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2013-07970

  • Federal Register, Volume 78 Issue 70 (Thursday, April 11, 2013)[Federal Register Volume 78, Number 70 (Thursday, April 11, 2013)]

    [Rules and Regulations]

    [Pages 21749-21785]

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

    [FR Doc No: 2013-07970]

    [[Page 21749]]

    Vol. 78

    Thursday,

    No. 70

    April 11, 2013

    Part III

    Commodity Futures Trading Commission

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    17 CFR Part 50

    Clearing Exemption for Swaps Between Certain Affiliated Entities; Final

    Rule

    Federal Register / Vol. 78 , No. 70 / Thursday, April 11, 2013 /

    Rules and Regulations

    [[Page 21750]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 50

    RIN 3038-AD47

    Clearing Exemption for Swaps Between Certain Affiliated Entities

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Final rule.

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    SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)

    is adopting regulations to exempt swaps between certain affiliated

    entities within a corporate group from the clearing requirement under

    the Commodity Exchange Act (CEA or Act), enacted by Title VII of the

    Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank

    Act). The regulations include specific conditions, as well as reporting

    requirements, that affiliated entities must satisfy in order to elect

    the inter-affiliate exemption from required clearing.

    DATES: This final rule is effective June 10, 2013.

    FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director,

    202-418-5684, sjosephson@cftc.gov; Nadia Zakir, Associate Director,

    202-418-5720, nzakir@cftc.gov; Eric Lashner, Special Counsel, 202-418-

    5393, elashner@cftc.gov; Meghan Tente, Law Clerk, 202-418-5785,

    mtente@cftc.gov; Division of Clearing and Risk, Erik Remmler, Associate

    Director, 202-418-7630, eremmler@cftc.gov; Camden Nunery, Economist,

    202-418-5723, cnunery@cftc.gov, Office of the Chief Economist,

    Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

    Street NW., Washington, DC 20581.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Background

    II. Comments on the Notice of Proposed Rulemaking

    A. Overview of Comments Received

    B. Section 4(c) Authority

    C. Definition of Affiliate Status

    D. Inter-Affiliate Swap Documentation

    E. Centralized Risk Management Program

    F. Variation Margin

    G. Treatment of Outward-Facing Swaps and Relief

    H. Reporting Requirements and Annual Election

    I. Implementation

    III. Cost-Benefit Considerations

    A. Statutory and Regulatory Background

    B. Costs and Benefits of Exemption for Eligible Affiliate

    Counterparties

    C. Costs and Benefits of Exemption's Conditions

    D. Costs and Benefits to Market Participants and the Public

    E. Costs and Benefits Compared to Alternatives

    F. Consideration of CEA Section 15(a) Factors

    IV. Related Matters

    A. Regulatory Flexibility Act

    B. Paperwork Reduction Act

    I. Background

    On August 21, 2012, the Commission published a notice of proposed

    rulemaking proposing to exempt swaps between certain affiliated

    entities from the clearing requirement under section 2(h)(1)(A) of the

    CEA (NPRM).\1\ As proposed, Sec. 39.6(g) provides that counterparties

    to a swap may elect an inter-affiliate exemption from the clearing

    requirement if: (1) The financial statements of both counterparties are

    reported on a consolidated basis, and either one counterparty directly

    or indirectly holds a majority ownership interest in the other, or a

    third party directly or indirectly holds a majority ownership interest

    in both counterparties; (2) both counterparties comply with the

    conditions set forth in the proposed rule; and (3) one of the

    counterparties provides certain information on behalf of both

    affiliated counterparties to either a registered swap data repository

    (SDR) or the Commission if a registered SDR does not accept the

    information. The Commission is hereby adopting proposed Sec. 39.6(g),

    finalized as Sec. 50.52,\2\ subject to the changes discussed below.

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    \1\ Clearing Exemption for Swaps Between Certain Affiliated

    Entities, 77 FR 50425 (Aug. 21, 2012).

    \2\ For ease of reference, the Commission is re-codifying

    proposed Sec. 39.6(g) as Sec. 50.52 so that market participants

    are able to locate all rules related to the clearing requirement in

    one part of the Code of Federal Regulations.

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    Section 723(a)(3) of the Dodd-Frank Act amended the CEA to provide,

    under new section 2(h)(1)(A) of the CEA, that it shall be unlawful for

    any person to engage in a swap unless that person submits such swap for

    clearing to a derivatives clearing organization (DCO) that is

    registered under the CEA or a DCO that is exempt from registration

    under the CEA if the swap is required to be cleared.\3\ Section 2(h)(2)

    of the CEA charges the Commission with the responsibility for

    determining whether a swap is required to be cleared, through one of

    two means: (1) Pursuant to a Commission-initiated review; or (2)

    pursuant to a submission from a DCO of each swap, or any group,

    category, type, or class of swaps that the DCO ``plans to accept for

    clearing.'' On November 29, 2012, the Commission adopted its first

    clearing requirement determination, requiring that swaps meeting the

    specifications outlined in four classes of interest rate swaps and two

    classes of credit default swaps (CDS) are required to be cleared.\4\

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    \3\ Section 2(h)(7) of the CEA provides an exception to the

    clearing requirement when one of the counterparties to a swap (i) is

    not a financial entity, (ii) is using the swap to hedge or mitigate

    commercial risk, and (iii) notifies the Commission how it generally

    meets its financial obligations associated with entering into a non-

    cleared swap.

    \4\ Clearing Requirement Determination Under Section 2(h) of the

    CEA, 77 FR 74284 (Dec. 13, 2012) (hereinafter ``Clearing Requirement

    Determination'').

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    The Clearing Requirement Determination adopting release provided a

    specific compliance schedule for market participants to bring their

    swaps into compliance with the clearing requirement.\5\ Swap dealers

    (SDs), major swap participants (MSPs), and private funds active in the

    swaps market were required to comply beginning on March 11, 2013, for

    swaps they enter into on or after that date.\6\ Accounts managed by

    third-party investment managers, as well as ERISA pension plans, have

    until September 9, 2013, to begin clearing swaps entered into on or

    after that date. All other financial entities are required to clear

    swaps beginning on June 10, 2013, for swaps entered into on or after

    that date. With regard to the CDS indices on European corporate names,

    iTraxx, the Clearing Requirement Determination provided that, if no DCO

    offered iTraxx for client clearing by February 11, 2013, the Commission

    would delay compliance for those swaps until 60 days after an eligible

    DCO offers iTraxx indices for client clearing. On February 25, 2013,

    the Commission received notice from ICE Clear Credit LLC that it had

    begun offering customer clearing of the iTraxx CDS indices that are

    subject to the clearing requirement under Sec. 50.4(b). In accordance

    with the timeframe previously set forth by the Commission,\7\ the

    following compliance

    [[Page 21751]]

    dates shall apply to the clearing of iTraxx indices: Category 1

    Entities: Friday, April 26, 2013; Category 2 Entities: Thursday, July

    25, 2013; and all other entities: Wednesday, October 23, 2013.\8\

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    \5\ See Clearing Requirement Determination at 74319-21.

    \6\ The first compliance date for required clearing applies to

    Category 1 Entities, as defined in Sec. 50.25(a). SDs and MSPs and

    private funds active in the swaps market are defined as Category 1

    Entities. Security-based swap dealers and major security-based

    participants also are included in the definition. However, as the

    Commission has stated, if a security-based swap dealer or a major

    security-based swap participant is not yet required to register with

    the Securities and Exchange Commission (SEC) at such time as the

    Commission issues a clearing determination, then the security-based

    swap dealer or a major security-based swap participant would be

    treated as a Category 2 Entity, as defined in Sec. 50.25(a). See

    Swap Transaction Compliance Implementation Schedule: Clearing and

    Trade Execution Requirements under Section 2(h) of the CEA, 76 FR

    58186, 58190 n.38 (Sept. 20, 2011).

    \7\ Clearing Requirement Determination at 74319-21.

    \8\ See Press Release, CFTC's Division of Clearing and Risk

    Announces Revised Compliance Schedule for Required Clearing of

    iTraxx CDS Indices (Feb. 25, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6521-13.

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    II. Comments on the Notice of Proposed Rulemaking

    The Commission received 13 comments during the 30-day public

    comment period following publication of the NPRM on August 21, 2012,

    and one additional comment after the comment period ended. The

    Commission considered each of these comments in formulating the final

    regulation, Sec. 39.6(g) (finalized as Sec. 50.52).

    During the process of proposing and finalizing this rule, the

    Chairman and Commissioners, as well as Commission staff, participated

    in informational meetings with market participants, trade associations,

    public interest groups, and other interested parties. In addition, the

    Commission has consulted with other U.S. financial regulators

    including: (i) The SEC; (ii) the Board of Governors of the Federal

    Reserve System; (iii) the Office of the Comptroller of the Currency;

    and (iv) the Federal Deposit Insurance Corporation (FDIC). Staff from

    each of these agencies has had the opportunity to provide oral and/or

    written comments to this adopting release, and the final regulations

    incorporate elements of the comments provided.

    The Commission is mindful of the benefits of harmonizing its

    regulatory framework with that of its counterparts in foreign

    countries. The Commission has therefore monitored global advisory,

    legislative, and regulatory proposals, and has consulted with foreign

    authorities in developing the final regulations.

    A. Overview of Comments Received

    Of the 14 comment letters received by the Commission in response to

    its NPRM, ten commenters expressed general support for the concept of

    an inter-affiliate exemption from the clearing requirement.\9\ These

    commenters offered comments addressing the proposed rule generally and

    comments addressing specific provisions of the proposed rule. Comments

    addressing specific provisions of the proposed rule are discussed in

    detail below.

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    \9\ Cravath, Swaine & Moore LLP (Cravath), the Coalition for

    Derivatives End-Users (CDEU), the Financial Services Roundtable

    (FSR), Chris Barnard, the Commercial Energy Working Group (The

    Working Group), the Edison Electric Institute (EEI), The Prudential

    Insurance Company of America (Prudential), Metropolitan Life

    Insurance Company (MetLife), the International Swaps and Derivatives

    Association and Securities Industry and Financial Markets

    Association, (together, ISDA & SIFMA), and DLA Piper.

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    A number of commenters requested a broader exemption with few or no

    conditions. Cravath and DLA Piper requested that the Commission exempt

    swaps between affiliates from all clearing, margining, and reporting

    obligations. The Working Group, Cravath, CDEU, ISDA & SIFMA, DLA Piper,

    and EEI \10\ recommended that the Commission eliminate, simplify or

    minimize the conditions imposed, or unconditionally exempt inter-

    affiliate swaps from clearing. These commenters stated that inter-

    affiliate swaps pose little or no risk to the U.S. financial system and

    do not increase the interconnectedness between major financial

    institutions, particularly if affiliates' financial statements are

    consolidated for accounting purposes. The Working Group commented that

    entities use inter-affiliate trades not only to net risk related to

    market-facing swaps, but also to transfer physical commodity or futures

    exposure between affiliates for compliance with international tax law,

    customs, or accounting laws. Similarly, MetLife and Prudential

    supported the proposed exemption and noted that transactions between

    affiliates do not present the same risks as market-facing swaps.

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    \10\ EEI commented that ``corporate families typically face

    bankruptcy together'' and that it is ``unusual for only one member

    of a corporate group to go bankrupt.'' EEI also noted that a

    bankruptcy could cause increased risk to clearinghouses that would

    face multiple entities going into default at the same time if all

    affiliates of one corporate group were required to clear their

    inter-affiliate swaps.

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    ISDA & SIFMA commented that inter-affiliate swaps provide important

    benefits to corporate groups by enabling centralized management of

    market, liquidity, capital, and other risks, and allowing affiliated

    groups to realize associated hedging efficiencies and netting benefits.

    Imposing mandatory clearing on inter-affiliate swaps, according to ISDA

    & SIFMA, could compromise the ability of affiliated groups to realize

    these benefits.\11\ ISDA & SIFMA also commented that third parties face

    no increased risk from inter-affiliate swaps. In their view, the credit

    risks faced by a third party entering into an uncleared swap with a

    group member are a function of the group member's entire portfolio of

    assets and liabilities and other credit factors.

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    \11\ ISDA & SIFMA commented that inter-affiliate swaps do not

    introduce risk into a corporate group, stating, ``[b]ecause capital,

    liquidity and risk allocation decisions, as well as the exercise of

    default remedies between group members are under unified management,

    group entities do not face default risk of other group entities, so

    long as the group as a whole is solvent.''

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    Along the same lines, CDEU commented that non-financial entities

    typically enter into external swaps with swap dealers and other large

    banks that typically evaluate the risks of entering into swaps based on

    the overall creditworthiness of their counterparties. These financial

    entity counterparties, according to CDEU, have the opportunity to

    review financial statements, the creditworthiness of any guarantor, and

    a number of other credit-related items. After the credit review,

    according to CDEU, the counterparties may request credit risk mitigants

    such as corporate parent guarantees, collateral, and credit-based legal

    terms.

    On the other hand, Americans for Financial Reform (AFR) commented

    that a wide-ranging exemption for inter-affiliate swaps could create

    systemic risk and threaten the U.S. financial system. AFR cited a

    number of reasons for its concern such as: the risk transfer between

    separate corporate entities; the possibility for financial contagion to

    be transferred from one part of a large financial institution to

    different groups within the institution; restrictions on access to

    affiliate assets across national boundaries; and reduction in volumes

    at DCOs that could hurt liquidity and risk management. AFR further

    noted that because the end-user exception is available for non-

    financial and small financial entities in connection with swaps that

    hedge or mitigate systemic risk, the inter-affiliate exemption is

    primarily available for large financial institutions and speculative

    trades by large commercial institutions with many affiliates.

    Better Markets Inc. (Better Markets) also expressed concern that an

    inter-affiliate exemption could be contrary to Congressional intent, as

    expressed in the Dodd-Frank Act, if it is not a very narrow and

    strictly implemented exemption.

    Two individual persons commented against the proposed exemption.

    Steve Wentz requested that the Commission not issue any exemptions

    because the exemptions ``would just open the door to divert trades

    through that open door to avoid protective oversight.'' Aaron D. Small

    commented that the ``unregulated derivatives market has been a disaster

    for the U.S. and world economy and must be reined in.''

    Having considered these comments, and the specific comments

    discussed below, the Commission is adopting the

    [[Page 21752]]

    proposed inter-affiliate exemption rule, subject to several important

    modifications. The Commission recognizes the need for an exemption from

    clearing for inter-affiliate swaps, but believes it is important to

    establish certain conditions for entities electing the exemption. In

    reaching this conclusion, the Commission considered the benefits of

    clearing as recognized by the fact that Congress included a clearing

    requirement in the Dodd-Frank Act, against the benefit to market

    participants of being able to continue entering into inter-affiliate

    swaps on an uncleared basis. The Commission believes it has reached an

    appropriate balance by allowing an exemption from required clearing for

    certain inter-affiliate swaps while imposing necessary conditions on

    that exemption in order to ensure that all inter-affiliate swaps

    exempted from required clearing meet certain risk-mitigating

    conditions.

    1. Benefits of Clearing and Its Role in the Dodd-Frank Act

    As the Commission has previously stated,\12\ in the fall of 2008, a

    series of large financial institution failures triggered a financial

    and economic crisis that led to unprecedented governmental intervention

    to ensure the stability of the U.S. financial system. The financial

    crisis made clear that an uncleared, over-the-counter (OTC) derivatives

    market can pose significant risks to the U.S. financial system.\13\

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    \12\ See Clearing Requirement Determination at 74284-86; Cross-

    Border Application of Certain Swaps Provisions of the Commodity

    Exchange Act, 77 FR 41214, 41215-17 (July 12, 2012) (hereinafter

    ``Proposed Cross-Border Interpretive Guidance'').

    \13\ See Financial Crisis Inquiry Commission, ``The Financial

    Crisis Inquiry Report: Final Report of the National Commission on

    the Causes of the Financial and Economic Crisis in the United

    States,'' Jan. 2011, at 386, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (``The scale and nature of the [OTC]

    derivatives market created significant systemic risk throughout the

    financial system and helped fuel the panic in the fall of 2008:

    millions of contracts in this opaque and deregulated market created

    interconnections among a vast Web of financial institutions through

    counterparty credit risk, thus exposing the system to a contagion of

    spreading losses and defaults.'').

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    One of the most significant examples of this risk was the

    accumulation of uncleared CDS entered into by an affiliate in the AIG

    corporate group providing default protection on more than $440 billion

    in bonds, leaving it with obligations that the AIG corporate family

    could not cover as a result of changed market conditions.\14\ As a

    result of the CDS exposure of this one affiliate, the U.S. Federal

    government bailed out the AIG corporate group with over $180 billion of

    taxpayer money in order to prevent AIG's failure and a possible

    contagion event in the broader economy.\15\ While the downfall of AIG

    was not caused by inter-affiliate swaps, the events surrounding AIG

    during the 2008 crisis demonstrate how the risks of uncleared swaps at

    one affiliate can have significant ramifications for the entire

    affiliated business group.

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    \14\ Adam Davidson, ``How AIG fell apart,'' Reuters, Sept. 18,

    2008, available at http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918.

    \15\ Hugh Son, ``AIG's Trustees Shun `Shadow Board,' Seek

    Directors,'' Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.

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    Recognizing the peril that the U.S. financial system faced during

    the financial crisis, Congress and the President came together to pass

    the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes

    a comprehensive new regulatory framework for swaps, and the requirement

    that certain swaps be cleared by DCOs is one of the cornerstones of

    that reform. The CEA, as amended by Title VII, now requires a swap to

    be cleared through a DCO if the Commission has determined that the

    swap, or group, category, type, or class of swaps, is required to be

    cleared, unless an exception to the clearing requirement applies. As

    noted above, the only exception to the clearing requirement provided by

    Congress was the end-user exception in section 2(h)(7) of the CEA.\16\

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    \16\ Congress did not provide for an exception or exemption for

    inter-affiliate swaps in the Dodd-Frank Act. However, commenters

    have pointed to legislative history and statements made by members

    of Congress supporting such an exemption at the time the Dodd-Frank

    Act was enacted.

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    The benefits of clearing derivatives have been recognized

    internationally, as well. In September 2009, leaders of the Group of 20

    (G-20)--whose membership includes the United States, the European

    Union, and 18 other countries--agreed that: (1) OTC derivatives

    contracts should be reported to trade repositories; (2) all

    standardized OTC derivatives contracts should be cleared through

    central counterparties by the end of 2012; and (3) non-centrally

    cleared contracts should be subject to higher capital requirements.

    The Commission believes that required clearing through a DCO is the

    best means of mitigating counterparty credit risk and providing an

    organized mechanism for collateralizing the risk exposures posed by

    swaps. By clearing a swap, each counterparty no longer needs to rely on

    the individual creditworthiness of the other counterparty for payment.

    Both original counterparties now look to the DCO that has cleared their

    swap to ensure that the payment obligations associated with the swap

    are fulfilled. The DCO manages the risk of failure of a counterparty

    through appropriate margining, a mutualized approach to default

    management among clearinghouse members, and other risk management

    mechanisms that have been developed over the more than 100 years that

    modern clearinghouses have been in operation. Clearing can avert the

    development of systemic risk by reducing the potential knock-on, or

    domino, effect resulting from counterparties with large outstanding

    exposures defaulting on their swap obligations and causing their

    counterparties--counterparties that would otherwise be financially

    sound if they had been paid--to default. Failure of those

    counterparties could lead to the failure of yet other counterparties,

    cascading through the economy and potentially causing systemic harm to

    the U.S. financial system. Required clearing reduces this risk by

    ensuring that uncollateralized risk does not accumulate in the

    financial system.

    2. Risks and Benefits Posed by Inter-affiliate Swaps

    The Commission is not persuaded by comments suggesting that inter-

    affiliate swaps pose no risk to the financial system or that clearing

    would not mitigate those risks. Entities that are affiliated with each

    other are separate legal entities notwithstanding their affiliation. As

    separate legal entities, affiliates generally are not legally

    responsible for each other's contractual obligations. This legal

    reality becomes readily apparent when one or more affiliates become

    insolvent.\17\ Affiliates, as separate legal entities, are managed in

    bankruptcy as separate estates and the trustee for each debtor estate

    has a duty to the creditors of the affiliate, not the corporate family,

    the parent of the affiliates, or the corporate family's creditors.\18\

    This potential for separate

    [[Page 21753]]

    treatment in bankruptcy, calls into question commenters' claims that

    third parties can rely on the creditworthiness of the entire corporate

    group when entering into swaps with affiliates.

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    \17\ Note, for example, that while the Rule 1015 of the Federal

    Rules of Bankruptcy Procedure (FRBP) permits a court to consolidate

    bankruptcy cases between a debtor and affiliates, FRBP Rule 2009

    provides that, among other things, if the court orders a joint

    administration of two or more estates under FRBP Rule 1015, the

    trustee shall keep separate accounts of the property and

    distribution of each estate. See Federal Rules of Bankruptcy

    Procedure (2011).

    \18\ See In re L & S Indus., Inc., 122 B.R. 987, 993-994 (Bankr.

    N.D. Ill. 1991), aff'd 133 B.R. 119, aff'd 989 F.2d 929 (7th Cir.

    1993) (``A trustee in bankruptcy represents the interests of the

    debtor's estate and its creditors, not interests of the debtor's

    principals, other than their interests as creditors of estate.'');

    In re New Concept Housing, Inc., 951 F.2d 932, 938 (8th Cir. 1991)

    (quoting In re L & S Indus., Inc.). While the concept of

    ``substantive consolidation'' of affiliates in a business enterprise

    when they all enter into bankruptcy is sometimes used by a

    bankruptcy court, substantive consolidation is generally considered

    an extraordinary remedy to be used in limited circumstances. See

    Substantive Consolidation--A Post-Modern Trend, 14 Am. Bankr. Inst.

    L. Rev. 527 (Winter 2006).

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    On the other hand, inter-affiliate swaps offer certain risk-

    mitigating, hedging, and netting benefits as described by several

    commenters including ISDA & SIFMA, The Working Group, CDEU, and EEI.

    Furthermore, because affiliates in a corporate family generally

    internalize the risks of inter-affiliate transactions in the affiliated

    group, as described in the NPRM, the corporate family could face

    serious reputational harm if affiliates default on their swaps.

    Consequently, the entities within an affiliated group are incentivized

    to fulfill their inter-affiliate swap obligations to each other, to

    support each other to prevent outward-facing failures, and to resolve

    any disagreements about the terms of inter-affiliate swaps more quickly

    and amicably. As noted by ISDA & SIFMA, when an affiliated business

    group is fiscally sound, the capital, liquidity, and risk allocation

    decisions and default remedies between group members may be centrally

    managed thereby reducing the likelihood of group entities facing

    default risk of other group entities, ``so long as the group as a whole

    is solvent.''

    While in many circumstances, these characteristics of inter-

    affiliate swaps may mitigate the risk of an affiliate defaulting on its

    obligations--particularly when the group as a whole is financially

    healthy--they do not constitute legally enforceable obligations pre-

    bankruptcy or in bankruptcy.\19\ Accordingly, despite the existence of

    mutual support incentives, a corporate group facing insolvency risk may

    ultimately make the decision to allow some affiliates to fail and

    default on their swap obligations so that other affiliates can survive

    without becoming insolvent.\20\ In cases where an insolvent affiliate

    has multiple obligations to third parties (swap-related or otherwise),

    those third parties may be subject to a pro rata distribution along

    with other creditors if the trust estate of the defaulting affiliate

    does not have sufficient liquid assets to cover losses on its uncleared

    swaps. It is at such times of financial stress that central clearing

    serves as the most effective systemic risk mitigant.

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    \19\ See Bankrupt Subsidiaries: The Challenges to the Parent of

    Legal Separation, 25 Emory Bankr. Dev. J. 65 (2008); Liability of a

    Parent Corporation for the Obligations of an Insolvent Subsidiary

    Under American Case Law and Argentine Law, 10 Am. Bankr. Inst. L.

    Rev. 217 (Spring 2002).

    \20\ See, e.g., the bankruptcy of Residential Capital (ResCap)

    and its subsidiaries. ResCap was a mortgage subsidiary of Ally

    Financial Inc. ResCap declared bankruptcy independent of Ally

    Financial Inc., which is not part of the bankruptcy proceeding and

    continues to operate as a legally separate, solvent entity. See In

    re Residential Capital, LLC, No. 12-12020 (MG) (Bankr. S.D.N.Y.

    2012), available at http://www.kccllc.net/rescap. While the

    bankruptcy of ResCap was not the direct result of inter-affiliate

    swaps, ResCap's bankruptcy demonstrates that an affiliate can be put

    into bankruptcy without forcing the affiliated parent to declare

    bankruptcy or to be legally responsible for the affiliate's debts.

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    3. The Commission's Consideration of the Risks and Benefits

    In providing an inter-affiliate exemption from required clearing,

    the Commission has considered the benefits that inter-affiliate swaps

    offer corporate groups against the risk of allowing an exemption from

    required clearing for swaps entered into by separate, but affiliated,

    legal entities. In considering the risks and benefits, the Commission

    was guided, in part, by comments pointing to the risk-mitigating

    characteristics of inter-affiliate swaps and the sound risk management

    practices of corporate groups that rely on inter-affiliate swaps. In

    crafting the rule, the Commission sought to codify these

    characteristics as eligibility criteria, or conditions, for the

    exemption from required clearing. The conditions imposed are designed

    to increase the likelihood that affiliates will take into consideration

    their mutual interests when entering into, and fulfilling, their inter-

    affiliate swap obligations. For example, the inter-affiliate exemption

    may be elected only if the affiliates are majority owned and their

    financial statements are consolidated, thereby increasing the

    likelihood that entities will be mutually obligated to meet the group's

    swap obligations. Additionally, the affiliates must be subject to a

    centralized risk management program, the swaps and the trading

    relationship between affiliates must be documented, and outward-facing

    swaps must be cleared or subject to an exemption or exception from

    clearing.

    Despite the conditions to the exemption adopted in this final rule,

    the Commission reminds market participants that the conditions included

    in the final rule do not mitigate potential losses between inter-

    affiliates to the extent that clearing would, particularly if one or

    more affiliated entities become insolvent.

    B. Section 4(c) Authority

    Section 4(c)(1) of the CEA grants the Commission the authority to

    exempt any transaction or class of transactions, including swaps, from

    certain provisions of the CEA, including the clearing requirement, in

    order to ``promote responsible economic or financial innovation and

    fair competition.'' Section 4(c)(2) of the Act further provides that

    the Commission may not grant exemptive relief unless it determines

    that: (1) The exemption is appropriate for the transaction and

    consistent with the public interest; (2) the exemption is consistent

    with the purposes of the CEA; (3) the transaction will be entered into

    solely between ``appropriate persons''; and (4) the exemption will not

    have a material adverse effect on the ability of the Commission or any

    contract market to discharge its regulatory or self-regulatory

    responsibilities under the CEA.\21\ In enacting section 4(c), Congress

    noted that the purpose of the provision is to give the Commission a

    means of providing certainty and stability to existing and emerging

    markets so that financial innovation and market development can proceed

    in an effective and competitive manner.\22\

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

    \21\ 7 U.S.C. 6(c)(2).

    \22\ House Conf. Report No. 102-978, 1992 U.S.C.C.A.N. 3179,

    3213.

