

    positions cleared at other DCOs, to the extent that it is able to

    obtain such information.

    i. Minimum Capital Requirement--Sec. 39.12(a)(2)(iii)

    Proposed Sec. 39.12(a)(2)(iii) would prohibit a DCO from setting a

    minimum capital requirement of more than $50 million for any person

    that seeks to become a clearing member in order to clear swaps.

    Pierpont Securities LLC (Pierpont), Better Markets, SDMA, Newedge, MFA,

    Citadel, and Jefferies & Company (Jefferies) supported the proposed

    rule.

    Jefferies commented that the proposed rule would allow it to

    participate more actively in the swap market. Jefferies believes that

    taken together, the provisions of proposed Sec. 39.12(a) provide a DCO

    with more than sufficient authority to assure the financial integrity

    and efficient operation of its swaps clearing activities.

    Newedge commented that the proposed rule should not increase risk

    to a DCO because a DCO can mitigate risk by, among other things,

    imposing position limits, stricter margin requirements, or stricter

    default deposit requirements on lesser capitalized clearing members.

    Newedge proposed that the Commission prohibit DCOs from imposing a

    requirement that clearing members have an internal trading desk capable

    of liquidating or hedging a defaulting clearing member's positions. It

    said that there is no need for such a requirement because a non-

    defaulting member can handle a default event in a variety of ways,

    including having a contingent default manager. Newedge noted that under

    proposed Sec. 39.16(c)(2)(iii), any obligation of a clearing member to

    participate in an auction, or to accept the allocation of a defaulting

    clearing member's positions, would be proportionate to the size of the

    clearing member's own position at the DCO. Thus, a clearing member

    should be able to hedge an allocated position and carry the position

    over time without having to take a substantial charge to its capital.

    MFA commented that the threshold should not impose additional risk

    on a DCO because a DCO could ensure the safety of itself and clearing

    members by scaling each clearing member's net capital obligation in

    proportion to that clearing member's risk exposure. MFA expressed

    concern that a DCO could comply with the $50 million net capital

    requirement but impose a non-risk-based and excessive threshold

    guaranty fund contribution requirement that would unnecessarily exclude

    clearing members. MFA proposed that the regulations require that such

    scaling be determined by objective, risk-based methodologies that are

    based on reasonable stress and default scenarios, and the tests be

    consistently applied to all clearing members, without use of ``tiers''

    that could have discriminatory or anti-competitive effects.

    J.P. Morgan, the U.K. Financial Services Authority (FSA), CME, KCC,

    ISDA, IntercontinentalExchange, Inc. (ICE), State Street, Federal Home

    Loan Banks (FHLBanks), the Securities Industry and Financial Markets

    Association (SIFMA), and LCH expressed the view that the proposed rule

    could increase risk and the probability of default, and require DCOs to

    accept members who might not be able to participate in the default

    management process. FSA, KCC, and CME commented that a DCO must have

    reasonable discretion to determine the appropriate capital requirements

    for its clearing members based upon the DCO's analysis of the

    particular characteristics of the swaps that it clears.

    J.P. Morgan, however, commented that a cap on a member's minimum

    capital requirement would not impact the systemic stability of a DCO as

    long as: (1) Clearing members clear house and client business in

    proportion to their available capital; (2) DCOs employ real-time risk

    management processes to ensure compliance with this principle; (3) DCOs

    hold a sufficient amount of margin and funded default guarantee funds;

    and (4) the Commission monitors clearing members to ensure that they

    are able to meet their financial obligations with respect to all DCOs

    of which they are members.

    LCH and ISDA commented that the lower threshold could increase risk

    because a $50 million threshold would allow a clearing member to meet

    the eligibility requirements of multiple DCOs.

    LCH, CME, and FSA commented that the smaller firms may be unable to

    participate in the default management process. LCH and ISDA also

    commented that members should not be able to outsource default

    management to third parties because they may not be sufficiently

    reliable in times of stress.

    In addition, according to ISDA, there could be conflict-of-interest

    issues because the unaffiliated third party would not have ``skin in

    the game.'' As a result, through the actions of the unaffiliated third

    party, a clearing member could be assigned an unsuitable part of a

    defaulting clearing member's proprietary portfolio and/or at a sub-

    optimal valuation and/or wrongly accept customer positions from the

    defaulting clearing member. This conflict-of-interest concern is

    exacerbated where the entity to whom the default management obligations

    are outsourced is a ``competing'' clearing member in the same DCO.

    State Street and SDMA, however, commented that clearing members

    should be permitted to enter into committed arrangements with non-

    affiliated firms to perform default management functions. According to

    SDMA, there is no evidence to suggest that a legal arrangement with a

    third-party dealer somehow lessens the integrity to the system.

    Assuming the legal and financial arrangements between such firms are

    sufficiently strong to ensure performance when needed, State Street

    commented that there is no appreciable difference between the default

    management capacity of the traditional dealer-affiliated clearing

    member and a non-dealer clearing member outsourcing certain functions

    to a non-affiliate.

    Finally, SIFMA commented that the appropriate minimum capital

    requirement would be $300 million, while ISDA commented that if the

    Commission cannot monitor risk across all DCOs, a $1 billion capital

    requirement would be appropriate.

    After carefully considering the comments, the Commission is

    adopting Sec. 39.12(a)(2)(iii) as proposed. The Commission believes,

    as noted in numerous comments, that the rule will increase the number

    of firms clearing swaps, which will make markets more competitive,

    increase liquidity, reduce concentration, and reduce systemic risk. The

    Commission also believes that, as explained below, the $50 million

    threshold will not significantly increase risk or lead to admission of

    clearing members who are unable to meaningfully and responsibly

    participate in the clearing process.

    As an initial matter, the Commission emphasizes that the $50

    million threshold is not arbitrary. That number was arrived at by

    reviewing the capital of registered FCMs.\56\ This amount

    [[Page 69356]]

    captures firms that the Commission believes have the financial,

    operational, and staffing resources to participate in clearing swaps

    without posing an unacceptable level of risk to a DCO. This capital

    threshold is considered to be appropriate, particularly in light of

    other proposed rules (such as scaling capital and risk exposure and

    breaking down large swap positions into smaller units for more

    diversified allocation in the event of a clearing member default).

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

    \56\ See transcript of December 16, 2010 Commission meeting at

    77-81 available at www.cftc.gov (discussing $50 million threshold;

    Commission staff stating that of 126 FCMs, 63 currently have capital

    above $50 million and most FCMs with capital below that amount are

    not clearing members).

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

    The Commission considered whether to increase the capital threshold

    to $300 million as proposed by SIFMA or $1 billion as proposed by ISDA.

    The Commission analyzed the reduction in the number of firms that would

    be eligible to clear at CME, ICE Clear US, KCC, MGEX, and OCC using

    these thresholds. As set forth in the table below, depending on the

    basis used to measure capital, a capital threshold of $300 million

    would reduce the number of firms able to clear by 38-51 percent. A

    capital threshold of $1 billion would reduce the number of firms able

    to clear by 62-65 percent. The Commission believes that this reduction

    in participation would be contrary to the Congressional mandate for

    open access to clearing.\57\

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

    \57\ Clearing FCM and non-clearing FCM data for adjusted net

    capital and excess net capital was provided by FCM registrants and

    is available on the Commission Web site. The other data is non-

    public. Ownership equity data was provided by FCM registrants

    through the monthly financial statements that are submitted to the

    Commission. The data from the monthly financial statements reside in

    the Commission's RSR Express system, and all data for clearing non-

    FCMs was provided by the DCOs to the Commission's Risk Surveillance

    Group during the course of its routine oversight activities.

    [GRAPHIC] [TIFF OMITTED] TR08NO11.000

    The Commission does not believe that the rule will increase risk.

    Section 39.12(a)(2)(ii) requires DCOs to impose capital requirements

    that are scalable to the risks posed by clearing members. Accordingly,

    a small clearing member should not be able to expose a DCO to

    significant risk even if it is able to clear at multiple DCOs because

    its exposure at each DCO would be limited. DCOs that participate in the

    Shared Market Information System (SHAMIS) will be able to see a

    clearing member's pays and collects across participating DCOs, and a

    DCO also could on its own initiative require clearing members to

    directly report their clearing activity at other DCOs. The Commission

    also will be able to monitor clearing member exposure by means of DCO

    end-of-day reporting under the reporting requirements of Sec.

    39.19(c)(1)(i), which the Commission is adopting herein. It will also

    be able to monitor the financial strength of clearing members that are

    registrants pursuant to financial reporting requirements.

    In addition, the Commission is adopting other rules that will

    reinforce a DCO's oversight of its clearing members. In this regard,

    Sec. 39.12(a)(4) requires a DCO to verify, on an ongoing basis, the

    compliance of each clearing member with each participation requirement;

    Sec. 39.12(a)(5) requires a DCO to require all clearing members to

    file periodic financial statements and timely information that concerns

    any financial or business developments that may materially affect the

    clearing members' ability to continue to comply with participation

    requirements; and Sec. 39.13(h)(5) further requires a DCO to adopt

    rules that require clearing members to maintain current risk management

    policies and procedures and requires a DCO to review such policies and

    procedures on a periodic basis. The Commission also has proposed

    requirements for clearing member risk management.\58\

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

    \58\ See 76 FR 45724 (Aug. 1, 2011) (Clearing Member Risk

    Management).

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

    The Commission does not believe that the $50 million threshold

    would lead to a DCO having to admit clearing members that are unable to

    participate in the default management process. As discussed above, the

    regulation does not preclude highly-capitalized entities (such as swap

    dealers) from participating in a DCO as clearing members. Thus, the

    addition of smaller clearing members does not eliminate the role that

    larger clearing members can play in default management--it merely

    spreads the risk.

    The Commission wishes to emphasize that it will review DCO

    membership rules as a package in light of all of the provisions of

    Sec. 39.12(a). Thus, a DCO may not circumvent Sec. 39.12(a)(2)(iii)

    by enacting some additional financial requirement that effectively

    renders the $50 million threshold meaningless for some potential

    clearing members. Such an arrangement would violate Sec.

    39.12(a)(1)(i) (less restrictive alternatives), or Sec.

    39.12(a)(1)(iii) (exclusion of certain types of firms).

    As discussed below, under Sec. 39.12(a)(3), a DCO's participation

    requirements must include provisions for adequate operational capacity.

    This requirement should be read in conjunction with Sec.

    39.12(a)(1)(i), which prohibits restrictive clearing member standards

    if less restrictive standards could be adopted; Sec. 39.12(a)(1)(iii),

    which prohibits DCOs from excluding certain types of market

    participants from clearing membership if they can fulfill the

    obligations of clearing membership; and Sec. 39.16(c)(2)(iii), which

    permits a DCO to require a clearing member to participate in an auction

    or to accept allocations of a defaulting clearing member's customer or

    house positions, provided the allocated positions are proportional to

    the size of the clearing member's positions at the DCO and are

    permitted to be outsourced to a qualified third party subject to

    safeguards imposed by the DCO.

    Several commenters discussed the use of outsourcing to satisfy

    default management obligations. The Commission believes that open

    access to clearing and effective risk management need not be viewed as

    conflicting goals. Subject to appropriate safeguards, outsourcing of

    certain obligations can be an effective means of harmonizing these

    goals. For example, a small clearing member might have less ability to

    contribute meaningfully to a DCO's

    [[Page 69357]]

    auction process acting on its own than if an entity with greater

    expertise in the relevant markets acted in its place.

    Therefore, the Commission believes that it would be inconsistent

    with Sec. 39.12(a)(1)(i) and Sec. 39.12(a)(1)(iii) for a DCO to

    prohibit outsourcing. Accordingly, as discussed below, the Commission

    is adopting revised default procedure rules to require a DCO to permit

    outsourcing to qualified third parties of obligations to participate in

    auctions or in allocations, subject to appropriate safeguards imposed

    by the DCO.\59\

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

    \59\ See discussion of revised Sec. 39.16(c)(2)(iii) in section

    IV.G.4, below.

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

    Finally, the Commission has determined that it will not permit a

    DCO to require members to post a minimum amount of liquid margin or

    default guarantee contributions, or to participate in a liquidity

    facility per J.P. Morgan's suggestion. The Commission believes that the

    rules are sufficient to ensure that each member has adequate resources

    to withstand another member's default and such requirements could be

    used by a DCO to evade the open access to clearing intended by the

    Dodd-Frank Act.

    j. Operational Requirements--Sec. 39.12(a)(3)

    Proposed Sec. 39.12(a)(3) would require a DCO to require its

    clearing members to have adequate operational capacity to meet their

    obligations arising from participation in the DCO. The requirements

    would include, but not be limited to: The ability to process expected

    volumes and values of transactions cleared by a clearing member within

    required time frames, including at peak times and on peak days; the

    ability to fulfill collateral, payment, and delivery obligations

    imposed by the DCO; and the ability to participate in default

    management activities under the rules of the DCO and in accordance with

    proposed Sec. 39.16.

    LCH, FIA, Jefferies, and SDMA commented that the Commission has

    correctly identified the operational requirements. Jefferies commented

    that demonstrating sufficient operational capacity is more important

    than capital considerations. According to SDMA, these operational

    requirements are directly related to the core business of the clearing

    member and provide the services needed and relied upon by the DCO to

    clear trades. SDMA also believes that DCOs should be prohibited from

    imposing operational requirements that are not part of a clearing

    member's core business because they create discriminatory barriers to

    clearing, and it points to the following as examples of discriminatory

    operational eligibility requirements: Clearing members must (1) Have

    both execution and clearing capabilities; (2) provide end-of-day prices

    to mark its positions; and (3) have extensive experience in clearing

    swaps or ``sophistication.''

    J.P. Morgan and FIA commented that a DCO must ensure that each

    member has risk management resources to assist the DCO in its risk

    management process, and FIA suggested that the final rules add

    appropriate risk management requirements as a participant eligibility

    criterion, or make clear that nothing in the proposed rules is intended

    to prevent a DCO from adopting such requirements.

    ISDA commented that the ability to bid for portfolios of other

    clearing members of the DCO is critically important. According to ISDA,

    an appropriate risk management framework for a clearing member may be

    broadly categorized as follows: (1) Board and senior management

    oversight; (2) organizational structure; and (3) strong systems and

    procedures for controlling, monitoring and reporting risk.

    Finally, State Street commented that a clearing member must be able

    to demonstrate it can carry out its obligations to a DCO under a

    default scenario. That demonstration could include having the capacity

    to trade swaps using experienced swap traders, and the ability to

    execute transactions in the market by having appropriate trading

    relationships. A clearing member must also demonstrate an ability to

    monitor positions, calculate potential losses and market risk, perform

    stress tests, and maintain liquidity, among numerous other

    requirements.

    The Commission is adopting Sec. 39.12(a)(3) as proposed. The

    Commission believes that the rule correctly identifies the necessary

    operational requirements and is concerned that the heightened

    operational requirements suggested by some commenters could allow a DCO

    to evade the open access to DCO clearing intended by the Dodd-Frank

    Act. The Commission emphasizes that under the rule, any operational

    requirements must be necessary to meet clearing obligations. In

    addition, the Commission is adopting Sec. 39.13(h)(5) herein, which

    requires a DCO to adopt rules requiring clearing members to maintain

    current written risk management policies and procedures.\60\ The

    Commission has also proposed rules requiring clearing members that are

    FCMs (proposed Sec. 1.73) and swap dealers and major swap participants

    (proposed Sec. 23.609) to engage in specific risk management

    activities.\61\

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

    \60\ See discussion of Sec. 39.13(h)(5) in section IV.D.7.e,

    below.

    \61\ See 76 FR at 45729-45730 (Aug. 1, 2011) (Clearing Member

    Risk Management).

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

    k. Monitoring, Reporting, and Enforcement--Sec. 39.12(a)(4)

    Core Principle C requires each DCO to ``establish and implement

    procedures to verify, on an ongoing basis, the compliance of each

    clearing member with each participation requirement of the derivatives

    clearing organization.'' \62\ Proposed Sec. 39.12(a)(4) would codify

    these requirements.

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

    \62\ See Section 5b(c)(2)(C)(ii) of the CEA; 7 U.S.C. 7a-

    1(c)(2)(C)(ii).

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

    OCC supported the proposed rule ``if interpreted reasonably.'' J.P.

    Morgan commented that a clearing member may have committed to

    additional unfunded assessments at more than one clearinghouse and

    proposes that the Commission and DCOs monitor clearing members to

    ensure that they have sufficient liquid resources to support the

    business they clear at each DCO. According to J.P. Morgan, a DCO should

    monitor exposures against risk-based position limits on a real-time

    basis.

    The Commission is adopting Sec. 39.12(a)(4) as proposed. In

    response to J.P. Morgan's comments, the Commission notes that in

    monitoring firms, a DCO should take into consideration risks that the

    firm faces outside of that DCO. The Commission further notes that it is

    not prescribing the means by which DCOs should monitor compliance.

    l. Reporting Requirements--Sec. 39.12(a)(5)

    Proposed Sec. 39.12(a)(5)(i) would mandate that a DCO require all

    clearing members, including those that are not FCMs, to file with the

    DCO periodic financial reports containing any financial information

    that the DCO determines is necessary to assess whether participation

    requirements are met on an ongoing basis. The proposed rule also would

    mandate that a DCO require clearing members that are FCMs to file the

    financial reports that are specified in Sec. 1.10 of the Commission's

    regulations with the DCO, and would require the DCO to review all such

    financial reports for risk management purposes. Proposed Sec.

    39.12(a)(5)(i) would also require a DCO to require its clearing members

    that are not FCMs to make the periodic financial reports that they file

    with the DCO available to the Commission upon the Commission's

    [[Page 69358]]

    request. Proposed Sec. 39.12(a)(5)(ii) would mandate that a DCO adopt

    rules that require clearing members to provide to the DCO, in a timely

    manner, information that concerns any financial or business

    developments that may materially affect the clearing members' ability

    to continue to comply with participation requirements.

    LCH commented that a DCO based outside the U.S. may have clearing

    members that are not subject to the Commission's jurisdiction and would

    be regulated in their home jurisdiction. LCH proposed this provision be

    revised such that only FCMs and U.S.-based members that are not FCMs

    are required to provide this information to the Commission upon

    request. According to LCH, all other members should be required to

    submit the information to the DCO only or to their equivalent local

    regulator.

    LCH and MGEX commented that proposed Sec. 39.12(a)(5)(ii) would be

    more appropriately imposed on clearing members themselves, rather than

    on the DCO. KCC suggested that the Commission should evaluate its

    statutory authority to enact the proposed rule. MGEX commented that the

    proposed rules appear to require clearing members to report to each DCO

    with which they clear, which would create an additional, duplicative

    burden on clearing members. MGEX suggested that the Commission regulate

    the clearing members directly. As an alternative, MGEX proposed a new

    industry group similar to the Joint Audit Committee (JAC) in which each

    DCO would be represented and participate in developing an overall risk

    management program that would be used in fulfilling the new proposed

    requirements.

    The Commission is adopting Sec. 39.12(a)(5) with modifications to

    (1) provide that the financial information provided by non-FCM clearing

    members may be submitted by the clearing members to the Commission

    pursuant to DCO rules or may be submitted to the Commission by the DCO,

    in either case, upon the Commission's request; and (2) eliminate the

    proposed requirement that the DCO must review clearing members'

    financial reports for risk management purposes.

    The rule is intended to address circumstances where the Commission

    must obtain information in the possession of a clearing member. The

    Commission anticipates such requests will be few in number. However,

    when those occasions arise, the Commission must be able to obtain the

    information as expeditiously as possible. The rule addresses this need

    by allowing the Commission to obtain the information directly from the

    source and to minimize the burden on DCOs. In response to the comments,

    the Commission is revising the rule to provide that a DCO may either

    provide the requested information directly to the Commission or require

    clearing members to provide the information to the Commission.

    The Commission is eliminating the requirement that the DCO must

    review clearing members' financial reports for risk management

    purposes. Upon further consideration, the Commission has concluded that

    although a DCO may review such financial reports for several reasons,

    including risk management and to ensure that clearing members continue

    to meet participation requirements, it is not necessary to be

    prescriptive in this regard.

    In response to MGEX suggestion of a new industry group, Commission

    staff is considering such a step.

    The Commission is making certain technical revisions to Sec.

    39.12(a)(5) in connection with these changes.

    m. Enforcement of Participation Requirements--Sec. 39.12(a)(6)

    Proposed Sec. 39.12(a)(6) would require a DCO to enforce

    compliance with its participation requirements and establish procedures

    for the suspension and orderly removal of clearing members that no

    longer meet the requirements. MGEX commented that the proposed rule

    goes beyond the language of the Dodd-Frank Act.

    The Commission is adopting Sec. 39.12(a)(6) as proposed. A DCO

    must have the ability to enforce compliance with its participation

    requirements or its clearing members may not satisfy these

    requirements. A DCO also must have procedures for the suspension and

    orderly removal of clearing members that no longer meet the

    requirements. Otherwise, the enforcement process may not be orderly and

    could introduce additional risk to the DCO. This requirement

    complements Sec. 39.17, adopted herein, which implements Core

    Principle H (Rule Enforcement).\63\

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

    \63\ See discussion of Sec. 39.17 in section IV.H, below.

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

    2. Product Eligibility

    Core Principle C requires that each DCO establish appropriate

    standards for determining the eligibility of agreements, contracts, or

    transactions submitted to the DCO for clearing. Proposed Sec. 39.12(b)

    would codify these requirements.

    a. General Comments

    Citadel and MFA supported the proposed rules. To ensure non-

    discriminatory clearing, Citadel and MFA recommended the Commission

    make explicit that a DCO must provide highly standardized mechanisms

    and procedures for establishing connectivity with SEFs and any other

    permitted trading venue. According to Citadel, these mechanisms and

    procedures must be objective, commercially reasonable, publicly

    available, and treat all applicant execution facilities in an unbiased

    manner. Citadel and MFA also proposed that the rules mandate that a DCO

    keep the clearing acceptance process anonymous (i.e., without the

    customer's clearing member knowing the identity of the customer's

    executing counterparty).

    The Commission agrees that a DCO must provide mechanisms for

    establishing connectivity with SEFs and DCMs, which would provide

    executing counterparties with fair and open access. The Commission has

    proposed rules addressing this issue.\64\ The Commission also has

    proposed rules that address the anonymity issue.\65\

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

    \64\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through

    Processing).

    \65\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).

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

    b. Products Eligible for Clearing--Sec. 39.12(b)(1)

    Proposed Sec. 39.12(b)(1) would require a DCO to establish

    appropriate requirements for determining the eligibility of agreements,

    contracts, or transactions submitted to the DCO for clearing, taking

    into account the DCO's ability to manage the risks associated with such

    agreements, contracts, or transactions. Factors to be considered in

    determining product eligibility would include but would not be limited

    to: (1) Trading volume; (2) liquidity; (3) availability of reliable

    prices; (4) ability of market participants to use portfolio compression

    with respect to a particular swap product; (5) ability of the DCO and

    clearing members to gain access to the relevant market for purposes of

    creating and liquidating positions; (6) ability of the DCO to measure

    risk for purposes of setting margin requirements; and (7) operational

    capacity of the DCO and clearing members to address any unique risk

    characteristics of a product.\66\

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

    \66\ As proposed, Sec. 39.12(b)(1)(vii) referred to addressing

    any ``unique'' risk characteristics of a product. The Commission is

    revising this provision in the final rule to refer to any

    ``unusual'' risk characteristics to clarify that such

    characteristics are not limited to those that are one of a kind.

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

    OCC noted that the factors to be considered are already among the

    factors that a DCO would naturally consider and that OCC in fact

    considers, and it suggested that the application of

    [[Page 69359]]

    this new rule be limited to swaps. OCC also noted that the trading

    volume of new products is often unknown and unpredictable and suggested

    that factor not be a barrier to accepting a product for clearing.

    MGEX commented that the proposed rule considers legitimate factors,

    but mandating that a DCO establish eligibility requirements is not

    necessary, other than requirements for the contract size of swaps. Like

    OCC, MGEX noted that DCOs already use these factors as part of their

    sound business judgment in making these types of decisions. MGEX

    recommended that the Commission issue suggested guidelines or core

    principles and, on an as-needed basis, request that a DCO file with the

    Commission the rationale supporting its conclusion that a contract

    qualifies for clearing.

    LCH expressed concerns with proposed Sec. 39.12(b)(1)(iv) and

    commented that compression services have been developed only when swap

    markets are relatively large and well-established, and the introduction

    of cleared facilities has largely pre-dated the introduction of

    compression services. According to LCH, making swap clearing contingent

    on swap portfolio compression may have the effect of permitting fewer

    swaps to be cleared. LCH proposed that the Commission encourage the use

    of compression services where suitable and available, but not constrain

    the ability of a DCO to clear a given swap based on the availability of

    such services.

    LCH also commented that it is imperative that a DCO have the

    ability to ``transfer,'' ``auction,'' or ``allocate'' cleared swaps.

    LCH proposed that the factor listed in proposed Sec. 39.12(b)(1)(v),

    the ``[a]bility of the [DCO] and clearing members to gain access to the

    relevant market for purposes of creating and liquidating positions'' be

    modified to reflect these additional actions.

    The Commission agrees with LCH that a DCO must have the ability to

    ``transfer,'' ``auction,'' or ``allocate'' cleared swaps and it is

    revising Sec. 39.12(b)(1)(v) to incorporate LCH's suggestion.\67\ The

    Commission is otherwise adopting Section 39.12(b)(1) as proposed. The

    Commission believes that setting forth the minimum factors that all

    DCOs must consider when determining contract eligibility is necessary

    to prevent a DCO from seeking to clear transactions that present an

    unacceptable level of risk. The Commission also believes that OCC's and

    LCH's concerns are unfounded. The rule provides factors to be

    considered and does not prohibit a DCO from accepting a product for

    clearing if it does not satisfy one of the factors. Finally, the

    Commission is declining to limit the rule to swaps because it believes

    the eligibility factors are applicable to all products cleared by a

    DCO. The Commission is also declining to issue suggested guidelines or

    core principles, or to request that a DCO file with the Commission the

    rationale for why a contract qualifies for clearing. The Commission

    believes that Sec. 39.12(b)(1) is not burdensome because, as MGEX and

    OCC commented, these factors are already considered by DCOs. In

    contrast, filing rationales on an as-needed basis could be burdensome

    to the DCO and the Commission, and would not serve to mitigate risk

    more effectively.

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

    \67\ This is also consistent with Sec. 39.16(c)(2)(ii), adopted

    herein and discussed in section IV.G.4, below, which requires a DCO

    to adopt rules that set forth the actions that a DCO may take in the

    event of a default, which must include the prompt transfer,

    liquidation, or hedging of the defaulting clearing member's

    positions, and which may include the auctioning or allocation of

    such positions to other clearing members.

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

    c. Economic Equivalence--Sec. 39.12(b)(2)

    Proposed Sec. 39.12(b)(2) would require a DCO to adopt rules

    providing that all swaps with the same terms and conditions (as defined

    by templates established under DCO rules) submitted to the DCO for

    clearing are economically equivalent within the DCO and may be offset

    with each other within the DCO.

    ISDA, CME, and FIA commented that the term ``template'' is

    inappropriate. According to ISDA, ``template'' has no clear meaning,

    and it assumes that the term refers to the contract specifications

    currently used by a variety of futures facilities. ISDA noted that the

    development of specific templates for swap transactions is a mixed

    business/technological project that requires significant discussion

    involving each DCO and its market participants. It suggested that the

    Commission's regulations guide the meaning of ``template'' to achieve

    as much individual transactional variability as possible within the

    transaction or range of transactions that a template may cover.

    CME commented that references to ``templates'' are confusing

    because swap dealers generally maintain standard templates for

    documenting their trading relationships, and their counterparties

    frequently negotiate changes to those templates. According to CME, a

    DCO does not define the templates used by OTC participants, and DCO

    rules do not function as templates from which counterparties may

    negotiate. Rather, a DCO sets forth in its rulebook the product

    specifications of each contract it accepts for clearing, including

    swaps. CME suggested that the Commission revise Sec. 39.12(b)(2) to

    state as follows (change in italics): ``A [DCO] shall adopt rules

    providing that all swaps with the same terms and conditions, as defined

    by product specifications established under [DCO] rules, submitted to

    the [DCO] for clearing are economically equivalent within the [DCO] and

    may be offset with each other within the [DCO].''

    FIA requested that Commission confirm that economically equivalent

    swaps must have the same cash flows, values, and liquidation dates. FIA

    also suggested that terms and conditions of such templates--for

    example, events of default--should also be consistent with market

    practice.

    Finally, KCC commented that the proposed rule is redundant because

    Chapter 21 of the KCC rulebook already defines the terms and conditions

    for swaps that KCC will clear.

    The Commission is revising Sec. 39.12(b)(2) as suggested by CME to

    substitute the phrase ``product specifications'' for the word

    ``templates.'' As noted above, some commenters found the use of the

    word ``templates'' confusing. The Commission's intent was to ensure

    that a DCO sets the specifications for cleared products. The Commission

    is otherwise adopting the rule as proposed.

    In response to FIA, the Commission confirms that it regards cash

    flows, values, and liquidation dates as terms and conditions

    encompassed by this rule. The Commission, however, declines to require

    that terms and conditions be consistent with market practice. The

    Commission believes that a DCO should have the flexibility to determine

    whether to conform terms and conditions to market practice.

    d. Non-Discriminatory Treatment of Swaps--Sec. 39.12(b)(3)

    Proposed Sec. 39.12(b)(3) would require a DCO to provide for non-

    discriminatory clearing of a swap executed bilaterally or on or subject

    to the rules of an unaffiliated SEF or DCM. FIA and MFA commented in

    support of the proposed rule.

    OCC suggested that it should not be deemed a violation of Sec.

    39.12(b)(3) for a DCO to require a SEF or DCM desiring to transmit

    swaps to the DCO for clearing to enter into a non-exclusive clearing

    agreement on non-discriminatory terms similar to those offered by the

    DCO to other SEFs or DCMs for clearing of similar products. OCC

    believes that such agreements are

    [[Page 69360]]

    necessary and appropriate for purposes of addressing matters between

    the parties such as information sharing and furnishing price data by

    the exchange to the DCO.

    LCH suggested that the Commission clarify that ``non-

    discriminatory'' includes costs, technology, and other related

    considerations. LCH also suggested that the Commission impose the

    reverse requirements on execution venues such as DCMs and SEFs, so that

    those venues are also required to provide trade feeds to DCOs on a non-

    discriminatory basis.

    The Commission is adopting Sec. 39.12(b)(3) as proposed. In

    response to OCC, the Commission notes that the rule does not prohibit a

    DCO from requiring a SEF or DCM desiring to transmit swaps to the DCO

    for clearing to enter into a non-exclusive clearing agreement on non-

    discriminatory terms similar to those offered by the DCO to other SEFs

    or DCMs for clearing of similar products. The Commission agrees that

    such agreements are necessary and appropriate for purposes of

    addressing matters between the parties such as information sharing and

    furnishing price data by the exchange to the DCO. The Commission notes

    that it expects DCOs to review clearing agreements for compliance with

    Sec. 39.12(b)(3), the open access requirements of Core Principle C,

    and any relevant requirements of other core principles.

    In response to LCH's comment, the Commission notes that the

    requirement applies to the factors LCH enumerated. The Commission also

    notes that LCH's suggestion regarding trading venues is outside the

    scope of this rulemaking

    e. Prohibition on Requirement That Executing Party Is a Clearing

    Member--Sec. 39.12(b)(4)

    Proposed Sec. 39.12(b)(4) would prohibit a DCO from requiring one

    of the original executing parties to be a clearing member in order for

    a contract, agreement, or transaction to be eligible for clearing.

    CME concurred with the Commission's analysis and fully supported

    the proposed regulation. FIA, Citadel, and MFA also supported the

    proposed regulation.

    MFA suggested strengthening the proposed rule. According to MFA,

    when a non-clearing member trades with another non-clearing member, the

    clearing process should be identical and as prompt as when one of the

    parties is a clearing member, so long as the transaction satisfies the

    relevant DCO's rules, requirements, and standards otherwise applicable

    to such trades. MFA believes that providing this parity would allow new

    liquidity providers to efficiently and effectively enter into and

    compete within the market.

    MFA also suggested that the Commission revise the proposed rule to

    prohibit a DCO from adopting rules or engaging in conduct that is

    prejudicial to non-clearing members as compared to clearing members

    with respect to eligibility or the timing of clearing or processing of

    trades generally. The Commission has addressed this issue in the

    recently proposed rules on clearing documentation.\68\

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

    \68\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).

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

    ISDA commented that rules barring trades that don't involve a

    clearing member as a party are inappropriate in established DCOs, but

    new DCOs may need to roll out products and procedures in a contained

    way. According to ISDA, ``initial decisions on which market

    constituencies should have access to clearing must be the subject of

    legitimate, reasoned decision-making by each DCO with regard to its

    ability to properly serve each constituency and each constituency's

    readiness to participate in a cleared market.''

    Finally, NGX commented that if the proposed rule were applied to a

    non-intermediated DCO such as NGX, the rule would require a fundamental

    restructuring of the manner in which the DCO admits members, guarantees

    trades, and provides risk management. DCOs like NGX require all

    participants to become clearing participants at the DCO, and they do

    not clear contracts that involve non-clearing participants.

    The Commission is adopting Sec. 39.12(b)(4) as proposed. In

    response to the comments of ISDA and NGX, the Commission notes that

    some DCOs currently have only direct participants, i.e., participants

    that do not offer client clearing. NGX, for example, provides direct

    access to commercial end users who clear for themselves. The Commission

    notes that, consistent with principles of open access, a DCO must have

    rules in place to offer client clearing promptly if an FCM or a

    customer requests access. However, from a cost-benefit perspective, the

    Commission would expect that any DCO investment in building systems

    would be proportionate to evidence of demand for the service.

    Finally, in a separate rulemaking, the Commission has proposed

    rules that address MFA's suggestion that trades between indirect

    clearing members should have parity with trades between clearing

    members.\69\

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

    \69\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).

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

    f. Product Standardization--Sec. 39.12(b)(5)

    Proposed Sec. 39.12(b)(5) would require a DCO to select contract

    unit sizes and other product terms and conditions that maximize

    liquidity, facilitate transparency in pricing, promote open access, and

    allow for effective risk management.\70\ To the extent appropriate to

    further these objectives, a DCO would be required to select contract

    units for clearing purposes that were smaller than the contract units

    in which trades submitted for clearing were executed. \71\

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

    \70\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through

    Processing).

    \71\ Id.

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

    ISDA supported the goals identified by the Commission; however, it

    commented that ``unit size'' is not a meaningful concept in swap

    transactions because contract size is not standardized. According to

    ISDA, the only meaningful size limit is the smallest unit of relevant

    currency or relevant underlying. ISDA suggested that the Commission

    avoid focusing on ``unit size'' and instead articulate its ultimate

    objectives, as it has, leaving DCOs with the discretion to set suitable

    terms and conditions to further those objectives.

    FIA did not support the requirement that a DCO select contract unit

    sizes because FIA does not believe that the swap market has evolved to

    the point where DCOs can do this. FIA also does not believe the market

    is at a point where it would be appropriate for a DCO to establish

    templates regarding the terms and conditions of standardized swaps

    eligible for clearing. FIA believes that requiring swaps to fit within

    artificial, prescribed templates would be disruptive to the market and

    would not benefit customers. FIA, however, would support a requirement

    that DCOs study this matter and submit a report to the Commission on

    the feasibility of establishing templates regarding the terms and

    conditions of standardized swaps as soon as practicable.

    Finally, LCH commented that it is not appropriate to require a DCO

    to select contract units for clearing purposes that are smaller than

    the contract units in which trades submitted for clearing were

    executed. According to LCH, a DCO clearing swaps should be able to

    accept such swaps in any size, and swaps submitted for clearing should

    not

    [[Page 69361]]

    be broken down into sub-units. LCH suggested that the Commission strike

    Sec. 39.12(b)(5) and that any rules addressing average size of

    exposure traded in the swap markets be addressed in rules pertaining to

    trading and execution venues.

    The Commission is adopting Sec. 39.12(b)(5) as proposed. The

    Commission believes that standardizing products, including swaps, by

    requiring a DCO to determine product terms and conditions, including

    product size, will increase liquidity, lower prices, and increase

    participation. In addition, standardized products should make it easier

    for members to accept a forced allocation in the event of bankruptcy.

    The Commission recognizes that standardized products may create

    basis risk for some hedge positions. However, this circumstance has

    long existed in the futures markets. The Commission believes that the

    benefits of standardization, such as competitive pricing, liquid

    markets, and open access, outweigh the costs of imperfect hedging.

    In response to LCH, the Commission notes that the product unit size

    of a particular swap executed bilaterally may reflect the immediate

    circumstances of the two parties to the transaction. Once submitted for

    clearing, it may be possible to split the trade into smaller units

    without compromising the interests of the two original parties. Smaller

    units can promote liquidity by permitting more parties to trade the

    product, facilitate open access by permitting more clearing members to

    clear the product, and aid risk management by enabling a DCO, in the

    event of a default, to have more potential counterparties for

    liquidation. The Commission notes that under the rule, DCOs retain some

    discretion in determining how best to promote liquidity, facilitate

    open access, and aid risk management.

    g. Novation--Sec. 39.12(b)(6)

    Proposed Sec. 39.12(b)(6) would require a DCO that clears swaps to

    have rules providing that upon acceptance of a swap: (i) The original

    swap is extinguished; (ii) the original swap is replaced by equal and

    opposite swaps between clearing members and the DCO; (iii) the terms of

    the cleared swaps conform to templates established under DCO rules; and

    (iv) if a swap is cleared by a clearing member on behalf of a customer,

    all terms of the swap, as carried in the customer account on the books

    of the clearing member, must conform to the terms of the cleared swap

    established under the DCO's rules.

    Newedge supported this rule, in particular, the requirement for

    standardization.

    CME, FIA, and ICE commented that the proposed rule appears to

    presume the use of a ``principal'' model for all cleared swaps, even

    those swaps cleared on behalf of customers. CME noted that at CME, an

    FCM clearing customer business acts as an agent for undisclosed

    principals (i.e., the FCM's customers) vis-a-vis CME and guarantees its

    customers' performance to CME. CME suggested that in order to preserve

    the agency model for customer-cleared swaps, the Commission should

    adopt a revised Sec. 39.12(b)(6)(ii) to provide that, upon acceptance

    of a swap for clearing, ``the original swap is replaced by equal and

    opposite swaps with the DCO.'' As previously noted, CME also commented

    that the use of the term ``template'' is confusing. It suggested that

    the Commission revise Sec. 39.12(b)(6)(iii) to state: ``All terms of

    the cleared swaps must conform to product specifications established

    under [DCO] rules.''

    FIA commented that the proposed rule would conflict with the FCMs'

    position that, with respect to customer positions, FCMs are acting as

    agent, and not as principal, for customers in executing and clearing

    swaps (and futures) on behalf of customers. FIA suggested that the

    proposed rule be revised to confirm that, in clearing swaps on behalf

    of customers, a clearing member shall be deemed a guarantor and agent

    of a cleared swap and not a principal.

    ICE noted that U.S. futures markets may clear on an open offer

    basis, which allows straight-through processing. ICE commented that the

    Commission should not preclude open offer clearing of swaps by

    requiring the underlying swap to be novated.

    Finally, LCH suggested that the Commission revise the rule so that

    the obligation would fall on the clearing member rather than the DCO

    because the provisions relate to the clearing member's books and

    records, not the DCO's.

    The Commission is adopting Sec. 39.12(b)(6) with modifications to

    clarify its intended meaning. In response to the comments from CME,

    FIA, and ICE, the Commission is revising Sec. 39.12(b)(6)(ii) to

    provide that a DCO that clears swaps must have rules providing that,

    upon acceptance of a swap by the DCO for clearing, ``[t]he original

    swap is replaced by an equal and opposite swap between the derivatives

    clearing organization and each clearing member acting as principal for

    a house trade or acting as agent for a customer trade.''

    In response to the comment from CME, the Commission is revising

    Sec. 39.12(b)(6)(iii) to substitute the phrase ``product

    specifications'' for the word ``templates.'' This is consistent with

    the change to Sec. 39.12(b)(2), discussed above.

    In response to the comment by ICE, the Commission notes that ``open

    offer'' systems are acceptable under the rule. Effectively, under an

    open offer system there is no ``original'' swap between executing

    parties that needs to be novated; the swap that is created upon

    execution is between the DCO and the clearing member, acting either as

    principal or agent.

    Finally, with regard to LCH's comment, the Commission believes that

    it is proper for the requirement to fall on the DCO. The DCO is the

    central counterparty and is responsible for the transaction going

    forward.

    h. Confirmation of Terms--Sec. 39.12(b)(8)

    Proposed Sec. 39.12(b)(8) would require a DCO to have rules that

    provide that all swaps submitted to the DCO for clearing must include

    written documentation that memorializes all of the terms of the

    transaction and legally supersedes any previous agreement.\72\ The

    confirmation of all terms of the transaction would be required to take

    place at the same time as the swap is accepted for clearing.

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

    \72\ This provision was originally designated as Sec.

    39.12(b)(7)(v) in 76 FR 13101 (Mar. 10, 2011) (Straight-Through

    Processing). It was later proposed to be renumbered as Sec.

    39.12(b)(8) in 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).

    Section 39.12(b)(7), as currently proposed (76 FR at 13110), will be

    addressed in a separate final rulemaking.

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

    CME suggested that the Commission revise the proposed regulation to

    require a DCO to ``provide each clearing member carrying a cleared swap

    with a definitive record of the terms of the agreement, which will

    serve as a confirmation of the swap.''

    ISDA commented that it is not clear what efficiencies the proposed

    rule would achieve for the parties to the swap in confirming through a

    DCO. It suggested that the Commission be less prescriptive and

    recognize that the act of clearing a swap transaction through a DCO in

    and of itself should produce a definitive written record, tailored to

    the particular category of swap transaction by the DCO and its market

    constituency, which fulfills the Commission's objective of facilitating

    the timely processing and confirmation of swaps not executed on a SEF

    or a DCM.

    FIA requested that the Commission clarify the obligations of the

    parties under this proposed rule. According to FIA, the rule appears to

    place

    [[Page 69362]]

    responsibility on the parties to the swap to submit a written

    confirmation of the terms of the transaction to the DCO, which, upon

    acceptance by the DCO, will supersede any prior documents and serve as

    the confirmation of the trade. However, the notice of proposed

    rulemaking places responsibility on the DCO, explaining that the

    proposed rule ``would require that DCOs accepting a swap for clearing

    provide the counterparties with a definitive written record of the

    terms of their agreement, which will serve as a confirmation of the

    swap.'' Further, the proposed rule appears to apply to all swaps

    submitted for clearing, but the notice of proposed rulemaking appears

    to limit the requirement to swaps not executed on a SEF or DCM, noting

    that swaps executed on a SEF or DCM are confirmed upon execution.\73\

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

    \73\ The notice of proposed rulemaking states: ``Proposed Sec.

    39.12(b)(7)(v) would require that DCOs accepting a swap for clearing

    provide the counterparties with a definitive written record of the

    terms of their agreement, which will serve as a confirmation of the

    swap.'' 76 FR at 13105-13106 (Mar. 10, 2011) (Straight-Through

    Processing).

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

    OCC commented that the terms and conditions applicable to a cleared

    swap would already be specified in the DCO rules or product

    specifications, and it does not think it is necessary for a DCO to

    provide a confirmation that is similar in form to detailed trade

    documentation such as an ISDA Master Agreement. OCC believes that the

    term ``written documentation'' should be interpreted broadly to mean

    any documentation that sufficiently memorialized the agreement of the

    counterparties with respect to the terms of a swap, which may consist

    of a confirmation (electronic or otherwise) that confirms the values

    agreed upon for terms that can be varied by the parties.

    MarkitSERV noted that the proposed rule would require a

    confirmation of all terms of the transaction at the time the swap is

    accepted for clearing, and commented that the rule is unclear as to

    whether, when a swap is to be submitted for clearing, confirmation

    would ever be required of the pre-clearing initial transaction between

    the original counterparties. In contrast, the Commission has elsewhere

    stated that it expects a DCO to require pre-clearing transactions to be

    confirmed before clearing.\74\ MarkitSERV also noted that when a

    transaction is not rapidly accepted for clearing the parties will still

    be responsible for confirming the transaction under Commission

    regulations. It recommended that the Commission clarify that when a

    transaction is not accepted for clearing within the time frame

    established for mandatory confirmation the parties should be permitted

    to satisfy their confirmation obligations by confirming the transaction

    prior to clearing.

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

    \74\ See 75 FR 81519, at 81521 (Dec. 28, 2010) (Confirmation,

    Portfolio Reconciliation, and Portfolio Compression Requirements for

    Swap Dealers and Major Swap Participants) (``if a swap is executed

    bilaterally, but subsequently submitted to a DCO for clearing, the

    DCO will require a definitive written record of all terms to the

    counterparties' agreement prior to novation by the DCO'').

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

    The Commission is adopting Sec. 39.12(b)(8) in modified form to

    read as set forth in the regulatory text of this final rule.

    The change to the heading is responsive to the comment by FIA that

    it was unclear whether the rule applied to all cleared swaps or only to

    those that are executed bilaterally. Regardless of the execution venue,

    confirmation of a cleared swap is ultimately provided by the DCO. In

    the case of a trading facility with a central limit order book,

    execution and acceptance for clearing are simultaneous and confirmation

    occurs at that time. In all other cases, there is an interim time

    between execution and acceptance, or rejection, for clearing.

    The Commission notes that applicable confirmation requirements may

    depend on the length of time between execution and acceptance or

    rejection for clearing. For example, if a trade executed on a SEF is

    accepted for clearing within seconds, the DCO notification would serve

    as the single confirmation. But, if a trade is executed bilaterally and

    later submitted for clearing, there may need to be an initial bilateral

    confirmation that is later superseded by the clearing confirmation.

    The changes to the text are responsive to the comments of FIA, CME,

    ISDA, OCC, and MarkitSERV. As FIA pointed out, the proposed rule text

    seems to place the confirmation obligation on the submitting parties,

    while the discussion in the notice of proposed rulemaking places it on

    the DCO. Consistent with the language in the discussion and the

    recommendations of FIA, CME, and ISDA, the revised rule clarifies that

    DCOs provide confirmations of cleared trades. This interpretation was

    implicit in the proposal given that the second sentence of the rule

    provides that confirmation takes place when the trade ``is accepted''

    for clearing.

    D. Core Principle D--Risk Management--Sec. 39.13

    Core Principle D, \75\ as amended by the Dodd-Frank Act, requires

    each DCO to ensure that it possesses the ability to manage the risks

    associated with discharging the responsibilities of the DCO through the

    use of appropriate tools and procedures. It further requires each DCO

    to measure its credit exposures to each clearing member not less than

    once during each business day and to monitor each such exposure

    periodically during the business day. Core Principle D also requires

    each DCO to limit its exposure to potential losses from defaults by

    clearing members, through margin requirements and other risk control

    mechanisms, to ensure that its operations would not be disrupted and

    that non-defaulting clearing members would not be exposed to losses

    that non-defaulting clearing members cannot anticipate or control.

    Finally, Core Principle D provides that a DCO must require margin from

    each clearing member sufficient to cover potential exposures in normal

    market conditions and that each model and parameter used in setting

    such margin requirements must be risk-based and reviewed on a regular

    basis. The Commission proposed to adopt Sec. 39.13 to establish

    requirements that a DCO would have to meet in order to comply with Core

    Principle D.

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

    \75\ Section 5b(c)(2)(D) of the CEA, 7 U.S.C. 7a-1(c)(2)(D).

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

    1. General--Sec. 39.13(a)

    Proposed Sec. 39.13(a) would require a DCO to ensure that it

    possesses the ability to manage the risks associated with discharging

    its responsibilities through the use of appropriate tools and

    procedures. The Commission did not receive any comments on proposed

    Sec. 39.13(a) and is adopting Sec. 39.13(a) as proposed.

    2. Risk Management Framework--Sec. 39.13(b)

    Proposed Sec. 39.13(b) would require a DCO to establish and

    maintain written policies, procedures, and controls, approved by its

    board of directors, which establish an appropriate risk management

    framework that, at a minimum, clearly identifies and documents the

    range of risks to which the DCO is exposed, addresses the monitoring

    and management of the entirety of those risks, and provides a mechanism

    for internal audit. In addition, proposed Sec. 39.13(b) would require

    a DCO to regularly review its risk management framework and update it

    as necessary.

    Mr. Barnard recommended that the Commission comprehensively and

    explicitly address all elements that make up a risk management

    framework, including organizational structure, governance, risk

    functions, internal controls, compliance, internal audit,

    [[Page 69363]]

    and legal functions.\76\ In particular, with respect to organizational

    structure, Mr. Barnard noted that reporting lines and the allocation of

    responsibilities and authority within a DCO should be clear, complete,

    well-defined and enforced.

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

    \76\ Mr. Barnard also recommended that the Commission focus more

    on operational risk and the role of reporting and public

    disclosures. With respect to operational risk, the Commission notes

    that it is adopting Sec. 39.18 herein, which addresses system

    safeguards, and which is discussed in section I, below. Reporting

    and public information are addressed in Sec. Sec. 39.19 and 39.21,

    respectively, also adopted herein, which are discussed in sections J

    and L, respectively, below.

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

    The Commission believes that a DCO should adopt a comprehensive and

    documented risk management framework that addresses all of the various

    types of risks to which it is exposed and the manner in which they may

    relate to each other. The Commission believes that a written risk

    policy is important because it will help to ensure the DCO has

    carefully considered its risk management framework, and it will provide

    guidance to DCO management, staff, and market participants. It will

    also allow the Commission to assess the DCO's risk management framework

    more efficiently. The risks to be addressed may include, but are not

    limited to, legal risk, credit risk, liquidity risk, custody and

    investment risk, concentration risk, default risk, operational risk,

    market risk, and business risk. However, the Commission does not

    believe that it is necessary to explicitly list such risks in the final

    rule.

    MGEX commented that the documentary and procedural requirements of

    proposed Sec. 39.13(b) would impose heavy costs and turn the goal of

    practical risk management into one of paperwork compliance, and that

    while having a framework containing all the various policies can be

    beneficial for DCOs, the development and implementation of such

    policies must be flexible and left to each DCO. The Commission notes

    that DCOs generally already have certain written risk management

    policies, procedures and controls, although the substance, level of

    detail, and integration of each DCO's documentation of such policies,

    procedures and controls may vary. The Commission believes that Sec.

    39.13(b) provides DCOs with the appropriate amount of flexibility with

    regard to the documentation of their risk management frameworks,

    without imposing significant additional costs upon DCOs.

    OCC noted that its risk management policies are highly complex and

    are embodied in multiple separate written documents, and much of its

    day-to-day operations are related to risk management. OCC stated that

    the Commission should make it clear that the proposal would not require

    the board to approve every document related to risk management, as it

    would be burdensome and would inappropriately require the board to

    micro-manage the day-to-day functions of a DCO. OCC indicated that it

    does not believe that the function of the committee that is responsible

    for the oversight of its risk management activities would be enhanced

    by the creation of additional written policies, procedures, and

    controls.

    The Commission recognizes that many of the day-to-day functions of

    a DCO are related to risk management, and Sec. 39.13(b) is not

    intended to require that a DCO's board must approve every document at a

    DCO that addresses risk management issues nor is it intended to require

    that a DCO's board must approve every day-to-day decision regarding the

    implementation of the DCO's risk management framework.

    CME and ICE took the position that a DCO's Risk Management

    Committee should have the authority to approve the written policies,

    procedures, and controls that establish a DCO's risk management

    framework, noting that this would be consistent with proposed Sec.

    39.13(c), which would require a DCO's Chief Risk Officer to make

    appropriate recommendations to the DCO's Risk Management Committee or

    board of directors, as applicable, regarding the DCO's risk management

    function.

    The Commission believes that a DCO's risk management framework

    should be subject to the approval of its board of directors. The

    Commission recognizes that a DCO's Risk Management Committee may play a

    crucial role in the development of the risk management policies of a

    DCO. However, the board has the ultimate responsibility for the

    management of the DCO's risks. Requiring board approval of a DCO's risk

    management framework is also consistent with proposed international

    standards.\77\

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

    \77\ See CPSS-IOSCO Consultative Report, Principle 2:

    Governance, Key Consideration 5, at 23.

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

    In addition, a requirement that a DCO's board approve its risk

    management framework is consistent with Sec. 39.13(c), which permits a

    DCO's Chief Risk Officer to make appropriate recommendations to the

    DCO's Risk Management Committee regarding the DCO's risk management

    functions. Although the board would approve the framework, it could

    delegate defined decision-making authority to the Risk Management

    Committee in connection with the implementation of the framework. The

    Commission is adopting Sec. 39.13(b) as proposed.

    3. Chief Risk Officer--Sec. 39.13(c)

    Proposed Sec. 39.13(c) would require a DCO to have a Chief Risk

    Officer (CRO) who would be responsible for the implementation of the

    risk management framework and for making appropriate recommendations

    regarding the DCO's risk management functions to the DCO's Risk

    Management Committee or board of directors, as applicable. In a

    separate rulemaking, the Commission has proposed to adopt Sec.

    39.13(d) to require DCOs to have a Risk Management Committee with

    defined composition requirements and specified minimum functions.\78\

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

    \78\ See 75 FR at 63750 (Oct. 18, 2010) (Conflicts of Interest).

    In that proposed rulemaking, the provisions relating to the Risk

    Management Committee were designated as Sec. 39.13(g). In the final

    rulemaking with respect to that proposal, those provisions will be

    redesignated as Sec. 39.13(d).

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

    Better Markets commented that the proposal should provide

    substantive parameters for a CRO and that the CRO rules applicable to

    FCMs should be applied to DCOs. Mr. Greenberger indicated that the CRO

    of a DCO should be subject to the same rules regarding reporting and

    independence as the CROs of other registered entities.

    The Commission does not believe that it is necessary to further

    define the responsibilities of a DCO's CRO in the final rule. The

    Commission notes that it has not proposed any rules regarding a CRO for

    FCMs or any other registered entities, as suggested by Better Markets

    and Mr. Greenberger.\79\

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

    \79\ However, the Commission has proposed rules regarding a CCO

    for futures commission merchants, swap dealers, and major swap

    participants, at 75 FR 70881 (Nov. 19, 2010) (Designation of a Chief

    Compliance Officer; Required Compliance Policies; and Annual Report

    of a Futures Commission Merchant, Swap Dealer, or Major Swap

    Participant), with respect to which Better Markets filed a comment

    letter.

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

    As noted in the notice of proposed rulemaking, given the importance

    of the risk management function and the comprehensive nature of the

    responsibilities of a DCO's CCO, which are governed by Sec. 39.10, as

    adopted in this rulemaking, the Commission expects that a DCO's CRO and

    its CCO would be two different individuals. The Commission is adopting

    Sec. 39.13(c) as proposed.

    4. Measurement of Credit Exposure--Sec. 39.13(e)

    Proposed Sec. 39.13(e) would require a DCO to: (1) Measure its

    credit exposure to each clearing member and mark to market such

    clearing member's open positions at least once each business

    [[Page 69364]]

    day; and (2) monitor its credit exposure to each clearing member

    periodically during each business day. Proposed Sec. 39.13(e) was a

    prerequisite for proposed Sec. 39.14(b), which would address daily

    settlements based on a DCO's measurement of its credit exposures to its

    clearing members.

    LCH commented that a DCO should be required to measure its credit

    exposures ``several times each business day'' and that a DCO should be

    obliged to recalculate initial and variation margin requirements more

    than once each business day. By contrast, OCC requested that the

    Commission clarify that the proposed requirement that a DCO monitor its

    credit exposure to each clearing member periodically during each

    business day would not require a DCO to update clearing member

    positions on an intra-day basis for purposes of monitoring risk, which

    would not be practical, and that intra-day monitoring of credit

    exposures based on periodic revaluation of beginning-of-day positions

    would be sufficient to comply with the proposed rule.

    The Commission does not believe that a DCO should be required to

    mark each clearing member's open positions to market and recalculate

    initial and variation margin requirements more than once each business

    day, and notes that the requirement that a DCO monitor its credit

    exposure to each clearing member periodically during each business day

    could be satisfied through intra-day monitoring of credit exposures

    based on periodic revaluation of beginning-of-day positions as

    suggested by OCC.

    However, as discussed in section IV.E.2, below, Sec. 39.14(b)

    requires a DCO to effect a settlement with each clearing member at

    least once each business day, and to have the authority and operational

    capacity to effect a settlement with each clearing member, on an

    intraday basis, either routinely, when thresholds specified by the DCO

    are breached, or in times of extreme market volatility. Therefore, in

    order to comply with Sec. 39.14(b), a DCO would be required to have

    the authority and operational capacity to mark each clearing member's

    open positions to market and recalculate initial and variation margin

    requirements, on an intraday basis, under the circumstances defined in

    Sec. 39.14(b).

    The Commission is adopting Sec. 39.13(e) as proposed, except that

    the Commission is making a technical revision by replacing the phrase

    ``such clearing member's open positions'' with the phrase ``such

    clearing member's open house and customer positions'' to eliminate

    possible ambiguity and to clarify the Commission's intent to reflect

    current industry practice and include both house and customer

    positions, not just house positions. The Commission notes that Sec.

    39.13(e) is consistent with international recommendations.\80\

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

    \80\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Key Consideration 4, at 40.

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

    5. Limitation of Exposure to Potential Losses From Defaults--Sec.

    39.13(f)

    Proposed Sec. 39.13(f) would require a DCO, through margin

    requirements and other risk control mechanisms, to limit its exposure

    to potential losses from defaults by its clearing members to ensure

    that: (1) Its operations would not be disrupted; and (2) non-defaulting

    clearing members would not be exposed to losses that nondefaulting

    clearing members cannot anticipate or control. The language of proposed

    Sec. 39.13(f) is virtually identical to the language in Section

    5b(c)(2)(D)(iii) of the CEA, as amended by the Dodd-Frank Act.

    FIA supported the proposal and MGEX stated that it appeared

    reasonable if applied appropriately. FIA acknowledged that clearing

    members understand and accept that they are subject to losses in the

    event of a default of another clearing member but noted that these

    potential losses must be measurable and subject to a reasonable cap

    over a period of simultaneous or multiple defaults. MGEX suggested that

    the Commission adopt an interpretation that each clearing member, by

    becoming a clearing member, can reasonably anticipate that another

    clearing member may potentially default and that a DCO can apply its

    rules accordingly.

    The Commission believes that every clearing member is aware that

    another clearing member may default. The Commission also notes that the

    potential losses resulting from such a default will be mitigated to the

    extent that a DCO is bound to comply with the CEA, Commission

    regulations, and its own rules, particularly with regard to financial

    resources and default rules and procedures.

    KCC commented that there would appear to be little cost/benefit

    justification for duplicating the statutory language of the core

    principle in the form of a rule.\81\ The Commission believes that

    codifying provisions of the CEA does not impose an additional cost on a

    DCO because a DCO must satisfy such requirements to comply with the

    law. At the same time, the Commission believes that codifying this

    statutory provision provides a DCO with a single location in which to

    identify the minimum standards necessary to fulfill the requirements of

    Core Principle D. The Commission is adopting Sec. 39.13(f) as

    proposed.

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

    \81\ See Section 5b(c)(2)(D)(iii) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(D)(iii).

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

    6. Margin Requirements--Sec. 39.13(g)

    a. General

    Several commenters made general comments about margin requirements

    that did not address specific provisions of proposed Sec. 39.13(g).

    The Commission has summarized those comments, and responded to those

    comments, below.

    KCC expressed its belief that the Commission's detailed proposed

    margin requirements are not consistent with the Dodd-Frank Act's

    changes to the CEA, which simply require that a DCO's margin models and

    parameters must be ``risk-based.'' The Commission notes that Section

    5b(c)(2) of the CEA, as amended by the Dodd-Frank Act, requires a DCO

    to comply with the statutory core principles ``and any requirement that

    the Commission may impose by rule or regulation pursuant to section

    8a(5).'' As noted in section I.A, above, legally enforceable standards

    set forth in regulations serve to increase legal certainty, prevent

    DCOs from lowering risk management standards for competitive reasons,

    and increase market confidence. These goals are especially important

    with respect to margin, which is one of the key tools used by DCOs in

    managing risk. Therefore, the Commission believes it is appropriate to

    impose more detailed margin requirements than those contained in the

    statutory language of Core Principle D.

    ISDA urged the Commission to adopt rules requiring DCOs to adopt

    risk methodologies that would reduce the impact that customer account

    risk has on the size of default fund contributions. ISDA noted that

    this would enable DCOs to better guaranty the portability of client

    portfolios, but would increase risk to the DCO; however, ISDA stated

    that this increased risk could be addressed by increasing the risk

    margin of the customer account. The Commission has not proposed and is

    not adopting such rules. The Commission believes that a DCO should have

    reasonable discretion to determine how it will calculate the amounts of

    any default fund contributions that it may require from its clearing

    members, and the extent to which customer risk will be a factor in such

    calculations.

    MFA and Citadel stated that it is important that a DCO's process

    for setting initial margin be transparent in order to give all market

    participants

    [[Page 69365]]

    certainty as to the margin they can expect the DCO to assess.

    Therefore, MFA and Citadel urged the Commission to adopt final rules

    that would require a DCO to make available to all market participants,

    at no cost, a margin calculation utility, so that they would be able to

    replicate the calculation of the margin that the DCO would assess.

    The Commission notes that it is adopting Sec. Sec. 39.21(c)(3) and

    (d) herein, which require a DCO to disclose information concerning its

    margin-setting methodology on its Web site. However, the Commission is

    not requiring a DCO to provide a margin calculation utility to market

    participants free of cost, although the Commission notes that some DCOs

    have chosen to do so.\82\ The Commission believes that whether a DCO

    will provide a margin calculation utility to market participants, and

    whether and how much it might charge for such a utility, is a business

    decision that should be left to the discretion of a DCO.

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

    \82\ See e.g., http://www.cmegroup.com/clearing/cme-core-cme-clearing-online-risk-engine.html and https://www.theice.com/publicdocs/ice_trust/ICE_Margin_Simulation_Calculator_Training_Presentation.pdf.

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

    The FHLBanks indicated that it may be appropriate, in some

    circumstances, for a DCO to waive its initial margin requirements with

    respect to certain highly creditworthy customers of a clearing member.

    Therefore, the FHLBanks urged the Commission to grant DCOs discretion

    to waive initial margin requirements when doing so would not pose risk

    to the DCO or its clearing members. In light of the fact that the Dodd-

    Frank Act requires the removal of reliance on credit ratings, the

    FHLBanks recommended that the Commission adopt alternative criteria by

    which a DCO could exercise such discretionary waivers, or alternatively

    grant DCOs discretion to establish their own criteria, subject to

    Commission approval, or to guidelines established by the Commission in

    the final rule.

    The Commission has not proposed a rule that would permit it to

    grant DCOs the discretion to waive initial margin requirements and it

    is not adopting such a rule, as requested by the FHLBanks. Even if

    there were an objective way to define highly creditworthy customers,

    the Commission does not believe that permitting such waivers would

    constitute prudent risk management.

    b. Amount of Initial Margin Required--Sec. 39.13(g)(1)

    Proposed Sec. 39.13(g)(1) would require that the initial margin

    \83\ that a DCO requires from each clearing member must be sufficient

    to cover potential exposures in normal market conditions and that each

    model and parameter used in setting initial margin requirements must be

    risk-based and reviewed on a regular basis. The Commission invited

    comment regarding whether a definition of ``normal market conditions''

    should be included in the proposed regulation and, if so, how normal

    market conditions should be defined.

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

    \83\ The term ``initial margin'' is now defined in Sec.

    1.3(lll), adopted herein.

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

    MFA, BlackRock, and Citadel expressed their support for the

    proposal. CME and OCC commented that the Commission should not define

    normal market conditions, while ISDA stated that the Commission should

    define normal market conditions. The Commission noted in the notice of

    proposed rulemaking that the 2004 CPSS-IOSCO Recommendations defined

    ``normal market conditions'' as ``price movements that produce changes

    in exposures that are expected to breach margin requirements or other

    risk control mechanisms only 1 percent of the time, that is, on average

    on only one trading day out of 100.'' \84\ The CPSS-IOSCO Consultative

    Report was published subsequent to the issuance of proposed Sec.

    39.13(g)(1). The CPSS-IOSCO Consultative Report replaced the concept of

    ``normal market conditions'' with a proposed requirement that

    ``[i]nitial margin should meet an established single-tailed confidence

    level of at least 99 percent for each product that is margined on a

    product basis, each spread within or between products for which

    portfolio margining is permitted, and for each clearing member's

    portfolio losses.'' \85\ The Commission had also proposed similar

    requirements for a 99 percent confidence level in proposed Sec.

    39.13(g)(2)(iii), discussed below. Therefore, in adopting Sec.

    39.13(g)(1), the Commission is declining to adopt the proposed explicit

    requirement that initial margin must be sufficient to cover potential

    exposures in normal market conditions, in order to avoid any ambiguity

    over the meaning of ``normal market conditions.''

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

    \84\ See 2004 CPSS-IOSCO Recommendations at 21.

    \85\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Key Consideration 3, at 40.

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

    FIA recommended that parameters used in setting initial margin

    requirements should be reviewed monthly and models should be reviewed

    annually and on an ad hoc basis if substantive changes are made,

    whereas OCC took the position that the Commission should permit a DCO

    to use its reasonable discretion in determining what constitutes a

    ``regular basis'' for reviewing margin models and parameters. The

    Commission has determined not to specify the appropriate frequency of

    review, as it may differ based on the characteristics of particular

    products and markets, and the nature of the margin models and

    parameters that apply to those products and markets. However, although

    Sec. 39.13(g)(1) would permit a DCO to exercise its discretion in

    determining how often it should review its margin models and

    parameters, the Commission would apply a reasonableness standard in

    determining whether the frequency of reviews conducted by a particular

    DCO was appropriate.

    Moreover, as discussed in section IV.D.6.d, below, Sec.

    39.13(g)(3) requires that a DCO's systems for generating initial margin

    requirements, including the DCO's theoretical models, must be reviewed

    and validated by a qualified and independent party, on a regular basis.

    As the Commission noted in the notice of proposed rulemaking, the

    Commission would expect a DCO to obtain an independent validation prior

    to implementation of a new margin model and when making any significant

    change to a model that is in use by the DCO. This express expectation

    would address FIA's suggestion that a DCO should be required to review

    its margin models on an ad hoc basis if substantive changes are made.

    For the reasons discussed, the Commission is adopting Sec. 39.13(g)(1)

    with the modification described above.

    c. Methodology and Coverage

    (1) General--Sec. 39.13(g)(2)(i)

    Proposed Sec. 39.13(g)(2)(i) would require a DCO to establish

    initial margin requirements that are commensurate with the risks of

    each product and portfolio, including any unique characteristics of, or

    risks associated with, particular products or portfolios.\86\ In

    particular, proposed Sec. 39.13(g)(2)(i) would require a DCO that

    clears credit default swaps (CDS) to appropriately address jump-to-

    default risk in setting initial margins.\87\ The Commission

    [[Page 69366]]

    invited comment regarding whether there are specific risks that should

    be identified and addressed in the proposed regulation in addition to

    jump-to-default risk.

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

    \86\ As proposed, Sec. 39.13(g)(2)(i) referred to addressing

    any ``unique'' characteristics of, or risks associated with,

    particular products or portfolios. The Commission is revising this

    provision in the final rule to refer to any ``unusual''

    characteristics of, or risks associated with, particular products or

    portfolios to clarify that such characteristics or risks are not

    limited to those that are one of a kind. See also n. 66, above.

    \87\ In the notice of proposed rulemaking, the Commission

    defined jump-to-default risk as referring to the possibility that a

    CDS portfolio with large net sales of protection on an underlying

    reference entity could experience significant losses over a very

    short period of time following an unexpected event of default by the

    reference entity.

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

    CME and Nadex, Inc. (Nadex) expressed the opinion that it would not

    be beneficial to attempt to identify additional specific risks that a

    DCO must address in determining initial margins and LCH commented that

    the reference to jump-to-default risk should either be removed or

    amended to cover all other products that are subject to jump-to-default

    risk. The Commission agrees with CME and Nadex that it is not necessary

    to identify additional specific risks in the regulation, and also

    agrees with LCH that the reference to jump-to-default risk should

    generally apply to any product that may be subject to such risk.