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

    In the NPRM, the Commission requested comment as to whether

    exempting inter-affiliate swaps from the clearing requirement under

    certain terms and conditions would be an appropriate exercise of its

    section 4(c) authority.\23\ A number of commenters supported the

    Commission's use of its section 4(c) authority to exempt inter-

    affiliate swaps from clearing. According to MetLife and Prudential, the

    inter-affiliate exemption as proposed promotes responsible economic or

    financial innovation and fair competition by allowing corporate groups

    to use inter-affiliate swaps to engage in effective and efficient risk

    management activities. As an example, MetLife and Prudential explained

    that corporate groups can use a single conduit in the market on behalf

    of multiple affiliates within the group, which permits the corporate

    group to net affiliates' trades. This netting effectively reduces the

    overall risk of the corporate group and the number of open positions

    with external market participants, which in turn reduces operational,

    market, counterparty credit, and settlement risk. MetLife and

    Prudential both expressed the view that inter-affiliate swaps do not

    pose risks to

    [[Page 21754]]

    corporate groups and third parties, and both stated that inter-

    affiliate swaps may pose less risk to corporate groups given efficient

    netting across the corporate group. EEI also supported the Commission's

    use of its section 4(c) authority for similar reasons to those stated

    by MetLife and Prudential.

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

    \23\ See NPRM at 50428.

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

    ISDA & SIFMA stated that the Commission's proposed exemption meets

    the requirements of section 4(c) of the CEA by promoting innovation and

    competition, and the exemption serves the public interest. ISDA & SIFMA

    noted that inter-affiliate swaps are integral to the strategies

    consolidated financial institutions rely upon to meet customer needs in

    an efficient, competitive, and sound manner. According to ISDA & SIFMA,

    inter-affiliate swaps maximize hedging efficiencies and allow customers

    to transact with a single client-facing entity in the customer's

    jurisdiction, which increases the scope of risk-reducing netting with

    individual customers as well as risk-reducing netting of offsetting

    positions within the financial group. This allows the institution to

    meet customer needs across jurisdictions and provide improved pricing

    or other risk management benefits to customers, thereby promoting

    financial innovation and competition. ISDA & SIFMA also commented that

    inter-affiliate swaps allocate and transfer risks among members of a

    corporate group rather than increasing risks.

    CDEU also supported the Commission's use of its section 4(c)

    authority. CDEU stated that the inter-affiliate exemption would promote

    financial innovation, fair competition, and the public interest by

    preserving the ability of corporate entities to centrally hedge the

    risks of their affiliates. CDEU stated that without such an exemption

    firms that currently use a central hedging model will be disadvantaged

    as compared to direct competitors that do not use the same, efficient

    risk management model. CDEU also noted the additional costs that would

    be incurred from subjecting inter-affiliate swaps to clearing.

    In the NPRM, the Commission requested comments on whether the

    inter-affiliate exemption would be in the public interest. In addition

    to responses noted above with regard to the public interest,\24\ the

    Commission received two comment letters questioning whether the

    proposed exemption serves the public interest.

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

    \24\ As noted above, CDEU, MetLife, Prudential, and ISDA & SIFMA

    stated that an inter-affiliate exemption is consistent with the

    public interest.

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

    According to AFR, there are serious doubts about whether the inter-

    affiliate exemption is in the public interest. AFR stated that any

    hedging and netting benefits gained from corporate groups engaging in

    inter-affiliate swaps must be weighed against the benefits of full

    novation to a central counterparty in the form of a clearinghouse,

    which is a more comprehensive level of risk management. Given the

    experience of the 2008 financial crisis, AFR noted that any risk-

    reducing benefit of corporate group risk management practices assumes

    that the corporate group actually implements and adheres to sufficient

    risk management procedures. AFR is concerned about relying on such an

    assumption in light of the fact that there was a large-scale failure of

    proper risk management prior to and during the 2008 financial crisis.

    Better Markets similarly commented that only a very narrow and

    strict inter-affiliate exemption could be in the public interest.

    Better Markets suggested ways in which the Commission should strengthen

    the proposed exemption to satisfy the public interest standard,

    including requiring a 100% majority ownership interest standard,

    requiring that both initial and variation margin be exchanged, and

    banning rehypothecation of posted collateral.\25\

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

    \25\ As discussed further below, both AFR and Better Markets

    contend that all the proposed conditions must be retained and the

    conditions must be strengthened in a number of ways.

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

    After considering the complete record in this matter, the

    Commission has determined that the requirements of section 4(c) of the

    Act have been met with respect to the exemptive relief described above.

    The Commission believes that the exemption, as modified in this

    release, is consistent with the public interest and with the purposes

    of the CEA. The Commission's determination is based, in large part, on

    the transactions that are covered under the exemption. Namely, as most

    commenters noted, inter-affiliate transactions provide an important

    risk management role within corporate groups. In addition, and as

    discussed in the NPRM, the Commission recognizes that swaps entered

    into between corporate affiliates, if properly risk-managed, may be

    beneficial to the entity as a whole. Accordingly, in promulgating this

    rule, the Commission concludes that an exemption subject to certain

    conditions is appropriate for the transactions at issue, promotes

    responsible financial innovation and fair competition, and is

    consistent with the public interest. As the Commission noted in the

    NPRM and as reiterated in AFR's comment, any benefits to the corporate

    entity have to be considered in light of the risks that uncleared swaps

    pose to corporate groups and market participants generally. For this

    reason, the Commission is adopting an inter-affiliate exemption that is

    narrowly tailored and subject to a number of important conditions,

    including that affiliates seeking eligibility for the exemption

    document and manage the risks associated with the swaps.

    Further, the Commission finds that the exemption is only available

    to ``appropriate persons.'' Section 4(c)(3) of the CEA includes within

    the term ``appropriate person'' a number of specified categories of

    persons, including ``such other persons that the Commission determines

    to be appropriate in light of their financial or other qualifications,

    or the applicability of appropriate regulatory protections.'' \26\

    Given that only eligible contract participants (ECPs) can enter into

    uncleared swaps and that the elements of the ECP definition (as set

    forth in section 1a(18)(A) of the CEA and Commission regulation 1.3(m))

    generally are more restrictive than the comparable elements of the

    enumerated ``appropriate person'' definition, the Commission finds that

    ECPs are appropriate persons within the scope of section 4(c)(3)(K) for

    purposes of this final release and that in so doing, the class of

    persons eligible to rely on the exemption will be limited to

    ``appropriate persons'' within the scope of section 4(c)(3) of the CEA.

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

    \26\ 7 U.S.C. 6(c)(3)(K).

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

    Finally, the Commission finds that this exemption will not have a

    material effect on the ability of the Commission to discharge its

    regulatory responsibilities. This exemption is limited in scope and, as

    described further below, the Commission will have access to information

    regarding the inter-affiliate swaps subject to this exemption because

    they will be reported to an SDR pursuant to the conditions of the

    exemption. In addition to the reporting conditions in the rule, the

    Commission retains its special call, anti-fraud, and anti-evasion

    authorities, which will enable it to adequately discharge its

    regulatory responsibilities under the CEA.

    For the reasons described in this release, the Commission believes

    it is appropriate and consistent with the public interest to adopt such

    an exemption.

    [[Page 21755]]

    C. Definition of Affiliate Status

    As proposed, Sec. 39.6(g)(1) provides that counterparties to a

    swap may elect the inter-affiliate exemption to the clearing

    requirement if the financial statements of both counterparties are

    reported on a consolidated basis, and either one counterparty directly

    or indirectly holds a majority ownership interest in the other, or a

    third party directly or indirectly holds a majority ownership interest

    in both counterparties. The proposed rule further specified that a

    counterparty or third party directly or indirectly holds a majority

    ownership interest if it directly or indirectly holds a majority of the

    equity securities of an entity, or the right to receive upon

    dissolution, or the contribution of, a majority of the capital of a

    partnership.

    1. Majority Ownership Interest

    Four commenters supported proposed Sec. 39.6(g)(1), which set

    forth the requirements of an affiliate status. CDEU commented that the

    majority-ownership test strikes an appropriate balance between ensuring

    that the rule is not overly broad and providing companies with the

    flexibility to account for differences in corporate structures. EEI

    stated that majority ownership is sufficient to mitigate what EEI

    believes is ``minimal'' risk posed by uncleared inter-affiliate swaps.

    In addition, EEI noted that majority-owned affiliates will have strong

    incentives to internalize one another's risks because the failure of

    one affiliate impacts all affiliates within the corporate group. The

    Working Group generally supported the Commission's definition, but

    stated that inter-affiliate swaps should be unconditionally exempt from

    mandatory clearing when the affiliates are consolidated for accounting

    purposes.\27\ MetLife stated that it would likely limit inter-affiliate

    trading to ``commonly-owned'' affiliates, but agreed with the

    flexibility of including majority-owned affiliates.\28\

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

    \27\ The Working Group also stated that it was unable to

    determine the scope of the proposed rule until the Commission

    provides further guidance on the definition of ``financial entity''

    under section 2(h)(7) of the CEA. In particular, The Working Group

    asked that the Commission clarify the status of treasury affiliates

    acting on behalf of affiliates able to claim an exception or

    exemption from required clearing. The Working Group further

    requested that the Commission provide guidance regarding what

    constitutes being predominantly engaged in activities that are in

    the business of banking or in activities that are financial in

    nature, as defined in section 4(k) of the Bank Holding Company Act

    of 1956, and clarify that trading physical commodities is not

    financial in nature. In response to The Working Group and other

    comments regarding the applicability of the end-user exception for

    certain inter-affiliate swaps, the Commission notes that it will

    address the use of treasury affiliates under a separate Commission

    action. With regard to the definition of financial entity, the

    Commission provided additional guidance in the end-user exception

    rulemaking, and declined to interpret statutory provisions within

    the jurisdiction of other U.S. authorities. See End-User Exception

    to the Clearing Requirement for Swaps, 77 FR 42560, 42567 (July 19,

    2012) (explaining that ``business of banking'' is a term of art

    found in the National Bank Act and is within the jurisdiction of,

    and therefore subject to interpretation by, the Office of the

    Comptroller of the Currency and section 4(k) of the Bank Holding

    Company Act is within the jurisdiction of, and therefore subject to

    interpretation by, the Board of Governors of the Federal Reserve

    System). Accordingly, further guidance on this issue is beyond the

    scope of this rulemaking, except as provided in note 76 of this

    release.

    \28\ Prudential stated that its affiliates are all wholly-owned

    affiliates and expressed no view on the issue of majority-owned

    affiliates.

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

    Two commenters objected to proposed Sec. 39.6(g)(1) and requested

    the Commission require 100% ownership of affiliates. AFR stated that

    the systemic impact of swaps is based on ownership, not on corporate

    control. AFR also stated that permitting such a low level of joint

    ownership would lead to evasion of the clearing requirement through the

    creation of joint ventures set up to enable swap trading between banks

    without the need to clear the swaps. Similarly, Better Markets agreed

    that only 100% owned affiliates should be eligible for the exemption

    because allowing the exemption for the majority owner permits that

    owner to disregard the views of its minority partners \29\ and creates

    an incentive to evade the clearing requirement by structuring

    subsidiary partnerships. Finally, Better Markets stated that the

    majority-ownership standard would result in corporate groups

    transferring price risk and credit risk to different locations,

    facilitating interconnectedness and potentially giving rise to systemic

    risk during times of market stress.

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

    \29\ Two other commenters also discussed the issue of minority

    investors. ISDA & SIFMA stated that any concerns about the

    protection of minority investors in group entities is ``the province

    of corporate and securities laws.'' EEI noted that ``to the extent

    minority owners have an opinion about electing the exemption, they

    may negotiate with majority-owners as they deem commercially

    appropriate for the right to participate in inter-affiliate clearing

    decisions.''

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

    Having considered these comments, the Commission is adopting

    proposed Sec. 39.6(g)(1) (now Sec. 50.52(a)) with the modifications

    discussed below. The Commission believes that the majority-owned

    standard is not overly broad and provides entities with flexibility to

    account for differences in corporate structure. In particular,

    requiring majority ownership serves to ensure that counterparty credit

    risk posed by inter-affiliate swaps is internalized by the corporate

    group.

    In addition, as the NPRM noted, it is important for the inter-

    affiliate clearing exemption to be harmonized with foreign

    jurisdictions that have or are developing comparable clearing regimes

    consistent with the 2009 G-20 Leaders' Statement.\30\ For example, the

    European Parliament and Council of the European Union have adopted the

    European Market Infrastructure Regulation (EMIR).\31\ Subject to the

    relevant provisions, technical standards, and regulations under EMIR,

    certain OTC derivatives transactions between parent and subsidiary

    entities, could be exempt from its general clearing requirement.

    Generally speaking, it appears that the intragroup exemptions under

    EMIR will require majority-ownership rights and consolidated accounting

    and annual reporting.\32\

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

    \30\ At the G-20 meeting in Pittsburgh in 2009, as noted above,

    the G-20 Leaders declared that, ``[a]ll standardized OTC derivative

    contracts should be traded on exchanges or electronic trading

    platforms, where appropriate, and cleared through central

    counterparties by end-2012 at the latest.'' G-20 Leaders' Final

    Statement at Pittsburgh Summit: Framework for Strong, Sustainable

    and Balanced Growth (Sept. 29, 2009).

    \31\ See Regulation (EU) No 648/2012 of the European Parliament

    and of the Council on OTC Derivatives, Central Counterparties and

    Trade Repositories, 2012 O.J. (L 201) (hereinafter ``EMIR'')

    available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.

    \32\ Id. at Articles 3 and 4.

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

    In response to the concerns of AFR and Better Markets regarding the

    need for the Commission to adopt a stricter requirement of 100%

    ownership, the Commission recognizes the potential for corporate

    entities to structure their affiliates in such a manner as to evade the

    clearing requirement. However, the Commission believes it has carefully

    crafted a narrow exemption based on the condition that the affiliate is

    majority-owned, along with the other conditions imposed under this

    exemption. In terms of the interests of minority shareholders, the

    Commission believes that the views of all shareholders should be taken

    into account when an entity decides whether to clear a swap, but

    ultimately, the decision is a matter for corporate and securities laws.

    2. Consolidated Financial Statements

    In addition to the majority-ownership requirement, proposed Sec.

    39.6(g)(1) provided that counterparties to a swap may elect the inter-

    affiliate exemption to the clearing requirement if the financial

    statements of both counterparties are reported on a consolidated basis.

    The Commission received several comments on this provision. The FSR

    requested that the

    [[Page 21756]]

    Commission clarify that alternative accounting standards can be used

    for purposes of meeting the requirement that the financial statements

    of both affiliates be reported on a consolidated basis. In response to

    a question in the NPRM regarding whether the exemption should be

    limited to the ownership threshold based on section 1504 of the

    Internal Revenue Code, MetLife and Prudential both explained that a

    U.S. taxpayer cannot file consolidated U.S. tax returns with its non-

    U.S. affiliate. Accordingly, both MetLife and Prudential stated that

    they did not support such a limitation on the exemption.

    In an effort to clarify the consolidated financial reporting

    condition, the Commission is modifying the requirement that financial

    statements be reported on a consolidated basis in two ways. First, the

    Commission is clarifying which entities are subject to the consolidated

    reporting condition. Under revised Sec. 50.52(a)(1)(i), if one of the

    two affiliate counterparties claiming the exemption holds a majority

    interest in the other affiliate counterparty (the ``majority-interest

    holder''), then the financial statements of the majority-interest

    holder must be reported on a consolidated basis and such statements

    must include the financial results of the majority-owned counterparty.

    On the other hand, under revised Sec. 50.52(a)(1)(ii), if a third

    party is the majority-interest holder of both affiliate counterparties

    claiming the exemption (the ``third-party majority-interest holder''),

    then the financial statements of the third-party majority-interest

    holder must be reported on a consolidated basis and such statements

    must include the financial results of both affiliate counterparties to

    the swap. In essence, the rule requires that the financial statements

    of the majority-owner (whether a third party or not) are subject to

    consolidation under accounting standards and must include either the

    other affiliate counterparty's or both majority-owned affiliate

    counterparties' financial results. The Commission is using the term

    ``financial results'' to refer to the financial statements, reports, or

    other material of the majority-owned counterparty or counterparties

    that must be consolidated with the majority owner's financial

    statements.

    The second modification to the proposed rule responds to FSR's

    request that the Commission clarify that alternative accounting

    standards are permitted. Accordingly, the consolidated financial

    statements of the majority-interest holder or the third-party majority-

    interest holder, as appropriate, may be prepared under either Generally

    Accepted Accounting Principles (GAAP) or International Financial

    Reporting Standards (IFRS). The modification reflects the fact that

    entities claiming the exemption may be subject to different accounting

    standards.

    The Commission is not modifying the rule to limit the exemption to

    an ownership threshold based on section 1504 of the Internal Revenue

    Code.

    D. Inter-Affiliate Swap Documentation

    As proposed, Sec. 39.6(g)(2)(ii) provided that eligible affiliate

    counterparties that elect the inter-affiliate exemption must enter into

    swaps with a swap trading relationship document that is in writing and

    includes all the terms governing the relationship between the

    affiliates. These terms include, but are not limited to, payment

    obligations, netting of payments, transfer of rights and obligations,

    governing law, valuation, and dispute resolution. This requirement will

    be satisfied if an eligible affiliate counterparty is an SD or MSP that

    complies with the swap trading relationship documentation requirements

    of Sec. 23.504. Regulation 23.504 includes all the proposed terms

    under proposed Sec. 39.6(g)(2)(ii) plus a number of other specific

    requirements. The NPRM stated that the burden on affiliates would not

    be onerous because all affiliates should be able to use a master

    agreement to document their swaps, however, in the NPRM the Commission

    did not require the use of such a master agreement.

    The Commission received a number of comments both supporting and

    opposing the swap documentation requirement. Better Markets, MetLife,

    and Prudential all supported the proposed documentation requirement.

    Specifically, MetLife and Prudential did not believe that the

    documentation requirement would be any more ``burdensome or costly''

    for them because they already document all of their swaps.

    Additionally, MetLife and Prudential commented that the proposed

    documentation method is ``preferable'' to any other method and

    represents industry best practice. Better Markets agreed with the

    conditions imposed on the exemption, including the documentation

    requirements, and stated that the conditions should not be

    weakened.\33\

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

    \33\ While it did not address the documentation requirements

    specifically, AFR stated that the proposed conditions on the

    exemption should be fully retained. Similarly, Chris Barnard

    generally expressed support for the proposed rules but did not

    specifically mention the documentation provisions.

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

    Cravath, EEI, CDEU, and DLA Piper opposed the proposed

    documentation requirement. Cravath stated that the costs associated

    with the imposition of documentation requirements outweigh any benefits

    to the financial system, and that the Commission should leave the

    determination as to the appropriate level of documentation to boards of

    directors and management of companies, to determine based on the

    ``reasonable exercise of their fiduciary responsibilities.'' DLA Piper

    commented that inter-affiliate swaps are typically documented by a

    simple intercompany agreement, trade ticket or accounting entry rather

    than ISDA Master Agreements, and that the documentation requirements

    would be burdensome.

    CDEU expressed concern that proposed Sec. 39.6(g)(2)(ii)(B) would

    require that full ISDA Master Agreements be used to document inter-

    affiliate swaps. CDEU explained that while many market participants use

    master agreements, some end users many not have full master agreements

    because inter-affiliate swaps are purely internal and do not increase

    systemic risk.\34\ CDEU recommended that the proposed rule be revised

    to require that the swap documentation ``include all terms necessary

    for compliance with its centralized risk management program'' and

    eliminate the list of required terms. CDEU also requested that the

    Commission clarify that (1) market participants can continue to use

    documentation required by their risk management programs, and (2) the

    rule does not require market participants to use the ISDA Master

    Agreements.

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

    \34\ CDEU recognized that SDs and MSPs and their counterparties,

    including affiliates, will be subject to the requirements of Sec.

    23.504, but stated that it is not appropriate to apply the same

    requirements to non-registrant affiliates.

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

    EEI recommended that the Commission eliminate the documentation

    requirement because the requirement is duplicative of corporate

    accounting records that affiliates maintain as a matter of prudent

    business practice. According to EEI, current accounting practices will

    address the Commission's tracking and proof-of-claim concerns related

    to inter-affiliate swaps. EEI commented that a documentation

    requirement imposes ``an additional, costly layer of ministerial

    process and documentation that is unnecessary to achieve the

    Commission's stated objectives.'' \35\ EEI

    [[Page 21757]]

    requested that the Commission allow market participants ``to document

    their inter-affiliate risk transfers pursuant to standard commercial

    accounting and business records practices.''

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

    \35\ EEI commented on the NPRM's consideration of costs and

    benefits and stated that the costs of the proposed documentation

    requirement are unjustified. The NPRM included an estimate that

    there would be a one-time cost of $15,000 to develop appropriate

    documentation for use by an entity's affiliates. EEI objected to

    this estimate because, in its view, the legal costs associated with

    individually negotiating and amending standard agreements between

    individual affiliates would exceed the NPRM's estimates. In

    addition, EEI objected to the NPRM's estimate of 22 affiliated

    counterparties for each corporate group as ``far too low'' for U.S.

    energy companies. However, EEI did not provide specific,

    quantitative information in terms of either the legal costs of

    complying with the proposed documentation requirement or number of

    affiliates for a corporate group subject to this rule.

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

    ISDA & SIFMA stated that the documentation requirements were overly

    prescriptive and would impose unnecessary costs on affiliates.

    Specifically, ISDA & SIFMA identified the valuation and dispute

    resolution requirements as serving little purpose. ISDA & SIFMA

    recommended a more flexible approach that would require adequate

    documentation of ``all transaction terms under applicable law.''

    The Commission considered all of the comments relating to the

    proposed documentation requirement and is retaining the swap

    documentation requirement subject to certain modifications recommended

    by commenters. As discussed in the NPRM, the Commission is concerned

    that without adequate documentation entities will be unable to track

    and manage the risks arising from inter-affiliate swaps. Equally

    important, affiliates must be able to offer sufficient proof of claim

    in the event of insolvency. The Commission is adopting proposed Sec.

    39.6(g)(2)(ii)(A) (now Sec. 50.52(b)(2)(i)), which essentially

    confirms the applicability of Sec. 23.504 to swaps between affiliates

    where one of the affiliates is an SD or MSP. However, with regard to

    swaps between affiliates that are not SDs or MSPs, and in response to

    commenters' requests for a more flexible standard, the Commission is

    adopting ISDA & SIFMA's recommendation that the focus of the

    documentation requirement be on documenting all of an inter-affiliate

    transaction's terms. Accordingly, the Commission is modifying proposed

    Sec. 39.6(g)(2)(ii)(B) (now Sec. 50.52(b)(2)(ii)), to require that

    ``the terms of the swap are documented in a swap trading relationship

    document that shall be in writing and shall include all terms governing

    the trading relationship between the eligible affiliate

    counterparties.''

    Under this modification, the Commission is eliminating the non-

    exclusive list of terms, which included payment obligations, netting of

    payments, transfer of rights and obligations, governing law, valuation,

    and dispute resolution. The change responds to commenters' requests for

    a more flexible approach that reflects current market best practices.

    While, in most instances, the Commission anticipates that documentation

    between affiliates will include all of the previously enumerated terms,

    the more general rule formulation signals that market participants

    retain the ability to craft appropriate documentation for their

    affiliated entities. This modification also serves to address concerns

    that the intent of the proposed rule was to require formal master

    agreements, such as the ISDA Master Agreement. As explained above, the

    proposed rule was not intended to require affiliates to enter into

    formal master agreements. Rather, the Commission observed that parties

    that already use master agreements to document their inter-affiliate

    swaps would likely meet the requirements of the inter-affiliate

    exemption without additional costs.\36\ This observation was supported

    by commenters such as MetLife and Prudential.

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

    \36\ See Confirmation, Portfolio Reconciliation, Portfolio

    Compression, and Swap Trading Relationship Documentation

    Requirements for Swap Dealers and Major Swap Participants, 77 FR

    55904, 55906 (Sept. 11, 2012) (recognizing that the ISDA Master

    Agreement, and other associated documents in their pre-printed form

    as published by ISDA are capable of compliance with the rules, but

    noting that such agreements are subject to customization by

    counterparties and such customization may or may not comply with

    Commission requirements).

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

    This modification also responds, in part, to CDEU's request that

    the documentation ``include all terms necessary for compliance with its

    centralized risk management program.'' While the Commission is

    modifying the rule to delete the specific references to valuation and

    dispute resolution procedures, ensuring that affiliates entering into

    swaps have sound procedures in place to value their swaps and resolve

    any disputes is critical to risk management. Accordingly, as discussed

    further below, the Commission anticipates that affiliates will include

    rigorous valuation provisions and procedures for elevating and

    resolving disputes in their risk management programs.

    In response to comments from Better Markets and AFR that the

    proposed regulations should be retained and not weakened, the

    Commission does not believe that eliminating the non-exclusive list of

    terms and replacing it with a simple requirement that all terms of the

    swap transaction and the relationship between the affiliates be

    documented will weaken the rule. Rather, eligible affiliates will have

    some discretion, but also have the obligation to ensure that their

    documentation contains an accurate and thorough written record of their

    swaps. The Commission clarifies, however, that book entries would not

    suffice for purposes of complying with the swap documentation condition

    because such entries do not contain sufficient information to

    adequately document the swap or the trading relationship between

    affiliates.

    EEI requested that, if the Commission retains the documentation

    requirement, the Commission clarify that swap confirmations are not

    required because executing confirmations would impose substantial

    costs. In response to this request, the Commission clarifies that for

    swaps between affiliates where one or both of the affiliates is an SD

    or MSP, the confirmation rules under Sec. 23.501 are incorporated into

    Sec. 23.504.\37\ As a result, those affiliates must confirm all the

    terms of their transactions according to the applicable timeframes set

    forth under Sec. 23.501.\38\ By contrast, for swaps between affiliates

    that are not SDs or MSPs, the provisions of Sec. 23.501 do not apply

    and formal confirmation pursuant to Sec. 23.501 is not required.

    However, the Commission notes that the terms of the swap will be

    documented by the affiliates and confirmation of those terms will be

    reported to an SDR under the Commission's reporting rules.\39\

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

    \37\ See 17 CFR 23.504(b)(2); 77 FR 55907-08.

    \38\ See 17 CFR 23.501.

    \39\ See, e.g., 17 CFR 45.3(c)(1)(iii) (requiring the reporting

    counterparty to report all confirmation data for the swap as soon as

    technologically practicable after confirmation, but no later than 30

    minutes after confirmation if confirmation occurs electronically or

    24 business hours after confirmation if confirmation does not occur

    electronically).

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

    E. Centralized Risk Management Program

    Proposed Sec. 39.6(g)(2)(iii) requires the swap to be subject to a

    centralized risk management program that is ``reasonably designed to

    monitor and manage the risks associated with the swap.'' If at least

    one of the eligible affiliate counterparties is an SD or MSP, the

    centralized risk management requirement is satisfied by complying with

    the requirements of Sec. 23.600.\40\

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

    \40\ 17 CFR 23.600; Swap Dealer and Major Swap Participant

    Recordkeeping, Reporting, and Duties Rules; Futures Commission

    Merchant and Introducing Broker Conflict of Interest Rules; and

    Chief Compliance Officer Rules for Swap Dealers, Major Swap

    Participants, and Futures Commission Merchants, 77 FR 20128 (Apr. 2,

    2012).

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    [[Page 21758]]

    Five commenters generally supported proposed Sec. 39.6(g)(2)(iii).