    Therefore, the Commission is adopting a revised Sec. 39.13(g)(2)(i)

    that eliminates the specific reference to CDS. The Commission has also

    added the phrase ``or similar jump risk.'' This is intended to address

    the possibility of a large payment obligation in a product accumulating

    in a very short period of time following an extreme market event.

    (2) Liquidation Time--Sec. 39.13(g)(2)(ii)

    Proposed Sec. 39.13(g)(2)(ii) would require a DCO to use margin

    models that generate initial margin requirements sufficient to cover

    the DCO's potential future exposures to clearing members based on price

    movements in the interval between the last collection of variation

    margin \88\ and the time within which the DCO estimates that it would

    be able to liquidate a defaulting clearing member's positions

    (liquidation time). As proposed, a DCO would have to use a liquidation

    time that is a minimum of five business days for cleared swaps that

    were not executed on a DCM, and a liquidation time that is a minimum of

    one business day for all other products that it clears, although it

    would be required to use longer liquidation times, if appropriate,

    based on the unique characteristics of particular products or

    portfolios. The Commission invited comment regarding whether the

    minimum liquidation times specified in proposed Sec. 39.13(g)(2)(ii)

    were appropriate, or whether there were minimum liquidation times that

    were more appropriate.

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

    \88\ The term ``variation margin'' is now defined in Sec.

    1.3(ooo), adopted herein.

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

    LCH suggested that ``or transfer'' should be inserted after

    ``liquidate'' in the proposed rule and that an appropriate liquidation

    period should be a period that would be sufficient to enable a DCO to

    adequately hedge or close out a defaulting member's risk. The

    Commission does not believe that it is appropriate to add ``or

    transfer,'' or to interpret the liquidation period to include the time

    that would be sufficient to hedge a defaulting clearing member's

    positions. In a worst-case scenario, a DCO would need to liquidate a

    defaulting clearing member's positions, and the time it would take to

    do so should be the relevant consideration in setting initial margin

    requirements.

    ISDA commented that a DCO should continually monitor the risk

    associated with concentration in participants' positions, and if a DCO

    determines that a participant's cleared portfolio is so large that it

    could not be liquidated within the liquidation period assumed in the

    DCO's default management plan, the DCO should have the discretion to

    include an extra charge for concentration risk in the initial margin

    requirements of that participant. FIA made similar comments but

    suggested that prudent risk management should require the imposition of

    concentration margin in appropriate circumstances. FIA further noted

    that when a DCO imposes concentration margin on a clearing member, the

    additional margin should be included in the DCO's minimum margin

    calculations for any customers of the clearing member that generate the

    increased risk.

    Although the regulations adopted by the Commission herein do not

    specifically address concentration margin as described by ISDA and FIA,

    they do not limit a DCO's discretion to impose extra charges on its

    clearing members for concentration risk. It should also be noted that

    Sec. 39.13(h)(6), adopted herein,\89\ requires a DCO to take

    additional actions with respect to particular clearing members, when

    appropriate, based on the application of objective and prudent risk

    management standards, which actions may include imposing enhanced

    margin requirements.

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

    \89\ See discussion of Sec. 39.13(h)(6)(ii) in section

    IV.D.7.f, below.

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

    Numerous commenters objected to the proposed difference in

    requirements that would subject swaps that were either executed

    bilaterally or executed on a SEF to a minimum five-day liquidation

    time, while permitting equivalent swaps that were executed on a DCM to

    be subject to a minimum one-day liquidation time. Commenters variously

    argued that the proposed one-day/five-day distinction for swap

    transactions depending on the venue of execution would: (1) Be

    inconsistent with the open access provisions of Section 2(h)(1)(B) of

    the CEA \90\ and/or proposed Sec. 39.12(b)(2) \91\ (GFI Group Inc.

    (GFI), VMAC, LCC (VMAC), BlackRock, Wholesale Markets Brokers'

    Association, Americas (WMBAA), and FX Alliance Inc. (FXall)); (2) be

    inconsistent with Congressional intent, expressed in Section 731 of the

    Dodd-Frank Act,\92\ which recognizes a difference in risk between

    cleared and uncleared swaps that could be addressed by differential

    margin requirements, but does not differentiate between the risk of

    swaps executed on a DCM and those executed on a SEF (Asset Management

    Group of the Securities Industry and Financial Markets Association

    (AMG)); (3) discriminate against trades not executed on DCMs by

    requiring DCOs to impose higher margin requirements for swaps that are

    executed on SEFs than for swaps that are executed on DCMs (GFI, VMAC,

    MarketAxess Corporation (MarketAxess), WMBAA, Tradeweb Markets LLC

    (Tradeweb), Nodal Exchange, LLC (Nodal), and FXall); (4) raise the cost

    of clearing for swaps traded on a SEF (National Energy Marketers

    Association (NEM), NGX, and BlackRock); \93\ (5) put SEFs at a

    competitive disadvantage to DCMs (GFI, MarketAxess, and BlackRock); (6)

    artificially restrict the ability of market participants, including

    asset managers, to select the best means of execution for their swap

    transactions (BlackRock); (7) penalize market participants that desire

    to effect swap transactions on a SEF rather than a DCM (WMBAA and

    Tradeweb); (8) undermine the goal of the Dodd-Frank Act to promote

    trading of swaps on SEFs (Tradeweb and FXall); (9) potentially create

    detrimental arbitrage between standardized swaps traded on a SEF and

    futures contracts with the same terms and conditions traded on a DCM

    (Nodal); (10) impose onerous and unnecessary administrative costs on

    DCOs, which would likely be passed on to clearing members and their

    customers (VMAC and BlackRock); (11) create a disincentive for DCOs to

    practice appropriate default management ``drills'' to reduce the

    [[Page 69367]]

    liquidation time of portfolios of swaps (ISDA); (12) remove the

    incentive for DCOs to detail, practice and leverage clearing member

    expertise in default management (FIA); (13) discourage voluntary

    clearing (NGX); and (14) require DCOs and clearing members to manage

    margin calls and netting based on the execution platform for the

    relevant swaps (VMAC and BlackRock).

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

    \90\ See Section 2(h)(1)(B) of the CEA, 7 U.S.C. 2(h)(1)(B).

    \91\ See discussion of Sec. 39.12(b)(2) in section IV.C.2.c,

    above.

    \92\ Section 731 of the Dodd-Frank Act amended the CEA to insert

    Section 4s. See Section 4s(e)(3)(A)(ii) of the CEA, 7 U.S.C.

    6s(e)(3)(A)(ii).

    \93\ NGX estimated that the impact of transitioning from its

    current two-day requirement to a five-day requirement for all of the

    energy products that it clears would lead to an approximate 60

    percent increase in initial margins.

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

    In addition, a number of commenters argued that there was no basis

    for concluding that swaps executed on a SEF would be less liquid than

    swaps executed on a DCM (GFI, WMBAA, NGX, MarketAxess, AMG, and FXall).

    BlackRock recommended that the Commission require a DCO to use a

    consistent liquidation time for cleared swaps that are executed on SEFs

    and DCMs.

    Commenters variously contended that a liquidation time of five

    business days may be excessive for some swaps (CME and Citadel \94\), a

    one-day liquidation period is too short (LCH), a one-day liquidation

    period is appropriate for swaps executed on a DCM or a SEF (AMG), and a

    two-day liquidation period is appropriate for cleared swaps (NGX).

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

    \94\ Citadel further commented that excessive margin

    requirements relative to risk exposure could adversely affect market

    liquidity and deter clearing.

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

    Various commenters encouraged the Commission to permit a DCO to

    determine the appropriate liquidation time for all products that it

    clears based on the unique characteristics and liquidity of each

    relevant product or portfolio (CME, MFA, ISDA, LCH, NYPC, NGX, FIA,\95\

    Nadex, Citadel, and FXall) or to grant DCOs such discretion subject to

    a one-day minimum for all products, including cleared swaps (GFI, VMAC,

    MarketAxess, Nodal, WMBAA, and Tradeweb).

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

    \95\ FIA also commented that liquidation times should be set at

    times appropriate to manage the liquidation of the vast majority of

    the portfolios carried by a DCO's clearing members, and not

    necessarily that of the largest clearing member.

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

    FIA and ISDA commented that the appropriate liquidation time should

    be derived from a DCO's default management plan and the results of its

    periodic testing of such plan. FIA further stated that a DCO should

    adjust its minimum margin requirements if its periodic testing of its

    default management plan demonstrates that a defaulting clearing

    member's positions could be resolved in a shorter period of time.

    Similarly, NGX stated that the Commission should permit a DCO to

    demonstrate through back testing and stress testing that a particular

    type of cleared transaction should be subject to a shorter liquidation

    time.

    MFA and Citadel recommended that if the Commission were to mandate

    minimum liquidation times in the final rules, it should allow DCOs to

    apply for exemptions for specific groups of swaps if market conditions

    prove that such minimum liquidation times are excessive. Citadel

    further recommended that the Commission make it explicit that the

    Commission may re-evaluate and, if necessary, re-calibrate such minimum

    liquidation times as markets evolve.

    The Commission is persuaded by the views expressed by numerous

    commenters that requiring different minimum liquidation times for

    cleared swaps that are executed on a DCM and equivalent cleared swaps

    that are executed on a SEF could have negative consequences. Therefore,

    after further consideration, the Commission has determined not to

    mandate different minimum liquidation times for cleared swaps based on

    their venue of execution, and has further determined that the same

    minimum liquidation time should be used with respect to cleared swaps

    that are executed bilaterally. This approach is consistent with the

    open access requirements of Section 2(h)(1)(B) of the CEA and Sec.

    39.12(b)(2), adopted herein.

    The Commission also acknowledges the concerns expressed by

    commenters that a five-day liquidation period may be excessive for some

    swaps. For example, for a number of years, CME and ICE have

    successfully cleared swaps based on physical commodities using a one-

    day liquidation time.\96\ By contrast, as noted in the notice of

    proposed rulemaking, several DCOs currently use a five-day liquidation

    time in determining margin requirements for certain swaps based on

    financial instruments.\97\ These differences reflect differences in the

    risk characteristics of the products.

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

    \96\ NYMEX, now CME, has cleared OTC swaps generally with a one

    day liquidation time since 2002. CME currently offers more than

    1,000 products for clearing through its ClearPort system.

    \97\ In particular, ICE Clear Credit LLC and CME use a five-day

    liquidation time for credit default swaps and LCH and CME use a

    five-day liquidation time for interest rate swaps.

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

    The Commission has carefully considered whether it should prescribe

    any liquidation time or, alternatively, permit each DCO to exercise its

    discretion in applying liquidation times based on the risk profile of

    particular products or portfolios. In this regard, the Commission notes

    that even without a specified minimum liquidation time, under Sections

    5b(c)(2)(D) and 8a(7)(D) of the CEA, the Commission can require a DCO

    to adjust its margin methodology if it determines that the current

    margin levels for a product or portfolio are inadequate based on back

    testing or current market volatility.

    Weighing the advantages and drawbacks of the alternatives, the

    Commission believes that a bright-line requirement, with a provision

    for making exceptions, will best serve the public interest. While a DCO

    will still have considerable latitude in setting risk-based margin

    levels, the Commission has determined that establishing a minimum

    liquidation time will provide legal certainty for an evolving

    marketplace, will offer a practical means for assuring that the

    thousands of different swaps that are going to be cleared subject to

    the Commission's oversight will have prudent minimum margin

    requirements, and will prevent a potential ``race to the bottom'' by

    competing DCOs. Moreover, given the large number of swaps already

    cleared, this alleviates the need for the Commission, with its limited

    staff resources, to evaluate immediately the liquidation time for each

    swap that is cleared.\98\

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

    \98\ E.g., the 950,000 trades in LCH's SwapClear have an

    aggregate notional principal amount of over $295 trillion. Source:

    http://www.lch.com/swaps/swapclear_for_clearing_members/.

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

    Taking into account these considerations, and in response to the

    comments, the Commission is adopting Sec. 39.13(g)(2)(ii) with a

    number of modifications. First, the final rule requires a DCO to use

    the same liquidation time for a product whether it is executed on a

    DCM, a SEF, or bilaterally. This addresses the competitive concerns

    raised by numerous commenters and recognizes that once a swap is

    cleared, its risk profile is not affected by the method by which it was

    executed.\99\

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

    \99\ See Section 2(h)(1)(B) of the CEA and Sec. 39.12(b)(2),

    adopted herein (swaps submitted to a DCO with the same terms and

    conditions are economically equivalent within the DCO and may be

    offset with each other within the DCO).

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

    Second, the final rule provides that the minimum liquidation time

    for swaps based on certain physical commodities, i.e., agricultural

    commodities,\100\ energy, and metals, is one day. For all other swaps,

    the minimum liquidation time is five days. This distinction is based on

    the differing risk characteristics of these product groups and is

    consistent with existing requirements that reflect the risk assessments

    DCOs have made over the course of their experience clearing these types

    of swaps. The longer liquidation time, currently five days for credit

    default swaps at ICE Clear Credit, LLC, and CME, and for interest rate

    [[Page 69368]]

    swaps at LCH and CME, is based on their assessment of the higher risk

    associated with these products.\101\ Contributing factors include a

    concentration of positions among clearing members, the number and

    variety of products listed, the complexity of the portfolios, the long-

    dated expiration time for many swaps, and the challenges of the

    liquidation process in the event of a default.\102\

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

    \100\ See 76 FR 41048 (July 13, 2011) (Agricultural Commodity

    Definition; final rule).

    \101\ See e.g., Cleared OTC Interest Rate Swaps at 7 (Aug.

    2011), available at http://www.cmegroup.com/clearing/cme-core-cme-clearing-online-risk-engine.html; ICE Clear Credit Clearing Rules,

    Schedule 401 (Jul. 16, 2011) available at https://www.theice.com/publicdocs/clear_credit/ICE_Clear_Credit_Rules.pdf.

    \102\ The liquidation of the Lehman interest rate swap portfolio

    in the fall of 2008 demonstrates that the actual liquidation time

    for a swap portfolio could be longer than 5 days. Between September

    15, 2008 (the day Lehman Bros. Holdings declared bankruptcy) and

    October 3, 2008, LCH and ``OTCDerivnet,'' an interest rate

    derivatives forum of major market dealers, wound down the cleared

    OTC interest rate swap positions of Lehman Bros. Special Financing

    Inc. (LBSFI). This portfolio had a notional value of $9 trillion and

    consisted of 66,390 trades across 5 major currencies. LCH and

    OTCDerivnet competitively auctioned off LBSFI's five hedge currency

    portfolios to their members between September 24 and October 3,

    2008. The margin held by LCH proved sufficient to cover the costs

    incurred. Source: LCH Press Release of October 8, 2008, available

    at: http://www.lchclearnet.com/Images/2008-10-08%20SwapClear%20default_tcm6-46506.pdf.

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

    Third, to provide further flexibility, the Commission is adding a

    provision specifying that, by order, the Commission may provide for a

    different minimum liquidation time for particular products or

    portfolios. As markets evolve, it may become appropriate to ease the

    requirement for certain swaps subject to the five-day minimum.

    Conversely, analysis may reveal that for other products or portfolios

    the five-day or one-day minimum is insufficient. The Commission

    believes that in light of the novelty, complexity, and potential

    magnitude of the risk posed by financial swaps, prudential

    considerations dictate that this type of fine-tuning should be used in

    appropriate circumstances. Such an order could be granted upon the

    Commission's initiative or in response to a petition from a DCO.

    In this regard, the Commission emphasizes that it is retaining the

    proposed requirement that a DCO must use longer liquidation times, if

    appropriate, based on the specific characteristics of particular

    products or portfolios.\103\ Such longer liquidation times may be based

    on a DCO's testing of its default management plan. If a DCO determines

    that a longer liquidation time is appropriate for a particular swap,

    the Commission would expect that the DCO would use the same longer

    liquidation time for the equivalent swaps that it clears, whether the

    swaps are executed on a DCM, a SEF, or bilaterally. Among the factors

    that DCOs should consider in establishing minimum liquidation times

    are: (i) Average daily trading volume in a product; (ii) average daily

    open interest in a product; (iii) concentration of open interest; (iv)

    availability of a predictable basis relationship with a highly liquid

    product; and (v) availability of multiple market participants in

    related markets to take on positions in the market in question. The

    Commission would also consider these factors in determining whether a

    particular liquidation time was appropriate.

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

    \103\ As proposed, Sec. 39.13(g)(2)(ii) referred to the

    ``unique'' characteristics of particular products or portfolios. The

    Commission is revising this phrase in the final rule to refer to the

    ``specific'' characteristics of a particular product or portfolio to

    clarify that such characteristics are not limited to those that are

    one of a kind.

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

    The Commission is adopting Sec. 39.13(g)(2)(ii) revised to read as

    set forth in the regulatory text of this final rule.\104\

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

    \104\ In a technical revision, the Commission has eliminated the

    phrase, ``whether the swaps are carried in a customer account

    subject to Section 4d(a) or 4d(f) of the Act, or carried in a house

    account,'' because it is superfluous.

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

    (3) Confidence Level--Sec. 39.13(g)(2)(iii)

    Proposed Sec. 39.13(g)(2)(iii) would require that the actual

    coverage of the initial margin requirements produced by a DCO's margin

    models, along with projected measures of the models' performance, would

    have to meet a confidence level of at least 99 percent, based on data

    from an appropriate historic time period with respect to: (A) each

    product that is margined on a product basis; (B) each spread within or

    between products for which there is a defined spread margin rate, as

    described in proposed Sec. 39.13(g)(3); (C) each account held by a

    clearing member at the DCO, by customer origin and house origin,\105\

    and (D) each swap portfolio, by beneficial owner. The Commission

    invited comment regarding whether a confidence level of 99 percent is

    appropriate with respect to all applicable products, spreads, accounts,

    and swap portfolios.

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

    \105\ The terms ``customer account or customer origin'' and

    ``house account or house origin'' are now defined in Sec. 39.2,

    adopted herein.

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

    Alice Corporation supported the proposed 99 percent confidence

    level, especially for new swaps and swaps with non-linear

    characteristics. ISDA commented that the proposed 99 percent confidence

    level is appropriate given current levels of mutualization in a DCO

    default fund and mutualization in omnibus client accounts.\106\ MGEX

    stated that it did not oppose the proposed 99 percent confidence level

    for each account held by a clearing member at a DCO, by customer origin

    and house origin.\107\

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

    \106\ ISDA contended that if there were a requirement to have

    individualized client accounts, the appropriate confidence level

    should be higher than 99 percent because the funds available to a

    DCO to manage a client account default would be reduced.

    \107\ MGEX requested that the Commission clarify that this

    proposed requirement applies to the net account of each clearing

    member and not the underlying accounts at each clearing member. The

    Commission did not intend proposed Sec. 39.13(g)(2)(iii)(C), which

    would refer to ``[e]ach account held by a clearing member at the

    DCO, by customer origin and house origin * * *, '' to apply to

    individual customer accounts by beneficial owner. However, the

    Commission notes that Sec. 39.13(g)(2)(iii)(D), as proposed and as

    adopted herein, applies the 99 percent confidence level requirement

    to ``[e]ach swap portfolio, by beneficial owner.''

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

    FIA opposed the proposed 99 percent requirement because it sets an

    artificial floor that may remove the incentive for DCOs to conduct the

    rigorous analysis necessary to establish an appropriate confidence

    level. FIA further stated that if a different regulatory scheme than

    loss mutualization for the protection of customer funds were to be

    adopted for cleared swaps, a much higher level of confidence may be

    required.

    CME, Nadex, KCC,\108\ and Citadel took the position that the

    Commission should not prescribe a specific confidence level, but should

    instead continue to give each DCO the discretion to determine the

    appropriate confidence levels. CME and Nadex noted that one or more of

    the following factors could be considered by a DCO in determining the

    appropriate confidence levels: the particular characteristics of the

    products and portfolios it clears, the depth of the underlying markets,

    the existence of multiple venues trading similar products on which a

    defaulting clearing member's portfolio could be liquidated or hedged,

    the duration of the products, the size of the DCO and its systemic

    importance, its customer base, or its other risk management tools.

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

    \108\ KCC also expressed its belief that ultra-high confidence

    level modeling does not protect against risk as well as direct

    margin intervention by the DCO in the case of significant market

    movements, such as retaining the right to review recent price

    movements to re-establish margins at a higher level and retaining

    the right to demand special margin from certain clearing members.

    The Commission believes that a DCO should retain the right to take

    such actions in addition to, rather than instead of, using a 99

    percent confidence level, as required by Sec. 39.13(g)(2)(iii). For

    example, Sec. 39.13(h)(6)(ii), discussed below, requires a DCO to

    take additional actions with respect to particular clearing members,

    when appropriate, including imposing enhanced margin requirements.

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

    The Commission does not agree such discretion is appropriate and

    has

    [[Page 69369]]

    determined to establish a minimum confidence level. The Commission

    believes that a minimum confidence level will provide legal certainty

    for an evolving marketplace, will offer a practical means for assuring

    market participants that the thousands of different products that are

    going to be cleared subject to the Commission's oversight will have

    prudent minimum margin requirements, and will prevent a potential

    ``race to the bottom'' by competing DCOs. Moreover, given the large

    number of products already cleared, this alleviates the need for the

    Commission, with its limited staff resources, to evaluate immediately

    the confidence level requirements for each product that is cleared.

    The Commission is adopting the proposed minimum 99 percent

    confidence level. This is consistent with proposed international

    standards.\109\ Moreover, given the potential costs of default, the

    Commission agrees with those commenters who stated that a 99 percent

    level is appropriate. An individual DCO may determine to set a higher

    confidence level, in its discretion.

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

    \109\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Key Consideration 3, at 40. In addition, on September 15, 2010, the

    European Commission (EC) proposed the European Market Infrastructure

    Regulation (EMIR), available at http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/20100915_proposal_en.pdf, ``to ensure implementation of the G20 commitments to clear

    standardized derivatives [which can be accessed at http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf, and that Central Counterparties (CCPs) comply with high

    prudential standards * * *,'' among other things, and expressed its

    intent to be consistent with the Dodd-Frank Act. (EMIR, at 2-3). The

    EMIR requires that margins ``* * * shall be sufficient to cover

    losses that result from at least 99 per cent of the exposures

    movements over an appropriate time horizon * * *.'' (EMIR, Article

    39, paragraph 1, at 46).

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

    NASDAQ OMX Commodities Clearing Company (NOCC) supported an

    approach that would allow DCOs to set margin requirements for new and

    low-volume products at a lower coverage level if the potential losses

    resulting from such products are minimal. According to NOCC, this would

    allow DCOs to include more products and market participants by

    attracting them at an early stage without materially increasing the

    risk of the DCO.

    VMAC suggested that the Commission add to the requirement that

    initial margin levels must be based upon ``an established confidence

    level of at least 99 percent,'' language that states ``or, subject to

    specific authorization from the CFTC, a lower confidence level.'' In

    particular, VMAC commented that although a DCO should be required to

    demonstrate that the given confidence level results in an initial

    margin amount which is sufficient to allow the DCO to fully discharge

    its obligations upon a clearing member default, a DCO should not be

    required to collect margin substantially in excess of its obligations

    to clearing members in a default scenario.

    The Commission is not modifying the language of Sec.

    39.13(g)(2)(iii) in a manner that would permit DCOs to set margin

    requirements at a lower coverage level for new and low-volume products,

    as recommended by NOCC, or provide for a lower confidence level subject

    to specific Commission authorization, as suggested by VMAC. In the

    notice of proposed rulemaking, the Commission noted that the 2004 CPSS-

    IOSCO Recommendations stated that ``[m]argin requirements for new and

    low-volume products might be set at a lower coverage level [than the

    major products cleared by a CCP] if the potential losses resulting from

    such products are minimal.'' \110\ However, the CPSS-IOSCO Consultative

    Report, which was issued subsequent to the Commission's proposed rules,

    does not contain similar language. The Commission believes that it is

    prudent to apply the same standard to all products.

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

    \110\ See 2004 CPSS-IOSCO Recommendations at 23.

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

    OCC and NYPC encouraged the Commission to modify its proposal to

    make clear that, when swaps are commingled in either a Section 4d(a)

    futures account or a Section 4d(f) cleared swaps account, pursuant to

    Sec. 39.15(b)(2),\111\ the 99 percent test need not be separately

    applied to the swaps positions alone. The Commission agrees with OCC

    and NYPC that if swaps and futures are held in the same customer

    account pursuant to rules approved by the Commission or a 4d order

    issued by the Commission, as specified in Sec. 39.15(b)(2), the 99

    percent test would apply to the entire commingled account, and not just

    the swap positions, under Sec. 39.13(g)(2)(iii)(D). Therefore, the

    Commission is modifying Sec. 39.13(g)(2)(iii)(D) to add ``including

    any portfolio containing futures and/or options and held in a

    commingled account pursuant to Sec. 39.15(b)(2) of this part,'' after

    ``[e]ach swap portfolio.'' The Commission is making similar

    modifications in Sec. 39.13(g)(7) with respect to back testing

    requirements, which are discussed in section IV.D.6.g, below.

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

    \111\ See discussion of Sec. 39.15(b)(2), adopted herein, in

    section IV.F.3, below.

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

    OCC also requested that the Commission clarify that, in the case of

    a margin system that calculates margin for all positions in an account

    on the basis of the net risk of those positions based upon historical

    price correlations rather than on a product or a pre-defined spread

    basis, the 99 percent confidence level would be applied only on an

    account-by-account basis, and not to individual products, product

    groups, or specified spread positions. NYPC made a similar request,

    stating that its historical Value at Risk (VaR)-based margin model

    calculates initial margin requirements at the portfolio level, rather

    than on a product or spread basis.

    The Commission notes that, as proposed, Sec. 39.13(g)(2)(iii)(A)

    would require the application of the 99 percent confidence level to

    ``[e]ach product (that is margined on a product basis)'' and Sec.

    39.13(g)(2)(iii)(B) would require the application of the 99 percent

    confidence level to ``[e]ach spread within or between products for

    which there is a defined spread margin rate * * *.'' The Commission's

    intent was that Sec. Sec. 39.13(g)(2)(iii)(A) and (B) would apply to

    products and pre-defined spreads under margin models that calculate

    initial margin requirements on a product and pre-defined spread basis,

    respectively. Further, with respect to margin models that do not

    calculate margin on a product or pre-defined spread basis, the 99

    percent requirement would apply with respect to each account held by a

    clearing member at the DCO by house origin and by each customer origin,

    and to each swap portfolio, by beneficial owner, pursuant to Sec. Sec.

    39.13(g)(2)(iii)(C) and (D), respectively.\112\

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

    \112\ For purposes of clarification, certain references to

    customer origin in Sec. Sec. 39.13 and 39.19 have been replaced

    with references to ``each customer origin'' to clarify the

    distinction between customer positions in futures and options

    segregated pursuant to Section 4d(a) of the CEA, and customer

    positions in swaps segregated pursuant to Section 4d(f) of the CEA.

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

    In order to clarify the Commission's intent, the Commission is

    adopting Sec. 39.13(g)(2)(iii)(A) to read as follows: ``[e]ach product

    for which the derivatives clearing organization uses a product-based

    margin methodology,'' while striking ``(that is margined on a product

    basis).'' In addition, the Commission is adopting Sec.

    39.13(g)(2)(iii)(B) to read as follows: ``[e]ach spread within or

    between products for which there is a defined spread margin rate,''

    while striking ``as described in paragraph (g)(4) of this section.''

    LCH commented that the Commission's approach to setting margin

    based on products and spreads, while appropriate for futures, is not

    [[Page 69370]]

    suitable or sufficient for swaps. LCH proposed that the key requirement

    for swaps should be for the DCO to ensure that it has enough margin and

    guarantee funds to cover its exposures, and for the DCO to prove this

    on an individual client and clearing member basis. The Commission did

    not intend to suggest that swaps should be margined pursuant to a

    product-based margin methodology, nor that they should be subject to

    defined spread margin rates. The Commission recognizes that swaps are

    often margined on a portfolio basis and specifically addressed swap

    portfolios in Sec. 39.13(g)(2)(iii)(D). The Commission would also like

    to clarify that a 99 percent confidence level, as applied to swap

    portfolios, means that each portfolio is covered 99 percent of the

    time, and not that a collection of portfolios is covered 99 percent of

    the time on an aggregate basis.

    The Commission is adopting Sec. 39.13(g)(2)(iii) with the

    modifications described above.

    (4) Appropriate Historic Time Period--Sec. 39.13(g)(2)(iv)

    Proposed Sec. 39.13(g)(2)(iv) would require each DCO to determine

    the appropriate historic time period of data that it would use for

    establishing the 99 percent confidence level based on the

    characteristics, including volatility patterns, as applicable, of each

    product, spread, account, or portfolio.

    LCH recommended that the Commission define the ``historic time

    period'' as a minimum of one calendar year in order to provide for

    adequate historical observations. The Commission believes that a DCO

    should be permitted to exercise its discretion with respect to the

    appropriate time periods that should be used, based on the

    characteristics, including volatility patterns, as applicable, of the

    relevant products, spreads, accounts, or portfolios. The Commission

    also notes that proposed international standards do not specify a

    historic time period that would be appropriate in all circumstances,

    recognizing that either a shorter or a longer historic time period may

    be appropriate based on the volatility patterns of a particular

    product.\113\ The Commission expects that DCOs would include periods of

    significant financial stress. Therefore, the Commission is adopting

    Sec. 39.13(g)(2)(iv) as proposed.

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

    \113\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Explanatory Note 3.6.7, at 43.

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

    d. Independent Validation--Sec. 39.13(g)(3)

    Proposed Sec. 39.13(g)(3) would require that a DCO's systems for

    generating initial margin requirements, including the DCO's theoretical

    models, must be reviewed and validated by a qualified and independent

    party, on a regular basis. The Commission invited comment regarding

    whether a qualified and independent party must be a third party or

    whether there may be circumstances under which an employee of a DCO

    could be considered to be independent.

    In the notice of proposed rulemaking, the Commission explained that

    a validation should include a comprehensive analysis to ensure that

    such systems and models achieve their intended goals. The Commission

    also noted that, although the proposed regulation did not define the

    meaning of ``regular basis,'' the Commission would expect that, at a

    minimum, a DCO would obtain such an independent validation prior to

    implementation of a new margin model and when making any significant

    change to a model that was in use by the DCO.\114\ The Commission

    further stated that significant changes would be those that could

    materially affect the nature or level of risks to which a DCO would be

    exposed, and that the Commission would expect a DCO to obtain an

    independent validation prior to any significant change that would relax

    risk management standards. However, the Commission noted that if a DCO

    needed to adopt a significant change in an expedited manner to enhance

    risk protections, the Commission would expect the DCO to obtain an

    independent validation promptly after the change was made.

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

    \114\ The Commission also notes that the CPSS-IOSCO Consultative

    Report recommends that a CCP's initial margin models should be

    independently validated at least on a yearly basis. CPSS-IOSCO

    Consultative Report, Principle 6: Margin, Explanatory Note 3.6.8, at

    43. The Commission is not requiring an annual validation at this

    time, although it may revisit this issue in the future.

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

    CME, OCC, MGEX, and KCC all expressed the view that an employee of

    a DCO could be independent in appropriate circumstances. CME commented

    that permitting employees of a DCO to conduct the required reviews

    would be consistent with proposed Sec. 39.18(j)(2), which would allow

    employees of a DCO to conduct the required testing of a DCO's business

    continuity and disaster recovery systems, provided that such employees

    are not the persons responsible for developing or operating the systems

    being tested.\115\ OCC and MGEX took the position that employees of a

    DCO could be independent as long as they are not, or have not been,

    involved in designing the models, and OCC further stated that internal

    personnel must not otherwise be biased due to their involvement in

    implementation of the models.\116\ However, FIA argued that margin

    models should be required to be validated by an independent third party

    with expertise in risk and the product being cleared.

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

    \115\ Section 39.18(j)(2), as proposed, and as adopted herein,

    states that testing shall be conducted by qualified, independent

    professionals. Such qualified independent professionals may be

    independent contractors or employees of the derivatives clearing

    organization, but shall not be persons responsible for development

    or operation of the systems or capabilities being tested.

    \116\ In particular, OCC noted that the Office of the

    Comptroller of the Currency, the Department of the Treasury, the

    Federal Reserve System and the Federal Deposit Insurance Corporation

    recently proposed revisions to their risk-based capital guidelines,

    which would require that, with respect to the validation of banks'

    internal risk models, ``[t]he review personnel [would] not

    necessarily have to be external to the bank in order to achieve the

    required independence'' but that ``[a] bank should ensure that

    individuals who perform the review are not biased in their

    assessment due to their involvement in the development,

    implementation, or operation of the models.'' See 76 FR 1890, at

    1897 (Jan. 11, 2011) (Risk-Based Capital Guidelines: Market Risk).

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

    The Commission recognizes that a third party could be more critical

    of a DCO's margin model than an employee of a DCO, even if that

    employee is ``qualified and independent.'' However, the Commission also

    believes that a third party could be less critical if, for example, it

    seeks to provide services to the DCO or the industry in the future.

    The Commission agrees with CME, OCC, MGEX, and KCC that an employee

    of a DCO could be a ``qualified and independent party,'' and thus could

    review and validate the DCO's systems for generating initial margin

    requirements, under appropriate circumstances. It would probably be

    more costly for a DCO to use a third party for this purpose rather than

    an employee.

    On balance, the Commission believes that it may be appropriate for

    a DCO to have an employee review and validate its margin systems.

    Therefore, the Commission is adopting Sec. 39.13(g)(3) with the

    addition of a sentence stating that ``[s]uch qualified and independent

    parties may be independent contractors or employees of the derivatives

    clearing organization, but shall not be persons responsible for

    development or operation of the systems and models being tested.'' This

    is consistent with the language contained in Sec. 39.18(j)(2), as

    adopted herein, as well as the

    [[Page 69371]]

    proposed approach of other financial regulators.\117\ The Commission

    also notes that the reference to independent contractors as well as

    employees in the added language will also prohibit a DCO from using a

    particular third party to conduct the validation if that third party

    was or is responsible for development or operation of the relevant

    systems and models.

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

    \117\ Id.

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

    KCC requested that the Commission clarify that the CRO or other

    comparable personnel with responsibility for overall risk management at

    the DCO would meet the requirements of a ``qualified and independent

    party.'' The Commission does not believe that a DCO's CRO or personnel

    responsible for overall risk management would categorically qualify as

    an ``independent party.'' This determination would need to be made on a

    case-by-case basis depending on whether the CRO or other similar person

    was or is responsible for development or operation of the systems and

    models being tested.

    MGEX requested that the Commission clarify whether the requirement

    for independent validation would apply to the primary risk-based

    portfolio system such as SPAN,\118\ or each DCO's analysis program for

    determining margins, noting its belief that requiring independent tests

    on the latter would be excessive. It is not clear what MGEX means by

    ``each DCO's analysis program for determining margins.'' However, Sec.

    39.13(g)(3) requires independent validation with respect to a DCO's

    underlying model, e.g., SPAN or OCC's STANS model, as well as the

    methodology used to compute the inputs to any such model. On the other

    hand, a DCO would not be required to obtain an independent validation

    of a change in SPAN parameters as described by CME.\119\

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

    \118\ For a description of SPAN, see CME's Web site, at http://www.cmegroup.com/clearing/risk-management/span-overview.html#works.

    \119\ See id. for a description of SPAN parameters. Therefore,

    Sec. 39.13(g)(1), which requires that a DCO review its margin

    models and parameters, on a regular basis, requires a broader review

    than would be met by compliance with Sec. 39.13(g)(3).

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

    OCC commented that, as described in the notice of proposed

    rulemaking, the ``could materially affect'' standard is deficient in

    two respects in that: (1) It fails to include any reference to the

    likelihood that a change would actually materially affect the nature or

    level of risk, and (2) it omits any reference to the direction of the

    change in level of risk. OCC contended that a more appropriate standard

    would be to provide that significant changes are those that ``are

    reasonably likely to materially change the nature or increase the level

    of risks to which the DCO would be exposed.''

    In response to this comment, the Commission is modifying the

    standard to provide that significant changes are those for which there

    is a reasonable possibility that they would materially affect the

    nature or level of risks to which a DCO would be exposed. While this

    standard identifies the likelihood that a change would materially

    affect the nature or level of such risks, the Commission believes that

    it is more appropriate than identifying significant changes as only

    those that are ``reasonably likely to materially change'' the nature or

    level of such risks.

    The Commission does not believe that significant changes should be

    limited to those that are likely to increase the level of risks. As

    described in the notice of proposed rulemaking, the Commission would

    expect a DCO to obtain an independent validation prior to any

    significant change that would relax risk management standards, but the

    Commission would permit a DCO to obtain an independent validation

    promptly after a significant change that would enhance risk

    protections, in appropriate circumstances. A DCO should obtain such a

    validation even if the change were designed to enhance risk

    protections, in order to ensure that the change would be effective in

    achieving its objective.

    OCC also requested that the Commission clarify that the addition of

    a new product or new underlying interest would not inherently be deemed

    to trigger the independent evaluation requirement. The Commission

    believes that whether the addition of a new product or a new underlying

    interest would trigger the independent validation requirement would

    need to be determined on a case-by-case basis, depending on whether

    there is a reasonable possibility that such addition will materially

    change the nature or level of risks to which the DCO would be exposed.

    One example would be if the addition necessitates a significant change

    to the margin model as it applies to the new product or new underlying

    interest. Thus, the addition of a futures contract based on a new

    broad-based securities index where the DCO already clears futures

    contracts based on broad-based securities indexes might not require a

    significant change to the applicable margin model. However, the

    addition of a new category of swaps, even if the DCO already clears

    swaps, might require a significantly different margin model. Another

    example might be if a swap cleared by a DCO became subject to a

    clearing mandate and the risk profile changed because of changes in

    volume and open interest.

    e. Spread and Portfolio Margins--Sec. 39.13(g)(4)(i)

    Proposed Sec. 39.13(g)(4)(i) would permit a DCO to allow

    reductions in initial margin requirements for related positions (spread

    margins), if the price risks with respect to such positions were

    significantly and reliably correlated. Under the proposed regulation,

    the price risks of different positions would only be considered to be

    reliably correlated if there were a theoretical basis for the

    correlation in addition to an exhibited statistical correlation.

    Proposed Sec. 39.13(g)(4)(i) would include a non-exclusive list of

    possible theoretical bases, including the following: (A) The products

    on which the positions are based are complements of, or substitutes

    for, each other; (B) one product is a significant input into the other

    product(s); (C) the products share a significant common input; or (D)

    the prices of the products are influenced by common external factors.

    The Commission requested comment regarding the appropriateness of

    requiring a theoretical basis for the correlation between related

    positions before reductions in initial margin requirements would be

    permitted. In addition, proposed Sec. 39.13(g)(4)(ii) would require a

    DCO to regularly review its spread margins and the correlations on

    which they are based.\120\

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

    \120\ In addition to the other comments discussed herein, Alice

    Corporation noted that it supported the cautious approach taken by

    the Commission and that offsets across products with different

    maturities and risk profiles should be avoided where possible, and

    ISDA stated that spread margins should only permitted when a DCO can

    demonstrate a strong correlation in stressed market conditions and

    agrees to periodic public disclosure of its methodology and results.

    With respect to ISDA's comment, the Commission notes that Sec.

    39.13(g)(2)(iii), discussed in section IV.D.6.c.(3), above, requires

    a DCO to ensure that the actual coverage of its initial margin

    requirements, along with projected measures of the performance of

    its margin models, must meet an established confidence level of at

    least 99 percent, based on data from an appropriate historic time

    period, for, among other things, spreads within or between products

    for which there is a defined spread margin rate, for each account

    held by a clearing member at the DCO, by customer and house origin,

    and for each swap portfolio, by beneficial owner, and Sec.

    39.13(g)(7), discussed in section IV.D.6.g, below, imposes related

    back testing requirements. In addition, Sec. 39.21(c)(3), discussed

    in section IV.L, below, requires a DCO to publicly disclose its

    margin methodology.

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

    KCC and OCC addressed the proposed requirement that the price risks

    of related positions would only be considered to be reliably

    correlated, and thus be eligible for initial margin reductions, if

    there were a theoretical basis for the correlation in addition to

    [[Page 69372]]

    an exhibited statistical correlation. KCC contended that the proposed

    requirement would be difficult for the Commission to implement and

    unnecessary because DCOs have no incentive to offer margin reductions

    in the absence of high correlation between positions. KCC further noted

    that the proposal does not detail what level of observed statistical

    correlation is required, and the proposed requirement to articulate a

    theoretical basis is vague.

    OCC also questioned the appropriateness of the requirement that

    there must be a theoretical basis for the correlation, noting that a

    theoretical basis for correlation is, by definition, theoretical and

    may not be directly observable or verifiable except through the

    correlation. OCC stated that it is difficult to imagine a correlation

    for which no theoretical basis can be constructed, and in many if not

    most cases, the theoretical basis for any significant correlation is

    obvious.

    The Commission continues to believe that reductions in initial

    margin requirements should only be allowed if a DCO is able to

    articulate a reasonable theoretical explanation for an observed

    statistical correlation to ensure that the positions are reliably

    correlated. The Commission notes that it is a matter of basic

    statistics that correlation does not equal causation. The world is

    replete with examples of events or data that are highly correlated at

    various points in time but for which there is no theoretical

    relationship. If there is no theoretical relationship, a DCO has no

    basis to believe that a statistical relationship--no matter how

    strong--is stable, and a margin based on such a relationship may be

    insufficient to capture price variation.

    Several commenters addressed the appropriateness of applying

    proposed Sec. 39.13(g)(4) to portfolio-based margin systems. LCH

    commented that the spread margin measure which the Commission proposed

    is unsuited and inappropriate for swaps clearing and that the Portfolio

    Approach to Interest Rate Scenarios (PAIRS), the historical simulation

    method that LCH uses, is more suitable to non-standardized swaps.

    Therefore, LCH urged the Commission to amend proposed Sec. 39.13(g)(4)

    to afford recognition to this technique. OCC requested that the

    Commission acknowledge that its STANS methodology meets the

    requirements of proposed Sec. 39.13(g)(4), noting that STANS currently

    relies on over 20 million separate correlations. OCC stated that it

    would be impractical to attempt to document or even articulate the

    ``theoretical basis'' for all of these correlations even though it

    believes that they would be supportable on a theoretical level, and

    further believes that its systems for determining and reviewing the

    validity of the correlations it uses are sufficient to ensure that OCC

    does not allow unjustified margin offsets. NYPC requested that the

    Commission clarify that Sec. 39.13(g)(4) would not be applicable to

    margin models that calculate initial margin requirements at the account

    level, including NYPC's historical VaR-based margin model.

    The Commission intends Sec. 39.13(g)(4) to apply to portfolio-

    based margin models as well as product-based margin models. For some

    products, DCOs establish defined spread margin rates, pursuant to a

    product-based margin methodology. Typically, this occurs where there is

    a bilateral correlation, e.g., a March-June calendar spread or a

    correlation between two related products.\121\ For other products,

    there may be multilateral correlations for which margin is calculated

    on a portfolio basis, pursuant to a portfolio-based margin methodology.

    In the latter instance, there is not a defined margin amount or margin

    reduction for a defined portfolio that remains the same over time.

    Instead, margin is recalculated each day for each individual portfolio.

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

    \121\ A defined spread margin rate may also apply to three

    related products, e.g., the Chicago Board of Trade's soybean crush

    spread with respect to soybeans, soybean oil and soybean meal.

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

    Therefore, the Commission is adopting Sec. 39.13(g)(4), with

    several modifications, in order to clarify that margin reductions

    calculated on a portfolio basis are also permissible if they meet the

    standards of the regulation. First, the Commission is changing the

    heading of the provision from ``[s]pread margins'' to ``[s]pread and

    portfolio margins.'' The Commission is also removing the parenthetical

    ``(spread margins)'' after the clause in Sec. 39.13(g)(4)(i) that

    states ``[a] derivatives clearing organization may allow reductions in

    initial margin requirements for related positions.'' Finally, the

    Commission is changing the reference to ``spread margins'' in Sec.

    39.13(g)(4)(ii) to ``margin reductions.'' These changes are designed to

    make it clear that Sec. 39.13(g)(4) applies to reductions in initial

    margin requirements for related positions, whether a DCO uses a

    product-based margin model or a portfolio-based margin model.

    Better Markets and Mr. Greenberger commented that Sec. 39.13(g)(4)

    must require that the relationship between positions be calculated

    using the same standards (with respect to volatility and liquidity

    requirements) that are applied to the calculation of initial margin for

    the individual positions. The Commission agrees with Better Markets and

    Mr. Greenberger and, as discussed above, spread and portfolio margins

    would also be subject to a 99 percent coverage standard.

    f. Price Data--Sec. 39.13(g)(5)

    Proposed Sec. 39.13(g)(5) would require a DCO to have a reliable

    source of timely price data to measure its credit exposure accurately,

    and to have written procedures and sound valuation models for

    addressing circumstances where pricing data is not readily available or

    reliable.

    Interactive Data Corporation expressed its belief that the concept

    of ``sound valuation models'' should be expanded further with

    additional prescriptive guidance in four key dimensions, including: (1)

    Leveraging greater trade transparency; (2) using multiple sources; (3)

    mitigating conflicts of interest; and (4) sourcing of independent price

    data.

    The Commission does not believe that it is necessary to be more

    specific or prescriptive with respect to this requirement, and is

    adopting Sec. 39.13(g)(5) as proposed. As the Commission noted in the

    notice of proposed rulemaking, the nature of the applicable valuation

    models would necessarily depend on the particular products and the

    available sources of any relevant pricing data.

    g. Daily Review and Back Tests--Sec. Sec. 39.13(g)(6) and (g)(7)

    Proposed Sec. 39.13(g)(6) would require a DCO to determine the

    adequacy of its initial margin requirements for each product, on a

    daily basis, with respect to those products that are margined on a

    product basis.

    Proposed Sec. 39.13(g)(7) would require a DCO to conduct certain

    back tests. The Commission has defined ``back test'' in Sec. 39.2,

    adopted herein, as ``a test that compares a derivatives clearing

    organization's initial margin requirements with historical price

    changes to determine the extent of actual margin coverage.''

    For purposes of proposed Sec. 39.13(g)(7)(i) and (ii), the

    introductory paragraph of proposed Sec. 39.13(g)(7) would require

    that, in conducting back tests, a DCO use historical price change data

    based on a time period that is equivalent in length to the historic

    time period used by the applicable margin model for establishing the

    minimum 99 percent confidence level or a longer time period. The

    applicable time period

    [[Page 69373]]

    was separately specified for the back tests required by proposed Sec.

    39.13(g)(7)(iii), as discussed below.

    Proposed Sec. 39.13(g)(7)(i) would require a DCO, on a daily

    basis, to conduct back tests with respect to products that are

    experiencing significant market volatility. Specifically, a DCO would

    be required to test the adequacy of its initial margin requirements and

    its spread margin requirements for such products that are margined on a

    product basis.

    Proposed Sec. 39.13(g)(7)(ii) would require a DCO, on at least a

    monthly basis, to conduct back tests to test the adequacy of its

    initial margin requirements and spread margin requirements for each

    product that is margined on a product basis. The Commission requested

    comment regarding whether initial margin requirements for all products

    should be subject to back tests on a monthly basis or whether some

    other time period, such as quarterly, would be sufficient to meet

    prudent risk management standards.

    Proposed Sec. 39.13(g)(7)(iii) would require a DCO, on at least a

    monthly basis, to conduct back tests to test the adequacy of its

    initial margin requirements for each clearing member's accounts, by

    customer origin and house origin, and each swap portfolio, by

    beneficial owner, over at least the previous 30 days. In the notice of

    proposed rulemaking, the Commission noted that, since the composition

    of such accounts and swap portfolios may change on a daily basis, it

    was anticipated that back tests with respect to such accounts and

    portfolios would involve a review of the initial margin requirements

    for each account and portfolio as it existed on each day during the 30-

    day period. The Commission also requested comment regarding whether

    initial margin requirements for all clearing members' accounts, by

    origin, and swap portfolios, by beneficial owner, should be subject to

    back tests on a monthly basis or whether some other time period, such

    as quarterly (based on the previous quarter's historical data), would

    be sufficient to meet prudent risk management standards.

    Several commenters addressed the appropriate frequency of back

    tests and/or the appropriate historic time period for the analysis of

    price change data. FIA commented that initial margin requirements

    should be back tested monthly. MGEX stated that it was not opposed to a

    monthly back testing requirement with respect to proposed Sec.

    39.13(g)(7)(iii) based on its understanding that the Commission

    intended that the DCO must look at its clearing member's net account

    and not each underlying customer account with the exception of

    swaps.\122\

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

    \122\ MGEX correctly understands that the Commission's reference

    to ``each account held by a clearing member at the DCO, by origin,

    house and customer'' in proposed Sec. 39.13(g)(7)(iii) was not

    intended to apply to individual accounts by beneficial owner,

    although proposed Sec. 39.13(g)(7)(iii) would require monthly back

    tests with respect to initial margin requirements for each swap

    portfolio, by beneficial owner.

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

    LCH took the position that back tests should be conducted at least

    on a daily basis for all products cleared by a DCO. However, LCH argued

    that such back tests should be conducted at the portfolio level because

    margining techniques appropriate for swaps, such as LCH's PAIRS

    methodology, do not allow for the disaggregation of initial margin and

    spread margin requirements at a product level. LCH also commented that,

    for back tests to be statistically meaningful, the applicable historic

    time period should be a minimum of one calendar year.

    KCC stated that it may be appropriate for the Commission to further

    define ``significant market volatility,'' for purposes of proposed

    Sec. 39.13(g)(7)(i),\123\ but that, more generally, any back-testing

    requirements should be based on a discretionary, risk-based

    determination by the DCO. In addition, KCC expressed its belief that

    the back testing period should be subject to the discretion of the DCO

    in light of then-current market conditions, i.e., imposing a specific

    back-testing period may inappropriately reflect an exaggerated or

    understated level of market volatility.

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

    \123\ The Commission believes that each DCO should determine

    what ``significant volatility'' means based upon the volatility

    patterns of each individual product or swap portfolio that it

    clears.

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

    NOCC took the position that products, customers or spread credits

    should reach a specified volume or risk exposure level before being

    required to be back tested with the proposed frequencies so long as the

    DCO can demonstrate that it is meeting the core principle objectives

    underlying proposed Sec. 39.13(f).

    NYPC requested that the Commission clarify that proposed Sec. Sec.

    39.13(g)(6) and (g)(7)(i)-(ii) would not be applicable to margin models

    that calculate initial margin requirements at the account level,

    including NYPC's historical VaR-based margin model. OCC also stated its

    belief that it would not be subject to the requirement for daily review

    in proposed Sec. 39.13(g)(7)(i), as it does not margin on a product

    basis, but noted that it does conduct daily back testing on all

    accounts, i.e., on a portfolio basis.

    The Commission is adopting Sec. 39.13(g)(6), eliminating the

    language stating ``for each product (that is margined on a product

    basis),'' in order to correct a potential inconsistency between the

    text of the rule and the notice of proposed rulemaking. In the notice

    of proposed rulemaking, the Commission stated that ``[d]aily review and

    periodic back testing are essential to enable a DCO to provide adequate

    coverage of the DCO's risk exposures to its clearing members.'' As

    proposed, Sec. 39.13(g)(6) would only require a DCO to determine the

    adequacy of its initial margin requirements, on a daily basis, for

    products that were margined on a product basis. The adequacy of a DCO's

    initial margin requirements for futures and options on futures products

    margined on a portfolio basis, and for swap portfolios, would not have

    been subject to such daily review. The Commission believes that such a

    result is untenable, as one of the most rudimentary steps in risk

    management is to conduct daily review of margin coverage, i.e., to

    determine whether any margin breaches have occurred. Moreover, the

    Commission believes that the change will not impose any burden because

    it believes that all DCOs currently conduct some form of daily review

    of the adequacy of their initial margin requirements, whether they use

    a product-based or a portfolio-based margin methodology.

    The Commission is adopting Sec. 39.13(g)(7)(i) with modifications

    that require a DCO to conduct back tests, on a daily basis, to test the

    adequacy of its initial margin requirements with respect to products or

    swap portfolios that are experiencing significant market volatility:

    (a) For that product if the DCO uses a product-based margin

    methodology; (b) for each spread involving that product if there is a

    defined spread margin rate; (c) for each account held by a clearing

    member at the DCO that contains a significant position \124\ in that

    product, by house origin and by each customer origin; and (d) for each

    such swap portfolio, including any portfolio containing futures and/or

    options and held in a commingled account pursuant to Sec.

    39.15(b)(2),\125\ by beneficial owner.

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

    \124\ The Commission has not defined a ``significant position,''

    leaving that determination to the discretion of each DCO, as the

    size of a position that would be a ``significant position'' may vary

    depending on the nature of the particular product or the composition

    of the particular account.

    \125\ See discussion of the addition of the same language to

    Sec. 39.13(g)(2)(iii)(D), in section IV.D.6.c.(3), above.

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

    Similarly, the Commission is adopting Sec. 39.13(g)(7)(ii) with

    modifications that

    [[Page 69374]]

    require a DCO to conduct back tests, on at least a monthly basis: (a)

    For each product for which the DCO uses a product-based margin

    methodology; (b) for each spread for which there is a defined spread

    margin rate; (c) for each account held by a clearing member at the DCO,

    by house origin and by each customer origin; and (d) for each swap

    portfolio, including any portfolio containing futures and/or options

    and held in a commingled account pursuant to Sec. 39.15(b)(2),\126\ by

    beneficial owner. As adopted, Sec. 39.13(g)(7) no longer contains a

    paragraph (iii) as paragraph (ii) now describes all monthly back

    testing requirements.

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

    \126\ Id.

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

    As originally proposed, Sec. 39.13(g)(7) would only require daily

    back testing for products that were experiencing significant market

    volatility if the DCO used a product-based margin methodology, and for

    spreads involving that product if there was a defined spread margin

    rate. It would not require daily back testing for each account, by

    customer origin and house origin, that contained a significant position

    in that product, whether the DCO used a product-based or a portfolio-

    based margin methodology, or for each swap portfolio that was

    experiencing significant market volatility. As with respect to Sec.

    39.13(g)(6), there was a potential inconsistency in the treatment of

    different positions. There is no reasonable basis to require daily back

    tests solely with respect to products that are experiencing significant

    market volatility for which the DCO uses a product-based margin

    methodology and spreads involving such products if there is a defined

    spread margin rate, and not to require daily back tests with respect to

    accounts, by customer origin and house origin, which contain

    significant positions in those products simply because the DCO uses a

    portfolio-based margin methodology. Similarly, there is no

    justification for requiring daily back tests with respect to products

    that are experiencing significant market volatility and not requiring

    daily back tests with respect to swap portfolios that are experiencing

    significant market volatility. A DCO should be required to conduct

    daily back tests when the instruments that it clears are subject to

    significant market volatility, whether the DCO bases its initial margin

    requirements on a product-based or a portfolio-based margin

    methodology, and whether those instruments are futures, options on

    futures, or swaps.

    Although OCC stated that it currently conducts daily back tests on

    all accounts on a portfolio basis, and LCH expressed its view that back

    tests should be conducted on a daily basis for all products and swap

    portfolios cleared by a DCO, the Commission has determined to permit a

    DCO to conduct back tests on at least a monthly basis when significant

    market volatility is not present. FIA and MGEX supported monthly back

    testing. Apart from KCC's contention that back testing should be

    subject to the discretion of the DCO, and NOCC's suggestion that DCOs

    should be able to obtain an exemption from the proposed frequencies for

    products, customers and spread credits that have not reached a

    specified volume or risk exposure level,\127\ none of the commenters

    indicated that back tests should be conducted less frequently than

    monthly. Moreover, a particular DCO would be able to exercise its

    discretion to conduct back tests on a more frequent basis than that

    required by the Commission's regulation.

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

    \127\ The Commission does not believe that it is appropriate to

    adopt a regulation establishing an exemption process with respect to

    back testing requirements based on volume or risk exposure or

    otherwise.

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

    The Commission has not proposed and is not adopting LCH's

    suggestion that the applicable historic time period for the price

    change data used for back testing should be a minimum of one calendar

    year. However, the Commission is removing the proposed language from

    the introductory paragraph of Sec. 39.13(g)(7) regarding the time

    periods for historical price changes that must be used in the required

    back tests and is revising the introductory paragraph to require a DCO

    to use an appropriate time period but not less than the previous 30

    days for all of the back tests required by Sec. Sec. 39.13(g)(7)(i)

    and (ii).

    h. Customer Margin

    (1) Gross Margin for Customer Accounts --Sec. 39.13(g)(8)(i)

    Proposed Sec. 39.13(g)(8)(i) would require a DCO to collect

    initial margin on a gross basis for each clearing member's customer

    account equal to the sum of the initial margin amounts that would be

    required by the DCO for each individual customer within that account if

    each individual customer were a clearing member and would prohibit a

    DCO from netting positions of different customers against one another.

    The proposed regulation would permit a DCO to collect initial margin

    for its clearing members' house accounts on a net basis.

    Better Markets and LCH (with a suggested exception described below)

    supported proposed Sec. 39.13(g)(8)(i).\128\ CME, KCC, OCC, ICE, NYPC,

    FIA, and the Commodity Markets Council (CMC) argued against the

    adoption of proposed Sec. 39.13(g)(8)(i).

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

    \128\ LCH also expressed its belief that a DCO should also

    collect margin from all affiliated legal entities within a house

    account on a gross basis unless there is legal certainty of the

    DCO's right to offset risks across the affiliates in the event of

    the default of the group or one or more of its affiliated legal

    entities. The Commission has not proposed and is not adopting such a

    requirement. However, although Sec. 39.13(g)(8)(i) permits a DCO to

    collect initial margin for its clearing members' house accounts on a

    net basis, it does not require it to do so, and a DCO could

    determine to collect house margin in the manner suggested by LCH.

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

    KCC and ICE pointed out that DCOs that perform net margining have

    not had any clearing member defaults or customer losses, including

    during the 2008 financial crisis.

    Various commenters opposed the proposal based on the potential

    extent and costs of operational and technology changes that would need

    to be made by clearing members and DCOs: (1) To convert net margining

    systems to gross margining systems, and (2) to permit clearing members

    to provide individual customer position information to DCOs, and DCOs

    to receive individual customer position information and calculate the

    margin required for each individual customer account (CME, KCC, ICE,

    NYPC, and CMC).

    OCC stated that the only means by which it could calculate margin

    requirements on a customer-by-customer basis within a clearing member's

    omnibus futures customers' account would be to create subaccounts for

    each customer. CME, NYPC, KCC, and FIA commented that DCOs do not

    currently receive position-level information for each individual

    customer of their clearing members. CME and FIA expressed concern about

    the costs associated with clearing members having to provide individual

    customer position information, and CME indicated that DCOs would incur

    costs in processing the information received from clearing members in

    order to calculate margin requirements on individual customer accounts

    on a daily basis. NYPC also stated that the adoption of proposed Sec.

    39.13(g)(8)(i) would require it to make significant changes to its

    systems.\129\

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

    \129\ See further discussion of these costs in section VII,

    below. NYPC also commented that given the necessary technology

    builds, it would need more than three years to come into compliance

    with proposed Sec. Sec. 39.13(g)(8)(i) and 39.13(h)(2). The

    Commission believes that the modifications to Sec. 39.13(g)(8)(i),

    discussed in this section, would minimize any technology changes

    that would be necessary in order to comply with Sec.

    39.13(g)(8)(i).

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

    KCC stated that managing gross customer margin at the DCO level

    [[Page 69375]]

    would require a DCO to assume the role of a back-office account

    management service, requiring continuous updates from each clearing

    member regarding customer positions. KCC further noted that DCOs would

    be required to adjust the timing deadlines for margin payments, DCOs'

    ability to track margin requirements closely with market movements

    would be decreased, and DCOs may face difficulty in relaying variation

    margin payment information to their settlement banks quickly.

    ICE noted that converting to a gross margining system would be a

    major operational change for clearing firms and DCOs that use net

    margining. However, ICE also stated that most DCOs currently use gross

    margining, including ICE Trust (now ICE Clear Credit LLC) and ICE Clear

    U.S., although ICE Clear Europe uses net margining. In particular, ICE

    stated that gross margining would require reengineering of firms' end-

    of-day processing. According to ICE, changes would need to be made to

    such DCOs' margining technology, data submission/input mechanism and

    margin reporting specifications, and clearing firms or their service

    providers would need to implement software updates. ICE noted that

    changes to position reporting, reconciliation and margining methodology

    are challenging technology changes for clearing members and their

    third-party software vendors and typically take at least six to nine

    months to complete. However, ICE indicated that an implementation

    period of at least 12 months would allow DCOs that currently use net

    margining, and their clearing members, to adequately test and implement

    the systems necessary for gross margining.

    CME, KCC, and CMC all argued that requiring clearing members to

    report gross customer positions by beneficial owner to DCOs is not

    necessary in order to accomplish reasonable and adequate ``modified''

    gross margining. Specifically, CME and KCC urged the Commission to

    permit a version of gross margining of customer accounts that would

    only require clearing members to report gross customer positions to

    DCOs (not by beneficial owner) and that would allow clearing firms to

    submit positions as spreadable for those accounts that have recognized

    calendar spreads or spreads between correlated products. However, CME

    further represented that ``[t]his version of gross margining will

    sometimes lead to less than aggregate gross margins as a result of

    optimal spreading that occasionally occurs between accounts.

    Nevertheless, it approximates aggregate gross margins without imposing

    significant costs on the industry.''

    In light of the various concerns raised by CME, KCC, ICE, NYPC, and

    CMC regarding the operational and technology changes that would be

    needed and related costs of requiring a DCO to obtain individual

    customer position information from its clearing members and to use such

    information to calculate the margin requirements for each individual

    customer, the Commission is modifying Sec. 39.13(g)(8)(i). In

    particular, the Commission is adding a provision, which states that

    ``[f]or purposes of calculating the gross initial margin requirement

    for each clearing member's customer account(s), to the extent not

    inconsistent with other Commission regulations, a derivatives clearing

    organization may require its clearing members to report the gross

    positions of each individual customer to the derivatives clearing

    organization, or it may permit each clearing member to report the sum

    of the gross positions of its customers to the derivatives clearing

    organization.'' \130\

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

    \130\ The Commission is including the phrase ``to the extent not

    inconsistent with other Commission regulations'' because, in a

    separate rulemaking, the Commission has proposed regulations that

    would require FCM clearing members to provide daily information

    identifying the positions of individual cleared swaps customers to

    the relevant DCO and that would require such DCOs to calculate the

    amount of collateral required for each cleared swaps customer of

    such clearing members on a daily basis. If these regulations are

    adopted, they will supersede the provisions of Sec. 39.13(g)(8)(i)

    to the extent that they are inconsistent with such provisions, with

    respect to cleared swaps. See 76 FR 33818 (June 9, 2011) (Protection

    of Cleared Swaps Customer Contracts and Collateral; Conforming

    Amendments to the Commodity Broker Bankruptcy Provisions).

    The Commission is also making a conforming amendment by

    inserting ``and may not permit its clearing members to'' in the

    sentence that now reads as follows (added text in italics): ``A

    derivatives clearing organization may not, and may not permit its

    clearing members to, net positions of different customers against

    one another.''.

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

    Thus, the Commission is providing a DCO with the discretion to

    either calculate customer gross margin requirements based on individual

    customer position information that it obtains from its clearing members

    or based on the sum of the gross positions of all of a clearing

    member's customers that the clearing member provides to the DCO,

    without forwarding individual customer position information to the DCO.

    In either case, the customer gross margin requirement determined by a

    DCO must equal ``the sum of the initial margin amounts that would be

    required by the derivatives clearing organization for each individual

    customer within that account if each individual customer were a

    clearing member.'' The customer gross margin collected by a DCO may not

    be subject to ``spreading that occasionally occurs between accounts''

    that may lead to ``less than aggregate gross margins,'' as described by

    CME.

    CME commented that proposed Sec. 39.13(g)(8)(i) was unclear

    regarding how DCOs would be expected to treat customer omnibus accounts

    of non-clearing FCMs and foreign brokers for which the clearing firm

    carrying the account generally does not know the identities of

    individual customers within the omnibus accounts. Under current

    industry practice, omnibus accounts report gross positions to their

    clearing members and clearing members collect margins on a gross basis

    for positions held in omnibus accounts.\131\ The Commission does not

    intend to alter this current practice by adopting Sec. 39.13(g)(8)(i).

    Therefore, the Commission is adding a provision, which states that

    ``[f]or purposes of this paragraph, a derivatives clearing organization

    may rely, and may permit its clearing members to rely, upon the sum of

    the gross positions reported to the clearing members by each domestic

    or foreign omnibus account that they carry, without obtaining

    information identifying the positions of each individual customer

    underlying such omnibus accounts.''

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

    \131\ See, e.g., Margins Handbook, http://www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf, at 34; CME

    Rule 930.J.; ICE Futures U.S. Inc. Rule 5.04; and CBOE Futures

    Exchange, LLC Rule 516.

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

    The Commission believes that giving a DCO the option of permitting

    its clearing members to provide the sum of their customers' gross

    positions to a DCO, without the need to provide individual customer

    position information to the DCO, allows DCOs to provide their clearing

    members with a much less costly alternative to requiring clearing

    members to provide individual customer position information to the DCO,

    and requiring the DCO to calculate the gross margin requirement for

    each customer of each clearing member.

    The Commission recognizes that Sec. 39.13(g)(8)(i), even as

    modified, will require DCOs and their clearing members to incur certain

    costs. However, the Commission continues to believe, as stated in the

    notice of proposed rulemaking, that gross margining of customer

    accounts will: (a) More appropriately address the risks posed to a DCO

    by its clearing members' customers than net margining; (b) will

    increase the financial resources available to a DCO in the event of a

    [[Page 69376]]

    customer default; \132\ and (c) with respect to cleared swaps, will

    support the requirement in Sec. 39.13(g)(2)(iii) that a DCO must

    margin each swap portfolio at a minimum 99 percent confidence level.

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

    \132\ ICE commented that the Commission's rationale for gross

    margining, i.e., that it would increase the financial resources

    available to a DCO in the event of a customer default, is based upon

    the mutualization of customer risk to protect the DCO. ICE stated

    its belief that this rationale conflicts with the reasoning behind

    the proposal that DCOs individually segregate cleared swaps customer

    funds to protect such customers from fellow customer risk. The

    Commission notes, however, that gross margining is not only

    consistent with, but will be instrumental in achieving, complete

    legal segregation for cleared swaps accounts. See 76 FR 33818 (June

    9, 2011) (Protection of Cleared Swaps Customer Contracts and

    Collateral; Conforming Amendments to the Commodity Broker Bankruptcy

    Provisions).

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

    The Commission believes that the clearing of swaps will increase

    the risk that DCOs face. Gross margining will maximize the amount of

    money DCOs hold. Because a DCO may not have access to customer initial

    margin collected by and held at an FCM if the DCO collects initial

    margin on a net basis, if the FCM defaults, the Commission believes

    that holding gross initial margin at a DCO is the safest mechanism by

    which DCOs can protect themselves from increased risk. If a DCO is

    unable to obtain customer margin in the event of default, there is

    significant risk of contagion. Consequently, if more margin is held at

    the DCO, the potential risk that the failure of one clearing member

    will propagate throughout the financial system to other clearing

    members and other entities is decreased.\133\

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

    \133\ As pointed out in the CPSS-IOSCO Consultative Report,

    under certain circumstances gross margining may also increase the

    portability of customer positions in an FCM insolvency. That is, a

    gross margining requirement would increase the likelihood that there

    will be sufficient collateral on deposit in support of a customer

    position to enable the DCO to transfer it to a solvent FCM. See

    CPSS-IOSCO Consultative Report, Principle 14: Segregation and

    Portability, Explanatory Notes 3.14.6 and 3.14.8, at 67-68.

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

    CME and KCC commented that proposed Sec. 39.13(g)(8)(i) would

    require clearing members to ``pass-through'' the margin deposits that

    they receive from their customers to the DCO, thus requiring clearing

    members to apply to their customers the DCO's standards for acceptable

    collateral as well as the DCO's concentration limits with respect to

    collateral types. CME indicated that this would add pressure with

    respect to the available collateral pool, and argued that the

    Commission should not impose such additional and costly constraints on

    market participants in the absence of significant and demonstrable

    benefits. The Commission notes that, although as a business matter

    clearing members may determine to ``pass-through'' the margin deposits

    that they receive from their customers to the relevant DCO, proposed

    Sec. 39.13(g)(8)(i) does not require that a clearing member only

    accept from its customers those types of margin assets that are

    acceptable for the clearing member to deposit with the DCO.

    KCC requested that the Commission clarify whether the requirement

    to collect gross customer margin imposes an obligation on the DCO to

    determine the defaulting customer accounts in a customer default

    situation (which would be costly and burdensome) and stated that having

    the total customer gross margin available to the DCO in the event of a

    customer default is a prudent risk management technique. The Commission

    notes that Commission rules currently permit a DCO to commingle the

    initial margin with respect to all of a clearing member's customers in

    a single customer origin account at the DCO and to apply the entire

    customer origin account to cover losses with respect to a customer

    default, whether the DCO collects initial margin on a net basis or on a

    gross basis. The Commission does not intend Sec. 39.13(g)(8)(i), by

    its terms, to alter this approach.

    In a separate rulemaking, however, the Commission has proposed to

    require DCOs to legally segregate customer funds and assets margining

    swap positions that are held by a clearing member at the DCO in a

    commingled cleared swaps customer account.\134\ In addition, European

    Union legislation, although not yet finalized, would require central

    counterparties to provide individual customer segregation in certain

    circumstances.\135\ As previously noted, gross margining will be

    instrumental if individual customer segregation is adopted. OCC

    requested that the Commission restrict the applicability of proposed

    Sec. 39.13(g)(8)(i) to futures customer accounts at both the clearing

    level and the FCM level, to make it clear that it does not intend to

    impose these margin requirements on accounts that are restricted to

    securities products (with respect to an entity that is both a DCO and

    an SEC-regulated clearing agency). OCC is correct that Sec.

    39.13(g)(8)(i) applies only to customer and house accounts, cleared by

    a DCO, which contain futures, options on futures, and/or swap positions

    that are subject to the jurisdiction of the Commission. It does not

    apply to accounts that only contain securities products that are

    subject to the jurisdiction of the SEC.

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

    \134\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared

    Swaps Customer Contracts and Collateral; Conforming Amendments to

    the Commodity Broker Bankruptcy Provisions).

    \135\ See Financial markets: OTC derivatives, central

    counterparties and trade repositories (amend. Directive 98/26/EC),

    COD/2010/0250 (June 7, 2011), available at http://www.europarl.europa.eu/oeil/FindByProcnum.do?lang=en&procnum=COD/2010/0250.

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

    LCH requested that the Commission allow DCOs operating from non-

    U.S. jurisdictions to offer ``net omnibus'' account structures for

    associated entities operating under the same group or umbrella

    structure to customers outside the U.S. The treatment of customers is

    outside the scope of this rulemaking. However, to the extent a DCO is

    clearing products subject to the Commission's jurisdiction, this rule

    would apply at the clearing level regardless of the location of the DCO

    or the customer.

    The Commission is adopting Sec. 39.13(g)(8)(i) with the

    modifications described above. The Commission recognizes that DCOs that

    currently use net margining, or that use a ``modified'' version of

    gross margining, as well as their clearing members and their service

    providers, will need time to make the necessary operational and

    technology enhancements that will facilitate gross margining, as

    described herein. Therefore, the Commission is adopting an effective

    date that is 12 months after the publication of final Sec.

    39.13(g)(8)(i) in the Federal Register.

    (2) End-of-Day Position Reporting--Sec. 39.19(c)(1)(iv)

    Proposed Sec. 39.19(c)(1)(iv) would require each DCO to report to

    the Commission, on a daily basis, the end-of-day positions for each

    clearing member, by customer origin and house origin; and for customer

    origin, separately, the gross positions of each beneficial owner.\136\

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

    \136\ As originally proposed, Sec. 39.19(c)(1)(iv) would

    require each DCO to report to the Commission, on a daily basis, the

    end-of-day positions for each clearing member, by customer origin

    and house origin. See 75 FR 78185 (Dec. 15, 2010) (Information

    Management). The preamble in the notice of proposed rulemaking (76

    FR 3698 (Jan. 20, 2011) (Risk Management)), described a proposed

    amendment to proposed Sec. 39.19(c)(1)(iv) to add ``and for

    customer origin, separately, the gross positions of each beneficial

    owner.'' However, this clause was inadvertently omitted from the

    language of the regulation in the notice of proposed rulemaking.

    Therefore, the Commission subsequently issued a correction at 76 FR

    16588 (Mar. 24, 2011) (Risk Management Requirements for Derivatives

    Clearing Organizations; Correction).

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

    As noted by KCC and CMC, the Commission currently receives certain

    information about the ownership and control of reportable positions

    through its large trader reporting program, under Parts 15 through 21

    of the Commission's

    [[Page 69377]]

    regulations. Commission staff reviews the effectiveness of this program

    on a regular basis, and will continue to adopt enhancements where

    appropriate.\137\ The large trader reporting system, however, does not

    currently apply to many swaps that are, or may be, cleared. The

    Commission may need information about large swap positions to assess

    the risk profile of a DCO or a clearing FCM.

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

    \137\ For example, the Commission recently adopted final rules

    on Large Trader Reporting for Physical Commodity Swaps at 76 FR

    43851 (July 22, 2011).

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

    CME, KCC, MGEX, FIA, and CMC commented that clearing members do not

    generally have information identifying the underlying customers in

    customer omnibus accounts carried on behalf of non-clearing member

    FCMs, foreign brokers, hedge funds or commodity pools, and therefore

    clearing members cannot reasonably be expected to report such

    information to DCOs, and DCOs cannot reasonably be expected to report

    such information to the Commission. The Commission notes that a DCO may

    be able to obtain such information under its own rules. For example,

    CME Rule 960 requires a clearing member to immediately disclose the

    identities and positions of the beneficial owners of any omnibus

    account to CME upon its request.

    MGEX expressed its concern that the significant costs resulting

    from compliance with a requirement for the routine daily reporting of

    all gross customer positions by beneficial owner could lead to further

    consolidation in the industry at the FCM, clearing member, and DCO

    levels.

    The Commission is not adopting the proposed requirement in Sec.

    39.19(c)(1)(iv) that a DCO provide daily reports to the Commission of

    the gross positions of each beneficial owner within each clearing

    member's customer origin account. However, the Commission is adopting

    Sec. 39.19(c)(5)(iii),\138\ which requires a DCO to provide this

    information to the Commission upon the Commission's request, in the

    format and manner, and within the time, specified by the Commission.

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

    \138\ See further discussion of Sec. 39.19, adopted herein, in

    section IV.J, below.

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

    For example, the Commission could request that a DCO provide

    information about customer positions by beneficial owner, on a case-by-

    case basis, with respect to a particular clearing member, customer, or

    product. Moreover, the Commission could request that such information

    be provided for a particular day, month, or until further notice by the

    Commission. In recent years, the Commission has worked cooperatively

    with several DCOs to obtain information about cleared swap positions.

    The Commission notes that any potential costs should be substantially

    reduced by the modified requirement that a DCO provide information to

    the Commission identifying the positions of beneficial owners of

    customer accounts only upon Commission request and not on a daily

    basis.

    (3) Customer Initial Margin Requirements--Sec. 39.13(g)(8)(ii)

    Proposed Sec. 39.13(g)(8)(ii) would require a DCO to require its

    clearing members to collect customer initial margin \139\ from their

    customers for non-hedge positions at a level that is greater than 100

    percent of the DCO's initial margin requirements \140\ with respect to

    each product and swap portfolio. Proposed Sec. 39.13(g)(8)(ii) would

    permit a DCO to have reasonable discretion in determining the

    percentage by which customer initial margins would have to exceed the

    DCO's initial margin requirements with respect to particular products

    or swap portfolios. However, under the proposed regulation, the

    Commission could review such percentage levels and require different

    percentage levels if the Commission deemed the levels insufficient to

    protect the financial integrity of the clearing members or the DCO in

    accordance with Core Principle D.\141\

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

    \139\ The term ``customer initial margin'' is now defined in

    Sec. 1.3(kkk), adopted herein.

    \140\ A DCO's initial margin requirements are also referred to

    herein as ``clearing initial margin'' requirements. ``Clearing

    initial margin'' is defined as ``initial margin posted by a clearing

    member with a [DCO]'' in Sec. 1.3(jjj), adopted herein.

    \141\ Section 5b(c)(2)(D)(iii) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(D)(iii).

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

    OCC stated its view that exchanges, which have historically set

    customer level margin requirements, should continue to do so, rather

    than DCOs, noting that clearing organizations would ordinarily have no

    means to enforce customer level margin requirements.

    KCC stated that it generally supports the concept that clearing

    members should collect customer initial margin at a level above that of

    DCO initial margin, but requested that the Commission clarify the

    circumstances in which it may deem the ratio of customer initial margin

    to DCO initial margin insufficient to protect the DCO. Although the

    FHLBanks opposed the proposal, they recommended that if the Commission

    were to adopt it, the Commission should provide additional guidance

    and/or establish criteria for DCOs with respect to setting the required

    amount of excess margin. MGEX noted that although it currently

    maintains a 130 percent requirement, this is a decision that should be

    left to each DCO and its clearing members to determine. Because the

    circumstances for each DCO or the nature of its clearing members vary,

    it would be difficult to provide the general clarification or criteria

    that KCC and the FHLBanks are seeking, because such a determination

    would need to be made on a case-by-case basis.

    MFA argued that a requirement that a DCO must require its clearing

    members to collect customer initial margin at a level that is greater

    than the DCO's initial margin requirements would be inappropriate

    because DCOs do not have information about individual customers'

    creditworthiness and such a requirement would impair market liquidity

    by limiting the trading activity of certain market participants,

    resulting in greater market concentration. Citadel and the FHLBanks

    made similar comments.

    ICE stated that FCMs are best able to determine how much to charge

    above the initial margin requirement because they have complete

    visibility into their customers' positions, and the Commission should

    not place this requirement on a DCO, but should address this with FCMs

    through another set of rules. FIA opposed the proposed rule stating

    that the amount of excess margin, if any, that an FCM may require from

    its customers is a credit decision that should be made by each FCM

    based on its analysis of the creditworthiness of the particular

    customer, including the nature of the customer's trading activity and

    its record of meeting margin calls.

    Currently DCMs require their FCM members to impose customer initial

    margin requirements that are a specified percentage higher than the

    DCO's initial margin requirements, generally in the neighborhood of 125

    percent to 140 percent, as determined by the DCM. DCMs generally permit

    FCM members to impose customer initial margin requirements for hedge

    positions that are equal to the applicable maintenance margin

    requirements (which are generally the same as the applicable clearing

    initial margin requirements). This rule simply shifts the

    responsibility for establishing customer initial margin requirements

    from DCMs to DCOs.

    DCOs have greater expertise in risk management and a direct

    financial stake in whether their clearing members' customers, and

    consequently their clearing members, are able to meet their margin

    obligations. Moreover, it is anticipated that some DCOs will clear

    fungible swaps that may be listed on multiple SEFs. SEFs may or may not

    [[Page 69378]]

    impose customer initial margin requirements on their members for

    cleared swaps. Requirements set by DCOs may be less susceptible to

    pressure to being lowered for competitive reasons. Finally, DCOs will

    be the only self-regulatory organizations that will be in a position to

    set customer initial margin requirements for swaps that are executed

    bilaterally, and voluntarily cleared. Moreover, DCOs will have the

    opportunity to review whether their clearing members are collecting

    customer initial margin, as required by the DCO, during their reviews

    of the risk management policies, procedures, and practices of their

    clearing members, pursuant to Sec. 39.13(h)(5).\142\

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

    \142\ See discussion of Sec. 39.13(h)(5), adopted herein, in

    section IV.D.7.e, below.

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

    Section 39.13(g)(8)(ii) permits a DCO to exercise its discretion in

    determining the appropriate percentage by which the customer initial

    margin for a particular product or swap portfolio should exceed the

    clearing initial margin,\143\ as DCMs do today with respect to futures

    and options. This percentage should be based on the nature and

    volatility patterns of the particular product or swap portfolio, and

    the DCO's related evaluation of the potential risks posed by customers

    in general to their clearing members and, in turn, the potential risks

    posed by such clearing members in general to the DCO, rather than the

    creditworthiness of particular customers. Consequently, a DCO will

    retain the flexibility to establish an appropriate percentage for

    customer initial margin that applies to each product that it clears,

    which will apply to all of its clearing FCMs and all of their

    customers. However, as is also the case today, such clearing FCMs would

    remain free to exercise their discretion to determine whether they will

    collect additional margin over and above that amount either from all of

    their customers, or from particular customers based on such customers'

    risk profiles.\144\

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

    \143\ OCC commented that its STANS margin system calculates

    margin based on all positions in an account and not on a position-

    by-position basis; therefore it would not be able to furnish

    clearing members with a number representing the initial margin on a

    particular position without conducting subaccounting for each

    customer. OCC also noted that since STANS requirements are data-

    driven on a month-to-month, and even a day-to-day, basis they can

    vary in ways that cannot be readily predicted. The Commission is

    adopting Sec. 39.13(g)(8)(i) herein, which requires a DCO to

    collect initial margin on a gross basis for its clearing members'

    customer accounts. Therefore, a clearing member (or the DCO) will be

    required to determine the initial margin that must be posted with

    the DCO with respect to each customer's positions. Even if that

    amount changes from day to day as a result of the application of a

    portfolio-based margin system, a DCO could require that its clearing

    members collect customer initial margin in an amount that is a given

    percentage in excess of 100 percent of the daily clearing initial

    margin requirement with respect to each customer.

    \144\ See, e.g., CME Rule 8G930.E (``IRS Clearing members may

    call for additional performance bond at their discretion.'')

    (available at http://www.cmegroup.com/rulebook/CME/I/8G/) and

    International Derivatives Clearinghouse, LLC Rule 614(g) (``A

    Clearing Member may call, at any time, for [margin] above and beyond

    the minimums required by the Clearinghouse.'') (available at http://www.idch.com/pdfs/idch/20100901rulebook.pdf).

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

    The Commission continues to believe that requiring a DCO to require

    its clearing members to collect customer initial margin in a percentage

    higher than 100 percent of the clearing initial margin, for non-hedge

    positions, provides a valuable cushion of readily available customer

    margin. Citadel stated that the market's extensive experience in a

    range of cleared markets demonstrates preparedness for the regular

    exchange of margin between clearing members and their customers for

    cleared OTC derivatives, even where margin calls occur more frequently

    than once daily, and that frequent exchange of margin is also current

    market practice for uncleared trades. However, the maintenance of such

    a cushion would enable clearing members to deposit additional margin

    with a DCO on behalf of their customers, as necessitated by adverse

    market movements, without the need for the clearing members to make

    such frequent margin calls to their customers. In addition, many

    clearing members choose to deposit excess margin with their DCOs to

    provide their own cushion, which may in some instances obviate the need

    to transfer funds to the DCO on a daily basis in order to meet

    variation margin requirements.

    ISDA, FIA, and the FHLBanks commented that if the Commission were

    to adopt proposed Sec. 39.13(g)(8)(ii), it should clarify the meaning

    of ``non-hedge positions.'' The FHLBanks also stated that the

    Commission should provide guidance regarding how the determination as

    to whether a position is a hedge or a non-hedge position would be made,

    whether by the DCO, the clearing member, or the customer, and expressed

    the belief that a clearing member's customers should be responsible for

    determining and certifying, to their clearing members or DCOs, whether

    their swap positions are ``hedge'' or ``non-hedge'' positions.

    Several commenters have argued that there is no basis for

    distinguishing between hedge positions and non-hedge positions in

    determining whether such positions should be subject to customer

    initial margin requirements in excess of clearing initial margin

    requirements.\145\ LCH stated that it does not believe that a DCO or a

    clearing member should distinguish in any way between a customer's

    hedge and non-hedge positions because: (1) if the two parts of the

    hedge are carried by the same clearing member within the same DCO, such

    hedges would in any event implicitly be recognized by the DCO's risk

    calculations and the provision would be unnecessary; and (2) if one or

    the other leg of the hedge is uncleared, or is carried by a different

    clearing member, or by the same or another clearing member at another

    DCO, no recognition of the offsetting hedge should be allowed either by

    the DCO(s) or by the clearing member(s), as neither party would have

    the economic benefit of the hedged transaction. The Commission notes

    that the categorization of a position as a hedge for purposes of this

    regulation does not affect the margin collected by the DCO; it only

    affects the additional increment that the clearing member collects from

    its customer.

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

    \145\ MFA stated that it would be highly burdensome to

    distinguish between hedge and non-hedge positions for purposes of

    the application of differentiated margining, especially in a

    portfolio margining context. As noted in n. 143, above, a DCO that

    uses a portfolio-based margin model could require that its clearing

    members collect customer initial margin in an amount that is a given

    percentage in excess of 100 percent of the daily clearing initial

    margin requirement with respect to each customer. If all of a

    particular customer's positions were hedge positions, the DCO could

    permit the clearing member to collect customer initial margin in an

    amount that equals the amount of clearing initial margin with

    respect to that customer's positions. It is only in those

    circumstances where a hedger may also engage in speculative trading

    that it may be difficult to distinguish between positions for

    purposes of the application of differentiated margining in a

    portfolio margining context.

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

    Freddie Mac indicated that the Commission should consider

    eliminating the proposed requirement for increased customer initial

    margin for ``non-hedge positions,'' noting that customers with non-

    hedge positions are not inherently riskier or more likely to miss

    margin calls than customers with ``hedge positions.''

    As previously noted, DCMs have historically drawn a distinction

    between hedge positions and non-hedge positions in setting customer

    initial margin requirements, and the Commission believes that it is

    reasonable to assume that hedgers may present less risk than

    speculators, in that losses on their derivatives positions should be

    offset by gains on the positions whose risks they are hedging. The

    relevant consideration is the relative risks posed by hedgers versus

    non-hedgers, rather than the

    [[Page 69379]]

    creditworthiness of particular customers.

    Freddie Mac recommended that, if the Commission does not eliminate

    the distinction between hedge and non-hedge positions, the Commission

    should clarify that, for purposes of Sec. 39.13(g)(8)(ii): (1) ``hedge

    positions'' would include all swaps that hedge or mitigate any form of

    a customer's business risks; (2) such swaps may qualify as ``hedge

    positions'' regardless of whether they qualify as ``bona fide hedging

    transactions'' under the CEA and Sec. 1.3(z) or qualify as hedges

    under applicable accounting standards; and (3) such swaps may qualify

    as ``hedge positions'' regardless of the nature of the entity that

    holds such positions (e.g., whether it is a financial entity or a non-

    financial entity). Freddie Mac indicated that such treatment would be

    consistent with Commission proposals for defining hedging for purposes

    of other Dodd-Frank Act rules, including the definition of a ``major-

    swap participant'' \146\ and rules relating to the availability of the

    end-user exception to mandatory clearing.\147\

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

    \146\ See 75 FR 80174 (Dec. 21, 2010) (Further Definition of

    ``Swap Dealer,'' ``Security-Based Swap Dealer,'' ``Major Swap

    Participant,'' ``Major Security-Based Swap Participant'' and

    ``Eligible Contract Participant'').

    \147\ See 75 FR 80747 (Dec. 23, 2010) (End-User Exception to

    Mandatory Clearing).

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

    The Commission intends to interpret ``hedge positions,'' for

    purposes of Sec. 39.13(g)(8)(ii), as referring to those that meet

    either the definition set forth in Sec. 1.3(z), or the definition set

    forth in Sec. 1.3(ttt), when, and in the form in which, it is

    ultimately adopted.\148\ The Commission also believes that, as is

    currently the practice, it would be the customer's responsibility to

    identify its positions as hedge positions to its clearing FCM.

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

    \148\ The Commission has proposed a definition of ``hedging or

    mitigating commercial risk,'' to be codified at Sec. 1.3(ttt), for

    the purposes of the definition of ``Major Swap Participant,'' 75 FR

    at 80214-80215 (Further Definition of ``Swap Dealer,'' ``Security-

    Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-

    Based Swap Participant'' and ``Eligible Contract Participant'').

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

    The Commission is adopting Sec. 39.13(g)(8)(ii) as proposed.

    (4) Withdrawal of Customer Initial Margin--Sec. 39.13(g)(8)(iii)

    Proposed Sec. 39.13(g)(8)(iii) would require a DCO to require its

    clearing members to prohibit their customers from withdrawing funds

    from their accounts with such clearing members unless the net

    liquidating value plus the margin deposits remaining in the customer's

    account after the withdrawal would be sufficient to meet the customer

    initial margin requirements with respect to the products or swap

    portfolios in the customer's account, which were cleared by the DCO.

    LCH agreed with the underlying requirement, but stated that it

    should be imposed in rules that directly apply to clearing members

    rather than in rules applicable to DCOs. KCC also supported the concept

    but noted that DCM rules already require customers to maintain minimum

    margin levels and that these restrictions are generally tested by a

    clearing member's risk department and the clearing member's self-

    regulatory organization during examinations. KCC further noted that

    DCOs do not have full access to information regarding each customer's

    financial condition. MGEX took the position that the Commission \149\

    or a clearing member's designated self-regulatory organization (DSRO)

    should monitor compliance with such a requirement rather than the DCO,

    indicating that it would not be economically feasible for the DCO to do

    so.

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

    \149\ The Commission does not believe that it would be practical

    for the Commission to review each clearing member of each DCO to

    determine whether the clearing member is prohibiting its customers

    from making impermissible withdrawals from their accounts.

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

    As noted in the notice of proposed rulemaking, the requirement

    stated in Sec. 39.13(g)(8)(iii) is consistent with the definition of

    ``Margin Funds Available for Disbursement'' in the Margins Handbook

    prepared by the JAC.\150\ Therefore, DSROs currently review FCMs to

    determine whether they are appropriately prohibiting their customers

    from withdrawing funds from their futures accounts unless the net

    liquidating value plus the margin deposits remaining in such customers'

    accounts after the withdrawal would be sufficient to meet the customer

    initial margin requirements with respect to such accounts. However, it

    is unclear to what extent this requirement would apply to cleared swaps

    accounts when such swaps are executed on a DCM which participates in

    the JAC. Moreover, clearing members which only clear swaps that are

    executed on a SEF will not be subject to the requirements set forth in

    the Margins Handbook or subject to review by a DSRO.

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

    \150\ See http://www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf, at 45.

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

    The Commission anticipates that, at a minimum, DCOs will be able to

    review whether their clearing members are ensuring that customers do

    not make withdrawals from their accounts unless the specified

    conditions are met, when they conduct reviews of their clearing

    members' risk management policies, procedures, and practices pursuant

    to Sec. 39.13(h)(5).\151\

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

    \151\ See discussion of Sec. 39.13(h)(5), adopted herein, in

    section IV.D.7.e, below.

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

    The Commission is adopting Sec. 39.13(g)(8)(iii) as proposed.

    i. Time Deadlines--Sec. 39.13(g)(9)

    Proposed Sec. 39.13(g)(9) would require a DCO to establish and

    enforce time deadlines for initial and variation margin payments.

    LCH submitted a comment letter indicating that it agrees with the

    proposal, but stated that it should apply only to a DCO's clearing

    members since a DCO has no direct relationship with clients of its

    clearing members. Consistent with its original intent, the Commission

    is adopting Sec. 39.13(g)(9) with a modification to make it clear that

    it only applies to time deadlines for initial and variation margin

    payments to a DCO by its clearing members.

    7. Other Risk Control Mechanisms

    a. Risk Limits--Sec. 39.13(h)(1)(i)

    Proposed Sec. 39.13(h)(1)(i) would require a DCO to impose risk

    limits on each clearing member, by customer origin and house origin, in

    order to prevent a clearing member from carrying positions where the

    risk exposure of those positions exceeds a threshold set by the DCO

    relative to the clearing member's financial resources, the DCO's

    financial resources, or both. The Commission believes that an FCM

    engages in excess risk-taking if it, or its customers, take on

    positions that require financial resources that exceed this threshold.

    The DCO would have reasonable discretion in determining: (1) the method

    of computing risk exposure; (2) the applicable threshold(s); and (3)

    the applicable financial resources, provided however, that the ratio of

    exposure to capital would have to remain the same across all capital

    levels. For example, if a DCO set limits under which margin could not

    exceed 200 percent of capital, the limit for a $100 million clearing

    member would be $200 million and the limit for a $200 million clearing

    member would be $400 million. The Commission could review any of these

    determinations and require different methods, thresholds, or financial

    resources, as appropriate.

    Proposed Sec. 39.13(h)(1)(ii) would allow a DCO to permit a

    clearing member to exceed the threshold(s) applied pursuant to

    paragraph (h)(1)(i) provided that the DCO required the clearing member

    to post additional initial margin that the DCO deemed sufficient to

    appropriately eliminate excessive risk

    [[Page 69380]]

    exposure at the clearing member. The Commission could review the amount

    of additional initial margin and require a different amount, as

    appropriate.

    J.P. Morgan and Alice Corporation supported the proposal to require

    DCOs to establish risk-based position limits for their clearing

    members. J.P. Morgan indicated that in setting such position limits

    applicable to any one clearing member, a DCO should consider its

    overall exposure to clearing members in the aggregate. The Commission

    agrees that this would be prudent and expects that DCOs would take into

    consideration the aggregate exposure in establishing individual levels.

    J.P. Morgan further took the position that DCOs should monitor

    exposures against these limits on a real time basis. As discussed in

    section IV.D.4, above, Sec. 39.13(e)(2) requires a DCO to monitor its

    credit exposure to each clearing member periodically during each

    business day.

    FIA stated that it generally agrees with the proposed requirement

    that ``the ratio of exposure to capital must remain the same across all

    capital levels'' but indicated that the rule should make clear that, in

    computing the ratio of exposure to capital, a clearing member's capital

    should be calculated net of all risk exposures and potential assessment

    obligations at other clearing organizations of which it is a clearing

    member. The Commission agrees that it would be appropriate for a DCO to

    consider a clearing member's exposures to other clearing organizations,

    to the extent that it is able to obtain such information, in

    determining a clearing member's applicable financial resources for the

    purpose of setting appropriate risk limits.

    CME argued that a requirement that DCOs impose risk limits for

    every clearing member would be overly prescriptive and unnecessary,

    provided that a DCO collects adequate margin, its stress-test results

    regarding the clearing member's exposures are acceptable, and it

    employs concentration margining (whereby the DCO would set a level of

    risk at which it would begin to charge higher margins based on

    indicative stress-test levels). In other words, CME suggested that risk

    limits may be unnecessary if a DCO sets a level of risk at which it

    would begin to charge higher margins based on stress test results with

    respect to a clearing member. However, Sec. 39.13(h)(1)(ii) would

    allow a DCO to permit a clearing member to exceed an established risk

    limit provided that the DCO required the clearing member to post

    additional margin. Although CME's proposed approach is worded slightly

    differently, the effect would be the same as that of Sec.

    39.13(h)(1)(ii), i.e., a clearing member could only exceed a defined

    risk level if it posted additional margin.

    MGEX indicated that the proposed rule requiring DCOs to impose risk

    limits on each clearing member might not be practical, adding

    additional cost with little benefit, noting that DCOs currently address

    credit and default risk via margins and security deposits on a daily

    basis and conduct risk reviews. Rather, according to MGEX, a DCO should

    be looking for risk signs and focusing on those that are most relevant.

    The Commission believes that the establishment of risk limits for

    clearing members would impose little additional cost on DCOs since DCOs

    are already required to monitor their clearing members' capital levels

    and their own financial resources, as well as the trading activity of

    their clearing members. On the other hand, the Commission believes that

    the establishment of such risk limits would add significant risk

    management benefits to the benefits already conferred by margins,

    security deposits, and reviews of clearing members' risk management

    policies and procedures.

    The Commission is adopting Sec. 39.13(h)(i) as proposed, except

    for a technical revision that replaces the phrase ``by customer orgin

    and house origin'' with ``by house origin and by each customer

    origin,'' which conforms the language with other provisions of part 39.

    OCC requested that the Commission clarify that proposed Sec.

    39.13(h)(i) would not apply to securities accounts of broker-dealers

    that are not FCMs and do no futures business. The Commission does not

    intend for Sec. 39.13(h)(i) to apply to such accounts. The Commission

    is also adopting Sec. 39.13(h)(ii) as proposed.

    b. Large Trader Reports--Sec. 39.13(h)(2)

    Proposed Sec. 39.13(h)(2) would require a DCO to obtain from its

    clearing members, copies of all reports that such clearing members are

    required to file with the Commission pursuant to part 17 of the

    Commission's regulations, i.e., large trader reports. Large trader

    reports are necessary for stress testing to ensure that FCMs and their

    customers have not taken on too much risk. A DCO would be required to

    obtain such reports directly from the relevant reporting market if the

    reporting market exclusively listed self-cleared contracts, and would

    therefore be required to file such reports on behalf of clearing

    members pursuant to Sec. 17.00(i).

    Proposed Sec. 39.13(h)(2) would further require a DCO to review

    the large trader reports that it receives from its clearing members, or

    reporting markets, as applicable, on a daily basis to ascertain the

    risk of the overall portfolio of each large trader. A DCO would be

    required to review positions for each large trader, across all clearing

    members carrying an account for the large trader. A DCO would also be

    required to take additional actions with respect to such clearing

    members in order to address any risks posed by a large trader, when

    appropriate. Such actions would include those actions specified in

    proposed Sec. 39.13(h)(6).\152\

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

    \152\ See discussion of Sec. 39.13(h)(6), adopted herein, in

    section IV.D.7.f, below.

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

    FIA supported the proposal to require DCOs to obtain copies of all

    large trader reports that are filed with the Commission. MGEX commented

    that the Commission should provide large trader reports to each DCO

    rather than imposing a requirement that would require clearing members

    to make redundant filings. KCC argued that the proposed requirement

    that DCOs obtain large trader reports from clearing members is

    duplicative because a DCO receives large trader information from the

    exchange.\153\

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

    \153\ KCC further noted that, in its case, the exchange in turn

    receives the relevant large trader reports from the Commission.

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

    MGEX recommended that the Commission perform the review of large

    trader reports itself or permit a clearing member's DSRO to perform

    such review instead of DCOs.

    NYPC recommended that the Commission not adopt proposed Sec.

    39.13(h)(2) because the Commission has expended considerable resources

    to modify its own internal programs and processes in order to glean

    potentially relevant financial and risk management information from the

    large trader data that it receives from clearing members and DCMs, and

    even if DCOs had comparable financial and human resources that they

    could deploy for such a purpose, the information that they would obtain

    would frequently be fragmented and inconclusive, given that--unlike the

    Commission--no single DCO will ever have access to information relating

    to the futures, option and swap positions that are cleared by other

    DCOs or to uncleared swaps. NYPC further argued that given the

    necessary technology builds, it would need more than three years to

    come into compliance with proposed Sec. Sec. 39.13(g)(8)(i) and

    39.13(h)(2).

    OCC indicated that it should be the role of a clearing member's

    DSRO to require that an FCM submit sufficient information to permit the

    DSRO to identify customer accounts that could potentially cause a

    clearing member to

    [[Page 69381]]

    default, and that if DCOs were required to perform all tasks required

    by the proposed rules alone, they would be required to build new

    surveillance systems and significantly increase their surveillance

    staff.

    In response to suggestions that the Commission should conduct the

    required review of large trader reports, the Commission notes that it

    does review large trader reports for financial, market, and risk

    surveillance purposes. However, the Commission believes that DCOs

    should also have an obligation to review large trader reports for those

    large traders whose trades they clear, for their own risk surveillance

    purposes, even though as noted by NYPC, they may not have access to

    information relating to positions cleared by other DCOs or to uncleared

    swaps. Moreover, Sec. 39.13(h)(2) requires a DCO to review such large

    trader reports with a view toward taking any necessary additional

    actions with respect to such large traders' clearing members in order

    to address risks posed by such large traders to the DCO.

    In addition, it would not be feasible for a clearing member's DSRO

    to review large trader reports. DSRO designations apply to FCMs that

    are members of multiple DCMs. Therefore, clearing members that only

    trade for their own accounts do not have a DSRO. Clearing members that

    solely clear SEF-executed trades also will not have DSROs. Moreover,

    risk management ultimately is the responsibility of each DCO. A DSRO

    would not be in a position to analyze the daily risk of the overall

    portfolio of each large trader at a particular DCO, nor to take any

    additional actions to address such risks at a particular DCO.

    KCC stated that it is the clearing member's obligation to determine

    the financial fitness of large trader customers, in that clearing

    members have better, more direct information regarding the credit

    quality of the customer and the exposures of the customer under

    positions the customer may hold outside the DCO. KCC stated its belief

    that imposing a duplicative requirement on DCOs would achieve little

    risk management benefit at a high cost. The Commission agrees that

    clearing members must determine the financial capacity of their

    customers and they may have information which a particular DCO may not

    have regarding positions that they may clear for their customers on

    other DCOs.\154\ However, this does not obviate the need for each

    relevant DCO to ascertain the risks that the large trader poses to that

    DCO based on the information which the DCO is able to obtain through

    large trader reports.

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

    \154\ The Commission is modifying the language in proposed Sec.

    39.13(h)(2), which would have referred to ``positions at all

    clearing members carrying accounts for each such large trader'' by

    revising it to read as follows: ``futures, options, and swaps

    cleared by the [DCO] which are held by all clearing members carrying

    accounts for each such large trader.'' This will make it clear that

    the Commission is not attempting to require a DCO to review a large

    trader's positions that were cleared by another DCO, as it would not

    typically have access to information about such positions. The

    technical change from ``positions'' to ``futures, options, and

    swaps'' conforms the language with other provisions of part 39.

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

    ISDA noted that while the expansion of oversight required by

    proposed Sec. Sec. 39.13(h)(2) and Sec. 39.13(h)(3) \155\ may provide

    benefits, many DCOs do not currently have the systems or infrastructure

    to monitor or assess non-clearing member risk.\156\

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

    \155\ See discussion of Sec. 39.13(h)(3), adopted herein, in

    section IV.D.7.c, below.

    \156\ ISDA also stated that further clarity regarding how the

    Commission intends to apply the large trader definition to swaps is

    needed. The Commission notes that it has begun this process by

    adopting final rules for Large Trader Reporting for Physical

    Commodity Swaps, in a new part 20, at 76 FR 43851 (July 22, 2011).

    Since these large trader reporting rules were adopted subsequent to

    the Commission's proposal of Sec. 39.13(h)(2), the Commission is

    modifying Sec. 39.13(h)(2) to refer to reports required to be filed

    with the Commission by, or on behalf of, clearing members pursuant

    to parts 17 and 20 of this chapter.

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

    In response to ISDA's comment, as well as other comments that in

    order to comply with Sec. 39.13(h)(2), DCOs would need technology

    builds (NYPC), new surveillance systems and additional surveillance

    staff (OCC), and that there would be a high cost (KCC), the Commission

    notes that some DCOs already receive and review large trader reports

    for risk surveillance purposes on a daily basis. In fact, KCC stated in

    its comment letter that ``KCC would also remind the Commission that DCO

    compliance staff review the reportable position files that they receive

    on a daily basis to ascertain large trader risks that [clearing

    members] face.'' In addition, at least five years ago, Commission staff

    began recommending that DCOs do so, if they had not already been doing

    so, in DCO reviews that Commission staff has conducted to determine

    whether such DCOs were in compliance with relevant core principles

    under the CEA.

    The Commission is modifying Sec. 39.13(h)(2) to require a DCO to

    obtain large trader reports either from its clearing members or from a

    DCM or a SEF for which it clears, which are required to be filed with

    the Commission by, or on behalf of, such clearing members. However, the

    Commission does not believe that it is practical or appropriate for a

    DCO to rely on the Commission to provide large trader reports to the

    DCO.

    The Commission is adopting Sec. 39.13(h)(2) with the modifications

    described above.

    c. Stress Tests--Sec. 39.13(h)(3)

    Proposed Sec. 39.13(h)(3) would require a DCO to conduct certain

    daily and weekly stress tests. The Commission has defined a ``stress

    test'' in Sec. 39.2, adopted herein, as ``a test that compares the

    impact of potential extreme price moves, changes in option volatility,

    and/or changes in other inputs that affect the value of a position, to

    the financial resources of a derivatives clearing organization,

    clearing member, or large trader, to determine the adequacy of such

    financial resources.'' \157\

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

    \157\ See further discussion of Sec. 39.2 in section III.B,

    above.

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

    Proposed Sec. 39.13(h)(3)(i) would require a DCO to conduct daily

    stress tests with respect to each large trader who poses significant

    risk to a clearing member or the DCO in the event of default, including

    positions at all clearing members carrying accounts for the large

    trader. The DCO would have reasonable discretion in determining which

    traders to test and the methodology used to conduct the stress tests.

    However, the Commission could review the selection of accounts and the

    methodology and require changes, as appropriate.

    Proposed Sec. 39.13(h)(3)(ii) would require a DCO to conduct

    stress tests at least once a week with respect to each account held by

    a clearing member at the DCO, by customer origin and house origin, and

    each swap portfolio, by beneficial owner, under extreme but plausible

    market conditions. The DCO would have reasonable discretion in

    determining the methodology used to conduct the stress tests. However,

    the Commission could review the methodology and require any appropriate

    changes. The Commission requested comment regarding whether all

    clearing member accounts, by origin, and all swap portfolios should be

    subject to such stress tests on a weekly basis or whether some other

    time period, such as monthly, would be sufficient to meet prudent risk

    management standards.

    Several commenters addressed daily stress testing. FIA recommended

    that all of the proposed stress tests should be conducted on a daily

    basis. LCH stated its belief that stress testing requirements should

    not be extended to cover large traders that are clients of clearing

    [[Page 69382]]

    members but that the proposed weekly stress tests should be conducted

    daily. OCC stated that it did not see a sufficient benefit to justify

    the increased DCO resources that would be required to undertake daily

    stress tests on each large trader,\158\ noting that the costs would be

    passed on to clearing members and their customers. MGEX indicated that

    a requirement for daily stress testing of large traders seems excessive

    since the data may be dated even after one day and may not be more

    relevant than doing an average stress test over a weekly or monthly

    period. MGEX also expressed the view that the value of stress testing

    large traders is diminished if they have accounts with different

    clearing members.

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

    \158\ As noted above, proposed Sec. 39.13(h)(3)(i) would not

    require daily stress tests on each large trader, but only with

    respect to those large traders who pose significant risk to a

    clearing member or the DCO in the event of default.

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

    As stated above, proposed Sec. 39.13(h)(3)(i) would require a DCO

    to include positions at all clearing members carrying accounts for the

    large trader in the required stress tests. The Commission is making the

    same change to Sec. 39.13(h)(3)(i) that it is making to Sec.

    39.13(h)(2) by replacing the reference to ``positions at all clearing

    members carrying accounts for each such large trader'' with ``futures,

    options, and swaps cleared by the derivatives clearing organization,

    which are held by all clearing members carrying accounts for each such

    large trader.''

    KCC stated its belief that the frequency of stress testing should

    be left to the discretion of the DCO and should be risk-based in light

    of prevailing market conditions. NOCC indicated that products,

    customers or spread credits should reach a specified volume or risk

    exposure level before being required to be stress tested with the

    proposed frequencies so long as the DCO can demonstrate that it is

    meeting the core principle objectives underlying proposed Sec.

    39.13(f).\159\

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

    \159\ NOCC made a similar comment with respect to the frequency

    of back testing, which is discussed in section IV.D.6.g,, above. The

    Commission does not believe that it is appropriate to adopt a

    regulation establishing an exemption process with respect to stress

    testing requirements based on volume or risk exposure or otherwise.

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

    The Commission believes that it is appropriate to specify the

    minimum frequency of stress tests as set forth in Sec. 39.13(h)(3). As

    noted above, several commenters supported certain daily stress testing

    requirements. With the exception of KCC's and NOCC's comments, no

    commenters suggested that stress tests should be conducted less

    frequently than weekly.

    LCH recommended that the Commission prescribe that the stress

    scenarios used by the DCO in its testing should be adapted for current

    market conditions such that price or market shifts should not be

    translated literally, but rather proportionally. The Commission

    believes that Sec. 39.13(h)(3) should explicitly permit DCOs to

    exercise reasonable discretion in determining the methodology to be

    used in conducting the required stress tests. The Commission would

    recognize the approach suggested by LCH to be an appropriate element of

    a DCO's stress testing methodology, but does not believe that it is

    necessary to adopt such a prescriptive requirement.

    OCC indicated that for regulatory reasons associated with OCC's

    status as a dual SEC/Commission registrant, OCC's system does not

    consolidate all positions into a single ``customer origin'' and ``house

    origin'' for each clearing member, but rather permits multiple account

    types, including a firm (proprietary) account that incorporates both

    securities and futures positions, a securities customers' account, a

    regular futures customer segregated funds account subject to Section 4d

    of the CEA, separate segregated funds accounts for cross-margining

    arrangements as provided in various Commission orders approving such

    arrangements, and others. OCC further stated that because of the

    mathematical properties of the risk measures that it uses, its

    unconsolidated account level stress testing is more rigorous than if

    such stress testing were conducted at the level of each origin as a

    whole and argued that it makes sense to aggregate positions for stress

    testing in the same manner as they would be aggregated or netted for

    liquidation purposes. Therefore, OCC requested that the Commission

    clarify that this method of stress testing at the unconsolidated

    account level based on appropriate historical data would meet the

    requirements of proposed Sec. 39.13(h)(3)(ii). The Commission agrees

    with OCC that it would be appropriate for a DCO to conduct the stress

    tests required by Sec. 39.13(h)(3)(ii) with respect to separate house

    origin and customer origin accounts such as the house account that

    incorporates both securities and futures positions identified by

    OCC,\160\ separate customer accounts subject to Sections 4d(a) and

    4d(f) of the CEA, respectively, or cross-margining accounts.

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

    \160\ A DCO that is dually-registered as a securities clearing

    agency would not be subject to the stress testing requirements of

    Sec. 39.13(h)(3)(ii) with respect to an account that only contains

    securities positions. However, such a DCO would be subject to the

    requirements of Sec. 39.13(h)(3)(ii) with respect to any relevant

    account that contains positions in instruments regulated by the

    Commission, even if that account also contains securities positions.

    In this regard, the Commission is revising Sec. 39.13(h)(3)(ii) to

    refer to ``each clearing member account, by house origin and by each

    customer origin, and each swap portfolio, including any portfolio

    containing futures and/or options and held in a commingled account

    pursuant to Sec. 39.15(b)(2) of this part, * * *''

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

    OCC also argued that while the requirement of conducting stress

    tests under ``extreme but plausible'' market conditions may be

    appropriate for determining the adequacy of a clearing organization's

    resources for withstanding the default of its largest participant, it

    would be inappropriate for measuring the adequacy of an individual

    clearing member's margin deposits. In particular, OCC expressed its

    belief that stress testing the positions, including margin assets, in

    clearing member accounts on a daily basis to ensure a positive

    liquidating value at more than a 99 percent confidence level is

    adequate and appropriate and that DCOs should have the ability to cover

    for more extreme market conditions through the use of additional

    financial resources, including clearing fund deposits.

    A stress test, as defined by the Commission, is not designed to

    measure the adequacy of a clearing member's margin deposits or to

    ensure that margin assets in clearing members' accounts meet a 99

    percent confidence level. Rather, these are the functions of the daily

    review and back testing required by Sec. Sec. 39.13(g)(6) and (g)(7),

    adopted herein.\161\ Stress tests address the adequacy of the

    applicable financial resources to cover losses resulting from potential

    extreme price moves, changes in option volatility, and/or changes in

    other inputs that affect the value of a position. In other words, if

    margin deposits would be sufficient to cover losses 99 percent of the

    time, stress tests would determine whether other financial resources

    would be available and sufficient to cover losses the remaining 1

    percent of the time. Such other financial resources could include the

    capital of the clearing member or the DCO, or a DCO's guaranty fund.

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

    \161\ See discussion of Sec. Sec. 39.13(g)(6) and (g)(7) in

    section IV.D.6.g, above.

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

    The Commission is adopting Sec. 39.13(h)(3) with the modifications

    described above.

    d. Portfolio Compression--Sec. 39.13(h)(4)

    Proposed Sec. 39.13(h)(4)(i) would require a DCO to offer

    multilateral portfolio compression exercises, on a regular basis, for

    its clearing members that clear swaps, to the extent that such

    [[Page 69383]]

    exercises are appropriate for those swaps that it clears. The

    Commission requested comment regarding whether such exercises should be

    offered monthly, quarterly, or on another frequency. In addition, the

    Commission requested comment regarding whether the frequency of such

    exercises should vary for different categories of swaps.

    Proposed Sec. 39.13(h)(4)(ii) would mandate that a DCO require its

    clearing members to participate in all multilateral portfolio

    compression exercises offered by the DCO, to the extent that any swap

    in the applicable portfolio was eligible for inclusion in the exercise,

    unless including the swap would be reasonably likely to significantly

    increase the risk exposure of the clearing member.

    Proposed Sec. 39.13(h)(4)(iii) would permit a DCO to allow

    clearing members participating in such exercises to set risk tolerance

    limits for their portfolios, provided that the clearing members could

    not set such risk tolerances at an unreasonable level or use such risk

    tolerances to evade the requirements of proposed Sec. 39.13(h)(4).

    CME commended the Commission for recognizing the importance of

    portfolio compression exercises as an important risk management tool.

    CME further suggested that the Commission refrain from prescribing the

    frequency of such exercises, stating its belief that each DCO is best

    positioned to determine the optimal frequency of portfolio compression

    exercises for the swaps that it clears, based on the unique

    characteristics of the particular products and markets. On the other

    hand, the FHLBanks stated that the Commission should specify how often

    portfolio compression exercises are to take place. The Commission

    agrees with CME and is retaining the language that simply refers to ``a

    regular basis.''

    ISDA requested that the Commission clarify the meaning of

    ``multilateral portfolio compression'' in these proposals. ISDA stated

    that if the Commission is referring to position netting, then it agrees

    that a DCO must offer such exercises. However, ISDA indicated that if

    it refers to the provision of multilateral portfolio compression

    services such as those currently provided by entities such as

    TriOptima, DCOs should not be required to build such duplicative

    services, which would be likely to delay their roll-out of

    comprehensive clearing services. The Commission agrees that a DCO

    should not be required to incur the expense of building its own

    multilateral compression services. Therefore, the Commission is

    modifying the requirement to make it clear that although a DCO may

    develop its own portfolio compression services if it chooses, it is

    only required to make such exercises available to its clearing members

    if applicable portfolio compression services have been developed by a

    third party for those swaps that it clears.\162\

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

    \162\ This also addresses the FHLBanks' comment that the

    Commission should specify what types of swaps are to be included in

    portfolio compression exercises.

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

    The FHLBanks urged the Commission to further define ``reasonably

    likely to increase risk exposure to a clearing member'' to include the

    risk exposures of a clearing member's customers, and also stated their

    view that a clearing member's customers must have the ability to ``opt-

    out'' of portfolio compression requirements to the extent that those

    customers' swap positions need to be retained for hedge accounting and

    other business purposes. In particular, the FHLBanks expressed their

    concern that the proposal's ambiguities would cause the internal risk

    management strategies of entities that are not swap dealers or major

    swap participants to be adversely affected, noting that portfolio

    compression could potentially jeopardize hedge accounting treatment for

    customers' swap transactions and disrupt anticipated cash flows.

    LCH stated that it strongly supports the use of compression

    services and believes that they should be encouraged by the Commission

    to the greatest extent possible, but it would not necessarily always be

    appropriate for a DCO to require its clearing members to participate in

    all such exercises. First, LCH noted that a DCO's clearing members may

    not always be subject to the Commission's supervision and may not be

    required to engage in such compression activities; therefore imposing

    such a requirement on the DCO may discourage such firms from becoming

    clearing members of that DCO and thereby have the perverse effect of

    discouraging such firms from clearing. Second, LCH stated that a

    clearing member may have legitimate reasons for not participating in

    such compression exercises at all times, or for not submitting all

    eligible swaps to such exercises. Therefore, LCH took the position that

    the use of compression services should be encouraged but should not be

    compulsory, and suggested that the Commission eliminate Sec. 39.13

    (h)(4)(ii) in its entirety. For the reasons stated by LCH and the

    FHLBanks, the Commission is modifying Sec. 39.13(h)(4) to provide that

    participation in compression exercises by clearing members and their

    customers would be voluntary.

    e. Clearing Members' Risk Management Policies and Procedures--Sec.

    39.13(h)(5)

    Proposed Sec. 39.13(h)(5) would impose several requirements upon

    DCOs relating to their clearing members' risk management policies and

    procedures. Specifically, a DCO would be required to adopt rules that:

    (a) require its clearing members to maintain current written risk

    management policies and procedures (proposed Sec. 39.13(h)(5)(i)(A));

    (b) ensure that the DCO has the authority to request and obtain

    information and documents from its clearing members regarding their

    risk management policies, procedures, and practices, including, but not

    limited to, information and documents relating to the liquidity of

    their financial resources and their settlement procedures (proposed

    Sec. 39.13(h)(5)(i)(B)); and (c) require its clearing members to make

    information and documents regarding their risk management policies,

    procedures, and practices available to the Commission upon the

    Commission's request (proposed Sec. 39.13(h)(5)(i)(C)).

    In addition, proposed Sec. 39.13(h)(5)(ii) would require a DCO to

    review the risk management policies, procedures, and practices of each

    of its clearing members on a periodic basis and document such reviews.

    The Commission invited comment regarding whether it should require that

    a DCO must conduct risk reviews of its clearing members on an annual

    basis or within some other time frame. The Commission also requested

    comment regarding whether it should require that such reviews be

    conducted in a particular manner, e.g., whether there must be an on-

    site visit or whether any particular testing should be required. In

    addition, the Commission invited comment regarding whether, and to what

    extent, a DCO should be permitted to vary the method and depth of such

    reviews based upon the nature, risk profiles, or other regulatory

    supervision of particular clearing members.

    ISDA and FIA supported the proposed requirement in Sec.

    39.13(h)(5)(i)(A) that clearing members must have written risk

    management policies and procedures. FIA also recommended that clearing

    members should be required to have adequate staff and systems to

    monitor customer risk on a real-time or near-real time basis and to

    routinely test their risk management procedures under theoretical

    stress scenarios.

    NGX stated that the requirement that clearing members have and

    follow risk management policies is a sensible requirement in the

    context of the

    [[Page 69384]]

    typical, intermediated clearinghouse.However, NGX argued that such

    requirements should not apply to a non-intermediated DCO such as NGX,

    where clearing participants are commercial end users, trading and

    clearing for their own accounts, and none of the clearing participants

    are exposed to the default risk of any other clearing participant or to

    that of fellow customers of a clearing participant.

    The Commission believes that it is appropriate for a DCO to require

    all of its clearing members to maintain written risk management

    policies and procedures, regardless of whether such clearing members

    have customer business or are exclusively self-clearing. As noted

    above, the Commission believes that written policies are a crucial

    component of any risk management framework. Moreover, Sec.

    39.13(h)(5)(i)(A) does not specify the nature or extent of the required

    written risk management policies and procedures, which could vary as

    appropriate to a particular type of clearing member, subject to the

    requirements of any other applicable Commission regulations.\163\

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

    \163\ For example, in a separate rulemaking, proposed Sec.

    23.600 would set forth detailed requirements for the risk management

    programs of swap dealers and major swap participants, and would

    require such entities to maintain written procedures and policies

    describing their Risk Management Programs. See 75 FR 71397 (Nov. 23,

    2010) (Regulations Establishing and Governing the Duties of Swap

    Dealers and Major Swap Participants). Such swap dealers and major

    swap participants may or may not be clearing members.

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

    The Commission has not proposed and is not adopting the additional

    requirements suggested by FIA, described above, as part of this

    rulemaking. However, the Commission has proposed additional

    requirements with respect to clearing members' risk management policies

    and procedures in a separate rulemaking applicable directly to clearing

    members.\164\

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

    \164\ See 76 FR 45724 (Aug. 1, 2011) (Clearing Member Risk

    Management). In that rulemaking, the Commission has proposed to

    require FCMs, swap dealers, and major swap participants, each of

    which are clearing members, to adopt certain specified risk

    management procedures, including written procedures to comply with

    the proposed requirements.

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

    With respect to the proposed requirement in Sec. 39.13(h)(5)(i)(C)

    that a DCO must have rules requiring its clearing members to make

    information regarding their risk management policies, procedures, and

    practices available to the Commission, MGEX stated that the Commission

    should seek access to a clearing member's risk management policies and

    processes directly and a DCO should not act as an unnecessary conduit

    between the Commission and clearing members. The Commission notes that

    even if it were to propose a regulation to impose such a requirement

    directly on clearing members in the future, it does not preclude the

    Commission from requiring DCOs to impose this requirement on their

    clearing members at this time.\165\

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

    \165\ In another context, e.g., a DCM has adopted a rule that

    requires the operator of a DCM-approved delivery facility to '' * *

    * make such reports, keep such records and permit such facility

    visitation as the Exchange, the Commodity Futures Trading Commission

    or any other applicable government agency may require * * * .'' See

    CBOT Rule 703.A.

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

    LCH stated that it concurs with the provisions of proposed Sec.

    39.13(h)(5) but suggested that the Commission limit the requirements

    under proposed paragraph (h)(5)(C) so that they would be applicable

    only to those clearing members that are subject to the Commission's

    oversight and not to all clearing members of a DCO regardless of the

    jurisdiction in which they operate. The Commission notes that risk

    management practices of clearing members of registered DCOs, to the

    extent that such clearing members are clearing products subject to the

    Commission's oversight, are of importance to the Commission in its

    capacity as the regulator of the DCO. For purposes of risk management

    oversight, there is no basis for differentiating among clearing members

    because of their registration status or domicile. Although the

    Commission does not directly supervise non-registrants, the Commission

    has previously adopted rules that apply to clearing members, whether or

    not they are Commission registrants, e.g., Sec. Sec. 1.35(b) and (c)

    (recordkeeping requirements), and Part 17 of the Commission's

    regulations (reporting requirements). Section 39.13(h)(5)(C) is

    consistent with the Commission's approach with respect to such other

    rules, and is an appropriate component of the regulatory framework for

    DCO risk management.

    With regard to the proposed requirement in Sec. 39.13(h)(5)(ii)

    that a DCO must review the risk management policies, procedures, and

    practices of each of its clearing members on a periodic basis, FIA

    stated that all clearing members should be subject to on-site audits at

    least annually. NGX suggested that if the Commission requires non-

    intermediated DCOs to require their members to have written risk

    management policies, the Commission should provide guidance that a non-

    intermediated DCO would not be required to conduct on-site audits of

    clearing participants and that the DCO would meet its obligations to

    review the policies of such clearing participants if it does so only on

    a for-cause basis.

    The Commission is adopting Sec. 39.13(h)(5)(ii) as proposed,

    without prescribing the specific frequency, depth, or methodology of

    such reviews, and without specifying when an on-site audit may or may

    not be appropriate. The Commission believes that such a review is

    important to ensure that each clearing member's risk management

    framework is sufficient and properly implemented. The Commission also

    believes that a DCO should be permitted to exercise reasonable

    discretion with respect to each of these matters, based upon the

    nature, risk profiles, or other regulatory supervision of particular

    clearing members. The requirement that such reviews must be conducted

    on a ``periodic basis'' means that reviews must be conducted routinely

    and, therefore, the requirement would not permit a DCO to only conduct

    such reviews on a for-cause basis.

    A number of commenters noted that many clearing members are

    clearing members of multiple DCOs and thus could be subject to multiple

    duplicative risk reviews. CME, OCC, MGEX, ICE, and NYPC indicated that

    this would be burdensome for such clearing members. For example, MGEX

    noted ``the burden a clearing member may be faced with due to

    duplication of efforts and associated costs.'' KCC indicated that such

    duplicative reviews would achieve little with great expenditure of

    resources.

    OCC and NYPC also expressed their concerns about the costs to DCOs.

    In particular, OCC noted that requiring DCOs to conduct such reviews

    would impose a very high cost on a DCO that is not integrated with a

    DCM. NYPC noted its concern that the Commission may be underestimating

    the immensity of conducting such reviews in that a clearing member's

    risk management plan will not address solely the risks associated with

    clearing membership, but will be integrated and cover the broad

    spectrum of risks, including market, credit, liquidity, capital, and

    operational risk, that are associated with the entirety of the clearing

    member's securities, banking and futures business, much of which may

    have nothing to do with business through the DCO.

    In order to address NYPC's specific concern, the Commission is

    modifying Sec. 39.13(h)(5)(i)(A) to add the qualifier ``which address

    the risks that such clearing members may pose to the derivatives

    clearing organization'' after ``risk management policies and

    procedures'' and is adding the same qualifier in Sec. 39.13(h)(5)(ii)

    after ``risk

    [[Page 69385]]

    management policies, procedures, and practices of each of its clearing

    members.''

    To reduce the potential burden of duplicative risk reviews of

    clearing members that are clearing members of multiple DCOs, CME and

    NYPC urged the Commission to give each DCO reasonable discretion

    regarding the frequency, scope, or manner in which it conducts risk

    reviews of its clearing members, taking into account various factors

    including other regulatory supervision, or review by a governmental

    entity or self-regulatory organization, of particular firms. Other

    commenters variously suggested that risk reviews should be conducted by

    the Commission (OCC and MGEX), by the clearing member's DSRO or a

    similar DCO industry group (KCC, OCC, ICE, and MGEX), or by NFA (OCC).

    The Commission notes that the current DSRO system is not a viable

    option for reviewing clearing members' risk management policies,

    procedures and practices. Because DSROs are only responsible for

    conducting examinations of DCM-member FCMs' compliance with financial

    requirements, clearing members that only engage in house trading do not

    have a DSRO, nor will clearing members that solely clear SEF-executed

    trades. Moreover, such examinations do not address all of the risk

    issues which would concern a particular DCO. Furthermore, even if the

    current DSRO system were expanded to include DCOs, or a similar

    industry group composed of DCOs were formed, it would be impractical to

    allocate the responsibility to one DCO to analyze the risk management

    policies, procedures and practices of a common clearing member, on

    behalf of all relevant DCOs, when each DCO may impose different risk

    management requirements on its clearing members and each DCO may have

    differing margin methodologies that call for different risk management

    responses from clearing members.

    The Commission does not believe that it should assume the sole

    oversight of the risk management policies, procedures, and practices of

    clearing members of DCOs. The Commission conducts risk surveillance

    with respect to both DCOs and clearing members; however, this cannot

    replace a DCO's obligation to ensure that its clearing members are

    appropriately managing the risks that such clearing members pose to

    that particular DCO. Similarly, it does not appear that NFA would be an

    efficient alternative. The Commission recognizes that certain DCMs have

    entered into regulatory services agreements with NFA, and that NFA has

    thereby assumed certain audit responsibilities with respect to FCMs

    that are members of those DCMs. However, a DCO remains in the best

    position to review the risk management policies, procedures, and

    practices of its clearing members in the context of their obligations

    to that particular DCO.

    The Commission is adopting Sec. 39.13(h)(5) with the modifications

    described above.

    f. Additional Authority--Sec. 39.13(h)(6)

    Proposed Sec. 39.13(h)(6) would require a DCO to take additional

    actions with respect to particular clearing members, when appropriate,

    based on the application of objective and prudent risk management

    standards. Such actions could include, but would not be limited to: (i)

    Imposing enhanced capital requirements; (ii) imposing enhanced margin

    requirements; (iii) imposing position limits; (iv) prohibiting an

    increase in positions; (v) requiring a reduction of positions; (vi)

    liquidating or transferring positions; and (vii) suspending or revoking

    clearing membership.

    KCC stated that it generally supports the concept that DCOs should

    impose heightened risk management requirements on clearing members as

    their risk profiles change and requested that the Commission clarify

    whether each of the potential heightened risk management requirements

    enumerated in proposed Sec. 39.13(h)(6)(i)-(vii) must be explicitly

    delineated in DCO rules or in the DCO's clearing membership agreement.

    The Commission believes that a DCO must have the authority and ability

    to take appropriate additional actions with respect to particular

    clearing members, as described in Sec. 39.13(h)(6), but how the DCO

    asserts such authority, whether by rule or contractual agreement,

    should be left to the discretion of the DCO.

    J.P. Morgan expressed the view that higher margin multipliers

    should be adopted for members who present a higher risk profile as a

    result of excessive concentration of risk cleared, reduced

    creditworthiness, or other factors affecting a particular member, and

    that such margin multipliers should be documented in risk management

    policies applicable to all members.

    J.P. Morgan's concern that margin multipliers should be applied to

    clearing members with a higher risk profile, is addressed in Sec.

    39.13(h)(1), adopted herein and discussed in section IV.D.7.a, above,

    which requires a DCO to impose risk limits on each clearing member.

    The Commission is adopting Sec. 39.13(h)(6) as proposed.

    E. Core Principle E--Settlement Procedures--Sec. 39.14

    Core Principle E,\166\ as amended by the Dodd-Frank Act, requires a

    DCO to: (1) Complete money settlements on a timely basis, but not less

    frequently than once each business day; (2) employ money settlement

    arrangements to eliminate or strictly limit its exposure to settlement

    bank risks (including credit and liquidity risks from the use of banks

    to effect money settlements); (3) ensure that money settlements are

    final when effected; (4) maintain an accurate record of the flow of

    funds associated with money settlements; (5) possess the ability to

    comply with the terms and conditions of any permitted netting or offset

    arrangement with another clearing organization; (6) establish rules

    that clearly state each obligation of the DCO with respect to physical

    deliveries; and (7) ensure that it identifies and manages each risk

    arising from any of its obligations with respect to physical

    deliveries. The Commission proposed Sec. 39.14 to establish

    requirements that a DCO would have to meet in order to comply with Core

    Principle E.\167\

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

    \166\ Section 5b(c)(2)(E) of the CEA, 7 U.S.C. 7a-1(c)(2)(E)

    (Core Principle E).

    \167\ Without addressing any specific aspect of proposed Sec.

    39.14, LCH commented that it agrees with the Commission's proposals

    for settlement procedures.

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

    1. Definitions--Sec. 39.14(a)

    ``Settlement'' was defined in proposed Sec. 39.14(a)(1) to

    include: (i) Payment and receipt of variation margin for futures,

    options, and swap positions; (ii) payment and receipt of option

    premiums; (iii) deposit and withdrawal of initial margin for futures,

    options, and swap positions; (iv) all payments due in final settlement

    of futures, options, and swap positions on the final settlement date

    with respect to such positions; and (v) all other cash flows collected

    from or paid to each clearing member, including but not limited to,

    payments related to swaps such as coupon amounts. ``Settlement bank''

    was defined in proposed Sec. 39.14(a)(2) as ``a bank that maintains an

    account either for the [DCO] or for any of its clearing members, which

    is used for the purpose of transferring funds and receiving transfers

    of funds in connection with settlements with the [DCO].''

    ISDA and FIA commented that posting of variation margin on swaps

    should not be viewed as ``settling'' the present value of the trade and

    noted that price alignment interest would still be paid on variation

    margin. ISDA stated that, similarly, initial margin is not ``paid'' by

    a clearing member to a DCO

    [[Page 69386]]

    but is often posted with a security interest granted by the clearing

    member. FIA also commented that the deposit and withdrawal of initial

    margin is not properly defined as a settlement.

    NGX stated that, with the exception of a relatively small power

    contract, its clearing model does not require daily variation margin

    payments and collections from its clearing participants; rather, it

    holds collateral (initial margin) in an account at a depository bank

    rather than in a settlement account, and additional collateral may be

    called for as required. Therefore, NGX stated that it would be clearer

    when applied to the NGX model, to use the term ``payment and receipt''

    rather than the term ``deposit'' when referring to initial margin.

    The Commission proposed a broad definition of ``settlement'' in

    Sec. 39.14(a)(1) to encompass all cash flows between clearing members

    and a DCO. The Commission recognizes that accounts that are used for

    the payment and receipt of variation margin are frequently called

    settlement accounts, while accounts that are used for the deposit and

    withdrawal of initial margin may be called deposit accounts, or custody

    accounts, if the initial margin deposited therein is in the form of

    securities. The definition of ``settlement bank'' in Sec. 39.14(a)(2)

    was intended to encompass any bank that a DCO uses for settlements, as

    defined in Sec. 39.14(a)(1), whether the relevant accounts are called

    settlement accounts, deposit accounts, or custody accounts. In order to

    avoid confusion, the Commission is modifying Sec. 39.14(a)(2) to

    define a settlement bank simply as ``a bank that maintains an account

    either for the [DCO] or for any of its clearing members, which is used

    for the purpose of any settlement described in paragraph (a)(1)

    above.'' The Commission is adopting Sec. 39.14(a)(1) as proposed,

    except for a non-substantive change, which replaces each reference to

    ``futures, options, and swap positions'' with ``futures, options, and

    swaps.''

    2. Daily Settlements--Sec. 39.14(b)

    Proposed Sec. 39.14(b) would require a DCO to effect a settlement

    with each clearing member at least once each business day, and to have

    the authority and operational capacity to effect a settlement with each

    clearing member, on an intraday basis, either routinely, when

    thresholds specified by the DCO were breached, or in times of extreme

    market volatility.

    CME expressed its support for intra-day settlements. LCH suggested

    that a DCO must measure its credit exposures ``several times each

    business day,'' and should be obliged to recalculate initial and

    variation margin requirements more than once each business day. J.P.

    Morgan stated that intraday margin calls should be made with greater

    frequency for clearing members who have a higher risk profile.

    The Commission does not believe that it is necessary to adopt a

    requirement that all DCOs recalculate initial and variation margin

    requirements more than once each business day or an explicit

    requirement for intraday margin calls for clearing members with a

    higher risk profile. The Commission believes that it has struck the

    appropriate balance in Sec. 39.14(b), by requiring a DCO to conduct

    daily settlements, while permitting a DCO to exercise its discretion

    regarding whether it will conduct routine intraday settlements, or

    whether it will settle positions on an intraday basis only when certain

    thresholds are breached \168\ or in times of extreme market volatility.

    This approach is also generally consistent with proposed international

    standards.\169\ A particular DCO could determine to conduct routine

    intraday settlements, as some have done, or to conduct intraday

    settlements for particular clearing members based on their risk

    profiles.

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

    \168\ E.g., a DCO could establish thresholds that relate to the

    extent of market volatility, or with respect to a particular

    clearing member, the extent of losses that it has suffered on a

    particular day or whether it has reached a risk limit established by

    the DCO pursuant to Sec. 39.13(h)(1)(i), which is discussed in

    section IV.D.7.a, above.

    \169\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Key Consideration 4, at 40; EMIR, Article 39, paragraph 3, at 46.

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

    NEM, NGX, and NOCC all requested that the Commission afford

    recognition to a clearing model that does not require daily variation

    margin payments and collections but permits accrual accounting with

    respect to certain energy products.

    NEM noted that most Retail Energy Marketers (REMs) \170\ use an

    accrual accounting practice that recognizes revenues and costs after

    energy delivery to their retail customers and that clearing solutions

    that require daily cash settlements would either complicate their

    accounting practices or significantly impact REM cash flows.

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

    \170\ NEM stated that REMs ``sell electricity and natural gas to

    consumers as a competitive alternative to the local utility'' and

    ``often purchase wholesale physical natural gas and electricity on a

    spot (delivery) month (day) basis and also purchase swaps to lock in

    prices for any consumers who want a long-term fixed price

    contract.''

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

    NGX stated that its clearing model generally does not require daily

    variation margin payments and collections, and that settlement on its

    energy contracts \171\ occurs only on a monthly basis, after clearing

    participant obligations have been netted, consistent with practices in

    the cash market and with the end-user nature of the vast majority of

    NGX clearing participants. NGX noted that, therefore, the type of daily

    settlement risk that proposed Sec. 39.14 addresses is not present in

    the NGX model and the degree of risk in the monthly settlement process

    is reduced.

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

    \171\ NGX stated that it ``operates a trading and clearing

    system for energy products that provides electronic trading, central

    counterparty clearing and data services to the North American

    natural gas, electricity and oil markets.''