    AFR supported the proposed risk management program requirement and

    stated that dispensing with or weakening this condition, or any of the

    conditions, would heighten systemic risk and call into question the

    Commission's exemptive authority. Better Markets agreed that requiring

    a centralized risk management program was wholly appropriate and should

    be maintained as a requirement.

    Prudential and MetLife confirmed that both companies currently have

    centralized risk management programs and consider them to be consistent

    with current practice in the industry. Prudential noted that it

    structured its risk management system to allow only one affiliate to

    enter into swaps with third parties, which permits Prudential to impose

    a single credit limit on its market-facing counterparty relationships.

    MetLife's enterprise-wide risk management system provides all

    affiliates trading derivatives with affiliate-specific sets of

    guidelines and limits that are also included in enterprise-wide

    guidance and limits.

    Finally, CDEU expressed support for the centralized risk management

    program requirement, but requested that the Commission clarify that the

    level of risk management for inter-affiliate swaps not be interpreted

    as requiring the same level of risk management that end-users maintain

    for external third-party swaps. CDEU noted that most end users that use

    inter-affiliate swaps currently have robust centralized risk management

    programs in place to monitor all external swap risks and affiliates are

    required to follow group-wide risk polices. CDEU was supportive of the

    proposal so long as the requirement is interpreted reasonably and

    permits entities to ``implement risk policies and procedures

    appropriate to the risks of a corporate group's inter-affiliate

    swaps.''

    Four commenters objected to the proposed requirement, suggested

    alternatives, and/or requested clarification. FSR stated that the

    condition should be eliminated because integrated risk management

    systems ``are generally not established across international

    boundaries'' and are not consistent with general risk practices in

    large, multinational organizations. FSR suggested that the requirement

    be dropped in favor of each entity making ``its own evaluations of the

    risk associated with an inter-affiliate position.''

    Cravath stated that in many cases, for companies outside of the

    financial sector, the proposed rule will require a substantial change

    in the processes and procedures currently maintained by such companies,

    and the cost of complying with the risk management program requirements

    outweigh any benefits to the financial system. Cravath commented that

    rather than subject companies to a risk management rule, ``[c]ompanies

    should have the flexibility to engage in prudent risk management for

    their corporate group in a manner consistent with the overall level of

    risks to their business.''

    EEI suggested that the Commission eliminate the centralized risk

    management program requirement on the grounds that it would be

    duplicative for corporate groups that already have risk management

    programs in place. According to EEI, it is standard industry practice

    for both private and public companies to have a risk management

    program. EEI accordingly does not see a ``need to impose a separate,

    discrete regulatory requirement to document with an SDR or the

    Commission the existence of a centralized risk management program.'' If

    the Commission decides to retain the requirement, EEI requested that

    the Commission require a program be ``reasonably designed to monitor

    and manage the risks associated with the swap'' and provide the

    flexibility to design risk management programs that address the unique

    risks of an entity's business.

    The Working Group requested that the Commission clarify whether

    non-SDs and non-MSPs would be subject to the same enterprise-level risk

    management program as required for SDs and MSPs under Sec. 23.600. If

    the Commission intended to require the same level of risk management,

    The Working Group commented that there are ``a number of commercially

    and legally valid reasons'' why a centralized risk management program

    in accordance with Sec. 23.600 would be inconsistent with current

    industry practice. The Working Group cited cost as a reason companies

    do not provide for centralized risk management on different continents,

    in addition to antitrust and other regulatory reasons. The Working

    Group requested that the Commission clarify that the rule requires only

    that both counterparties be subject to a ``robust risk management

    program.''

    In response to comments, the Commission observes a general

    consensus that market participants have risk management policies and

    procedures in place, at least with regard to affiliates located in the

    same jurisdiction. FSR and The Working Group questioned whether

    entities have centralized risk management programs for affiliates in

    different jurisdictions and whether such cross-border risk management

    systems are prohibitively costly. In response to these comments, the

    Commission points to comments stating that inter-affiliate swaps play a

    critical role in an entity's overall management of risk and provide

    netting benefits among affiliates. Consequently, it stands to reason

    that inter-affiliate swaps between affiliates in different

    jurisdictions are as much a part of an entity's overall risk management

    framework as swaps between affiliates located in the same jurisdiction.

    The Commission does not believe that it would be prudent business

    practice for affiliates to enter into inter-affiliate swaps without

    risk management systems integrated across international boundaries to

    the extent that the entity permits affiliates across jurisdictions to

    enter into swaps with one another.

    In response to comments asking that the Commission clarify the

    level of risk management required for non-SDs and non-MSPs, the

    Commission confirms that the requirements of proposed Sec.

    39.6(g)(2)(iii) (now Sec. 50.52(b)(3)) are intended to be flexible and

    do not require the same level of policies and procedures as required

    under Sec. 23.600 for SDs and MSPs. Under the rule, a company is free

    to structure its centralized risk management program according to its

    unique needs, provided that the program reasonably monitors and manages

    the risks associated with its uncleared inter-affiliate swaps. In all

    likelihood, if a corporate group has a centralized risk management

    program in place that reasonably monitors and manages the risk

    associated with its inter-affiliate swaps as part of current industry

    practice, it is likely that the program would fulfill the requirements

    of proposed Sec. 39.6(g)(2)(iii) (now Sec. 50.52(b)(3)).

    The Commission did not receive comments regarding the requirement

    that SD and MSP affiliates must comply with Sec. 23.600.\41\ The

    Commission is adopting that provision of the rule as proposed.

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

    \41\ 17 CFR 23.600(c)(1)(ii) (``The Risk Management Program

    shall take into account risks posed by affiliates and the Risk

    Management Program shall be integrated into risk management at the

    consolidated entity level.'').

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

    Given that a number of commenters stated that it is common practice

    for market participants, including end users, to have risk management

    programs in place, the Commission is not persuaded by Cravath's comment

    that the rule will require a substantial change in the processes and

    procedures currently maintained by companies to manage risk.

    Accordingly, costs will be

    [[Page 21759]]

    limited where an entity only needs to make modifications to existing

    risk management programs. Moreover, a corporate group may not have to

    incur any costs if it already has a risk management system that meets

    the requirements of the inter-affiliate exemption in place.

    F. Variation Margin

    Proposed Sec. 39.6(g)(2)(iv) required that variation margin be

    collected for swaps between affiliates that are financial entities, in

    compliance with the proposed variation margin requirements in proposed

    Sec. 39.6(g)(3).\42\ The rule further proposed an exception to the

    variation margin requirement for 100% commonly-owned and commonly-

    guaranteed affiliates, provided that the common guarantor is under 100%

    common ownership.

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

    \42\ The Commission also requested comments on, among other

    things, whether the Commission should promulgate regulations that

    set forth minimum standards for initial margin for inter-affiliate

    swaps.

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

    Some commenters expressed support for the proposed variation margin

    requirement. Prudential commented that it did not take issue with the

    variation margin requirement, but noted that variation margin may not

    be appropriate or required in every circumstance.\43\ Prudential also

    commented that the Commission should not impose initial margin

    requirements for the inter-affiliate exemption.\44\ Chris Barnard

    agreed that the Commission should require the exchange of variation

    margin for financial entities and noted that the exchange of variation

    margin is consistent with the key principles proposed by the Basel

    Committee on Banking Supervision (BCBS) and the Board of the

    International Organization of Securities Commissions (IOSCO).\45\

    Better Markets expressed support for the variation margin requirement

    and commented that it should be expanded to non-financial entities.\46\

    AFR expressed support for the variation margin proposal. Both Better

    Markets and AFR also expressed support for the requirement that

    affiliates post initial margin for inter-affiliate swaps subject to the

    exemption.\47\

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

    \43\ Prudential also commented that there is ``no less costly

    risk-management tool'' than variation margin.

    \44\ MetLife also commented that the Commission should not

    impose initial margin requirements for the inter-affiliate

    exemption.

    \45\ See Margin Requirements for Non-Centrally-Cleared

    Derivatives, Consultative Report (July 2012), available at http://www.bis.org/publ/bcbs226.pdf.

    \46\ Better Markets also suggested that the Commission ban the

    rehypothecation of collateral.

    \47\ Better Markets commented that initial margin should be

    required because initial margin is the true ``statistical estimate

    of the potential consequences of a default'' and that variation

    margin is merely the ``daily recalibration'' of the risk estimation

    of initial margin.

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

    Several commenters stated that the proposed variation margin

    requirement for swaps between affiliates that are financial entities is

    not necessary and should not be a condition of the inter-affiliate

    exemption to clearing.\48\ ISDA & SIFMA commented that the benefits of

    variation margin for inter-affiliate swaps are ``tenuous'' because the

    third party to a swap is exposed to the credit risk of the entire group

    not just the specific affiliate with which it enters into a swap. ISDA

    & SIFMA maintain that it is not necessary to protect group entities

    from the credit risk of other group entities because group management

    possesses the tools needed to resolve potential defaults within the

    group. According to ISDA & SIFMA, the Commission can fully achieve its

    regulatory mandate to protect third-party swap counterparties through

    the application of the clearing requirement to those outward-facing

    swaps that are subject to the Commission's regulation, as well as

    regulation of those group entities whose outward-facing swap activities

    are sufficiently large to subject them to SD and MSP registration.\49\

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

    \48\ Cravath commented that variation margin requirements ``tie

    up capital that could otherwise be used for investment purposes to

    create jobs and goods and services for the economy.'' MetLife

    commented that while it is subject to variation margin under state

    insurance law, MetLife believes that the Commission should eliminate

    the variation margin requirement for 100%-owned affiliates and

    should not require ``inter-affiliate guarantees.'' DLA Piper also

    urged the Commission to provide corporate groups with legal

    certainty that no margin requirements will be imposed on any inter-

    company swaps.

    \49\ ISDA & SIFMA claimed that the additional liquidity demands

    resulting from variation margin will distort the group's risk

    management choices. ISDA & SIFMA further claimed that while they

    have previously stated that inter-affiliate margin occurs

    ``routinely,'' this does not mean that it occurs ``uniformly'' or

    that imposing variation margin would not increase cost.

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

    FSR commented that affiliates should be required to post margin

    only in instances where their primary regulator imposes such a

    requirement for affiliate transactions.\50\ FSR states that requiring

    variation margin for inter-affiliate swaps involving non-bank financial

    entities will limit the ability of companies to efficiently allocate

    risk among affiliates and manage risk centrally.\51\ FSR further

    commented that initial margin should not be required between

    affiliates, and requested that the Commission clarify that the

    exemption does not require the exchange of initial margin between

    affiliates.

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

    \50\ Citing to sections 23A and 23B of the Federal Reserve Act

    and Regulation W as well as public utility, insurance, and

    investment company law, FSR commented that a number of regulated

    entities may be subject to various restrictions on affiliate

    transactions and that for purposes of the inter-affiliate exemption,

    margin requirements should only apply ``to the extent other

    applicable law . . . imposes such restrictions on affiliate

    transactions.'' FSR also points out that subsidiaries of banks are

    ``generally not treated as `affiliates' '' within the restrictions

    of sections 23A and 23B of the Federal Reserve Act.

    \51\ FSR further requested that the Commission clarify that to

    the extent that financial entities are required, through credit

    support arrangements with their affiliates, to have minimum transfer

    amounts, thresholds, and other similar arrangements in place, that

    such arrangements would be permitted in connection with inter-

    affiliate swaps relying on the inter-affiliate exemption.

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

    CDEU commented that the Commission should not require variation

    margin, or initial margin, with respect to inter-affiliate swaps

    between end-user affiliates. According to CDEU, while margin

    requirements may serve as a risk-management tool for market-facing

    swaps, inter-affiliate swaps do not increase counterparty credit risk

    or contribute to interconnectedness among market participants. CDEU

    stated that a number of specific entities, including banks and

    insurance companies, already post variation margin for inter-affiliate

    swaps, largely because of prudential requirements, and that applying

    variation margin requirement to these entities is unnecessary.\52\ CDEU

    requested that if the Commission retains the variation margin

    requirement, that it limit the exchange of variation margin to SDs and

    MSPs, and that the requirement should not apply to entities that are

    considered ``financial entities.''

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

    \52\ Moreover, CDEU claims that many inter-affiliate swaps

    between end-user corporate groups are not subject to variation

    margin requirements, and that these entities likely will not have

    the liquidity to exchange variation margin, and would likely be

    required to borrow the money from the centralized hedging unit with

    which it is entering the internal swap. Such an arrangement,

    according to CDEU, would transfer the loan back to the centralized

    hedging unit and effectively eliminate any perceived benefit from

    the exchange of variation margin.

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

    With respect to the proposed common guarantor exception to the

    variation margin requirement, ISDA & SIFMA commented that the

    Commission has not provided adequate rationale for requiring a common

    guarantor as a condition for exempting group members from the proposed

    variation margin requirement, nor has the Commission made it clear

    which obligations must be guaranteed. ISDA & SIFMA requested that the

    Commission further clarify the guarantee exception in proposed Sec.

    39.6(g)(2)(iv), including to clarify that it includes ``direct or

    indirect'' ownership, and that swaps between the

    [[Page 21760]]

    common guarantor and its affiliates are eligible for the exception.\53\

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

    \53\ ISDA requested that the Commission clarify that the

    shareholders of a publicly-owned holding company are the common

    owners and that its 100% owned subsidiaries meet the definition of

    ``100% commonly owned,'' and further stated that the Commission

    should address the consequences of a guarantee of a swap being

    considered a swap itself.

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

    CDEU commented that the Commission should not limit the guarantee

    exception to 100% commonly-owned affiliates and should allow the

    exception for majority-owned affiliates. CDEU requested that the

    Commission clarify that only the related market-facing swaps with third

    parties are required to be guaranteed by the common owner or parent.

    CDEU suggested that the Commission clarify that the parent company has

    the option to act as the guarantor of the transactions.

    FSR commented that the variation margin requirement should not

    apply to 100% commonly-owned affiliates even if they do not have a

    common guarantor that is under 100% common ownership. According to FSR,

    the 100% common ownership requirement creates sufficient alignment of

    interests between swap counterparties and places the risk of the swap

    on the ultimate parent entity, and thus, the exchange of variation

    margin would do little to mitigate intercompany risk.

    MetLife and Prudential commented that inter-affiliate swaps should

    not be commonly guaranteed by a 100% wholly-owned affiliate in order to

    be exempt from the variation margin requirement. Specifically, MetLife

    stated that the Commission should not require guarantees or explicit

    credit support as a condition for an exception from the variation

    margin requirement and should rely instead on the direct or indirect

    common ownership requirement. Both MetLife and Prudential stated that

    the corporate group of 100% wholly owned affiliates should be able to

    decide whether internal swaps need to be guaranteed by an affiliate.

    After considering the comments submitted in response to the

    proposed variation margin requirement, the Commission is determining

    not to require variation or initial margin as a condition for electing

    the inter-affiliate exemption. In so doing, the Commission was guided

    by comments expressing concern that a variation margin requirement will

    limit the ability of U.S. companies to efficiently allocate risk among

    affiliates and manage risk centrally. Notwithstanding the Commission's

    determination not to impose variation margin as a condition of the

    inter-affiliate exemption, the Commission is encouraged by comments

    noting that many companies already exchange variation margin, and

    agrees with commenters that collateralizing risk exposure with respect

    to any swaps, including inter-affiliate swaps, is critical, and

    encourages market participants to do so as a matter of sound business

    practice.

    G. Treatment of Outward-Facing Swaps and Relief

    Proposed Sec. 39.6(g)(2)(v) provided that eligible affiliate

    counterparties to a swap may elect the inter-affiliate exemption from

    clearing provided that each affiliate counterparty either: (i) Is

    located in the United States; (ii) is located in a jurisdiction with a

    clearing requirement that is comparable and comprehensive to the

    clearing requirement in the United States; (iii) is required to clear

    swaps with non-affiliated parties in compliance with U.S. law; or (iv)

    does not enter into swaps with non-affiliated parties.\54\

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

    \54\ In this release, the requirements of proposed Sec.

    39.6(g)(2)(v), which are now being adopted in new Sec. 50.52(b)(4),

    are referred to as the ``treatment of outward-facing swaps

    condition.''

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

    The Commission received several comments both in support of and in

    opposition to various aspects of the conditions related to the

    treatment of outward-facing swaps in proposed Sec. 39.6(g)(2)(v). The

    Commission has considered each of the comments and has determined to

    adopt the treatment of outward-facing swaps conditions of the inter-

    affiliate exemption, with certain modifications described below,

    because such conditions are necessary to prevent evasion of the

    clearing requirement and to help protect the U.S. financial markets.

    The remainder of this Section II.G describes the comments received in

    response to proposed Sec. 39.6(g)(2)(v) (now Sec. 50.52(b)(4)), along

    with the Commission's responses and clarifications with respect to

    those comments.

    1. Basis for the Cross-border Conditions

    While recognizing the benefits of exempting certain inter-affiliate

    transactions from the clearing requirement, in the NPRM, the Commission

    described two separate grounds for proposing the treatment of outward-

    facing swaps condition to the inter-affiliate exemption. First, the

    Commission explained that an inter-affiliate exemption from required

    clearing could enable entities to evade the clearing requirement

    through trades with affiliates that are located in foreign

    jurisdictions that do not have a comparable and comprehensive clearing

    regime. In addition, the Commission noted in the NPRM that uncleared

    inter-affiliate swaps may pose risk to other market participants, and

    therefore, the financial system if the affiliate enters into swaps with

    third parties that are related on a back-to-back or matched book basis

    with inter-affiliate swaps.

    In support of the proposed treatment of outward-facing swaps

    conditions, AFR stated that inter-affiliate swaps could, without

    appropriate restrictions, bring risk back to the U.S. from foreign

    affiliates. AFR commented that an inter-affiliate swap might be used to

    move parts of the U.S. swaps market outside of U.S. regulatory

    oversight by transferring risk to jurisdictions with little or no

    regulatory oversight, whereby a non-U.S. affiliate of a U.S. entity

    could enter into an outward-facing swap. AFR stated that an inter-

    affiliate swap could contribute to financial contagion across different

    groups within a complex financial institution, making it more difficult

    to ``ring-fence'' risks in one part of an organization. AFR further

    commented that laws and regulations of a foreign country might prevent

    U.S. counterparties to swaps from having access to the financial

    resources of an affiliate in the event of a bankruptcy or

    insolvency.\55\ The inability of an affiliate to access resources in

    other jurisdictions, according to AFR, may threaten the ability of U.S.

    creditors to retrieve assets and may put U.S. taxpayers at risk.\56\

    Better Markets also

    [[Page 21761]]

    supported the proposed treatment of outward-facing swaps condition.\57\

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

    \55\ AFR suggested that the Commission consult with the U.S.

    banking agencies, such as the FDIC, regarding the potential issues

    relating to bankruptcy of non-U.S. affiliates. As noted above, the

    Commission has consulted with both U.S. and international

    authorities in preparing this adopting release. In response to AFR's

    comments pertaining to the limitations of foreign bankruptcy laws,

    the Commission notes that the specific bankruptcy limitations

    attendant to U.S. counterparties with respect to their non-U.S.

    affiliates are outside the scope of this rulemaking. The Commission

    further notes that the conditions imposed by the rules being adopted

    in this release, in large part, are aimed at ensuring that the

    benefits of central clearing, particularly with respect to

    counterparty and systemic risk mitigation, are maintained with

    respect to inter-affiliate swaps involving non-U.S. affiliates.

    Specifically, the Commission believes that the conditions imposed by

    the rules being adopted in this release will help to mitigate

    potential issues that could arise in uncleared inter-affiliate swaps

    when financial solvency is not an issue for the corporate

    enterprise. Furthermore, these conditions may, to some extent,

    diminish the impact of swaps in transmitting losses across

    affiliates, and in turn, to third-party creditors, following a

    default.

    \56\ AFR also noted restrictions under U.S. banking law with

    respect to the transfer of risk from non-depository to depository

    institutions, and stated that it may be necessary to require ``ring-

    fencing'' and separate capitalization of swaps affiliates. The

    Commission believes that these issues are outside of the scope of

    this rulemaking, and as AFR correctly noted, may be an issue that is

    more appropriate for the prudential regulators of such entities to

    consider.

    \57\ Prudential also commented that in relation to its own

    structure, it did not have concerns with the proposed cross-border

    conditions applicable to inter-affiliate swaps involving foreign

    affiliates.

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

    By contrast, ISDA & SIFMA, The Working Group, and CDEU all stated

    that the treatment of outward-facing swaps condition of the proposed

    rule is not necessary or appropriate and that the Commission should

    eliminate it altogether. FSR commented that the inter-affiliate

    exemption should extend to swaps between non-U.S. affiliates, such that

    the swaps should not be subject to mandatory clearing or margin

    requirements, even if the affiliated parties are financial entities.

    Certain commenters stated that the proposed treatment of outward-

    facing swaps condition is not necessary to prevent evasion. ISDA &

    SIFMA noted that the Commission's existing anti-evasion authority \58\

    can address the anti-evasion objectives of the proposed condition, and

    the CDEU made a similar argument with respect to the Commission's new

    anti-evasion authority under section 721(c) of the Dodd-Frank Act. ISDA

    & SIFMA further noted that the Commission should limit application of

    its anti-evasion authority to instances where a foreign affiliate

    engages in a pattern of back-to-back swaps with the U.S. affiliate and

    where neither the affiliates nor the third-party counterparty are

    subject to capital regulation.\59\

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

    \58\ See e.g., Section 2(i)(2) of the CEA (providing authority

    to promulgate rules addressing activities outside of the U.S. to

    prevent evasion of the Dodd-Frank Act); section 2(h)(4) of the CEA

    (requiring the Commission to issue rules to prevent evasion of the

    mandatory clearing requirement); section 721(c) of the Dodd-Frank

    Act (requiring the Commission to promulgate a rule defining certain

    terms to prevent evasion of the Dodd-Frank Act).

    \59\ Entities that are subject to capital regulations include

    SDs, MSPs, and banking entities subject to prudential regulation.

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

    Other commenters opposed the proposed treatment of outward-facing

    swaps condition based on their view that inter-affiliate swaps

    involving non-U.S. affiliates do not pose a risk to the U.S. financial

    markets. CDEU commented that the proposed ``comparable and

    comprehensive'' condition is not necessary or appropriate to reduce

    risk and prevent evasion because, according to CDEU, transactions

    between affiliates do not increase systemic risk, regardless of the

    location of the affiliate.\60\ ISDA & SIFMA stated that the concern

    that foreign inter-affiliate swaps pose risk to the U.S. financial

    system is unfounded because internal swaps have no conclusive effect on

    systemic risk.\61\

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

    \60\ CDEU further stated that inter-affiliate swaps do not

    create systemic risk.

    \61\ Prudential also stated that it does not believe that there

    are any additional risk implications of cross-border inter-affiliate

    swaps for the U.S. market, to the extent that the market-facing

    entity is located in the U.S.

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

    The Commission has considered these comments, and for the reasons

    described below, has determined to retain the treatment of outward-

    facing swaps condition to the inter-affiliate exemption, with certain

    modifications and amendments, in order to address comments and provide

    greater clarity.

    i. Prevention of Evasion

    As an initial matter, as discussed above, the Commission believes

    that the benefits of inter-affiliate swaps for entities in affiliated

    groups warrant the Commission's use of its exemptive authority under

    section 4(c) of the Act to exclude certain inter-affiliate swaps from

    the clearing requirement. However, the Commission must exercise its

    exemptive authority in view of the Commission's charge under the CEA to

    prevent evasion of the clearing requirement.\62\ The Commission remains

    concerned that absent the treatment of outward-facing swaps condition,

    the inter-affiliate exemption from clearing may create a ready means

    through which some U.S. entities may be able to evade the clearing

    requirement. Accordingly, the Commission believes that the treatment of

    outward-facing swaps condition to the inter-affiliate clearing

    exemption is necessary to address the potential for evasion.

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

    \62\ See sections 2(h)(4) and 2(i)(2) of the CEA.

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

    Section 2(h)(4)(A) of the CEA requires that ``the Commission shall

    prescribe rules * * * as determined by the Commission to be necessary

    to prevent evasions of the clearing requirement under this Act.'' \63\

    As the Commission explained in the NPRM, and as AFR also described in

    its comments, a broad inter-affiliate exemption from the clearing

    requirement could enable entities to evade the clearing requirement

    potentially through third-party trades with their foreign affiliates

    that are located in jurisdictions that do not have a clearing regime

    that is comparable to, or as comprehensive as, the Commission's

    clearing requirement. For example, rather than execute a swap opposite

    a U.S. counterparty, which would be subject to the clearing

    requirements of section 2(h) of the Act, a U.S. entity could execute an

    uncleared swap with its foreign affiliate or subsidiary, which could

    then execute a swap with a non-affiliated third-party in a jurisdiction

    that is either unregulated or does not have a clearing requirement that

    is comparable to or as comprehensive as the U.S. clearing requirement.

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

    \63\ 7 U.S.C. 2(h)(4).

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

    The Commission disagrees with commenters that suggest that the

    treatment of outward-facing swaps condition is not necessary to deter

    evasion because the Commission can rely on its general anti-evasion

    authority under the CEA or under section 721(c) of the Dodd-Frank Act

    to address the Commission's evasion concerns pertaining to the inter-

    affiliate exemption. The Commission notes that section 2(h)(4)(A) of

    the CEA specifically imposes an obligation on the part of the

    Commission to ``prescribe rules'' and ``issue interpretations of

    rules'' that are necessary to prevent evasions of the clearing

    requirement.\64\ Furthermore, from an enforcement perspective, a

    specific regulation provides more transparency to market participants

    with respect to the Commission's enforcement program. While the

    Commission has ample general authority to prevent evasion of the CEA

    and the swaps-related provisions of the Dodd-Frank Act, the Commission

    believes it is appropriate to impose the treatment of outward-facing

    swaps condition to the inter-affiliate exemption to prevent evasion of

    the clearing requirement.

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

    \64\ Under the authority of sections 2(h)(4)(A), 2(h)(7)(F), and

    8a(5) of the CEA, the Commission recently adopted Sec. 50.10 to

    prohibit evasions of the requirements of section 2(h) of the CEA,

    including the end-user exception or any other exception or exemption

    that the Commission may provide by rule, regulation, or order. See

    Clearing Requirement Determination at 74317-19.

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

    In response to ISDA & SIFMA's claim that anti-evasion authority

    should only be applied in limited scenarios where there are back-to-

    back trades involving affiliates and non-affiliates who are not subject

    to capital requirements, the Commission declines to pre-judge the

    potential incentives or ways of evading, or complying with, the

    Commission's clearing requirement and the inter-affiliate exemption

    from clearing. To the extent that ISDA & SIFMA suggest that the

    treatment of outward-facing swaps condition should be limited to

    transactions involving back-to-back trades where the affiliates and the

    respective third-party are subject to capital requirements, the

    Commission is not persuaded that the rule should be so narrowly

    tailored to address only the scenario ISDA & SIFMA describe. In

    particular, the Commission notes that back-to-back transactions may not

    serve as the only potential means by which

    [[Page 21762]]

    affiliates can evade the U.S. clearing mandate, and for that matter,

    transfer risk to one another. Accordingly, the Commission does not

    believe that the treatment of outward-facing swaps condition should be

    limited to the specific circumstances described by ISDA & SIFMA.

    ii. Protection of Financial Markets

    In addition to preventing evasion, the Commission believes that the

    treatment of outward-facing swaps condition will help to limit the

    potential transfer of risks to U.S. companies and financial markets

    that may result from third-party swaps between affiliates and non-

    affiliated entities domiciled in jurisdictions that do not regulate

    swaps or where the regulation is not comparable to, or as comprehensive

    as, the CEA and Commission regulations. As described in the preceding

    sections of this adopting release, there are numerous benefits

    associated with central clearing of swaps. In particular, clearing

    mitigates counterparty credit risk, provides an organized mechanism for

    collateralizing the risk exposures posed by swaps, and when applied on

    a market-wide scale, clearing reduces systemic risk. The counterparty

    and systemic risk mitigation benefits of central clearing are also

    realized from clearing transactions between affiliates.

    The benefits of clearing notwithstanding, the Commission recognized

    in the NPRM, commenters' assertions that there is less counterparty

    risk associated with inter-affiliate swaps than with swaps between

    third parties to the extent that the affiliated counterparties that are

    members of the same corporate group internalize each other's

    counterparty credit risk.\65\ While the Commission recognizes,

    generally, the benefits of inter-affiliate swaps and the incentives for

    inter-affiliates to fulfill their inter-affiliate swap obligations to

    each other, these swaps are not immune from some of the risks that are

    associated with swaps between non-affiliated parties.

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

    \65\ See NPRM at 50427.

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

    In particular, the Commission is not persuaded that inter-affiliate

    swaps, and swaps between affiliate counterparties outside the U.S. and

    non-affiliated counterparties, pose no risks to the U.S financial

    markets or that central clearing would not mitigate the risks

    associated with such swaps. To the contrary, the counterparty and

    systemic risks associated with inter-affiliate swaps are heightened

    where, for example, the inter-affiliate transaction involves an

    uncleared swap with a foreign affiliate counterparty that is

    subsequently hedged with a third-party uncleared swap. Thus, the

    Commission disagrees with commenters that suggested that inter-

    affiliate swaps involving foreign affiliates do not have the potential

    to create systemic risk. As the Commission noted in the NPRM, systemic

    risk implications may be present where the foreign affiliate has large

    inter-affiliate swap positions and enters into related outward-facing

    swaps. If the foreign affiliate defaults on its obligations arising

    from the inter-affiliate swaps, it then increases the likelihood that

    the foreign affiliate could default on the outward-facing swaps,

    potentially jeopardizing the financial integrity of the third-party

    counterparty. Furthermore, to the extent that a foreign affiliate

    enters into both inter-affiliate swaps and related third-party swaps,

    any losses incurred by the foreign affiliate with respect to its inter-

    affiliate swaps may flow not only to the unaffiliated third-party

    counterparty, but conceivably, to the broader financial system.\66\

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

    \66\ In the Proposed Cross-Border Interpretive Guidance, the

    Commission specifically discussed the flow of risk to the U.S. by

    entities that facilitate a U.S. person's ability to execute swaps

    outside the Dodd-Frank Act regulatory regime. 77 FR 41228-29, 41234.

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

    Moreover, the Commission notes AFR's comment that inter-affiliate

    swaps can, in some circumstances, contribute to financial contagion

    across different groups within a complex financial institution, making

    it more difficult to contain risks in one part of an organization. As

    evidenced by the events surrounding the 2008 financial crisis, many

    large financial institutions are interconnected and highly inter-

    dependent, with affiliated legal entities that are inextricably linked

    to each other.\67\ The interconnected nature of corporate groups,

    therefore, increases the potential that risk in any part of a corporate

    group may spread throughout the organization, jeopardizing the

    financial integrity of not only the U.S affiliate, but depending on the

    scope of a potential default, the broader financial system.

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

    \67\ For a discussion of specific institutional risks leading up

    to the 2008 financial crisis, see Proposed Cross-Border Interpretive

    Guidance at 41215-16.

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

    For the aforementioned reasons, the Commission believes that the

    risk of evasion of U.S. laws and the potential systemic risk associated

    with uncleared inter-affiliate swaps involving foreign affiliates

    necessitates that the inter-affiliate exemption include the treatment

    of outward-facing swaps condition.

    The treatment of outward-facing swaps condition that is being

    adopted as part of the inter-affiliate clearing exemption in this final

    release is aimed at addressing the potential risks associated with an

    eligible foreign affiliate's swaps with non-affiliated counterparties.

    As modified, the final rule requires that, as a condition to the inter-

    affiliate exemption, each eligible affiliate counterparty must clear

    all swaps that it enters into with an unaffiliated counterparty to the

    extent that the swap is included in the Commission's clearing

    requirement, i.e., in a class of swaps identified in Sec. 50.4.\68\ In

    order to satisfy this requirement, eligible affiliate counterparties

    must clear their third-party swaps pursuant to the Commission's

    clearing requirement or comply with the requirements for clearing the

    swap under a foreign jurisdiction's clearing mandate that is

    comparable, and comprehensive but not necessarily identical, to the

    clearing requirement of section 2(h) of the Act and part 50 of the

    Commission's regulations, as determined by the Commission. In addition,

    the Commission is modifying the inter-affiliate exemption to allow for

    recognition of clearing exceptions and exemptions under the CEA and an

    exception or exemption under a foreign clearing mandate provided that

    the foreign jurisdiction's clearing mandate is comparable, and

    comprehensive but not necessarily identical, to the clearing

    requirement of section 2(h) of the Act and part 50 and the foreign

    jurisdiction's exception or exemption is comparable to an exception or

    exemption under the CEA or part 50, in each instance as determined by

    the Commission.

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

    \68\ Currently, the scope of the Commission's clearing

    requirement is limited to four classes of interest rate swaps and

    two classes of CDS.

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

    For eligible affiliate counterparties that are not located in the

    U.S. or in a comparable foreign jurisdiction, as determined by the

    Commission, the rule permits such eligible affiliates to clear any

    outward-facing swap that is required to be cleared under Sec. 50.4

    through a registered DCO or a clearing organization that is subject to

    supervision by appropriate government authorities in the home country

    of the clearing organization and has been assessed to be in compliance

    with the Principles for Financial Market Infrastructures (PFMIs).\69\

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

    \69\ See Principles for Financial Market Infrastructures, April

    2012, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf.

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

    The Commission believes that this modified formulation of the

    treatment of outward-facing swaps condition being adopted as part of

    the final rule will

    [[Page 21763]]

    more clearly establish the conditions to the exemption and alternative

    methods by which eligible affiliates may satisfy the requirements.

    Moreover, in finalizing the requirement that eligible affiliate

    counterparties clear their swaps with unaffiliated counterparties, the

    Commission considered the approach adopted in EMIR. Articles 3, 4, and

    13 of EMIR generally exempt from clearing OTC derivatives transactions

    between intragroup counterparties, where one counterparty is located in

    the European Union and the other counterparty is located outside the

    European Union, provided that, among other things, the European

    Commission determines that the foreign counterparty is established in a

    country with ``equivalent'' requirements to EMIR.\70\ By requiring that

    a foreign counterparty to an intragroup transaction be located in a

    country with equivalent requirements to EMIR, including clearing, any

    third-party swaps entered into by either the European Union

    counterparty or the non-European Union counterparty would be subject to

    a clearing requirement under EMIR or one that is equivalent to that

    required under EMIR, respectively.

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

    \70\ See EMIR Article 13(1)-(3). The European Union has yet to

    make determinations as to whether third countries have equivalent

    requirements to EMIR. The European Commission (EC) has instructed

    the European Securities and Markets Authority (ESMA) to prepare

    possible implementing acts concerning the equivalence between the

    legal and supervisory frameworks of certain third countries and

    EMIR. Pursuant to the EC's instructions, ESMA must make its

    determination regarding the United States' clearing requirement by

    March 15, 2013. ``Formal Request to ESMA for Technical Advice on

    Possible Implementing Acts Concerning Regulation 648/2012 on OTC

    Derivatives, Central Counterparties and Trade Repositories (EMIR)''

    available at http://www.esma.europa.eu/system/files/formal_request_for_technical_advice_on_equivalence.pdf.

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

    In addition to the modifications to the treatment of outward-facing

    swaps condition described above, the Commission also is providing a

    transition period with alternative compliance frameworks, in response

    to concerns raised by commenters pertaining to the timing and

    sequencing of the implementation of the inter-affiliate exemption,

    which are discussed below.

    2. Time-limited Alternative Compliance Frameworks

    A number of commenters expressed concern with respect to the

    ``comparable and comprehensive'' requirement of the proposed rule.

    Several commenters expressed concern with respect to the timing and

    sequencing of the Commission's comparability determination in relation

    to the expected compliance date for the initial clearing requirement

    under section 2(h) of the Act.\71\ These commenters noted that the

    comparability requirement is dependent upon the adoption of clearing

    regimes by other jurisdictions, and that because the U.S. clearing

    requirement is likely to take effect in advance of other jurisdictions

    adopting or finalizing their clearing regimes, non-U.S. affiliates

    effectively will not be able to rely on the inter-affiliate exemption

    from clearing when the Commission's initial clearing requirement takes

    effect. Significantly, ISDA & SIFMA commented that the cross-border

    condition may prove to be unnecessary because it is expected that the

    major financial jurisdictions will implement their own clearing

    regimes. However, ISDA & SIFMA and CDEU noted that questions of timing

    and criteria for comparability render the proposed treatment of

    outward-facing swaps condition problematic, and that unless the

    condition is satisfactorily resolved, the condition could hamper the

    ability of U.S.-based groups to compete in foreign markets. ISDA &

    SIFMA further commented that if the Commission retains the cross-border

    requirements, the Commission should provide an appropriate transition

    period in order to allow foreign jurisdictions to implement their own

    G-20 mandates.

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

    \71\ See Clearing Requirement at 74319-21 (discussing the

    compliance dates for the first clearing requirement determination).

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

    The Working Group commented that because no other jurisdiction has

    a comparable clearing requirement,\72\ the proposed rule would impose

    an obligation on almost all non-U.S. persons to comply with the U.S.

    clearing requirement in the event such entities wanted to engage in a

    non-hedge swap that was subject to mandatory clearing with a U.S.

    person affiliate. The Working Group claimed that this limitation would

    render the exemption unusable and questioned the public policy benefit

    of extending the clearing requirement in such instances. The Working

    Group further commented that the proposed rule represents a broad

    extension of U.S. law by, in effect, imposing the clearing requirement

    under section 2(h)(1)(A) on non-U.S. persons that enter into swaps with

    U.S. person affiliates in order to satisfy the conditions of the inter-

    affiliate exemption. AFR supported the comparability condition and

    suggested that the Commission should grant the inter-affiliate

    exemption only with respect to foreign affiliate swaps once foreign

    jurisdictions finalize and implement their own clearing requirements.

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

    \72\ This assertion is no longer accurate. As discussed below,

    Japan has adopted a clearing mandate for certain interest rate swaps

    and CDS.

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

    The Commission recognizes commenters' concerns pertaining to the

    timing and sequencing of the inter-affiliate exemption in light of the

    Commission's clearing requirement, and in view of the ongoing progress

    of other jurisdictions to adopt and implement their respective clearing

    regimes. Accordingly, the Commission has determined to modify the

    proposed rule, as described in this release.

    As an initial matter, and informed in large part by the reports of

    relevant international organizations and ongoing dialogue with

    international regulators, the Commission believes that many

    jurisdictions have made significant progress in implementing their

    clearing regimes. It is the Commission's understanding that the G-20

    Leaders reaffirmed their commitment that all standardized OTC

    derivatives should be cleared through central counterparties by end-

    2012.\73\ Importantly, the majority of G-20 members with major

    financial markets have been preparing for mandatory clearing, and

    significant steps towards further implementation have been taken by the

    United States, Japan, Singapore, and the European Union. In Japan, for

    example, the Japanese Financial Services Authority (JFSA) cabinet

    office ordinance regarding central counterparties and trade

    repositories which, among other things, subjects certain transactions

    to mandatory central clearing, became effective on November 1, 2012.

    The JFSA initially requires certain financial institutions to clear

    yen-denominated interest rate swaps that reference Yen-LIBOR, and CDS

    based on the Japanese iTraxx indices at a licensed CCP.

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

    \73\ ``G20 Leaders Declaration Los Cabos Mexico'' (June 18-19,

    2012) at paragraph 39. According to the October 2012 Report of the

    Financial Stability Board (FSB), 10 out of the 19 members of the G-

    20 group have either proposed or adopted legislation and/or

    regulations to implement their clearing framework, as of the date of

    that release. FSB, OTC Derivatives Market Reforms: Fourth Progress

    Report on Implementation, Oct. 31, 2012 at 74-77, available at

    https://www.financialstabilityboard.org/publications/r_121031a.pdf.

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

    On November 15, 2012, the Singapore Parliament passed the

    Securities and Futures (Amendment) Bill 2012 to amend the Singapore

    Securities and Futures Act (SFA). This bill puts in place the

    regulatory regime for OTC derivatives in Singapore. This legislation

    institutes mandatory reporting and clearing requirements for financial

    entities and large non-financial entities. The Monetary Authority of

    [[Page 21764]]

    Singapore is deliberating how to implement these legislative

    requirements and is expected to issue further consultation in 2013.

    In the European Union, EMIR entered into force on August 16, 2012,

    and requires the clearing of all OTC derivatives subject to the

    clearing obligation. Clearing determinations are made at the initiative

    of the national authorities or the European Securities and Markets

    Authority (ESMA). Within six months of ESMA receiving notification by a

    national authority that a central counterparty has been authorized to

    clear a class of OTC derivatives, ESMA must determine whether that the

    class of OTC derivatives should be subject to the clearing obligation.

    At its own initiative, ESMA can also identify classes of OTC

    derivatives that should be subject to the clearing obligation.

    Additional details regarding the specific manner in which clearing

    determinations will be made have been set forth in implementing

    regulations adopted by the European Commission on December 19,

    2012.\74\

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

    \74\ See http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm.

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

    As evidenced by the progress of these jurisdictions, and others

    that host major financial markets across the world in implementing

    their clearing frameworks, the Commission agrees with ISDA & SIFMA that

    the comparability requirement of the inter-affiliate exemption is

    unlikely to pose a significant impediment to the use of the inter-

    affiliate exemption by most foreign affiliates because it is expected

    that the major financial jurisdictions will implement their own

    mandatory clearing regimes. Notwithstanding the progress of other

    jurisdictions to implement their clearing regimes, as discussed above,

    the Commission is mindful of commenters' concerns that the compliance

    timeframe for the clearing requirement in the U.S. is likely to precede

    the adoption and/or implementation of the clearing regimes of most

    other jurisdictions.

    Accordingly, the Commission believes that it is important to

    provide for a transition period for foreign regimes to implement their

    clearing mandates to bring swaps into clearing. For certain eligible

    affiliate counterparties located in jurisdictions that have adopted

    swap clearing regimes and are currently in the process of

    implementation, namely Japan, the European Union, and Singapore, the

    Commission is modifying the proposed rule to allow for a transition

    period of one year from the first compliance date of the U.S. clearing

    mandate, until March 11, 2014, for those foreign jurisdictions that are

    working to implement their mandatory clearing regimes.\75\ The

    Commission believes that a transition period of 12 months after

    required clearing began in the U.S. is appropriate given its

    understanding of the progress being made on mandatory clearing in the

    specified foreign jurisdictions. Regulation 50.52(b)(4)(ii)(A) provides

    that during that one-year period, affiliates domiciled in such foreign

    jurisdictions can satisfy the requirements of Sec. 50.52(b)(4)(i)

    through the following: (i) Each eligible affiliate counterparty, or a

    majority-interest holder on behalf of both eligible affiliate

    counterparties, pays and collects full variation margin daily on all

    its swaps with unaffiliated counterparties; or (ii) each eligible

    affiliate counterparty, or a majority-interest holder on behalf of both

    eligible affiliate counterparties, pays and collects full variation

    margin daily on all its swaps with other eligible affiliate

    counterparties.

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

    \75\ While the time-limited alternative compliance framework of

    Sec. 50.52(b)(4)(ii) is limited to jurisdictions that currently

    have the legal authority to adopt mandatory clearing regimes, any

    jurisdiction that later adopts a mandatory clearing regime will be

    eligible for a comparability determination for purposes of this

    rule.

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

    Moreover, the Commission has determined to provide further time-

    limited relief for certain eligible affiliated counterparties located

    in the European Union, Japan, or Singapore from complying with the

    requirements of Sec. 50.52(b)(4)(i) (or (b)(4)(ii)(A)) as a condition

    of electing the inter-affiliate exemption. In particular, Sec.

    50.52(b)(4)(ii)(B) provides that if one of the eligible affiliate

    counterparties is located in the European Union, Japan, or Singapore,

    the requirements of paragraph (b)(4)(i) will not apply to such eligible

    affiliate counterparty until March 11, 2014, provided that two

    conditions are met. The first condition provides that the one

    counterparty that directly or indirectly holds a majority ownership

    interest in the other counterparty or the third party that directly or

    indirectly holds a majority ownership interest in both counterparties

    is not a ``financial entity'' as defined in section 2(h)(7)(C)(i) of

    the Act.\76\ The second condition requires that neither eligible

    affiliate counterparty is affiliated with an entity that is an SD or

    MSP, as defined in Sec. 1.3. This condition essentially requires that

    the eligible affiliate counterparties are not part of a corporate group

    with a member affiliate that is an SD or MSP. Accordingly, eligible

    affiliate counterparties that are located in European Union, Japan, or

    Singapore and meet these two conditions, are exempt from the

    requirements of Sec. 50.52(b)(4)(i) until March 11, 2014. The

    Commission believes that providing the time-limited exemption in Sec.

    50.52(b)(4)(ii)(B) to the specific entities described above is

    consistent with comments requesting that the exchange of variation

    margin requirement, to the extent retained, be limited to SDs and MSPs.

    Specifically, ISDA & SIFMA noted in their comments that the scope of

    the Commission's regulatory concern should be limited to SDs and MSPs,

    and that the regulatory regime applicable to SDs already contained

    applicable safeguards, including variation margin requirements.

    Similarly, CDEU commented that any variation margin requirements be

    limited to SDs and MSPs.

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

    \76\ For purposes of meeting the requirements of Sec.

    50.52(b)(4)(ii)(B)(1) until March 11, 2014, the holding company

    (i.e., the ultimate parent of the corporate group) may not be

    considered to be a ``financial entity,'' as defined in section

    2(h)(7)(C)(i) of the CEA, under certain circumstances. The holding

    company must be able to identify all affiliates that meet the

    requirements of Sec. 50.52(a). Of those identified affiliates, a

    predominant number must qualify for the end-user exception under

    Sec. 50.50. If a predominant number of the affiliates meeting the

    requirements of Sec. 50.52(a) qualify for the end-user exception

    under Sec. 50.50, then the holding company may treat the activities

    of all of its affiliates meeting the requirements of Sec. 50.52(a)

    as if the holding company was engaged directly in such activities

    and consider such affiliates' activities on a cumulative basis with

    the holding company's other activities when assessing whether the

    holding company is ``predominantly engaged in activities that are in

    the business of banking, or in activities that are financial in

    nature, as defined in section 4(k) of the Bank Holding Company Act

    of 1956'' under section 2(h)(7)(C)(i)(VIII) of the CEA. In effect,

    the holding company may ``look through'' its investment in

    affiliates to all of the activities of the affiliates meeting the

    requirements of Sec. 50.52(a). Accordingly, the activities of

    affiliates meeting the requirements of Sec. 50.52(a) that are not

    in the business of banking or financial in nature, as defined in

    section 4(k) of the Bank Holding Company Act of 1956, would be

    attributed to the holding company. Conversely, if the affiliates

    meeting the requirements of Sec. 50.52(a) are engaged in activities

    that are in the business of banking or of a financial nature, then

    those activities would be attributed to the holding company for

    purposes of determining whether the holding company is a financial

    entity for purposes of meeting the requirements of Sec.

    50.52(b)(4)(ii)(B)(1).

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

    For eligible affiliate counterparties that are located in

    jurisdictions other than the European Union, Japan or Singapore, the

    Commission also is providing another time-limited alternative

    compliance framework for meeting the requirements of Sec.

    50.52(b)(4)(i). Specifically, Sec. 50.52(b)(4)(iii) provides that if

    an eligible affiliate counterparty located in the United States enters

    into swaps (that are included in a class of swaps identified in Sec.

    50.4), with eligible

    [[Page 21765]]

    affiliate counterparties located in jurisdictions other than the United

    States, the European Union, Japan, and Singapore, and the aggregate

    notional value of such swaps, which are included in a class of swaps

    identified in Sec. 50.4 does not exceed five percent of the aggregate

    notional value of all swaps, which are included in a class of swaps

    identified in Sec. 50.4, in each instance the notional value as

    measured in U.S. dollar equivalents and calculated for each calendar

    quarter, held by the eligible affiliate counterparty located in the

    United States, then such swaps shall be deemed to satisfy the

    requirements of paragraph (b)(4)(i) until March 11, 2014, provided

    that: (A) Each eligible affiliate counterparty, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, pays and collects full variation margin daily

    on all swaps entered into between the eligible affiliate counterparties

    located in jurisdictions other than the United States, the European

    Union, Japan, and Singapore and an unaffiliated counterparty; or (B)

    each eligible affiliate counterparty, or a third party that directly or

    indirectly holds a majority interest in both eligible affiliate

    counterparties, pays and collects full variation margin daily on all of

    the eligible affiliate counterparties' swaps with the other eligible

    affiliate counterparties.

    The options provided under the two alternative compliance

    frameworks described above are intended to mitigate the risk associated

    with uncleared third-party swaps. The payment and collection of

    variation margin is a vital component of the clearing process. As the

    Commission noted in the NPRM, variation margin is an essential risk-

    management tool that serves both as a check on risk-taking that might

    exceed a party's financial capacity and as a limitation on losses when

    there is a failure.\77\ In addition to the risk-management benefits of

    variation margin, certain commenters expressed support for the

    inclusion of variation margin as a condition of the inter-affiliate

    exemption, and thus, the inclusion of variation margin within the

    alternative compliance frameworks is consistent with those comments.

    The Commission further clarifies that eligible affiliate counterparties

    that are eligible to comply with the alternative compliance frameworks

    in Sec. 50.52(b)(4)(ii) or Sec. 50.52(b)(4)(iii) and choose to pay

    and collect variation margin daily on either all of their inter-

    affiliate swaps or all of their third party swaps, will have

    flexibility in tailoring their daily variation margin arrangements,

    including with respect to establishing appropriate prices for purposes

    of marking to market and threshold levels at which margin will be

    settled.

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

    \77\ As described in the NPRM, variation margin entails marking

    open positions to their current market value each day and

    transferring funds between the parties to reflect any change in

    value since the previous time the positions were marked. This

    process prevents uncollateralized exposures from accumulating over

    time and thereby reduces the size of any loss resulting from a

    default should one occur. NPRM at 50429.

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

    Notwithstanding the alternative compliance frameworks, the

    Commission encourages all eligible affiliate counterparties to clear

    their outward-facing swaps on a voluntary basis in order to best

    mitigate the risks associated with those swaps. The Commission notes

    that in lieu of complying with the alternative compliance frameworks

    through March 11, 2014, eligible affiliate counterparties also may

    satisfy the outward-facing swap condition by complying with Sec.

    50.52(b)(4)(ii)(E) by clearing their third-party swaps through a

    registered DCO or a clearing organization that is subject to

    supervision by the appropriate government authorities in the home

    country of the clearing organization and has been assessed to be in

    compliance with the PFMIs.

    The Commission believes that the alternative compliance framework

    adopted in this release addresses commenters' concerns pertaining to

    the timing and sequencing of the inter-affiliate exemption and the

    effective date of the Commission's initial clearing determination, and

    incorporates ISDA & SIFMA's recommendation to provide an appropriate

    transition period for foreign jurisdictions to implement their clearing

    regimes.

    In response to The Working Group, the Commission notes that the

    treatment of outward-facing swaps condition is needed to protect U.S.

    financial markets and to prevent evasion of the clearing requirement.

    The modified condition requires that eligible affiliate counterparties,

    whether domiciled in the U.S. or in a foreign jurisdiction, that elect

    the inter-affiliate exemption must clear their outward-facing swaps, if

    such swaps fall within a class identified in Sec. 50.4, or satisfy one

    the provisions in the alternative compliance frameworks, as applicable,

    until March 11, 2014. The alternative compliance frameworks are a

    direct response to concerns raised by The Working Group, and other

    commenters, regarding providing other jurisdictions with sufficient

    time to implement their clearing regimes. The alternative compliance

    framework provides eligible affiliates that elect the inter-affiliate

    exemption with other options, in addition to clearing, for managing the

    risks associated with their outward-facing swaps. In response to

    concerns that foreign-domiciled eligible affiliates would not be able

    to enter into uncleared non-hedge swaps with third parties that are

    foreign-domiciled end users, the Commission notes that it would take

    into consideration any comparable exceptions or exemptions granted

    under a comparable foreign jurisdiction's clearing regime.

    In response to The Working Group's statement that the treatment of

    outward-facing swap condition expands the cross-border application of

    the clearing requirement to cover swaps between U.S. persons and non-

    U.S. persons, the Commission observes that U.S. persons are subject to

    the CEA's clearing requirement and part 50 of the Commission's

    regulations. Furthermore, the Commission notes that the final rule

    would permit eligible affiliate counterparties that are not located in

    the U.S. or in a comparable and comprehensive jurisdiction, to elect

    the inter-affiliate exemption provided that they clear any outward-

    facing swaps that are required to be cleared under Sec. 50.4, through

    a registered DCO or a clearing organization that is subject to

    supervision by appropriate government authorities in the home country

    of the clearing organization and has been assessed to be in compliance

    with the PFMIs.\78\

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

    \78\ The Commission believes that the use of an international

    standard that is substantially similar, though not identical, to the

    requirements under part 39 imposed upon DCOs registered with the

    Commission is appropriate for purposes of the condition. The PFMIs

    were developed with broad participation and comment from entities

    from multiple nations and have been approved by both IOSCO's

    Technical Committee and the CPSS. The Commission further notes that

    eligible affiliate counterparties that are not located in the U.S.

    or in a comparable and comprehensive jurisdiction must comply with

    the requirements of Sec. 50.52(b)(4)(i)(E). However, if such

    entities prefer to clear their swaps pursuant to the clearing

    requirement regime in the U.S. or in a jurisdiction that the

    Commission has determined to have a comparable clearing requirement,

    they also may comply with one of the conditions in Sec.

    50.52(b)(4)(i)(A) or (b)(4)(i)(B).

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

    Although the Commission believes that the alternative frameworks

    described above are necessary in the circumstances described, these

    alternatives are not equivalent to clearing and would not mitigate

    potential losses between swap counterparties in the same manner that

    clearing would. Thus, notwithstanding the alternative compliance

    frameworks, the Commission believes that the requirement that eligible

    affiliates clear

    [[Page 21766]]

    swaps entered into with non-affiliated counterparties is the most

    appropriate method in which to prevent evasion of the clearing

    requirement and to help protect U.S. financial markets, and encourages

    market participants to do so. As noted above, incorporated within the

    requirement that eligible affiliate counterparties clear their outward-

    facing swaps is the option to comply with the requirements of a foreign

    jurisdiction's clearing mandate for the outward-facing swaps, including

    any comparable exception or exemption granted under the foreign

    clearing mandate, provided that such foreign jurisdiction's clearing

    mandate is determined by the Commission to be comparable, and

    comprehensive but not necessarily identical, to the clearing

    requirement established under the CEA, and the exception or exemption

    is determined by the Commission to be comparable to an exception or

    exemption provided under the CEA or part 50.