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

    Although NOCC supported adoption of proposed Sec. 39.14(b) for

    traditional futures and cleared swaps, it indicated that it intends to

    develop a clearinghouse that will seek registration as a DCO to clear

    energy products, including commercial forward contracts that it

    believes will be outside the scope of regulation as futures contracts

    or as swaps under the CEA, as well as financial forwards that it

    believes will fall within the definition of swaps under the CEA. NOCC

    stated that while gains and losses on the commercial forward contracts

    and financial forwards that it intends to clear are calculated daily,

    they are accrued throughout the delivery period and following the

    delivery period, and are not cash settled until final payment occurs

    approximately three weeks after the month in which the commodity is

    delivered. NOCC proposed that the Commission adopt a rule that would

    permit exemptions for alternative risk management frameworks, which

    would provide NOCC with the ability to demonstrate to the Commission

    that daily accrual settlement of variation margin is a sound practice

    appropriately tailored to the unique characteristics of the cash energy

    markets and market participants for which NOCC is seeking to provide

    the benefits of clearing.

    The Commission has not proposed and is not adopting a rule

    permitting exemptions for alternative risk management frameworks.

    However, a particular DCO may petition the Commission for an exemption

    if it believes that it can demonstrate that the daily accrual of gains

    and losses provides the same protection to the DCO as would daily

    variation margin payments and collections. Therefore, the Commission is

    adding a clause to Sec. 39.14(b) that states ``[e]xcept as otherwise

    provided by Commission order'' prior to the requirement that a DCO

    ``shall effect a settlement with each clearing member at least once

    each business day.''

    [[Page 69387]]

    3. Settlement Banks--Sec. 39.14(c)

    The introductory paragraph of proposed Sec. 39.14(c) would require

    a DCO to employ settlement arrangements that eliminate or strictly

    limit its exposure to settlement bank risks, including the credit and

    liquidity risks arising from the use of such banks to effect

    settlements with its clearing members.

    OCC commented that it would not be possible for a DCO to

    ``eliminate'' all exposure to settlement bank risks and that the

    Commission had not provided any guidance as to what it means to

    ``strictly limit'' such exposure. The Commission notes that the

    language in the introductory paragraph of proposed Sec. 39.14(c),

    which would require a DCO to ``employ settlement arrangements that

    eliminate or strictly limit its exposure to settlement bank risks,

    including the credit and liquidity risks arising from the use of such

    banks to effect settlements * * *,'' is virtually identical to the

    statutory language in Core Principle E.\172\ The Commission is adopting

    the introductory paragraph of Sec. 39.14(c) with two modifications.

    First, in response to OCC's comment, the Commission is adding the words

    ``as follows:'' at the end of the sentence, in order to clarify that a

    DCO that complies with Sec. 39.14(c)(1), (2), and (3), discussed

    below, will be deemed to have ``employ[ed] settlement arrangements that

    eliminate or strictly limit its exposure to settlement bank risks''

    within the meaning of Sec. 39.14(c). The Commission is also inserting

    parentheses around the letter ``s'' in the word ``banks'' in order to

    clarify that the Commission is not intending to require that a DCO must

    have more than one settlement bank in all circumstances. However, a DCO

    will need to have more than one settlement bank to the extent that it

    is reasonably necessary in order to eliminate or strictly limit the

    DCO's exposures to settlement bank risks, pursuant to Sec.

    39.14(c)(3), as further discussed below.

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

    \172\ See Section 5b(c)(2)(E)(ii) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(E)(ii).

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

    4. Criteria for Acceptable Settlement Banks--Sec. Sec. 39.14(c)(1) and

    (c)(2)

    Proposed Sec. 39.14(c)(1) would require a DCO to have documented

    criteria with respect to those banks that are acceptable settlement

    banks for the DCO and its clearing members, including criteria

    addressing the capitalization, creditworthiness, access to liquidity,

    operational reliability, and regulation or supervision of such banks.

    Proposed Sec. 39.14(c)(2) would require a DCO to monitor each approved

    settlement bank on an ongoing basis to ensure that such bank continues

    to meet the criteria established pursuant to Sec. 39.14(c)(1).

    Proposed Sec. Sec. 39.14(c)(1) and (c)(2) are consistent with

    international recommendations.\173\

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

    \173\ See CPSS-IOSCO Consultative Report, Principle 9: Money

    Settlements, Key Consideration 3, at 54.

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

    NYPC agreed with the proposed requirement that DCOs must articulate

    the standards that they apply to the selection of settlement banks.

    OCC indicated that a DCO may have to deviate from its written

    policies on the selection of clearing banks during a major market

    disruption, as those settlement banks that are the best options

    available at the time may not meet the technical criteria set forth in

    a DCO's written policies. The Commission agrees with OCC that a DCO may

    have to deviate from its written policies during a major market

    disruption. However, whether the Commission would permit a DCO to do so

    would need to be addressed in the context of the particular major

    market disruption, e.g., based on an analysis of whether all available

    settlement banks no longer meet such written criteria.

    MGEX commented that the Federal Reserve and other banking

    authorities are in the best position to review a bank's financial

    condition. NYPC recommended that the Commission modify the proposed

    rule to reflect the fact that the only criteria that are likely to be

    susceptible to observation by a DCO are a bank's operational

    reliability, regulatory capital, and the rating of its parent bank

    holding company. The Commission agrees that the Federal Reserve and

    other banking authorities may be in the best position to review a

    bank's financial condition and that there is certain information about

    settlement banks to which a DCO will not have regular access.

    Nonetheless, a DCO has a responsibility to undertake reasonable efforts

    to ensure that its settlement bank(s) continue to meet the criteria

    established by the DCO. A DCO may be able to obtain pertinent

    information from public sources, and it should be able to request and

    obtain information from an approved settlement bank, which demonstrates

    whether the bank continues to meet the criteria established by the DCO.

    The Commission is adopting Sec. 39.14(c)(1) with a modification

    that replaces the language that states: ``with respect to those banks

    that are acceptable settlement banks for the derivatives clearing

    organization and its clearing members'' with ``that must be met by any

    settlement bank used by the derivatives clearing organization or its

    clearing members.'' In addition, the Commission is inserting

    parentheses around the letter ``s'' in the word ``banks.'' Consistent

    with the modification to the introductory paragraph of Sec. 39.14(c)

    described above, these modifications also clarify that there may be

    circumstances in which it may be appropriate for a DCO to use a single

    settlement bank. The Commission is adopting Sec. 39.14(c)(2) as

    proposed.

    5. Monitoring and Addressing Exposure to Settlement Banks--Sec.

    39.14(c)(3)

    Proposed Sec. 39.14(c)(3) would require a DCO to monitor the full

    range and concentration of its exposures to its own and its clearing

    members' settlement banks and assess its own and its clearing members'

    potential losses and liquidity pressures in the event that the

    settlement bank with the largest share of settlement activity were to

    fail.\174\ A DCO would be required to: (i) maintain settlement accounts

    at additional settlement banks; (ii) approve additional settlement

    banks for use by its clearing members; (iii) impose concentration

    limits with respect to its own or its clearing members' settlement

    banks; and/or (iv) take any other appropriate actions if any such

    actions are reasonably necessary in order to eliminate or strictly

    limit such exposures.

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

    \174\ Some DCOs have their own settlement accounts at each

    settlement bank used by their clearing members, in which case a

    clearing member's settlement bank is also the DCO's settlement bank,

    and transfers between a clearing member's settlement account and a

    DCO's settlement account are made internally. Other DCOs permit

    their clearing members to use settlement banks at which such DCOs do

    not have their own settlement accounts, and settlement transfers are

    made between a clearing member's settlement bank and the DCO's

    settlement bank. In either event, the settlement bank with the

    largest share of settlement activity will always be a bank at which

    the DCO maintains a settlement account, as all settlement activity

    will involve the DCO.

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

    OCC commented that the requirement that a DCO monitor its clearing

    members' exposure to the settlement banks used by such clearing members

    could result in a massive duplication of effort and would be very

    burdensome for the DCO. Therefore, OCC suggested that clearing members

    or their primary regulators should be responsible for monitoring

    clearing members' exposure to their settlement banks.

    The Commission does not agree with OCC that proposed Sec.

    39.14(c)(3) could result in a massive duplication of effort. The focus

    of the monitoring required by Sec. 39.14(c)(3) is on a DCO's exposures

    and its clearing members' potential losses insofar as they may create

    exposures for the DCO. Therefore, each

    [[Page 69388]]

    DCO must conduct the required monitoring as each DCO's exposures are

    unique to that DCO. In addition, this provision of Sec. 39.14(c)(3) is

    consistent with proposed international standards.\175\

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

    \175\ See CPSS-IOSCO Consultative Report, Principle 9: Money

    Settlements, Explanatory Note, 3.9.5, at 56.

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

    NYPC commented that since initial and variation margin requirements

    fluctuate daily, proposed Sec. 39.14(c)(3) would require DCOs to

    monitor their exposures to all settlement banks and not merely the

    largest. The Commission agrees with NYPC. Proposed Sec. 39.14(c)(3)

    would require a DCO to ``monitor the full range and concentration of

    its exposures to its own and its clearing members' settlement banks,''

    which means that a DCO must conduct such monitoring with respect to all

    such settlement banks. The reference to ``the settlement bank with the

    largest share of settlement activity'' was made in the context of

    requiring a DCO to assess the potential impact of the failure of such

    bank.

    CME and OCC requested that the Commission clarify that a DCO would

    only be required to take any of the actions specified in proposed Sec.

    39.14(c)(3)(i)-(iv), if the specific action were reasonably necessary

    in order to eliminate or strictly limit exposures to settlement banks,

    and that a DCO would not be required to take all of the specified

    actions in all cases. CME supported this interpretation and OCC stated

    its belief that these requirements would be reasonable if the final

    rule were expressly limited in this manner. The Commission is modifying

    Sec. 39.14(c)(3)(i)-(iv) to clarify the Commission's intent to

    obligate a DCO to employ any one or more of the actions specified in

    (i) through (iv), only if any one or more of such actions is reasonably

    necessary in order to eliminate or strictly limit such exposures.

    CME, ICE, MGEX, and KCC variously commented that prescribing

    concentration limits and requiring that a DCO and its clearing members

    maintain multiple settlement banks would impose significant expenses on

    the DCO, its clearing members, and their customers. CME, MGEX, and NYPC

    stated their belief that it would be difficult to comply with this

    regulation given the limited number of banks that are qualified and

    willing to serve as settlement banks.\176\ CME also commented that the

    meaning of ``concentration limits'' is unclear, and stated its belief

    that it would be unwise to impose artificial limits on the number of

    clearing members or the size of clearing member accounts at a

    particular settlement bank.

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

    \176\ CME also expressed concern that, as drafted, the proposed

    regulation appears to require a DCO to approve at least two more

    settlement banks, because of the reference to ``settlement banks''

    in the plural.

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

    ICE took the position that hard concentration limits could increase

    systemic risk because a DCO would need to distribute funds across

    multiple banks. ICE indicated that as settlement funds increased,

    highly rated banks would eventually be consumed by the concentration

    limits and DCOs may have to open accounts with lower rated banks. ICE

    further commented that concentration limits could act as a constraint

    on customer choice, in that if one bank had a large number of

    settlement customers, there would be natural concentration of

    settlement flows, and the DCO could have to direct customers not to use

    their chosen bank.

    NYPC also questioned whether current settlement banks would be

    willing to continue to act in that role if the Commission required a

    DCO and some of its clearing members to transfer their business to

    other banks. NYPC stated that this would leave the existing settlement

    banks with an expensive infrastructure supported by fewer client

    accounts.

    MGEX stated its belief that requiring a DCO to oversee clearing

    members' banks and establishing credit or concentration limits would be

    intrusive and suggested that the final rule should provide DCOs with

    flexibility.

    The Commission notes that proposed Sec. 39.14(c)(3)(iii) would

    require a DCO to impose concentration limits with respect to its own or

    its clearing members' settlement banks if such action were reasonably

    necessary in order to eliminate or strictly limit its exposures to such

    settlement banks. Section 39.14(c)(3) would provide a DCO with other

    possible options for addressing such exposures. For example, a DCO

    could open an account at an additional settlement bank pursuant to

    Sec. 39.14(c)(3)(i), or approve an additional settlement bank for use

    by its clearing members pursuant to Sec. 39.14(c)(3)(ii), without

    imposing concentration limits, if doing so would mean that such limits

    would not be reasonably necessary. In addition, proposed Sec.

    39.14(c)(3)(iv) would allow a DCO to take other appropriate actions,

    which could obviate the potential need for concentration limits.

    KCC commented that identifying multiple settlement banks for use by

    clearing members could increase a DCO's operational risk by fragmenting

    the DCO's margin pool. KCC suggested that there is no need for multiple

    settlement banks because there would be little effect on the operations

    of a DCO if a non-systemically significant settlement bank failed. KCC

    noted that the Federal Deposit Insurance Corporation generally

    facilitates the transfer of the accounts and operations of a failed

    bank to a successor institution or a bridge bank with little or no

    disruption to depositors at the failed bank. KCC further stated that a

    DCO's settlement account is essentially a pass-through account and DCOs

    generally do not maintain large, long-term balances in the account.

    According to KCC, even if a DCO held significant guaranty funds or

    security deposits at a settlement bank, such assets would likely be

    held in a trust or custody account, which would be unavailable to

    creditors of the failed institution and would generally be available to

    the DCO within a short period of time following the insolvency of the

    settlement bank. KCC also noted that a requirement that DCOs identify

    additional settlement banks for use by clearing members would cause a

    significant rise in bank service fees for DCOs and clearing members.

    NGX noted that proposed Sec. 39.14(c) generally refers to

    settlement banks, in the plural, assuming that all DCOs will maintain

    accounts with at least two settlement banks. NGX questioned the benefit

    of requiring all DCOs, regardless of size, to use multiple settlement

    banks. According to NGX, settlement risk varies across DCOs, and the

    type of daily settlement risk the proposed rule addresses is not

    present at a DCO like NGX, which does not engage in daily variation

    margin payments and collections from its clearing participants. NGX

    stated that the rule should take account of the level of settlement

    activity because requiring a DCO with a relatively small need for

    settlement services to divide the flow of funds may cause the DCO to be

    less attractive, bear higher costs, and be less competitive with larger

    DCOs, while having a negligible impact on systemic risk.\177\ NGX also

    commented that the rule could result in increased operational risk at a

    DCO like NGX with complex contract settlement and delivery that

    requires a settlement bank to have specialized expertise and to

    maintain specialized processes and operational capabilities. NGX

    requested that the Commission provide the flexibility to permit a DCO

    to

    [[Page 69389]]

    demonstrate that the use of a single settlement bank is appropriate

    from both a policy and a financial perspective.

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

    \177\ However, NGX stated that where a DCO has daily settlements

    or monthly settlements in a greater amount, requiring more than one

    settlement bank may materially reduce systemic risk without adverse

    effects.

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

    As noted above, the Commission does not intend to require a DCO to

    use more than one settlement bank if the particular DCO otherwise

    employs settlement arrangements that eliminate or strictly limit its

    exposure to settlement bank risks. The Commission understands that the

    number of banks that are willing to serve settlement functions might be

    limited, particularly for smaller DCOs. The Commission further

    understands that it might be costly for some DCOs that currently only

    have one settlement bank to use an additional settlement bank. However,

    pursuant to Sec. 39.14(c)(3), a DCO would be required to have a second

    settlement bank, if it were reasonably necessary in order to eliminate

    or strictly limit the DCO's exposures to settlement bank risks.

    The Commission is modifying Sec. Sec. 39.14(c)(3)(i) and (ii) to

    refer to ``one or more'' additional settlement banks, so that it will

    be clear that a DCO would not necessarily be required to maintain

    settlement accounts with more than one additional settlement bank or to

    approve more than one additional settlement bank that its clearing

    members could choose to use, under the specified circumstances. In

    addition, the Commission is modifying Sec. 39.14(c)(3)(iii) to

    similarly clarify that a DCO may only be required to impose

    concentration limits with respect to ``one or more'' of its own or its

    clearing members' settlement banks, under the specified circumstances.

    The Commission is also modifying Sec. 39.14(c)(3)(ii) by replacing

    ``for use by its clearing members'' with ``that its clearing members

    could choose to use'' to make it clear that the Commission is not

    suggesting that a single clearing member might be required to use more

    than one settlement bank.\178\

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

    \178\ For example, it appears that CME may have interpreted

    proposed Sec. 39.14(c)(3)(ii) in this unintended manner, since it

    stated that ``we do not believe the CFTC should require clearing

    members to have accounts at multiple settlement banks, which may

    prove to be an impossible (and/or extremely costly) requirement to

    satisfy.'' It appears that KCC may also have interpreted proposed

    Sec. 39.14(c)(3)(ii) in this manner, in light of its comment that a

    requirement that DCOs identify additional settlement banks for use

    by clearing members would cause a significant rise in bank service

    fees for DCOs and clearing members. There is no reason that

    providing greater choice to clearing members regarding which single

    settlement bank they could elect to use would cause a rise in bank

    service fees for clearing members.

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

    The Commission is adopting Sec. 39.14(c)(3) with the modifications

    described above.

    6. Settlement Finality--Sec. 39.14(d)

    Proposed Sec. 39.14(d) would require a DCO to ensure that

    settlement fund transfers are irrevocable and unconditional when the

    DCO's accounts are debited or credited. In addition, the proposed

    regulation would require that a DCO's legal agreements with its

    settlement banks must state clearly when settlement fund transfers

    would occur and a DCO was required to routinely confirm that its

    settlement banks were effecting fund transfers as and when required by

    those legal agreements.

    ISDA and FIA requested that the rule allow for the correction of

    errors.\179\ The Commission agrees with ISDA and FIA that settlement

    finality should not preclude the correction of errors, and is adding a

    clause to Sec. 39.14(d) that explicitly provides that a DCO's legal

    agreements with its settlement banks may provide for the correction of

    errors.

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

    \179\ ISDA also requested that the Commission clarify how the

    proposed requirement would be compatible with the fact that title

    transfer of initial margin may not occur when it is posted to a DCO.

    Title transfer is not a necessary element of settlement finality.

    Although in some jurisdictions a clearing member may need to

    transfer title to margin collateral to a DCO in order for the DCO to

    effectively exert control over such collateral, in other

    jurisdictions a clearing member may transfer margin collateral to a

    DCO and grant a security interest to the DCO without transfer of

    title.

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

    In addition, the Commission is adding the modifier ``no later

    than'' before ``when the derivatives clearing organization's accounts

    are debited or credited'' in recognition of the fact that a DCO's legal

    agreements with its settlement banks may provide for settlement

    finality prior to the time when the DCO's accounts are debited or

    credited, e.g., upon the bank's acceptance of a settlement instruction.

    KCC commented that a DCO can never effectively ensure that

    settlement payments are irrevocable, given the existence of a legal

    risk that a settlement payment may be deemed to be an inappropriate

    transfer pursuant to applicable bankruptcy law. Therefore, KCC urged

    the Commission to eliminate the requirement or to restate the rule as a

    requirement to monitor operational risks related to settlement

    finality. The Commission does not believe that it is appropriate to do

    so. Core Principle E requires a DCO to ``ensure that money settlements

    are final when effected.'' \180\ In addition, Section 546(e) of the

    U.S. Bankruptcy Code \181\ provides that a bankruptcy trustee may not

    avoid a transfer that is a margin payment or a settlement payment made

    to a DCO by a clearing member, or made to a clearing member by a DCO

    (with the exception of fraudulent transfers). However, the Commission

    is modifying Sec. 39.14(d) to state that ``[a DCO] shall ensure that

    settlements are final when effected by ensuring that it has entered

    into legal agreements that state that settlement fund transfers are

    irrevocable and unconditional * * *'' (added text in italics).

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

    \180\ See Section 5b(c)(2)(E)(iii) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(E)(iii).

    \181\ 11 U.S.C. 546(e).

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

    The Commission is adopting Sec. 39.14(d) with the modifications

    described above.

    7. Recordkeeping--Sec. 39.14(e)

    Proposed Sec. 39.14(e) would require a DCO to maintain an accurate

    record of the flow of funds associated with each settlement.

    KCC expressed its general support of the concept of maintaining

    accurate records of settlement fund flows, but stated that it may be

    prudent for the Commission to further clarify the extent to which the

    additional recordkeeping applies to cross-margining and netting

    arrangements that a DCO may have in place with certain clearing members

    and their customers. The language in Sec. 39.14(e) is virtually

    identical to the Core Principle E language, which the Dodd-Frank Act

    added to the CEA.\182\ Moreover, this language is similar to the

    language that had been contained in Core Principle E prior to its

    amendment by the Dodd-Frank Act.\183\

    Therefore, proposed Sec. 39.14(e) would not impose any additional

    recordkeeping requirements. The Commission believes that the

    requirement that a DCO must maintain an accurate record of the flow of

    funds associated with each settlement would necessarily require the

    maintenance of an accurate record with respect to any cross-margining

    or netting arrangements, without the need to separately address such

    arrangements. The Commission is adopting Sec. 39.14(e) as proposed.

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

    \182\ See Section 5b(c)(2)(E)(iv) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(E)(iv).

    \183\ Prior to amendment by the Dodd Frank Act, Core Principle E

    provided, in part, that a [DCO] applicant shall have the ability to

    ``* * * [m]aintain an adequate record of the flow of funds

    associated with each transaction that the applicant clears. * * *''

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

    8. Netting Arrangements--Sec. 39.14(f)

    Proposed Sec. 39.14(f) would incorporate Core Principle E's

    requirement that a DCO must possess the ability to comply with each

    term and condition of any permitted netting or offset arrangement with

    any other clearing organization.\184\

    [[Page 69390]]

    The Commission did not receive any comment letters discussing Sec.

    39.14(f) and is adopting Sec. 39.14(f) as proposed.

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

    \184\ See Section 5b(c)(2)(E)(v) of the CEA, 7 U.S.C. 7a-

    1(c)(2)(E)(v).

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

    9. Physical Delivery--Sec. 39.14(g)

    Proposed Sec. 39.14(g) would require a DCO to establish rules

    clearly stating each obligation that the DCO has assumed with respect

    to physical deliveries, including whether it has an obligation to make

    or receive delivery of a physical instrument or commodity, or whether

    it indemnifies clearing members for losses incurred in the delivery

    process, and to ensure that the risks of each such obligation are

    identified and managed.

    KCC commented that it generally supports the concept of proposed

    Sec. 39.14(g), but requested that the Commission clarify that a DCO

    may be deemed to have satisfied its obligation to establish rules

    relating to physical deliveries if the rules of the exchange that lists

    the cleared contracts clearly delineates such physical delivery

    obligations. The Commission notes that the rules referenced in Sec.

    39.14(g) must be enforceable by and against the DCO. If a DCO were

    integrated with a DCM and the DCM's rules were enforceable by and

    against the DCO, then it may be that the DCM's rules would satisfy the

    requirements of Sec. 39.14(g). However, such compliance would need to

    be determined on a case-by-case basis. The Commission is adopting Sec.

    39.14(g) as proposed, except for a technical revision that replaces

    ``contracts, agreements and transactions'' with ``products'' to ensure

    consistency with other provisions in part 39.

    F. Core Principle F--Treatment of Funds--Sec. 39.15

    Core Principle F, \185\ as amended by the Dodd-Frank Act, requires

    a DCO to: (i) Establish standards and procedures that are designed to

    protect and ensure the safety of its clearing members' funds and

    assets; (ii) hold such funds and assets in a manner by which to

    minimize the risk of loss or of delay in the DCO's access to the assets

    and funds; and (iii) only invest such funds and assets in instruments

    with minimal credit, market, and liquidity risks. The Commission

    proposed Sec. 39.15 to establish requirements that a DCO would have to

    meet in order to comply with Core Principle F.

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

    \185\ Section 5b(c)(2)(F) of the CEA, 7 U.S.C. 7a-1(c)(2)(F)

    (Core Principle F).

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

    1. Required Standards and Procedures--Sec. 39.15(a)

    Proposed Sec. 39.15(a) would require a DCO to establish standards

    and procedures that are designed to protect and ensure the safety of

    funds and assets belonging to clearing members and their

    customers.\186\ The Commission did not receive any comments on proposed

    Sec. 39.15(a) and is adopting the provision as proposed.

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

    \186\ Such ``assets'' would include any securities or property

    that clearing members deposit with a DCO in order to satisfy initial

    margin obligations, which are also sometimes referred to as

    ``collateral.'' Proposed Sec. 39.15 uses the term ``assets'' rather

    than ``securities or property'' or ``collateral'' in order to be

    consistent with the statutory language.

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

    2. Segregation--Sec. 39.15(b)(1)

    Proposed Sec. 39.15(b)(1) would require a DCO to comply with the

    segregation requirements of Section 4d of the CEA and Commission

    regulations thereunder, or any other applicable Commission regulation

    or order requiring that customer funds and assets be segregated, set

    aside, or held in a separate account.

    LCH suggested that the Commission clarify the meaning of

    ``segregated'' and limit the segregation requirement to the funds of

    clearing members' clients. LCH also urged the Commission to limit these

    requirements to client business cleared by the DCO under the FCM

    clearing structure, noting that a DCO based outside the United States

    may offer client clearing services through alternative structures and

    that it did not believe it would be appropriate for clients clearing

    under these non-U.S. structures to be subject to the segregation

    requirements of Section 4d of the CEA, but rather to the requirements

    set out by the DCO's home or other regulators.

    FIA recommended that the proposed rule be revised to make clear

    that a DCO should keep margin posted by clearing members to support

    proprietary positions separate from the DCO's own assets, noting that

    although proprietary funds held at a DCO are not subject to the

    segregation provisions of the CEA, it is essential that these funds are

    protected in the event of the default of the DCO. The Commission has

    not proposed and is not adopting FIA's suggestion that the Commission

    expand the applicability of Sec. 39.15(b)(1) in this manner.

    BlackRock and FHLBanks expressed their views on specific

    segregation models. The Commission has proposed rules in a separate

    rulemaking regarding the segregation of cleared swaps customer

    contracts and collateral, and the Commission will address BlackRock's

    and FHLBanks' comments in connection with the final rulemaking for that

    proposal.\187\

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

    \187\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared

    Swaps Customer Contracts and Collateral; Conforming Amendments to

    the Commodity Broker Bankruptcy Provisions).

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

    The comments submitted by LCH, FIA, BlackRock, and FHLBanks all

    address the substance or applicability of segregation requirements.

    Proposed Sec. 39.15(b)(1) would not have imposed any additional

    substantive segregation requirements upon a DCO. It would simply

    require a DCO to comply with the substantive segregation requirements

    of the CEA and other Commission regulations or orders, which are

    currently applicable or which may become applicable in the future. In

    particular, Sec. 39.15(b)(1) is not intended to extend the

    extraterritorial reach of existing segregation requirements beyond that

    which may already exist in such requirements. However, in order to

    clarify the Commission's intent in this regard, the Commission has

    added ``applicable'' before ``segregation requirements'' in Sec.

    39.15(b)(1). In addition, the Commission wishes to clarify that its

    current segregation requirements apply to a non-U.S. based DCO with

    respect to clearing members that are registered as FCMs, whether they

    are clearing business for U.S. based customers or non-U.S. based

    customers. Such requirements do not apply with respect to clearing

    members that are non-U.S. based and that are not registered as FCMs,

    nor required to be registered as FCMs.

    The Commission is adopting Sec. 39.15(b)(1) with the modification

    described above.

    3. Commingling of Futures, Options on Futures, and Swap Positions--

    Sec. 39.15(b)(2)

    Proposed Sec. 39.15(b)(2)(i) would permit a DCO to commingle, and

    a DCO to permit clearing member FCMs to commingle, customer positions

    in futures, options on futures, and swaps, and any money, securities,

    or property received to margin, guarantee, or secure such positions, in

    an account subject to the requirements of Section 4d(f) of the CEA

    (cleared swaps account), pursuant to DCO rules that have been approved

    by the Commission under Sec. 40.5 of the Commission's regulations. The

    DCO's rule filing \188\ would have to include, at a minimum, the

    following: (A) an identification of the futures, options on futures,

    and swaps that would be commingled, including contract specifications

    or the criteria that would

    [[Page 69391]]

    be used to define eligible futures, options on futures, and swaps; (B)

    an analysis of the risk characteristics of the eligible products; (C) a

    description of whether the swaps would be executed bilaterally and/or

    executed on a DCM and/or a SEF; (D) an analysis of the liquidity of the

    respective markets for the futures, options on futures, and swaps that

    would be commingled, the ability of clearing members and the DCO to

    offset or mitigate the risks of such products in a timely manner,

    without compromising the financial integrity of the account, and, as

    appropriate, proposed means for addressing insufficient liquidity; (E)

    an analysis of the availability of reliable prices for each of the

    eligible products; (F) a description of the financial, operational, and

    managerial standards or requirements for clearing members that would be

    permitted to commingle the eligible products; (G) a description of the

    systems and procedures that would be used by the DCO to oversee such

    clearing members' risk management of the commingled positions; (H) a

    description of the financial resources of the DCO, including the

    composition and availability of a guaranty fund with respect to the

    commingled products; (I) a description and analysis of the margin

    methodology that would be applied to the commingled products, including

    any margin reduction applied to correlated positions, and any

    applicable margin rules with respect to both clearing members and

    customers; (J) an analysis of the ability of the DCO to manage a

    potential default with respect to any of the commingled products; (K) a

    discussion of the procedures that the DCO would follow if a clearing

    member defaulted, and the procedures that a clearing member would

    follow if a customer defaulted, with respect to any of the commingled

    products; and (L) a description of the arrangements for obtaining daily

    position data from each beneficial owner of the commingled

    products.\189\

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

    \188\ The DCO's rule filing would also need to comply with the

    procedural requirements of Sec. 40.5(a).

    \189\ As noted in the Commission's notice of proposed rulemaking

    regarding the protection of cleared swaps customer contracts and

    collateral, 76 FR at 33818 (June 9, 2011) (Protection of Cleared

    Swaps Customer Contracts and Collateral; Conforming Amendments to

    the Commodity Broker Bankruptcy Provisions), if the complete legal

    segregation model is adopted for cleared swaps, a DCO could more

    easily justify the approval of rules or the issuance of a 4d order

    allowing the commingling of futures, options, and swaps, since the

    impact of any different risk from the product being brought into the

    portfolio would be limited to the customer who chooses to trade that

    product. In such case, the Commission may still wish to obtain and

    review all of the information specified in proposed Sec.

    39.15(b)(2)(i), although its specific concerns may be minimized.

    However, if the complete legal segregation model is adopted for

    cleared swaps, and after the Commission obtains experience with

    respect to considering requests to commingle futures, options, and

    swaps under Sec. 39.15(b)(2) in an environment where that margin

    model applies, the Commission may revisit its ongoing need for all

    of the information listed in Sec. 39.15(b)(2)(i).

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

    Proposed Sec. 39.15(b)(2)(ii) would address situations where

    customer positions in futures, options on futures, and cleared swaps

    could be carried in a futures account subject to Section 4d(a) of the

    CEA. Proposed Sec. 39.15(b)(2)(ii) would incorporate the informational

    requirements of proposed Sec. 39.15(b)(2)(i), but would require a DCO

    to file a petition with the Commission for an order pursuant to Section

    4d(a) of the CEA, permitting the DCO and its clearing members to

    commingle customer positions in futures, options on futures, and swaps

    in a futures account (4d order).

    Proposed Sec. 39.15(b)(2)(iii)(A) would provide that the

    Commission may request additional information in support of a rule

    submission and that it may approve the rules in accordance with Sec.

    40.5.\190\ Proposed Sec. 39.15(b)(2)(iii)(B) would provide that the

    Commission could request additional information in support of a

    petition and that it could issue a 4d order in its discretion.

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

    \190\ A rule submitted for prior approval would be approved

    unless the rule is inconsistent with the CEA or the Commission's

    regulations. See Section 5c(c)(5) of the CEA, 7 U.S.C. 7a-2(c)(5);

    and 75 FR at 44793-44794 (Provisions Common to Registered Entities;

    final rule).

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

    As noted in the notice of proposed rulemaking, in the case of a

    rule approval under Sec. 39.15(b)(2)(i), as well as the issuance of an

    order under Sec. 39.15(b)(2)(ii), the Commission would take action

    pursuant to Section 4d of the CEA (permitting commingling) and Section

    4(c) of the CEA (exempting the DCO and clearing members from the

    requirement to hold customer positions in a 4d(a) or 4d(f) account, as

    applicable).

    The Commission requested comment on whether it should take the same

    approach (rule submission or petition for an order) with respect to the

    futures account and the cleared swap account and, if so, what that

    approach should be. In addition, the Commission requested comment on

    whether the enumerated informational requirements fully capture the

    relevant considerations for making a determination on either rule

    approval or the granting of an order, and whether the Commission's

    analysis should take into consideration the type of account in which

    the positions would be carried, the particular type of products that

    would be involved, or the financial resources of the clearing members

    that would hold such accounts. The Commission further requested comment

    on what, if any, additional or heightened requirements should be

    imposed to manage the increased risks introduced to a futures account

    that also holds cleared swaps.

    In some instances, commenters addressed topics that are more

    properly considered by the Commission in connection with a separate

    rulemaking,\191\ that relate to substantive requirements that the

    Commission might impose as a condition of approving a rule or granting

    an order under Sec. 39.15(b)(2),\192\ or that relate to other

    provisions adopted herein.\193\ The Commission is not addressing those

    comments in its discussion of Sec. 39.15(b)(2) because they are not

    within the scope of the proposal.

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

    \191\ E.g., CME and FIA raised operational concerns in the event

    the Commission adopts a different segregation regime for each type

    of customer account. Those comments will be considered in connection

    with the Commission's proposal regarding the appropriate segregation

    regime for cleared swaps accounts. See 76 FR 33818 (June 9, 2011)

    (Protection of Cleared Swaps Customer Contracts and Collateral;

    Conforming Amendments to the Commodity Broker Bankruptcy

    Provisions).

    \192\ E.g., LCH suggested additional factors that the Commission

    should consider before a DCO or its clearing members should be able

    to commingle, and offer offsets between, futures, options on

    futures, and swaps, including: (a) clients must hold their futures,

    options, and swaps under the same account structure and within the

    same legal entity, and (b) the DCO must margin the futures, options,

    and swaps using the same margin model; and ELX expressed the view

    that in order for a customer to gain the portfolio margining

    benefits of commingling futures, options, and swaps executed on a

    SEF, it would be necessary for a customer to clear its futures,

    options, and swaps through the same DCO.

    \193\ LCH stated that all offset assumptions in the DCO's margin

    calculations must, at a minimum, be replicated in the DCO's stress

    testing and must be recalibrated frequently. The Commission notes

    that permitted spread and portfolio margins are addressed in Sec.

    39.13(g)(4), discussed in section IV.D.6.e, above, and back testing

    of such spread and portfolio margins is addressed in Sec.

    39.13(g)(7), discussed in section IV.D.6.g, above.

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

    CME, FIA, and MFA expressed their general support for the adoption

    of rules that would allow commingling of customer positions in futures,

    options on futures, and cleared swaps. In particular, CME indicated

    that such commingling could achieve important benefits with respect to

    greater capital efficiency which would result from margin reductions

    for correlated positions, and that adoption of a regulation permitting

    such commingling would be consistent with the public interest, in

    accordance with Section 4(c) of the CEA. CME further stated that

    ``[h]aving positions in a single account can also enhance risk

    management practices and systemic risk containment by allowing the

    customer's portfolio to

    [[Page 69392]]

    be handled in a coordinated fashion in a transfer or liquidation

    scenario.''

    CME stated its belief that it would be logical to apply the same

    methodology (rule submission or petition for an order) with respect to

    the futures account and the cleared swaps account, and that a rule

    submission would be the most efficient and optimal approach. The

    Commission is retaining the proposed distinction whereby the Commission

    may permit futures to be commingled in a Section 4d(f) cleared swaps

    account subject to a rule approval process, and may permit cleared

    swaps to be commingled in a Section 4d(a) futures account subject to a

    4d order. In the latter instance, the 4d petition process would provide

    additional procedural protections in that: (1) Review of a 4d petition

    by the Commission is not subject to the time limits that apply to a

    request for rule approval under Sec. 40.5; and (2) the Commission may

    impose conditions in a 4d order, as appropriate. The Commission has

    determined that, at this time, it is appropriate to provide these

    additional procedural protections before exposing futures customers to

    the risks of swaps that may be commingled in a futures account. As also

    noted in other contexts in this notice of final rulemaking, DCOs have

    greater experience in clearing futures. Swaps will expose DCOs to risks

    that can differ in their nature and magnitude. However, as the

    Commission and the industry gain more experience with cleared swaps,

    the Commission may revisit this issue in the future.

    The Commission is adopting CME's suggestion that it revise Sec.

    39.15(b)(2)(i)(L) to remove the reference to obtaining daily position

    data ``from each beneficial owner.'' Therefore, Sec.

    39.15(b)(2)(i)(L), as modified, requires a DCO to submit ``[a]

    description of the arrangements for obtaining daily position data with

    respect to futures, options on futures, and swaps in the account,''

    without specifying the level of detail or the source of the daily

    position data that the DCO must obtain. As noted by CME, the Commission

    could request additional information from the DCO, in support of its

    request for rule approval or petition for a 4d order, pursuant to Sec.

    39.15(b)(2)(iii).

    The Commission is also making conforming changes to Sec.

    39.15(b)(2), to replace a reference to ``cleared swap account'' with

    ``cleared swaps account'' to achieve consistency with the terminology

    in another Commission rulemaking; \194\ is revising the references to

    ``futures, options on futures, and swap positions'' and ``futures,

    options on futures, and swaps'' to read ``futures, options, and

    swaps;'' \195\ is replacing a reference to ``contract'' with

    ``product;'' and is correcting the references to Sec. 39.15(b)(2)(i)

    and (ii) in Sec. 39.15(b)(iii)(A) and (B), respectively.

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

    \194\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared

    Swaps Customer Contracts and Collateral; Conforming Amendments to

    the Commodity Broker Bankruptcy Provisions).

    \195\ This conforming terminology, which appears elsewhere in

    part 39, streamlines the rule text without changing the meaning of

    the provision. The scope of part 39 covers only those products

    subject to the Commission's oversight and would not include, for

    example, options on securities. Refinements in the definitions of

    products subject to Commission oversight will be addressed in the

    future.

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

    The Commission is adopting Sec. 39.15(b)(2) with the modifications

    described above.

    4. Holding of Funds and Assets--Sec. 39.15(c)

    The introductory paragraph of proposed Sec. 39.15(c) would require

    that a DCO hold funds and assets belonging to clearing members and

    their customers in a manner that minimizes the risk of loss or of delay

    in the DCO's access to those funds and assets. The Commission did not

    receive any comment letters discussing the introductory paragraph of

    proposed Sec. 39.15(c) and is adopting the provision as proposed.

    5. Types of Assets--Sec. 39.15(c)(1)

    Proposed Sec. 39.15(c)(1) would require a DCO to limit the assets

    it accepts as initial margin to those that have minimal credit, market,

    and liquidity risks, and prohibit a DCO from accepting letters of

    credit as initial margin.

    LCH agreed with the provisions of proposed Sec. 39.15(c), but

    added that the rules might more properly require that a DCO must be

    able to convert any funds and assets held promptly into cash, and

    should prove that it is able to do so on an ongoing basis. J.P. Morgan

    stated that it is necessary for DCOs to maintain sufficient liquidity,

    and that this could be achieved by requiring that clearing members post

    a minimum amount of liquid (cash and qualifying government securities)

    margin, among other things.\196\

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

    \196\ J.P. Morgan also suggested that DCOs could maintain

    liquidity by requiring clearing members to make guarantee fund

    contributions or by requiring clearing members to participate in a

    liquidity facility. The Commission has not proposed and is not

    adopting such requirements.

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

    The Commission believes that the standard of ``minimal credit,

    market, and liquidity risks'' is sufficient and that it is not

    necessary to modify the language of the regulation to include an

    explicit requirement that a DCO must be able to convert funds and

    assets promptly into cash or to require that clearing members must post

    a minimum amount of cash and qualifying government securities.

    Moreover, the requirement that a DCO shall limit the assets that it

    accepts as initial margin to those that have ``minimal credit, market,

    and liquidity risks'' is consistent with international

    recommendations.\197\

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

    \197\ See CPSS-IOSCO Consultative Report, Principle 5:

    Collateral, at 37.

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

    OCC expressed its belief that the proposal places an excessive

    focus on the types of assets that may be used as margin and that the

    Commission's central focus should be on whether a DCO's procedures and

    risk management systems are sufficient to provide a high degree of

    assurance that a portfolio, including margin assets, can be liquidated

    with a positive liquidation value. OCC further noted its concern that

    some of the collateral that it currently accepts as initial margin,

    including less-liquid stocks and long-dated Treasury securities, would

    no longer be permitted under the proposed rule. OCC explained that its

    ``collateral in margins'' or ``CIM'' program looks at each type of

    collateral as an asset with specific risk characteristics rather than

    as a fixed value, and it recognizes both positive and negative

    correlations with other assets and liabilities in a particular account.

    As an example, OCC stated that even though XYZ stock may be less

    liquid than other stocks, it may have a greater value than a more

    liquid stock when it is used as margin for a short position in XYZ call

    options. Therefore, OCC urged the Commission not to impose a standard

    of ``minimal credit, market, and liquidity risk,'' or not to adopt an

    interpretation of such a standard in a manner that would reduce the

    opportunities for diversification of collateral and use of assets that

    may have specific risk-reducing properties in a particular portfolio.

    In particular, OCC stated that ``[w]here a DCO is capable of reflecting

    the risk of certain assets in its margin model, we see no reason why

    less liquid instruments or instruments with higher than average credit

    or market risks should not be acceptable for initial margin.''

    The Commission agrees that a DCO should be permitted to accept

    assets as initial margin if such assets have specific risk-reducing

    properties in a particular portfolio and the DCO's margin model is

    capable of appropriately reflecting the risk of those

    [[Page 69393]]

    assets. Accordingly, although the Commission is retaining the standard

    of minimal credit, market, and liquidity risk, it is revising the

    provision to add the following: ``A [DCO] may take into account the

    specific risk-reducing properties that particular assets have in a

    particular portfolio.'' As illustrated by OCC, an asset that would not

    generally be acceptable could be acceptable for use in connection with

    a particular portfolio.

    Freddie Mac requested that the Commission clarify that DCOs may

    accept collateral types beyond those specified as permitted investments

    under Sec. 1.25. Section 39.15(c) does not prohibit a DCO from

    accepting collateral types that are not specified as permitted

    investments under Sec. 1.25. The Commission believes that it is

    appropriate to permit DCOs to retain the flexibility to accept a

    broader range of assets that meet the general requirement of ``minimal

    credit, market, and liquidity risks'' than those which are appropriate

    investments for funds received from clearing members.

    Several comment letters specifically discussed the proposal to

    prohibit the use of letters of credit as initial margin. The commenters

    disagreed with the Commission's proposed requirement that a DCO may not

    accept letters of credit for this purpose. CME stated that letters of

    credit provide an absolute assurance of payment and, therefore, the

    issuing bank must honor the demand even in circumstances where the DCO

    (the beneficiary) breached its duty to the clearing member and even if

    the clearing member is unable to reimburse the bank for its payment.

    CME also stated that it was not aware of any instances in the cleared

    derivatives industry in which a beneficiary of a letter of credit

    posted as collateral had sought to draw upon the letter of credit and

    had not been promptly paid by the issuer. CME noted that letters of

    credit have been especially useful for clearing members to post as

    collateral for late-day margin calls. ICE and NOCC similarly commented

    that letters of credit should be permitted to serve as non-cash

    collateral. NGX indicated that letters of credit are consistent with

    Section 4s(e)(3)(D) of the CEA, which provides that the financial

    regulators shall establish comparable capital requirements and minimum

    initial and variation margin requirements, including the use of non-

    cash collateral, for swap dealers.\198\

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

    \198\ The Commission notes that the minimum initial and

    variation margin requirements referenced in Section 4s(e)(3)(D) of

    the CEA, 7 U.S.C. 6s(e)(3)(D), apply to uncleared swaps.

    NGX also stated its view that in a non-intermediated model, such

    as that operated by NGX, the DCO is familiar with its clearing

    participants, and can exercise a degree of discretion in accepting

    letters of credit without the same risk management challenges that

    may be faced by an intermediated DCO.

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

    Many commenters suggested that letters of credit should be

    acceptable if they are subject to appropriate conditions. OCC

    recommended that the Commission should allow letters of credit as long

    as a DCO sets criteria with respect to issuers, diversifies

    concentration of risk among issuers, and limits the proportion of a

    clearing member's margin requirement that can be represented by letters

    of credit. In addition, OCC stated that it would be appropriate for the

    Commission to prohibit a DCO from accepting a letter of credit from a

    clearing member if the letter of credit is issued by an institution

    affiliated with the clearing member.

    Similarly, FIA suggested that a DCO should be permitted to accept

    letters of credit on a case-by-case basis subject to the credit quality

    of the bank and appropriate limits on the percentage of a clearing

    member's margin requirements that can be met by letters of credit. FIA

    also indicated that DCOs should limit the aggregate value of letters of

    credit that may be issued by any one bank.

    FHLBanks wrote that ``a hard and fast prohibition against letters

    of credit is inappropriate because it fails to take into account that a

    letter of credit issued by a highly creditworthy entity could contain

    terms that would make the letter of credit just as liquid as a funded

    asset.'' \199\

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

    \199\ The FHLBanks further noted that the prohibition on letters

    of credit may unnecessarily constrain certain end-users from

    clearing swaps because they may be precluded from pledging other

    assets, e.g., by loan covenants.

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

    CME stated that it only accepts letters of credit that comply with

    its specified terms and conditions, including payment within one hour

    of notification of a draw, from issuers that it has reviewed and

    approved and that meet its criteria for issuing banks. CME further

    noted that it conducts periodic reviews of approved banks and uses caps

    and concentration limits in connection with letters of credit.

    NGX stated that it has accepted letters of credit that comply with

    its requirements regarding timing and acceptable institutions, for many

    years, and has successfully drawn on such letters of credit.

    Several commenters warned of the potential risks associated with

    prohibiting letters of credit, including higher costs for clearing

    members and their customers (OCC), the placement of U.S. DCOs at a

    disadvantage to foreign clearing houses (ICE),\200\ and increased

    systemic risk as a result of decreased voluntary clearing (NOCC).

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

    \200\ ICE noted that the CPSS-IOSCO Consultative Report did not

    prohibit any type of collateral.

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

    The Commission acknowledges that DCOs have historically been

    permitted to exercise their discretion regarding whether and to what

    extent they would accept letters of credit for initial margin for

    futures and options. Certain DCOs have accepted such letters of credit

    without incident and continue to do so. On the other hand, as stated in

    the notice of proposed rulemaking, letters of credit are unfunded

    financial resources with respect to which funds might be not be

    available when they are most needed by the DCO. Moreover, the initial

    margin of a defaulting clearing member would typically be the first

    asset tapped to cure the clearing member's default. Taking into account

    both the strong track record of letters of credit in connection with

    cleared futures and options on futures and the potentially greater

    risks of cleared swaps, the Commission is modifying the provision to

    permit DCOs to accept letters of credit as initial margin for futures

    and options on futures. However, the Commission has determined to

    maintain an additional safeguard for swaps at this time by prohibiting

    a DCO from accepting letters of credit as initial margin for swaps. In

    cases where futures and swaps are margined together, the Commission has

    determined that letters of credit may not be accepted. The Commission

    will monitor developments in this area and may revisit this issue in

    the future.

    The Commission is adopting Sec. 39.15(c)(1), redesignated as Sec.

    39.13(g)(10),\201\ with the modification described above.

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

    \201\ Redesignation of this provision and several other

    provisions proposed as part of Sec. 39.15 is a non-substantive

    change that moves the provisions to the risk management rules for

    margin requirements. As a risk management rule, the provision

    implements Core Principle D, Section 5b(c)(2)(D)(iii) of the CEA,

    which provides that ``Each [DCO], through margin requirements and

    other risk control mechanisms, shall limit the exposure of the [DCO]

    to potential losses from defaults by members and participants of the

    [DCO].''

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

    6. Valuation and Haircuts--Sec. Sec. 39.15(c)(2) and 39.15(c)(3)

    Proposed Sec. 39.15(c)(2) would require a DCO to use prudent

    valuation practices to value assets posted as initial margin on a daily

    basis. Proposed Sec. 39.15(c)(3) would require a DCO to apply

    appropriate reductions in value to reflect the market and credit risk

    of the assets that it accepts in satisfaction of

    [[Page 69394]]

    initial margin obligations and to evaluate the appropriateness of its

    haircuts on at least a quarterly basis.

    OCC commented that if a DCO can only accept instruments with

    minimal risk, then haircuts should either not be required at all or

    should be very small. The Commission notes that, as defined in Sec.

    39.15(c)(3), haircuts are ``appropriate reductions in value to reflect

    market and credit risk.'' This is a flexible standard that would allow

    a DCO to determine the extent of the haircut based on the extent of the

    risk posed by the instrument deposited as initial margin.

    OCC further stated that proposed Sec. 39.15(c)(3) is ambiguous

    regarding what OCC would be required to test on a quarterly basis. OCC

    explained that its STANS margin methodology does not apply fixed

    haircuts to securities deposited as collateral, but rather treats

    collateral as part of a clearing member's overall portfolio, revisiting

    each ``haircut'' or valuation on a security-by-security, account-by-

    account, and day-by-day basis. Thus, OCC stated that it checks the

    adequacy of its haircuts through back testing and not through a

    periodic review.

    The general language of Sec. 39.15(c)(3), requiring a DCO to

    ``apply appropriate reductions in value to reflect market and credit

    risk * * * to the assets that it accepts in satisfaction of initial

    margin obligations'' and to ``evaluate the appropriateness of such

    haircuts on at least a quarterly basis,'' is broad enough to encompass

    the method of daily valuation and back testing described by OCC.

    The Commission is adopting Sec. 39.15(c)(2), redesignated as Sec.

    39.13(g)(11), as proposed. The Commission is adopting a technical

    revision to Sec. 39.15(c)(3), redesignated as Sec. 39.13(g)(12), by

    adding a reference to ``liquidity'' risk to conform the terminology

    used to describe haircuts (proposed as ``appropriate reductions in

    value to reflect market and credit risk'') with the terminology used in

    Sec. 39.13(g)(10), which refers to assets that have ``minimal credit,

    market, and liquidity risks.'' \202\ The Commission is also making a

    non-substantive revision to replace the phrase ``including in stressed

    market conditions'' with ``taking into consideration stressed market

    conditions.''

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

    \202\ Credit, market, and liquidity risks are concepts that are

    not mutually exclusive, and this articulation of the types of risks

    to be evaluated by a DCO appears in the CEA (Core Principle F,

    Treatment of Funds (requiring that ``[f]unds and assets invested by

    a [DCO] shall be held in instruments with minimal credit, market,

    and liquidity risks''), and ``minimal credit, market, and liquidity

    risks'' is set forth as the standard for assets acceptable for a

    guaranty fund (Sec. 39.11(e)(3)(i)), and as the standard for assets

    acceptable as initial margin (Sec. 39.13(g)(10)).

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

    7. Concentration Limits--Sec. 39.15(c)(4)

    Proposed Sec. 39.15(c)(4) would require a DCO to apply appropriate

    limitations on the concentration of assets posted as initial margin, as

    necessary, in order to ensure the DCO's ability to liquidate those

    assets quickly with minimal adverse price effects. The proposed

    regulation also would require a DCO to evaluate the appropriateness of

    its concentration limits, on at least a monthly basis.

    OCC indicated that the proposed rule was not clear regarding

    whether it would be sufficient to impose concentration charges rather

    than imposing concentration limits, but argued that if the margin

    system adequately penalizes concentration of risk, it does not believe

    that fixed concentration limits are required. The Commission agrees

    that concentration charges, rather than concentration limits, may be

    appropriate in certain circumstances, and is modifying the provision to

    permit a DCO to apply ``appropriate limitations or charges on the

    concentration of assets posted as initial margin'' and to ``evaluate

    the appropriateness of any such concentration limits or charges, on at

    least a monthly basis.'' The inclusion of concentration charges as an

    acceptable alternative to concentration limits is consistent with

    international recommendations.\203\

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

    \203\ See CPSS-IOSCO Consultative Report, Principle 5:

    Collateral, Explanatory Note 3.5.4, at 38.

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

    CME stated its view that the Commission should not prescribe the

    frequency of a DCO's reviews of its concentration limits and it urged

    the Commission to revise Sec. 39.15(c)(4) to replace ``on at least a

    monthly basis'' with ``on a regular basis.'' The Commission believes

    that it is appropriate to require a DCO to evaluate the appropriateness

    of its concentration limits (or charges) on at least a monthly basis

    and notes that Sec. 39.15(c)(4) provides a DCO with the discretion to

    determine the nature of such evaluation.

    The Commission is adopting Sec. 39.15(c)(4), redesignated as Sec.

    39.13(g)(13), with the modifications described above.

    8. Pledged Assets--Sec. 39.15(c)(5)

    Under proposed Sec. 39.15(c)(5), if a DCO were to permit its

    clearing members to pledge assets for initial margin while retaining

    such assets in accounts in the names of such clearing members, the DCO

    would have to ensure that the assets are unencumbered and that the

    pledge has been validly created and validly perfected in the relevant

    jurisdiction. The Commission did not receive any comments discussing

    proposed Sec. 39.15(c)(5) and is adopting the provision, redesignated

    as Sec. 39.13(g)(14), as proposed.

    9. Permitted Investments--Sec. 39.15(d)

    Proposed Sec. 39.15(d) would require that clearing members' funds

    and assets that are invested by a DCO must be held in instruments with

    minimal credit, market, and liquidity risks and that any investment of

    customer funds or assets by a DCO must comply with Sec. 1.25 of the

    Commission's regulations. Moreover, the proposed regulation would apply

    the limitations contained in Sec. 1.25 to all customer funds and

    assets, whether they are the funds and assets of futures and options

    customers subject to the segregation requirements of Section 4d(a) of

    the CEA, or the funds and assets of cleared swaps customers subject to

    the segregation requirements of Section 4d(f) of the CEA.

    The Commission did not receive any comment letters discussing

    proposed Sec. 39.15(d). The Commission is adopting the provision,

    redesignated as Sec. 39.15(e), as proposed.

    10. Transfer of Customer Positions--Sec. 39.15(d)

    The Commission proposed regulations addressing the processing,

    clearing, and transfer of customer positions by swap dealers (SDs),

    major swap participants (MSPs), FCMs, SEFs, DCMs, and DCOs.\204\

    Proposed Sec. 39.15(d) would require a DCO to have rules providing

    that, upon the request of a customer and subject to the consent of the

    receiving clearing member, the DCO would promptly transfer all or a

    portion of such customer's portfolio of positions and related funds

    from the carrying clearing member of the DCO to another clearing member

    of the DCO, without requiring the close-out and rebooking of the

    positions prior to the requested transfer.

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

    \204\ 76 FR 13101 (March 10, 2011) (Straight-Through

    Processing).

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

    MFA, Citadel, and FHLBanks supported the proposal. MFA and Citadel

    suggested that the Commission clarify that associated margin should

    transfer simultaneously with the transferred positions.

    LCH also suggested that the section should be revised to require

    that the transfer of positions and related funds be effected

    simultaneously. LCH believes that absent such a provision, a

    [[Page 69395]]

    DCO could be understood to be required to transfer either the positions

    or the funds, but not both, and such an obligation would expose the DCO

    to risk during the customer transfer.

    FIA agreed with the Commission that a customer should not be

    required to close-out and re-book positions as a condition of

    transferring such positions, and that a clearing member should not

    unnecessarily interfere with a customer's request to transfer

    positions. However, FIA noted that a DCO will not have the immediate

    ability to determine which positions carried in a clearing member's

    omnibus account belong to a particular customer. FIA suggested that a

    DCO's rules provide that the customer submit its request to transfer

    its positions to the clearing member carrying the positions, not to the

    DCO. FIA also suggested that the Commission revise the proposed rule to

    confirm that a clearing member is required to transfer a customer's

    positions only after that customer has met all contractual obligations,

    including outstanding margin calls and any additional margin required

    to support any remaining positions.

    OCC also noted that a customer will not ask a DCO directly to

    transfer a customer position. Like FIA, OCC believes that any such

    transfer must be subject to all legitimate conditions or restrictions

    established by the DCO in connection with its clearing of swaps.

    CME stated that it fully supports the concept of applying the same

    standards to transfer of customer cleared swaps as have historically

    been applied to transfer of customer futures. It noted that a customer

    request to transfer its account is made not to a DCO but to the FCM

    that carries the customer's account.

    ISDA commented that any transfer rule must provide that a party

    seeking transfer not be in default to its existing clearing member.

    ISDA believes that the transfer rule must take into account any cross-

    cleared or cross-margined transactions and in the case where only a

    portion of a customer's portfolio is transferred, clearing members must

    have the ability to condition the transfer on the posting of additional

    margin by the customer.

    KCC commented that this rule is not necessary because KCC has never

    required a futures position to be closed out and re-booked prior to

    transfer from the carrying clearing member to another clearing member,

    nor would KCC require a wheat calendar swap to be closed out and re-

    booked prior to transfer. The Commission notes that such a requirement

    has been imposed by other clearinghouses in connection with swaps.

    In response to concerns raised by commenters, the Commission is

    revising Sec. 39.15(d) to read as set forth in the regulatory text of

    this final rule.

    The language making it explicit that positions and margin be

    transferred at the same time is responsive to the comments of MFA,

    Citadel, and LCH and consistent with prudent risk management

    procedures. The language clarifying that a customer transfer

    instruction would go to a clearing member and not directly to the DCO

    is responsive to the comments of FIA, OCC, and CME. The requirement

    that a customer may not be in default is responsive to the comments of

    FIA and ISDA and consistent with the statement in the notice of

    proposed rulemaking that transfers should be subject to contractual

    requirements. The requirement that positions at both clearing members

    will have appropriate margin is responsive to the comments of MFA,

    Citadel, and ISDA and consistent with the statement in the notice of

    proposed rulemaking that transfers should be subject to contractual

    requirements.

    G. Core Principle G--Default Rules and Procedures--Sec. 39.16

    Core Principle G,\205\ as amended by the Dodd-Frank Act, requires

    each DCO to have rules and procedures designed to allow for the

    efficient, fair, and safe management of events during which clearing

    members become insolvent or otherwise default on their obligations to

    the DCO. In addition, Core Principle G requires each DCO to clearly

    state its default procedures, make its default rules publicly

    available, and ensure that it may take timely action to contain losses

    and liquidity pressures and to continue meeting its obligations. The

    Commission proposed Sec. 39.16 to establish requirements that a DCO

    would have to meet in order to comply with Core Principle G.

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

    \205\ Section 5b(c)(2)(G) of the CEA, 7 U.S.C. 7a-1(c)(2)(G)

    (Core Principle G).

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

    1. General--Sec. 39.16(a)

    Proposed Sec. 39.16(a) would require a DCO to adopt rules and

    procedures designed to allow for the efficient, fair, and safe

    management of events during which clearing members become insolvent or

    default on the obligations of such clearing members to the DCO.

    The Commission did not receive any comment letters discussing

    proposed Sec. 39.16(a), although LCH stated that it concurs with all

    the provisions set out under proposed Sec. 39.16. The Commission is

    adopting Sec. 39.16(a) as proposed.

    2. Default Management Plan--Sec. 39.16(b)

    Proposed Sec. 39.16(b) would require a DCO to maintain a current

    written default management plan that delineates the roles and

    responsibilities of its board of directors, its Risk Management

    Committee, any other committee that has responsibilities for default

    management, and the DCO's management, in addressing a default,

    including any necessary coordination with, or notification of, other

    entities and regulators. The proposed regulation also would require the

    default management plan to address any differences in procedures with

    respect to highly liquid contracts (such as certain futures) and less

    liquid contracts (such as certain swaps). In addition, proposed Sec.

    39.16(b) would require a DCO to conduct and document a test of its

    default management plan on at least an annual basis.

    OCC agreed with the proposal for annual testing of a DCO's default

    management plan, while ISDA stated that such tests should be conducted

    at least on a semi-annual basis. FIA indicated that the default

    management plan should be subject to frequent, periodic testing. The

    Commission believes that it is appropriate and sufficient to require at

    least annual testing of a DCO's default management plan. A particular

    DCO could determine to test its plan on a semi-annual or other periodic

    basis, in its discretion.

    ISDA expressed its view that regulators should review and sign off

    on the default management plans of DCOs. KCC requested that the

    Commission clarify that the default management plan concepts in

    proposed Sec. 39.16(b) may be satisfied by annual testing of the DCO's

    existing set of default rules and procedures. The Commission does not

    believe that it is necessary to adopt an explicit requirement that the

    Commission review and approve a DCO's default management plan. However,

    Commission staff will review a DCO's default management plan in the

    context of the Commission's ongoing DCO review program, including a

    determination of whether a DCO's ``existing set of default rules and

    procedures'' meet the requirements of Sec. 39.16(b).

    The Commission is making a technical revision to Sec. 39.16(b),

    removing the parentheticals and substituting the word ``products'' for

    the word ``contracts.'' The sentence now reads: ``Such plan shall

    address any differences in procedures with respect

    [[Page 69396]]

    to highly liquid products and less liquid products.''

    3. Default Procedures--Sec. 39.16(c)(1)

    Proposed Sec. 39.16(c)(1) would require a DCO to adopt procedures

    that would permit the DCO to take timely action to contain losses and

    liquidity pressures and to continue meeting its obligations in the

    event of a default on the obligations of a clearing member to the DCO.

    The Commission did not receive any comment letters discussing

    proposed Sec. 39.16(c)(1) and is adopting Sec. 39.16(c)(1) as

    proposed.

    4. Default Rules--Sec. 39.16(c)(2)

    Proposed Sec. 39.16(c)(2) would require a DCO to include certain

    identified procedures in its default rules. In particular, proposed

    Sec. 39.16(c)(2)(i) would require a DCO to set forth its definition of

    a default. Proposed Sec. 39.16(c)(2)(ii) would require a DCO to set

    forth the actions that it is able to take upon a default, which must

    include the prompt transfer, liquidation, or hedging of the customer or

    proprietary positions of the defaulting clearing member, as applicable.

    Proposed Sec. 39.16(c)(2)(ii) would further state that such procedures

    could also include, in the DCO's discretion, the auctioning or

    allocation of such positions to other clearing members. Proposed Sec.

    39.16(c)(2)(iii) would require a DCO to include in its default rules

    any obligations that the DCO imposed on its clearing members to

    participate in auctions, or to accept allocations, of a defaulting

    clearing member's positions, and would specifically provide that any

    allocation would have to be proportional to the size of the

    participating or accepting clearing member's positions at the DCO.

    Proposed Sec. 39.16(c)(2)(iv) would require that a DCO's default

    rules address the sequence in which the funds and assets of the

    defaulting clearing member and the financial resources maintained by

    the DCO would be applied in the event of a default. Proposed Sec.

    39.16(c)(2)(v) would require that a DCO's default rules contain a

    provision that customer margin posted by a defaulting clearing member

    could not be applied in the event of a proprietary default.\206\

    Proposed Sec. 39.16(c)(2)(vi) would require that a DCO's default rules

    contain a provision that proprietary margins posted by a defaulting

    clearing member would have to be applied in the event of a customer

    default, if the relevant customer margin were insufficient to cover the

    shortfall.

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

    \206\ This is consistent with the segregation requirements of

    Section 4d of the CEA and Sec. 1.20 of the Commission's

    regulations.

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

    The Commission did not receive any comment letters discussing

    proposed Sec. 39.16(c)(2)(i), (ii) or (iii). The Commission is

    adopting Sec. 39.16(c)(2)(i) as proposed. The Commission is making

    technical revisions to Sec. Sec. 39.16(c)(2)(ii), (iii), (v) and (vi),

    as well as Sec. 39.16(d)(3), by replacing each use of the word

    ``proprietary'' with ``house.''

    As discussed above in connection with participant eligibility

    requirements under Sec. 39.12,\207\ the Commission is revising Sec.

    39.16(c)(2)(iii) to require a DCO that imposes obligations on its

    clearing members to participate in auctions or to accept allocations of

    a defaulting clearing member's positions, to permit its clearing

    members to outsource these obligations to qualified third parties,

    subject to appropriate safeguards imposed by the DCO. The Commission

    believes that it is important to permit outsourcing, while recognizing

    that it is essential to limit participation only to qualified third

    parties. Accordingly, a DCO's rules may impose appropriate terms and

    conditions on outsourcing arrangements, addressing, for example, the

    necessary qualifications to be eligible to act in the clearing member's

    place and conflicts of interest issues. Thus, for example, a clearing

    member could hire a qualified third party to act as its agent in an

    auction. The Commission cautions, however, that any DCO imposing terms

    and conditions that could indirectly deny fair and open access and

    therefore are not ``appropriate,'' i.e., not supported by sound risk

    management policies, may run afoul of Core Principle C and Sec. 39.12.

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

    \207\ See discussion in section IV.C.1.i, above.

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

    The Commission is also making two additional technical revisions to

    Sec. 39.16(c)(2)(iii). First, the Commission is replacing ``a

    defaulting clearing member's positions'' with ``the customer or house

    positions of the defaulting clearing member,'' to correct an oversight

    in the proposed language. Second, the Commission is revising Sec.

    39.16(c)(2)(iii)(A) to provide that any allocation shall be

    ``[p]roportional to the size of the participating or accepting clearing

    member's positions in the same product class at the derivatives

    clearing organization'' (added text in italics) to clarify the

    Commission's intent.

    With respect to proposed Sec. 39.16(c)(2)(iv), OCC agreed that it

    would be appropriate to require DCOs to adopt rules that would define

    the sequence in which the funds and assets of a defaulting clearing

    member and the financial resources maintained by the DCO would be

    applied in the event of a default.

    Freddie Mac expressed concern with the broad discretion that would

    be given to DCOs to determine the sequence in which financial resources

    would be applied in the event of a clearing member default, and

    recommended that DCOs should be required to place non-customer

    resources (e.g., clearing member guaranty funds and their own capital)

    ahead of non-defaulting customer collateral in the risk waterfall. In

    particular, Freddie Mac indicated that if the Commission does not

    require individual segregation of customer collateral, it should

    require DCOs to place non-defaulting customers at the bottom of the

    risk waterfall. Freddie Mac stated that the Commission should defer

    adoption of proposed Sec. 39.16(c) until after adoption of rules

    relating to customer segregation.

    The Commission is adopting Sec. 39.16(c)(2)(iv) to require that a

    DCO adopt rules that identify the sequence of its default waterfall, as

    proposed, without imposing any substantive requirements with respect to

    such sequence, as suggested by Freddie Mac. The Commission is

    addressing the issue of the application of the collateral of non-

    defaulting swaps customers in a separate pending rulemaking,\208\ but

    does not believe that it is appropriate to defer the adoption of

    proposed Sec. 39.16(c) until that rulemaking is complete.

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

    \208\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared

    Swaps Customer Contracts and Collateral; Conforming Amendments to

    the Commodity Broker Bankruptcy Provisions).

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

    The Commission is making a technical revision to Sec.

    39.16(c)(2)(iv) by inserting ``and its customers'' after ``the funds

    and assets of the defaulting clearing member'' to correct an oversight

    in the proposed language.

    ISDA commented that proposed Sec. 39.16(c)(2)(v), which would

    require a DCO to adopt ``[a] provision that customer margin posted by a

    defaulting clearing member shall not be applied in the event of a

    proprietary default'' should be revised to replace the words ``in the

    event of'' with ``to cover losses in respect of''; otherwise, ISDA

    believed that customer margin would not be able to be applied even to

    cover customer losses. The Commission agrees with ISDA and is modifying

    Sec. 39.16(c)(2)(v) by replacing ``in the event of'' with ``to cover

    losses with respect to'' and has made a similar modification to Sec.

    39.16(c)(2)(vi).

    CME recommended that the Commission replace ``proprietary

    [[Page 69397]]

    margins posted by a defaulting clearing member'' in Sec.