    In the next section of the release, the Commission describes the

    specific comments raised with respect to the proposed ``comparable and

    comprehensive'' standard and provides a discussion of the its

    consideration of these comments, as well as an explanation of the

    Commission's anticipated process for reviewing and issuing

    comparability determinations in the context of the inter-affiliate

    exemption from clearing.

    3. Application of the Comparable and Comprehensive Standard to

    Mandatory Clearing

    Commenters raised questions as to the criteria the Commission would

    consider in rendering a comparability determination. ISDA & SIFMA

    requested that the Commission clarify that ``comparability'' does not

    mean that the host country must have the ``same'' requirement. CDEU

    questioned what specific criteria the Commission would consider in

    making a comparability finding. CDEU recommended that the Commission

    limit the applicability of the comparability requirement to SDs and

    MSPs, and claimed that extending the condition to end-users would

    disproportionately impact end-users that have global operations,

    particularly in emerging markets.\79\ CDEU further suggested that the

    Commission extend the inter-affiliate exemption to non-U.S. affiliates

    that enter into 20 or less third-party swaps per month. The Working

    Group noted that many commercial energy firms have operations in

    foreign jurisdictions that have less commercially robust financial

    markets than those in the U.S., and that the treatment of outward-

    facing swaps condition may place significant limitations on the ability

    of commercial enterprises to hedge risk associated with such

    operations, thereby resulting in higher cost of doing business in the

    foreign country or decreasing the business activity of the U.S. company

    in the foreign jurisdiction. The Working Group further commented that

    the proposed rule extends the reach of U.S. law on non-U.S. persons

    ``far beyond'' the immediate clearing requirement.\80\

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

    \79\ CDEU claimed that end users would be adversely impacted by

    the increased costs for risk-mitigating transactions between

    affiliates, and noted that the Dodd-Frank Act did not contemplate

    regulation of end-user transactions in the same manner as SD and MSP

    transactions.

    \80\ According to The Working Group, the proposed rule, for

    instance, would require certain non-U.S. persons to enter into an

    agreement with a futures commission merchant (FCM), and to enter

    into a commercial relationship in the U.S. including posting capital

    in U.S. markets that would subject such entities to U.S. bankruptcy

    law.

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

    AFR suggested that the final rule should specifically state that

    the ``comparable and comprehensive'' requirement must apply to each

    ``specific type of swap'' being considered for the exemption. AFR

    further stated that the Commission should provide a detailed

    comparability procedure, such as the procedure described in the

    proposed cross-border guidance. MetLife also suggested that rather than

    broadly prohibiting non-U.S. affiliates (that are not located in a

    comparable jurisdiction) from entering into any third-party swaps as a

    condition of the inter-affiliate exemption, the Commission should

    narrow the prohibition in the proposed rule to prohibit non-U.S.

    affiliates (that are not located in a comparable jurisdiction) from

    entering into ``similar swaps of the same product type'' with

    unaffiliated third parties.

    As described above, a number of commenters requested further

    clarification on how the Commission will apply the ``comparable and

    comprehensive'' standard in the context of the mandatory clearing. The

    comparability requirement originally was discussed in the Commission's

    Proposed Cross-Border Interpretive Guidance. Drawing on its experience

    in exempting foreign brokers from certain registrations requirements

    under its rule 30.10 ``comparability'' determinations, the Commission

    proposed the ``comparable and comprehensive'' concept in the Proposed

    Cross-Border Interpretive Guidance \81\ in order to permit certain

    classes of non-U.S. registrants to substitute compliance with the

    requirements of its home jurisdiction's law and regulations, in lieu of

    compliance with the CEA and the Commission's regulations, if the

    Commission finds that the relevant jurisdiction's laws and regulations

    are comparable to the relevant requirements of the CEA and Commission

    regulations.\82\

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

    \81\ Proposed Cross-Border Interpretive Guidance at 41232-35.

    \82\ The Proposed Cross-Border Interpretive Guidance identified

    transaction-level requirements to include mandatory clearing and

    swap processing, margining, segregation, trade execution, swap

    trading documentation, portfolio reconciliation and compression,

    real time public reporting, trade confirmation, and daily trading

    records requirements. The Proposed Cross-Border Interpretive

    Guidance proposed to allow substituted compliance with respect to

    transaction level requirements for swaps between a non-U.S. SD or

    non-U.S. MSP with a non-U.S. person that is guaranteed by a U.S.

    person, as well as swaps with non-U.S. affiliate conduits. See

    Proposed Cross-Border Interpretive Guidance at 41230.

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

    In the Proposed Cross-Border Interpretive Guidance, the Commission,

    in describing its intended approach to making comparability

    determinations, noted that similar to its policy with respect to rule

    30.10, the Commission would retain broad discretion to determine that

    the objectives of any program elements are met, notwithstanding the

    fact that the foreign requirements may not be identical to that of the

    Commission.

    i. Comparability of Foreign Clearing Mandate

    In response to comments seeking additional clarity around the

    Commission's comparability determination process, the Commission

    clarifies that it will review the comparability and comprehensiveness

    of a foreign jurisdiction's clearing mandate under Sec.

    50.52(b)(4)(i)(B) by reviewing: (i) The foreign jurisdiction's laws and

    regulations with respect to its mandatory clearing regime (i.e.,

    jurisdiction-specific review), and (ii) the foreign jurisdiction's

    clearing determinations with respect to each class of swaps for which

    the Commission has issued a clearing determination under Sec. 50.4 of

    the Commission's regulations (i.e., product-specific review).

    As noted above, and in response to ISDA & SIFMA, the Commission

    reiterates that for purposes of the treatment of outward-facing swaps

    condition of the inter-affiliate exemption, comparability findings with

    respect to a foreign jurisdiction's clearing regime will not require an

    identical regime to the clearing framework established under the Act

    and Commission regulations. Rather, the Commission anticipates that it

    will

    [[Page 21767]]

    make jurisdiction-specific comparability determinations by comparing

    the regulatory requirements of a foreign jurisdiction's clearing regime

    with the requirements and objectives of the Dodd-Frank Act. Notably,

    the Commission anticipates that the product-specific comparability

    determination will necessarily be made on the basis of whether the

    applicable swap is included in a class of swaps covered under Sec.

    50.4, and if so, whether such swap or class of swaps is covered under

    the foreign jurisdiction's clearing mandate.

    ii. Comparability of Exemption or Exception Under Foreign Clearing

    Regime

    With respect to determining whether an exemption or exception under

    a comparable foreign clearing mandate is comparable to an exception or

    exemption under the CEA or part 50, as provided under Sec.

    50.52(b)(4)(i)(D), the Commission anticipates that it would review for

    comparability purposes the foreign jurisdiction's laws and regulations

    with respect to its mandatory clearing regime, as well as the relevant

    exception or exemption. In doing so, the Commission would exercise

    broad discretion to determine whether the requirements and objectives

    of such exemption or exception are consistent with those under the

    Dodd-Frank Act and that such objectives are being met, notwithstanding

    the fact that the exemption or exception from clearing under the

    comparable foreign clearing regime may not be identical to those

    established under the Act or the Commission's regulations. Accordingly,

    the Commission anticipates that comparability determinations with

    respect to a foreign jurisdiction's exemption or exception from

    mandatory clearing could be made at either the entity level, or the

    transaction type, as appropriate.

    iii. Responses to Additional Comments

    In response to comments seeking clarification on what will trigger

    a Commission comparability determination, the Commission anticipates

    that it will render jurisdiction-specific and product-specific

    comparability determinations upon the adoption of clearing regimes by

    foreign jurisdictions for classes of swaps covered under Sec. 50.4,

    upon the request of a counterparty that is located in a foreign

    jurisdiction, or upon receipt of a request from another appropriate

    party.

    The Commission further anticipates that once a comparability

    determination is made with respect to the foreign jurisdiction's

    clearing regime, and with regard to a particular class of swaps covered

    under Sec. 50.4, eligible affiliates domiciled in such jurisdiction

    may rely on such determinations for swaps included within the

    applicable class, without further Commission action. To the extent that

    the Commission proposes a change to its regulations governing the

    clearing requirement generally or with respect to any particular

    product class, the Commission will reevaluate whether the proposed

    regulatory change would affect the basis upon which the Commission made

    the comparability determination. To the extent that there are

    discrepancies in the requirements between the foreign jurisdiction and

    the Commission's proposed regulatory change, the Commission anticipates

    that it would issue additional guidance or notifications to market

    participants to determine how affected entities can address any

    discrepancy in requirements.

    The Commission declines to limit the condition that eligible

    affiliates clear their outward-facing swaps to SDs and MSPs, as

    suggested by CDEU. As explained throughout this release, the Commission

    believes that the requirements of Sec. 50.52(b)(4) are necessary to

    prevent evasion of the clearing requirement and to protect U.S.

    financial markets. Moreover, the requirements of section 2(h)(1)(A)

    apply to all market participants not able to elect an exception under

    section 2(h)(7) of the CEA, not just to SDs and MSPs. The Commission

    believes that the modified rule and time-limited alternative compliance

    frameworks adopted in the final rule will provide end users, amongst

    others, with substantial flexibility to comply with the conditions of

    the exemption. Furthermore, the Commission notes that end users also

    may elect the end-user exception from clearing for hedging transactions

    that comply with the requirements of the CEA and Sec. 50.50.

    For the reasons described in this release, the Commission is

    adopting in Sec. 50.52(b) the conditions to the inter-affiliate

    exemption, initially proposed as Sec. 39.6(g)(2)(v), pertaining to

    swaps entered into with unaffiliated counterparties, with the

    modifications described above.

    H. Reporting Requirement and Annual Election

    In the NPRM, the Commission explained that general reporting

    requirements under sections 2(a)(13) and 4r of the CEA and part 45

    apply to uncleared inter-affiliate swaps.\83\ In addition, the proposed

    regulations require the reporting counterparty to provide, or cause to

    be provided, to a registered SDR, or if no registered SDR is available,

    to the Commission, certain additional information. Proposed Sec.

    39.6(g)(4)(i) requires the reporting counterparty to confirm that both

    counterparties to the inter-affiliate swap are electing not to clear

    the swap and that both counterparties meet the requirements in proposed

    Sec. 39.6(g)(1)-(2). Proposed Sec. 39.6(g)(4)(ii) requires the

    reporting counterparty to submit information regarding how the

    financial obligations of both counterparties are generally satisfied

    with respect to uncleared swaps. Proposed Sec. 39.6(g)(4)(iii)

    implements section 2(j) of the CEA for purposes of the inter-affiliate

    exemption. Section 2(j) of the CEA applies to an issuer of securities

    registered under section 12 of the Securities Exchange Act of 1934

    (Exchange Act) \84\ or an entity required to file reports under

    Exchange Act section 15(g) (``electing SEC Filers'') that elects an

    exemption from the CEA's clearing requirement under section 2(h)(1)(A)

    of the CEA. Section 2(j) requires that an appropriate committee of the

    electing SEC Filer's board or governing body review and approve its

    decision to enter into swaps subject to an exemption clearing. Proposed

    Sec. 39.6(g)(4)(iii)(A) requires an electing SEC Filer to notify the

    Commission of its SEC Filer status by submitting its SEC Central Index

    Key number. In addition, proposed Sec. 39.6(g)(4)(iii)(B) requires the

    counterparty to report whether an appropriate committee of its board of

    directors (or equivalent governing body) has reviewed and approved the

    decision to enter into the inter-affiliate swaps that are exempt from

    clearing.\85\

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

    \83\ See NPRM at 50432.

    \84\ 15 U.S.C. 78l.

    \85\ The proposed requirements under regulations implementing

    section 2(j) mirror the requirements that the Commission finalized

    in its end-user exception rulemaking, End-User Exception to the

    Clearing Requirement for Swaps, 77 FR 42560.

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

    Lastly, proposed Sec. 39.16(g)(5) permits a counterparty to

    provide information related to how it generally meets its financial

    obligations and information related to its status as an electing SEC

    Filer on an annual basis in anticipation of electing the inter-

    affiliate clearing exemption for one or more swaps. This election is

    effective for inter-affiliate swaps entered into within 365 days

    following the date of such reporting. During the 365-day period, the

    affiliate counterparty would be required to amend the information as

    necessary to

    [[Page 21768]]

    reflect any material changes to the reported information. Under the

    proposal, confirmation that both counterparties are electing not to

    clear the swap and that they both satisfy the other requirements of the

    exemption would not be subject to an annual filing, but must be done on

    a swap-by-swap basis.

    The Commission received several comments in response to the

    reporting obligations of affiliates. Prudential and MetLife both

    commented that the Commission should clarify that only one counterparty

    is required to report the swap to an SDR. In addition, both Prudential

    and MetLife stated that annual reporting is more efficient than swap-

    by-swap reporting.

    EEI stated that the Commission should eliminate the transaction-by-

    transaction reporting requirement under proposed Sec. 39.6(g)(4)(i)

    for the election of the exemption and confirmation that the conditions

    have the exemption have been met. Instead, EEI recommended that one of

    the affiliates be permitted to file an annual notice on behalf of both

    affiliates to exempt all of their swaps from clearing for an entire

    year. EEI contended that it will increase costs if both affiliates have

    to communicate that they elect not to clear the swap and meet the

    conditions of the exemption for each swap. EEI also stated that the

    Commission should state that part 45 does not apply to inter-affiliate

    swaps because the Commission will be able to obtain information

    regarding an inter-affiliate transaction based on reporting of a

    corresponding market-facing swap.\86\

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

    \86\ EEI cited to a statement in the NPRM's consideration of

    costs and benefits as support for an argument that the Commission

    did not intend for part 45 reporting to apply to inter-affiliate

    swaps. See NPRM at 50433. The statement in the cost-benefit

    consideration of the NPRM merely drew a comparison between the

    reporting requirements under the proposed exemption and the general

    reporting requirements under parts 45 and 46, and those reporting

    requirements applicable to SDs and MSPs under part 23. The statement

    should not be read as calling into question the applicability of

    part 45 to inter-affiliate swaps.

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

    CDEU also objected to reporting any information to an SDR on a

    trade-by-trade basis for inter-affiliate swaps as such reporting would

    be costly and onerous for parties. Instead, CDEU recommended that all

    reporting be done on an annual basis through a board resolution.\87\

    CDEU also requested that part 45 data be reported on a quarterly basis

    for all inter-affiliate swaps between financial and non-financial end

    users, and that inter-affiliate swaps not be subject to historical swap

    reporting under part 46. Similarly, Cravath asked that the Commission

    ``provide meaningful relief from the reporting requirements of Part 45

    and Part 46.''

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

    \87\ Cravath stated that the Commission has determined that part

    43 reporting does not apply to inter-affiliate swaps.

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

    DLA Piper commented that the regulatory reporting requirements are

    unnecessary for inter-affiliate swaps and should be eliminated.\88\ DLA

    Piper claimed that the reporting of both the outward-facing swap and

    the inter-affiliate swap would increase systemic risk by distorting the

    risk to the financial system. DLA Piper also commented that the

    imposition of recordkeeping obligations with respect to inter-affiliate

    swaps would result in significant additional burdens on corporate

    groups. DLA Piper stated that inter-affiliate swaps should be expressly

    exempt from the part 45 and part 46 reporting requirements.

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

    \88\ According to its comment letter, DLA Piper's comments are

    limited to corporate end-users who enter into intercompany hedging

    transactions.

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

    Under sections 2(a)(13) and 4r of the CEA, all swaps must be

    reported to an SDR (or the Commission if there is no available SDR) and

    are subject to comprehensive recordkeeping obligations.\89\ Reporting

    and recordkeeping obligations apply to both historical swaps \90\ and

    those swaps executed after the applicable compliance date listed in

    part 45 of the Commission's regulations.\91\ As indicated in the

    preamble to the final end-user exception \92\ and the NPRM,\93\ parts

    45 and 46 of the Commission's regulations apply to inter-affiliate

    swaps.\94\ Whether an inter-affiliate swap is subject to the part 43

    real-time reporting rules will depend on whether the transaction fits

    within the definition of a ``publically reportable swap transaction.''

    \95\

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

    \89\ See 17 CFR part 45; 17 CFR 45.2 (recordkeeping

    obligations); Swap Data Recordkeeping and Reporting Requirements, 77

    FR 2136 (Jan. 13, 2012); 17 CFR part 46; Swap Data Recordkeeping and

    Reporting: Pre-Enactment and Transition Swaps, 77 FR 35200 (June 12,

    2012).

    \90\ As described in the part 46 rules, historical swaps include

    pre-enactment swaps, that is, swaps still in existence after the

    date of enactment of the Dodd-Frank Act, and transition swaps, that

    is, swaps entered into on or after the date of enactment but before

    the compliance date specified in part 45 and other no-action or

    regulatory guidance issued by the Commission or one of the

    Commission's divisions or offices.

    \91\ These reporting obligations may be subject to no-action or

    other regulatory guidance issued by the Commission or any of the

    Commission's divisions or offices. See www.cftc.gov for a complete

    list of the staff no-action letters, Frequently Asked Questions, and

    other regulatory guidance.

    \92\ See End-User Exception to the Clearing Requirement for

    Swaps, 77 FR 42567 (``Congress did not exempt such inter-affiliate

    swaps from the reporting requirements'' and ``inter-affiliate swaps

    must be reported'').

    \93\ NPRM at 50432 (noting that section 4r applies to uncleared

    swaps and that counterparties must comply with proposed rule

    39.6(g)(4) ``[i]n addition to any general reporting requirements

    applicable under other applicable rules'').

    \94\ In addition, under part 45 non-SDs and MSPs must keep

    ``full, complete, and systematic records, together with all

    pertinent data and memoranda, with respect to each swap in which

    they are a counterparty.'' 17 CFR 45.2(b). These recordkeeping

    obligations applied to inter-affiliate swaps as early as October 14,

    2010. See Interim Final Rule for Reporting Pre-Enactment Swap

    Transactions, 75 FR 63090 (Oct. 14, 2010). Thus, as of the date of

    this release, swap counterparties already have an obligation to

    maintain swap records that has existed for more than two years.

    \95\ See 17 CFR 43.2 (defining ``publicly reportable swap

    transaction'' as an executed swap that is an arm's length

    transaction between two parties that results in a change in the

    market risk position between the two parties and citing ``internal

    swaps between one-hundred percent owned subsidiaries of the same

    parent entity'' as an example of a swap that does not meet the

    definition); see also Real-Time Public Reporting of Swap Transaction

    Data, 77 FR 1182, 1187 (Jan. 9, 2012) (discussing the real-time

    public reporting of inter-affiliate swaps).

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

    In response to commenters' requests, the Commission is clarifying

    that the reporting obligations under Sec. 39.6(g)(2)(i) (now Sec.

    50.52(c)) can be fulfilled by one of the affiliate counterparties on

    behalf of both counterparties. The selection of which affiliate will be

    considered to be the reporting counterparty should be determined in

    accordance with the provisions of Sec. 45.8 and, for part 43, the

    reporting party under Sec. 43.3(a)(3).

    As noted in the NPRM, the Commission believes that affiliates

    within a corporate group may make independent determinations on whether

    to submit an inter-affiliate swap for clearing. Given the possibility

    that each affiliate may reach different conclusions regarding clearing

    the swap, Sec. 39.6(g)(2)(i) would require that both counterparties

    elect the proposed inter-affiliate clearing exemption. The Commission

    is therefore adopting the electing requirement as proposed.

    With regard to comments recommending that all reporting be done on

    an annual basis rather than a swap-by-swap basis, the Commission

    declines to modify the rule. The Commission believes it is appropriate

    to provide for annual reporting of certain information, including how

    affiliates generally meet their financial obligations and information

    related to its status as an electing SEC Filer.\96\ However, it would

    not be appropriate to allow one annual report to cover both

    [[Page 21769]]

    affiliate counterparties' election of the exemption from clearing and

    the confirmation that both affiliates meet the conditions of the

    exemption because each affiliate is under an ongoing obligation to

    demonstrate its eligibility to claim the exemption and because

    effective regulatory monitoring requires an indication of the election

    on a swap-by-swap basis.\97\ Accordingly, the election of the exemption

    and the confirmation that the exemption's conditions are met must be

    made for each swap. The Commission does not believe that this reporting

    requirement will impose a significant burden on affiliate

    counterparties because, as discussed above, other detailed information

    for every swap must be reported under sections 2(a)(13) and 4r of the

    CEA and Commission regulations. This approach comports with the

    approach adopted for market participants claiming the end-user

    exception under section 2(h)(7) of the CEA.\98\

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

    \96\ The Commission is modifying the proposed reporting

    requirements relating to section 2(j) of the CEA to make them

    consistent with the approach adopted in the end-user exception to

    required clearing. As finalized, under Sec. 50.52(c)(3)(ii), the

    committee of the board of directors (or equivalent body) of the

    eligible affiliate counterparty must have ``reviewed and approved

    the decision to enter into swaps that are exempt from the

    requirements of sections 2(h)(1) and 2(h)(8) of the Act.''

    \97\ If reports to the SDR were made on an annual basis, but

    included swap-by-swap information, regulators would not be able to

    monitor the transmission of risk through the market in a timely

    fashion. Regulators would have a one-year lag before such data could

    be used effectively for such purposes. If reports to the SDR were

    made on an annual basis and did not include swap-by-swap

    information, the regulators would be permanently hindered in their

    ability to monitor the swap markets. As noted above, inter-affiliate

    swaps and outward-facing swaps both transfer risk, but they do so in

    different ways and in differing degrees. Regulators must be able to

    distinguish between inter-affiliate swaps and outward-facing swaps

    in order to monitor markets effectively. If electing entities

    provided an annual statement that they are electing the exemption,

    and do not identify the individual swaps for which the exemption has

    been elected, the data would not allow regulators to distinguish

    between the two groups.

    \98\ See End-User Exception to the Clearing Requirement for

    Swaps, 77 FR 42565-66.

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

    The Commission does not agree with EEI's comment that the

    Commission will be able to obtain information on inter-affiliate swaps

    from the information reported on market-facing swaps, and disagrees

    with DLA Piper's comment that reporting and recordkeeping obligations

    are unnecessary or would increase systemic risk. The reporting and

    recordkeeping requirements promote accountability and transparency, and

    will aid the Commission in monitoring compliance with the inter-

    affiliate exemption. Moreover, the Commission does not believe that the

    information relating to inter-affiliate swaps will necessarily be

    identical to market-facing swaps. Also, the Commission does not believe

    that all inter-affiliate swaps will match up to market-facing swaps

    because, as The Working Group commented, entities use inter-affiliate

    trades to transfer physical commodity or futures exposure between

    affiliates for compliance with international tax law, customs, or

    accounting laws.

    I. Implementation

    The clearing requirement under section 2(h)(1)(A) of the CEA and

    part 50 of the Commission's regulations shall not apply to a swap

    executed between affiliated counterparties that have the status of

    eligible affiliate counterparties, as defined in Sec. 50.52(a), and

    elect not to clear such swap until the effective date of this

    rulemaking. The effective date of this rulemaking shall be 60 days

    after publication in the Federal Register.

    III. Cost-Benefit Considerations

    A. Statutory and Regulatory Background

    Section 15(a) of the CEA \99\ requires the Commission to consider

    the costs and benefits of its actions before promulgating a regulation

    under the CEA or issuing certain orders. Section 15(a) further

    specifies that the costs and benefits shall be evaluated in light of

    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. The Commission considers the costs and benefits

    resulting from its discretionary determinations with respect to the

    section 15(a) factors.

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

    \99\ 7 U.S.C. 19(a).

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

    Prior to the passage of the Dodd-Frank Act, swaps were not required

    to be cleared. In the wake of the financial crisis of 2008, Congress

    adopted the Dodd-Frank Act, which, among other things, amends the CEA

    to impose a clearing requirement for swaps based on determinations by

    the Commission regarding which swaps are required to be cleared through

    a DCO.\100\ This clearing requirement is designed to reduce

    counterparty risk associated with swaps and, in turn, mitigate the

    potential systemic impact of such risk and reduce the risk that swaps

    could cause or exacerbate instability in the financial system.\101\ In

    amending the CEA, however, the Dodd-Frank Act preserved the

    Commission's authority to ``promote responsible economic or financial

    innovation and fair competition'' by exempting any transaction or class

    of transactions, including swaps, from select provisions of the

    CEA.\102\ For reasons explained above,\103\ the Commission proposes to

    exercise its authority under section 4(c)(1) of the CEA to exempt

    inter-affiliate swaps--that is, swaps between majority-owned affiliates

    with financial statements that are reported on a consolidated basis

    under GAAP or IFRS--from the clearing requirement under section

    2(h)(1)(A) of the CEA, subject to certain conditions.

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

    \100\ See section 2(h)(1) of the CEA, 7 U.S.C. 2(h)(1).

    \101\ When a bilateral swap is moved into clearing, the

    clearinghouse becomes the counterparty to each of the original

    participants in the swap. This standardizes counterparty risk for

    the original swap participants in that they each bear the same risk

    attributable to facing the clearinghouse as counterparty. In

    addition, clearing mitigates counterparty risk to the extent that

    the clearinghouse is a more creditworthy counterparty relative to

    those that each participant in the trade might have otherwise faced.

    Clearinghouses have demonstrated resilience in the face of past

    market stress. Most recently, they remained financially sound and

    effectively settled positions in the midst of turbulent events in

    2007-2008 that threatened the financial health and stability of many

    other types of entities.

    \102\ Section 4(c)(1) of the CEA, 7 U.S.C. 6(c)(1). Section

    4(c)(1) is discussed in greater detail above in Section II.A.

    \103\ See Section II.A above.

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

    In the discussion that follows, the Commission considers the costs

    and benefits of the inter-affiliate exemption to the public and market

    participants generally. The Commission also separately considers the

    costs and benefits of the conditions placed on affiliates that would

    elect the exemption: (1) Majority ownership and financial statements

    that are reported on a consolidated basis under GAAP or IFRS as

    conditions for status as an eligible affiliate counterparty; (2) swap

    trading relationship documentation, which would require affiliates to

    document in writing all terms governing the trading relationship; (3)

    centralized risk management requirement, which would require affiliates

    to subject the swap to centralized risk management; and (4) reporting

    requirements, which would require counterparties to advise an SDR, or

    the Commission if no SDR is available, that both counterparties elect

    the inter-affiliate clearing exemption and to identify the types of

    collateral used to meet financial obligations. In addition to the

    foregoing reporting requirements, counterparties that are issuers of

    securities registered under section 12 of the Securities Exchange Act

    of 1934 or those that are required to file reports under section 15(d)

    of that Act, would be required to identify the SEC central index key

    number and confirm that an appropriate committee of board of directors

    has approved of the affiliates' decision not to clear a swap. The rule

    also would permit affiliates to report certain information on an annual

    basis, rather

    [[Page 21770]]

    than swap-by-swap. Finally, the Commission considers the costs and

    benefits of the condition regarding the treatment of outward-facing

    swaps.

    In the NPRM, where reasonably feasible, the Commission sought to

    estimate quantifiable dollar costs. In some instances, however, the

    Commission explained that certain costs were not susceptible to

    meaningful quantification, and in those instances, the Commission

    discussed proposed costs and benefits in qualitative terms. As stated

    above, the Commission received a total of 14 comment letters following

    the publication of the NPRM, many of which strongly supported the

    proposed regulations. Some commenters generally addressed the cost-and-

    benefit aspect of the current rule; none of them, however, provided any

    quantitative data in response to the Commission's requests for

    comment.\104\

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

    \104\ As discussed further below, EEI commented on the NPRM's

    consideration of costs and benefits and stated that the costs of the

    proposed documentation requirement are unjustified. The NPRM

    included an estimate that there would be a one-time cost of $15,000

    to develop appropriate documentation for use by an entity's

    affiliates. EEI objected to this estimate because, in its view, the

    legal costs associated with individually negotiating and amending

    standard agreements between individual affiliates would exceed the

    NPRM's estimates. In addition, EEI objected to the NPRM's estimate

    of 22 affiliated counterparties for each corporate group as ``far

    too low'' for U.S. energy companies. However, EEI did not provide

    specific, quantitative information in terms of either the legal

    costs of complying with the proposed documentation requirement or

    number of affiliates for a corporate group subject to this rule.

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

    In the sections that follow the Commission considers: (1) Costs and

    benefits of the exemption for eligible affiliate counterparties; (2)

    costs and benefits of the exemption for market participants and the

    public; (3) alternatives contemplated by the Commission and the costs

    and benefits relative to the approach adopted herein; (4) the impact of

    exemption in light of the 15(a) factors. The Commission also discusses

    the corresponding comments accordingly.

    B. Costs and Benefits of Exemption for Eligible Affiliate

    Counterparties

    Without the final rule exempting swaps between certain affiliated

    counterparties, those entities would have to clear their inter-

    affiliate swaps pursuant to section 2(h)(1)(A) of the CEA (unless one

    of the affiliates is able to claim an exception under section 2(h)(7)

    of the CEA and/or Sec. 50.50).\105\ This rule allows eligible

    affiliates to exempt inter-affiliate swaps from clearing, which creates

    both costs and benefits for those entities. Regarding costs, by

    allowing affiliates not to clear certain swaps that would otherwise be

    subject to required clearing, the rule may allow those affiliates to be

    exposed to greater measures of counterparty credit risk with respect to

    one another. On the other hand, the primary benefit of providing this

    exemption for inter-affiliate swaps between eligible affiliate

    counterparties is that each affiliate will not have to incur the costs

    of required clearing. These costs include clearing fees, as well as

    costs associated with margin and capital requirements. The rule also

    facilitates affiliates' use of swaps to hedge various types of risk

    more efficiently.

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

    \105\ Under the Sec. 50.50 exception, end users and small

    financial institutions that are hedging or mitigating commercial

    risk may elect not to clear their swaps, subject to certain

    conditions. Because of this exception, as explained in the NPRM, the

    Commission anticipates that the inter-affiliate exemption will be

    elected only when the two counterparties are financial entities that

    do not qualify for the end-user exception. See NPRM at 50426.

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

    1. Benefits of Clearing Inter-Affiliate Swaps

    The benefits of required clearing have been well-documented by the

    Commission.\106\ As described in the preceding sections of this

    adopting release, there are numerous benefits associated with central

    clearing of swaps. In particular, clearing mitigates counterparty

    credit risk, provides an organized mechanism for collateralizing the

    risk exposures posed by swaps, and when applied to channels where

    systemic risk could be transmitted, clearing reduces systemic risk.

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

    \106\ See e.g., Clearing Requirement Determination at 74329.

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

    The counterparty and systemic risk mitigation benefits of central

    clearing also are realized from clearing transactions between

    affiliates. Central clearing would ensure that inter-affiliate swaps

    are fully documented and abide by valuation procedures set by the DCO,

    which would help to ensure that affiliates have current and accurate

    information regarding the value of their positions and would help

    prevent the possibility of valuation disputes.\107\ In addition, when a

    bilateral swap is cleared, the clearinghouse becomes the counterparty

    to each of the original counterparties to the swap. This reduces and

    standardizes the counterparty risk borne by each of the original

    parties to the swap.\108\ Moreover, clearing mitigates the risk of

    financial contagion because the clearinghouse serves as a sort of

    ``buffer'' that protects each of the original counterparties from the

    credit risk of the other. This would also be true for inter-affiliate

    swaps. Novating the swap to a clearinghouse so that each affiliate

    faces the clearinghouse would ensure that each affiliate is facing

    minimal counterparty credit risk and would minimize the possibility of

    inter-affiliate swaps becoming a mechanism through which financial

    instability could pass from one affiliate to another.

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

    \107\ ISDA & SIFMA stated that valuation and dispute resolution

    procedures would appear to serve little purpose among majority-owned

    affiliates. This comment is discussed above in Section II.D, as well

    as in Section III.C.2. below.

    \108\ A clearinghouse is one of the most credit-worthy

    counterparties available in the market because of the panoply of

    risk management tools it has at its disposal. These tools include

    the contractual right to: (1) Collect initial and variation margin

    associated with outstanding swap positions; (2) mark positions to

    market regularly (usually one or more times per day) and issue

    margin calls whenever the margin in a customer's account has dropped

    below predetermined levels set by the DCO; (3) adjust the amount of

    margin that is required to be held against swap positions in light

    of changing market circumstances, such as increased volatility in

    the underlying; and (4) close out the swap positions of a customer

    that does not meet margin calls within a specified period of time.

    Moreover, in the event that a clearing member defaults on their

    obligations to the DCO, the latter has a number of remedies to

    manage associated risks, including transferring the swap positions

    of the defaulted member, and covering any losses that may have

    accrued with the defaulting member's margin and other collateral on

    deposit. In order to transfer the swap positions of a defaulting

    member and manage the risk of those positions while doing so, the

    DCO has the ability to: (1) Hedge the portfolio of positions of the

    defaulting member to limit future losses; (2) partition the

    portfolio into smaller pieces; (3) auction off the pieces of the

    portfolio, together with their corresponding hedges, to other

    members of the DCO; and (4) allocate any remaining positions to

    members of the DCO. In order to cover the losses associated with

    such a default, the DCO would typically draw from (in order): (1)

    The initial margin posted by the defaulting member; (2) the guaranty

    fund contribution of the defaulting member; (3) the DCO's own

    capital contribution; (4) the guaranty fund contribution of non-

    defaulting members; and (5) an assessment on the non-defaulting

    members. These mutualized risk mitigation capabilities are largely

    unique to clearinghouses, and help to ensure that they remain

    solvent and creditworthy swap counterparties even when dealing with

    defaults by their members or other challenging market circumstances.

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

    This rule reduces these benefits by allowing affiliates to exempt

    swaps from required clearing. In the absence of clearing, affiliated

    entities will not be required to collect initial or variation margin,

    or to implement other measures that clearinghouses typically use to

    mitigate their own counterparty credit risk. As a consequence, the

    affiliates may accumulate large outstanding positions with one another

    as the value of their swap positions change value between payment

    dates. If an affiliate with large, out-of-the-money, inter-affiliate

    swap positions defaulted, it could cause financial instability in its

    affiliates, leading to a cascading series of defaults among them. As

    discussed below, the Commission expects that internalization of costs

    and risks among

    [[Page 21771]]

    affiliated entities, as well as the conditions for electing the

    exemption will mitigate this cost, but will not eliminate it entirely.

    2. Reduced Clearing Costs

    As stated above, by exempting qualified affiliates from clearing

    inter-affiliate swaps that would otherwise be subject to the clearing

    requirement, the rule ensures that each affiliate will not incur the

    costs of required clearing for those swaps. These costs include

    clearing fees as well as costs associated with margin and capital

    requirements. Regarding clearing fees, assuming that the affiliated

    counterparties cannot clear on their own behalves or through an

    affiliated clearing member of a DCO, the affiliated counterparties

    would have to arrange to clear their swaps through a futures commission

    merchant (FCM) that is a member of a DCO. Regardless of whether the

    affiliated counterparties clear on their own behalf or contract with an

    FCM, they will incur fees from the DCO.

    For customer clearing, DCOs typically charge FCMs an initial

    transaction fee for each customer swap that is cleared, as well as an

    annual maintenance fee for each of the customers' open positions. For

    example, not including customer-specific and volume discounts, the

    transaction fees for interest rate swaps at CME range from $1 to $24

    per million notional amount and the maintenance fees are $2 per year

    per million notional amount for open positions.\109\ LCH transaction

    fees for interest rate swaps range from $1 to $20 per million notional

    amount, and the maintenance fee ranges from $5 to $20 per swap per

    month, depending on the number of outstanding swap positions that an

    entity has with the DCO.\110\ It is within the FCM's discretion to

    determine whether or how to pass these fees on to their customers.\111\

    Accordingly, allowing affiliates to elect not to clear swaps that meet

    the requirements of the final rule will result in the affiliates not

    having to pay clearing-related fees, either directly or indirectly,

    with respect to those swaps.

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

    \109\ See CME pricing charts at: http://www.cmegroup.com/trading/cds/files/CDS-Fees.pdf; http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Customer-Fee.pdf; and http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Self-Clearing-Fee.pdf.

    \110\ See LCH pricing for clearing services related to OTC

    interest rate swaps at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.

    \111\ See discussion of clearing fees in the Clearing

    Requirement Determination, 77 FR 74324-25.

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

    Second, permitting an exemption from clearing for swaps between

    affiliates, the final rule will reduce the amount of initial margin

    that such entities are required to post or pay for those swaps. In the

    clearing requirement determination, the Commission estimated that if

    every interest rate swap and CDS that is not currently cleared were

    moved into clearing, the additional initial margin that would need to

    be posted is approximately $19.2 billion for interest rate swaps and

    $53 billion for CDS.\112\ While the estimates provided by the

    Commission in its clearing requirement determination adopting release

    did not include data related to inter-affiliate swaps,\113\ the

    estimates do support a conclusion that the exemption will reduce the

    amount of margin that affiliates would be obligated to allocate to

    initial margin in order to clear inter-affiliate swaps that are subject

    to the clearing requirement. As a consequence, the exemption is likely

    to increase the amount of capital that affiliates may distribute to

    their owners or put to other uses.

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

    \112\ See Clearing Requirement Determination at 74326

    (explaining how this estimate was reached and noting that the

    estimate may either over-estimate or under-estimate the amount of

    additional initial margin that would need to be posted).

    \113\ For example, swap data collected by the Bank of

    International Settlements (BIS) does not contain information

    regarding transactions between affiliates (i.e., branches and

    subsidiaries) of the same institution. See, e.g., Statistical

    release: OTC derivatives statistics at end-June 2012, Monetary and

    Economic Department, Bank of International Settlements (Nov. 2012),

    available at http://www.bis.org/publ/otc_hy1211.pdf. The Commission

    relied on BIS data in calculating its additional initial margin

    requirements for required clearing of certain interest rate swaps

    and credit default swaps.

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

    Third, by exempting inter-affiliate swaps from required clearing,

    inter-affiliate swaps would not be subject to variation margin

    requirements under a DCO's rules. Exempting inter-affiliate swaps from

    required clearing's variation margin requirements may help affiliates

    and corporate entities as a whole manage their liquidity needs because

    the entities would not have to routinely collateralize losses at the

    DCO. It is also likely to reduce the operational costs that the

    affiliates would otherwise bear in order to manage margin calls and

    associated variation margin payments.

    3. Risk Management Benefits of Inter-Affiliate Swaps

    A number of commenters stated that executing swaps with the market

    through one affiliate enables entities to more efficiently and

    effectively manage corporate risk.\114\ In this arrangement, the one

    affiliate engages in inter-affiliate swaps with other affiliated

    entities in order to hedge the risks of those affiliates. The one,

    central affiliate then engages in market-facing swaps to offset the

    risk that it has taken on. Executing swaps through one affiliate may

    enable corporate entities to concentrate their swap and hedging

    expertise and activity within a single affiliate, which reduces

    personnel costs. It also allows the corporation to net various

    positions before facing the market, thus reducing the number of market

    facing swaps, and the attendant fees.

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

    \114\ See, e.g., letters from The Working Group, EEI, and ISDA &

    SIFMA.

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

    Moreover, these affiliate structures may not only reduce costs, but

    certain types of risk for the corporation as well. By concentrating

    personnel with swap and hedging expertise in one affiliate, and running

    inter-affiliate and market facing swap activities through a single

    entity, corporations may reduce the risk of operational errors. Such

    errors can create considerable risk when engaging in large hedging

    transactions. Moreover, the corporation's operational risk may be

    further mitigated by reducing the total number of market facing swaps

    into which the affiliated entities enter.\115\

    Additionally, as stated above and as noted in the NPRM, affiliates

    that are commonly owned internalize a portion of one another's

    risk.\116\ To the extent that affiliated entities internalize one

    another's risk, those entities have an economic incentive to perform on

    their obligations with respect to one another, thus reducing the

    counterparty risk that they bear as a consequence of their swaps with

    one another. However, the qualification ``to the extent that affiliated

    entities internalize one other's risk'' is significant. Two important

    factors limit the degree to which affiliates internalize one another's

    risk. First, if either of the affiliated entities has a portion of

    ownership that is not held in common, then a corresponding portion of

    the risks transferred to that entity will not be borne by the common

    owners, and thus will not be internalized. In other words, a smaller

    common ownership stake will cause less counterparty risk to be

    internalized, and will lessen the incentive affiliates will have to

    perform on their obligations toward one another. Second, as described

    above, there are circumstances in bankruptcy where affiliates do not

    internalize each other's risks, which may also reduce, or

    [[Page 21772]]

    eliminate, the affiliates' incentives to perform with respect to their

    obligations they have toward one another.\117\

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

    \115\ Commenters also asserted that inter-affiliate swaps are

    used in order to assist in tax management and compliance with

    international laws, stating that the exemption would help to

    preserve those benefits. Commenters did not provide sufficient

    information regarding their operations, tax management strategies,

    and international compliance requirements for the Commission to

    evaluate these stated benefits.

    \116\ See NPRM at 50426 and Section II.A.

    \117\ See Section II.A.

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

    Reduced internalization of risk among affiliates may create

    incentives for certain affiliates to use inter-affiliate swaps to shift

    risk to other affiliates in ways that are not necessarily in the best

    interests of minority stakeholders or counterparties to certain

    affiliates. In order to address this concern, the Commission has

    conditioned election of the exemption on several requirements that are

    intended to mitigate the costs created by reduced internalization of

    risk among affiliates, as well as the foregone benefits of required

    clearing.

    C. Costs and Benefits of Exemption's Conditions

    The inter-affiliate exemption from required clearing sets forth

    five conditions that must be satisfied in order to elect the exemption:

    (1) Both affiliates must be majority-owned and their financial

    statements must be reported on a consolidated basis; (2) the swap must

    be documented in a written swap trading relationship document; (3) the

    swap must be subject to a centralized risk management program; (4)

    certain information regarding the swap must be reported to an SDR; and

    (5) both affiliates must meet certain conditions with regard to their

    outward-facing swaps. The Commission believes that entities will have

    to incur costs to satisfy these conditions. Those costs may offset some

    of the benefits that would otherwise result from the exemption.

    However, the exemption is permissive, and therefore the Commission also

    believes that an affiliate will elect the exemption only if these costs

    are less than the costs that an affiliate will incur should it decide

    not to elect the exemption. Moreover, as described below, the

    conditions provide certain benefits to the affiliates' counterparties

    and to the public that the Commission believes are essential in order

    to mitigate counterparty credit risk in situations where affiliates do

    not completely internalize each other's risks. Lastly, the Commission

    believes that in some cases entities are already meeting some or all of

    the requirements for electing the exemption, in which cases the

    affiliates would bear less new costs, or no new costs at all, due to

    the conditions.\118\

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

    \118\ See, e.g., letters from MetLife and Prudential (explaining

    that it is current business practice to document inter-affiliate

    swaps); letter from EEI (explaining that inter-affiliate swaps are

    subject to risk management).

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

    1. Eligible Affiliate Counterparty Status

    In order to qualify as an eligible affiliate counterparty under the

    terms of the exemption, two factors must be met. First, one affiliate

    must directly or indirectly hold a majority ownership interest in the

    other, or a third party must hold a majority ownership interest in

    both. Second, the financial statements of both affiliates are reported

    on a consolidated basis under Generally Accepted Accounting Principles

    (GAAP) or International Financial Reporting Standards (IFRS).

    The Commission anticipates that in a relatively small number of

    cases entities may alter their ownership structures in order to qualify

    for the inter-affiliate exemption's majority-ownership condition. In

    these cases, entities may bear certain legal costs, and in some cases,

    costs associated with negotiations with other owners in the entity.

    These costs could vary significantly, depending on the complexity of

    the entity's existing ownership structure, including the number of

    owners and the alignment or misalignment of their interests. The

    Commission does not have adequate information to determine which

    entities or how many entities may consider altering their ownership

    structure in order to become eligible for the inter-affiliate

    exemption, but notes again that entities would only do this if they

    anticipate that the benefits of the exemption are greater than the

    costs of meeting the qualifying criteria.

    Four commenters supported proposed majority-ownership requirement.

    CDEU commented that the majority-ownership test strikes an appropriate

    balance between ensuring that the rule is not overly broad and

    providing companies with the flexibility to account for differences in

    corporate structures. EEI noted that majority-owned affiliates will

    have strong incentives to internalize one another's risks because the

    failure of one affiliate impacts all affiliates within the corporate

    group. The Working Group generally supported the Commission's

    definition, but stated that inter-affiliate swaps should be

    unconditionally exempt from mandatory clearing when the affiliates are

    consolidated for accounting purposes. MetLife stated that it would

    likely limit inter-affiliate trading to ``commonly-owned'' affiliates,

    but agreed with the flexibility of including majority-owned affiliates.

    Two commenters objected to the proposal and requested the

    Commission require 100% ownership of affiliates. AFR stated that

    permitting such a low level of joint ownership would lead to evasion of

    the clearing requirement through the creation of joint ventures set up

    to enable swap trading between banks without the need to clear the

    swaps. Similarly, Better Markets agreed that only 100% owned affiliates

    should be eligible for the exemption because allowing the exemption for

    the majority owner permits that owner to disregard the views of its

    minority partners and creates an incentive to evade the clearing

    requirement by structuring subsidiary partnerships. Finally, Better

    Markets stated that the majority-ownership standard will result in

    corporate groups transferring price risk and credit risk to different

    locations facilitating interconnectedness and potentially giving rise

    to systemic risk during times of market stress.

    As discussed above, the degree to which one affiliate's risks are

    internalized by another affiliate depends significantly on the

    percentage of common ownership between them. For example, two

    affiliates that are 100% commonly owned are likely to internalize much

    of one another's risk. This creates a strong incentive for affiliates

    to perform on their obligations to one another. Therefore, if the

    Commission were to increase the common ownership requirement above a

    majority stake, it would likely result in affiliate counterparties

    internalizing more of one another's risk with respect to inter-

    affiliate swaps in order to qualify for the exemption. This, in turn,

    would provide additional incentives for affiliates to perform on their

    inter-affiliate swap obligations. However, if the Commission were to

    increase the common ownership percentage requirement, it also would

    reduce the number of affiliates that could qualify for, and benefit

    from, the exemption.

    On the other hand, if the Commission lowered the percentage of

    common ownership that is required to be eligible for the exemption

    (i.e., made it 50% or less), it would increase the number of affiliates

    that are eligible for the exception. This lower standard would allow

    affiliates that internalize less of each other's risks and therefore

    have weaker incentives to perform on their obligations to one another

    to qualify for the exemption. Moreover, the absence of a majority

    common ownership requirement could create opportunities for otherwise

    unrelated entities to form joint ventures and transact swaps with one

    another in order to claim the inter-affiliate exemption from clearing,

    which would undermine the effectiveness of the clearing requirement.

    The Commission considered each of these factors and concluded that

    the majority stake requirement is sufficient to internalize costs and

    incentivize affiliates to perform on their obligations

    [[Page 21773]]

    to one another. The Commission also believes that the potential for

    evasion is mitigated through the conditions to the final rule, which

    have been carefully crafted in order to narrow the exemption. For

    example, two unrelated entities cannot each hold a majority stake in

    the same affiliate. Consequently, such unrelated entities cannot use an

    inter-affiliate swap as an indirect means of trading without being

    subject to the clearing requirement under section 2(h) of the CEA and

    part 50 of the Commission's regulations.

    As an additional consideration, as noted above, the majority

    requirement also harmonizes with Commission's understanding of the EMIR

    requirements. Harmonizing with EMIR is likely to reduce compliance

    monitoring costs for entities electing the affiliated entity exemption.

    In terms of potential costs in the form of disregarding the interests

    of minority shareholders, the Commission recognizes that a 100%

    ownership requirement would eliminate the risk of minority

    shareholders' interests not being aligned with decisions to elect the

    exemption. However, the Commission is also cognizant that such a

    requirement would reduce the number of affiliates that are able to

    claim the exemption. The Commission believes that the majority-

    ownership requirement appropriately considers the risk of the former

    and the benefits of the latter.

    With regard to the consolidation of financial statements, FSR

    requested that the Commission clarify that alternative accounting

    standards can be used for purposes of meeting the requirement that the

    financial statements of both affiliates be reported on a consolidated

    basis. The Commission considered this comment and is adopting the

    alternative suggested by FSR. As modified the rule requires that the

    financial statements of both counterparties be reported on a

    consolidated basis under GAAP or IFRS. This change recognizes the fact

    that some entities claiming the exemption may report their financial

    statements under different accounting standards, and makes it possible

    for those entities to elect the exemption as long as they would be

    required to report their financial statements on a consolidated basis

    under GAAP or IFRS. This likely increases the number of entities that

    may elect the exemption relative to the form of the rule proposed in

    the NPRM while maintaining the protections that were intended with the

    requirement for consolidated financial statements. The Commission also

    modified the rule to clarify which entities are subject to the

    consolidated financial statement requirement.

    2. Inter-Affiliate Swap Documentation

    As proposed, the inter-affiliate exemption required that eligible

    affiliate counterparties that elect the inter-affiliate exemption must

    enter into swaps with a swap trading relationship document that is in

    writing and includes all the terms governing the relationship between

    the affiliates. These terms included, but were not limited to, payment

    obligations, netting of payments, transfer of rights and obligations,

    governing law, valuation, and dispute resolution. This requirement

    would be satisfied if an eligible affiliate counterparty is an SD or

    MSP that complies with the swap trading relationship documentation

    requirements of Sec. 23.504.\119\

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

    \119\ For a discussion of the costs and benefits incurred by

    swap dealers and major swap participants that must satisfy

    requirements under Sec. 23.504, see Confirmation, Portfolio

    Reconciliation, Portfolio Compression, and Swap Trading Relationship

    Documentation Requirements for Swap Dealers and Major Swap

    Participants, 77 FR 55904, 55906 (Sept. 11, 2012) (final rule) and

    Swap Trading Relationship Documentation Requirements for Swap

    Dealers and Major Swap Participants, 76 FR 6715, 6724-25 (Feb. 8,

    2011) (proposed rule).

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

    The Commission received a number of comments both supporting and

    opposing the swap documentation requirement. Better Markets, MetLife,

    and Prudential all supported the proposed documentation requirement.

    Specifically, MetLife and Prudential did not believe that the

    documentation requirement would be any more ``burdensome or costly''

    for them because they already document all of their swaps.

    Cravath, EEI, CDEU, and DLA Piper opposed the proposed

    documentation requirement. Cravath stated that the costs associated

    with the imposition of documentation requirements outweigh any benefits

    to the financial system, and that the Commission should leave the

    determination as to the appropriate level of documentation to boards of

    directors and management of companies, to determine based on the

    ``reasonable exercise of their fiduciary responsibilities.'' DLA Piper

    commented that the documentation requirements are burdensome and

    questioned the benefits of imposing documentation requirements on

    transactions between two parties.

    CDEU expressed concern that proposed documentation condition would

    require that full ISDA Master Agreements be used to document inter-

    affiliate swaps. CDEU explained that while many market participants use

    master agreements, some end users many not have full master agreements

    because inter-affiliate swaps are purely internal and do not increase

    systemic risk. CDEU recommended that the proposed rule be revised to

    require that the swap documentation ``include all terms necessary for

    compliance with its centralized risk management program'' and eliminate

    the list of required terms. CDEU also requested that the Commission

    clarify that (1) market participants can continue to use documentation

    required by their risk management programs and (2) the rule does not

    require market participants use ISDA Master Agreements.

    EEI recommended that the Commission eliminate the documentation

    requirement because the requirement is duplicative of corporate

    accounting records that affiliates currently maintain. EEI commented

    that a documentation requirement imposes ``an additional, costly layer

    of ministerial process and documentation that is unnecessary to achieve

    the Commission's stated objectives.'' EEI commented on the NPRM's

    consideration of costs and benefits and stated that the costs of the

    proposed documentation requirement are unjustified. The NPRM included

    an estimate that there would be a one-time cost of $15,000 to develop

    appropriate documentation for use by an entity's affiliates. EEI

    objected to this estimate because, in its view, the legal costs

    associated with individually negotiating and amending standard

    agreements between individual affiliates would exceed the NPRM's

    estimates. In addition, EEI objected to the NPRM's estimate of 22

    affiliated counterparties for each corporate group as ``far too low''

    for U.S. energy companies.\120\ However, EEI did not provide specific,

    quantitative information in terms of either the legal costs of

    complying with the proposed documentation requirement or number of

    affiliates for a corporate group subject to this rule. Accordingly, the

    Commission is unable to verify whether the legal costs or average

    number of affiliates estimates are too low.

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

    \120\ This estimate appeared in the NPRM section regarding the

    Paperwork Reduction Act not in the consideration of costs and

    benefits section.

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

    ISDA & SIFMA stated that the documentation requirements were overly

    prescriptive and would impose unnecessary costs on affiliates. ISDA &

    SIFMA recommended a more flexible approach that would require adequate

    documentation of ``all transaction terms under applicable law.''

    In response to commenters' requests for a more flexible standard,

    the Commission modified the proposal for swaps between affiliates that

    are not

    [[Page 21774]]

    SDs or MSPs. The Commission adopted ISDA & SIFMA's recommendation that

    the focus of the documentation requirement be on documenting all of an

    inter-affiliate transaction's terms.\121\

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

    \121\ The Commission is modifying the documentation condition to

    require that ``the terms of the swap are documented in a swap

    trading relationship document that shall be in writing and shall

    include all terms governing the trading relationship between the

    affiliates.''

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

    Under this modification, the Commission is eliminating the non-

    exclusive list of terms, which included payment obligations, netting of

    payments, transfer of rights and obligations, governing law, valuation,

    and dispute resolution. The change responds to commenters' requests for

    a more flexible approach that reflects current market best practices,

    and signals that market participants retain the ability to craft

    appropriate documentation for their affiliated entities so long as such

    documentation includes the terms of the swap and ``all terms governing

    the trading relationship between the eligible affiliate

    counterparties.'' \122\ This modification also serves to address

    concerns that the intent of the proposed rule was to require formal

    master agreements, such as the ISDA Master Agreement.\123\ The proposed

    rule was not intended to require affiliates to enter into formal master

    agreements. Rather, the Commission observed that parties that already

    use master agreements (of any sort) to document their inter-affiliate

    swaps would likely meet the requirements of the proposed rule without

    additional costs. This observation was supported by commenters such as

    MetLife and Prudential. The Commission believes that these

    modifications to the proposal and clarifications respond to commenters'

    concerns and will serve to reduce documentation costs for those

    electing the inter-affiliate exemption.\124\

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

    \122\ See Sec. 50.52(b)(2)(ii).