    39.16(c)(2)(vi) with ``proprietary margins, positions and any other

    assets in the account of the defaulting clearing member.'' CME argued

    that the Commission's proposed reference to ``proprietary margins

    posted by a defaulting clearing member'' is too narrow in scope, since

    in the event of a clearing member default (whether originating in the

    customer origin or the house origin), a DCO would likely liquidate

    positions in the defaulting clearing member's house account and then

    apply excess funds and not just proprietary margins to cure the

    default. The Commission agrees that ``proprietary margins posted by a

    defaulting clearing member'' is too narrow and is replacing the phrase

    in Sec. 39.16(c)(2)(vi) with ``house funds and assets of a defaulting

    clearing member.'' The Commission believes that ``house funds and

    assets'' is broad enough to include ``proprietary margins, positions

    and any other assets,'' as suggested by CME, and is consistent with the

    language in Sec. 39.16(c)(2)(iv) and Sec. 39.15. The Commission is

    similarly replacing ``customer margin posted by a defaulting clearing

    member'' in Sec. 39.16(c)(2)(v) with ``the funds and assets of a

    defaulting clearing member's customers'' and is replacing ``customer

    margin'' in Sec. 39.16(c)(2)(vi) with ``customer funds and assets.''

    ISDA commented that proposed Sec. 39.16(c)(2)(vi) should be

    revised to insert the word ``excess'' immediately before the words

    ``proprietary margins'' to make it clear that proprietary margin is to

    be applied first to cover proprietary losses, noting that the use of

    proprietary margin to cover customer losses ahead of proprietary losses

    would hasten the mutualization of losses among clearing members, which

    would likely result in higher margin levels being imposed with respect

    to customer positions in order to avoid that outcome. The Commission

    agrees with ISDA and is modifying Sec. 39.16(c)(2)(vi) by inserting

    ``excess'' before ``house funds and assets of a defaulting clearing

    member,'' as suggested by ISDA.

    The Commission is adopting Sec. 39.16(c)(2) with the modifications

    described above.

    5. Publication of Default Rules--Sec. 39.16(c)(3)

    Proposed Sec. 39.16(c)(3) would require that a DCO must make its

    default rules publicly available, and would cross-reference Sec.

    39.21, adopted herein, which also addresses this requirement.\209\

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

    \209\ See discussion of Sec. 39.21 in section IV.L, below.

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

    The Commission did not receive any comment letters discussing

    proposed Sec. 39.16(c)(3) and is adopting Sec. 39.16(c)(3) as

    proposed.

    6. Insolvency of a Clearing Member--Sec. 39.16(d)

    Proposed Sec. 39.16(d)(1) would require a DCO to adopt rules that

    require a clearing member to provide prompt notice to the DCO if the

    clearing member becomes the subject of a bankruptcy petition, a

    receivership proceeding, or an equivalent proceeding, e.g., a foreign

    liquidation proceeding. Proposed Sec. 39.13(d)(2) would require a DCO

    to review the clearing member's continuing eligibility for clearing

    membership, upon receipt of such notice. Proposed Sec. 39.16(d)(3)

    would require a DCO to take any appropriate action, in its discretion,

    with respect to the clearing member or its positions, including but not

    limited to liquidation or transfer of positions, and suspension or

    revocation of clearing membership, upon receipt of such notice.

    CME recommended that, in order to preserve a DCO's right to take

    appropriate steps before a clearing member files for, or is placed

    into, bankruptcy, the Commission should amend proposed Sec. Sec.

    39.16(d)(2) and (3) to require DCOs to take appropriate actions ``no

    later than upon receipt'' of notice that the clearing member is the

    subject of a bankruptcy petition or similar proceeding. The Commission

    is adopting Sec. 39.16(d) with the modifications to Sec. Sec.

    39.16(d)(2) and (3) suggested by CME. In addition, the Commission is

    making a technical revision to Sec. 39.16(d)(3) by replacing the

    phrase ``with respect to such clearing member or its positions'' with

    the phrase ``with respect to such clearing member or its house or

    customer positions.'' This revision eliminates possible ambiguity in

    the reference to ``its positions,'' which was intended to reflect

    current industry practice and include both house and customer

    positions, not just house positions.

    H. Core Principle H--Rule Enforcement--Sec. 39.17

    Core Principle H,\210\ as amended by the Dodd-Frank Act, requires a

    DCO to maintain adequate arrangements and resources for the effective

    monitoring and enforcement of compliance with its rules and resolution

    of disputes. It also requires a DCO to have the authority and ability

    to discipline, limit, suspend, or terminate the activities of a member

    or participant due to a violation by the member or participant of any

    rule of the DCO. It further requires that a DCO report to the

    Commission regarding rule enforcement activities and sanctions imposed

    against clearing members.

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

    \210\ Section 5b(c)(2)(H) of the CEA, 7 U.S.C. 7a-1(c)(2)(H).

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

    Proposed Sec. 39.17 would codify these requirements, adding a

    provision that would require a DCO to report to the Commission in

    accordance with proposed Sec. 39.19(c)(4)(xiii). As proposed, Sec.

    39.19(c)(4)(xiii) would require a DCO to report the initiation of a

    rule enforcement action against a clearing member or the imposition of

    sanctions against a clearing member, no later than two business days

    after the DCO takes such action. As discussed in connection with rules

    implementing Core Principle J (Reporting), the Commission is adopting

    that reporting requirement with a modification that only requires a DCO

    to report sanctions imposed against a clearing member.\211\

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

    \211\ See discussion of rule enforcement reporting in section

    IV.J.5.j, below.

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

    The Commission received no comments on proposed Sec. 39.17. The

    Commission is adopting Sec. 39.17 as proposed, but with a change to

    the cross-reference to Sec. 39.19(c)(4)(xiii) in Sec. 39.17(a)(3) to

    reflect the redesignation of that provision as Sec.

    39.19(c)(4)(xi).\212\

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

    \212\ See id. (The Commission is adopting Sec.

    39.19(c)(4)(xiii) as a renumbered Sec. 39.19(c)(4)(xi)).

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

    I. Core Principle I--System Safeguards--Sec. 39.18

    Core Principle I,\213\ as amended by the Dodd-Frank Act, requires a

    DCO to establish and maintain a program of risk analysis and oversight

    that identifies and minimizes sources of operational risk through the

    development of appropriate controls and procedures, and automated

    systems that are reliable, secure and have adequate scalable capacity.

    Core Principle I also requires that the emergency procedures, back-up

    facilities, and disaster recovery plans that a DCO is obligated to

    establish and maintain specifically allow for the timely recovery and

    resumption of the DCO's operations and the fulfillment of each

    obligation and responsibility of the DCO. Finally, Core Principle I

    requires that a DCO periodically conduct tests to verify that the DCO's

    back-up resources are sufficient to ensure daily processing, clearing,

    and settlement.

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

    \213\ Section 5b(c)(2)(I) of the CEA, 7 U.S.C. 7a-1(c)(2)(I).

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

    Proposed Sec. 39.18 would codify the obligations contained in Core

    Principle I and delineate the minimum requirements that a DCO would be

    required to satisfy in order to comply with Core Principle I. Proposed

    Sec. 39.18 also would define the terms ``relevant

    [[Page 69398]]

    area,'' ``recovery time objective,'' and ``wide-scale disruption'' for

    purposes of that section.

    The Commission received one general comment from LCH. LCH generally

    ``concurred with all the provisions set out under proposed rule

    39.18,'' but urged the Commission to align these provisions with the

    CPSS-IOSCO standards, and to phase in such standards.

    As discussed below, the Commission received comments on proposed

    Sec. Sec. 39.18 (h), (j), and (k), and proposed Sec. 39.30(a).

    The Commission did not receive any comments specifically related to

    the definitions contained in proposed Sec. 39.18(a); proposed

    Sec. Sec. 39.18(b),(c) and (d), which would address the required

    program of risk analysis and oversight; proposed Sec. 39.18(e), which

    would require a DCO to have a business continuity and disaster recovery

    (BC-DR) plan and resources sufficient to enable the DCO to resume daily

    processing, clearing and settlement no later than the next business day

    following a disruption; proposed Sec. 39.18(f), which would address

    outsourcing by a DCO of resources required to meet its responsibilities

    with respect to business continuity and disaster recovery plans;

    proposed Sec. 39.18(g), which would delineate certain exceptional

    events upon the occurrence of which a DCO would be obligated to notify

    promptly the Commission's Division of Clearing and Risk; proposed Sec.

    39.18(h)(1), which would require a DCO to provide timely advance notice

    to the Division of Clearing and Risk of certain planned changes to

    automated systems; or proposed Sec. 39.18(i), which would set forth

    certain records that a DCO would be required to maintain. The

    Commission is adopting each of these provisions as proposed, except

    that the Commission is replacing ``contracts'' with ``products'' in

    Sec. 39.18(a) and is adding ``of the derivatives clearing

    organization's'' before ``own and outsourced resources'' in Sec.

    39.18(f)(2)(ii) for clarification.

    1. Notice of Changes to Program of Risk Analysis and Oversight--Sec.

    39.18(h)(2)

    Proposed Sec. 39.18(h)(2) would require a DCO to give Division of

    Clearing and Risk staff ``timely advance notice'' of ``planned changes

    to the DCO's program of risk analysis and oversight.'' CME commented

    that this is an ``extraordinarily broad requirement'' and urged the

    Commission to ``appropriately consider[] context and relative risks.''

    The Commission is adopting Sec. 39.18(h)(2) as proposed. The

    provision merely requires that DCOs submit such notice as part of their

    planning process. The Commission expects that staff will evaluate

    compliance with this provision, as with all other provisions, giving

    appropriate consideration to context and relative risks.

    2. Testing--Sec. 39.18(j)

    Proposed Sec. 39.18(j) would set forth the requirements for the

    testing that a DCO must conduct of its automated systems and BC-DR

    plans. Proposed Sec. 39.18(j)(1) would require that DCOs conduct

    regular, periodic, and objective testing and review of (i) their

    automated systems, to ensure that such systems are reliable, secure,

    and have adequate scalable capacity, and (ii) their BC-DR capabilities,

    to ensure that the DCO's backup resources meet the standards set forth

    in proposed Sec. 39.18(e). Proposed Sec. 39.18(j)(2) would require

    that these tests ``be conducted by qualified, independent professionals

    * * * [who] may be independent contractors or employees [of the DCO]

    but shall not be persons responsible for development or operation of

    the capabilities being tested.'' Proposed Sec. 39.18(j)(3) would

    require that reports setting forth the protocols for, and the results

    of, such tests ``be communicated to, and reviewed by, senior management

    of the [DCO]'' and that ``[p]rotocols of tests which result in few or

    no exceptions shall be subject to more searching review.''

    ICE, OCC, and MGEX objected to the obligation that the testing

    required by Sec. 39.18(j) be performed by ``qualified, independent

    professionals.'' ICE contended that the proper standard should be to

    have qualified, independent professionals review, rather than conduct

    testing of, systems or capabilities. Similarly, OCC suggested that the

    testing could be overseen, rather than conducted, by an independent

    professional. MGEX objected more generally to the requirement that

    tests of its BC-DR capabilities be performed by ``independent

    professionals'' and expressly objected to the proposal's prohibition on

    the use of any employees who participated in the development or the

    operation of the systems or capabilities being tested to fulfill this

    role. MGEX argued that such persons are the most qualified persons to

    run the tests. KCC requested that a DCO's CRO or other similar official

    qualify as an `independent professional' for purposes of the testing

    rule.

    The Commission is adopting Sec. 39.18(j) as proposed. The

    Commission notes that the obligation that the required testing of

    automated systems and BC-DR capabilities be performed by qualified,

    independent professionals is consistent with the Commission's

    historical practice of requiring independent testing of systems where

    appropriate.\214\

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

    \214\ For example, paragraph (a)(2) of the application guidance

    to Core Principle 9 (prior to amendment by the Dodd-Frank Act) for

    contract markets noted that ``Any program of independent testing and

    review of [an automated] system should be performed by a qualified,

    independent professional.'' 17 CFR part 38, appendix B at Core

    Principle 9, paragraph (a)(2).

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

    The Commission recognizes that persons charged with developing or

    operating a system are frequently called upon to test that system. The

    Commission believes, however, that the active involvement and direction

    of qualified, independent professionals in the testing process is

    needed to ensure objective and accurate results.

    MGEX's requested approach would result in tests being conducted

    only by persons with an inherent conflict of interest (because negative

    results of the tests might call into question the work of those who

    developed or operate the systems) and, separately, would deny the DCO

    the benefit of an independent analysis of the workings of the system.

    Accordingly, while some testing of a DCO's automated systems and BC-DR

    capabilities may be conducted by persons who design or operate such

    system or capabilities, the Commission has decided to retain the

    requirement that the objective testing performed to satisfy Sec.

    39.18(j) must be conducted by qualified, independent persons, as

    defined therein. While a DCO's CRO may appropriately serve this

    function if he or she has the appropriate training and experience to be

    ``qualified'' in this context, and the appropriate role in the

    organization to be ``independent,'' the Commission does not believe it

    would be advisable to determine that the person serving in such a role

    is necessarily qualified and independent.

    3. Coordination of BC-DR Plans With Members and Providers of Essential

    Services--Sec. 39.18(k)

    Proposed Sec. 39.18(k) would require that a DCO to the extent

    practicable: (1) Coordinate its BC-DR plan with those of its clearing

    members, in a manner adequate to enable effective resumption of daily

    processing, clearing, and settlement following a disruption; (2)

    initiate and coordinate periodic, synchronized testing of its BC-DR

    plans and the plans of its clearing members; and (3) ensure that its

    BC-DR plan takes into account the plans of its providers

    [[Page 69399]]

    of essential services, including telecommunications, power, and water.

    MGEX proposed that industry-sponsored events should suffice to

    satisfy the requirement that a DCO must coordinate its BC-DR plan with

    those of its members. Similarly, KCC requested that the Commission

    clarify that coordination would be deemed to be satisfied if the DCO

    reviews the BC-DR plans of its clearing members and essential service

    providers and subsequently provides to such parties the DCO's own BC-DR

    plan. KCC stated that it does not believe that coordination should

    involve extensive efforts at achieving specific consistency between the

    procedures of each party, as each has a distinct business model that

    faces varying operational risks.

    NYPC objected to the requirement contained in proposed Sec.

    39.18(k)(3). NYPC noted that its business continuity plan (BCP) would

    be invoked any time a service provider ceases to provide an essential

    service, regardless of whether that service provider has invoked its

    own BCP, and thus such information would not necessarily give DCOs any

    additional insight into their own BCP. Similarly, CME noted that, while

    it obtains representations that its major vendors have disaster

    recovery plans, CME does not control, or generally have access to, the

    details of the proprietary plans of those service providers.

    The Commission is adopting Sec. 39.18(k) as proposed. With respect

    to the requirements of Sec. Sec. 39.18(k)(1) and (2), the Commission

    recognizes that participation in industry-sponsored events, such as the

    annual testing conducted by FIA, serves as an important assessment of

    the connectivity between the systems of DCOs and their members

    (including backup sites), but such participation would not, in and of

    itself, satisfy the requirements of these regulations. The level of

    participation of a particular DCO in a particular industry test is left

    to the discretion of the DCO, and different DCOs may participate in

    such tests to different extents. Moreover, while such industry-

    sponsored events may be helpful, it is the responsibility of each DCO--

    not that of an industry organization--to ensure that the functionality

    of clearing will be maintained between the DCO and its members. The

    Commission believes that a DCO will best be able to meet its

    responsibilities reliably in a wide-area disaster that affects a DCO

    and its clearing members if the DCO has actively worked together with

    those clearing members to coordinate their plans and has obtained some

    evidence that such plans will appropriately mesh when implemented.

    While it is true that a DCO should have backup arrangements that

    promptly can be engaged to address a failure of essential services, it

    is likely that most DCOs will prepare for a temporary, rather than an

    indefinite, loss of such services. Among the benefits provided by

    coordination of a DCO's BCP with that of providers of essential

    services is an insight into the period of time for which the DCO should

    be prepared to provide such services itself.

    The Commission recognizes that a service provider may reasonably be

    reluctant to provide sensitive details of its own BCP, such as the

    precise location of backup facilities, and notes that the proposed

    requirement is prefaced with the limitation that a DCO is required to

    obtain this information only ``to the extent practicable.''

    Nonetheless, merely obtaining a representation that states that a

    service provider has a backup plan--with no detail as to the Recovery

    Time Objective (RTO) of that service provider, and no insight into how

    that service provider's BCP might affect the BCP of the DCO--would

    likely be insufficient.

    4. Recovery Time Objective--Sec. 39.18(a)

    Proposed Sec. 39.18(a) would define an RTO as the period within

    which an entity should be able to achieve recovery and resumption of

    clearing and settlement of existing and new contracts after those

    capabilities become temporarily inoperable for any reason up to a wide-

    scale disruption, and defines a wide-scale disruption as an event that

    causes a severe disruption or destruction of transportation,

    telecommunications, power, water or other critical infrastructure

    components in a relevant area, or an event that results in an

    evacuation or unavailability of the population in a relevant area.

    Proposed Sec. 39.18(e)(3) would require that a DCO have an RTO of the

    next business day, while proposed Sec. 39.30(a) would require that a

    SIDCO have an RTO of two hours.

    ICE noted that proposed Sec. 39.18(a) does not specify a minimum

    time that a wide-scale disruption must be accommodated, and that costs

    would be higher if the unavailability of staff in the relevant area

    that must be accommodated is the total loss of personnel. ICE suggested

    that one week would allow relocation of personnel outside the affected

    area.

    The Commission is adopting Sec. Sec. 39.18(a) and 39.18(e)(3) as

    proposed. However, as discussed above in connection with the financial

    resources requirements, the Commission believes that it would be

    premature to take action regarding Sec. 39.30 at this time. The

    Commission will consider the proposals relating to SIDCOs together in

    the future.

    J. Core Principle J--Reporting Requirements--Sec. 39.19

    Core Principle J,\215\ as amended by the Dodd-Frank Act, requires a

    DCO to provide the Commission with all information that the Commission

    determines to be necessary to conduct oversight of the DCO. The

    Commission proposed Sec. 39.19 to establish requirements that a DCO

    would have to meet in order to comply with Core Principle J. Under

    proposed Sec. 39.19, certain reports would have to be made by a DCO to

    the Commission: (1) On a periodic basis (daily, quarterly, or

    annually), (2) where the reporting requirement is triggered by the

    occurrence of a significant event; and (3) upon request by the

    Commission. Section 39.19(a) states the general requirement of Core

    Principle J. The Commission did not receive any comment letters

    discussing Sec. 39.19(a) and is adopting the provision as proposed.

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

    \215\ Section 5b(c)(2)(J) of the CEA, 7 U.S.C. 7a-1(c)(2)(J).

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

    1. Submission of Reports--Sec. 39.19(b)

    The Commission proposed Sec. 39.19(b) to establish procedural

    requirements for electronic submission of reports and determination of

    time zones applicable to filing deadlines. The Commission received no

    comments and is adopting Sec. Sec. 39.19(b)(1) and (2) as proposed.

    For purposes of clarification, the Commission is also adopting Sec.

    39.19(b)(3) to provide a definition of ``business day'' as ``the

    intraday period of time starting at the business hour of 8:15 a.m. and

    ending at the business hour of 4:45 p.m., on all days except Saturdays,

    Sundays, and Federal holidays.'' This is consistent with the definition

    of ``business day'' set forth in Sec. 40.1(a).\216\

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

    \216\ See 76 FR at 44790 (July 27, 2011) (Provisions Common to

    Registered Entities; final rule).

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

    2. Daily Reporting--Sec. 39.19(c)(1)

    Proposed Sec. 39.19(c)(1) would require a DCO to submit daily

    reports with certain initial margin and variation margin data as well

    as other cash flows for each clearing member. More specifically, Sec.

    39.19(c)(1)(i) would require a DCO to report both the initial margin

    requirement for each clearing member, by customer origin and house

    origin, and the initial margin on deposit for each clearing member, by

    origin.

    [[Page 69400]]

    Proposed Sec. 39.19(c)(1)(ii) would require a DCO to report the daily

    variation margin collected and paid by the DCO, listing the mark-to-

    market amount collected from or paid to each clearing member, by

    origin.\217\

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

    \217\ This requirement would apply to options transactions only

    to the extent a DCO uses futures-style margining for options.

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

    Proposed Sec. 39.19(c)(1)(iii) would require a DCO to report all

    other cash flows relating to clearing and settlement including, but not

    limited to, option premiums and payments related to swaps such as

    coupon amounts, collected from or paid to each clearing member, by

    origin. Proposed Sec. 39.19(c)(1)(iv) would require a DCO to report

    the end-of-day positions for each clearing member, by customer origin

    and house origin.

    In addition, as discussed in section IV.D.6.h.(2), above, in

    connection with the Commission's proposal to require DCOs to collect

    initial margin for customer accounts on a gross basis under proposed

    Sec. 39.13(g)(8)(i), the Commission further proposed an addition to

    proposed Sec. 39.19(c)(1)(iv) that would also require DCOs to report,

    for each clearing member's customer account, the end-of-day positions

    of each beneficial owner. The Commission is adopting Sec. 39.19(c)(1)

    with two modifications. First, the Commission is not requiring

    reporting of customer positions by beneficial owner, except upon

    Commission request.\218\ Second, as discussed below, the Commission is

    renumbering the paragraphs in Sec. 39.19(c)(1) and adding a new

    paragraph (ii) to clarify the applicability of the daily reporting

    requirements to FCM/BDs. In addition, the Commission is replacing ``by

    customer origin and house origin'' with ``by house origin and by each

    customer origin''; and is replacing ``options on futures positions''

    with ``options positions.''

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

    \218\ See further discussion of reports of beneficial ownership

    in section IV.D.6.h.(2), above.

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

    MGEX and KCC commented that while such information is available to

    them,\219\ they are concerned that if the Commission mandates a

    specific form of delivery, the cost to DCOs will be significantly

    higher than expected. MGEX referred to its recent experience with the

    Trade Capture Reporting initiative conversion to the Commission's new

    FIXML standards, which was more costly and time consuming than

    expected. KCC commented that all of the data proposed to be reported to

    the Commission is already made readily available to the Commission in

    varying degrees, and there is little need for the Commission to require

    the increasing level of detailed information in specified formats. In

    addition, MGEX expressed concern with the Commission's potential data

    storage capacity limitations. MGEX concluded that the combination of

    these two factors suggest that the burden of the daily reporting

    requirements on DCOs and the Commission outweigh the value of these

    reports.

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

    \219\ MGEX noted that it is already ``internally performing

    these tasks'' in reference to the several daily reporting

    requirements. KCC has also noted that it already submits trading

    activity and positions by each clearing member by origin on a daily

    basis in file formats prescribed by the Commission.

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

    MGEX suggested that requiring such data on an as-needed, rather

    than a daily, basis would limit the burden on DCOs and the Commission

    while ensuring relevancy as to the data being requested. KCC asked that

    the Commission reconsider the amount and detail of information

    necessary for its oversight role. While CME supported the proposed

    reporting requirement, it suggested that the Commission work with DCOs

    to determine the form and manner of delivery.

    As mentioned in the notice of proposed rulemaking, many DCOs

    already provide the Commission with much of the data required under

    this provision. The Commission recognizes that the daily reporting

    requirements may place an additional burden on a DCO, particularly if

    the DCO must employ a specific form of delivery that it does not

    already have in place. However, establishment of an automated reporting

    system is a one-time cost, and a uniform reporting format for all DCOs

    is necessary to facilitate the Commission's ability to receive data

    promptly and quickly disseminate it within the agency.\220\

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

    \220\ The Commission notes that its staff is in the process of

    developing a plan for uniform submission of DCO reports.

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

    The overall purpose of receiving the daily data is to enable

    Commission staff to analyze the data on a regular basis so that it can

    detect certain trends or unusual activity on a timely basis. Receiving

    such data less frequently would significantly reduce its usefulness.

    While there may be initial costs for DCOs to set up the reporting

    systems, there should be little cost to DCOs on a continuing

    basis.\221\ Finally, MGEX's suggestion to require such data on an as-

    needed basis does not further the objective of enhanced risk

    surveillance, given that the purpose of gathering the data is to

    identify and address potential problems at the earliest possible time.

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

    \221\ See further discussion of the costs and benefits of the

    reporting requirements in section VII.J, below.

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

    OCC expressed concern that the reporting requirements make no

    accommodation for clearing members that are FCM/BDs, with respect to

    their securities positions. In response to OCC's comment, the

    Commission is adding a new paragraph (ii) to Sec. 39.19(c)(1) to

    clarify the limited applicability of the daily reporting requirements

    to securities positions. The final rule provides that ``The report

    shall contain the information required by paragraph (c)(1)(i) of this

    section for (A) all futures positions, and options on futures

    positions, as applicable; (B) all swaps positions; and (C) all

    securities positions that are held in a customer account subject to

    Section 4d of the Act or are subject to a cross-margining agreement.''

    3. Quarterly Reporting--Sec. 39.19(c)(2)

    The Commission is adopting Sec. 39.19(c)(2), requirements for

    quarterly reporting of financial resources, as proposed.\222\

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

    \222\ See further discussion of the quarterly reporting

    requirement under Sec. 39.11(f) in section IV.B.10, above.

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

    4. Annual Reporting--Sec. 39.19(c)(3)

    Proposed Sec. 39.19(c)(3) would require a DCO to submit a report

    of the CCO and an audited financial statement annually, as required by

    Sec. 39.10(c). The Commission received no comments on proposed Sec.

    39.19(c)(3), and the Commission is adopting Sec. 39.19(c)(3) as

    proposed.

    The Commission notes that in a separate proposed rulemaking

    implementing Core Principle O (Governance Fitness Standards), it

    proposed a new Sec. 39.24(b)(4) which would require annual

    verification that directors, members of the disciplinary panel and

    disciplinary committee, clearing members, persons with direct access,

    and certain affiliates of a DCO, satisfy applicable fitness

    standards.\223\ In connection with this, the Commission subsequently

    proposed to cross-reference this annual reporting obligation as a

    renumbered Sec. 39.19(c)(3)(iii). At such time as the Commission may

    adopt the verification requirement as a final rule, Sec. 39.19(c)(3)

    will be amended accordingly.

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

    \223\ See 76 FR at 736 (Jan. 6, 2011) (Governance).

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

    5. Event-Specific Reporting--Sec. 39.19(c)(4)

    a. Decrease in Financial Resources--Sec. 39.19(c)(4)(i)

    Under proposed Sec. 39.19(c)(4)(i), a DCO would be required to

    report to the

    [[Page 69401]]

    Commission a 10 percent decrease in the total value of the financial

    resources required to be maintained by the DCO under Sec. 39.11(a),

    either from the last quarterly report. or from the value as of the

    close of the previous business day. Such notification would alert the

    Commission of potential strain on the DCO's financial resources, either

    gradual or precipitous.

    The Commission invited comments regarding possible alternatives as

    to what would be considered a significant drop in the value of

    financial resources. Although many commenters opposed using the 10

    percent threshold as a barometer for a ``significant'' decrease, no

    commenter questioned the Commission's objective in obtaining this type

    of information in a timely manner.

    MGEX commented that 10 percent is an arbitrary threshold and it is

    not uncommon for financial resources to fluctuate by 10 percent even in

    a stable market. Similarly, OCC and KCC stated that the threshold is

    arbitrary and would most likely be crossed on a frequent basis during

    the ordinary course of business.\224\ In addition, KCC suggested that

    this requirement is duplicative, as a material drop in financial

    resources would already be required to be reported by the proposed

    requirement to report all material adverse changes (Material Adverse

    Change Reporting Requirement).\225\

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

    \224\ KCC mentioned that changes in the level of excess

    permanent margin deposited by clearing members, changes in the

    minimum margin requirements on contracts or in the level of the

    guarantee pool requirements, and changes in the level of assessments

    that can be levied against clearing members in the event of a

    default, could cause financial resources to drop more than 10

    percent within the ordinary course of business. OCC stated it would

    cross the 10 percent threshold on an almost monthly basis, i.e., the

    day after monthly expirations occur.

    \225\ See discussion of proposed Sec. 39.19(c)(4)(xiv)

    (finalized as Sec. 39.19(c)(4)(xii)) in section IV.J.5.k, below.

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

    OCC, Better Markets, and Mr. Barnard were also concerned about the

    types of financial resources to consider when calculating a decrease.

    OCC suggested it is counterproductive to report a decrease in financial

    resources as a result of a decrease in margin requirements, which is a

    sign of risk reduction. Similarly, Better Markets suggested that

    coincidental increases in margin-based financial resources, which could

    fluctuate substantially, could offset decreases by more important

    financial resources. In addition, Mr. Barnard raised concerns

    regarding: (1) Grouping all types of financial resources together for

    purposes of calculating decreases, and (2) whether only requiring a

    report of a decrease in financial resources is sufficient.

    Several commenters proposed using a different threshold: (1) OCC

    suggested 25 percent; (2) MGEX suggested allowing a DCO to determine

    what constitutes a material decrease or, as an alternative, adopting a

    threshold of 30 percent over a five-day period and 25 percent when

    compared to the previous quarter; and (3) Better Markets suggested

    adopting a threshold of 5 percent of non-margin-based financial

    resources. NYPC recommended taking an approach similar to the FCM

    ``early warning'' reporting requirement.\226\

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

    \226\ Section 1.12(b)(2) requires an FCM to give 24 hours notice

    to the Commission if it ``knows or should have known'' that its

    adjusted net capital is at any time less than 110 percent of the

    amount required by the Commission's net capital rule.

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

    To compensate for an upwards adjustment of the financial resources

    requirement, Better Markets suggested also requiring a report if the

    ratio of financial resources to minimum required levels decreases to 1

    to 1. Mr. Barnard suggested splitting financial resources into two

    groups: (1) The more ``robust'' financial resources (a DCO's own

    capital and guaranty fund), and (2) market or risk-related items

    (margins); and requiring a report for a decrease in either amount or a

    decrease in the total of both amounts. Mr. Barnard also suggested

    requiring a DCO to report a calculation of its ``solvency ratio''

    (available financial resources/financial resources requirements) and a

    5 percent or more drop in such ratio.

    In response to commenters' objections to setting the level at 10

    percent, the Commission is setting the reporting threshold at a level

    of 25 percent for both the daily and quarterly financial resources

    decreases. As noted, OCC suggested 25 percent while MGEX suggested 25

    percent for the quarterly and 30 percent for a report covering any 5-

    day period. MGEX did not explain why there should be a distinction

    between the percentage decrease triggering the quarterly and shorter-

    term reports. The Commission believes that a 25 percent level addresses

    the commenters' concerns about ``noise'' while providing the Commission

    with notification of material decreases.

    The Commission is not excluding certain financial resources from

    the decrease calculation as suggested by several commenters. Although

    there are certain financial resources that may fluctuate in the

    ordinary course of business, the Commission believes that setting the

    reporting threshold level higher should resolve many of these issues

    because fewer fluctuations that occur in the ordinary course of

    business would trigger the higher 25 percent threshold. Additionally,

    the purpose of the financial resources requirement in Core Principle B

    and as codified in the Commission's regulations is to ensure that a DCO

    has adequate resources to cover the default of the clearing member with

    the largest exposure. Financial resources are looked at in the

    aggregate. Thus, fluctuations during the ordinary course of business,

    even coincidental decreases in financial resources, all reflect the

    financial health of the DCO at that time.

    The Commission is not replacing the financial resources percentage

    decrease reporting requirement with a requirement similar to the FCM

    ``early warning'' reporting requirement, as suggested by NYPC. While

    FCMs do have an ``early warning'' reporting requirement, this is only

    in addition to an FCM's requirement to also report decreases of 20

    percent pursuant to Sec. 1.12(g)(1).\227\ In fact, even with the new

    financial resources reporting requirement for DCOs, DCOs still have a

    lesser reporting requirement than FCMs in this regard: DCOs are only

    required to report 25 percent decreases, while FCMs are required to

    report 20 percent decreases in addition to reporting decreases below

    certain thresholds (the ``early warning'' requirement).

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

    \227\ Section 1.12(g)(1) requires an FCM to provide written

    notice within two business days of a substantial reduction in

    capital as compared to that last reported in a financial report if

    there is a reduction in net capital of 20 percent or more.

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

    The Commission is adopting the modified Sec. 39.19(c)(4)(i)

    reporting requirement described herein. The Commission does not

    consider it to be duplicative of the Material Adverse Change Reporting

    Requirement, or the quarterly financial resource reporting requirement

    under Sec. 39.11(f), as suggested by KCC. Each reporting requirement,

    including the financial resources reporting requirement, relates to

    specific circumstances that the Commission has determined to be

    material and which, based on its experience in conducting financial

    risk surveillance, the Commission believes warrants notification. The

    Material Adverse Change Reporting Requirement is intended to cover more

    unusual changes that are not readily identifiable in advance but would

    nonetheless be of interest to Commission staff in conducting its

    oversight of a DCO. The Commission is also not requiring the solvency

    ratio decrease reporting requirement suggested by Mr. Barnard. The

    Commission believes that receiving reports regarding financial

    resources decreases will serve the purpose of alerting the Commission

    to possible financial distress at a DCO, without

    [[Page 69402]]

    unnecessarily burdening a DCO with additional reporting requirements.

    NYPC pointed out that the proposed rule language referring to a

    decrease in the ``total value of financial resources'' could be read to

    refer to the total combined default and operating resources. It also

    raised a question as to whether the reference to financial resources

    ``required to be maintained * * * under Sec. 39.11(a)'' referred to

    the minimum amount ``required'' or if it was intended to encompass all

    financial resources ``available to satisfy'' the requirements.

    The Commission intends the reporting requirement in Sec.

    39.19(c)(4)(i) to refer only to financial resources available to cover

    a default in accordance with Sec. 39.11(a)(1). A significant change in

    the amount of financial resources available to meet operating expenses

    is addressed by Sec. 39.19(c)(4)(iv).\228\ In response to the

    interpretive issues raised by NYPC, the Commission is revising the

    language in Sec. 39.19(c)(4)(i) to clarify that the decrease in

    financial resources refers to a decrease in resources ``available to

    satisfy the requirements under Sec. 39.11(a)(1)'' so it is clear that

    the reporting requirement applies only to default resources and refers

    to those resources available to the DCO to satisfy the default resource

    requirements, even if the amount of those resources exceeds the minimum

    amount that is required by Sec. 39.11(a)(1).\229\

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

    \228\ See discussion of Sec. 39.19(c)(4)(iv) in section

    IV.J.5.d, below.

    \229\ As a technical matter, ICE Clear sought clarification in

    the rule text regarding the reference to Sec. 39.11(a), pointing

    out that Sec. 39.11(a) sets the standard for financial resources

    and Sec. 39.11(b) lists the financial resources available to

    satisfy those standards. ICE Clear recommended that Sec.

    39.19(c)(4)(i) be revised to refer to both Sec. Sec. 39.11(a) and

    (b). The Commission declines to include a reference to Sec.

    39.11(b) as the purpose of the cross-reference is to incorporate by

    reference the standard, not the means for satisfying the standard.

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

    The Commission notes that it should be apprised when a DCO

    experiences a 25 percent decrease in the value of its default resources

    from the value as of the close of the previous business day, even if

    their value has increased substantially since the last quarterly

    report. Such a change could signal a significant change in a DCO's risk

    profile and early reporting will enable the Commission to take

    appropriate measures to facilitate proper risk management at the DCO.

    b. Decrease in Ownership Equity--Sec. 39.19(c)(4)(ii)

    Proposed Sec. 39.19(c)(4)(ii) would require a DCO to report an

    expected 20 percent decrease in ownership equity two business days

    prior to the event (or two business days following the event, if the

    DCO does not and reasonably should not have known prior to the event).

    Such report must include pro forma financial statements (or current

    financial statements) reflecting the anticipated condition of the DCO

    following the decrease (or current condition). The report is intended

    to alert the Commission of major planned events that would

    significantly affect ownership equity, most of which are events of

    which the DCO would have advance knowledge, such as a reinvestment of

    capital, dividend payment, or a major acquisition.

    Better Markets commented that a decrease in ownership equity is an

    extraordinary event which would warrant notification for even a 5

    percent decrease, the threshold the SEC uses for triggering reporting

    of acquisition of beneficial ownership of a class of shares. While a

    decrease in ownership equity can have a significant effect on the

    financial resources of a DCO, the Commission determined that 20 percent

    is a level that would represent a significant decrease and yet would

    not occur on a frequent basis. The Commission believes that setting the

    threshold lower than 20 percent would unnecessarily increase the

    potential burden on DCOs as well as on the Commission, which could then

    be responsible for reviewing a larger number of reports.

    Better Markets also suggested that five business days advance

    notice is more appropriate and would not pose a significant burden for

    DCOs. While changing the requirement to five business days does not

    itself pose an additional burden on a DCO, the Commission is adopting

    the two-day notification requirement, as proposed. The Commission has

    determined that requiring the report two days prior to such an event is

    sufficient for its purposes in reviewing the transaction, particularly

    given the confidential nature of such a transaction.

    OCC expressed concern that it would be problematic to provide the

    necessary financial statements within the time frame required; OCC

    stated that it runs financial statements on a monthly basis, thus it

    would not have them readily available within two days. Rather, OCC

    suggested keeping the notification time frame at two days, but allowing

    up to 30 days, or when the financial statements are ready, whichever

    occurs first, to provide the financial statements. The Commission is

    adopting the two-day requirement, as proposed. A 20 percent decrease in

    ownership equity is generally a major, planned event and the Commission

    believes it would be highly unusual for a DCO not to have financial

    statements prepared in connection with such a transaction.

    The Commission is adopting Sec. 39.19(c)(4)(ii) as proposed.

    c. Six-Month Liquid Asset Test--Sec. 39.19(c)(4)(iii)

    Proposed Sec. 39.19(c)(4)(iii) would require immediate notice of a

    deficit in the six months of liquid assets required by Sec.

    39.11(e)(2). CME expressed concern with other ``immediate notice''

    events,\230\ stating that this would require a DCO to immediately

    notify the Commission, in the specific form and manner requested, even

    before the DCO attends to the situation and gathers all the relevant

    information. CME recommended only requiring ``prompt'' notice, which

    would require the DCO to notify the Commission ``quickly and

    expeditiously,'' while allowing the DCO to first attend to the

    situation at hand and ensure that the information reported to the

    Commission is correct and accurate. CME also suggested ``prompt''

    notice for the Material Adverse Change Reporting Requirement.

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

    \230\ CME referred to the immediate notice required under

    proposed Sec. Sec. 39.19(c)(4)(v)-(ix).

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

    The Commission is adopting the rule as proposed and retaining the

    ``immediate'' reporting requirement for both Sec. 39.19(c)(4)(iii) and

    the Material Adverse Change Reporting Requirement.\231\ While the

    Commission appreciates that in such situations a DCO would be busy

    attending to the matter at hand, the burden to contact the Commission

    is minimal. The Commission does not specify a particular form or manner

    of delivery, so as to minimize the burden on the DCO. Moreover, the

    Commission is concerned that using a time frame of ``prompt'' would

    leave too much open to interpretation by the DCO and could lead to

    untimely notices.

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

    \231\ See further discussion of the Material Adverse Change

    Reporting Requirement in section IV.J.5.k, below.

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

    d. Change in Working Capital (Current Assets)--Sec. 39.19(c)(4)(iv)

    Proposed Sec. 39.19(c)(4)(iv) would require a DCO to report to the

    Commission no later than two business days after working capital is

    negative. The report must include a current balance sheet of the DCO.

    Better Markets commented that allowing a DCO two days to report

    negative working capital is too much time, given the potential gravity

    of the situation, and that anything less than a requirement of

    immediate notification is ``simply indefensible.''

    [[Page 69403]]

    As with the ownership equity decrease reporting requirement, OCC

    commented that it is problematic to submit a balance sheet in two

    business days. OCC suggested keeping the notification requirement at

    two days, but allowing up to 30 days (or sooner if ready) to provide a

    balance sheet.

    The Commission is adopting Sec. 39.19(c)(4)(iv) as proposed,

    except that it is revising certain terminology to clarify the intended

    meaning of the term ``working capital.'' While the Commission agrees

    that negative working capital is a serious matter, immediate reporting

    is not necessary to further the Commission's purpose in obtaining this

    information. The Commission is allowing up to two days for notification

    because immediate notification would require a DCO to put in place a

    potentially expensive system to allow for real-time tracking of working

    capital. Nonetheless, a DCO is expected to have a general knowledge of

    the level of its working capital at all times. By allowing two days for

    notification, a DCO will have time to compute whether working capital

    is negative if it has reason to believe that this may be the case,

    without being required to implement a real-time notification system.

    Thus, the purpose of the two business days is actually to give a DCO

    time to become aware of its obligation to report, not to allow the DCO

    to wait two days after it becomes aware of the situation.

    The Commission is also requiring the DCO to submit a balance sheet

    within two business days of the DCO experiencing negative working

    capital. Given that a DCO would be expected to update its balance sheet

    upon realizing that it has negative working capital, the Commission

    does not believe this requirement imposes an additional burden on the

    DCO.

    As ``working capital'' is not a defined term, the Commission is

    substituting the term ``current assets'' for ``working capital'' for

    purposes of clarification. Thus, ``negative working capital'' now

    refers to a situation when current liabilities exceed current assets.

    Section 39.19(c)(4)(iv) now reads as follows: ``Change in current

    assets. No later than two business days after current liabilities

    exceed current assets; the notice shall include a balance sheet that

    reflects the derivatives clearing organization's current assets and

    current liabilities and an explanation as to the reason for the

    negative balance.''

    e. Intraday Initial Margin Calls--Sec. 39.19(c)(4)(v)

    Proposed Sec. 39.19(c)(4)(v) would require a DCO to report to the

    Commission any intraday margin call to a clearing member, no later than

    one hour following the margin call. Several commenters stated that the

    requirement is unnecessary and a burden on DCOs, while other commenters

    requested certain modifications to the proposal.

    The Commission is not adopting the intraday margin call reporting

    requirement in proposed Sec. 39.19(c)(4)(v). While such information

    could provide early notice of potential problems at a DCO, the

    Commission has concluded that the requirement would be overly

    burdensome to DCOs given the amount of work commenters indicated it

    would entail. In addition, the Commission will still receive much of

    the same information as part of each DCO's daily reporting under Sec.

    39.19(c)(1), and unusual intraday initial margin calls that reflect a

    material adverse change will still be reported under the Material

    Adverse Change Reporting Requirement.

    f. Issues Related to Clearing Members--Sec. Sec. 39.19(c)(4)(vi)-(ix)

    Proposed Sec. Sec. 39.19(c)(4)(vi)-(ix) would require a DCO to

    report the following issues related to clearing members: (1) A delay in

    collection of initial margin; (2) a request to clearing members to

    reduce positions; (3) a determination by the DCO to transfer or

    liquidate a clearing member position; and (4) a default of a clearing

    member. The Commission received comments suggesting that these

    reporting requirements are unnecessary or, at the very least, require

    some modification. KCC suggested not adopting these requirements

    altogether, because notification of these events would still be

    required under the Material Adverse Change Reporting Requirement.

    The Commission has concluded that delays in the collection of

    initial margin are not necessarily signs of a financial problem at

    either the DCO or its clearing members. The Commission therefore is not

    adopting the requirement to report such delays under proposed Sec.

    39.19(c)(4)(vi). Nonetheless, if a delay is evidence of a material

    adverse change in the financial condition of a clearing member, it

    would still have to be reported under the Material Adverse Change

    Reporting Requirement.

    The Commission is adopting the remainder of these reporting

    requirements as proposed. However, it is redesignating proposed

    Sec. Sec. 39.19(c)(4)(vii)-(ix) as Sec. Sec. 39.19(c)(4)(v)-(vii).

    These reporting requirements relate to events that occur infrequently

    but can be of significance to the Commission's risk surveillance

    program even if they do not rise to the level of having ``a material

    adverse financial impact'' on the DCO or represent ``a material adverse

    change in the financial condition of any clearing member'' under the

    Material Adverse Change Reporting Requirement. Thus, with respect to

    these reports, the Commission is not relying on the Material Adverse

    Change Reporting Requirement as suggested by KCC.

    In connection with these proposed requirements, the Commission also

    proposed removing Sec. 1.12(f)(1) in light of the fact that its

    requirements were substantially similar to those being proposed as

    Sec. 39.19(c)(4)(viii). The Commission did not receive any comments on

    this proposal and is removing Sec. 1.12(f)(1) as proposed.

    g. Change in Ownership or Corporate or Organizational Structure--Sec.

    39.19(c)(4)(x)

    Proposed Sec. 39.19(c)(4)(x) would require a DCO to report certain

    changes in ownership or corporate or organizational structure. In

    general, such reports must be submitted to the Commission three months

    in advance of the anticipated change. With the exception of the change

    discussed below, the Commission is adopting Sec. 39.19(c)(4)(x) as

    proposed, redesignated as Sec. 39.19(c)(4)(viii).

    Proposed Sec. 39.19(c)(4)(x)(A)(2) (redesignated as Sec.

    39.19(c)(4)(viii)(A)(2)) would require a DCO to report the creation of

    a new subsidiary, or the elimination of a current subsidiary, of the

    DCO or its parent company. CME commented that the creation or

    elimination of a separate subsidiary of the DCO's parent company would

    not serve the Commission's purpose of conducting effective oversight of

    the DCO or enhance the Commission's ability to conduct timely analysis

    of a DCO's activities. CME added that the plans of a DCO's parent

    company to create (or eliminate) a subsidiary may be highly

    confidential.\232\ CME urged the Commission to eliminate such reporting

    requirement, asserting that ``the value of this information to the

    [Commission] is questionable, and the burdens associated with providing

    it may be substantial.'' CME did not provide any explanation as to why

    the burden of reporting might be substantial.

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

    \232\ MGEX also commented on the highly confidential nature of

    changes in ownership, corporate or organizational structure. The

    Commission believes MGEX's concerns are addressed by the

    Commission's procedures for nonpublic records and confidential

    treatment requests set forth in Part 145 of the Commission's

    regulations.

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

    While information about corporate changes that potentially impact a

    DCO's

    [[Page 69404]]

    financial standing or operations is helpful to the Commission in its

    oversight of a DCO, to avoid creating an unintended burden on DCOs and

    Commission staff, particularly where a DCO is part of a complex

    corporate structure, the Commission is modifying Sec.

    39.19(c)(4)(viii)(A)(2) to eliminate the requirement to report a change

    in subsidiaries of the DCO's parent company. Thus, Sec.

    39.19(c)(4)(viii)(A) now requires only that a DCO report ``[a]ny

    anticipated change in the ownership or corporate or organizational

    structure of the [DCO] or its parent(s) that would: * * * (2) Create a

    new subsidiary or eliminate a current subsidiary of the [DCO]. * * *

    \233\

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

    \233\ As proposed, the provision referred to the DCO's ``parent

    company.'' The Commission is adopting a technical amendment to refer

    to the ``parent(s)'' to clarify that there could be more than one

    parent, such as in the case of a DCO owned by a joint venture, and

    the parent need not have any particular corporate form. For purposes

    of these reporting requirements, a ``parent'' is a direct parent,

    not an entity further up the chain of ownership.

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

    h. Change in Key Personnel--Sec. 39.19(c)(4)(xi)

    Proposed Sec. 39.19(c)(4)(xi) would require a DCO to report the

    departure or addition of any person who qualifies as ``key personnel,''

    as defined in Sec. 39.2, no later than two business days following the

    change. KCC suggested requiring a report ``within a reasonable period

    of time.'' The Commission notes that key personnel are not likely to

    change often, and KCC did not provide any explanation as to why the two

    business day notification period is inappropriate. The Commission is

    adopting Sec. 39.19(c)(4)(xi) as proposed, but redesignated as Sec.

    39.19(c)(4)(ix).

    i. Change in Credit Facility Funding Arrangement--Sec.

    39.19(c)(4)(xii)

    Proposed Sec. 39.19(c)(4)(xii) would require a DCO to report no

    later than one business day after a DCO changes an existing credit

    facility funding arrangement, is notified that such arrangement has

    changed, or knows or reasonably should have known that the arrangement

    will change. KCC commented that this requirement is duplicative: such

    reports would already be required by the Material Adverse Change

    Reporting Requirement. CME had no objection to the requirement to

    report such changes, but opposed the requirement to notify the

    Commission when it knows that the arrangement will change in the

    future, stating that it serves little purpose to notify the Commission

    without knowing what will change. CME suggested that the requirement

    should be to report to the Commission after the terms have changed.

    Conversely, Better Markets opposed several components of the proposed

    rule, asserting that it is ``too narrow and too loose,'' allowing one

    business day is too long, and the standard of reporting when the DCO

    ``knows or reasonably should have known'' is insufficient. Better

    Markets suggested expanding the reporting requirement to cover

    alternative sources of liquidity such as access to commercial paper and

    repurchase agreement markets. It also suggested requiring such a report

    (i) immediately, and (ii) when ``there is a reasonable likelihood that

    the arrangement may change.''

    The Commission is modifying the rule as suggested by CME by

    removing the following: ``or knows or reasonably should have known that

    the arrangement will change.'' Thus, a DCO is required to report a

    change in a credit facility funding arrangement no later than one

    business day after it changes the arrangement or is notified that such

    arrangement has changed. The provision is also being redesignated as

    Sec. 39.19(c)(4)(x). The Commission is not adopting KCC's suggestion

    to rely on the Material Adverse Change Reporting Requirement because a

    change in a credit facility funding arrangement would be of specific

    interest to the Commission in its conduct of DCO oversight, but such a

    change is not likely to rise to the level of being a material adverse

    change. The Commission also is declining to adopt Better Markets'

    recommendations because they would result in the filing of multiple

    reports, many of limited usefulness, which, on balance, would place an

    unnecessary burden on DCOs and Commission staff. Nonetheless, the

    Commission notes that unusual market conditions such as those that

    might limit a DCO's access to commercial paper or ability to enter into

    repurchase agreements, thereby adversely affecting the DCO's liquidity,

    could constitute a material adverse change that would have to be

    reported under the Material Adverse Change Reporting Requirement.

    j. Rule Enforcement--Sec. 39.19(c)(4)(xiii)

    Proposed Sec. 39.19(c)(4)(xiii) would require a DCO to report the

    initiation of a rule enforcement action against a clearing member or

    the imposition of sanctions against a clearing member, no later than

    two business days after the DCO takes such action. Several commenters

    observed that this would result in multiple reports with little useful

    information. They further noted that the DCO would otherwise inform the

    Commission about serious financial issues, as a matter of current

    practice and pursuant to the Material Adverse Change Reporting

    Requirement. MGEX recommended that the Commission not adopt the rule

    enforcement reporting requirement. OCC and CME recommended that the

    Commission not adopt the enforcement reporting requirement as proposed.

    MGEX commented that requiring notification of the initiation of

    rule enforcement is unnecessary and premature, noting that many

    investigations are unrelated to financial risk and many are routine.

    OCC made a similar comment. MGEX expressed concern about the harm such

    a report could cause to a clearing member's reputation by notifying the

    Commission before there has been any determination of any guilt. MGEX

    also noted that the Commission is already routinely informed or is

    aware of ongoing or potential actions.

    OCC stated that the proposed enforcement reports would serve no

    purpose because if there were serious financial issues, the DCO would

    already have been in regular contact with the Commission long before

    the DCO reached the stage of initiating a rule enforcement action.

    Thus, OCC believes these reports would not serve as an effective early

    warning sign. OCC further opposed this reporting requirement because a

    clearing member could appeal a decision after a sanction is imposed.

    OCC recommended notification to the Commission within 30 days after a

    final decision on a disciplinary matter.

    CME believes it is unclear when the notification requirement would

    be triggered, and that there are situations when it is unclear when an

    enforcement action is considered to be initiated.

    The Commission is adopting the rule with modifications. While the

    Commission considers information about enforcement actions to be useful

    in its oversight of a DCO's rule enforcement program under Core

    Principle H, and more broadly in its oversight of a DCO's overall risk

    management program, the Commission has concluded that the requirement,

    as proposed, could result in the reporting of many events that are not

    material to the Commission's oversight of a DCO.\234\ The Commission

    recognizes that many enforcement actions may be based on relatively

    minor offenses and are

    [[Page 69405]]

    unlikely to have a significant impact on a DCO's ability to manage risk

    related to the provision of clearing and settlement services.

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

    \234\ Core Principle H provides in relevant part that ``each

    derivatives clearing organization shall * * * (iii) report to the

    Commission regarding rule enforcement activities and sanctions

    imposed against members and participants. * * * '' See also

    discussion of Sec. 39.17 in section IV.H, above.

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

    Therefore, the Commission is adopting the regulation with a

    modification such that it would only require the reporting of sanctions

    against clearing members, no later than two business days after the DCO

    takes such action, and would not require the reporting of the

    initiation of rule enforcement actions. The Commission is also

    redesignating the provision as Sec. 39.19(c)(4)(xi). The Commission

    notes that events or circumstances that rise to the level of having a

    material adverse impact on a DCO's ability to comply with the

    requirements of Part 39, or relate to a material adverse change in the

    financial condition of any clearing member, whether or not they form

    the basis of an enforcement action, will have to be formally reported

    under Sec. 39.19(c)(4)(xii)(B) or (C), respectively.

    Last, OCC requested clarification as to whether the rule

    enforcement reporting requirement applies to DCO enforcement activities

    involving a clearing member that is only registered as a BD. The

    Commission confirms that the requirement to report the imposition of

    sanctions against clearing members does not apply to a DCO's clearing

    members that are registered as BDs only and engaged solely in

    securities-based transactions. However, insofar as such a clearing

    member's actions might have a material adverse impact on the DCO's

    ability to comply with the requirements of Part 39 or would constitute

    a material adverse change in the financial condition of a clearing

    member, the DCO would be required to submit a Material Adverse Change

    Report, as discussed below.

    k. Financial Condition and Events (Material Adverse Change Reporting

    Requirement)--Sec. 39.19(c)(4)(xiv)

    Proposed Sec. 39.19(c)(4)(xiv) would require a DCO to immediately

    notify the Commission after the DCO knows or reasonably should have

    known of certain material adverse changes, i.e., the institution of any

    legal proceedings which may have a material adverse financial impact on

    the DCO; any event, circumstance or situation that materially impedes

    the DCO's ability to comply with part 39 of the Commission's

    regulations and is not otherwise required to be reported; or a material

    adverse change in the financial condition of any clearing member that

    is not otherwise required to be reported.\235\ CME and OCC are opposed

    to this ``catch-all'' requirement. In particular, CME is concerned that

    the requirement is too broad and thus would include a reporting

    requirement for anything that is technically in violation of Part 39,

    e.g., even if the DCO's email or Web site goes down temporarily. OCC

    also commented that the requirement is unnecessary because the

    Commission will be receiving adequate reporting as a result of other

    reporting requirements in Part 39 and the reporting requirements for

    FCMs. Alternatively, CME suggested requiring ``prompt'' notice, rather

    than ``immediate'' notice.

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

    \235\ Because of the potential impact on a DCO of an adverse

    change in the financial condition of a clearing member, this

    reporting requirement would apply to ``any'' clearing member,

    including one that is solely a BD engaging in securities activities.

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

    The Commission is adopting Sec. 39.19(c)(4)(xiv) as proposed, but

    redesignated as Sec. 39.19(c)(4)(xii). CME's concerns are unwarranted

    as the reporting requirement would only require reporting incidents

    that could have a material adverse effect on the DCO. A Web site

    temporarily going down would not necessarily be expected to have a

    ``material'' adverse effect on the DCO. However, if it did have a

    material adverse impact, the Commission would expect it to be reported.

    The Commission recognizes that it is requiring a DCO to exercise its

    discretion in the first instance to determine what events trigger this

    reporting requirement, but the Commission considers this to be an

    appropriate responsibility for a DCO.

    Moreover, while the Commission will be getting information as a

    result of other Part 39 and FCM reporting requirements, there may be

    certain conditions or events that could materially impact a DCO that

    the Commission could not anticipate, yet about which it would still be

    important for the Commission to be notified. This is especially

    important in light of the Commission's decision not to adopt certain

    proposed reporting requirements, as discussed above.

    The Commission is also keeping the timing of the reporting

    requirement as ``immediate'' rather than ``prompt,'' as these are

    material changes for which immediate notification is essential and for

    which the more ambiguous ``prompt'' is not appropriate.\236\

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

    \236\ See discussion of timing requirements in section IV.J.5.c,

    above.

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

    l. Financial Statements Material Inadequacies--Sec. 39.19(c)(4)(xv)

    Proposed Sec. 39.19(c)(4)(xv) would require a DCO to report

    material inadequacies in its financial statements. The Commission

    received no comments on this requirement, and the Commission is

    adopting Sec. 39.19(c)(4)(xv) as proposed (redesignated as Sec.

    39.19(c)(4)(xiii)), with the exception of a technical revision to add a

    reference to ``in a financial statement'' so that the language now

    reads ``If a derivatives clearing organization discovers or is notified

    by an independent public accountant of the existence of any material

    inadequacy in a financial statement, such derivatives clearing

    organization shall give notice. * * *'' \237\

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

    \237\ The Commission is also making a technical non-substantive

    change by substituting the word ``shall'' for the word ``must'' to

    conform this provision with other provisions in Sec. 39.19.

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

    m. Action of Board of Directors or Risk Management Committee--Sec.

    39.19(c)(4)(xvi)

    In a separate proposed rulemaking that would implement Core

    Principle P (Conflicts of Interest), the Commission proposed Sec.

    39.25(b), which would require a DCO to report when the board of

    directors of a DCO rejects a recommendation or supersedes an action of

    the DCO's Risk Management Committee, or when the Risk Management

    Committee rejects a recommendation or supersedes an action of its

    subcommittee.\238\ In connection with this, the Commission subsequently

    proposed to cross reference this reporting obligation in proposed Sec.

    39.19(c)(4)(xvi). At such time as the Commission may adopt the

    reporting requirement in Sec. 39.25(b) as a final rule, Sec.

    39.19(c)(4) will be amended accordingly.

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

    \238\ See 76 FR at 736 (Jan. 6, 2011) (Governance).

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

    n. Election of Board of Directors--Sec. 39.19(c)(4)(xvii)

    In a separate proposed rulemaking that would implement Core

    Principles P (Conflicts of Interest) and Q (Composition of Governing

    Boards), the Commission proposed Sec. 40.9(b)(1)(iii), which would

    require a DCO to report certain information to the Commission after

    each election of its board of directors.\239\ In connection with this,

    the Commission subsequently proposed to cross-reference this reporting

    obligation in proposed Sec. 39.19(c)(4)(xvii). At such time as the

    Commission may adopt the reporting requirement in Sec. 40.9(b)(1)(iii)

    as a final rule, Sec. 39.19(c)(4) will be amended accordingly.

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

    \239\ Id.

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

    o. System Safeguards--Sec. 39.19(c)(4)(xviii)

    Proposed Sec. 39.19(c)(4)(xviii) would require a DCO to report

    certain exceptional events and planned changes as required by Sec.

    39.18(g) and Sec. 39.18(h),

    [[Page 69406]]

    respectively. The Commission received no comments on this reporting

    requirement, and the Commission is adopting Sec. 39.19(c)(4)(xviii),

    redesignated as Sec. 39.19(c)(4)(xvi), as proposed.\240\

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

    \240\ See discussion of system safeguards reporting in section

    IV.I, above.

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

    K. Core Principle K--Recordkeeping--Sec. 39.20

    Core Principle K,\241\ as amended by the Dodd-Frank Act, requires a

    DCO to maintain records of all activities related to the business of

    the DCO as a DCO, in a form and manner that is acceptable to the

    Commission and for a period of not less than 5 years. The Commission

    proposed Sec. 39.20 to establish requirements that a DCO would have to

    meet in order to comply with Core Principle K.

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

    \241\ Section 5b(c)(2)(K) of the CEA, 7 U.S.C. 7a-1(c)(2)(K).

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

    Under proposed Sec. 39.20(b), a DCO would have to maintain records

    of all activities related to its business as a DCO ``for a period of

    not less than 5 years,'' except for swap data that must be maintained

    in accordance with the SDR rules in part 45 of the Commission's

    regulations. Mr. Barnard expressed the view that limiting record

    retention to five years is insufficient and records should be required

    to be kept indefinitely.

    The Commission is adopting Sec. 39.20 as proposed. The Commission

    believes that codifying the statutory minimum requirement of five years

    is appropriate, noting that a five-year minimum is consistent with

    other Commission recordkeeping requirements.\242\ In addition, the

    exception for swap data recordkeeping addresses situations where the

    Commission has previously determined that a five-year minimum may not

    be sufficient.\243\

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

    \242\ See, e.g., Sec. 1.31 of the Commission's regulations.

    \243\ See 75 FR 76574 (Dec. 8, 2010) (Swap Data Recordkeeping

    and Reporting Requirements).

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

    L. Core Principle L--Public Information--Sec. 39.21

    Core Principle L,\244\ as amended by the Dodd-Frank Act, requires a

    DCO to provide market participants sufficient information to enable the

    market participants to identify and evaluate accurately the risks and

    costs associated with using the DCO's services. More specifically, a

    DCO is required to make available to market participants information

    concerning the rules and operating and default procedures governing its

    clearing and settlement systems and also to disclose publicly and to

    the Commission the terms and conditions of each contract, agreement,

    and transaction cleared and settled by the DCO, each clearing and other

    fee charged to members,\245\ the DCO's margin-setting methodology,

    daily settlement prices, and other matters relevant to participation in

    the DCO's clearing and settlement activities.

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

    \244\ Section 5b(c)(2)(L) of the CEA, 7 U.S.C. 7a-1(c)(2)(L).

    \245\ The statutory language refers to fees charged to ``members

    and participants,'' and the Commission interprets this phrase to

    mean fees charged to ``clearing members.''

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

    Proposed Sec. 39.21 would require a DCO to 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. In particular, proposed

    Sec. Sec. 39.21(c)(2), (3) and (4) would require a DCO to disclose

    publicly and to the Commission information concerning its margin-

    setting methodology and the size and composition of the financial

    resource package available in the event of a clearing member default.

    KCC, MGEX, and NGX variously commented that DCO fees and charges,

    margin methodology and financial resource information are confidential

    and should not be required to be publicly disclosed for the following

    reasons: (1) It is intellectual property, (2) there is no correlation

    between the availability of such information and the decision whether

    to invest in or trade with a DCO, and (3) privately held companies (or

    non-intermediated DCOs in the case of NGX) should not have to disclose

    such information. MGEX also suggested that making margin methodology

    information available to the public could lead to market manipulation

    by those who might attempt to influence the margin level. MGEX

    suggested that the rule should only require making the financial

    resource package information available upon request by a clearing

    member that has signed the DCO's confidentiality agreement. Conversely,

    Better Markets believes that Sec. 39.21 does not go far enough and

    that many of the DCO reports required by Sec. 39.19 should also be

    required to be disclosed to the public, as the Dodd-Frank Act requires

    that market participants and the public be informed of the risks and

    other potential consequences of transacting with a DCO.\246\ Similarly,

    Mr. Barnard suggested requiring public disclosure of all items of

    public interest, including event-specific reports under Sec.

    39.19(c)(4), except for those that would expose business-specific

    confidential issues.

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

    \246\ In particular, Better Markets stated that, at a minimum, a

    DCO should be required to publicly disclose (i) the adequacy of its

    financial resources, measured by the required level of financial

    resources under Commission rules, and (ii) to the extent they must

    be reported to the Commission, a reduction in financial resources,

    decrease in ownership equity, or change in ownership or corporate

    structure.

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

    The Commission is adopting Sec. 39.21 as proposed, except for

    proposed Sec. 39.21(c)(7), which would require the public disclosure

    of information related to governance and conflicts of interest in

    accordance with provisions that were proposed in a separate rulemaking.

    At such time as the Commission adopts those provisions, Sec. 39.21

    will be amended accordingly. The requirement to publicly disclose

    clearing and other fees charged by the DCO, margin methodology and

    financial resources information comes directly from Core Principle L.

    Moreover, the Commission believes that concerns regarding the

    confidential nature of this information are unfounded because such

    information would seem to be fundamental to a clearing member or

    potential clearing member's assessment of the strengths and weaknesses

    of a DCO. This does not necessarily require disclosure of proprietary

    information; certain DCOs, e.g., CME, already disclose this type of

    information on their Web sites.

    The Commission is not revising the rule to incorporate Better

    Markets' or Mr. Barnard's proposals. From a practical standpoint, some

    of the information Better Markets and Mr. Barnard have requested to be

    publicly disclosed is otherwise going to be public information,

    particularly if the DCO is a public company, and thus subject to SEC

    filing requirements. Regardless, the Commission does not interpret Core

    Principle L as requiring disclosure of all of the financial workings of

    a DCO.

    M. Core Principle M--Information Sharing--Sec. 39.22

    Core Principle M,\247\ as amended by the Dodd-Frank Act, requires a

    DCO to enter into and abide by the terms of each appropriate and

    applicable domestic and international information-sharing agreement and

    to use relevant information obtained under such agreements in carrying

    out its risk management program. The Commission proposed Sec. 39.22 to

    codify the statutory requirement.

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

    \247\ Section 5b(c)(2)(M) of the CEA, 7 U.S.C. 7a-1(c)(2)(M).

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

    Proposed Sec. 39.22 would require a DCO to enter into certain

    information-sharing agreements and use relevant information obtained

    from those

    [[Page 69407]]

    agreements in carrying out the risk management program of the DCO. MGEX

    is opposed to sharing confidential information such as proprietary

    intellectual property. MGEX also asked for further clarity to be able

    to comment further on this requirement.

    The Commission is adopting Sec. 39.22 as proposed. The provision

    purposely lacks specific details to allow each DCO the discretion to

    make its own determination as to which information-sharing agreements

    are necessary and appropriate, including taking into account

    confidentiality concerns. DCOs may seek further guidance from

    Commission staff if they have specific questions about existing or

    potential information-sharing arrangements.

    N. Core Principle N--Antitrust Considerations--Sec. 39.23

    Core Principle N,\248\ as amended by the Dodd-Frank Act, conforms

    the standard for DCOs with the standard applied to DCMs under Core

    Principle 19.\249\ Proposed Sec. 39.23 would codify Core Principle N.

    CME commented that the proposed regulation is adequate, and the

    Commission is adopting the rule as proposed.

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

    \248\ Section 5b(c)(2)(N) of the CEA, 7 U.S.C. 7a-1(c)(2)(N).

    \249\ See Section 5(d)(19) of the CEA, 7 U.S.C. 7(d)(19) (DCM

    Core Principle 19).

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

    O. Core Principle R--Legal Risk--Sec. 39.27

    Section 725(c) of the Dodd-Frank Act sets forth a new Core

    Principle R (Legal Risk).\250\ Core Principle R requires a DCO to have

    a well-founded, transparent, and enforceable legal framework for each

    aspect of the DCO's activities. Proposed Sec. 39.27 would set forth

    the required elements of such a legal framework. The Commission

    solicited comment as to the legal risks addressed in proposed Sec.

    39.27 and whether the rule should address additional legal risks.

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

    \250\ Section 5b(c)(2)(R) of the CEA, 7 U.S.C. 7a-1(c)(2)(R).

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

    CME commented that proposed Sec. 39.27(c)(1), which would require

    a DCO that provides clearing services outside the United States to

    identify and address all conflict of law issues, should only require a

    DCO to identify and address any ``material'' conflict of law issues.

    The Commission agrees with CME that a DCO should not be burdened to

    identify non-material conflict of law issues and has revised Sec.

    39.27(c)(1) to provide that such a DCO must identify and address ``any

    material conflict of law issues.'' The Commission is otherwise adopting

    the rule as proposed.

    P. Special Enforcement Authority for SIDCOs

    Under Section 807(c) of the Dodd-Frank Act, for purposes of

    enforcing the provisions of Title VIII, a SIDCO is subject to, and the

    Commission has authority under the provisions of subsections (b)

    through (n) of Section 8 of, the Federal Deposit Insurance Act \251\ in

    the same manner and to the same extent as if the SIDCO were an insured

    depository institution and the Commission were the appropriate Federal

    banking agency for such insured depository institution. Proposed Sec.

    39.31 would codify this special authority. The Commission did not

    receive any comments on this provision. Nevertheless, as discussed

    above in connection with the proposals relating to SIDCO financial

    resources and system safeguards for SIDCOs, the Commission is not

    finalizing the rules relating to SIDCOs at this time. The Commission

    expects to consider all the proposals relating to SIDCOs together in

    the future.