    \123\ In the NPRM, the Commission estimated that affiliates

    could pay a law firm for up to 30 hours of work at $495 per hour to

    modify an ISDA Master Agreement, resulting in a one-time cost of

    $15,000, and there may be additional costs related to revising

    documentation to address a particular swap. All salaries in these

    calculations are taken from the 2011 SIFMA Report on Management and

    Professional Earnings in the Securities Industry. Annual wages were

    converted to hourly wages assuming 1,800 work hours per year and

    then multiplying by 5.35 to account for bonuses, firm size, employee

    benefits and overhead. The Commission also estimated that affiliates

    would incur costs of less than $1,000 per year related to signing

    swap documents and retaining copies.

    \124\ In response to comments from Better Markets and AFR that

    the proposed regulations should be retained and not weakened, the

    Commission does not believe that eliminating the non-exclusive list

    of terms and replacing it with a simple requirement that all terms

    of the swap transaction and the relationship between the affiliates

    be documented will weaken the rule. Rather, while affiliates will

    have discretion to select the appropriate terms to document their

    swap, they will still have an obligation to ensure that their

    documentation contains an accurate and thorough written record of

    their swaps. In most instances, this will necessarily include all of

    the previously enumerated terms.

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

    Entities that have already established systems for documenting the

    terms of their inter-affiliate swaps and all the terms of the trading

    relationship between eligible affiliates will not bear any costs as a

    consequence of this requirement.\125\ However, as noted in the NPRM,

    the Commission understands that some affiliates may enter into inter-

    affiliate swaps with little documentation regarding the terms of the

    swaps.\126\ Such entities may not have systems to document the terms of

    their inter-affiliate swaps or all the terms of the trading

    relationship between eligible affiliates. They will bear some initial

    costs and ongoing costs in order to comply with this requirement. In

    the NPRM, the Commission estimated that the initial costs of up to

    $15,000 to create such the necessary documentation, and less than

    $1,000 per year on an ongoing basis to sign and retain appropriate

    documentation.\127\

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

    \125\ See comments letters from MetLife and Prudential.

    \126\ See NPRM at 50428-50429.

    \127\ See id. at 50434.

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

    In response to EEI's comment regarding duplicative requirements, to

    the extent that the documentation requirement is duplicative of an

    affiliate's existing recordkeeping practices, it will not introduce new

    costs. However, the Commission notes that if existing records do not

    contain the terms of each inter-affiliate swap or all the terms of the

    trading relationship between affiliates, affiliates will be required to

    implement new documentation that creates incremental costs, as noted

    above.

    Regarding benefits, documentation of inter-affiliate swaps is

    essential to effective risk management. In the absence of such

    documentation, affiliates cannot track or value their swaps

    effectively. Documentation also helps ensure that affiliates have proof

    of claim in the event of bankruptcy. As explained earlier, insufficient

    proof of claim could create challenges and uncertainty at bankruptcy

    that could adversely affect affiliates and third party creditors. The

    documentation requirement, to the extent that it requires entities to

    document all the terms that are necessary in order to value inter-

    affiliate swaps and to provide legal certainty in the event of

    bankruptcy, will promote effective risk management and resolution of

    claims in the event of insolvency.\128\

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

    \128\ As discussed in Section II.D above, the Commission expects

    that, in most instances, documentation between affiliates will

    include all of the previously enumerated terms, several of which are

    essential to effective valuation of swaps and resolution in

    bankruptcy. However, the Commission notes that a more flexible

    approach makes it possible that some entities could document the

    terms of their inter-affiliate swaps and all the terms of their

    trading relationship without covering all of the terms that are

    necessary for effective valuation or resolution in bankruptcy. If

    this occurs, it would reduce the risk management and bankruptcy

    benefits created by the documentation requirement.

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

    3. Centralized Risk Management

    Another condition of the inter-affiliate exemption requires that

    the swap be subject to a centralized risk management program that is

    ``reasonably designed to monitor and manage the risks associated with

    the swap.'' If at least one of the eligible affiliate counterparties is

    an SD or MSP, the centralized risk management requirement is satisfied

    by complying with the requirements of Sec. 23.600.\129\

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

    \129\ For a discussion of the costs and benefits incurred by

    swap dealers and major swap participants that must satisfy

    requirements under Sec. 23.600, see Swap Dealer and Major Swap

    Participant Recordkeeping, Reporting, and Duties Rules; Futures

    Commission Merchant and Introducing Broker Conflicts of Interest

    Rules; and Chief Compliance Officer Rules for Swap Dealers, Major

    Swap Participants, and Futures Commission Merchants, 77 FR 20173-75.

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

    Four commenters objected to the proposed requirement, suggested

    alternatives, and/or requested clarification. FSR stated that the

    condition should be eliminated because integrated risk management

    systems ``are generally not established across international

    boundaries'' and are not consistent with general risk practices in

    large, multinational organizations. FSR suggested that the requirement

    be dropped in favor of each entity making ``its own evaluations of the

    risk associated with an inter-affiliate position.''

    Cravath stated that in many cases, for companies outside of the

    financial sector, the proposed rule will require a substantial change

    in the processes and procedures currently maintained by such companies,

    and the cost of complying with the risk management program requirements

    outweigh any benefits to the financial system. Cravath commented that

    rather than subject companies to a risk management rule, ``[c]ompanies

    should have the flexibility to engage in prudent risk management for

    their corporate group in a manner consistent with the overall level of

    risks to their business.''

    EEI suggested that the Commission eliminate the centralized risk

    [[Page 21775]]

    management program requirement on the grounds that it would be

    duplicative for corporate groups that already have risk management

    programs in place. According to EEI, it is standard industry practice

    for both private and public companies to have a risk management

    program. EEI accordingly does not see a ``need to impose a separate,

    discrete regulatory requirement to document with an SDR or the

    Commission the existence of a centralized risk management program.'' If

    the Commission decides to retain the requirement, EEI requested that

    the Commission require a program be ``reasonably designed to monitor

    and manage the risks associated with the swap'' and provide the

    flexibility to design risk management programs that address the unique

    risks of an entity's business.

    The Working Group requested that the Commission clarify whether

    non-SDs and non-MSPs would be subject to the same enterprise-level risk

    management program as required for SDs and MSPs under Sec. 23.600. The

    Working Group proposed that the Commission require ``a robust risk

    management program'' rather than ``a centralized risk management

    program.''

    In response to comments asking that the Commission clarify the

    level of risk management required for non-SDs and non-MSPs, the

    Commission confirms that the risk management condition is intended to

    be flexible and does not require the same level of policies and

    procedures as required under Sec. 23.600 for SDs and MSPs. Under the

    rule, a company would be free to structure its centralized risk

    management program according to its unique needs, provided that the

    program reasonably monitors and manages the risks associated with its

    uncleared inter-affiliate swaps. In all likelihood, if a corporate

    group has a centralized risk management program in place that

    reasonably monitors and manages the risk associated with its inter-

    affiliate swaps as part of current industry practice, it is likely that

    the program would fulfill the requirements of exemption and therefore

    the exemption would not create new costs in such cases.

    Given that a number of commenters stated that it is common practice

    for market participants, including end users, to have risk management

    programs in place,\130\ expects that the majority of companies with

    eligible affiliates will not have to create centralized risk management

    programs from scratch in order to meet the eligibility requirements for

    the exemption. Those with existing systems may need to make some

    changes in order to centralize them, but the Commission has provided

    significant flexibility to companies in determining the specific

    contours of the centralized risk management system. Given this

    flexibility, and the fact that it is common practice for market

    participants to have risk management programs in place, the Commission

    is not persuaded by Cravath's comment that the rule will require a

    substantial change in the processes and procedures currently maintained

    by companies to manage risk. Accordingly, costs will be limited where

    an entity only needs to make modifications to existing risk management

    programs. Moreover, a corporate group may not have to incur any costs

    if it already has in place a risk management system that meets the

    requirements of the inter-affiliate exemption.

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

    \130\ See, e.g., letters from Prudential, MetLife, and CDEU.

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

    The Commission also declined to modify the requirement to state ``a

    robust risk management program'' rather than ``a centralized risk

    management program.'' While change proposed by the Working Group may

    prevent certain entities from having to reorganize their risk

    management program in order to meet the requirements of the inter-

    affiliate exemption, it could also significantly reduce the ability of

    the risk management program to mitigate counterparty risk among

    affiliates. In the absence of variation margin, or clearing to mitigate

    counterparty credit risk among affiliates, risk management committees

    must have a clear line of sight into the financial health and

    obligations of each affiliate involved in inter-affiliate swaps.

    In the NPRM, the Commission explained that some affiliates may have

    to create a risk management system to meet the risk management

    condition.\131\ The Commission itemized a number of specific costs,

    including the purchase of equipment and software to adequately evaluate

    and measure inter-affiliate swap risk.\132\ In addition, in the NPRM,

    the Commission estimated that centralized risk management could require

    up to ten full-time staff at an average salary of $150,000 per

    year.\133\ The Commission received no comments in response to its risk

    management condition cost estimates.

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

    \131\ As pointed out above, industry commenters underscored the

    fact that many corporate groups that currently use inter-affiliate

    swaps have centralized-risk-management procedures in place.

    \132\ See NPRM at 50434 (estimating such costs to be as high as

    $150,000 for purchasing a computer network at approximately $20,000;

    purchasing personal computers and monitors for 15 staff members at

    approximately $30,000; purchasing software at approximately $20,000;

    purchasing other office equipment, such as printers, at

    approximately $5,000; and installation and unexpected costs that

    could increase up-front costs).

    \133\ This average annual salary is based on 15 senior credit

    risk analysts only. The Commission appreciates that an affiliate

    would likely choose to employ different positions as well, such as

    risk management specialists at $130,000 per year, and computer

    supervisors at $140,000. But for the purposes of this estimate, the

    Commission has assumed salaries at the high end for risk management

    professionals. The Commission also estimated a data subscription for

    price and other market data may have to be purchased at cost of up

    to $100,000 per year.

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

    There are benefits that derive from the centralized-risk management

    condition. The Commission expects that centralized risk management

    programs will establish appropriate measurements and procedures to

    monitor the amount of risk that each individual affiliate bears, and to

    monitor the condition of each entity's affiliate counterparties.

    Because a centralized risk management program is more likely to have a

    clear line of sight into the financial condition of all affiliated

    entities, it is better positioned to manage each affiliate's exposure

    to the counterparty risk of other affiliates than a risk management

    program situated inside any single affiliate. As a consequence,

    centralized risk management programs may reduce the likelihood that

    individual affiliates could become insolvent because of their exposure

    to other affiliates, which not only benefits the affiliates, but their

    third party counterparties as well.

    4. Reporting to an SDR

    Another condition of electing the inter-affiliate exemption is that

    certain information about the swap and the election of the exemption be

    reported to an SDR. The reporting condition requires affiliates to

    report specific information to an SDR, or to the Commission if no SDR

    is available. Such information includes a notice that both affiliates

    are electing the exemption and that they both meet the other conditions

    of exemption, as well as information regarding how the financial

    obligations of both affiliates are generally satisfied with respect to

    uncleared swaps. The final rule also requires reporting certain

    information if the affiliate is an SEC filer.

    The Commission received several comments in response to the

    reporting obligations of affiliates. Prudential and MetLife both

    commented that the Commission should clarify that only one counterparty

    is required to report the swap to an SDR. EEI stated that the

    Commission should eliminate the transaction-by-transaction reporting

    [[Page 21776]]

    requirement for the election of the exemption and confirmation that the

    conditions have the exemption have been met. Instead, EEI recommended

    that one of the affiliates be permitted to file an annual notice on

    behalf of both affiliates to exempt all of their swaps from clearing

    for an entire year. EEI contended that it will increase costs if both

    affiliates have to communicate that they elect not to clear the swap

    and meet the conditions of the exemption for each swap.\134\ CDEU also

    objected to reporting any information to an SDR on a trade-by-trade

    basis for inter-affiliate swaps as such reporting would be costly and

    onerous for parties. Instead, CDEU recommended that all reporting be

    done on an annual basis through a board resolution.

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

    \134\ EEI also commented that the Commission should state that

    part 45 does not apply to inter-affiliate swaps because the

    Commission will be able to obtain information regarding an inter-

    affiliate transaction based on reporting of a corresponding market-

    facing swap. EEI cited to a statement in the NPRM's consideration of

    costs and benefits as support for an argument that the Commission

    did not intend for part 45 reporting to apply to inter-affiliate

    swaps. See NPRM at 50433. As explained above, the statement in the

    cost-benefit consideration of the NPRM merely drew a comparison

    between the reporting requirements under the proposed exemption and

    the general reporting requirements under parts 45 and 46, and those

    reporting requirements applicable to SDs and MSPs under part 23. The

    statement should not be read as calling into question the

    applicability of part 45 to inter-affiliate swaps.

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

    In response to commenters' requests, the Commission clarified that

    the reporting condition can be fulfilled by one of the affiliate

    counterparties on behalf of both counterparties. As noted in the NPRM,

    the Commission believes that affiliates within a corporate group may

    make independent determinations on whether to submit an inter-affiliate

    swap for clearing. Given the possibility that each affiliate may reach

    different conclusions regarding clearing the swap, the final rule

    requires that both counterparties elect the proposed inter-affiliate

    clearing exemption.

    DLA Piper commented that corporate groups do not maintain back-

    office systems necessary to keep the level of detail required under

    parts 45 and 46 with respect to their inter-company swaps. DLA Piper

    further commented that many corporate groups will need to develop

    costly systems and procedures, which will increase their hedging costs,

    in order to comply with the reporting rules. The Commission observes

    that the costs of parts 45 and 46 reporting have been addressed in

    prior rulemakings and are beyond the scope of this rule.

    With regard to comments recommending that all reporting be done on

    an annual basis rather than a swap-by-swap basis, the Commission

    declines to modify the rule. The Commission believes it is appropriate

    to provide for annual reporting of certain information, including how

    affiliates generally meet their financial obligations and information

    related to its status as an electing SEC Filer. However, it would not

    be sufficient to allow one annual report to cover both affiliate

    counterparties' election of the exemption from clearing and the

    confirmation that both affiliates meet the conditions of the exemption.

    Eligible affiliates may choose to elect or not elect the exemption

    on a swap-by-swap basis. As noted above, whether a swap is cleared or

    not has a significant impact on its ability to transfer credit risk

    from one entity to another. Regulators must know which swaps are

    cleared and which swaps are not cleared in order to monitor potential

    accumulations and transfers of risk within the financial system. In

    addition, they must know which exemption is being used to exempt

    certain swaps in order to monitor the use of each exemption and its

    possible effect on systemic risk. Consequently, the election of the

    exemption and the confirmation that the exemption's conditions are met

    must be made for each swap.

    The Commission does not believe that this reporting requirement

    will impose a significant burden on affiliate counterparties because,

    as discussed above, other detailed information for every swap must be

    reported under sections 2(a)(13) and 4r of the CEA and Commission

    regulations. This approach comports with the approach adopted for

    market participants claiming the end-user exception under section

    2(h)(7) of the CEA.\135\

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

    \135\ See End-User Exception to the Clearing Requirement for

    Swaps, 77 FR 42565-66.

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

    In the NPRM, the Commission estimated specific costs for the

    reporting condition, including entering a notice of election into the

    reporting system.\136\ Cost estimates in the NPRM also included costs

    of identifying how the affiliates expect to meet the financial

    obligations associated with their uncleared swap and providing

    information if either electing affiliate is an SEC Filer.\137\ The

    Commission also estimated costs for entities to modify their reporting

    systems to accommodate the additional data fields required by this

    rule.\138\ The Commission also estimated costs for non-reporting

    affiliates.\139\ Finally, in the NPRM, the Commission explained that

    SDRs would bear costs associated with the reporting conditions insofar

    as SDRs would be required to add or edit reporting data fields to

    accommodate information reported by affiliates electing the inter-

    affiliate clearing exemption.\140\ The Commission received no comments

    in response to its cost estimates for the reporting condition.

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

    \136\ The NPRM at 50435, included an estimate that each

    counterparty may spend 15 seconds to two minutes per swap entering a

    notice of election of the exemption into the reporting system. The

    hourly wage for a compliance attorney is $390, resulting in a per

    transaction cost of $1.63-$13.00.

    \137\ See NPRM at 50435. Affiliates may decide to report

    financial obligation information and SEC Filer information on either

    a swap-by-swap or annual basis, and the costs would vary depending

    on the reporting frequency. Regarding the financial obligation

    information, the Commission estimated in the NPRM that it may take

    the reporting counterparty up to 10 minutes to collect and submit

    the information for the first transaction, and one to five minutes

    to collect and submit the information for subsequent transactions

    with that same counterparty. The hourly wage for a compliance

    attorney is $390 resulting in a cost of $65.00 for reporting the

    first inter-affiliate swap, and a cost range of $6.50-$32.50 for

    reporting subsequent inter-affiliate swaps.

    \138\ See id. (estimating that such modifications would create a

    one-time programming expense of approximately one to ten burden

    hours per affiliate, which means a one-time, per entity cost ranging

    from $341 and $3,410).

    \139\ See id. (noting that costs would likely vary substantially

    depending on how frequently the affiliate enters into swaps, whether

    the affiliate undertakes an annual filing, and the due diligence

    that the reporting counterparty chooses to conduct, but estimating

    that a non-reporting affiliate would incur annually between five

    minutes and ten hours of compliance attorney time to communicate

    information to the reporting counterparty, translating to an

    aggregate annual cost for communicating information to the reporting

    counterparty of between $33 to $3,900). See also, id. (noting that

    an annual filing option may be less costly than swap-by-swap

    reporting and estimating that such an option would take an average

    of 30 to 90 minutes, translating to an aggregate annual cost for

    submitting the annual report of between $195 to $585).

    \140\ See generally, Swap Data Recordkeeping and Reporting

    Requirements, 77 FR 2176-2193 (for costs and benefits incurred by

    SDRs). To the extent that no SDR is available to accept this data,

    the costs would fall to the Commission.

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

    The benefits of the reporting condition include enhancing the level

    of transparency associated with inter-affiliate swaps activity, thereby

    affording the Commission new insights into the practices of affiliates

    that engage in inter-affiliate swaps, and helping the Commission and

    other appropriate regulators identify emerging or potential risks. As

    noted above, regulators must know whether swaps are cleared or

    uncleared in order to use swap data to monitor emerging risks. In

    short, the overall benefit of reporting would be a greater body of

    information for the Commission to analyze with the goal of identifying

    and reducing systemic risk.\141\

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

    \141\ The Commission received no comments in response to its

    cost estimates for the reporting condition.

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

    [[Page 21777]]

    5. Treatment of Outward-Facing Swaps

    The final condition imposed on the inter-affiliate exemption from

    required clearing relates to the treatment of outward-facing swaps

    entered into by the two eligible affiliate counterparties to the inter-

    affiliate swap. As proposed, the condition required that each affiliate

    counterparty either: (i) Is located in the United States; (ii) is

    located in a jurisdiction with a clearing requirement that is

    comparable and comprehensive to the clearing requirement in the United

    States; (iii) is required to clear swaps with non-affiliated parties in

    compliance with U.S. law; or (iv) does not enter into swaps with non-

    affiliated parties.

    The Commission received a number of comments in support of and

    opposed to this proposed condition, but did not receive any comments

    quantifying the costs or benefits of the proposed condition. AFR

    supported the proposal and stated that inter-affiliate swaps could,

    without appropriate restrictions, bring risk back to the U.S. from

    foreign affiliates. AFR commented that an inter-affiliate swap might be

    used to move parts of the U.S. swaps market outside of U.S. regulatory

    oversight by transferring risk to jurisdictions with little or no

    regulatory oversight, whereby a non-U.S. affiliate of a U.S. entity

    could enter into an outward-facing swap. AFR stated that an inter-

    affiliate swap could contribute to financial contagion across different

    groups within a complex financial institution, making it more difficult

    to ``ring-fence'' risks in one part of an organization. AFR further

    commented that laws and regulations of a foreign country might prevent

    U.S. counterparties to swaps from having access to the financial

    resources of an affiliate in the event of a bankruptcy or insolvency.

    Better Markets also supported the proposed treatment of outward-facing

    swaps condition.

    In opposition to the proposed condition, CDEU commented that the

    proposed ``comparable and comprehensive'' condition is not necessary or

    appropriate to reduce risk and prevent evasion because, according to

    CDEU, transactions between affiliates do not increase systemic risk,

    regardless of the location of the affiliate. ISDA & SIFMA stated that

    the concern that foreign inter-affiliate swaps pose risk to the U.S.

    financial system is unfounded because internal swaps have no conclusive

    effect on systemic risk.\142\

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

    \142\ Other commenters, including The Working Group and FSR also

    opposed the condition regarding treatment of outward-facing swaps.

    See Section II.G above.

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

    The Commission considered each of these comments and decided to

    adopt the treatment of outward-facing swaps condition, with certain

    important modifications, because the Commission believes that the risk

    of evasion of the U.S. clearing requirement and the potential systemic

    risk associated with uncleared inter-affiliate swaps involving foreign

    affiliates and non-affiliated counterparties necessitates that the

    inter-affiliate exemption include such a condition. As modified, the

    final rule requires that each eligible affiliate counterparty must

    clear all swaps that it enters into with third parties to the extent

    that the swap is subject to the Commission's clearing requirement. In

    order to satisfy this requirement, eligible affiliates may clear their

    third-party swaps pursuant to the Commission's clearing requirement or

    comply with the requirements for clearing the swap under a foreign

    jurisdiction's clearing mandate that is comparable to, and as

    comprehensive as, the clearing requirement of section 2(h) of the Act

    and part 50 of the Commission's regulations, as determined by the

    Commission. In addition, the Commission modified the condition to allow

    for recognition of clearing exemptions and exceptions under the CEA and

    an exception or exemption under a comparable foreign jurisdiction's

    clearing mandate that is comparable to an exception or exemption under

    section 2(h)(7) of the CEA or part 50. For entities that are not in a

    jurisdiction with a clearing requirement that is comparable to, and as

    comprehensive as, the clearing mandate in 2(h) of the Act, they may

    comply by clearing swaps with unaffiliated counterparties through a

    registered DCO or clearing organization that is subject to supervision

    by appropriate government authorities in the home country of the

    clearing organization and has been assessed to be in compliance with

    the PFMIs.

    The Commission believes that this modification will provide greater

    clarity and transparency by more clearly establishing the conditions to

    the exemption and alternative methods by which eligible affiliates may

    satisfy the requirements. In addition, the Commission considered the

    approach adopted in EMIR.\143\ To the extent there is consistency with

    the international authorities, including the European Union, the

    likelihood of regulatory arbitrage is reduced. Regulatory arbitrage can

    impose high costs in terms of market efficiency.

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

    \143\ See Section II.G above.

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

    As AFR noted, without appropriate restrictions, inter-affiliate

    swaps could transfer risk back to the United States from foreign

    affiliates. The final rule takes steps to mitigate this risk insofar as

    the intent of the condition on outward-facing swaps is to narrow the

    exemption such that the risk of a cascading series of defaults among

    unrelated entities is reduced.

    For companies whose inter-affiliate swap activities are conducted

    exclusively through entities in the United States and jurisdictions

    with clearing mandates that are comparable to, and as comprehensive as,

    the clearing requirement of section 2(h) of the CEA, all outward-facing

    swaps that fall under a Sec. 50.4 class will be subject to required

    clearing,\144\ which will serve as a buffer to the spread of credit

    risk from one corporation to another through those swaps, thus reducing

    the risk of financial contagion. Affiliates that meet the conditions of

    the inter-affiliate exemption will be able to transfer risk from one

    affiliate to the other without clearing those swaps, but third parties

    that enter into swaps that are required to be cleared with either of

    those affiliates will continue to be protected by clearing requirement.

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

    \144\ In these jurisdictions, outward-facing swaps that are not

    subject to required clearing may be subject to margin requirements,

    which can serve to mitigate counterparty credit risk.

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

    For companies whose inter-affiliate swap activities extend to

    countries without clearing mandates that are comparable to, and as

    comprehensive as, the clearing requirement of section 2(h) of the CEA,

    the requirements of the rule mitigate counterparty risk associated with

    swaps that are required to be cleared under Sec. 50.4 by requiring

    those swaps to be cleared at a DCO or a clearing organization that is

    subject to supervision by appropriate government authorities and that

    is in compliance with the PFMIs. In this manner, swaps that the

    Commission has determined must be cleared cannot be used as a means of

    transferring financial risk among unaffiliated entities where one of

    the counterparties is also claiming an exemption from required clearing

    under this inter-affiliate exemption. However, the Commission observes

    that outward-facing swaps that are not required to be cleared under

    Sec. 50.4 and that are entered into between unrelated entities in a

    jurisdiction without comparable margin requirements, may be a means

    through which financial risk could be passed between unaffiliated

    entities without the protection of required clearing, creating the

    possibility of

    [[Page 21778]]

    financial contagion.\145\ It is possible that such contagion could then

    be transferred back to the United States or other jurisdictions through

    inter-affiliate swaps, creating potential costs for the public.\146\

    The Commission notes, however, that this is only a concern to the

    extent that affiliates in such jurisdictions enter into outward-facing

    swaps that are not required to be cleared under Sec. 50.4 in order to

    meet their needs.

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

    \145\ This risk may be mitigated if such swaps were subject to

    bilateral margining.

    \146\ Not only is there the possibility of risk transfer but

    also a potential inability for regulators to monitor the risks that

    are capable of being transferred.

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

    The Commission does not agree with CDEU's assertion that

    transactions between affiliates do not increase systemic risk,

    regardless of the location of the affiliate, or with ISDA & SIFMA's

    comment that the concern that foreign inter-affiliate swaps pose risk

    to the U.S. financial system is unfounded. As noted above, in the

    absence of any restrictions on outward-facing swaps, inter-affiliate

    swaps could be used to transfer risk to jurisdictions without clearing

    requirements or margin requirements for uncleared swaps. Risk could

    then be transferred between unrelated entities without the protection

    of clearing or margin requirements to mitigate the risk of financial

    contagion spreading from one to the other.

    In addition to the modifications to the treatment of outward-facing

    swaps condition described above, the Commission also accepted

    commenter's suggestions and is providing a transition period with two

    alternative compliance frameworks for eligible affiliates domiciled in

    certain foreign jurisdictions that have the legal authority to

    implement mandatory clearing regimes. As noted above, ISDA & SIFMA and

    CDEU stated that questions of timing and criteria for comparability

    render the proposed treatment of outward-facing swaps condition

    problematic, and that unless the condition is satisfactorily resolved,

    the condition could hamper the ability of U.S.-based groups to compete

    in foreign markets. ISDA & SIFMA further commented that if the

    Commission retains the cross-border requirements, the Commission should

    provide an appropriate transition period in order to allow foreign

    jurisdictions to implement their own G-20 mandates. The Commission is

    adopting two alternative compliance frameworks in response to concerns

    raised by commenters pertaining to the timing and sequencing of the

    implementation of the inter-affiliate exemption.