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

    \251\ 12 U.S.C. 1818.

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

    V. Part 140 Amendments--Delegations of Authority

    Under Sec. 140.94, the Commission delegates the authority to

    perform certain functions that are reserved to the Commission to the

    Director of the Division of Clearing and Risk. In connection with the

    regulations the Commission is adopting herein, as well as previously

    adopted Sec. 39.5, the Commission is amending Sec. 140.94 to delegate

    authority to perform certain functions to the Director of the Division

    of Clearing and Risk, as discussed below.

    With respect to DCO applications, under Sec. 140.94(a)(6), the

    Commission is delegating authority to determine whether a DCO

    application is materially complete under Sec. 39.3(a)(2), and to

    request that an applicant submit supplemental information in order for

    the Commission to process a DCO application under Sec. 39.3(a)(3).

    In addition to the authority delegated to the Director of the

    Division of Clearing and Risk in connection with the Commission's final

    rulemaking for Sec. 39.5,\252\ Sec. 140.94(a)(7) delegates authority

    to request specific additional information as part of a DCO's swap

    submission under Sec. 39.5(b)(3)(ix).

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

    \252\ The Commission has already delegated authority to the

    Director of the Division of Clearing and Risk to: (1) consolidate

    multiple swap submissions from one DCO or subdivide a submission as

    appropriate for review under Sec. 39.5(b)(2); and request

    information from a DCO to assist the Commission's review of a

    clearing requirement that has been stayed under Sec. 39.5(d)(3).

    See 76 FR at 44474 (July 26, 2011) (Process for Review of Swaps for

    Mandatory Clearing; final rule).

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

    Section 140.94(a)(8) delegates authority to grant an extension of

    time for a DCO to file its annual compliance report under Sec.

    39.10(c)(4)(iv).

    With respect to financial resources requirements for DCOs, Sec.

    140.94(a)(9) delegates authority to: (1) determine whether a particular

    financial resource may be used to satisfy the requirements of Sec.

    39.11(a)(1) under Sec. 39.11(b)(1)(vi); (2) determine whether a

    particular financial resource may be used to satisfy the requirements

    of Sec. 39.11(a)(2) under Sec. 39.11(b)(2)(ii); (3) review the

    methodology used to compute the requirements of Sec. 39.11(a)(1) and

    require changes as appropriate under Sec. 39.11(c)(1); (4) review the

    methodology used to compute the requirements of Sec. 39.11(a)(2) and

    require changes as appropriate under Sec. 39.11(c)(2); (5) request

    financial reporting from a DCO (in addition to the quarterly reports)

    under Sec. 39.11(f)(1); and (6) grant an extension of time for a DCO

    to file its quarterly financial report under Sec. 39.11(f)(4).

    Section 140.94(a)(10) delegates authority to request the periodic

    financial reports of a DCO's clearing members that are not FCMs under

    Sec. 39.12(a)(5)(i)(B).

    With respect to risk management requirements, Sec. 140.94(a)(11)

    delegates authority to: (1) Review percentage levels for customer

    initial margin requirements and require different percentage levels if

    levels are deemed insufficient under Sec. 39.13(g)(8)(ii); (2) review

    methods, thresholds, and financial resources and require the

    application of different methods, thresholds, and financial resources

    as appropriate (relating to risk limits on clearing members) under

    Sec. 39.13(h)(1)(i)(C); (3) review the amount of additional initial

    margin required of a clearing member permitted to exceed its risk

    threshold and require a different amount as appropriate under Sec.

    39.13(h)(1)(ii); (4) review the selection of accounts and methodology

    used in daily stress testing of large trader positions and require

    changes as appropriate under Sec. 39.13(h)(3)(i); (5) review

    methodology for weekly stress testing of clearing member accounts and

    swap portfolios and require changes as appropriate under Sec.

    39.13(h)(3)(ii); and (6) request clearing member information and

    documents regarding their risk management policies, procedures, and

    practices under Sec. 39.13(h)(5)(i)(A).

    With respect to rule submissions and 4d petitions relating to the

    commingling of futures, options on futures, and cleared swaps in a

    cleared swaps

    [[Page 69408]]

    account or futures account, respectively, Sec. 140.94(a)(12) delegates

    authority to request additional information in support of a rule

    submission, under Sec. 39.15(b)(2)(iii)(A), and to request additional

    information in support of a 4d petition, under Sec.

    39.15(b)(2)(iii)(B).

    With respect to DCO reporting requirements, Sec. 140.94(a)(13)

    delegates authority to: (1) Grant an extension of time for filing of

    reports required to be filed annually under Sec. 39.19(c)(3)(iv); (2)

    request that a DCO file information related to its business as a

    clearing organization, including information relating to trade and

    clearing details, under Sec. 39.19(c)(5)(i); (3) request that a DCO

    file a written demonstration that the DCO is in compliance with one or

    more core principles and relevant rule provisions under Sec.

    39.19(c)(5)(ii); and (4) request that a DCO file, for each clearing

    member, by customer origin, the end-of day positions for each

    beneficial owner under Sec. 39.19(c)(5)(iii).

    Finally, Sec. 140.94(a)(14) delegates authority to permit a DCO to

    refrain from publishing on its Web site information that is otherwise

    required to be published under Sec. 39.21(d).

    VI. Effective Dates

    For purposes of publication in the Code of Federal Regulations, all

    of the rules adopted herein will have an effective date of 60 days

    after publication in the Federal Register. The Commission received a

    number of comments, however, that discussed a DCO's need for time to

    develop appropriate systems and procedures to come into compliance with

    some of the rules. The Commission is extending the date by which DCOs

    must come into compliance for certain rules as follows:

    DCOs must comply with the following rules 180 days after

    publication in the Federal Register: Financial resources--Sec. 39.11;

    participant and product eligibility--Sec. 39.12; risk management--

    Sec. 39.13 (except gross margin--Sec. 39.13(g)(8)(i)); and settlement

    procedures--Sec. 39.14.

    DCOs must comply with the following rules 1 year after publication

    in the Federal Register: chief compliance officer--Sec. 39.10(c);

    gross margin--Sec. 39.13(g)(8)(i); system safeguards--Sec. 39.18;

    reporting--Sec. 39.19; and recordkeeping--Sec. 39.20.

    VII. Section 4(c)

    Proposed Sec. Sec. 39.15(b)(2)(i) and 39.15(b)(2)(ii) would

    establish procedures for permitting futures and options on futures to

    be carried in a cleared swaps account (subject to Section 4d(f) of the

    CEA), and for cleared swaps to be carried in a futures account (subject

    to Section 4d(a) of the CEA), respectively. In connection with

    proposing those rules, the Commission proposed to grant an exemption

    under Section 4(c) of the CEA and requested comment on its proposed

    exemption.\253\

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

    \253\ See 76 FR at 3715-3716 (Jan. 20, 2011) (Risk Management).

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

    Section 4(c) of the CEA provides that, in order to promote

    responsible economic or financial innovation and fair competition, the

    Commission, by rule, regulation or order, after notice and opportunity

    for hearing, may exempt any agreement, contract, or transaction, or

    class thereof, including any person or class of persons offering,

    entering into, rendering advice or rendering other services with

    respect to, the agreement, contract, or transaction, from the contract

    market designation requirement of Section 4(a) of the CEA, or any other

    provision of the CEA other than certain enumerated provisions, if the

    Commission determines that the exemption would be consistent with the

    public interest.\254\

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

    \254\ 7 U.S.C. 6(c).

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

    Proper treatment of customer funds requires, among other things,

    segregation of customer money, securities and property received to

    margin, guarantee, or secure positions in futures or options on

    futures, in an account subject to Section 4d(a) of the CEA (i.e., a

    futures account), and segregation of customer money, securities and

    property received to margin, guarantee, or secure positions in cleared

    swaps, in an account subject to Section 4d(f) of the CEA (i.e., a

    cleared swaps account). Customer funds required to be held in a futures

    account cannot be commingled with non-customer funds and cannot be held

    in an account other than an account subject to Section 4d(a), absent

    Commission approval in the form of a rule, regulation or order. Section

    4d(f) of the CEA mirrors these limitations as applied to customer

    positions in cleared swaps.

    Under the proposed exemption, a DCO and its clearing members would

    be exempt from complying with the segregation requirements of Section

    4d(a) when holding customer segregated funds in a cleared swaps account

    subject to Section 4d(f) of the CEA, instead of a futures account; and

    similarly, a DCO and its clearing members would be exempt from

    complying with the segregation requirements of Section 4d(f) when

    holding customer funds related to cleared swap positions in a futures

    account subject to Section 4d(a) of the CEA, instead of a cleared swaps

    account. For the reasons discussed below, the Commission has determined

    to grant the exemption under Section 4(c) of the CEA.

    In the notice of proposed rulemaking, the Commission expressed its

    view that the adoption of proposed Sec. Sec. 39.15(b)(2)(i) and

    39.15(b)(2)(ii) would promote responsible economic and financial

    innovation and fair competition, and would be consistent with the

    ``public interest,'' as that term is used in Section 4(c) of the CEA.

    However, the Commission solicited public comment on whether the

    proposed regulations would satisfy the requirements for exemption under

    Section 4(c) of the CEA.

    The Commission received one comment. CME supported the Commission's

    conclusion, agreeing that in appropriate circumstances, the commingling

    of customer positions in futures, options on futures, and cleared swaps

    could achieve important benefits with respect to greater capital

    efficiency resulting from margin reductions for correlated positions.

    CME believes that adoption of a regulation permitting such commingling

    would be consistent with the public interest, adding that ``[h]aving

    positions in a single account can also enhance risk management

    practices and systemic risk containment by allowing the customer's

    portfolio to be handled in a coordinated fashion in a transfer or

    liquidation scenario.''

    In light of the foregoing, the Commission finds that permitting the

    commingling of positions pursuant to Sec. Sec. 39.15(b)(2)(i) and

    39.15(b)(2)(ii) will promote responsible economic and financial

    innovation and fair competition, and is consistent with the ``public

    interest,'' as that term is used in Section 4(c) of the CEA.

    VIII. Considerations of Costs and Benefits

    Section 15(a) of the CEA requires the Commission to ``consider the

    costs and benefits'' of its actions before promulgating a

    regulation.\255\ In particular, these costs and benefits must be

    evaluated in light of 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. In conducting its evaluation, the Commission

    may, in its discretion, give greater weight to any one of the five

    enumerated areas and it may determine that, notwithstanding

    [[Page 69409]]

    costs, a particular rule is necessary to protect the public interest or

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

    purposes of the CEA.\256\

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

    \255\ 7 U.S.C. 19(a).

    \256\ See, e.g., Fisherman's Doc Co-op., Inc v. Brown, 75 F.3d

    164 (4th Cir. 1996); Center for Auto Safety v. Peck, 751 F.2d 1336

    (D.C. Cir. 1985) (noting that an agency has discretion to weigh

    factors in undertaking cost-benefit analysis). Section 3 of the CEA

    states the purposes of the Act:

    It is the purpose of this Act to serve the public interests

    described in subsection (a) through a system of effective self-

    regulation of trading facilities, clearing systems, market

    participants and market professionals under the oversight of the

    Commission. To foster these public interests, it is further the

    purpose of this Act to deter and prevent price manipulation or any

    other disruptions to market integrity; to ensure the financial

    integrity of all transactions subject to this Act and the avoidance

    of systemic risk; to protect all market participants from fraudulent

    or other abusive sales practices and misuses of customer assets; and

    to promote responsible innovation and fair competition among boards

    of trade, other markets and market participants.

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

    In the following discussion, the Commission presents its

    considerations of the costs and benefits of the final rulemaking in

    light of the comments it received, other relevant data and information,

    and the five broad areas of market and public concern as required by

    section 15(a) of the CEA.

    A. Background

    A derivatives clearing organization (DCO) is an entity registered

    with the Commission through which derivatives transactions are cleared

    and settled. A DCO acts as a central counterparty, serving principally

    to ensure performance of the contractual obligations of the original

    counterparties to derivatives transactions and to manage and mitigate

    counterparty risk and systemic risk in the markets they serve. This is

    accomplished by interposing the DCO between the counterparties so that

    the DCO becomes the buyer to every seller and the seller to every

    buyer. Upon novation by the original parties to a transaction, the

    contractual obligations of the original parties to one another are

    extinguished and replaced by a pair of equal and opposite transactions

    between the DCO and the counterparties or their agents.

    The DCO's role as central counterparty potentially exposes the DCO

    itself to risk from every user whose transactions are cleared through

    the DCO. Conversely, if a DCO itself fails or suffers a risk of

    failure, the consequences for the market at large are likely to be

    serious and widespread. Effective risk management, therefore, is

    critical to the functioning of a marketplace in which swaps are cleared

    through DCOs.

    Clearing members are the entities that deal directly with DCOs.

    They may be acting on their own behalf or as agents. DCOs establish

    rules and risk management requirements for their clearing members,

    which typically include specified levels of financial resources,

    operational capacity, and risk management capability; deposit of risk-

    based initial margin and payment of daily variation margin sized to

    cover current and potential losses of the member; and contribution to a

    guaranty fund that can be used in the event of a clearing member

    default. These requirements lower systemic risk by reducing the

    likelihood of a clearing member default and, in the event a clearing

    member default does occur, reducing the likelihood that it will result

    in the default of other market participants.

    Additionally, unlike bilateral derivatives transactions where

    parties do not know the exposures their counterparties have to other

    market participants, as a result of the multilateral nature of

    centralized clearing, DCOs have a real-time, more complete picture of

    each clearing member's risk exposure to multiple parties. Thus the DCO

    can more effectively and quickly identify developing risk exposures for

    individual clearing members and better manage these risks if clearing

    members become distressed.

    B. General Comments and Considerations

    The Dodd-Frank Act is intended to facilitate stability in the

    financial system of the United States by reducing risk, increasing

    transparency, and promoting market integrity. To accomplish these

    objectives, among other things, the Dodd-Frank Act provides for the

    mandatory clearing of certain swaps by DCOs and explicitly authorizes

    the Commission to promulgate rules to establish appropriate standards

    for DCOs in carrying out their risk mitigation function. Regulatory

    standards for DCOs will serve to assure market participants that credit

    and other risks associated with cleared swap transactions are being

    appropriately managed by DCOs. This, in turn, can promote the use of

    cleared swaps. Regulatory standards also can foster market confidence

    in the integrity of the derivatives clearing system.

    In this final rulemaking, the Commission is adopting regulations to

    implement 15 DCO core principles: A (Compliance), B (Financial

    Resources), C (Participant and Product Eligibility), D (Risk

    Management), E (Settlement Procedures), F (Treatment of Funds), G

    (Default Rules and Procedures), H (Rule Enforcement), I (System

    Safeguards), J (Reporting), K (Recordkeeping), L (Public Information),

    M (Information Sharing), N (Antitrust Considerations), and R (Legal

    Risk). In addition, the Commission is adopting regulations to implement

    the Chief Compliance Officer provisions of Section 725 of the Dodd-

    Frank Act, and to update the regulatory framework for DCOs to reflect

    standards and practices that have evolved over the past decade since

    the enactment of the CFMA.

    This rulemaking process has generated an extensive record, which is

    discussed at length throughout this notice as it relates to the

    substantive provisions in the final rules. A number of commenters

    expressed the view that there would be significant costs associated

    with implementing and complying with proposed rules. The Commission

    also received comments from KCC, CME, and OCC who stated generally that

    the cost-benefit analysis presented in the proposed rulemakings was

    insufficient. The Commission has carefully considered alternatives

    suggested by commenters, and in a number of instances, for reasons

    discussed in detail above, has adopted such alternatives or

    modifications to the proposed rules where, in the Commission's

    judgment, the alternative or modified standard accomplishes the same

    regulatory objective in a more cost-effective manner.

    The Commission invited comments on the comprehensive or

    ``systemic'' costs and benefits of the proposed rules. MFA and Better

    Markets addressed this issue stating that the Commission's cost-benefit

    analyses presented in the notices of proposed rulemaking may have

    understated the benefits of the proposed rules.\257\ MFA commented that

    the costs to market participants would be substantial if the Commission

    does not adopt the proposed regulations. Better Markets commented that

    the only reasonable way to consider costs and benefits of any of the

    Commission's rule proposals under Dodd-Frank is to view them as a

    whole. According to Better Markets:

    \257\ See Letter from Better Markets dated June 3, 2011; Letter

    from MFA dated March 21, 2011 (comment file for 76 FR 3698 (Risk

    Management)).

    It is undeniable that the Proposed Rules are intended and

    designed to work as a system. Costing-out individual components of

    the Proposed Rules inevitably double counts costs which are

    applicable to multiple individual rules. It also prevents the

    consideration of the full range of benefits that arise from the

    system as a whole that provides for greater stability, reduces

    [[Page 69410]]

    systemic risk and protects taxpayers and the public treasury from

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

    future bailouts.

    Better Markets believes that the benefits must include the avoided

    risk of a new financial crisis and the best measure of this benefit is

    the cost of the 2008 financial crisis, which is still accumulating. It

    cited Andrew G. Haldane, Executive Director, Financial Stability of the

    Bank of England, who estimated that the worldwide cost of the crisis in

    terms of lost output was between $60 trillion and $200 trillion,

    depending primarily on the long term persistence of the effects.

    The Commission agrees with Better Markets that the DCO rules

    operate in an integrated, systemic manner to ensure that the risks

    associated with cleared swap transactions are being appropriately

    managed or addressed by DCOs. When implemented in their entirety, these

    rules have the potential to significantly change not only the aggregate

    risk profile of the entire derivatives clearing industry, but also the

    allocation of risks among DCOs, clearing firms, and market

    participants. The final rules require DCOs to admit firms as clearing

    members that may differ substantially from existing members with

    respect to size, risk profiles, specializations, and risk management

    abilities. The rules also help create an environment in which DCOs will

    compete for the business of clearing trades of different sizes, and of

    many different derivatives products--both futures and swaps. In a

    potentially much more diverse range of both participants and products,

    these final rules will allow, and in some cases require, DCOs to make

    use of a number of risk management tools, including, among others,

    periodic valuation of financial resources; a potentially more rigorous

    design for margins; stress testing and back testing for financial

    resources and margin, respectively; and additional rules and procedures

    designed to allow for management of events associated with a clearing

    member defaulting on its obligations to the DCO. These rules help

    reduce the potential for DCO default, and the potential follow-on

    effects on financial markets as a whole. In addition, the daily,

    quarterly, annual, and event-specific reporting requirements for DCOs

    enhance the tools available to the Commission in conducting its

    financial risk surveillance in connection with derivatives clearing by

    DCOs.

    Certain of the regulations promulgated in this final rulemaking

    merely codify the requirements of the CEA, as amended by the Dodd-Frank

    Act, e.g., Sec. Sec. 39.10(a) and (b) (compliance with core

    principles); 39.17 (rule enforcement); 39.22 (information sharing); and

    39.23 (antitrust considerations). For such provisions, the Commission

    has not considered alternatives to the statute's prescribed

    requirements, even though a DCO may incur costs to comply with these

    provisions. As these requirements are imposed by the Dodd-Frank Act,

    any associated costs and benefits are the result of statutory

    directives, as previously determined by the Congress, that govern DCO

    activities independent of the Commission's regulations. By its terms,

    CEA Section 15(a) requires the Commission to consider and evaluate the

    prospective costs and benefits of regulations and orders of the

    Commission prior to their issuance; it does not require the Commission

    to evaluate the costs and benefits of the actions or mandates of the

    Congress.

    In its notice of proposed rulemaking, the Commission requested data

    or other information in connection with its cost-benefit

    considerations. The Commission received only a few comments providing

    quantitative information on the costs of the proposed rules. It

    received two comments on the benefits of the proposed rules.

    The Commission invited but did not receive public comments specific

    to, or related to, its consideration of costs and benefits for proposed

    Sec. Sec. 1.3, 39.1, 39.2, 39.4, 39.9, 39.16, 39.18, 39.20, 39.21, and

    39.27. However, the Commission received comments on substantive

    provisions of those proposed rules and such comments are addressed

    above.

    The following discussion summarizes the Commission's consideration

    of the costs and benefits of the final rules pursuant to CEA Section

    15(a).

    C. Form DCO--Sec. 39.3(a)(2)

    Section 5b(c)(1) of the CEA provides that ``[a] person desiring to

    register as a derivatives clearing organization shall submit to the

    Commission an application in such form and containing such information

    as the Commission may require for the purpose of making the

    determinations required for approval under paragraph (2).'' Paragraph

    (2), which sets forth the 18 core principles applicable to DCOs,

    further provides in paragraph (i) that ``[t]o be registered and to

    maintain registration as a derivatives clearing organization, a

    derivatives clearing organization shall comply with each core principle

    described in this paragraph and any requirement that the Commission may

    impose by rule or regulation pursuant to section 8a(5) [of the CEA].''

    Accordingly, the standard for approval of DCO registration is the

    applicant's ability to satisfy the DCO core principles.

    Proposed Sec. 39.3(a)(2) would require that any person seeking to

    register as a DCO submit a completed Form DCO, which would be provided

    as an appendix to part 39 of the Commission's regulations. The Form

    DCO, composed of a cover sheet and list of exhibits, would replace the

    general guidance contained in Appendix A to Part 39, ``Application

    Guidance and Compliance With Core Principles'' (Guidance), which was

    adopted by the Commission in 2001. In accordance with Section 5b(c) of

    the Act, the Form DCO is designed to elicit a demonstration that an

    applicant can satisfy each of the DCO core principles. Toward this end,

    the Form DCO requires submission of extensive information about an

    applicant's intended operations. This information has been required of

    applicants under the previous Guidance, and the use of the Form DCO

    does not represent a departure in substance from the Commission's

    practices over the past decade.

    Rather, as explained in the proposed rulemaking, the Form DCO was

    designed to standardize and clarify the information that the Commission

    has required from DCO applicants in the past, in an effort to

    facilitate a more streamlined and efficient application process. The

    Commission has learned from experience that the general guidance

    contained in the previous Appendix A did not provide sufficiently

    specific instructions to applicants. As a result, the registration

    process has been prolonged in some cases because of the need for

    Commission staff to provide applicants with additional guidance about

    the nature of the information that the Commission requires to conclude

    that the applicant has demonstrated its ability to comply with the core

    principles.

    The Commission did not receive comments specifically with respect

    to its cost-benefit analysis of proposed Sec. 39.3(a)(2) or to its

    Paperwork Reduction Act estimate that the cost of preparing a completed

    application would be $100,000. The Commission notes that applicants for

    DCO registration will incur direct costs associated with the

    preparation of the completed Form DCO. However, because the Form DCO to

    a large extent captures information that has already been required by

    the Commission under the Guidance or, with respect to new core

    principles, captures information that tracks the statutory

    [[Page 69411]]

    requirements,\258\ the use of the Form DCO will not impose greater

    costs than have been imposed in the past. In fact, by providing greater

    clarity as to what is expected from an applicant and by reducing the

    need for Commission staff to request, and the applicant to provide,

    supplementary information, the Form DCO should reduce costs for

    applicants.

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

    \258\ Exhibits O, P, and Q, relating to the requirements of Core

    Principles O (Governance Fitness Standards), P (Conflicts of

    Interest), and Q (Composition of Governing Boards), respectively.

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

    As discussed in more detail in this notice of final rulemaking, the

    Commission received two comment letters that addressed the proposed

    Form DCO.\259\ The comments did not oppose the concept of the Form DCO.

    The comments were directed at the large amount of information required

    and the necessity of submitting certain specific information. One of

    the comment letters focused on the use of the Form DCO for amending an

    existing DCO registration, and the Commission has provided a

    clarification to address that commenter's concerns. The Commission has

    determined to adopt the final Form DCO largely as proposed, but it has

    modified several of the exhibits in response to specific comments.

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

    \259\ See discussion in Section III.C.1, above.

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

    The Commission has evaluated the costs and benefits of the required

    use of Form DCO, under Sec. 39.3(a)(2), in light of the specific

    considerations identified in Section 15(a) of the CEA as follows:

    1. Protection of Market Participants and the Public

    Costs

    Applicants currently incur costs in demonstrating compliance with

    the core principles. As described above, based on the staff's

    experience in processing DCO applications over the last ten years, the

    Commission believes that use of the Form DCO will not increase, and

    often may decrease, the time and expense associated with applying for

    registration as a DCO for future applicants.

    Benefits

    The Commission expects that use of the Form DCO will promote the

    protection of market participants and the public. Given the critical

    role that DCOs play in providing financial integrity to the markets for

    which they clear--which now include swaps as well as futures markets--

    it is essential that the Commission conduct a comprehensive and

    thorough review of all DCO applications. Such review is essential for

    the protection of market participants and the public insofar as it

    serves to limit the performance of DCO functions to only those entities

    that have provided adequate demonstration that they are capable of

    satisfying the core principles.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    As noted, the Commission believes that use of the Form DCO will not

    increase, and often may decrease, the time and expense associated with

    applying for registration as a DCO for future applicants.

    Benefits

    The Commission expects that use of the Form DCO will promote

    efficiency, competitiveness, and financial integrity. As discussed

    above, the CEA requires that prospective DCO registrants submit an

    application and comply with the core principles. In connection with

    these requirements, in 2001, the Commission adopted the Guidance to

    assist applicants in preparing application materials. However, the

    Commission's experience with protracted reviews of draft applications

    and materially incomplete final submissions has indicated a need for

    streamlining the application process.

    By requiring the use of Form DCO, the Commission is promoting

    increased efficiency by providing greater clarity to applicants before

    they undertake the application process, thereby facilitating the

    submission of a materially complete final application in the first

    instance. This will also reduce the need for submission of supplemental

    materials and consultation between applicants and the Commission staff.

    The result will be more cost effective and expeditious review and

    approval of applications. This will benefit applicants as well as free

    Commission staff to handle other regulatory matters.

    In addition, use of the Form DCO makes available to the public the

    Commission's informational requirements so that all prospective

    applicants have a heightened understanding of what is involved in the

    preparation and processing of an application. It promotes greater

    transparency in the process and will enhance competition among DCOs by

    making it easier for qualified applicants to undertake and navigate the

    application process in a timely manner.

    The Form DCO is designed to address an applicant's ability to

    comply with the core principles. Compliance with the core principles is

    essential to ensure the financial integrity of the derivatives clearing

    process and of derivatives markets, generally. In particular, the

    required information in Form DCO Exhibits B (financial resources), D

    (risk management), E (settlement procedures), F (treatment of funds), G

    (default rules and procedures) and I (system safeguards) elicits

    important information supporting the applicant's ability to operate a

    financially sound clearing organization that can provide reliable

    clearing and settlement services and appropriately manage the risks

    associated with its role as a central counterparty.

    3. Price Discovery

    The Commission does not anticipate that use of the Form DCO will

    impact the price discovery process.

    4. Sound Risk Management Practices

    Costs

    As noted, the Commission believes that use of the Form DCO will not

    increase, and often may decrease, the time and expense associated with

    applying for registration as a DCO for future applicants.

    Benefits

    The Commission expects that use of the Form DCO will promote sound

    risk management practices. Use of the Form DCO will reinforce sound

    risk management by requiring an applicant to examine its proposed risk

    management program through the preparation of a series of detailed

    exhibits. The submission of exhibits relating to risk management also

    make it easier for Commission staff to analyze and evaluate an

    applicant's ability to comply with Core Principle D (risk management,

    which includes monitoring and addressing credit exposure through margin

    requirements and other risk control mechanisms). Sound risk management

    practices are required by the CEA and Commission regulations, and are

    essential to the effective functioning of a DCO.

    5. Other Public Interest Considerations

    Costs

    As noted, the Commission believes that use of the Form DCO will not

    increase, and often may decrease, the time and expense associated with

    applying for registration as a DCO for future applicants.

    Benefits

    There are considerable benefits to the public in standardizing and

    streamlining the DCO application process in terms of more efficient use

    of Commission resources and more cost-effective and transparent

    requirements for applicants. DCOs play a key role in

    [[Page 69412]]

    supporting the financial integrity of derivatives markets, and this

    role takes on even greater significance with the Dodd-Frank

    requirements for swaps clearing. A coherent and comprehensive approach

    to DCO registration is needed to ensure that only qualified applicants

    will be approved and that they are capable of satisfying the

    requirements of the core principles and Commission regulations.

    D. Chief Compliance Officer--Sec. 39.10(c)

    Section 725(b) of the Dodd-Frank Act added a new paragraph (i) to

    Section 5b of the CEA to require each DCO to designate an individual as

    its CCO, responsible for the DCO's compliance with the CEA and

    Commission regulations and the filing of an annual compliance report.

    The provisions regarding the CCO in proposed Sec. 39.10(c) would

    largely codify Section 5b(i) of the CEA. There are certain provisions,

    however, that effectuate or implement the statutory requirements. For

    example, the proposed rules would require that the CCO have the

    appropriate background and skills for the position and not be

    disqualified from registration under Sections 8a(2) or 8a(3) of the

    CEA; meet with the board of directors or the senior officer at least

    once a year to discuss the DCO's compliance program; and perform duties

    including establishing a code of ethics. In addition, with respect to

    the annual report, the proposed rules would set forth certain content

    requirements (e.g., discussing areas for compliance program improvement

    and listing any material changes to compliance policies and procedures

    since the last annual report) and procedural requirements (e.g.,

    submitting the annual report to the board of directors or senior

    officer prior to submitting the report to the Commission, and

    submitting the annual report not more than 90 days after the end of the

    DCO's fiscal year unless the Commission grants an extension of time.)

    As discussed in detail above, the Commission received a number of

    comments that supported the proposed rules for CCOs and the annual

    compliance report, and other comments that suggested alternatives or

    refinements to the Commission's proposed rules. Commenters did not

    provide any quantitative data regarding the costs to either DCOs or

    market participants and the public. The Commission addressed those

    comments above and, where appropriate, the final rules reflect

    commenters' suggestions.

    One commenter, MGEX, expressed concerns that relate to the

    Commission's implementation of the compliance framework established by

    Congress. MGEX stated that the regulations regarding organizational

    structure and reporting lines seem ``excessive and beyond what was

    contemplated by the passage of the Dodd-Frank Act.'' It also believes

    that the regulations do not ``guarantee improved market protection,

    which is one of the main goals of the Dodd-Frank Act.''

    The Commission does not agree with MGEX that the rules exceed what

    was contemplated by Congress. To a great extent the rules codify the

    relevant provisions of the CEA, as amended, and it was Congress, not

    the Commission, that specified the compliance framework that the

    Commission is now implementing. The additional requirements set forth

    by the rules are designed to increase the CCO's effectiveness and

    ensure that the annual report is a useful compliance and oversight

    tool.

    MGEX also commented that ``the rules will impose a cost and burden

    on the market that will be passed along to the market participants

    which decreases the overall efficiency and risk mitigation.'' MGEX did

    not provide any details to support its conclusion.

    The Commission disagrees with MGEX that the Commission's rules will

    impose such a significant burden on the market and market participants.

    The principal costs of the CCO requirement result from the statutory

    provisions of the CEA which, as amended by the Dodd-Frank Act, requires

    each DCO to designate a CCO and submit an annual compliance report.

    Although the Commission's rules would impose certain additional costs

    in order to implement this statutory requirement, these additional

    costs are not expected to significantly increase costs to the DCO or

    market participants. For example, a DCO may incur higher costs to the

    extent that it needs to pay a higher salary to a person who has the

    qualifications set forth in the rule to perform the statutory and

    regulatory duties of the CCO.\260\ The Commission believes that such

    costs are appropriate because it has determined that a CCO should have

    these qualifications to be effective, and notes that the standards are

    general enough to provide reasonable discretion to the DCO in its

    designation of a CCO.\261\ Similarly, a DCO may have to incur higher

    costs in terms of staff time to prepare an annual report that contains

    the information required by Sec. 39.10(c)(3), as opposed to a less

    comprehensive annual report. However, the Commission believes that the

    annual report must contain adequate information if it is to be useful

    to the DCO and the Commission. The Commission does not anticipate that

    these costs of hiring a qualified CCO, or of preparing a more detailed

    annual report, will be significantly higher than the costs to the DCO

    imposed by the basic statutory requirements for the CCO.\262\

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

    \260\ The Commission believes that even in the absence of this

    specific rule many DCOs would employ well-qualified persons to

    perform the responsibilities of the statutorily-required CCO. In

    such circumstances this rule would not result in any additional

    costs for a DCO.

    \261\ As noted in section IV.A.3, above, the rules do not

    require that the person designated as the CCO hold that position,

    exclusively. A CCO may have dual responsibilities so long as the CCO

    can effectively carry out his or her duties as the CCO. Accordingly,

    depending on the skills and background of the personnel within a

    particular DCO, a DCO may be able to use an existing staff member to

    perform the duties of the CCO.

    \262\ In light of the variations that exist today among DCO

    compliance programs, including the qualifications of DCO compliance

    personnel, the Commission does not believe it is feasible to

    quantify the incremental costs associated with Sec. 39.10(c).

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

    For purposes of the Paperwork Reduction Act, the notice of proposed

    rulemaking estimated the cost of preparing the annual report to be

    $8000 to $9000 per year. The Commission received no comments on this

    estimate. The Commission received comments that the annual report

    should be more limited than proposed. The Commission notes that those

    comments did not suggest limiting the annual report to achieve a more

    favorable cost-benefit ratio, and the Commission addressed those

    comments above.

    The Commission has evaluated the costs and benefits of Sec.

    39.10(c) in light of the specific considerations identified in Section

    15(a) of the CEA as follows:

    1. Protection of Market Participants and the Public

    Costs

    As discussed above, there are likely to be direct costs to DCOs in

    connection with designating a qualified CCO and annually preparing a

    comprehensive compliance report. To the extent that the Commission's

    regulations impose more specific or supplemental requirements when

    compared to those requirements explicitly imposed by Section 5b(i) of

    the CEA, those incremental costs are not likely to be significant.

    While it is possible that those incremental costs will be passed along

    to clearing members and market participants in the form of increased

    clearing fees, the size of those incremental costs, when spread across

    recipients of clearing services, are likely to be negligible.

    [[Page 69413]]

    Benefits

    The Commission believes that the CCO rules will protect market

    participants and the public by promoting compliance with the core

    principles and Commission regulations through the designation and

    effective functioning of the CCO, and the establishment of a framework

    for preparation of a meaningful annual review of a DCO's compliance

    program. While there may be incremental costs associated with

    imposition of the Commission's regulatory standards, those costs may be

    mitigated by the countervailing benefits of an effective compliance

    program that fosters financial integrity of the clearing process and

    responsible risk management practices to protect the public from the

    adverse consequences that would result from a DCO failure.

    The annual compliance report, in particular, will help the DCO and

    the Commission to assess whether the DCO has mechanisms in place to

    adequately address compliance issues and whether the DCO remains in

    compliance with the core principles and the Commission's regulations.

    Such compliance will protect market participants and the public.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The Commission believes that designation of a qualified CCO who

    will effectively perform required duties, including the preparation of

    an annual compliance report, will not increase costs and is likely to

    lead to reduction of costs, in terms of the efficiency,

    competitiveness, and financial integrity of the derivatives markets.

    Benefits

    Clearing is a critical component of the efficient, competitive, and

    financially sound functioning of derivatives markets. The financial

    integrity of these markets, in particular, is achieved through layers

    of protection. Requirements for an effective DCO compliance program

    will add a new layer of protection to ensure that the DCO remains

    compliant with the CEA and Commission regulations, especially relating

    to Core Principles B (financial resources), D (risk management), E

    (settlement procedures), F (treatment of funds), G (default rules and

    procedures), I (system safeguards), and N (antitrust considerations).

    An effective CCO will provide benefits to DCOs and the markets they

    serve by implementing measures that enhance the safety and efficiency

    of DCOs and reduce systemic risk. Reliable and financially sound DCOs

    are essential for the stability of the derivatives markets they serve,

    and for the greater public which benefits from a sound financial

    system.

    3. Price Discovery

    The Commission does not anticipate that Sec. 39.10(c) will impact

    the price discovery process.

    4. Sound Risk Management Practices

    Costs

    The Commission does not believe that the CCO provisions will impose

    costs in terms of sound risk management practices. To the contrary, the

    Commission perceives there to be benefits that will result from its CCO

    implementing regulations.

    Benefits

    The regulatory provisions that interpret or implement the statutory

    requirements for the CCO and annual report serve to enhance the

    standards for a DCO's compliance program which will necessarily

    emphasize risk management compliance because of its significance to the

    overall purpose and functioning of the DCO. Compliance with Core

    Principle D (risk management) and related regulations encompasses,

    among other things, measurement and monitoring of credit exposures to

    clearing members, implementation of effective risk-based margin

    methodologies, and appropriate calculation and back testing of margin

    levels. It is the responsibility of the CCO to ensure that the DCO is

    compliant with Core Principle D and the regulations thereunder, and is

    otherwise engaged in appropriate risk management activities in

    accordance with the DCO's own rules, policies and procedures.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on public interest considerations other than those identified

    above.

    E. Financial Resources--Sec. 39.11

    Section 5b(c)(2)(B) of the CEA, Core Principle B, as amended by the

    Dodd-Frank Act, requires a DCO to possess financial resources that, at

    a minimum, exceed the total amount that would enable the DCO to meet

    its financial obligations to its clearing members notwithstanding a

    default by the clearing member creating the largest financial exposure

    for the DCO in extreme but plausible market conditions, and to cover

    its operating costs for a period of one year, calculated on a rolling

    basis.

    Proposed Sec. 39.11 would codify these requirements and set forth

    additional standards for the types of financial resources that are

    acceptable (Sec. 39.11(b)); computation of the amount of financial

    resources required to satisfy the statutory default and operational

    resources requirements (Sec. 39.11(c)); valuation of financial

    resources (Sec. 39.11(d)); liquidity of financial resources (Sec.

    39.11(e)); and quarterly reporting of financial resources (Sec.

    39.11(f)).\263\

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

    \263\ The Commission also proposed Sec. 39.29 which would apply

    certain stricter requirements to SIDCOs. As discussed above, the

    Commission is not taking action on those proposed rules as part of

    this final rulemaking.

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

    As discussed in more detail above, the Commission received comment

    letters requesting further clarity as to the proposed requirements. The

    Commission also received comment letters that discussed how the

    proposed rules might impose costs or burdens on DCOs.\264\ Two

    commenters objected to the requirement that DCOs must monitor ``on a

    continual basis'' a clearing member's ability to meet potential

    assessments, which one of the commenters characterized as ``overly

    burdensome and difficult to administer.'' Regarding the proposed

    restrictions on the use of assessment powers, another commenter stated

    that the inclusion of assessment powers as a financial resource is

    necessary for it to meet its obligations in the event of a default. Two

    commenters recommended that the Commission permit letters of credit to

    be considered in the financial resources computation. Finally, several

    DCOs urged the Commission to allow U.S. Treasuries, in addition to

    cash, as a financial resource sufficient to meet the proposed financial

    resource liquidity requirement.

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

    \264\ See discussion in Section IV.B, above.

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

    As discussed above, in proposing that a DCO ``monitor, on a

    continual basis, the financial and operational capacity of its clearing

    members to meet potential assessments,'' the Commission did not intend

    to require real-time monitoring of clearing members. Rather, the

    purpose of the provision was to require a DCO to monitor often enough

    to enable it to become aware of any potential problems in a timely

    manner. The Commission has modified Sec. 39.11(d)(2)(ii) to remove the

    ``continual basis'' standard, leaving the DCO to exercise its

    discretion in determining the appropriate frequency of periodic reviews

    or more frequent reviews as circumstances warrant in connection with

    particular clearing members.

    The Commission is permitting DCOs to include potential clearing

    member

    [[Page 69414]]

    assessments in calculating default financial resources, as proposed,

    subject to the limitations of Sec. 39.11(d)(2)(iii) (30 percent

    haircut) and Sec. 39.11(d)(2)(iv) (DCO may count the value of

    assessments, after the haircut, to meet up to 20 percent of its default

    resources requirement). The comments on this proposal were varied. Some

    commenters stated that the Commission had proposed an appropriate,

    balanced approach; others stated that the limitations on assessments

    were too strict; and still others stated that the Commission should not

    permit assessments to count at all.

    It is the Commission's view that, in light of recent market events

    and as a general matter, it is not prudent to permit a DCO to rely on

    letters of credit. However, for the reasons discussed above, the

    Commission would consider permitting letters of credit to be included

    as a DCO financial resource on a very limited case-by-case basis.

    Finally, the Commission is revising Sec. 39.11(e)(1) so that, in

    addition to cash, a DCO may use U.S. Treasury obligations and high

    quality, liquid, general obligations of a sovereign nation to satisfy

    financial resource liquidity requirements. This revised standard

    reflects the current practices of U.S. and foreign-based DCOs.

    The Commission has evaluated the costs and benefits of Sec. 39.11

    in light of the specific considerations identified in Section 15(a) of

    the CEA as follows:

    1. Protection of Market Participants and the Public

    Costs

    The regulations require DCOs to take specific actions to ensure

    that they are able to meet the statutory requirements for covering

    default and operating expenses. These actions include monthly stress

    testing to calculate what those financial obligations are, and

    quarterly reporting to the Commission to demonstrate the adequacy of

    financial resources in terms of dollar amount and liquidity. DCOs will

    incur direct costs related to staffing and technology programming to

    calculate, monitor, and report financial resources.

    Existing DCOs will have already implemented certain practices and

    systems for tracking and managing financial resources in order to

    comply with Core Principle B, as originally enacted in 2000. Given the

    staffing and operational differences among DCOs, the Commission is

    unable to accurately estimate or quantify the additional costs DCOs may

    incur to comply with the new financial resource rules.\265\ Moreover,

    the cost-effects of new cleared products and new market participants

    clearing those products are too speculative and uncertain for the

    Commission to be able to quantify or estimate at this time. Such costs

    or benefits will depend upon a number of variables that are not

    estimable or quantifiable at this time, such as the nature and number

    of the new products that become subject to clearing, the nature and

    number of market participants that enter into transactions involving

    such products, and the resulting costs or benefits to such market

    participants from the clearing of such products.

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

    \265\ Commenters did not provide the Commission with

    quantitative data regarding such costs.

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

    As to costs associated with restrictions the Commission is imposing

    on the types and valuation of financial resources that may be counted

    as financial resources for purposes of satisfying Core Principle B,

    those too will vary among DCOs. For example, for DCOs that do not

    include potential clearing member assessments in their calculations of

    financial resources, the limitations on assessments will not result in

    increased costs. For DCOs that to any extent rely on potential

    assessments, the new limitations might require revisions to their

    default management plans, an increase in guaranty fund requirements, or

    an infusion of additional capital. The same would apply to letters of

    credit that cannot be considered to be financial resources for purposes

    of complying with Core Principle B, absent relief. Again, because of

    the range of circumstances of different DCOs, it is not feasible to

    estimate or quantify the costs of the safeguards imposed by the

    Commission's financial resource rules.

    Benefits

    The financial resource rules establish uniform standards that

    further the goals of avoiding market disruptions and financial losses

    to market participants and the general public, and avoiding systemic

    problems that could arise from a DCO's failure to maintain adequate

    default or operating resources. While it is not possible to estimate or

    quantify the benefits to market participants and the public in

    facilitating the financial soundness of a DCO, the Commission believes

    that a DCO failure, regardless of the size of the DCO, could adversely

    affect the financial markets, market participants, and the public.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    As discussed in connection with factor 1 above, quantification or

    estimation of these costs and benefits is not readily feasible. For

    some DCOs, the financial resource rules will have little or no direct

    or indirect impact. For others, the impact may be more substantial.

    Although there may be disparate impact among DCOs, overall the rules

    are not expected to impose significant costs in terms of efficiency,

    competitiveness, or financial integrity of derivatives markets.

    Benefits

    The regulations promote financial strength and stability, thereby

    fostering efficiency and a greater ability to compete in the broader

    financial markets. The regulations promote competition by preventing

    DCOs that lack adequate financial safeguards from expanding in ways

    that may ultimately harm the broader financial market. The regulations

    promote efficiency insofar as DCOs that operate with adequate financial

    resources are less likely to fail. The regulations are designed to

    ensure that DCOs can meet their financial obligations to market

    participants, thus contributing to the financial integrity of the

    derivatives markets as a whole.

    As highlighted by recent events in the global financial markets,

    maintaining sufficient financial resources is a critical aspect of any

    financial entity's risk management system, and ultimately contributes

    to the goal of stability in the broader financial markets. Therefore,

    the Commission believes it is prudent to include financial resources

    requirements for entities applying to become or operating as DCOs.

    Finally, Congress has determined that a DCO must comply with Core

    Principle B to achieve the purposes of the CEA and the Commission has

    determined that Sec. 39.11 sets forth the minimum standards for a DCO

    to do so.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    Costs

    Adequate financial resources are a corollary to strong risk

    management. To the extent that the financial resource rules result in

    additional costs, these costs are associated with implementing the

    practices and procedures that are necessary to ensure a DCO has

    adequate financial resources.

    [[Page 69415]]

    Benefits

    The regulations, by setting specific standards with respect to how

    DCOs should assess, monitor, and report the adequacy of their financial

    resources, contribute to DCOs' maintenance of sound risk management

    practices and further the goal of minimizing systemic risk. The

    reporting requirements, in particular, will enable the Commission to

    conduct more thorough and meaningful oversight of DCOs that will

    contribute to improved risk management by DCOs overall.

    5. Other Public Interest Considerations

    Costs

    The Commission has not identified any public interest

    considerations that would be negatively affected by the provisions of

    the financial resource rules that effectuate or implement the statutory

    requirements of Core Principle B (financial resources).

    Benefits

    The benefits to the public of a DCO maintaining adequate financial

    resources are discussed above.

    F. Participant and Product Eligibility--Sec. 39.12

    Participant Eligibility

    Section 5b(c)(2)(C) of the CEA, Core Principle C, as amended by the

    Dodd-Frank Act, requires each DCO to establish appropriate admission

    and continuing eligibility standards for members of, and participants

    in, the DCO, including sufficient financial resources and operational

    capacity to meet the obligations arising from participation. Core

    Principle C further requires that such participation and membership

    requirements be objective, be publicly disclosed, and permit fair and

    open access. Core Principle C also requires that each DCO establish and

    implement procedures to verify compliance with each participation and

    membership requirement, on an ongoing basis.

    As discussed above, the Commission crafted the provisions of

    proposed Sec. 39.12(a) and related rules to establish a regulatory

    framework that accomplishes two goals: (1) to provide for fair and open

    access, while (2) limiting risk to the DCO and its clearing members.

    The provisions in Sec. 39.12(a)(1) provide for fair and open access in

    a number of ways. A DCO is prohibited from adopting restrictive

    clearing member standards if less restrictive requirements that would

    not materially increase risk to the DCO or clearing members could be

    adopted (Sec. 39.12(a)(1)(i)); a DCO must allow all market

    participants who satisfy participation requirements to become clearing

    members (Sec. 39.12(a)(1)(ii)); the standards must be non-

    discriminatory (Sec. 39.12(a)(1)(iii)); and they may not require

    clearing members to be swap dealers (Sec. 39.12(a)(1)(iv)), or

    clearing members to maintain a swap portfolio of any particular size or

    meet a swap transaction volume threshold (Sec. 39.12(a)(1)(v)).

    Section 39.12(a)(2) facilitates greater participation by requiring

    that capital requirements for clearing members be based on objective,

    transparent, and commonly accepted standards that appropriately match

    capital to risk (Sec. 39.12(a)(2)(i)); and by setting the minimum

    capital requirement at not more than $50 million (Sec.

    39.12(a)(2)(ii)).

    A number of commenters supported the proposed rules. They asserted

    that increased access to clearing would stimulate competition and

    diversify risk. A number of other commenters opposed aspects of the

    proposed rules, particularly the $50 million capital standard. They

    argued that these provisions could increase risk by providing access to

    firms with insufficient financial resources or operational capacity.

    The Commission did not receive any comments that quantified the

    costs associated with the proposed participation rules. Instead,

    commenters focused on qualitative considerations, including how the

    proposed rules would affect market participants, market risk,

    efficiency, competitiveness, the financial integrity of futures

    markets, and price discovery.

    The Commission is adopting these provisions essentially as

    proposed.

    The Commission has evaluated the costs and benefits of the proposed

    regulations in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    The participant eligibility rules may result in costs beyond those

    incurred in the normal course of operating a DCO or clearing firm, but

    such potential costs are, at this time, speculative in nature and

    impossible to estimate or quantify. By providing access to clearing to

    additional firms, the rules could impose costs on DCOs, other clearing

    members, or customers if a firm admitted to clearing membership in a

    DCO pursuant to these rules failed to meet its obligations. Any such

    costs depend upon a number of factors that are not presently knowable,

    quantifiable, or estimable.

    It is not possible to estimate or quantify these costs in a

    reliable way for a number of reasons. The historical record prior to

    the enactment of the Dodd-Frank Act with respect to the operation of

    clearing organizations provides little guidance as to the costs that

    may be incurred in the future in the unlikely event of a default at a

    DCO. Defaults at DCOs are very rare and the circumstances of each one

    are unique. Moreover, the Dodd-Frank Act and implementing regulations

    will alter the landscape significantly. Existing DCOs and FCMs will be

    clearing new products. New DCOs and FCMs will enter the market.

    Mandatory clearing will bring new products and participants to DCOs and

    FCMs. The interaction of all these factors creates a wide range of

    uncertainty as to the nature of the potential consequences of a default

    under the new regulatory regime. In sum, the Commission believes that

    the possible future circumstances leading to and potential resulting

    consequences of a DCO default are too speculative and uncertain to be

    able to quantify or estimate the resulting costs to DCOs, clearing

    members, or market participants with any precision or degree of

    magnitude.

    Whatever these potential costs, the Commission believes that the

    participant eligibility rules will reduce the risk that clearing

    members will in fact incur such costs. First, increased access to

    clearing membership should reduce concentration at any one clearing

    member and diversify risk. Second, the rules contain risk management

    provisions specifically designed to minimize the likelihood and extent

    of defaults. The provisions in Sec. 39.12(a)(2) set forth requirements

    that mandate DCOs: Require that all clearing members have sufficient

    financial resources to meet obligations arising from participation in

    the DCO (Sec. 39.12(a)(2)(i)); establish capital requirements that are

    scalable so that they are proportional to the risks posed by clearing

    members (Sec. 39.12(a)(2)(ii)); require that clearing members have

    adequate operational capacity to meet obligations arising from

    participation in the DCO (Sec. 39.12(a)(3)); verify the compliance of

    each clearing member with the requirements of the DCO (Sec.

    39.12(a)(4)); satisfy certain reporting requirements (Sec.

    39.12(a)(5)); and have the ability to enforce participation

    requirements (Sec. 39.12(a)(6)).

    For reasons similar to those described above, it is also not

    feasible to quantify or estimate this reduction in costs with any

    confidence. Based on its judgment and experience with the regulation

    and operation of clearing organizations, the

    [[Page 69416]]

    Commission believes that these rules will lower the risk that clearing

    members will in fact incur such costs. However, the possible future

    circumstances leading to and potential resulting consequences of a

    future default are too speculative and uncertain to quantify or

    estimate, either under the current regulatory regime or under the rules

    being adopted by the Commission.

    Benefits

    Greater access to clearing should benefit market participants by

    increasing competition among clearing members. Allowing more firms to

    clear should increase competition among clearing firms on both price

    and service which should, in turn, reduce costs to market participants.

    Further, the safeguards in Sec. 39.12(a)(2) will benefit DCOs,

    clearing members, and market participants by reducing risk. Reductions

    in risk also benefit the general public by decreasing the probability

    of a systemic failure.

    For the reasons described above in connection with costs, it is

    also impractical to quantify or estimate these benefits associated with

    reductions in risk to clearing members, market participants, and the

    public.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are very similar to the

    considerations under the previous factor with respect to participant

    eligibility requirements. Quantification or estimation of these costs

    and benefits is not feasible for the reasons set forth under the first

    factor. The potential increase in risk of default resulting from open

    access is mitigated by the decrease in risk resulting from

    diversification of risk, increased competition, and the safeguards set

    forth in Sec. 39.12(a)(2).

    Benefits

    By opening access the rules should increase competition among

    clearing members thereby resulting in increased efficiency in the

    provision of clearing services. The safeguards in the rules such as the

    requirement that DCOs impose risk limits on clearing members will

    enhance the financial integrity of the DCO and its clearing members.

    3. Price Discovery

    Costs

    The Commission has not identified any way in which the rules will

    impair price discovery.

    Benefits

    Increased competition among clearing members could bring more

    participants into the markets which could result in more competitive

    pricing and enhanced price discovery.

    4. Sound Risk Management Practices

    Costs

    According to some commenters, the open access rules could hinder

    sound risk management practices by admitting clearing members unable to

    participate in the default management process. Other commenters assert

    that the rules provide appropriate protections and will facilitate

    sound risk management practices. The Commission believes that the open

    access rules, when coupled with the default management rules discussed

    below, will not impair sound risk management practices. Under the

    rules, clearing members will be required to demonstrate that they have

    operational capacity to carry out their responsibilities as well as

    sufficient financial resources to meet their obligations.

    Benefits

    As explained above, the provisions in Sec. 39.12(a)(2) require

    that DCOs establish a risk management framework with respect to their

    members. In addition, open access should lead to diversification of

    risk at DCOs and allow additional firms to assist in the resolution of

    any defaults.

    5. Other Public Interest Considerations

    Costs

    The Commission has not identified any other public interest

    considerations that would be negatively affected by the potential costs

    of the eligibility requirements.

    Benefits

    The CEA, as amended by the Dodd-Frank Act, requires DCOs to allow

    for open access and, therefore, broader participation. The Commission

    believes that greater participation in clearing could increase

    liquidity in the markets. This could help prevent price manipulation or

    other anti-competitive practices because it will be harder to organize

    concerted efforts to achieve such ends. Finally, Congress has

    determined that a DCO must comply with Core Principle C to achieve the

    purposes of the CEA and the Commission has determined that Sec.

    39.12(a) sets forth the minimum standards for a DCO to comply with the

    CEA's participation requirements.

    Product Eligibility

    Core Principle C also requires a DCO to establish ``appropriate

    standards for determining the eligibility of agreements, contracts, or

    transactions submitted to the [DCO] for clearing.'' Section 39.12(b)

    implements this provision.

    Proposed Sec. 39.12(b)(1) would require a DCO to establish

    requirements for determining product eligibility taking into account

    the DCO's ability to manage risks associated with the product. Proposed

    Sec. Sec. 39.12(b)(2) and (b)(3) would codify section 2(h)(1)(B) of

    the CEA. Proposed Sec. 39.12(b)(4) would prohibit a DCO from requiring

    an executing party to be a clearing member in order for the product to

    be eligible for clearing. Proposed Sec. 39.12(b)(5) would require a

    DCO to select contract units for clearing purposes that maximize

    liquidity, facilitate transparency, promote open access, and allow for

    effective risk management. Proposed Sec. 39.12(b)(6) would require

    novation upon acceptance of a swap. Finally, proposed Sec. 39.12(b)(8)

    would require a DCO to confirm the terms of a swap at the time the swap

    is accepted for clearing.\266\

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

    \266\ Proposed Sec. 39.12(b)(7) will be addressed in a separate

    rulemaking.

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

    The Commission did not receive any comments directly addressing

    cost-benefit considerations. The Commission did receive several

    comments on substantive provisions that bear on those considerations.

    One commenter suggested that Sec. 39.12(b)(4) may be an impediment to

    the development of new DCOs. Several commenters suggested that it would

    be impractical or inappropriate for a DCO to establish unit sizes for

    clearing that differ from the unit size at execution (Sec.

    39.12(b)(5)).

    The Commission also received several comments requesting

    clarification of certain provisions. As discussed above, the Commission

    has made changes to these rules that are responsive to the comments.

    The Commission is adopting Sec. 39.12(b) largely as proposed with

    several clarifying amendments as discussed above.

    The Commission has evaluated the costs and benefits of Sec.

    39.12(b) in light of the specific considerations identified in Section

    15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    The Commission has not identified any new costs arising out of

    Sec. Sec. 39.12(b)(1), 39.12(b)(6), or

    [[Page 69417]]

    39.12(b)(8). DCOs currently perform risk analysis before accepting new

    products for clearing, currently novate trades upon acceptance, and

    currently issue confirmations to clearing members.

    As noted, one commenter suggested that prohibiting a DCO from

    requiring one of the original executing parties to be a clearing member

    in order for a contract to be eligible for clearing may be an

    impediment to the development of new DCOs. The Commission believes

    that, to the contrary, such restrictions on product eligibility for

    clearing increase overall costs for market participants, and that

    prohibiting such restrictions will lead to lower overall costs. Such

    restrictions deny the availability and benefits of clearing to non-

    clearing members. Open access will enable non-clearing members to

    obtain the benefits of clearing and increase competition in clearing

    and trading, thereby increasing liquidity, and reducing costs.

    The commenters who questioned the unit size provision did not

    elaborate on the costs. It is not feasible to quantify these costs for

    a number of reasons. The rule provides DCOs with significant

    flexibility in selecting unit sizes. Different DCOs may select

    different sizes for the same or similar products. Numerous SEFs will

    also be making judgments concerning unit size which will influence the

    decisions of DCOs and traders. Some products will be subject to

    mandatory clearing and others to voluntary clearing. The unpredictable

    interaction of these variables creates a wide range of uncertainty as

    to the nature of the consequences of the selection of unit sizes by

    DCOs. Similar considerations apply to the other provisions of Sec.

    39.12(b). In sum, the Commission believes that the possible future

    circumstances leading to, and the potential resulting consequences of,

    the implementation of Sec. 39.12(b) are too speculative and uncertain

    to be able to quantify or estimate resulting costs with any precision

    or degree of magnitude.

    Benefits

    The Commission believes that Sec. 39.12(b) will protect market

    participants and the public in many ways. First, these provisions are

    likely to facilitate the standardization of swaps, thereby eliminating

    differences between the terms of a swap as cleared at the DCO level and

    as carried at the customer level. Any such outstanding differences

    would raise both customer protection and systemic risk concerns. From a

    customer protection standpoint, if the terms of the swap at the

    customer level differ from those at the clearing level, then the

    customer still has a bilateral position opposite its counterparty. The

    customer is still exposed to the credit risk of the counterparty and

    the position would not be able to be offset against other positions at

    the DCO. Similarly, from a systemic perspective, any differences in

    terms between the trades would eliminate the possibility of

    multilateral offset and thereby diminish liquidity.

    Second, Sec. 39.12(b) can promote liquidity by permitting more

    parties to trade the product and by permitting more clearing members to

    clear the product. Third, it can enhance risk management by enabling a

    DCO, in the event of a default, to have more potential counterparties

    for liquidation.

    Fourth, these provisions will support the requirement in section

    2(h)(1)(B) of the CEA and proposed Sec. 39.12(b)(2) that a DCO must

    adopt rules providing that all swaps with the same terms and conditions

    submitted to the DCO are economically equivalent within the DCO and may

    be offset with each other.

    Fifth, clearing will eliminate the need for a counterparty to

    ascertain the credit-worthiness of each of its counterparties. This

    will promote liquidity, competition, and financial integrity to the

    benefit of all market participants.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The Commission has not identified any ways in which the proposals

    would reduce efficiency, competitiveness, or financial integrity.

    Benefits

    The rules should increase participation by clearing members, which

    should increase competition among clearing members to provide services

    to customers. In addition, the rules will lead to standardization of

    products. Finally, the rules will allow for more clearing through

    novation, which should result in increased open interest and liquidity.

    In turn, this should lead to more competitive and efficient markets. As

    noted above, smaller units can promote liquidity and encourage

    prospective clearing members to bid on positions and enable them to

    accept a forced allocation in the event of a clearing member's default.

    This facilitates open access, and at same time promotes risk management

    by enabling a DCO, in the event of a default, to be able to rely on

    more potential counterparties for liquidation.

    3. Price Discovery

    Costs

    The Commission has not identified any ways in which the rules would

    reduce price discovery.

    Benefits

    As discussed above, the rules will increase competition, which

    should enhance price discovery by bringing more participants into the

    markets. In addition, standardization means that prices observed on

    different trades are more directly comparable, which can improve price

    discovery.

    4. Sound Risk Management Practices

    Costs

    The Commission has not identified any ways in which the rules would

    impair sound risk management practices.

    Benefits

    The rules require DCOs to establish appropriate standards for

    determining the eligibility of contracts submitted to the DCO for

    clearing taking into account the DCO's ability to manage risks

    associated with the product. Such standards are a sound risk management

    practice.

    5. Other Public Interest Considerations

    Costs

    The Commission has not identified any ways in which the rules would

    harm any other public interest considerations.

    Benefits

    As discussed above, open access, increased competition, greater

    liquidity, improved price discovery, and greater financial integrity

    are all benefits of the rules. All these factors will benefit the

    general public, which may not participate in these markets directly but

    may feel their impact on the larger economy.

    G. Risk Management--Sec. 39.13

    In General

    Core Principle D,\267\ as amended by the Dodd-Frank Act, requires

    each DCO to ensure that it possesses the ability to manage the risks

    associated with discharging the responsibilities of the DCO through the

    use of appropriate tools and procedures. It further requires each DCO

    to measure its credit exposures to each clearing member not less than

    once during each business day and to monitor each such exposure

    [[Page 69418]]

    periodically during the business day. Core Principle D also requires

    each DCO to limit its exposure to potential losses from defaults by

    clearing members, through margin requirements and other risk control

    mechanisms, to ensure that its operations would not be disrupted and

    that non-defaulting clearing members would not be exposed to losses

    that non-defaulting clearing members cannot anticipate or control.

    Finally, Core Principle D provides that a DCO must require margin from

    each clearing member sufficient to cover potential exposures in normal

    market conditions and that each model and parameter used in setting

    such margin requirements must be risk-based and reviewed on a regular

    basis.

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

    \267\ Section 5b(c)(2)(D) of the CEA; 7 U.S.C. 7a-1(c)(2)(D).

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

    The Commission proposed Sec. 39.13 to establish requirements that

    a DCO would have to meet in order to comply with Core Principle D. For

    a number of provisions of proposed Sec. 39.13, the Commission did not

    receive any comments on the associated costs or on cost-benefit

    analysis. The Commission discussed in the notice of proposed rulemaking

    and above why it believes a DCO must satisfy each of those provisions

    to be in compliance with the Core Principle D and why it is appropriate

    for market participants to incur any costs associated with implementing

    each of those provisions. The Commission also addressed comments that

    suggested alternative standards, frameworks, or procedures. Where

    appropriate, the Commission revised the proposed rules. To avoid

    repetition, the Commission incorporates by reference the above

    discussion of Sec. 39.13.

    Commenters raised concerns about the costs of Sec. Sec.

    39.13(g)(2)(ii) (minimum liquidation time), 39.13(g)(2)(iii) (margin

    confidence level), 39.13(g)(8)(i) (gross margin), 39.13(h)(1)(i) (risk

    limits), 39.13(h)(2) (large trader reports), and 39.13(h)(5)(ii)

    (clearing member risk review) or the Commission's cost-benefit analysis

    relating to these rules. The Commission's consideration of the costs

    and benefits associated with these rules is discussed in greater detail

    below.

    Minimum Liquidation Time

    As proposed, Sec. 39.13(g)(2)(ii) would require a DCO to use a

    liquidation time that is a minimum of five business days for cleared

    swaps that are not executed on a DCM, and a liquidation time that is a

    minimum of one business day for all other products that it clears,

    although it would be required to use longer liquidation times, if

    appropriate, based on the unique characteristics of particular products

    or portfolios.

    Numerous commenters objected to the proposed difference in

    requirements that would subject swaps that were either executed

    bilaterally or executed on a SEF to a minimum five-day liquidation

    time, while permitting equivalent swaps that were executed on a DCM to

    be subject to a minimum one-day liquidation time. The Commission did

    not receive any comments that quantified the costs of this rule.

    As to the actual periods proposed, commenters variously contended

    that a liquidation time of five business days may be excessive for some

    swaps, a one-day liquidation period is too short, a one-day liquidation

    period is appropriate for swaps executed on a DCM or a SEF, and a two-

    day liquidation period is appropriate for cleared swaps.

    Some commenters encouraged the Commission to permit a DCO to

    determine the appropriate liquidation time for all products that it

    clears based on the unique characteristics and liquidity of each

    relevant product or portfolio. Two commenters recommended that if the

    Commission were to mandate minimum liquidation times in the final

    rules, it should allow DCOs to apply for exemptions for specific groups

    of swaps if market conditions prove that such minimum liquidation times

    are excessive.

    Upon consideration of the comments, the Commission is adopting

    Sec. 39.13(g)(2)(ii) with a number of modifications. First, the final

    rule requires a DCO to use the same liquidation time for a product

    whether it is executed on a DCM, a SEF, or bilaterally. Second, the

    final rule provides that the minimum liquidation time for swaps based

    on certain physical commodities, i.e., agricultural commodities,

    energy, and metals, as well as futures and options, is one day. For all

    other swaps, the minimum liquidation time is five days. Third, to

    provide further flexibility, the Commission is adding a provision

    specifying that, by order, the Commission may provide for a different

    minimum liquidation time for particular products or portfolios.

    The Commission has evaluated the costs and benefits of the proposed

    regulations in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    The Commission anticipates that using only one criterion--i.e., the

    characteristic of the commodity underlying a swap--to determine

    liquidation time could result in less-than-optimal margin calculations.

    For some products, a five-day minimum may prove to be excessive and tie

    up more funds than are strictly necessary for risk management purposes.

    For other products, a one-day or even a five-day period may be

    insufficient and expose a DCO and market participants to additional

    risk.

    The Commission believes that it is not feasible to estimate or

    quantify these costs reliably. In addition to the liquidation time

    frame, the margin requirements for a particular instrument depend upon

    a variety of characteristics of the instrument and the markets in which

    it is traded, including the risk characteristics of the instrument, its

    historical price volatility, and liquidity in the relevant market.

    Determining such margin requirements does not solely depend upon such

    quantitative factors, but also requires expert judgment as to the

    extent to which such characteristics and data may be an accurate

    predictor of future market behavior with respect to such instruments,

    and applying such judgment to the quantitative results. Thousands of

    different swap products may be subject to clearing. Determining the

    risk characteristics, price volatility, and market liquidity of even a

    sample for purposes of determining a liquidation time specifically for

    such instrument would be a formidable task for the Commission to

    undertake and any results would be subject to a range of uncertainty.

    Reliable data is not readily available for many swaps that prior to the

    Dodd-Frank Act were executed in unregulated markets.

    Given the amount of uncertainty in estimating margin requirements

    using either a five-day liquidation time or a one-day liquidation time,

    the amount of uncertainty in estimating the cost of using one rather

    than the other is compounded. For all the reasons stated in the

    previous paragraph, the possible range within which the size of the

    difference would fall is very large. In sum, in the absence of a

    reasonably feasible and reliable methodology at the present time for

    the Commission to use in calculating the appropriate margin

    requirements for swaps with either five-day or one-day liquidation

    times,\268\ the

    [[Page 69419]]

    Commission believes that possible future circumstances surrounding

    margin levels are too speculative and uncertain to be able to quantify

    or estimate the resulting costs to DCOs, clearing members, or the

    public from the rule with any precision or degree of magnitude.

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

    \268\ The Commission notes that ``[t]he existence of significant

    outstanding notional exposures, trading liquidity, and adequate

    pricing data'' is one of the factors the Commission must consider in

    reviewing whether a swap or group or class of swaps is subject to

    the mandatory clearing requirement in CEA Section 2(h)(1). See

    Section 2(h)(2)(D) of the CEA. To enable the Commission to make this

    determination, the Commission requires DCOs that submit swaps to the

    Commission for a mandatory clearing determination to submit data and

    other information that would enable the Commission to effectively

    consider this factor. See Sec. 39.5(b)(3)(ii)(A), 76 FR at 44473

    (July 26, 2011) (Process for Review of Swaps for Mandatory Clearing;

    final rule). Not only is this type of information needed for the

    Commission to consider the statutory factors and make the

    determinations as to which swaps should be subject to mandatory

    clearing, but it also would be needed to calculate appropriate

    margin amounts for such swaps, were the Commission to attempt such

    calculations.

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

    Moreover, any potential costs of this rule may be mitigated by the

    provision that allows DCOs to request, or the Commission on its own

    initiative to make, a determination that the liquidation time for a

    particular contract is too long or too short. As markets evolve, it may

    become appropriate to ease the requirement for certain swaps subject to

    the five-day minimum. Conversely, analysis may reveal that for other

    products or portfolios the five-day or one-day minimum is insufficient.

    This procedure could serve to reduce costs that may arise from

    application of the rule.

    Benefits

    A minimum liquidation time is a standard input in value-at-risk

    models used by DCOs to compute a confidence interval to estimate their

    risk. The value-at-risk confidence interval protects DCOs, their

    clearing members, market participants, and the public by fixing the

    probability that a default will occur and the position cannot be

    liquidated in time.

    The five-day/one-day distinction for different types of swaps is

    based on the ease of liquidation of different product groups and is

    consistent with existing requirements that reflect the risk assessments

    DCOs have made over the course of their experience clearing these types

    of swaps. Several DCOs have determined that these are the appropriate

    standards for these instruments and apply it to their margin

    requirements. The Commission believes that this is a reasonable and

    prudent judgment.

    A minimum standard is designed to prevent DCOs from competing by

    offering lower margin requirements than other DCOs and, as a result,

    taking on more risk than is prudent. In addition, the Commission is

    concerned that a DCO may misjudge the appropriate liquidation time

    frame because of limited experience with clearing and managing the

    risks of financial swaps. A minimum liquidation time frame should

    prevent DCOs from taking on too much risk.

    While it is not possible to estimate or quantify the benefits to

    market participants and the public in facilitating the financial

    soundness of DCOs, the Commission believes that a DCO failure,

    regardless of the size of the DCO, could adversely affect the financial

    markets, market participants, and the public. This rule will diminish

    the chances that such a failure will occur.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are similar to the

    considerations under the first factor.

    Benefits

    The rule will promote efficiency, competitiveness and financial

    integrity by establishing a minimum standard for all DCOs. While a DCO

    will still have considerable latitude in setting risk-based margin

    levels, the Commission has determined that establishing a minimum

    liquidation time will provide legal certainty for an evolving

    marketplace, will offer a practical means for assuring that the

    thousands of different swaps that are going to be cleared subject to

    the Commission's oversight will have prudent minimum margin

    requirements, and will help prevent a potential ``race to the bottom''

    by competing DCOs. Competition among DCOs will be channeled to other

    areas such as level of service.

    The Commission believes that default by a clearing member could

    have a significant, adverse effect on market participants or the

    public. Market participants may have to incur the costs of making up

    any shortfall in margin through guaranty fund deposits and/or

    assessments, and any costs associated with participation in an auction

    or allocation of the positions of a defaulting clearing member. In a

    worst case scenario, a default by a clearing member may undermine the

    financial integrity of the DCO, which could have serious and widespread

    consequences for the U.S. financial markets. This rule protects market

    participants and the public from bearing these costs by requiring a DCO

    to follow certain minimum standards in establishing margin

    requirements.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    Costs

    Because the rule simply establishes minimums, it will not hinder

    the exercise of sound risk management practices. The rule specifically

    requires DCOs to use longer liquidation times if appropriate for

    particular products.

    Benefits

    As discussed under the first two factors, the rule will foster

    sound risk management practices.

    5. Other Public Interest Considerations

    The Commission has not identified any costs or benefits beyond

    those discussed under the first factor.

    Margin Confidence Level

    As proposed, Sec. 39.13(g)(2)(iii) would require a DCO's initial

    margin models to meet an established confidence level of at least 99%

    based on data from an appropriate historical period.

    A number of commenters stated that each DCO should have discretion

    to establish confidence levels based on the particular characteristics

    of the products and portfolios it clears and their underlying markets.

    However, a number of other commenters stated that a 99% confidence

    level was the proper minimum.

    The Commission is adopting the rule as proposed.

    The Commission has evaluated the costs and benefits of the proposed

    regulation in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    A 99% confidence level will require that more money be held as

    margin as compared to a lower confidence level. There is an opportunity

    cost to clearing members holding this money as margin.

    The Commission believes that it is not feasible to estimate or

    quantify this cost reliably. In addition to the confidence level, the

    margin requirements for a particular instrument depend upon a variety

    of characteristics of the instrument and the markets in which it is

    traded, including the risk characteristics of the instrument, its

    historical price volatility, and liquidity in the relevant market.

    Determining such margin requirements does not solely depend upon such

    quantitative

    [[Page 69420]]

    factors, but also requires expert judgment as to the extent to which

    such characteristics and data may be an accurate predictor of future

    market behavior with respect to such instruments, and applying such

    judgment to the quantitative results. Thousands of different swap

    products may be subject to clearing. Determining the risk

    characteristics, price volatility, and market liquidity of even a

    sample for purposes of determining a confidence level specifically for

    such instrument would be a formidable task for the Commission to

    undertake and any results would be subject to a range of uncertainty.

    Reliable data is not readily available for many swaps that prior to the

    Dodd-Frank Act were executed in unregulated markets. In sum, in the

    absence of a reasonably feasible and reliable methodology at the

    present time for the Commission to use in calculating the margin

    requirements for swaps,\269\ the Commission believes that possible

    future circumstances surrounding margin levels are too speculative and

    uncertain to be able to quantify or estimate the resulting costs to

    DCOs, clearing members, or the public from the rule with any precision

    or degree of magnitude.

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

    \269\ Id.

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

    Benefits

    A minimum confidence level is essential to protect market

    participants and the public. A minimum confidence level will prevent

    DCOs from competing with respect to how much risk they are willing to

    take on or from misjudging the amount of risk they would take on if

    they operated under lower standards. In addition, it will provide

    assurance to market participants that every DCO has sufficient margin

    to effectively manage a default.

    Some DCOs currently apply the 99 percent standard. Others use 95-99

    percent for some contracts depending on facts and circumstances.

    International standards currently recommend 99 percent.\270\ In view of

    the increased risk that DCOs will face as a result of clearing swaps,

    the Commission believes that protection of market participants and the

    public dictates that the minimum standard on this key risk management

    element should be set in accordance with current best practices among

    DCOs and international standards.

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

    \270\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,

    Key Consideration 3, at 40; EMIR, Article 39, paragraph 1, at 46.

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

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are very similar to the

    considerations under the first factor.

    Benefits

    The rule will promote efficiency, competitiveness and financial

    integrity by establishing a minimum standard for all DCOs. While a DCO

    will still have considerable latitude in setting risk-based margin

    levels, the Commission has determined that establishing a minimum

    confidence level will provide legal certainty for an evolving

    marketplace, will offer a practical means for assuring that the

    thousands of different swaps that are going to be cleared subject to

    the Commission's oversight will have prudent minimum margin

    requirements, and will prevent a potential ``race to the bottom'' by

    competing DCOs. As noted above, the Commission is adopting a 99%

    standard in order to conform to current best practices among DCOs as

    well as international standards. Competition among DCOs will be

    channeled to other areas such as level of service.

    The Commission believes that default by a clearing member could

    have a significant, adverse effect on market participants and the

    public. Market participants may have to incur the costs of making up

    any shortfall in margin through guaranty fund deposits and/or

    assessments, and any costs associated with participation in an auction

    or allocation of the positions of a defaulting clearing member. In a

    worst case scenario, a default by a clearing member may undermine the

    financial integrity of the DCO, which could have significant negative

    consequences for the financial stability of U.S. financial markets. As

    highlighted by recent events in the global financial markets, the

    ability to manage the risks associated with clearing is critical to the

    goal of stability in the broader financial markets. This rule protects

    market participants and the public from bearing these costs by

    requiring a DCO to follow certain minimum standards in establishing

    margin requirements.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    Costs

    Because the rule simply establishes minimums, it will not hinder

    the exercise of sound risk management practices. The rule specifically

    requires DCOs to use higher confidence levels if appropriate for

    particular products.

    Benefits

    As discussed under the first two factors, the rule will foster

    sound risk management practices.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on public interest considerations other than those identified

    above.

    Gross Margin

    As proposed, Sec. 39.13(g)(8)(i) would require a DCO to collect

    initial margin on a gross basis for customer accounts.

    Two commenters supported the proposal. Several commenters stated

    that the provision of individual customer position information to DCOs

    may entail significant, costly, and time-consuming changes to systems

    infrastructure at the clearing member level and the DCO level.

    In light of the various concerns regarding the operational and

    technology changes that would be needed and related costs of requiring

    a DCO to obtain individual customer position information from its

    clearing members and to use such information to calculate the margin

    requirements for each individual customer, the Commission is modifying

    Sec. 39.13(g)(8)(i). As amended, the rule provides a DCO with the

    discretion to either calculate customer gross margin requirements based

    on individual customer position information that it obtains from its

    clearing members or based on the sum of the gross positions of all of a

    clearing member's customers that the clearing member provides to the

    DCO, without forwarding individual customer position information to the

    DCO.

    The Commission has evaluated the costs and benefits of the proposed

    regulation in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    Three kinds of costs could result from a change from net to gross

    margining, for those DCOs that currently use net margining.\271\ First,

    gross margining could change the loss that customers of a clearing

    member may face in the event

    [[Page 69421]]

    of default by a fellow customer of that clearing member. Under net

    margining, a greater portion of customer margin is held at the clearing

    member and thereby insulated from the DCO, so that non-defaulting

    customers face lower risk of losing their margin deposits to the DCO if

    a fellow customer defaults. Gross margining gives a DCO access to the

    margin deposits of non-defaulting customers of a defaulting FCM.\272\

    In this sense, gross margining could shift a portion of the default

    risk from the DCO to fellow customers.\273\

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

    \271\ As discussed in section IV.D.6.h.(1), above, certain DCOs

    already use a version of gross margining, in which case the costs of

    complying with Sec. 39.13(g)(8)(i) would be considerably less.

    \272\ Offsetting this effect is the potential for a failing FCM

    to misappropriate customer funds. That potential is greater under

    net margining.

    \273\ The Commission has proposed rules that would not permit

    this in the case of swaps. See 76 FR 33818 (June 9, 2011)

    (Protection of Cleared Swaps Customer Contracts and Collateral;

    Conforming Amendments to the Commodity Broker Bankruptcy

    Provisions).

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

    It is not possible to estimate or quantify these costs--which would

    only arise in the event of a default of a customer--in a reliable way

    for a number of reasons. The historical record prior to the enactment

    of the Dodd-Frank Act with respect to the operation of clearing

    organizations provides little guidance as to the costs that may be

    incurred in the future in the unlikely event of a default at a DCO.

    Defaults at DCOs are very rare and the circumstances of each one are

    unique. Moreover, the Dodd-Frank Act and implementing regulations will

    alter the landscape significantly. Existing DCOs and FCMs will be

    clearing new products. New DCOs and FCMs will enter the market.

    Mandatory clearing will bring new products and participants to DCOs and

    FCMs. The interaction of all these factors creates a wide range of

    uncertainty as to the nature of the potential consequences of a default

    under the new regulatory regime. In sum, the Commission believes that

    the possible future circumstances leading to and potential resulting

    consequences of a future default are too speculative and uncertain to

    be able to quantify or estimate the resulting costs to clearing members

    with any precision or degree of magnitude.

    Second, because gross margining means that more customer margin is

    held at the DCO, rather than the FCM, gross margining also means that

    any return on this margin (e.g., interest earned) is earned by the DCO,

    rather than the FCM. This is largely a transfer between those parties.

    If there is no offsetting change in other terms of the relationship

    between customers, FCMs and DCOs, gross margining leads to a cost for

    FCMs and a benefit to DCOs from this change.

    Third, gross margining could result in changes in operating costs

    for DCOs and clearing members. Gross margining could require the DCO to

    possess more detailed information about customer positions. The

    provision of individual customer position information to DCOs may

    entail significant, costly, and time-consuming changes to systems

    infrastructure at the clearing firm level and the DCO level. For

    example, NYPC stated that its preliminary cost estimate for compliance

    with the customer gross margin and large trader report requirements

    contained in proposed Sec. Sec. 39.13(g)(8)(i) and 39.13(h)(2) was

    approximately 128,650 hours and $14.5 million.

    In order to reduce the potential costs, the Commission has revised

    Sec. 39.13(g)(8)(i) to allow a DCO to permit an FCM to provide the DCO

    with the sum of the gross positions of all of its customers so that the

    DCO may calculate the applicable gross margin requirement based on that

    sum. Under this scenario, a DCO will not have to establish a framework

    to receive each customer's position information and calculate the

    initial margin requirement applicable to each customer's positions. The

    Commission believes this alternative framework will be significantly

    less expensive for market participants. Whether a DCO chooses to make

    the calculation based on individual customer position information or

    the sum of customers' gross positions submitted by the clearing member,

    the clearing member's customer gross margin requirement will be the

    same.

    NYPC also commented that such implementation costs could

    significantly deter new clearinghouses like NYPC from launching.

    However, NYPC did not provide an estimate for the costs of a new

    clearinghouse system capable of gross margining in relation to the cost

    of retrofitting an existing net margin system. The Commission believes

    that retrofitting an existing system may be more expensive than

    implementing a new system from scratch, and that it is unclear whether

    additional implementation costs would deter any new clearinghouses.

    Benefits

    The Commission believes that the clearing of swaps will increase

    the risk that DCOs face. Gross margining will increase the amount of

    money that DCOs hold. Under gross margining, the amount of margin at

    the DCO more accurately approximates the risks posed to a DCO by its

    clearing members' customers than net margining and increases the

    financial resources available to a DCO in the event of a customer

    default.

    A DCO may not be able to collect initial customer margin from an

    FCM if the FCM defaults. This could have a serious adverse impact on

    the financial stability of a DCO, non-defaulting customers, and

    potentially wider markets. In this regard, a significant customer

    default leading to an FCM default could strain a DCO's financial

    resources, causing it to exhaust the initial margin available to cover

    the default and forcing other clearing members and/or the DCO to incur

    related costs. In the worst case, an FCM default resulting from a large

    customer default could cause a DCO to fail if its financial resources

    are inadequate to cover the losses it incurs as a result of the

    default. Gross margining provides the DCO with a larger financial

    cushion that can be tapped in the event of a default. Initial margin is

    the DCO's first ``line of defense'' in managing a default, and a larger

    initial margin held at the DCO will help compensate for the DCO's

    inability to collect additional margin from a defaulting clearing

    member. This rule protects market participants and the public from

    bearing these costs by requiring a DCO to hold additional margin.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are very similar to the

    considerations under the first factor.

    Benefits

    The rule promotes efficiency, competitiveness, and financial

    integrity by providing that the amount of margin at the DCO more

    accurately approximates the risks posed to a DCO by its clearing

    members' customers and by increasing the financial resources available

    to a DCO in the event of a customer default.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    The considerations relating to sound risk management practices are

    very similar to the considerations under the first factor.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on

    [[Page 69422]]

    public interest considerations other than those identified above.

    Risk Limits

    As proposed, Sec. 39.13(h)(1)(i) would require a DCO to impose

    risk limits on each clearing member, by customer origin and house

    origin, in order to prevent a clearing member from carrying positions

    where the risk exposure of those positions exceeds a threshold set by

    the DCO relative to the clearing member's financial resources, the

    DCO's financial resources, or both.

    Several commenters supported the rule as an appropriate risk

    management procedure. Two commenters suggested that the rule is overly

    prescriptive. The Commission did not receive any comments that

    quantified the costs of this rule.

    The Commission is adopting Sec. 39.13(h)(i) as proposed.

    The Commission has evaluated the costs and benefits of the proposed

    regulation in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    Some DCOs already set limits and will not incur any costs. Others

    will incur the costs of calculating limits for each clearing member.

    Such costs will be incremental because all DCOs currently have

    procedures for monitoring clearing member risk and may already have

    informal triggers or alerts in place. For clearing members, the rule

    would impose opportunity costs to the extent the limits constrain their

    activities.

    Under the rule each DCO would have discretion to set limits for

    each clearing member. It would be pure conjecture for the Commission to

    estimate what levels DCOs would set for their clearing members and how

    much that would constrain such clearing members. Each DCO would rely on

    the informed judgment of its risk management committee and/or risk

    management staff to assess the risks and resources of each clearing

    member and arrive at the applicable limits for each one. Estimating the

    extent to which this would constrain clearing members is even more

    speculative. That would entail a guess as to the risk appetite of each

    clearing member. In sum, the Commission believes that possible future

    circumstances surrounding risk limits are too speculative and uncertain

    to be able to quantify or estimate the resulting costs to DCOs,

    clearing members, or the public with any precision or degree of

    magnitude.

    Benefits

    The rule will benefit market participants by reducing the ability

    of clearing members and their customers to assume excessive risks. This

    will diminish the chances of default with all the attendant

    consequences previously discussed.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are very similar to the

    considerations under the first factor.

    Benefits

    Because the rule provides DCOs the discretion to tailor the limits

    for each clearing member in accordance with the DCO's assessment of the

    risk that the clearing member poses, it will foster efficiency and

    competitiveness in the markets. Because it will decrease the chance of

    default it will foster financial integrity.

    The Commission believes that default by a clearing member could

    have a significant, adverse effect on market participants or the

    public. Market participants may have to incur the costs of making up

    any shortfall in margin through guaranty fund deposits and/or

    assessments, and any costs associated with participation in an auction

    or allocation of the positions of a defaulting clearing member. In a

    worst case scenario, a default by a clearing member may undermine the

    financial integrity of the DCO, which could have serious and widespread

    consequences for the stability of U.S. financial markets. This rule

    protects market participants and the public from bearing these costs by

    requiring a DCO to analyze the risk posed by each clearing member and

    impose appropriate limits.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    Costs

    The considerations under this factor are very similar to the

    considerations under the first factor.

    Benefits

    Risk limits are a sound risk management practice currently employed

    by several DCOs. The rule will extend the practice across all DCOs.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on public interest considerations other than those identified

    above.

    Large Trader Reports

    As proposed, Sec. 39.13(h)(2) would require a DCO to obtain from

    its clearing members, copies of all reports that such clearing members

    are required to file with the Commission pursuant to part 17 of the

    Commission's regulations, i.e., large trader reports. Proposed Sec.

    39.13(h)(2) would further require a DCO to review the large trader

    reports that it receives from its clearing members on a daily basis to

    ascertain the risk of the overall portfolio of each large trader.

    One commenter supported the proposal. One commenter argued that the

    proposed requirement that DCOs obtain large trader reports from

    clearing members is duplicative because a DCO receives large trader

    information from the exchange. One commenter stated that a DCO would

    need new technology to implement the rule. One commenter stated that a

    DCO would need additional surveillance staff.

    The Commission is modifying Sec. 39.13(h)(2) to require a DCO to

    obtain large trader reports either from its clearing members or from a

    DCM or a SEF for which it clears.

    The Commission has evaluated the costs and benefits of the proposed

    regulations in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    The Commission notes that some DCOs already receive large trader

    reports from DCMs and review large trader reports for risk surveillance

    purposes on a daily basis. For them, this rule imposes no additional

    cost. For other DCOs, the receipt and analysis of large trader

    information may entail significant, costly, and time-consuming changes

    to systems infrastructure. Clearing members could also incur costs to

    provide large trader reports to DCOs. For example, NYPC stated that its

    preliminary cost estimate for compliance with the customer gross margin

    and large trader report requirements contained in proposed Sec. Sec.

    39.13(g)(8)(i) and 39.13(h)(2) was approximately 128,650 hours and

    $14.5 million.

    In order to reduce costs, the Commission modified Sec. 39.13(h)(2)

    to permit a DCO to obtain large trader reports either from its clearing

    members or from a DCM or a SEF for which it clears. The latter approach

    would

    [[Page 69423]]

    eliminate duplicative reporting for clearing members and would

    significantly reduce costs for DCOs by enabling them to obtain the data

    from a single source.

    Benefits

    Currently, at some DCOs, the receipt and analysis of large trader

    reports is an integral part of their risk management programs.

    Extension of this practice to all DCOs would benefit market

    participants and the public. Proactive analysis of this information

    allows DCOs to identify and to address incipient problems in customer

    accounts before they get out of hand. In particular, large trader

    reports are an essential part of a rigorous risk management system

    because they provide information that is required for stress testing.

    A default by a clearing member could have a significant, adverse

    effect on market participants or the public. Market participants may

    have to incur the costs of making up any shortfall in margin through

    guaranty fund deposits and/or assessments, and any costs associated

    with participation in an auction or allocation of the positions of a

    defaulting clearing member. In a worst case scenario, a default by a

    clearing member may undermine the financial integrity of the DCO, which

    could have serious and widespread consequences for the stability of

    U.S. financial markets. This rule protects market participants and the

    public by requiring a DCO to analyze the potential risks at an earlier

    stage.

    2. Efficiency, Competitiveness, and Financial Integrity

    The considerations under this factor are very similar to the

    considerations under the first factor.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    The considerations under this factor are very similar to the

    considerations under the first factor.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on public interest considerations other than those identified

    above.

    Clearing Member Risk Review

    As proposed, Sec. 39.13(h)(5)(ii) would require each DCO to review

    the risk management policies, procedures, and practices of each of its

    clearing members on a periodic basis.

    Several commenters asserted that the review would be burdensome for

    such clearing members. The Commission did not receive any comments that

    quantified the costs of this rule.

    The Commission is adopting the rule with two modifications. These

    changes clarify that a DCO's review need only cover those procedures of

    a clearing member which address the risks that such clearing member may

    pose to the DCO.

    The Commission has evaluated the costs and benefits of Sec.

    39.13(h)(5)(ii) in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    Those DCOs that currently conduct risk reviews of their clearing

    members are not likely to incur any additional costs as a result of the

    rule.\274\ Those DCOs that do not currently have such a program will

    incur costs to build on existing procedures for reviewing applicants

    for clearing membership in order to develop programs for ongoing review

    of clearing members. Clearing members will incur costs in working with

    the DCOs that review them. Commission staff intends to work with the

    DCOs to develop arrangements designed to avoid duplicative efforts

    without compromising the requirement that each DCO maintain an

    understanding of the risks of each of its clearing members.

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

    \274\ To the extent that some DCOs would conduct risk reviews in

    the absence of a rule, the incremental benefits of the rule are

    reduced. Even for these DCOs, however, a rule provides the market

    with the benefit of greater certainty that risk reviews of members

    will be continued in the future.

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

    In recognition that each DCO has a unique product mix and set of

    rules, the rule does not prescribe the specific frequency, depth, or

    methodology of such reviews, nor does it specify when an on-site audit

    may or may not be appropriate. Nevertheless, based on the Commission's

    experience overseeing DCOs that currently conduct risk reviews of

    clearing members, the Commission estimates the approximate costs of

    this rule as follows.\275\

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

    \275\ Figures used in the estimate are based on the judgment of

    Commission staff with experience overseeing DCO reviews of clearing

    member risk.

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

    The Commission estimates that a risk review by a large DCO

    typically would require on the order of 100 person-hours of work by a

    supervisor and several risk analysts. This includes preparation, an on-

    site visit, and drafting the report. The Commission also estimates that

    a large DCO would perform, on average, 40 risk reviews a year, although

    the number would vary depending on the number of clearing members a

    particular DCO has, and other circumstances. The Commission estimates

    compensation costs on the order of $150 an hour for risk analysts, and

    $250 an hour for a supervisor. Based on these estimates, the Commission

    estimates that the annual cost to a large DCO would be roughly on the

    order of $700,000.\276\ Costs for particular DCOs are likely to vary

    from this amount based on the size of the DCO, the DCO's management and

    compensation practices, and the DCO's exercise of the flexibility

    allowed by the rule provision. In light of the potential consequences

    of risk management failures by clearing members discussed below, and of

    the Commission's judgment that DCOs are the market participants in the

    best position to review clearing member risk management programs, the

    Commission believes that the benefits of this provision would justify

    the costs even if costs proved to be substantially larger than the

    Commission's estimate.

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

    \276\ For example, 20 hours supervisor time per review x $250/hr

    plus 80 hours analyst time per review x $150/hr = $17,000 x 40

    reviews = $680,000.

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

    Benefits

    Rigorous risk management programs at clearing members benefit

    market participants by providing safeguards to prevent default.

    Clearing members are at the front line of risk management. The

    Commission believes that risk reviews are important to ensure that each

    clearing member's risk management framework is sufficient and properly

    implemented. The Commission believes that a clearing member's DCO

    should undertake the review because that DCO is in the best position to

    review the risk management policies, procedures, and practices of its

    clearing members in the context of the clearing members' obligations

    under the DCO's rules.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The considerations under this factor are very similar to the

    considerations under the first factor.

    Benefits

    Ensuring that each clearing member has proper risk management

    procedures for each DCO at which it clears will promote efficiency and

    competitiveness in the clearing process by ensuring that the clearing

    member is in compliance

    [[Page 69424]]

    with each such DCO's rules and encouraging the exercise of best

    practices. The rule will foster financial integrity for the reasons set

    forth under the first factor.

    The Commission believes that default by a clearing member could

    have a significant, adverse effect on market participants and the

    public. Market participants may have to incur the costs of making up

    any shortfall in margin through guaranty fund deposits and/or

    assessments, and any costs associated with participation in an auction

    or allocation of the positions of a defaulting clearing member. In a

    worst case scenario, a default by an FCM may undermine the financial

    integrity of the DCO, which could have serious and widespread

    consequences for the stability of U.S. financial markets. This rule

    protects market participants and the public from bearing these costs by

    requiring a DCO to periodically review the risk management procedures

    of each of its clearing members.

    3. Price Discovery

    The Commission does not believe that this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    The considerations under this factor are similar to the

    considerations under the first factor.

    5. Other Public Interest Considerations

    The Commission does not believe that the rule will have a material

    effect on public interest considerations other than those identified

    above.

    H. Settlement Procedures--Sec. 39.14(c)(3)

    Section 5b(c)(2)(E) of the CEA, Core Principle E, as amended by the

    Dodd-Frank Act, requires a DCO to: (1) complete money settlements on a

    timely basis, but not less frequently than once each business day; (2)

    employ money settlement arrangements to eliminate or strictly limit its

    exposure to settlement bank risks (including credit and liquidity risks

    from the use of banks to effect money settlements); (3) ensure that

    money settlements are final when effected; (4) maintain an accurate

    record of the flow of funds associated with money settlements; (5)

    possess the ability to comply with the terms and conditions of any

    permitted netting or offset arrangement with another clearing

    organization; (6) establish rules that clearly state each obligation of

    the DCO with respect to physical deliveries; and (7) ensure that it

    identifies and manages each risk arising from any of its obligations

    with respect to physical deliveries.

    The Commission proposed Sec. 39.14 to implement Core Principle E.

    With the exception of proposed Sec. 39.14(c), the commenters did not

    address the costs of the proposed rule or the Commission's

    consideration of costs and benefits.

    Proposed Sec. 39.14(c)(3) would require a DCO to ``monitor the

    full range and concentration of its exposures to its own and its

    clearing members' settlement banks and assess its own and its clearing

    members' potential losses and liquidity pressures in the event that the

    settlement bank with the largest share of settlement activity were to

    fail.'' It would further require that a DCO (i) maintain settlement

    accounts at additional settlement banks; (ii) approve additional

    settlement banks for use by its clearing members; (iii) impose

    concentration limits with respect to its own or its clearing members'

    settlement banks; and/or (iv) take any other appropriate actions

    reasonably necessary in order to eliminate or strictly limit such

    exposures.

    As discussed above, several commenters expressed concern that these

    provisions would impose costly requirements that are unnecessary or

    could have unintended adverse consequences. In this regard, one

    commenter claimed that the requirement to monitor clearing members'

    exposure to their settlement banks could result in a duplication of

    effort that would be burdensome for a DCO. Commenters also stated that

    there are a limited number of banks that are qualified and willing to

    serve as settlement banks; as such, it may be difficult for smaller

    DCOs to maintain more than one settlement bank given the associated

    costs. Further, commenters stated that imposing concentration limits

    could increase systemic risk because a DCO would need to distribute

    funds across multiple banks and as settlement funds increased, highly

    rated banks would eventually reach the applicable concentration limit,

    potentially forcing DCOs to open accounts with lower rated banks.

    None of the commenters provided quantitative data or information to

    support their assertions as to the potential costs and burdens of

    compliance with Sec. 39.14(c)(3), and none addressed the benefits of

    the rule.

    As discussed above, the Commission believes that there are risks

    associated with a DCO concentrating all its funds in a single

    settlement bank. Bank failure in such a circumstance could have adverse

    consequences for the DCO, its clearing members, and their customers.

    However, the Commission also acknowledges the concerns expressed by

    commenters, particularly given the settlement practices and procedures

    that DCOs currently maintain in the absence of such a regulation.

    Accordingly, the Commission is modifying Sec. 39.14(c)(3) to

    eliminate any implied requirement that all DCOs must maintain

    settlement accounts at more than one bank, and is retaining the

    requirement that a DCO monitor exposure to its settlement bank(s) and

    those of its clearing members, including an ongoing assessment of the

    effect to the DCO of a failure of the settlement bank that has the

    largest share of settlement activity. It is also clarifying its intent

    to qualify the need to take actions set forth in Sec. 39.14(c)(3)(i)-

    (iv) (such as imposing concentration limits) ``to the extent that any

    such action or actions are reasonably necessary in order to eliminate

    or strictly limit such exposures.'' Thus, the Commission is providing

    DCOs with more flexibility than would have been provided under the

    proposed rule which, in turn, should reduce the costs associated with

    compliance.

    The Commission has evaluated the costs and benefits of Sec.

    39.14(c)(3) in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    A DCO's monitoring of its exposure to its settlement bank(s) and

    those of its clearing members is a sound business practice in which a

    DCO should be engaged notwithstanding the rule. Nevertheless, the

    Commission believes the rule will require commitment of DCO staff

    resources, the costs of which could be passed along to clearing members

    and market participants as part of the DCO's clearing fees. Such costs

    could vary significantly across DCOs given differences in operational

    and risk management procedures, settlement arrangements, and fee

    pricing practices. Given these circumstances, the Commission is unable

    to quantify the costs attributable to the Commission's rule, and no

    commenter provided an estimate. As a general matter, however, the

    Commission is mindful that the measures set forth in Sec.

    39.14(c)(3)(i)-(iv), specifically the requirement that DCOs take

    actions that are ``reasonably necessary in order to eliminate or

    strictly limit'' exposure to settlement banks, could cause DCOs to

    incur costs. Such costs could include, for example, the costs of

    establishing an account at an additional settlement bank, which would

    entail evaluating the bank to ensure that it meets the DCO's

    [[Page 69425]]

    criteria for a settlement bank, reviewing account agreements, and

    establishing connectivity to the bank. There may also be fees charged

    by a bank for standby services if the bank is not used as the primary

    settlement bank, or there may be other account-related fees. The

    Commission is unable to ascertain the specific amount of any such costs

    for DCOs because of the varying nature of settlement bank arrangements

    across DCOs.

    Benefits

    Use of multiple settlement banks by DCOs, as well as imposition of

    concentration limits and other safeguards provided for in Sec.

    39.14(c)(3)(i)-(iv), when reasonably necessary, could help insulate the

    DCO and its members from the risk of default by a settlement bank. This

    in turn could provide market participants and the public with greater

    protection from disruption of markets, as well as the clearing and

    settlement system.

    Affording a DCO flexibility in managing its settlement bank

    arrangements and, to a lesser degree, those of its clearing members,

    benefits market participants and the public by reducing the costs and

    potential inefficiencies associated with maintaining settlement

    arrangements with multiple settlement banks when that might not yield a

    concomitant benefit in the form of risk reduction. The rule sets forth

    general standards while permitting each DCO to tailor its settlement

    bank arrangements to its unique circumstances and risk tolerances.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    Quantification or estimation of costs to efficiency,

    competitiveness, and financial integrity of markets are not readily

    ascertainable, and no commenter provided an estimate.

    Benefits

    The rule permits DCOs to obtain settlement services from a single

    bank if the size and needs of the DCO, as well as the availability of

    suitable settlement bank services, makes the use of more than one

    settlement bank cost-prohibitive and it is not reasonably necessary to

    have more than one settlement bank in order to eliminate or strictly

    limit the DCO's exposures. More efficient use of DCO resources can

    result in enhanced efficiency and financial integrity of the markets

    for which the DCO clears. Particularly for smaller DCOs, it may not be

    practical to obtain settlement services from more than one settlement

    bank because of the costs of evaluating a bank's suitability to perform

    settlement functions, reviewing account agreements, and establishing

    connectivity to the bank. There also may be account-related fees

    charged by a bank, including fees for standby services, if the bank is

    used as a back-up settlement bank and not the primary settlement bank.

    3. Price Discovery

    The Commission has not identified any ways in which Sec.

    39.14(c)(3) could affect price discovery.

    4. Sound Risk Management Practices

    Costs

    The Commission has not identified any ways in which Sec.

    39.14(c)(3) could impair sound risk management practices.

    Benefits

    The Commission regards an effective settlement framework as a sound

    risk management practice because it reduces the risks associated with a

    bank's potential failure to make timely settlement. The requirements

    that a DCO monitor risk exposures to settlement banks and address

    diversification concerns, as reasonably necessary, are important

    adjuncts to a DCO's overall risk management practices.

    5. Other Public Interest Considerations.

    The Commission has not identified any other costs or benefits that

    should be taken into account.

    I. Treatment of Funds--Sec. 39.15

    Core Principle F, as amended by the Dodd-Frank Act, requires a DCO

    to: (i) Establish standards and procedures that are designed to protect

    and ensure the safety of its clearing members' funds and assets; (ii)

    hold such funds and assets in a manner by which to minimize the risk of

    loss or of delay in the DCO's access to the assets and funds; and (iii)

    only invest such funds and assets in instruments with minimal credit,

    market, and liquidity risks.\277\

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

    \277\ Section 5b(c)(2)(F) of the CEA; 7 U.S.C. 7a-1(c)(2)(F)

    (Core Principle F).

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

    Proposed Sec. 39.15 would establish minimum standards for DCO

    compliance with Core Principle F. Among other things, it would set

    forth standards for the types of assets that could be accepted as

    initial margin. In this regard, proposed Sec. 39.15(c)(1) would

    require a DCO to limit the assets it accepts as initial margin to those

    that have minimal credit, market, and liquidity risk. It would further

    specify that a DCO may not accept letters of credit as initial margin.

    The Commission received comments on substantive aspects of the

    proposed rules, and it has addressed those comments above. The

    Commission also received several comments on potential costs associated

    with the proposed Sec. 39.15(c)(1) prohibition on the acceptance of

    letters of credit as initial margin.\278\ CME asserted that the

    prohibition is unnecessary because letters of credit provide an

    absolute assurance of payment and, therefore, the issuing bank must

    honor the demand even in circumstances where the beneficiary is unable

    to reimburse the bank for its payment. Other commenters suggested that

    letters of credit should be acceptable if they are subject to

    appropriate conditions. Finally, several commenters warned of the

    potential risks associated with prohibiting letters of credit,

    including higher costs for clearing members and their customers, the

    potential placement of U.S. DCOs at a disadvantage as compared to

    foreign clearing houses, and increased systemic risk as a result of

    decreased voluntary clearing.

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

    \278\ The Commission notes that proposed 39.15(c)(1) regarding

    types of assets that can be accepted as initial margin has been

    redesignated as Sec. 39.13(g)(10) under the risk management rules.

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

    Taking into account both the strong track record of letters of

    credit in connection with cleared futures and options on futures and

    the potentially greater risks of cleared swaps, the Commission has

    determined to modify the rule to permit letters of credit in connection

    with cleared futures and options on futures but to retain the

    prohibition on letters of credit as initial margin for swaps. Certain

    DCOs have accepted letters of credit as initial margin for futures and

    options on futures for a number of years without incident and continue

    to do so. On the other hand, letters of credit are only a promise by a

    bank to pay, not an asset that can be sold. The Commission is concerned

    that the potential losses that swap market participants could incur may

    be of a greater magnitude than potential losses with respect to futures

    and options. Initial margin is the first financial resource that a DCO

    will apply in the event of a clearing member default. If a DCO were to

    need to draw on a letter of credit posted by a clearing member whose

    customers had suffered such losses, the larger the amount that it would

    need to draw, the greater the risk that the issuing bank may be unable

    to pay under the terms of the letter of credit. Accordingly, the

    Commission is modifying the proposal as described.

    [[Page 69426]]

    The Commission has evaluated the costs and benefits of Sec.

    39.13(g)(10) in light of the specific considerations identified in

    Section 15(a) of the CEA, as follows:

    1. Protection of Market Participants and the Public

    Costs

    The prohibition on accepting letters of credit as initial margin

    for swaps may impose higher costs for clearing members because they

    will have to deposit cash or other assets that have minimal credit,

    market, and liquidity risk for those products. This could increase

    costs for market participants and decrease capital efficiency. It may

    also place U.S. DCOs at a disadvantage to those foreign clearing houses

    that permit letters of credit to be used as initial margin for swaps.

    The Commission notes, however, that in response to the comments it has

    modified the rule to permit letters of credit for futures. Therefore,

    futures market participants will not incur any costs as a result of

    this provision.

    It is not possible to estimate or quantify these costs for a number

    of reasons. The Dodd-Frank Act and implementing regulations will

    significantly affect the manner in which swaps are developed, traded,

    executed, and cleared. Existing DCOs and FCMs will be clearing new

    products. New DCOs and FCMs will enter the market. Mandatory clearing

    will bring new products and participants to DCOs and FCMs. The

    interaction of all these factors creates a wide range of uncertainty as

    to which products will be cleared, what their margin requirements will

    be, and the extent to which clearing members would post letters of

    credit as margin if permitted. Under these circumstances, the potential

    opportunity costs that may arise from the deposit of cash or other

    assets rather than letters of credit depends on a variety of future

    circumstances and actions of market participants that cannot be known

    or predicted at the present time. In sum, the Commission believes that

    the possible future circumstances involving the posting of letters of

    credit as margin is too speculative and uncertain to be able to

    quantify or estimate the resulting costs to clearing members with any

    precision or degree of magnitude.

    Benefits

    One of the primary functions of a DCO is to guarantee financial

    performance, which includes performing daily variation settlement.

    Daily pays are made in cash, and to the extent a DCO relies on margin

    deposits to meet its end-of-day obligations, it must have access to

    sufficient cash or highly liquid assets. Similarly, initial margin may

    be tapped by a DCO in the event of a clearing member default. By

    limiting the use of letters of credit, the DCO will avoid the

    possibility that a letter of credit would be dishonored when presented

    to the issuing bank.

    Thus, requiring initial margin in the form of assets that can be

    immediately sold provides greater financial protection to the DCO,

    clearing members, and market participants.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    As noted above, there could be competitive disadvantages to DCOs if

    foreign competitors do not impose similar restrictions on initial

    margin deposits. In addition, the prospect of increased costs may

    reduce voluntary clearing of swaps, which would be inconsistent with

    the goals of the Dodd-Frank Act and could potentially lead to systemic

    risk.

    Benefits

    A DCO can be more efficient in facilitating payments if it has

    readily available liquid assets as opposed to a conditional obligation

    that must be presented for payment. Holding actual assets provides

    greater assurance of financial integrity to the clearing process, as

    the DCO will not have to bear the costs of possible default on the part

    of the issuing bank. Even an irrevocable letter of credit can be

    dishonored, with the DCO's only recourse being a lawsuit.

    3. Price Discovery

    The Commission does not believe this rule will have a material

    effect on price discovery.

    4. Sound Risk Management Practices

    Costs

    The Commission does not believe this rule will have a material

    adverse impact on sound risk management practices.

    Benefits

    The Commission expects that prohibiting the use of letters of

    credit as initial margin for swaps could serve to strengthen a DCO's

    risk management program. It eliminates the risk of funds not being

    available if a letter of credit were to be dishonored, which could have

    a significant impact because initial margin is the first financial

    resource to be tapped in the event of a clearing member default.

    5. Other Public Considerations

    The Commission does not believe this rule will have a material

    impact on public interest considerations other than those discussed

    above.

    J. Reporting--Sec. 39.19

    Core Principle J,\279\ as amended by the Dodd-Frank Act, requires a

    DCO to provide the Commission with all information that the Commission

    determines to be necessary to conduct oversight of the DCO.

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

    \279\ Section 5b(c)(2)(J) of the CEA, 7 U.S.C. 7a-1(c)(2)(J).

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

    The Commission proposed Sec. 39.19 to establish minimum

    requirements that a DCO would have to meet in order to comply with Core

    Principle J. Under proposed Sec. 39.19, certain reports would have to

    be made by a DCO to the Commission (1) On a periodic basis (daily,

    quarterly, or annually); (2) where the reporting requirement is

    triggered by the occurrence of a significant event; and (3) upon

    request by the Commission.

    The rules would require DCOs to provide information that the

    Commission has determined is necessary to conduct oversight of DCOs.

    The proposed reporting regime would assist the Commission in monitoring

    the financial strength and operational capabilities of a DCO and in

    evaluating whether a DCO's risk management practices are effective. The

    required reports also would assist the Commission in taking prompt

    action as necessary to identify incipient problems and address them at

    an early stage. A self-reporting program of this type enhances the

    Commission's ability to conduct oversight given its limited resources

    which do not permit routine on-site surveillance of DCOs.

    The proposed rules would require submission of information

    electronically and in a form and manner prescribed by the Commission.

    These general procedural standards would provide flexibility to the

    Commission in establishing and updating uniform format and delivery

    protocols that would assist the Commission in conducting timely review

    of submissions. In this regard, the transmission of information using a

    uniform format would enable Commission staff to sort and interpret data

    without the need to convert the data into a format that provides the

    necessary functionality, e.g., it would be designed to provide the

    Commission with the ability to compare data across DCOs when necessary.

    A number of commenters discussed costs associated with proposed

    Sec. 39.19

    [[Page 69427]]

    in the form of comments on the substantive provisions of the proposed

    rule. For example, a number of commenters discussed whether alternative

    reporting requirements might better inform the Commission of potential

    risks. Some commenters questioned the need for certain information and

    some commenters questioned the feasibility of the reporting

    requirements. The Commission has addressed those comments above.

    The Commission also received comments that directly addressed two

    areas of the Commission's cost-benefit analysis of proposed Sec.

    39.19: (1) The cost of preparing and submitting daily and annual

    audited financial reports; and (2) the cost of reporting a 10 percent

    decrease in financial resources. Those comments are discussed in detail

    below.

    a. Cost of Preparing and Submitting Daily and Annual Reports

    Proposed Sec. 39.19(c) would require a DCO to submit various

    periodic reports for the purposes of risk surveillance and oversight of

    the DCO's compliance with the core principles and Commission

    regulations. In the notice of proposed rulemaking, the Commission

    observed that the information that would be reported was information

    readily available to a DCO and which, in certain instances, was already

    being reported to the Commission. The Commission requested data or

    other information that could quantify or qualify costs.

    Only NYPC provided an estimate of the fixed cost of implementing an

    automated system for daily reporting. In a comment letter submitted by

    NYPC, the cost was estimated at $582,000.

    In a follow-up phone conversation with representatives of NYPC,

    Commission staff discussed the basis for NYPC's estimate that

    implementing an automated system for daily reporting would cost

    $582,000. Staff was told that NYPC already provides certain daily

    reports to the Commission, but that the additional data that it would

    have to report under the proposal (not including the proposed gross

    margin data or large trader data) would necessitate implementing an

    automated system. NYPC representatives confirmed that the estimate was

    for a one-time cost, not the cost of generating and transmitting the

    actual daily reports. NYPC also confirmed that the cost of generating

    and transmitting the actual daily reports would be minimal.

    The Commission was able to estimate the costs of providing reports

    and presented this information in the Paperwork Reduction Act

    discussion. It estimated that daily reporting could require a DCO to

    expend up to $8,280 per year, and an annual report could require a DCO

    to expend up to $482,110 per year.

    KCC and MGEX commented that the variable cost for daily reporting

    could be significantly more than the Commission's estimates if the

    Commission were to require a costly format and method of delivery. MGEX

    also commented that the Commission may have underestimated the cost of

    providing the annual report (audited financial report under Sec.

    39.19(c)(3)(ii)), and that the Commission's estimate is ``extremely

    excessive, particularly when most of [the annual reporting requirements

    do] not appear to be required by the Dodd-Frank Act.'' Finally, MGEX

    believes that the proposed rules will not guarantee increased market

    participation or improve legitimate risk management and hedging

    activity, and the additional costs will create barriers to entry and

    decrease DCO competition.

    Although KCC and MGEX commented that the costs of preparing the

    reports may be greater than the Commission's estimates, neither DCO

    provided an alternative estimate. Nor did they suggest alternative

    reporting requirements that would achieve the purposes of the CEA with

    a more favorable cost-benefit ratio. As to the estimated costs of the

    required format and method of delivery, the Commission notes that it

    based its estimate on the cost of using the SHAMIS system. The

    Commission has no basis for concluding that the cost of using an

    alternative system would be less substantial and it received no

    comments on this.

    The Commission believes that the costs that DCOs will incur to

    implement a system to provide such information to the Commission are

    necessary and justified. As explained above, the Commission has

    determined that the information required in the reports is necessary

    for the Commission to conduct adequate oversight of DCOs, particularly

    given its limited ability to conduct on-site reviews.

    b. Reporting a 10 Percent Decrease in Financial Resources

    Under proposed Sec. 39.19(c)(4)(i), a DCO would be required to

    report a decrease of 10 percent in the total value of its financial

    resources either from (1) the value reported in the DCO's last

    quarterly report or (2) from the value as of the close of the previous

    business day. This would allow the Commission to more quickly identify

    and address financial problems at the DCO. As discussed above, the

    Commission raised the reporting threshold from 10 percent to 25 percent

    in response to comments that a higher percentage might yield more

    meaningful results. In addition, the higher threshold is likely to

    reduce the number of reports that might be submitted under this

    requirement.

    NYPC commented that compliance with the proposed reporting

    requirement would necessitate an expenditure of approximately 15,000

    hours and $1.7 million. NYPC explained that this estimate reflects

    implementing a system that would track default resources and working

    capital, combined. After talking with Commission staff, NYPC submitted

    a comment letter that provided a preliminary estimate of approximately

    4,600 hours and $566,000 for designing, building, and testing a

    reporting system for a decline in default resources only.

    Based on NYPC's initial comment letter, the Commission believes

    that the material costs associated with Sec. 39.19(c)(4)(i) are the

    initial investments made by a DCO to develop and implement a system

    (automated or not) to alert the DCO that the valuation threshold has

    been met. As discussed above, it is important for the Commission to be

    apprised of a 25% reduction in default resources because it could

    indicate that the DCO's financial resources are strained and corrective

    action may be needed.

    The Commission has evaluated the costs and benefits of Sec. 39.19

    in light of the specific considerations identified in Section 15(a) of

    the CEA as follows:

    1. Protection of Market Participants and the Public

    Costs

    Section 39.19 requires DCOs to provide information that the

    Commission has determined is necessary for oversight of DCOs and to

    provide that information in a time frame, format, and delivery method

    that will enable effective use of the information. To the extent that

    DCOs do not already have an infrastructure for preparing and

    transmitting reports, they will incur one-time costs to put such a

    framework in place.

    Benefits

    The comprehensive regulatory reporting program will enhance

    protection of market participants and the public by promoting more in-

    depth and effective oversight by the Commission. The reports will

    assist the Commission's Risk Surveillance staff in monitoring clearing

    house risk and evaluating DCOs' management and mitigation of that risk.

    In addition, the

    [[Page 69428]]

    information will assist the Commission to identify incipient problems

    and address them at an early stage.

    2. Efficiency, Competitiveness, and Financial Integrity

    Costs

    The Commission does not believe that the reporting requirements

    will adversely impact efficiency, competitiveness, or the financial

    integrity of derivatives markets.

    Benefits

    The reporting requirements will protect the financial integrity of

    derivatives markets because they will support effective and timely

    oversight of DCOs. This will help to minimize the risk of default and

    the impact default would have on the markets.

    3. Price Discovery

    The Commission does not believe that Sec. 39.19 will have a

    material impact on price discovery.

    4. Sound Risk Management Practices

    Costs

    The Commission does not believe that the reporting requirements

    will adversely impact sound risk management practices.

    Benefits

    The reporting requirements are expected to enhance sound risk

    management practices because the Commission will be able to more

    effectively evaluate a DCO's risk management practices on an on-going

    basis. The Commission staff can build a knowledge base that will

    support prompt action if there are adverse changes in trends or

    financial profiles.

    5. Other Public Interest Considerations

    The Commission does not believe this rule will have a material

    impact on public interest considerations other than those discussed

    above. Effective oversight of DCOs will enhance the safety and

    efficiency of DCOs and reduce systemic risk. Safe and reliable DCOs are

    essential not only for the stability of the derivatives markets they

    serve but also the public which relies on the prices formed in these

    markets for all manner of commerce.

    IX. Related Matters

    A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (``RFA'') requires that agencies

    consider whether the rules they propose will have a significant

    economic impact on a substantial number of small entities and, if so,

    provide a regulatory flexibility analysis respecting the impact.\280\

    The rules adopted herein will affect only DCOs). The Commission has

    previously established certain definitions of ``small entities'' to be

    used by the Commission in evaluating the impact of its regulations on

    small entities in accordance with the RFA.\281\ The Commission has

    previously determined that DCOs are not small entities for the purpose

    of the RFA.\282\ Accordingly, the Chairman, on behalf of the

    Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that these

    rules will not have a significant economic impact on a substantial

    number of small entities. The Chairman made the same certification in

    the proposed rulemakings, and the Commission did not receive any

    comments on the RFA in relation to any of those rulemakings.

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

    \280\ 5 U.S.C. 601 et seq.

    \281\ 47 FR 18618 (Apr. 30, 1982).

    \282\ See 66 FR 45604, at 45609 (Aug. 29, 2001) (New Regulatory

    Framework for Clearing Organizations).

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

    B. Paperwork Reduction Act

    The Commission may not conduct or sponsor, and a registered entity

    is not required to respond to, a collection of information unless it

    displays a currently valid Office of Management and Budget (OMB)

    control number. The Commission's adoption of Sec. Sec. 39.3 (DCO

    registration application requirements), 39.10 (annual compliance report

    and recordkeeping), 39.11 (financial resources quarterly report), 39.14

    (settlement recordkeeping), 39.18 (system safeguards reporting and

    recordkeeping), 39.19 (periodic and event-specific reporting), and

    39.20 (general recordkeeping), imposes new information collection

    requirements on registered entities within the meaning of the Paperwork

    Reduction Act.\283\

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

    \283\ 44 U.S.C. 3501 et seq.

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

    Accordingly, the Commission requested and OMB assigned control

    numbers for the required collections of information. The Commission has

    submitted this notice of final rulemaking along with supporting

    documentation for OMB's review in accordance with 44 U.S.C. 3507(d) and

    5 CFR 1320.11. The titles for these collections of information are

    ``Financial Resources Requirements for Derivatives Clearing

    Organizations, OMB control number 3038-0066,'' ``Information Management

    Requirements for Derivatives Clearing Organizations, OMB control number

    3038-0069,'' ``General Regulations and Derivatives Clearing

    Organizations, OMB control number 3038-0081,'' and ``Risk Management

    Requirements for Derivatives Clearing Organizations, OMB control number

    3038-0076.'' Many of the responses to this new collection of

    information are mandatory.

    The Commission protects proprietary information according to the

    Freedom of Information Act and 17 CFR part 145, ``Commission Records

    and Information.'' In addition, Section 8(a)(1) of the CEA strictly

    prohibits the Commission, unless specifically authorized by the Act,

    from making public ``data and information that would separately

    disclose the business transactions or market positions of any person

    and trade secrets or names of customers.'' The Commission also is

    required to protect certain information contained in a government

    system of records according to the Privacy Act of 1974, 5 U.S.C. 552a.

    The regulations require each respondent to file certain information

    with the Commission and to maintain certain records.\284\ The

    Commission received comments from NYPC and MGEX regarding the estimated

    costs of preparing and submitting daily reports. It also received

    comments from MGEX regarding costs associated with annual reports and

    the proposed rules in general.

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

    \284\ See 75 FR at 63119 (Oct. 14, 2010) (Financial Resources)

    (requirement to file quarterly reports); see also discussion of the

    financial resources reporting requirements in section IV.B.10,

    above.

    See 75 FR at 77583-77584 (Dec. 13, 2010) (General Regulations)

    (proposed requirements: (i) For the CCO to submit an annual report

    to the Commission; (ii) to retain a copy of the policies and

    procedures adopted in furtherance of compliance with the CEA; (iii)

    to retain copies of materials, including written reports provided to

    the board of directors in connection with the board's review of the

    annual report; and (iv) to retain any records relevant to the annual

    report, including, but not limited to, work papers and other

    documents that form the basis of the report, and memoranda,

    correspondence, other documents, and records that are (a) created,

    sent or received in connection with the annual report and (b)

    contain conclusions, opinions, analyses, or financial data related

    to the annual report); see also discussion of Sec. 39.10 in section

    IV.A, above.

    See 75 FR at 78193 (Dec. 15, 2010) (Information Management)

    (proposed requirements to file specified information with the

    Commission (i) periodically, on a daily, quarterly, and annual

    basis; (ii) as specified events occur; and (iii) upon Commission

    request); see also discussion of reporting requirements in section

    IV.J, above.

    See 75 FR at 78196 (Dec. 15, 2010) (Information Management)

    (proposed requirement to maintain records of all activities related

    to its business as a DCO, including all information required to be

    created, generated, or reported under part 39, including but not

    limited to the results of and methodology used for all tests,

    reviews, and calculations); see also discussion of recordkeeping

    requirements in section IV.K, above.

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

    NYPC and MGEX commented that the costs associated with the rules in

    the Information Management proposed rulemaking would be higher than the

    [[Page 69429]]

    Commission estimated.\285\ With respect to daily reporting, NYPC

    commented that designing, building, and testing the application

    necessary to automate the process of producing daily reports would

    require approximately 5,200 hours and cost $582,000.\286\ MGEX

    commented that the cost to a DCO could be significantly more than the

    estimated cost if the Commission were to require a costly format and

    method of delivery.

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

    \285\ See 75 FR at 78193 (Dec. 15, 2010) (Information

    Management). In the Paperwork Reduction Act discussion, the

    Commission estimated that daily reporting would result in an

    aggregated cost of $8,280 initially (12 respondents x $690) and

    $16,800 per annum (12 respondents x $1,400). Annual reporting would

    result in an aggregated cost of $5,785,320 per annum (12 respondents

    x $482,110).

    \286\ In a follow-up phone conversation with representatives of

    NYPC, Commission staff discussed the basis for NYPC's estimate that

    implementing an automated system for daily reporting would cost

    $582,000. Commission staff was told that NYPC already provides

    certain daily reports to the Commission's Risk Surveillance Group,

    but that the additional data that it would have to report under the

    Information Management NPRM (not including the gross margin data or

    large trader data) would necessitate implementing an automated

    system. NYPC representatives confirmed that the estimate was for a

    one-time cost, not the cost of generating and transmitting the

    actual daily reports. NYPC also confirmed that the cost of

    generating and transmitting the actual daily reports would be

    minimal.

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

    With respect to annual reporting, MGEX commented that the

    Commission may have underestimated the associated costs because the

    Commission did not address the costs of building reporting methods,

    forms, programs, or the allocation of labor resources. In addition,

    MGEX believes that the estimated costs associated with the annual

    report are ``extremely excessive, particularly when most of [the annual

    report requirements do] not appear to be required by the Dodd-Frank

    Act.'' MGEX further commented that the proposed rules will not

    guarantee increased market participation or improve legitimate risk

    management and hedging activity, and the additional costs would create

    barriers to entry and decreased DCO competition.

    Finally, with respect to the estimated costs identified in the Risk

    Management notice of proposed rulemaking,\287\ MGEX noted that the

    Commission had estimated the total hours for the proposed collection of

    information to be 50 hours per year per respondent for the additional

    reporting requirements at an annual cost of $500 per respondent (50

    hours x $10). MGEX stated its belief that these estimates, both in

    hours and cost, are extremely low, and that it did not appear that the

    Commission had accounted for the costs to implement a system; collect,

    forward and format data; monitor and enforce compliance; and document

    compliance with the proposed rulemaking. MGEX noted that the costs are

    not limited to reporting to the Commission for many of the proposed

    rules, and that reporting may be the least expensive facet. MGEX

    specifically identified reporting the gross position of each beneficial

    owner as a requirement for which the Commission did not provide any

    cost estimates.

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

    \287\ See 76 FR at 3716-3717 (Jan. 20, 2011) (Risk Management).

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

    Although MGEX commented that the costs of the proposed requirements

    may be greater than the costs the Commission set forth in the

    Information Management and Risk Management proposed rulemakings, and

    that the Commission did not estimate the costs of building reporting

    methods, forms, programs, or the allocation of labor resources, MGEX

    did not provide an estimate of these costs. Nor did MGEX suggest

    alternative reporting requirements that would achieve the purposes of

    the CEA with a more favorable cost-benefit ratio.

    As to the estimated costs of the required format and method of

    delivery, the Commission notes that the estimates of these costs were

    based on the cost of using the SHAMIS system. There was no basis for

    concluding that the cost of using an alternative system would be more

    substantial and the Commission received no comment to that effect.

    Moreover, Core Principle J requires a DCO to provide reports to the

    Commission, and all DCOs will have to bear these costs in order to

    comply with Core Principle J. Core Principle J requires each DCO ``to

    provide to the Commission all information that the Commission

    determines to be necessary to conduct oversight of the [DCO].'' As

    discussed above and in the Information Management proposed rulemaking,

    the Commission believes that the daily and annual reporting

    requirements provide the Commission with information that is important

    to its oversight of a DCO to ensure the DCO is in compliance with the

    core principles. This can lead to increased market participation and

    improve legitimate risk management and hedging activity. Accordingly,

    the Commission believes the collection of information related to the

    reporting rules is necessary to achieve the purposes of the CEA,

    particularly in light of the Dodd-Frank Act clearing mandate for

    swaps.\288\

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

    \288\ See further discussion of the costs and benefits

    associated with the reporting requirements in section VII.J, above.

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

    The Commission has considered the comments of NYPC and MGEX but is

    declining to revise the estimated costs. The Commission believes that

    its original estimates remain appropriate for PRA purposes.

    List of Subjects

    17 CFR Part 1

    Brokers, Commodity futures, Consumer protection, Definitions,

    Swaps.

    17 CFR Part 21

    Brokers, Commodity futures, Reporting and recordkeeping

    requirements.

    17 CFR Part 39

    Definitions, Commodity futures, Reporting and recordkeeping

    requirements, Swaps, Business and industry, Participant and product

    eligibility, Risk management, Settlement procedures, Treatment of

    funds, Default rules and procedures, System safeguards, Enforcement

    authority, Application form.

    17 CFR Part 140

    Authority delegations (Government agencies), Conflict of interests,

    Organization and functions (Government agencies).

    For the reasons stated in the preamble, amend 17 CFR parts 1, 21,

    39, and 140 as follows:

    PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

    0

    1. The authority citation for part 1 is revised to read as follows:

    Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h,

    6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a,

    13a-1, 16, 16a, 19, 21, 23, and 24, as amended by Pub. L. 111-203,

    124 Stat. 1376.

    0

    2. Amend Sec. 1.3 to revise paragraphs (c) and (d), remove and reserve

    paragraph (k), and add paragraphs (aaa), (bbb), (ccc), (ddd), (eee),

    and (fff) to read as follows:

    Sec. 1.3 Definitions.

    * * * * *

    (c) Clearing member. This term means any person that has clearing

    privileges such that it can process, clear and settle trades through a

    derivatives clearing organization on behalf of itself or others. The

    derivatives clearing organization need not be organized as a membership

    organization.

    (d) Clearing organization or derivatives clearing organization.

    This term means a clearinghouse, clearing association, clearing

    corporation, or similar entity, facility, system, or

    [[Page 69430]]

    organization that, with respect to an agreement, contract, or

    transaction--

    (1) Enables each party to the agreement, contract, or transaction

    to substitute, through novation or otherwise, the credit of the

    derivatives clearing organization for the credit of the parties;

    (2) Arranges or provides, on a multilateral basis, for the

    settlement or netting of obligations resulting from such agreements,

    contracts, or transactions executed by participants in the derivatives

    clearing organization; or

    (3) Otherwise provides clearing services or arrangements that

    mutualize or transfer among participants in the derivatives clearing

    organization the credit risk arising from such agreements, contracts,

    or transactions executed by the participants.

    (4) Exclusions. The terms clearing organization and derivatives

    clearing organization do not include an entity, facility, system, or

    organization solely because it arranges or provides for--

    (i) Settlement, netting, or novation of obligations resulting from

    agreements, contracts or transactions, on a bilateral basis and without

    a central counterparty;

    (ii) Settlement or netting of cash payments through an interbank

    payment system; or

    (iii) Settlement, netting, or novation of obligations resulting

    from a sale of a commodity in a transaction in the spot market for the

    commodity.

    * * * * *

    (k) [Reserved]

    * * * * *

    (aaa) Clearing initial margin. This term means initial margin

    posted by a clearing member with a derivatives clearing organization.

    (bbb) Customer initial margin. This term means initial margin

    posted by a customer with a futures commission merchant, or by a non-

    clearing member futures commission merchant with a clearing member.

    (ccc) Initial margin. This term means money, securities, or

    property posted by a party to a futures, option, or swap as performance

    bond to cover potential future exposures arising from changes in the

    market value of the position.

    (ddd) Margin call. This term means a request from a futures

    commission merchant to a customer to post customer initial margin; or a

    request by a derivatives clearing organization to a clearing member to

    post clearing initial margin or variation margin.

    (eee) Spread margin. This term means reduced initial margin that

    takes into account correlations between certain related positions held

    in a single account.

    (fff) Variation margin. This term means a payment made by a party

    to a futures, option, or swap to cover the current exposure arising

    from changes in the market value of the position since the trade was

    executed or the previous time the position was marked to market.

    0

    3. Amend Sec. 1.12 to remove and reserve paragraph (f)(1).

    PART 21--SPECIAL CALLS

    0

    4. The authority citation for part 21 is revised to read as follows:

    Authority: 7 U.S.C. 1a, 2, 2a, 4, 6a, 6c, 6f, 6g, 6i, 6k, 6m,

    6n, 7, 7a, 12a, 19 and 21, as amended by Pub. L. 111-203, 124 Stat.

    1376; 5 U.S.C. 552 and 552(b), unless otherwise noted.

    0

    5. Redesignate Sec. 21.04 as Sec. 21.05.

    0

    6. Add a new Sec. 21.04 to read as follows:

    Sec. 21.04 Special calls for information on customer accounts or

    related cleared positions.

    Upon special call by the Commission, each futures commission

    merchant, clearing member or foreign broker shall provide information

    to the Commission concerning customer accounts or related positions

    cleared on a derivatives clearing organization in the format and manner

    and within the time provided by the Commission in the special call.

    0

    7. Add Sec. 21.06 to read as follows:

    Sec. 21.06 Delegation of authority to the Director of the Division of

    Clearing and Risk.

    The Commission hereby delegates, until the Commission orders

    otherwise, the special call authority set forth in Sec. 21.04 to the

    Director of the Division of Clearing and Risk to be exercised by such

    Director or by such other employee or employees of such Director as

    designated from time to time by the Director. 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 shall be deemed to prohibit the Commission, at

    its election, from exercising the authority delegated in this section

    to the Director.

    PART 39--DERIVATIVES CLEARING ORGANIZATIONS

    0

    8. Revise part 39 to read as follows:

    Subpart A--General Provisions Applicable to Derivatives Clearing

    Organizations

    Sec.

    39.1 Scope.

    39.2 Definitions.

    39.3 Procedures for registration.

    39.4 Procedures for implementing derivatives clearing organization

    rules and clearing new products.

    39.5 Submission of swaps for Commission determination regarding

    clearing requirements.

    39.6 [Reserved]

    39.7 Enforceability.

    39.8 Fraud in connection with the clearing of transactions on a

    derivatives clearing organization.

    Subpart B--Compliance With Core Principles

    39.9 Scope.

    39.10 Compliance with core principles.

    39.11 Financial resources.

    39.12 Participant and product eligibility.

    39.13 Risk management.

    39.14 Settlement procedures.

    39.15 Treatment of funds.

    39.16 Default rules and procedures.

    39.17 Rule enforcement.

    39.18 System safeguards.

    39.19 Reporting.

    39.20 Recordkeeping.

    39.21 Public information.

    39.22 Information sharing.

    39.23 Antitrust considerations.

    39.24 [Reserved]

    39.25 [Reserved]

    39.26 [Reserved]

    39.27 Legal risk considerations.

    Appendix A to Part 39--Form DCO Derivatives Clearing Organization

    Application for Registrations

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

    Stat. 1376.

    Subpart A--General Provisions Applicable to Derivatives Clearing

    Organizations

    Sec. 39.1 Scope.

    The provisions of this subpart A apply to any derivatives clearing

    organization as defined under section 1a(15) of the Act and Sec.

    1.3(d) of this chapter which is registered or deemed to be registered

    with the Commission as a derivatives clearing organization, is required

    to register as such with the Commission pursuant to section 5b(a) of

    the Act, or which voluntarily applies to register as such with the

    Commission pursuant to section 5b(b) or otherwise.

    Sec. 39.2 Definitions.

    For the purposes of this part,

    Back test means a test that compares a derivatives clearing

    organization's initial margin requirements with historical price

    changes to determine the extent of actual margin coverage.

    Customer means a person trading in any commodity named in the

    definition of commodity in section 1a(9) of the Act or in Sec. 1.3 of

    this chapter, or in any swap as defined in section 1a(47) of the Act or

    in Sec. 1.3 of this chapter; Provided, however, an owner or holder of

    a house

    [[Page 69431]]

    account as defined in this section shall not be deemed to be a customer

    within the meaning of section 4d of the Act, the regulations that

    implement sections 4d and 4f of the Act and Sec. 1.35, and such an

    owner or holder of such a house account shall otherwise be deemed to be

    a customer within the meaning of the Act and Sec. Sec. 1.37 and 1.46

    of this chapter and all other sections of these rules, regulations, and

    orders which do not implement sections 4d and 4f of the Act.

    Customer account or customer origin means a clearing member account

    held on behalf of customers, as that term is defined in this section,

    and which is subject to section 4d(a) or section 4d(f) of the Act.

    House account or house origin means a clearing member account which

    is not subject to section 4d(a) or 4d(f) of the Act.

    Key personnel means derivatives clearing organization personnel who

    play a significant role in the operations of the derivatives clearing

    organization, the provision of clearing and settlement services, risk

    management, or oversight of compliance with the Act and Commission

    regulations and orders. Key personnel include, but are not limited to,

    those persons who are or perform the functions of any of the following:

    chief executive officer; president; chief compliance officer; chief

    operating officer; chief risk officer; chief financial officer; chief

    technology officer; and emergency contacts or persons who are

    responsible for business continuity or disaster recovery planning or

    program execution.

    Stress test means a test that compares the impact of potential

    extreme price moves, changes in option volatility, and/or changes in

    other inputs that affect the value of a position, to the financial

    resources of a derivatives clearing organization, clearing member, or

    large trader, to determine the adequacy of such financial resources.

    Systemically important derivatives clearing organization means a

    financial market utility that is a derivatives clearing organization

    registered under section 5b of the Act, which has been designated by

    the Financial Stability Oversight Council to be systemically important

    and for which the Commission acts as the Supervisory Agency pursuant to

    section 803(8) of the Dodd-Frank Wall Street Reform and Consumer

    Protection Act.

    Sec. 39.3 Procedures for registration.

    (a) Application procedures. (1) An organization desiring to be

    registered as a derivatives clearing organization shall file

    electronically an application for registration with the Secretary of

    the Commission in the format and manner specified by the Commission.

    The Commission will review the application for registration as a

    derivatives clearing organization pursuant to the 180-day timeframe and

    procedures specified in section 6(a) of the Act. The Commission may

    approve or deny the application or, if deemed appropriate, register the

    applicant as a derivatives clearing organization subject to conditions.

    (2) Application. Any person seeking to register as a derivatives

    clearing organization, any applicant amending its pending application,

    or any registered derivatives clearing organization seeking to amend

    its order of registration (applicant), shall submit to the Commission a

    completed Form DCO, which shall include a cover sheet, all applicable

    exhibits, and any supplemental materials, including amendments thereto,

    as provided in the appendix to this part 39 (application). An

    applicant, when filing a Form DCO for purposes of amending its pending

    application or requesting an amendment to an existing registration, is

    only required to submit exhibits and updated information that are

    relevant to the requested amendment and are necessary to demonstrate

    compliance with the core principles affected by the requested

    amendment. The Commission will not commence processing an application

    unless the applicant has filed the application as required by this

    section. Failure to file a completed application will preclude the

    Commission from determining that an application is materially complete,

    as provided in section 6(a) of the Act. Upon its own initiative, an

    applicant may file with its completed application additional

    information that may be necessary or helpful to the Commission in

    processing the application.

    (3) Submission of supplemental information. The filing of a

    completed application is a minimum requirement and does not create a

    presumption that the application is materially complete or that

    supplemental information will not be required. At any time during the

    application review process, the Commission may request that the

    applicant submit supplemental information in order for the Commission

    to process the application. The applicant shall file electronically

    such supplemental information with the Secretary of the Commission in

    the format and manner specified by the Commission.

    (4) Application amendments. An applicant shall promptly amend its

    application if it discovers a material omission or error, or if there

    is a material change in the information provided to the Commission in

    the application or other information provided in connection with the

    application.

    (5) Public information. The following sections of all applications

    to become a registered derivatives clearing organization will be

    public: first page of the Form DCO cover sheet, proposed rules,

    regulatory compliance chart, narrative summary of proposed clearing

    activities, documents establishing the applicant's legal status,

    documents setting forth the applicant's corporate and governance

    structure, and any other part of the application not covered by a

    request for confidential treatment, subject to Sec. 145.9 of this

    chapter.

    (b) Stay of application review. (1) The Commission may stay the

    running of the 180-day review period if an application is materially

    incomplete, in accordance with section 6(a) of the Act.

    (2) Delegation of authority. (i) The Commission hereby delegates,

    until it orders otherwise, to the Director of the Division of Clearing

    and Risk or the Director's designee, with the concurrence of the

    General Counsel or the General Counsel's designee, the authority to

    notify an applicant seeking designation under section 6(a) of the Act

    that the application is materially incomplete and the running of the

    180-day period is stayed.

    (ii) 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 paragraph.

    (iii) Nothing in this paragraph prohibits the Commission, at its

    election, from exercising the authority delegated in paragraph

    (b)(2)(i) of this section.

    (c) Withdrawal of application for registration. An applicant for

    registration may withdraw its application submitted pursuant to

    paragraph (a) of this section by filing electronically such a request

    with the Secretary of the Commission in the format and manner specified

    by the Commission. Withdrawal of an application for registration shall

    not affect any action taken or to be taken by the Commission based upon

    actions, activities, or events occurring during the time that the

    application for registration was pending with the Commission.

    (d) Reinstatement of dormant registration. Before listing or

    relisting products for clearing, a dormant registered derivatives

    clearing organization as defined in Sec. 40.1 of this chapter must

    reinstate its registration under the procedures of paragraph (a) of

    this section; provided, however, that an application for reinstatement

    may rely

    [[Page 69432]]

    upon previously submitted materials that still pertain to, and

    accurately describe, current conditions.

    (e) Request for vacation of registration. A registered derivatives

    clearing organization may vacate its registration under section 7 of

    the Act by filing electronically such a request with the Secretary of

    the Commission in the format and manner specified by the Commission.

    Vacation of registration shall not affect any action taken or to be

    taken by the Commission based upon actions, activities or events

    occurring during the time that the entity was registered by the

    Commission.

    (f) Request for transfer of registration and open interest. (1) In

    anticipation of a corporate change that will result in the transfer of

    all or substantially all of a derivatives clearing organization's

    assets to another legal entity, the derivatives clearing organization

    shall submit a request for approval to transfer the derivatives

    clearing organization's registration and positions comprising open

    interest for clearing and settlement.

    (2) Timing of submission and other procedural requirements. (i) The

    request shall be submitted no later than three months prior to the

    anticipated corporate change, or as otherwise permitted under Sec.

    39.19(c)(4)(viii)(C) of this part.

    (ii) The derivatives clearing organization shall submit a request

    for transfer by filing electronically such a request with the Secretary

    of the Commission in the format and manner specified by the Commission.

    (iii) The derivatives clearing organization shall submit a

    confirmation of change report pursuant to Sec. 39.19(c)(4)(viii)(D) of

    this part.

    (3) Required information. The request shall include the following:

    (i) The underlying agreement that governs the corporate change;

    (ii) A narrative description of the corporate change, including the

    reason for the change and its impact on the derivatives clearing

    organization's financial resources, governance, and operations, and its

    impact on the rights and obligations of clearing members and market

    participants holding the positions that comprise the derivatives

    clearing organization's open interest;

    (iii) A discussion of the transferee's ability to comply with the

    Act, including the core principles applicable to derivatives clearing

    organizations, and the Commission's regulations thereunder;

    (iv) The governing documents of the transferee, including but not

    limited to articles of incorporation and bylaws;

    (v) The transferee's rules marked to show changes from the current

    rules of the derivatives clearing organization;

    (vi) A list of products for which the derivatives clearing

    organization requests transfer of open interest;

    (vii) A representation by the derivatives clearing organization

    that it is in compliance with the Act, including the core principles

    applicable to derivatives clearing organizations, and the Commission's

    regulations thereunder; and

    (viii) A representation by the transferee that it understands that

    the derivatives clearing organization is a regulated entity that must

    comply with the Act, including the core principles applicable to

    derivatives clearing organizations, and the Commission's regulations

    thereunder, in order to maintain its registration as a derivatives

    clearing organization; and further, that the transferee will continue

    to comply with all self-regulatory requirements applicable to a

    derivatives clearing organization under the Act and the Commission's

    regulations thereunder.

    (4) Commission determination. The Commission will review a request

    as soon as practicable, and based on the Commission's determination as

    to the transferee's ability to continue to operate the derivatives

    clearing organization in compliance with the Act and the Commission's

    regulations thereunder, such request will be approved or denied

    pursuant to a Commission order.

    Sec. 39.4 Procedures for implementing derivatives clearing

    organization rules and clearing new products.

    (a) Request for approval of rules. An applicant for registration,

    or a registered derivatives clearing organization, may request,

    pursuant to the procedures of Sec. 40.5 of this chapter, that the

    Commission approve any or all of its rules and subsequent amendments

    thereto, including operational rules, prior to their implementation or,

    notwithstanding the provisions of section 5c(c)(2) of the Act, at any

    time thereafter, under the procedures of Sec. 40.5 of this chapter. A

    derivatives clearing organization may label as, ``Approved by the

    Commission,'' only those rules that have been so approved.

    (b) Self-certification of rules. Proposed new or amended rules of a

    derivatives clearing organization not voluntarily submitted for prior

    Commission approval pursuant to paragraph (a) of this section must be

    submitted to the Commission with a certification that the proposed new

    rule or rule amendment complies with the Act and rules thereunder

    pursuant to the procedures of Sec. 40.6 of this chapter.

    (c) Acceptance of new products for clearing. (1) A dormant

    derivatives clearing organization within the meaning of Sec. 40.1 of

    this chapter may not accept for clearing a new product until its

    registration as a derivatives clearing organization is reinstated under

    the procedures of Sec. 39.3 of this part; provided however, that an

    application for reinstatement may rely upon previously submitted

    materials that still pertain to, and accurately describe, current

    conditions.

    (2) A derivatives clearing organization that accepts for clearing a

    new product that is a swap shall comply with the requirements of Sec.

    39.5 of this part.

    (d) Orders regarding competition. An applicant for registration or

    a registered derivatives clearing organization may request that the

    Commission issue an order concerning whether a rule or practice of the

    organization is the least anticompetitive means of achieving the

    objectives, purposes, and policies of the Act.

    (e) Holding securities in a futures portfolio margining account. A

    derivatives clearing organization seeking to provide a portfolio

    margining program under which securities would be held in a futures

    account as defined in Sec. 1.3(vv) of this chapter, shall submit rules

    to implement such portfolio margining program for Commission approval

    in accordance with Sec. 40.5 of this chapter. Concurrent with the

    submission of such rules for Commission approval, the derivatives

    clearing organization shall petition the Commission for an order under

    section 4d of the Act.

    Sec. 39.5 Review of swaps for Commission determination on clearing

    requirement.

    (a) Eligibility to clear swaps. (1) A derivatives clearing

    organization shall be presumed eligible to accept for clearing any swap

    that is within a group, category, type, or class of swaps that the

    derivatives clearing organization already clears. Such presumption of

    eligibility, however, is subject to review by the Commission.

    (2) A derivatives clearing organization that wishes to accept for

    clearing any swap that is not within a group, category, type, or class

    of swaps that the derivatives clearing organization already clears

    shall request a determination by the Commission of the derivatives

    clearing organization's eligibility to clear such a swap before

    accepting the swap for clearing. The request, which shall be filed

    electronically with the Secretary of the Commission, shall address the

    derivatives clearing

    [[Page 69433]]

    organization's ability, if it accepts the swap for clearing, to

    maintain compliance with section 5b(c)(2) of the Act, specifically:

    (i) The sufficiency of the derivatives clearing organization's

    financial resources; and

    (ii) The derivative clearing organization's ability to manage the

    risks associated with clearing the swap, especially if the Commission

    determines that the swap is required to be cleared.

    (b) Swap submissions. (1) A derivatives clearing organization shall

    submit to the Commission each swap, or any group, category, type, or

    class of swaps that it plans to accept for clearing. The derivatives

    clearing organization making the submission must be eligible under

    paragraph (a) of this section to accept for clearing the submitted

    swap, or group, category, type, or class of swaps.

    (2) A derivatives clearing organization shall submit swaps to the

    Commission, to the extent reasonable and practicable to do so, by

    group, category, type, or class of swaps. The Commission may in its

    reasonable discretion consolidate multiple submissions from one

    derivatives clearing organization or subdivide a derivatives clearing

    organization's submission as appropriate for review.

    (3) The submission shall be filed electronically with the Secretary

    of the Commission and shall include:

    (i) A statement that the derivatives clearing organization is

    eligible to accept the swap, or group, category, type, or class of

    swaps for clearing and describes the extent to which, if the Commission

    were to determine that the swap, or group, category, type, or class of

    swaps is required to be cleared, the derivatives clearing organization

    will be able to maintain compliance with section 5b(c)(2) of the Act;

    (ii) A statement that includes, but is not limited to, information

    that will assist the Commission in making a quantitative and

    qualitative assessment of the following factors:

    (A) The existence of significant outstanding notional exposures,

    trading liquidity, and adequate pricing data;

    (B) 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;

    (C) The effect on the mitigation of systemic risk, taking into

    account the size of the market for such contract and the resources of

    the derivatives clearing organization available to clear the contract;

    (D) The effect on competition, including appropriate fees and

    charges applied to clearing; and

    (E) The existence of reasonable legal certainty in the event of the

    insolvency of the relevant derivatives clearing organization or one or

    more of its clearing members with regard to the treatment of customer

    and swap counterparty positions, funds, and property;

    (iii) Product specifications, including copies of any standardized

    legal documentation, generally accepted contract terms, standard

    practices for managing any life cycle events associated with the swap,

    and the extent to which the swap is electronically confirmable;

    (iv) Participant eligibility standards, if different from the

    derivatives clearing organization's general participant eligibility

    standards;

    (v) Pricing sources, models, and procedures, demonstrating an

    ability to obtain sufficient price data to measure credit exposures in

    a timely and accurate manner, including any agreements with clearing

    members to provide price data and copies of executed agreements with

    third-party price vendors, and information about any price reference

    index used, such as the name of the index, the source that calculates

    it, the methodology used to calculate the price reference index and how

    often it is calculated, and when and where it is published publicly;

    (vi) Risk management procedures, including measurement and

    monitoring of credit exposures, initial and variation margin

    methodology, methodologies for stress testing and back testing,

    settlement procedures, and default management procedures;

    (vii) Applicable rules, manuals, policies, or procedures;

    (viii) A description of the manner in which the derivatives

    clearing organization has provided notice of the submission to its

    members and a summary of any views on the submission expressed by the

    members (a copy of the notice to members shall be included with the

    submission); and

    (ix) Any additional information specifically requested by the

    Commission.

    (4) The Commission must have received the submission by the open of

    business on the business day preceding the acceptance of the swap, or

    group, category, type, or class of swaps for clearing.

    (5) The submission will be made available to the public and posted

    on the Commission Web site for a 30-day public comment period. A

    derivatives clearing organization that wishes to request confidential

    treatment for portions of its submission may do so in accordance with

    the procedures set out in Sec. 145.9(d) of this chapter.

    (6) The Commission will review the submission and determine whether

    the swap, or group, category, type, or class of swaps described in the

    submission is required to be cleared. The Commission will make its

    determination not later than 90 days after a complete submission has

    been received, unless the submitting derivatives clearing organization

    agrees to an extension. The determination of when such submission is

    complete shall be at the sole discretion of the Commission. In making a

    determination that a clearing requirement shall apply, the Commission

    may impose such terms and conditions to the clearing requirement as the

    Commission determines to be appropriate.

    (c) Commission-initiated reviews. (1) The Commission, on an ongoing

    basis, will review swaps that have not been accepted for clearing by a

    derivatives clearing organization to make a determination as to whether

    the swaps should be required to be cleared. In undertaking such

    reviews, the Commission will use information obtained pursuant to

    Commission regulations from swap data repositories, swap dealers, and

    major swap participants, and any other available information.

    (2) Notice regarding any determination made under paragraph (c)(1)

    of this section will be made available to the public and posted on the

    Commission Web site for a 30-day public comment period.

    (3) If no derivatives clearing organization has accepted for

    clearing a particular swap, group, category, type, or class of swaps

    that the Commission finds would otherwise be subject to a clearing

    requirement, the Commission will:

    (i) Investigate the relevant facts and circumstances;

    (ii) Within 30 days of the completion of its investigation, issue a

    public report containing the results of the investigation; and

    (iii) Take such actions as the Commission 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, group,

    category, type, or class of swaps.

    (d) Stay of clearing requirement. (1) After making a determination

    that a swap, or group, category, type, or class of swaps is required to

    be cleared, the Commission, on application of a counterparty to a swap

    or on its own

    [[Page 69434]]

    initiative, may stay the clearing requirement until the Commission

    completes a review of the terms of the swap, or group, category, type,

    or class of swaps and the clearing arrangement.

    (2) A counterparty to a swap that wishes to apply for a stay of the

    clearing requirement for that swap shall submit a written request to

    the Secretary of the Commission that includes:

    (i) The identity and contact information of the counterparty to the

    swap;

    (ii) The terms of the swap subject to the clearing requirement;

    (iii) The name of the derivatives clearing organization clearing

    the swap;

    (iv) A description of the clearing arrangement; and

    (v) A statement explaining why the swap should not be subject to a

    clearing requirement.

    (3) A derivatives clearing organization that has accepted for

    clearing a swap, or group, category, type, or class of swaps that is

    subject to a stay of the clearing requirement shall provide any

    information requested by the Commission in the course of its review.

    (4) The Commission will complete its review not later than 90 days

    after issuance of the stay, unless the derivatives clearing

    organization that clears the swap, or group, category, type, or class

    of swaps agrees to an extension.

    (5) Upon completion of its review, the Commission may:

    (i) Determine, subject to any terms and conditions as the

    Commission determines to be appropriate, that the swap, or group,

    category, type, or class of swaps must be cleared; or

    (ii) Determine that the clearing requirement will not apply to the

    swap, or group, category, type, or class of swaps, but clearing may

    continue on a non-mandatory basis.

    Sec. 39.6 [Reserved]

    Sec. 39.7 Enforceability.

    An agreement, contract or transaction submitted to a derivatives

    clearing organization for clearing shall not be void, voidable, subject

    to rescission, or otherwise invalidated or rendered unenforceable as a

    result of:

    (a) A violation by the derivatives clearing organization of the

    provisions of the Act or of Commission regulations; or

    (b) Any Commission proceeding to alter or supplement a rule under

    section 8a(7) of the Act, to declare an emergency under section 8a(9)

    of the Act, or any other proceeding the effect of which is to alter,

    supplement, or require a derivatives clearing organization to adopt a

    specific rule or procedure, or to take or refrain from taking a

    specific action.

    Sec. 39.8 Fraud in connection with the clearing of transactions on a

    derivatives clearing organization.

    It shall be unlawful for any person, directly or indirectly, in or

    in connection with the clearing of transactions by a derivatives

    clearing organization:

    (a) To cheat or defraud or attempt to cheat or defraud any person;

    (b) Willfully to make or cause to be made to any person any false

    report or statement or cause to be entered for any person any false

    record; or

    (c) Willfully to deceive or attempt to deceive any person by any

    means whatsoever.

    Subpart B--Compliance with Core Principles

    Sec. 39.9 Scope.

    The provisions of this subpart B apply to any derivatives clearing

    organization, as defined under section 1a(15) of the Act and Sec.

    1.3(d) of this chapter, which is registered or deemed to be registered

    with the Commission as a derivatives clearing organization, is required

    to register as such with the Commission pursuant to section 5b(a) of

    the Act, or which voluntarily registers as such with the Commission

    pursuant to section 5b(b) or otherwise.

    Sec. 39.10 Compliance with core principles.

    (a) To be registered and to maintain registration as a derivatives

    clearing organization, a derivatives clearing organization shall comply

    with each core principle set forth in section 5b(c)(2) of the Act and

    any requirement that the Commission may impose by rule or regulation

    pursuant to section 8a(5) of the Act; and

    (b) Subject to any rule or regulation prescribed by the Commission,

    a registered derivatives clearing organization shall have reasonable

    discretion in establishing the manner by which it complies with each

    core principle.

    (c) Chief compliance officer--(1) Designation. Each derivatives

    clearing organization shall establish the position of chief compliance

    officer, designate an individual to serve as the chief compliance

    officer, and provide the chief compliance officer with the full

    responsibility and authority to develop and enforce, in consultation

    with the board of directors or the senior officer, appropriate

    compliance policies and procedures, to fulfill the duties set forth in

    the Act and Commission regulations.

    (i) The individual designated to serve as chief compliance officer

    shall have the background and skills appropriate for fulfilling the

    responsibilities of the position. No individual who would be

    disqualified from registration under sections 8a(2) or 8a(3) of the Act

    may serve as a chief compliance officer.

    (ii) The chief compliance officer shall report to the board of

    directors or the senior officer of the derivatives clearing

    organization. The board of directors or the senior officer shall

    approve the compensation of the chief compliance officer.

    (iii) The chief compliance officer shall meet with the board of

    directors or the senior officer at least once a year.

    (iv) A change in the designation of the individual serving as the

    chief compliance officer of the derivatives clearing organization shall

    be reported to the Commission in accordance with the requirements of

    Sec. 39.19(c)(4)(ix) of this part.

    (2) Chief compliance officer duties. The chief compliance officer's

    duties shall include, but are not limited to:

    (i) Reviewing the derivatives clearing organization's compliance

    with the core principles set forth in section 5b of the Act, and the

    Commission's regulations thereunder;

    (ii) In consultation with the board of directors or the senior

    officer, resolving any conflicts of interest that may arise;

    (iii) Establishing and administering written policies and

    procedures reasonably designed to prevent violation of the Act;

    (iv) Taking reasonable steps to ensure compliance with the Act and

    Commission regulations relating to agreements, contracts, or

    transactions, and with Commission regulations prescribed under section

    5b of the Act;

    (v) Establishing procedures for the remediation of noncompliance

    issues identified by the chief compliance officer through any

    compliance office review, look-back, internal or external audit

    finding, self-reported error, or validated complaint; and

    (vi) Establishing and following appropriate procedures for the

    handling, management response, remediation, retesting, and closing of

    noncompliance issues.

    (3) Annual report. The chief compliance officer shall, not less

    than annually, prepare and sign a written report that covers the most

    recently completed fiscal year of the derivatives clearing

    organization, and provide the annual report to the board of directors

    or the senior officer. The annual report shall, at a minimum:

    (i) Contain a description of the derivatives clearing

    organization's

    [[Page 69435]]

    written policies and procedures, including the code of ethics and

    conflict of interest policies;

    (ii) Review each core principle and applicable Commission

    regulation, and with respect to each:

    (A) Identify the compliance policies and procedures that are

    designed to ensure compliance with the core principle;

    (B) Provide an assessment as to the effectiveness of these policies

    and procedures;

    (C) Discuss areas for improvement, and recommend potential or

    prospective changes or improvements to the derivatives clearing

    organization's compliance program and resources allocated to

    compliance;

    (iii) List any material changes to compliance policies and

    procedures since the last annual report;

    (iv) Describe the financial, managerial, and operational resources

    set aside for compliance with the Act and Commission regulations; and

    (v) Describe any material compliance matters, including incidents

    of noncompliance, since the date of the last annual report and describe

    the corresponding action taken.

    (4) Submission of annual report to the Commission. (i) Prior to

    submitting the annual report to the Commission, the chief compliance

    officer shall provide the annual report to the board of directors or

    the senior officer of the derivatives clearing organization for review.

    Submission of the report to the board of directors or the senior

    officer shall be recorded in the board minutes or otherwise, as

    evidence of compliance with this requirement.

    (ii) The annual report shall be submitted electronically to the

    Secretary of the Commission in the format and manner specified by the

    Commission not more than 90 days after the end of the derivatives

    clearing organization's fiscal year, concurrently with submission of

    the fiscal year-end audited financial statement that is required to be

    furnished to the Commission pursuant to Sec. 39.19(c)(3)(ii) of this

    part. The report shall include a certification by the chief compliance

    officer that, to the best of his or her knowledge and reasonable

    belief, and under penalty of law, the annual report is accurate and

    complete.

    (iii) The derivatives clearing organization shall promptly submit

    an amended annual report if material errors or omissions in the report

    are identified after submission. An amendment must contain the

    certification required under paragraph (c)(4)(ii) of this section.

    (iv) A derivatives clearing organization may request from the

    Commission an extension of time to submit its annual report in

    accordance with Sec. 39.19(c)(3) of this part.

    (5) Recordkeeping. (i) The derivatives clearing organization shall

    maintain:

    (A) A copy of all compliance policies and procedures and all other

    policies and procedures adopted in furtherance of compliance with the

    Act and Commission regulations;

    (B) Copies of materials, including written reports provided to the

    board of directors or the senior officer in connection with the review

    of the annual report under paragraph (c)(4)(i) of this section; and

    (C) Any records relevant to the annual report, including, but not

    limited to, work papers and other documents that form the basis of the

    report, and memoranda, correspondence, other documents, and records

    that are created, sent, or received in connection with the annual

    report and contain conclusions, opinions, analyses, or financial data

    related to the annual report.

    (ii) The derivatives clearing organization shall maintain records

    in accordance with Sec. 1.31 of this chapter and Sec. 39.20 of this

    part.

    Sec. 39.11 Financial resources.

    (a) General. A derivatives clearing organization shall maintain

    financial resources sufficient to cover its exposures with a high

    degree of confidence and to enable it to perform its functions in

    compliance with the core principles set out in section 5b of the Act. A

    derivatives clearing organization shall identify and adequately manage

    its general business risks and hold sufficient liquid resources to

    cover potential business losses that are not related to clearing

    members' defaults, so that the derivatives clearing organization can

    continue to provide services as an ongoing concern. Financial resources

    shall be considered sufficient if their value, at a minimum, exceeds

    the total amount that would:

    (1) Enable the derivatives clearing organization to meet its

    financial obligations to its clearing members notwithstanding a default

    by the clearing member creating the largest financial exposure for the

    derivatives clearing organization in extreme but plausible market

    conditions; Provided that if a clearing member controls another

    clearing member or is under common control with another clearing

    member, the affiliated clearing members shall be deemed to be a single

    clearing member for purposes of this provision; and

    (2) Enable the derivatives clearing organization to cover its

    operating costs for a period of at least one year, calculated on a

    rolling basis.

    (b) Types of financial resources. (1) Financial resources available

    to satisfy the requirements of paragraph (a)(1) of this section may

    include:

    (i) Margin to the extent permitted under parts 1, 22, and 190 of

    this chapter and under the rules of the derivatives clearing

    organization;

    (ii) The derivatives clearing organization's own capital;

    (iii) Guaranty fund deposits;

    (iv) Default insurance;

    (v) Potential assessments for additional guaranty fund

    contributions, if permitted by the derivatives clearing organization's

    rules; and

    (vi) Any other financial resource deemed acceptable by the

    Commission.

    (2) Financial resources available to satisfy the requirements of

    paragraph (a)(2) of this section may include:

    (i) The derivatives clearing organization's own capital; and

    (ii) Any other financial resource deemed acceptable by the

    Commission.

    (3) A financial resource may be allocated, in whole or in part, to

    satisfy the requirements of either paragraph (a)(1) or paragraph (a)(2)

    of this section, but not both paragraphs, and only to the extent the

    use of such financial resource is not otherwise limited by the Act,

    Commission regulations, the derivatives clearing organization's rules,

    or any contractual arrangements to which the derivatives clearing

    organization is a party.

    (c) Computation of financial resources requirement. (1) A

    derivatives clearing organization shall, on a monthly basis, perform

    stress testing that will allow it to make a reasonable calculation of

    the financial resources needed to meet the requirements of paragraph

    (a)(1) of this section. The derivatives clearing organization shall

    have reasonable discretion in determining the methodology used to

    compute such requirements, provided that the methodology must take into

    account both historical data and hypothetical scenarios. The Commission

    may review the methodology and require changes as appropriate.

    (2) A derivatives clearing organization shall, on a monthly basis,

    make a reasonable calculation of its projected operating costs over a

    12-month period in order to determine the amount needed to meet the

    requirements of paragraph (a)(2) of this section. The derivatives

    clearing organization shall have reasonable discretion in determining

    the methodology used to compute such projected operating costs. The

    Commission may review the

    [[Page 69436]]

    methodology and require changes as appropriate.

    (d) Valuation of financial resources. (1) At appropriate intervals,

    but not less than monthly, a derivatives clearing organization shall

    compute the current market value of each financial resource used to

    meet its obligations under paragraph (a) of this section. Reductions in

    value to reflect credit, market, and liquidity risks (haircuts) shall

    be applied as appropriate and evaluated on a monthly basis.

    (2) If assessments for additional guaranty fund contributions are

    permitted by the derivatives clearing organization's rules, in

    calculating the financial resources available to meet its obligations

    under paragraph (a)(1) of this section:

    (i) The derivatives clearing organization shall have rules

    requiring that its clearing members have the ability to meet an

    assessment within the time frame of a normal end-of-day variation

    settlement cycle;

    (ii) The derivatives clearing organization shall monitor the

    financial and operational capacity of its clearing members to meet

    potential assessments;

    (iii) The derivatives clearing organization shall apply a 30

    percent haircut to the value of potential assessments, and

    (iv) The derivatives clearing organization shall only count the

    value of assessments, after the haircut, to meet up to 20 percent of

    those obligations.

    (e) Liquidity of financial resources. (1) (i) The derivatives

    clearing organization shall effectively measure, monitor, and manage

    its liquidity risks, maintaining sufficient liquid resources such that

    it can, at a minimum, fulfill its cash obligations when due. The

    derivatives clearing organization shall hold assets in a manner where

    the risk of loss or of delay in its access to them is minimized.

    (ii) The financial resources allocated by the derivatives clearing

    organization to meet the requirements of paragraph (a)(1) of this

    section shall be sufficiently liquid to enable the derivatives clearing

    organization to fulfill its obligations as a central counterparty

    during a one-day settlement cycle. The derivatives clearing

    organization shall maintain cash, U.S. Treasury obligations, or high

    quality, liquid, general obligations of a sovereign nation, in an

    amount greater than or equal to an amount calculated as follows:

    (A) Calculate the average daily settlement pay for each clearing

    member over the last fiscal quarter;

    (B) Calculate the sum of those average daily settlement pays; and

    (C) Using that sum, calculate the average of its clearing members'

    average pays.

    (iii) The derivatives clearing organization may take into account a

    committed line of credit or similar facility for the purpose of meeting

    the remainder of the requirement under paragraph (e)(1)(ii) of this

    section.

    (2) The financial resources allocated by the derivatives clearing

    organization to meet the requirements of paragraph (a)(2) of this

    section must include unencumbered, liquid financial assets (i.e., cash

    and/or highly liquid securities) equal to at least six months'

    operating costs. If any portion of such financial resources is not

    sufficiently liquid, the derivatives clearing organization may take

    into account a committed line of credit or similar facility for the

    purpose of meeting this requirement.

    (3)(i) Assets in a guaranty fund shall have minimal credit, market,

    and liquidity risks and shall be readily accessible on a same-day

    basis;

    (ii) Cash balances shall be invested or placed in safekeeping in a

    manner that bears little or no principal risk; and

    (iii) Letters of credit shall not be a permissible asset for a

    guaranty fund.

    (f) Reporting requirements.

    (1) Each fiscal quarter, or at any time upon Commission request, a

    derivatives clearing organization shall:

    (i) Report to the Commission;

    (A) The amount of financial resources necessary to meet the

    requirements of paragraph (a);

    (B) The value of each financial resource available, computed in

    accordance with the requirements of paragraph (d) of this section; and

    (C) The manner in which the derivatives clearing organization meets

    the liquidity requirements of paragraph (e) of this section;

    (ii) Provide the Commission with a financial statement, including

    the balance sheet, income statement, and statement of cash flows, of

    the derivatives clearing organization or of its parent company; and

    (iii) Report to the Commission the value of each individual

    clearing member's guaranty fund deposit, if the derivatives clearing

    organization reports having guaranty funds deposits as a financial

    resource available to satisfy the requirements of paragraph (a)(1) of

    this section.

    (2) The calculations required by this paragraph shall be made as of

    the last business day of the derivatives clearing organization's fiscal

    quarter.

    (3) The derivatives clearing organization shall provide the

    Commission with:

    (i) Sufficient documentation explaining the methodology used to

    compute its financial resources requirements under paragraph (a) of

    this section,

    (ii) Sufficient documentation explaining the basis for its

    determinations regarding the valuation and liquidity requirements set

    forth in paragraphs (d) and (e) of this section, and

    (iii) Copies of any agreements establishing or amending a credit

    facility, insurance coverage, or other arrangement evidencing or

    otherwise supporting the derivatives clearing organization's

    conclusions.

    (4) The report shall be filed not later than 17 business days after

    the end of the derivatives clearing organization's fiscal quarter, or

    at such later time as the Commission may permit, in its discretion,

    upon request by the derivatives clearing organization.

    Sec. 39.12 Participant and product eligibility.

    (a) Participant eligibility. A derivatives clearing organization

    shall establish appropriate admission and continuing participation

    requirements for clearing members of the derivatives clearing

    organization that are objective, publicly disclosed, and risk-based.

    (1) Fair and open access for participation. The participation

    requirements shall permit fair and open access;

    (i) A derivatives clearing organization shall not adopt restrictive

    clearing member standards if less restrictive requirements that achieve

    the same objective and that would not materially increase risk to the

    derivatives clearing organization or clearing members could be adopted;

    (ii) A derivatives clearing organization shall allow all market

    participants who satisfy participation requirements to become clearing

    members;

    (iii) A derivatives clearing organization shall not exclude or

    limit clearing membership of certain types of market participants

    unless the derivatives clearing organization can demonstrate that the

    restriction is necessary to address credit risk or deficiencies in the

    participants' operational capabilities that would prevent them from

    fulfilling their obligations as clearing members.

    (iv) A derivatives clearing organization shall not require that

    clearing members be swap dealers.

    (v) A derivatives clearing organization shall not require that

    clearing members maintain a swap portfolio of any particular size, or

    that clearing members meet a swap transaction volume threshold.

    [[Page 69437]]

    (2) Financial resources. (i) The participation requirements shall

    require clearing members to have access to sufficient financial

    resources to meet obligations arising from participation in the

    derivatives clearing organization in extreme but plausible market

    conditions. A derivatives clearing organization may permit such

    financial resources to include, without limitation, a clearing member's

    capital, a guarantee from the clearing member's parent, or a credit

    facility funding arrangement. For purposes of this paragraph,

    ``capital'' means adjusted net capital as defined in Sec. 1.17 of this

    chapter, for futures commission merchants, and net capital as defined

    in Sec. 240.15c3-1of this title, for broker-dealers, or any similar

    risk adjusted capital calculation for all other clearing members.

    (ii) The participation requirements shall set forth capital

    requirements that are based on objective, transparent, and commonly

    accepted standards that appropriately match capital to risk. Capital

    requirements shall be scalable to the risks posed by clearing members.

    (iii) A derivatives clearing organization shall not set a minimum

    capital requirement of more than $50 million for any person that seeks

    to become a clearing member in order to clear swaps.

    (3) Operational requirements. The participation requirements shall

    require clearing members to have adequate operational capacity to meet

    obligations arising from participation in the derivatives clearing

    organization. The requirements shall include, but are not limited to:

    the ability to process expected volumes and values of transactions

    cleared by a clearing member within required time frames, including at

    peak times and on peak days; the ability to fulfill collateral,

    payment, and delivery obligations imposed by the derivatives clearing

    organization; and the ability to participate in default management

    activities under the rules of the derivatives clearing organization and

    in accordance with Sec. 39.16 of this part.

    (4) Monitoring. A derivatives clearing organization shall establish

    and implement procedures to verify, on an ongoing basis, the compliance

    of each clearing member with each participation requirement of the

    derivatives clearing organization.

    (5) Reporting. (i) A derivatives clearing organization shall

    require all clearing members, including non-futures commission

    merchants, to provide to the derivatives clearing organization periodic

    financial reports that contain any financial information that the

    derivatives clearing organization determines is necessary to assess

    whether participation requirements are being met on an ongoing basis.

    (A) A derivatives clearing organization shall require clearing

    members that are futures commission merchants to provide the financial

    reports that are specified in Sec. 1.10 of this chapter to the

    derivatives clearing organization.

    (B) A derivatives clearing organization shall require clearing

    members that are not futures commission merchants to make the periodic

    financial reports provided pursuant to paragraph (a)(5)(i) of this

    section available to the Commission upon the Commission's request or,

    in lieu of imposing this requirement, a derivatives clearing

    organization may provide such financial reports directly to the

    Commission upon the Commission's request.

    (ii) A derivatives clearing organization shall adopt rules that

    require clearing members to provide to the derivatives clearing

    organization, in a timely manner, information that concerns any

    financial or business developments that may materially affect the

    clearing members' ability to continue to comply with participation

    requirements.

    (6) Enforcement. A derivatives clearing organization shall have the

    ability to enforce compliance with its participation requirements and

    shall establish procedures for the suspension and orderly removal of

    clearing members that no longer meet the requirements.

    (b) Product eligibility. (1) A derivatives clearing organization

    shall establish appropriate requirements for determining the

    eligibility of agreements, contracts, or transactions submitted to the

    derivatives clearing organization for clearing, taking into account the

    derivatives clearing organization's ability to manage the risks

    associated with such agreements, contracts, or transactions. Factors to

    be considered in determining product eligibility include, but are not

    limited to:

    (i) Trading volume;

    (ii) Liquidity;

    (iii) Availability of reliable prices;

    (iv) Ability of market participants to use portfolio compression

    with respect to a particular swap product;

    (v) Ability of the derivatives clearing organization and clearing

    members to gain access to the relevant market for purposes of creating,

    liquidating, transferring, auctioning, and/or allocating positions;

    (vi) Ability of the derivatives clearing organization to measure

    risk for purposes of setting margin requirements; and

    (vii) Operational capacity of the derivatives clearing organization

    and clearing members to address any unusual risk characteristics of a

    product.

    (2) A derivatives clearing organization shall adopt rules providing

    that all swaps with the same terms and conditions, as defined by

    product specifications established under derivatives clearing

    organization rules, submitted to the derivatives clearing organization

    for clearing are economically equivalent within the derivatives

    clearing organization and may be offset with each other within the

    derivatives clearing organization.

    (3) A derivatives clearing organization shall provide for non-

    discriminatory clearing of a swap executed bilaterally or on or subject

    to the rules of an unaffiliated swap execution facility or designated

    contract market.

    (4) A derivatives clearing organization shall not require that one

    of the original executing parties be a clearing member in order for a

    product to be eligible for clearing.

    (5) A derivatives clearing organization shall select product unit

    sizes and other terms and conditions that maximize liquidity,

    facilitate transparency in pricing, promote open access, and allow for

    effective risk management. To the extent appropriate to further these

    objectives, a derivatives clearing organization shall select product

    units for clearing purposes that are smaller than the product units in

    which trades submitted for clearing were executed.

    (6) A derivatives clearing organization that clears swaps shall

    have rules providing that, upon acceptance of a swap by the derivatives

    clearing organization for clearing:

    (i) The original swap is extinguished;

    (ii) The original swap is replaced by an equal and opposite swap

    between the derivatives clearing organization and each clearing member

    acting as principal for a house trade or acting as agent for a customer

    trade;

    (iii) All terms of a cleared swap must conform to product

    specifications established under derivatives clearing organization

    rules; and

    (iv) If a swap is cleared by a clearing member on behalf of a

    customer, all terms of the swap, as carried in the customer account on

    the books of the clearing member, must conform to the terms of the

    cleared swap established under the derivatives clearing organization's

    rules.

    (7) [Reserved]

    (8) Confirmation. A derivatives clearing organization shall provide

    each

    [[Page 69438]]

    clearing member carrying a cleared swap with a definitive written

    record of the terms of the transaction which shall legally supersede

    any previous agreement and serve as a confirmation of the swap. The

    confirmation of all terms of the transaction shall take place at the

    same time as the swap is accepted for clearing.

    Sec. 39.13 Risk management.

    (a) General. A derivatives clearing organization shall ensure that

    it possesses the ability to manage the risks associated with

    discharging the responsibilities of the derivatives clearing

    organization through the use of appropriate tools and procedures.

    (b) Documentation requirement. A derivatives clearing organization

    shall establish and maintain written policies, procedures, and

    controls, approved by its board of directors, which establish an

    appropriate risk management framework that, at a minimum, clearly

    identifies and documents the range of risks to which the derivatives

    clearing organization is exposed, addresses the monitoring and

    management of the entirety of those risks, and provides a mechanism for

    internal audit. The risk management framework shall be regularly

    reviewed and updated as necessary.

    (c) Chief risk officer. A derivatives clearing organization shall

    have a chief risk officer who shall be responsible for implementing the

    risk management framework, including the procedures, policies and

    controls described in paragraph (b) of this section, and for making

    appropriate recommendations to the derivatives clearing organization's

    risk management committee or board of directors, as applicable,

    regarding the derivatives clearing organization's risk management

    functions.

    (d) [Reserved]

    (e) Measurement of credit exposure. A derivatives clearing

    organization shall:

    (1) Measure its credit exposure to each clearing member and mark to

    market such clearing member's open house and customer positions at

    least once each business day; and

    (2) Monitor its credit exposure to each clearing member

    periodically during each business day.

    (f) Limitation of exposure to potential losses from defaults. A

    derivatives clearing organization, through margin requirements and

    other risk control mechanisms, shall limit its exposure to potential

    losses from defaults by its clearing members to ensure that:

    (1) The operations of the derivatives clearing organization would

    not be disrupted; and

    (2) Non-defaulting clearing members would not be exposed to losses

    that non-defaulting clearing members cannot anticipate or control.

    (g) Margin requirements. (1) General. Each model and parameter used

    in setting initial margin requirements shall be risk-based and reviewed

    on a regular basis.

    (2) Methodology and coverage. (i) A derivatives clearing

    organization shall establish initial margin requirements that are

    commensurate with the risks of each product and portfolio, including

    any unusual characteristics of, or risks associated with, particular

    products or portfolios, including but not limited to jump-to-default

    risk or similar jump risk.

    (ii) A derivatives clearing organization shall use models that

    generate initial margin requirements sufficient to cover the

    derivatives clearing organization's potential future exposures to

    clearing members based on price movements in the interval between the

    last collection of variation margin and the time within which the

    derivatives clearing organization estimates that it would be able to

    liquidate a defaulting clearing member's positions (liquidation time);

    provided, however, that a derivatives clearing organization shall use:

    (A) A minimum liquidation time that is one day for futures and

    options;

    (B) A minimum liquidation time that is one day for swaps on

    agricultural commodities, energy commodities, and metals;

    (C) A minimum liquidation time that is five days for all other

    swaps; or

    (D) Such longer liquidation time as is appropriate based on the

    specific characteristics of a particular product or portfolio; provided

    further that the Commission, by order, may establish shorter or longer

    liquidation times for particular products or portfolios.

    (iii) The actual coverage of the initial margin requirements

    produced by such models, along with projected measures of the models'

    performance, shall meet an established confidence level of at least 99

    percent, based on data from an appropriate historic time period, for:

    (A) Each product for which the derivatives clearing organization

    uses a product-based margin methodology;

    (B) Each spread within or between products for which there is a

    defined spread margin rate;

    (C) Each account held by a clearing member at the derivatives

    clearing organization, by house origin and by each customer origin; and

    (D) Each swap portfolio, including any portfolio containing futures

    and/or options and held in a commingled account pursuant to Sec.

    39.15(b)(2) of this part, by beneficial owner.

    (iv) A derivatives clearing organization shall determine the

    appropriate historic time period based on the characteristics,

    including volatility patterns, as applicable, of each product, spread,

    account, or portfolio.

    (3) Independent validation. A derivatives clearing organization's

    systems for generating initial margin requirements, including its

    theoretical models, must be reviewed and validated by a qualified and

    independent party, on a regular basis. Such qualified and independent

    parties may be independent contractors or employees of the derivatives

    clearing organization, but shall not be persons responsible for

    development or operation of the systems and models being tested.

    (4) Spread and portfolio margins. (i) A derivatives clearing

    organization may allow reductions in initial margin requirements for

    related positions if the price risks with respect to such positions are

    significantly and reliably correlated. The price risks of different

    positions will only be considered to be reliably correlated if there is

    a theoretical basis for the correlation in addition to an exhibited

    statistical correlation. That theoretical basis may include, but is not

    limited to, the following:

    (A) The products on which the positions are based are complements

    of, or substitutes for, each other;

    (B) One product is a significant input into the other product(s);

    (C) The products share a significant common input; or

    (D) The prices of the products are influenced by common external

    factors.

    (ii) A derivatives clearing organization shall regularly review its

    margin reductions and the correlations on which they are based.

    (5) Price data. A derivatives clearing organization shall have a

    reliable source of timely price data in order to measure the

    derivatives clearing organization's credit exposure accurately. A

    derivatives clearing organization shall also have written procedures

    and sound valuation models for addressing circumstances where pricing

    data is not readily available or reliable.

    (6) Daily review. On a daily basis, a derivatives clearing

    organization shall determine the adequacy of its initial margin

    requirements.

    (7) Back tests. A derivatives clearing organization shall conduct

    back tests, as defined in Sec. 39.2 of this part, using an appropriate

    time period but not less than the previous 30 days, as follows:

    (i) On a daily basis, a derivatives clearing organization shall

    conduct back

    [[Page 69439]]

    tests with respect to products or swap portfolios that are experiencing

    significant market volatility, to test the adequacy of its initial

    margin requirements, as follows:

    (A) For that product if the derivatives clearing organization uses

    a product-based margin methodology;

    (B) For each spread involving that product if there is a defined

    spread margin rate;

    (C) For each account held by a clearing member at the derivatives

    clearing organization that contains a significant position in that

    product, by house origin and by each customer origin; and

    (D) For each such swap portfolio, including any portfolio

    containing futures and/or options and held in a commingled account

    pursuant to Sec. 39.15(b)(2) of this part, by beneficial owner.

    (ii) On at least a monthly basis, a derivatives clearing

    organization shall conduct back tests to test the adequacy of its

    initial margin requirements, as follows:

    (A) For each product for which the derivatives clearing

    organization uses a product-based margin methodology;

    (B) For each spread for which there is a defined spread margin

    rate;

    (C) For each account held by a clearing member at the derivatives

    clearing organization, by house origin and by each customer origin; and

    (D) For each swap portfolio, including any portfolio containing

    futures and/or options and held in a commingled account pursuant to

    Sec. 39.15(b)(2) of this part, by beneficial owner.

    (8) Customer margin. (i) Gross margin. (A) A derivatives clearing

    organization shall collect initial margin on a gross basis for each

    clearing member's customer account(s) equal to the sum of the initial

    margin amounts that would be required by the derivatives clearing

    organization for each individual customer within that account if each

    individual customer were a clearing member.

    (B) For purposes of calculating the gross initial margin

    requirement for each clearing member's customer account(s), to the

    extent not inconsistent with other Commission regulations, a

    derivatives clearing organization may require its clearing members to

    report the gross positions of each individual customer to the

    derivatives clearing organization, or it may permit each clearing

    member to report the sum of the gross positions of its customers to the

    derivatives clearing organization.

    (C) For purposes of this paragraph (g)(8), a derivatives clearing

    organization may rely, and may permit its clearing members to rely,

    upon the sum of the gross positions reported to the clearing members by

    each domestic or foreign omnibus account that they carry, without

    obtaining information identifying the positions of each individual

    customer underlying such omnibus accounts.

    (D) A derivatives clearing organization may not, and may not permit

    its clearing members to, net positions of different customers against

    one another.

    (E) A derivatives clearing organization may collect initial margin

    for its clearing members' house accounts on a net basis.

    (ii) Customer initial margin requirements. A derivatives clearing

    organization shall require its clearing members to collect customer

    initial margin, as defined in Sec. 1.3 of this chapter, from their

    customers, for non-hedge positions, at a level that is greater than 100

    percent of the derivatives clearing organization's initial margin

    requirements with respect to each product and swap portfolio. The

    derivatives clearing organization shall have reasonable discretion in

    determining the percentage by which customer initial margins must

    exceed the derivatives clearing organization's initial margin

    requirements with respect to particular products or swap portfolios.

    The Commission may review such percentage levels and require different

    percentage levels if the Commission deems the levels insufficient to

    protect the financial integrity of the clearing members or the

    derivatives clearing organization.

    (iii) Withdrawal of customer initial margin. A derivatives clearing

    organization shall require its clearing members to ensure that their

    customers do not withdraw funds from their accounts with such clearing

    members unless the net liquidating value plus the margin deposits

    remaining in a customer's account after such withdrawal are sufficient

    to meet the customer initial margin requirements with respect to all

    products and swap portfolios held in such customer's account which are

    cleared by the derivatives clearing organization.

    (9) Time deadlines. A derivatives clearing organization shall

    establish and enforce time deadlines for initial and variation margin

    payments to the derivatives clearing organization by its clearing

    members.

    (10) Types of assets. A derivatives clearing organization shall

    limit the assets it accepts as initial margin to those that have

    minimal credit, market, and liquidity risks. A derivatives clearing

    organization may take into account the specific risk-reducing

    properties that particular assets have in a particular portfolio. A

    derivatives clearing organization may accept letters of credit as

    initial margin for futures and options on futures but shall not accept

    letters of credit as initial margin for swaps.

    (11) Valuation. A derivatives clearing organization shall use

    prudent valuation practices to value assets posted as initial margin on

    a daily basis.

    (12) Haircuts. A derivatives clearing organization shall apply

    appropriate reductions in value to reflect credit, market, and

    liquidity risks (haircuts), to the assets that it accepts in

    satisfaction of initial margin obligations, taking into consideration

    stressed market conditions, and shall evaluate the appropriateness of

    such haircuts on at least a quarterly basis.

    (13) Concentration limits or charges. A derivatives clearing

    organization shall apply appropriate limitations or charges on the

    concentration of assets posted as initial margin, as necessary, in

    order to ensure its ability to liquidate such assets quickly with

    minimal adverse price effects, and shall evaluate the appropriateness

    of any such concentration limits or charges, on at least a monthly

    basis.

    (14) Pledged assets. If a derivatives clearing organization permits

    its clearing members to pledge assets for initial margin while

    retaining such assets in accounts in the names of such clearing

    members, the derivatives clearing organization shall ensure that such

    assets are unencumbered and that such a pledge has been validly created

    and validly perfected in the relevant jurisdiction.

    (h) Other risk control mechanisms-- (1) Risk limits. (i) A

    derivatives clearing organization shall impose risk limits on each

    clearing member, by house origin and by each customer origin, in order

    to prevent a clearing member from carrying positions for which the risk

    exposure exceeds a specified threshold relative to the clearing

    member's and/or the derivatives clearing organization's financial

    resources. The derivatives clearing organization shall have reasonable

    discretion in determining:

    (A) The method of computing risk exposure;

    (B) The applicable threshold(s); and

    (C) The applicable financial resources under this provision;

    provided however, that the ratio of exposure to capital must remain the

    same across all capital levels. The Commission may review such methods,

    thresholds, and financial resources and require the application of

    different methods, thresholds, or financial resources, as appropriate.

    [[Page 69440]]

    (ii) A derivatives clearing organization may permit a clearing

    member to exceed the threshold(s) applied pursuant to paragraph

    (h)(1)(i) of this section provided that the derivatives clearing

    organization requires the clearing member to post additional initial

    margin that the derivatives clearing organization deems sufficient to

    appropriately eliminate excessive risk exposure at the clearing member.

    The Commission may review the amount of additional initial margin and

    require a different amount of additional initial margin, as

    appropriate.

    (2) Large trader reports. A derivatives clearing organization shall

    obtain from its clearing members or from a relevant designated contract

    market or swap execution facility, copies of all reports that are

    required to be filed with the Commission by, or on behalf of, such

    clearing members pursuant to parts 17 and 20 of this chapter. A

    derivatives clearing organization shall review such reports on a daily

    basis to ascertain the risk of the overall portfolio of each large

    trader, including futures, options, and swaps cleared by the

    derivatives clearing organization, which are held by all clearing

    members carrying accounts for each such large trader, and shall take

    additional actions with respect to such clearing members, when

    appropriate, as specified in paragraph (h)(6) of this section, in order

    to address any risks posed by any such large trader.

    (3) Stress tests. A derivatives clearing organization shall conduct

    stress tests, as defined in Sec. 39.2 of this part, as follows:

    (i) On a daily basis, a derivatives clearing organization shall

    conduct stress tests with respect to each large trader who poses

    significant risk to a clearing member or the derivatives clearing

    organization, including futures, options, and swaps cleared by the

    derivatives clearing organization, which are held by all clearing

    members carrying accounts for each such large trader. The derivatives

    clearing organization shall have reasonable discretion in determining

    which traders to test and the methodology used to conduct such stress

    tests. The Commission may review the selection of accounts and the

    methodology and require changes, as appropriate.

    (ii) On at least a weekly basis, a derivatives clearing

    organization shall conduct stress tests with respect to each clearing

    member account, by house origin and by each customer origin, and each

    swap portfolio, including any portfolio containing futures and/or

    options and held in a commingled account pursuant to Sec. 39.15(b)(2)

    of this part, by beneficial owner, under extreme but plausible market

    conditions. The derivatives clearing organization shall have reasonable

    discretion in determining the methodology used to conduct such stress

    tests. The Commission may review the methodology and require changes,

    as appropriate.

    (4) Portfolio compression. A derivatives clearing organization

    shall make portfolio compression exercises available, on a regular and

    voluntary basis, for its clearing members that clear swaps, to the

    extent that such exercises are appropriate for those swaps that it

    clears; provided, however, a derivatives clearing organization is not

    required to develop its own portfolio compression services, and is only

    required to make such portfolio compression exercises available, if

    applicable portfolio compression services have been developed by a

    third party.

    (5) Clearing members' risk management policies and procedures. (i)

    A derivatives clearing organization shall adopt rules that:

    (A) Require its clearing members to maintain current written risk

    management policies and procedures, which address the risks that such

    clearing members may pose to the derivatives clearing organization;

    (B) Ensure that it has the authority to request and obtain

    information and documents from its clearing members regarding their

    risk management policies, procedures, and practices, including, but not

    limited to, information and documents relating to the liquidity of

    their financial resources and their settlement procedures; and

    (C) Require its clearing members to make information and documents

    regarding their risk management policies, procedures, and practices

    available to the Commission upon the Commission's request.

    (ii) A derivatives clearing organization shall review the risk

    management policies, procedures, and practices of each of its clearing

    members, which address the risks that such clearing members may pose to

    the derivatives clearing organization, on a periodic basis and document

    such reviews.

    (6) Additional authority. A derivatives clearing organization shall

    take additional actions with respect to particular clearing members,

    when appropriate, based on the application of objective and prudent

    risk management standards including, but not limited to:

    (i) Imposing enhanced capital requirements;

    (ii) Imposing enhanced margin requirements;

    (iii) Imposing position limits;

    (iv) Prohibiting an increase in positions;

    (v) Requiring a reduction of positions;

    (vi) Liquidating or transferring positions; and

    (vii) Suspending or revoking clearing membership.

    Sec. 39.14 Settlement procedures.

    (a) Definitions--(1) Settlement. For purposes of this section,

    ``settlement'' means:

    (i) Payment and receipt of variation margin for futures, options,

    and swaps;

    (ii) Payment and receipt of option premiums;

    (iii) Deposit and withdrawal of initial margin for futures,

    options, and swaps;

    (iv) All payments due in final settlement of futures, options, and

    swaps on the final settlement date with respect to such positions; and

    (v) All other cash flows collected from or paid to each clearing

    member, including but not limited to, payments related to swaps such as

    coupon amounts.

    (2) Settlement bank. For purposes of this section, ``settlement

    bank'' means a bank that maintains an account either for the

    derivatives clearing organization or for any of its clearing members,

    which is used for the purpose of any settlement described in paragraph

    (a)(1) above.

    (b) Daily settlements. Except as otherwise provided by Commission

    order, a derivatives clearing organization shall effect a settlement

    with each clearing member at least once each business day, and shall

    have the authority and operational capacity to effect a settlement with

    each clearing member, on an intraday basis, either routinely, when

    thresholds specified by the derivatives clearing organization are

    breached, or in times of extreme market volatility.

    (c) Settlement banks. A derivatives clearing organization shall

    employ settlement arrangements that eliminate or strictly limit its

    exposure to settlement bank risks, including the credit and liquidity

    risks arising from the use of such bank(s) to effect settlements with

    its clearing members, as follows:

    (1) A derivatives clearing organization shall have documented

    criteria that must be met by any settlement bank used by the

    derivatives clearing organization or its clearing members, including

    criteria addressing the capitalization, creditworthiness, access to

    liquidity, operational reliability, and regulation or supervision of

    such bank(s).

    (2) A derivatives clearing organization shall monitor each approved

    settlement

    [[Page 69441]]

    bank on an ongoing basis to ensure that such bank continues to meet the

    criteria established pursuant to paragraph (c)(1) of this section.

    (3) A derivatives clearing organization shall monitor the full

    range and concentration of its exposures to its own and its clearing

    members' settlement bank(s) and assess its own and its clearing

    members' potential losses and liquidity pressures in the event that the

    settlement bank with the largest share of settlement activity were to

    fail. A derivatives clearing organization shall take any one or more of

    the following actions, to the extent that any such action or actions

    are reasonably necessary in order to eliminate or strictly limit such

    exposures:

    (i) Maintain settlement accounts at one or more additional

    settlement banks; and/or

    (ii) Approve one or more additional settlement banks that its

    clearing members could choose to use; and/or

    (iii) Impose concentration limits with respect to one or more of

    its own or its clearing members' settlement banks; and/or

    (iv) Take any other appropriate actions.

    (d) Settlement finality. A derivatives clearing organization shall

    ensure that settlements are final when effected by ensuring that it has

    entered into legal agreements that state that settlement fund transfers

    are irrevocable and unconditional no later than when the derivatives

    clearing organization's accounts are debited or credited; provided,

    however, a derivatives clearing organization's legal agreements with

    its settlement banks may provide for the correction of errors. A

    derivatives clearing organization's legal agreements with its

    settlement banks shall state clearly when settlement fund transfers

    will occur and a derivatives clearing organization shall routinely

    confirm that its settlement banks are effecting fund transfers as and

    when required by such legal agreements.

    (e) Recordkeeping. A derivatives clearing organization shall

    maintain an accurate record of the flow of funds associated with each

    settlement.

    (f) Netting arrangements. A derivatives clearing organization shall

    possess the ability to comply with each term and condition of any

    permitted netting or offset arrangement with any other clearing

    organization.

    (g) Physical delivery. With respect to products that are settled by

    physical transfers of the underlying instruments or commodities, a

    derivatives clearing organization shall:

    (1) Establish rules that clearly state each obligation that the

    derivatives clearing organization has assumed with respect to physical

    deliveries, including whether it has an obligation to make or receive

    delivery of a physical instrument or commodity, or whether it

    indemnifies clearing members for losses incurred in the delivery

    process; and

    (2) Ensure that the risks of each such obligation are identified

    and managed.

    Sec. 39.15 Treatment of funds.

    (a) Required standards and procedures. A derivatives clearing

    organization shall establish standards and procedures that are designed

    to protect and ensure the safety of funds and assets belonging to

    clearing members and their customers.

    (b) Segregation of funds and assets. (1) Segregation. A derivatives

    clearing organization shall comply with the applicable segregation

    requirements of section 4d of the Act and Commission regulations

    thereunder, or any other applicable Commission regulation or order

    requiring that customer funds and assets be segregated, set aside, or

    held in a separate account.

    (2) Commingling of futures, options, and swaps. (i) Cleared swaps

    account. In order for a derivatives clearing organization and its

    clearing members to commingle customer positions in futures, options,

    and swaps, and any money, securities, or property received to margin,

    guarantee or secure such positions, in an account subject to the

    requirements of section 4d(f) of the Act, the derivatives clearing

    organization shall file rules for Commission approval pursuant to Sec.

    40.5 of this chapter. Such rule submission shall include, at a minimum,

    the following:

    (A) Identification of the futures, options, and swaps that would be

    commingled, including product specifications or the criteria that would

    be used to define eligible futures, options, and swaps;

    (B) Analysis of the risk characteristics of the eligible products;

    (C) Identification of whether the swaps would be executed

    bilaterally and/or executed on a designated contract market and/or a

    swap execution facility;

    (D) Analysis of the liquidity of the respective markets for the

    futures, options, and swaps that would be commingled, the ability of

    clearing members and the derivatives clearing organization to offset or

    mitigate the risk of such futures, options, and swaps in a timely

    manner, without compromising the financial integrity of the account,

    and, as appropriate, proposed means for addressing insufficient

    liquidity;

    (E) Analysis of the availability of reliable prices for each of the

    eligible products;

    (F) A description of the financial, operational, and managerial

    standards or requirements for clearing members that would be permitted

    to commingle such futures, options, and swaps;

    (G) A description of the systems and procedures that would be used

    by the derivatives clearing organization to oversee such clearing

    members' risk management of any such commingled positions;

    (H) A description of the financial resources of the derivatives

    clearing organization, including the composition and availability of a

    guaranty fund with respect to the futures, options, and swaps that

    would be commingled;

    (I) A description and analysis of the margin methodology that would

    be applied to the commingled futures, options, and swaps, including any

    margin reduction applied to correlated positions, and any applicable

    margin rules with respect to both clearing members and customers;

    (J) An analysis of the ability of the derivatives clearing

    organization to manage a potential default with respect to any of the

    futures, options, or swaps that would be commingled;

    (K) A discussion of the procedures that the derivatives clearing

    organization would follow if a clearing member defaulted, and the

    procedures that a clearing member would follow if a customer defaulted,

    with respect to any of the commingled futures, options, or swaps in the

    account; and

    (L) A description of the arrangements for obtaining daily position

    data with respect to futures, options, and swaps in the account.

    (ii) Futures account. In order for a derivatives clearing

    organization and its clearing members to commingle customer positions

    in futures, options, and swaps, and any money, securities, or property

    received to margin, guarantee or secure such positions, in an account

    subject to the requirements of section 4d(a) of the Act, the

    derivatives clearing organization shall file with the Commission a

    petition for an order pursuant to section 4d(a) of the Act. Such

    petition shall include, at a minimum, the information required under

    paragraph (b)(2)(i) of this section.

    (iii) Commission action. (A) The Commission may request additional

    information in support of a rule submission filed under paragraph

    (b)(2)(i) of this section, and may grant approval of such rules in

    accordance with Sec. 40.5 of this chapter.

    (B) The Commission may request additional information in support of

    a

    [[Page 69442]]

    petition filed under paragraph (b)(2)(ii) of this section, and may

    issue an order under section 4d of the Act in its discretion.

    (c) Holding of funds and assets. A derivatives clearing

    organization shall hold funds and assets belonging to clearing members

    and their customers in a manner which minimizes the risk of loss or of

    delay in the access by the derivatives clearing organization to such

    funds and assets.

    (d) Transfer of customer positions. A derivatives clearing

    organization shall have rules providing that the derivatives clearing

    organization will promptly transfer all or a portion of a customer's

    portfolio of positions and related funds at the same time from the

    carrying clearing member of the derivatives clearing organization to

    another clearing member of the derivatives clearing organization,

    without requiring the close-out and re-booking of the positions prior

    to the requested transfer, subject to the following conditions:

    (1) The customer has instructed the carrying clearing member to

    make the transfer;

    (2) The customer is not currently in default to the carrying

    clearing member;

    (3) The transferred positions will have appropriate margin at the

    receiving clearing member;

    (4) Any remaining positions will have appropriate margin at the

    carrying clearing member; and

    (5) The receiving clearing member has consented to the transfer.

    (e) Permitted investments. Funds and assets belonging to clearing

    members and their customers that are invested by a derivatives clearing

    organization shall be held in instruments with minimal credit, market,

    and liquidity risks. Any investment of customer funds or assets by a

    derivatives clearing organization shall comply with Sec. 1.25 of this

    chapter, as if all such funds and assets comprise customer funds

    subject to segregation pursuant to section 4d(a) of the Act and

    Commission regulations thereunder.

    Sec. 39.16 Default rules and procedures.

    (a) General. A derivatives clearing organization shall adopt rules

    and procedures designed to allow for the efficient, fair, and safe

    management of events during which clearing members become insolvent or

    default on the obligations of such clearing members to the derivatives

    clearing organization.

    (b) Default management plan. A derivatives clearing organization

    shall maintain a current written default management plan that

    delineates the roles and responsibilities of its board of directors,

    its risk management committee, any other committee that a derivatives

    clearing organization may have that has responsibilities for default

    management, and the derivatives clearing organization's management, in

    addressing a default, including any necessary coordination with, or

    notification of, other entities and regulators. Such plan shall address

    any differences in procedures with respect to highly liquid products

    and less liquid products. A derivatives clearing organization shall

    conduct and document a test of its default management plan at least on

    an annual basis.

    (c) Default procedures. (1) A derivatives clearing organization

    shall adopt procedures that would permit the derivatives clearing

    organization to take timely action to contain losses and liquidity

    pressures and to continue meeting its obligations in the event of a

    default on the obligations of a clearing member to the derivatives

    clearing organization.

    (2) A derivatives clearing organization shall adopt rules that set

    forth its default procedures, including:

    (i) The derivatives clearing organization's definition of a

    default;

    (ii) The actions that the derivatives clearing organization may

    take upon a default, which shall include the prompt transfer,

    liquidation, or hedging of the customer or house positions of the

    defaulting clearing member, as applicable, and which may include, in

    the discretion of the derivatives clearing organization, the auctioning

    or allocation of such positions to other clearing members;

    (iii) Any obligations that the derivatives clearing organization

    imposes on its clearing members to participate in auctions, or to

    accept allocations, of the customer or house positions of the

    defaulting clearing member, provided that:

    (A) The derivatives clearing organization shall permit a clearing

    member to outsource to a qualified third party, authority to act in the

    clearing member's place in any auction, subject to appropriate

    safeguards imposed by the derivatives clearing organization;

    (B) The derivatives clearing organization shall permit a clearing

    member to outsource to a qualified third party, authority to act in the

    clearing member's place in any allocations, subject to appropriate

    safeguards imposed by the derivatives clearing organization; and

    (C) Any allocation shall be proportional to the size of the

    participating or accepting clearing member's positions in the same

    product class at the derivatives clearing organization;

    (iv) The sequence in which the funds and assets of the defaulting

    clearing member and its customers and the financial resources

    maintained by the derivatives clearing organization would be applied in

    the event of a default;

    (v) A provision that the funds and assets of a defaulting clearing

    member's customers shall not be applied to cover losses with respect to

    a house default;

    (vi) A provision that the excess house funds and assets of a

    defaulting clearing member shall be applied to cover losses with

    respect to a customer default, if the relevant customer funds and

    assets are insufficient to cover the shortfall; and

    (3) A derivatives clearing organization shall make its default

    rules publicly available as provided in Sec. 39.21 of this part.

    (d) Insolvency of a clearing member.

    (1) A derivatives clearing organization shall adopt rules that

    require a clearing member to provide prompt notice to the derivatives

    clearing organization if it becomes the subject of a bankruptcy

    petition, receivership proceeding, or the equivalent;

    (2) No later than upon receipt of such notice, a derivatives

    clearing organization shall review the continuing eligibility of the

    clearing member for clearing membership; and

    (3) No later than upon receipt of such notice, a derivatives

    clearing organization shall take any appropriate action, in its

    discretion, with respect to such clearing member or its house or

    customer positions, including but not limited to liquidation or

    transfer of positions, suspension, or revocation of clearing

    membership.

    Sec. 39.17 Rule enforcement.

    (a) General. Each derivatives clearing organization shall:

    (1) Maintain adequate arrangements and resources for the effective

    monitoring and enforcement of compliance with the rules of the

    derivatives clearing organization and the resolution of disputes;

    (2) Have the authority and ability to discipline, limit, suspend,

    or terminate the activities of a clearing member due to a violation by

    the clearing member of any rule of the derivatives clearing

    organization; and

    (3) Report to the Commission regarding rule enforcement activities

    and sanctions imposed against clearing members as provided in paragraph

    (a) (2) of this section, in accordance with Sec. 39.19(c)(4)(xi) of

    this part.

    (b) Authority to enforce rules. The board of directors of the

    derivatives clearing organization may delegate responsibility for

    compliance with the requirements of paragraph (a) of this

    [[Page 69443]]

    section to the risk management committee, unless the responsibilities

    are otherwise required to be carried out by the chief compliance

    officer pursuant to the Act or this part.

    Sec. 39.18 System safeguards.

    (a) Definitions. For purposes of this section:

    Recovery time objective means the time period within which an

    entity should be able to achieve recovery and resumption of clearing

    and settlement of existing and new products, after those capabilities

    become temporarily inoperable for any reason up to or including a wide-

    scale disruption.

    Relevant area means the metropolitan or other geographic area

    within which a derivatives clearing organization has physical

    infrastructure or personnel necessary for it to conduct activities

    necessary to the clearing and settlement of existing and new products.

    The term ``relevant area'' also includes communities economically

    integrated with, adjacent to, or within normal commuting distance of

    that metropolitan or other geographic area.

    Wide-scale disruption means an event that causes a severe

    disruption or destruction of transportation, telecommunications, power,

    water, or other critical infrastructure components in a relevant area,

    or an event that results in an evacuation or unavailability of the

    population in a relevant area.

    (b) General--(1) Program of risk analysis. Each derivatives

    clearing organization shall establish and maintain a program of risk

    analysis and oversight with respect to its operations and automated

    systems to identify and minimize sources of operational risk through:

    (i) The development of appropriate controls and procedures; and

    (ii) The development of automated systems that are reliable,

    secure, and have adequate scalable capacity.

    (2) Resources. Each derivatives clearing organization shall

    establish and maintain resources that allow for the fulfillment of each

    obligation and responsibility of the derivatives clearing organization

    in light of the risks identified pursuant to paragraph (b)(1) of this

    section.

    (3) Verification of adequacy. Each derivatives clearing

    organization shall periodically verify that resources described in

    paragraph (b)(2) of this section are adequate to ensure daily

    processing, clearing, and settlement.

    (c) Elements of program. A derivatives clearing organization's

    program of risk analysis and oversight with respect to its operations

    and automated systems, as described in paragraph (b) of this section,

    shall address each of the following categories of risk analysis and

    oversight:

    (1) Information security;

    (2) Business continuity and disaster recovery planning and

    resources;

    (3) Capacity and performance planning;

    (4) Systems operations;

    (5) Systems development and quality assurance; and

    (6) Physical security and environmental controls.

    (d) Standards for program. In addressing the categories of risk

    analysis and oversight required under paragraph (c) of this section, a

    derivatives clearing organization shall follow generally accepted

    standards and industry best practices with respect to the development,

    operation, reliability, security, and capacity of automated systems.

    (e) Business continuity and disaster recovery. (1) Plan and

    resources. A derivatives clearing organizat