    The Commission is adopting a time-limited alternative compliance

    framework, available until March 11, 2014, for certain eligible

    affiliates transacting swaps with affiliated counterparties located in

    the European Union, Japan, or Singapore. The alternative compliance

    framework will allow affiliated counterparties, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, to pay and collect full variation margin

    daily on all swaps entered into between affiliates or between an

    affiliate and its unaffiliated counterparties, rather than submitting

    such swaps for clearing. In addition, the Commission has determined to

    provide time-limited relief for certain eligible affiliated

    counterparties located in the European Union, Japan, or Singapore from

    complying with the requirements of Sec. 50.52(b)(4)(i) as a condition

    of electing the inter-affiliate exemption. In particular, Sec.

    50.52(b)(4)(ii)(B) provides that if one of the eligible affiliate

    counterparties is located in the European Union, Japan, or Singapore,

    the requirements of paragraph (b)(4)(i) will not apply to such eligible

    affiliate counterparty until March 11, 2014, provided that: (1) The one

    counterparty that directly or indirectly holds a majority ownership

    interest in the other counterparty or the third party that directly or

    indirectly holds a majority ownership interest in both counterparties

    is not a ``financial entity'' as defined in section 2(h)(7)(C)(i) of

    the Act, and (2) neither eligible affiliate counterparty is affiliated

    with an entity that is a swap dealer or major swap participant, as

    defined in Sec. 1.3.

    Another time-limited alternative compliance framework also will be

    available for eligible affiliates transacting swaps with affiliated

    counterparties located outside the European Union, Japan, and

    Singapore, as long as the aggregate notional value of such swaps, which

    are included in a class of swaps identified in Sec. 50.4, does not

    exceed five percent of the aggregate notional value of all swaps, which

    are included in a class of swaps identified in Sec. 50.4, in each

    instance the notional value as measured in U.S. dollar equivalents and

    calculated for each calendar quarter, entered into by the eligible

    affiliate counterparty located in the United States.

    These alternative compliance frameworks will mitigate the

    competitive effects that ISDA & SIFMA and CDEU noted by allowing

    certain entities to collect variation margin rather than clearing such

    swaps until March 11, 2014. The Commission expects that collecting full

    variation margin is likely to be less costly than clearing because the

    latter includes initial margin in addition to variation margin, as well

    as clearing fees. To the extent that the alternative compliance

    approach is less costly, it will reduce the competitive effects that

    foreign affiliates experience during the period of time when comparable

    clearing requirements do not yet exist for competitors operating in

    foreign jurisdictions.

    The time-limited alternative compliance frameworks may,

    nevertheless, have some temporary competitive effects in the market.

    Companies with foreign affiliates that are required to pay and collect

    variation margin daily on all swaps entered into between affiliates or

    between an affiliate and its unaffiliated counterparties will bear some

    costs that competing firms based entirely in foreign jurisdictions may

    not bear because comparable clearing mandates have not yet been

    implemented. In the European Union, Japan, and Singapore, these effects

    are likely to largely disappear once comparable regimes are established

    and companies with entities in those jurisdictions are required to

    clear. In jurisdictions where comparable regimes are never implemented,

    the competitive effects will be longer-standing.

    The Commission, however, believes that such costs are warranted in

    light of the benefits provided by mitigating the likelihood of

    transferring risk back to the United States through inter-affiliate

    swaps that are not cleared or margined. Requiring the payment and

    collection of full variation margin will address the possibility of

    foreign affiliates developing significant counterparty credit risk

    exposures and then passing that risk back to affiliates in the United

    States through non-cleared swaps. Variation margin is one of the tools

    used by clearinghouses to mitigate counterparty credit risk. As an

    independent risk management tool, it reduces counterparty credit risk

    by requiring counterparties to make daily payments reflecting gains or

    losses based on each swap's value. However, it is not a complete

    replacement for the panoply of risk management tools that are used by

    clearinghouses to manage counterparty credit risk. As a consequence,

    this time-limited alternative compliance framework will mitigate

    counterparty credit risk, but not to the extent that clearing would.

    The Commission, however, believes that this measure will enable

    affiliates in the European Union, Japan, or Singapore to take advantage

    of the exemption while comparable clearing regimes are being

    established in those jurisdictions, while

    [[Page 21779]]

    simultaneously mitigating the risk of financial risk being transferred

    back to the United States through uncleared inter-affiliate swaps. In

    this way it provides benefits to companies with affiliates in these

    jurisdictions, and also to the American public.

    Moreover, the Commission believes that providing additional time-

    limited relief for certain affiliates located in the European Union,

    Japan, or Singapore from the requirements of Sec. 50.52(b)(4)(i) to

    clear their outward-facing swaps until March 11, 2014 under Sec.

    50.52(b)(4)(ii)(B) also will mitigate the competitive effects noted

    commenters by allowing such entities to continue to enter into inter-

    affiliate swaps without requiring those swaps to be submitted to

    clearing or variation margin, and is likely to be less costly than

    requiring such entities to either clear or exchange variation margin on

    their inter-affiliate or outward-facing swaps.

    Lastly, the Commission received several comments regarding the

    criteria for issuing comparability determinations, and expressing

    concern that unless such issues are satisfactorily resolved, the

    condition could hamper the ability of U.S.-based groups to compete in

    foreign markets. In response, the Commission has provided in this final

    release a significant amount of additional information regarding how

    and when those determinations will be made.

    In the NPRM, the Commission stated that the condition for the

    treatment of outward-facing swaps would not impose additional

    costs.\147\ Commenters stated that the proposed condition would

    increase the costs of inter-affiliate swaps.\148\ In terms of the

    revised rule, there may be some additional costs for entities that must

    clear their outward-facing swaps. Such costs, as discussed above, would

    include the cost of initial and variation margin, contributions to a

    guaranty fund, and clearing fees. However, in light of the comments

    discussed above, the Commission observes that, as modified, and with

    the transition period provided for under the rule, costs have been

    mitigated to the extent possible while preserving the goal of

    preventing evasion.

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

    \147\ See NPRM at 50435.

    \148\ See e.g., letter from CDEU.

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

    In terms of benefits, the Commission stated in the NPRM that the

    corporate group and U.S. financial markets may bear additional risk if

    the foreign affiliate is free to enter into an uncleared swap with a

    third-party that would be subject to clearing were it entered into in

    the United States. The Commission believes that the requirements for

    outward-facing swaps will prevent foreign affiliates from taking on

    significant risk through outward-facing swaps that fall under a Sec.

    50.4 class, which reduces the risk that could then be transferred back

    to the United States through exempt inter-affiliate swaps.

    D. Costs and Benefits to Market Participants and the Public

    Many commenters asserted that inter-affiliate swaps do not create

    any additional risk for third parties facing those affiliates.\149\ In

    addition, some commenters state that third parties may benefit from an

    inter-affiliate exemption because it will allow corporate entities to

    hedge their swaps more efficiently.\150\

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

    \149\ See, e.g., letters from EEI, The Working Group, and DLA

    Piper.

    \150\ See, e.g., letters from EEI, The Working Group, and ISDA &

    SIFMA.

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

    The Commission recognizes that these claims may be true to the

    extent that each affiliate, or a common parent, completely internalizes

    the risks facing the other affiliate. Majority ownership facilitates

    such internalization of costs among affiliated entities, and the threat

    of reputational risk is another factor that may cause related entities

    to act in the best interests of affiliate counterparties. However, as

    discussed above, two other factors reduce the degree to which

    affiliated entities may internalize each other's costs. Ownership

    stakes that are less than 100% reduce the percentage of costs that one

    affiliate internalizes from another, and bankruptcy laws providing

    protection for the assets of one affiliate from the creditors of

    another affiliate may create incentives to permit one affiliate to

    fail. These factors reduce the internalization of costs among

    affiliates.

    As a consequence, the counterparty risk that creditors to a given

    entity face may be increased by the inter-affiliate swaps into which

    that the entity enters. This risk may not be ``new'' in the sense that

    it is risk that was previously borne by another affiliate. But from the

    perspective of counterparties to the entity that now bears the risk, it

    is new. It increases the credit risk that the entity they face bears.

    The Commission, however, has established conditions on the inter-

    affiliate exemption that are intended to mitigate any increase in

    counterparty risk that third parties might bear as the result of the

    exemption. As described above, the documentation and centralized risk

    management requirements help to ensure that each group of affiliates

    engaging in inter-affiliate swaps has a centralized risk management

    program with adequate information to value and risk manage swap

    positions effectively. Moreover, the reporting requirements will help

    to ensure that regulators have information that is necessary to

    understand the use of inter-affiliate swaps under this exemption.

    In terms of costs, some commenters assert that this exception

    creates risk of contagion and systemic risk that could threaten the

    U.S. financial system.\151\ As explained above, this concern is

    substantiated to the extent that the inter-affiliate exemption prevents

    affiliates from protecting themselves from counterparty risk they bear

    with respect to one another, and to the extent that it prevents third

    parties from protecting themselves from affiliates' counterparty risk.

    The Commission believes that internalization of risk among affiliated

    entities mitigates this concern, and that the application of required

    clearing to swaps between affiliates and third parties further reduces

    the probability of risk cascading through the financial system via

    inter-affiliate swaps.

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

    \151\ See letters from AFR and Better Markets.

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

    AFR stated that the exemption may deprive DCOs of swaps volume and

    liquidity that is necessary for risk management. In effect, the

    exemption will reduce the number of swaps being cleared. All other

    things being equal, this may cause DCOs to increase the margin

    requirements for those swaps to compensate for having less volume,

    which may increase the cost of using cleared swaps. AFR also stated

    that the inter-affiliate exception will enable banks to set up joint

    ventures to trade swaps without clearing them. The Commission believes

    that its conditions with regard to treatment of outward-facing swaps

    address AFR's concerns about evasion of the clearing requirement.

    E. Costs and Benefits Compared to Alternatives

    The Commission considered several alternatives to the final

    rulemaking, including: (1) Alternative definitions of eligible

    affiliate counterparty; (2) more prescriptive documentation

    requirements; (3) alternative risk management requirements; (4)

    different requirements for treatment of outward-facing swaps; and (5)

    requiring variation margin for swaps between affiliated financial

    entities. The first four alternatives are discussed at length above.

    The fifth alternative, the imposition of variation margin on swaps

    between affiliates that are financial entities, was considered by the

    Commission and ultimately rejected based on comments.

    [[Page 21780]]

    As proposed, the inter-affiliate exemption would have required

    affiliated financial entities to pay and collect variation margin

    associated with their swaps unless the affiliates were 100% commonly

    owned and commonly guaranteed by a 100% commonly owned guarantor. In

    the final rule, the Commission has eliminated the variation margin

    requirement. This change is likely to create significant savings for

    eligible affiliates. Reduced margin requirements will reduce the

    capital costs that entities bear when transacting inter-affiliate

    swaps, and may reduce the capital requirements for financial entities

    under prudential regulation. In addition, it may help entities avoid

    liquidity crunches when their positions move significantly out of the

    money in a short period of time.

    However, eliminating the variation margin requirement also

    significantly reduces the protective value of the eligibility

    requirements that the Commission established in order to reduce the

    likelihood of cascading defaults among affiliated entities, and the

    associated risk to third parties transacting with those entities.

    Without the variation margin requirements, affiliated entities may

    develop large outstanding exposures toward one another, and to the

    degree that affiliated entities do not internalize one another's costs,

    an affiliate that is out of the money will have incentives not to

    perform on its obligations. In addition if the obligations of one

    entity are sufficiently large, its default may jeopardize the health of

    other affiliated entities, which would also increase counterparty risk

    for third parties that have uncleared outstanding positions with those

    entities.

    F. Consideration of CEA Section 15(a) Factors

    1. Protection of Market Participants and the Public

    In deciding to finalize the inter-affiliate clearing exemption, the

    Commission assessed how to protect affiliated entities, third parties

    in the swaps market, and the public. The Commission has sought to

    ensure that in the absence of a clearing requirement the risks

    presented by uncleared inter-affiliate swaps would be mitigated so that

    significant losses to one affiliate counterparty or a default of one of

    the affiliate counterparties is less likely to create significant

    repercussions for third-parties or the American public. Toward that

    end, the Commission has required that affiliates to execute swap

    trading relationship documentation, maintain a centralized-risk

    management process, and report specific information to an SDR, and meet

    certain requirements related to outward-facing swaps in order to be

    eligible for the exception. As explained in this cost-benefit section,

    these conditions serve multiple objectives that ultimately protect

    market participants and the public.

    For instance, the documentation requirement will reduce

    uncertainties where affiliates incur significant swaps-related losses

    or where there is a defaulting affiliate. Because the documentation

    would be in writing, the Commission expects that there will be less

    contractual ambiguity should disagreements between affiliates arise.

    The condition that an inter-affiliate swap be subject to a centralized

    risk management program reasonably designed to monitor and manage risk

    will also help mitigate the risks associated with inter-affiliate

    swaps. As noted throughout this final rulemaking, inter-affiliate swap

    risk could adversely impact third parties that enter into uncleared

    swaps or other contracts with affiliates engaging in inter-affiliate

    swaps.

    The reporting condition would help the Commission and the

    affiliate's leadership monitor compliance with the inter-affiliate

    clearing exemption. For example, an affiliate that also is an SEC Filer

    must receive a governing board's approval for electing the proposed

    exemption. It cannot act independently. In the Commission's opinion,

    the reporting conditions promote accountability and transparency,

    offering another public safeguard by keeping the Commission and each

    entity's board of directors informed.

    On the other hand, the rule also creates certain costs that will be

    borne by eligible entities, the counterparties to those entities, and

    the public. Regarding costs for eligible entities, the qualification

    requirements will create some new costs for those that do not already

    have recordkeeping and risk management systems that are in compliance

    with the rule. However, as noted above, the Commission believes that

    some entities may already have systems in place that meet most or all

    of the requirements. Moreover, entities will elect the exemption only

    if they project the benefit of doing so is greater than the costs

    associated with the qualifying requirements. Therefore, these costs may

    decrease the value of the exemption, but they will not create new costs

    for entities that choose not to elect the exemption.

    2. Efficiency, Competitiveness, and Financial Integrity of Futures

    Markets

    Exempting swaps between majority-owned affiliates within a

    corporate group from the clearing requirement will promote allocational

    efficiency by reducing overall clearing costs for eligible affiliate

    counterparties. The Commission also anticipates that the exemption will

    increase allocational efficiency and the financial integrity of markets

    because it will make it less costly for corporate groups to centralize

    their hedging and market facing swap activities within a single

    affiliate. As explained above, commenters stated that clearing swaps

    through single affiliates enables affiliates and corporate groups to

    more efficiently and effectively manage corporate risk.

    Certain provisions of the proposed rule, such as the requirements

    that inter-affiliate swaps be subject to centralized risk management

    and that certain information be reported, also would discourage abuse

    of the exemption. Together, these conditions promote the financial

    integrity of swap markets and financial markets as a whole.

    3. Price Discovery

    Under Commission regulation 43.2, a ``publicly reportable swap

    transaction,'' means, among other things, ``any executed swap that is

    an arm's length transaction between two parties that results in a

    corresponding change in the market risk position between the two

    parties.'' \152\ The Commission does not consider non-arms-length swaps

    as contributing to price discovery in the markets.\153\ Given that

    inter-affiliate swaps as defined in this rulemaking are generally not

    arm's length transactions, the Commission does not anticipate the

    inter-affiliate clearing exemption to have any significant effect on

    price discovery.\154\

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

    \152\ 17 CFR 43.2. See also Real-Time Public Reporting of Swap

    Transaction Data, 77 FR 1182 (Jan. 9, 2012).

    \153\ Transactions that fall outside the definition of

    ``publicly reportable swap transaction''--that is, transactions that

    are not arms-length--``do not serve the price discovery objective of

    CEA section 2(a)(13)(B).'' Real-Time Public Reporting of Swap

    Transaction Data, 77 FR 1195. See also id. at 1187 (discussing

    ``Swaps Between Affiliates and Portfolio Compression Exercises'').

    \154\ The definition of ``publicly reportable swap transaction''

    identifies two examples of transactions that fall outside the

    definition, including ``internal swaps between one-hundred percent

    owned subsidiaries of the same parent entity.'' 17 CFR 43.2 (adopted

    by Real-Time Public Reporting of Swap Transaction Data, 77 FR 1244).

    The Commission notes that the list of examples is not exhaustive.

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

    4. Sound Risk Management Practices

    As a general rule, the Commission believes that clearing swaps is a

    sound

    [[Page 21781]]

    risk management practice. Exempting certain inter-affiliate swaps from

    the clearing requirement creates additional counterparty exposure for

    affiliates that do not completely internalize each other's risk, and

    for third parties that enter into uncleared swaps or other transactions

    with those affiliated entities. This increased counterparty risk among

    affiliates may increase the likelihood that a default within one

    affiliate could cause significant losses in other affiliated entities.

    If the default causes other affiliated entities to default, then third

    parties that have entered into uncleared swaps or other agreements with

    those entities also could be affected. But, in finalizing the inter-

    affiliate clearing exemption, the Commission has assessed the risks of

    inter-affiliate swaps, and believes that the partial internalization of

    costs among affiliated entities, combined with the documentation, risk

    management, reporting, and treatment of outward-facing swaps

    requirements for electing the exception, will mitigate some of the

    risks associated with uncleared inter-affiliate swaps. However, they

    are not a complete substitute for the protections that would be

    provided by required clearing, or by a requirement to use some of the

    same risk management tools that a clearinghouse would use to mitigate

    counterparty credit risk (i.e., initial and variation margin).

    Also, as noted above, without clearing to mitigate transmission of

    risk among affiliates, the risk that any one affiliate takes on, and

    any contagion that may be caused by that risk, may be transferred more

    easily to other affiliates. This makes the risk mitigation requirements

    for outward-facing swaps more important. The Commission's requirements

    for outward-facing swaps mitigate the risk that swaps that the

    Commission has determined are required to be cleared could transfer

    risk that would then be spread among the affiliates, but does not

    eliminate the possibility that swaps that are not required to be

    cleared and are transacted in a regime without mandatory clearing (or

    bilateral margin requirements) for uncleared swaps could result in

    financial risk that impacts its affiliates and counterparties of those

    affiliates.\155\

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

    \155\ The Commission notes that even in the absence of required

    clearing or margin requirements for swaps between certain affiliated

    entities, such entities may choose to use initial and variation

    margin to manage risks that could otherwise be transferred from one

    affiliate to another. Similarly, third parties that have entered

    into swaps with affiliates may also include variation margin

    requirements in their swap agreements.

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

    The Commission also believes that SEC Filer reporting is a prudent

    practice. As detailed in this preamble and the rule text, SEC Filers

    are affiliates that meet certain SEC-related qualifications, and their

    governing boards or equivalent bodies are directly responsible to

    shareholders for the financial condition and performance of the

    affiliate. The boards also have access to information that would give

    them a comprehensive picture of the company's financial condition and

    risk management strategies. Therefore, any oversight they provide to

    the affiliate's risk management strategies would likely encourage sound

    risk management practices. In addition, the condition that affiliates

    electing the inter-affiliate clearing exemption must report their

    boards' knowledge of the election is a sound risk management practice.

    5. Other Public Interest Considerations

    Aside from those discussed in Section II.A above, the Commission

    has identified no other public interest considerations.

    IV. 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.\156\

    As stated in the NPRM, the clearing requirement determinations and

    rules proposed by the Commission will affect only ECPs because all

    persons that are not ECPs are required to execute their swaps on a

    designated contract market (DCM), and all contracts executed on a DCM

    must be cleared by a DCO, as required by statute and regulation; not by

    operation of any clearing requirement.\157\ Accordingly, the Chairman,

    on behalf of the Commission, certified pursuant to 5 U.S.C. 605(b) that

    the proposed rules would not have a significant economic impact on a

    substantial number of small entities. The Commission then invited

    public comment on this determination. The Commission received no

    comments.

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

    \156\ See 5 U.S.C. 601 et seq.

    \157\ To the extent that this rulemaking affects DCMs, DCOs, or

    FCMs, the Commission has previously determined that DCMs, DCOs, and

    FCMs are not small entities for purposes of the RFA. See,

    respectively and as indicated, 47 FR 18618, 18619 (Apr. 30, 1982)

    (DCMs and FCMs); and 66 FR 45604, 45609 (Aug. 29, 2001) (DCOs).

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

    The Commission has previously determined that ECPs are not small

    entities for purposes of the RFA.\158\ However, in its proposed

    rulemaking to establish a schedule to phase in compliance with certain

    provisions of the Dodd-Frank Act, including the clearing requirement

    under section 2(h)(1)(A) of the CEA, the Commission received a joint

    comment (Electric Associations Letter) from the Edison Electric

    Institute (EEI), the National Rural Electric Cooperative Association

    (NRECA) and the Electric Power Supply Association (EPSA) asserting that

    certain members of NRECA may both be ECPs under the CEA and small

    businesses under the RFA.\159\ These members of NRECA, as the

    Commission understands, have been determined to be small entities by

    the Small Business Administration (SBA) because they are ``primarily

    engaged in the generation, transmission, and/or distribution of

    electric energy for sale and [their] total electric output for the

    preceding fiscal year did not exceed 4 million megawatt hours.'' \160\

    Although the Electric Associations Letter does not provide details on

    whether or how the NRECA members that have been determined to be small

    entities use the interest rate swaps and CDS that are the subject of

    this rulemaking, the Electric Associations Letter does state that the

    EEI, NRECA, and EPSA members ``engage in swaps to hedge commercial

    risk.'' \161\ Because the NRECA members that have been determined to be

    small entities would be using swaps to hedge commercial risk, the

    Commission expects that they would be able to use the end-user

    exception from the clearing requirement and therefore would not be

    affected to any significant extent by this rulemaking.

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

    \158\ See 66 FR 20740, 20743 (Apr. 25, 2001).

    \159\ See joint letter from EEI, NRECA, and ESPA, dated Nov. 4,

    2011, (Electric Associations Letter), commenting on Swap Transaction

    Compliance and Implementation Schedule: Clearing and Trade Execution

    Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20,

    2011).

    \160\ Small Business Administration, Table of Small Business

    Size Standards, Nov. 5, 2010.

    \161\ See Electric Associations Letter, at 2. The letter also

    suggests that EEI, NRECA, and EPSA members are not financial

    entities. See id., at note 5, and at 5 (the associations' members

    ``are not financial companies'').

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

    Thus, because nearly all of the ECPs that may be subject to the

    proposed clearing requirement are not small entities, and because the

    few ECPs that have been determined by the SBA to be small entities are

    unlikely to be subject to the clearing requirement, the Chairman, on

    behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that

    the rules herein will not have a significant economic impact on a

    substantial number of small entities.

    [[Page 21782]]

    B. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (PRA) \162\ imposes certain

    requirements on Federal agencies in connection with their conducting or

    sponsoring any collection of information as defined by the PRA. An

    agency may not conduct or sponsor, and a person is not required to

    respond to, a collection of information unless it has been approved by

    the Office of Management and Budget (OMB) and displays a currently

    valid control number.\163\

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

    \162\ 44 U.S.C. 3501 et seq.

    \163\ Id.

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

    Certain provisions of this final rulemaking impose new information

    collection requirements within the meaning of the PRA, for which the

    Commission must obtain a valid control number. Accordingly, the

    Commission requested, and OMB has assigned control number 3038-0104 for

    the new collection of information. The Commission also has submitted

    this final rule release, the proposed rulemaking, and all required

    supporting documentation to OMB for review in accordance with 44 U.S.C.

    3507(d) and 5 CFR 1320.11. The title for this new collection of

    information is ``Rule 50.52 (proposed as rule 39.6(g)) Affiliate

    Transaction Uncleared Swap Notification.'' Responses to this collection

    of information will be mandatory.

    The Commission will protect proprietary information in accordance

    with the Freedom of Information Act and 17 CFR part 145, entitled

    ``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.'' \164\ 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.

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

    \164\ 7 U.S.C. 12(a)(1).

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

    1. Information Provided by Reporting Entities

    The regulations being adopted in this final rule release impose

    certain reporting requirements on eligible affiliates that enter into

    inter-affiliate swaps and elect the inter-affiliate exemption from

    clearing such swaps. As described in the NPRM and in this final

    release, the reporting requirements are designed to address Commission

    concerns regarding inter-affiliate swap risk and to provide the

    Commission with information necessary to regulate the swaps market. In

    particular, regulation 50.52(c) (proposed as Sec. 39.6(g)(4)) will

    require an electing counterparty to provide, or cause to be provided,

    certain information to a registered SDR or, if no registered SDR is

    available to receive the information, to the Commission, in the form

    and manner specified by the Commission. As further described in this

    final rule release, Sec. 50.52(c)(1) requires reporting counterparties

    to notify the Commission each time they elect the inter-affiliate

    clearing exemption for each swap, by reporting certain information to a

    registered SDR, or to the Commission, if no registered SDR is available

    to receive the information. Reporting counterparties also must report

    the information required by Sec. 50.52(c)(2) and (3), and have the

    option to report such information each time that the eligible

    counterparties elect the inter-affiliate exemption for each swap, or on

    an annual basis in anticipation of electing the exemption.

    To determine the total time burden and cost associated with the

    proposed rule for PRA purposes, the Commission estimated the number of

    affiliates that likely would seek to claim the exemption and the

    average number of inter-affiliate swaps for which the affiliates would

    elect to use the proposed exemption. The Commission also estimated the

    time burden required for entities to comply with the reporting

    requirements.

    In estimating the number of affiliates and the average number of

    inter-affiliate swaps that likely would claim the inter-affiliate

    exemption, the Commission used data from the U.S. Bureau of Economic

    Analysis (BEA) to estimate that there are approximately 22 subsidiaries

    per U.S. multinational parent company (MNC), resulting in a total of

    53,195 affiliates that might elect the inter-affiliate exemption.\165\

    As more fully described in the NPRM, the Commission surveyed five

    corporations to obtain information that allowed it to estimate that

    affiliates enter into an average of 2,230 inter-affiliate swaps

    annually.\166\

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

    \165\ NPRM at 50439-40.

    \166\ Id.

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

    In estimating the time burden associated with complying with the

    reporting requirements of the rules, the Commission stated in the NPRM

    that it expected each reporting counterparty would likely spend between

    15 seconds to two minutes per transaction entering information required

    by Sec. 50.52(c)(1) (proposed Sec. 39.6(g)(4)(i)) into the reporting

    system.\167\ The Commission further estimated that it would take the

    reporting counterparty up to 10 minutes to collect and submit the

    information required under Sec. 50.52(c)(2)-(3) (proposed Sec.

    39.6(g)(4)(ii)-(iii)), for the first transaction and one to five

    minutes to collect and submit the information for subsequent

    transactions with that same counterparty. The Commission estimated that

    together these requirements would cost a reporting counterparty between

    $1.63 and $13.00 to comply with Sec. 50.52(c)(1) (proposed Sec.

    39.6(g)(4)(i)), $65.00 to comply with Sec. 50.52(c)(2)-(3) (proposed

    Sec. 39.6(g)(4)(ii)-(iii)) for the first inter-affiliate swap, and

    between $6.50 and $32.50 to comply with Sec. 50.52(c)(2)-(3) (proposed

    Sec. 39.6(g)(4)(ii)-(iii)) for subsequent inter-affiliate swaps with

    the same counterparty.\168\

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

    \167\ The NPRM noted that to comply with proposed Sec.

    39.6(g)(4)(i) (now Sec. 50.52(c)(1)), each reporting counterparty

    would be required to check a box indicating that both counterparties

    to the swap are electing not to clear the swap.

    \168\ NPRM at 50440.

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

    With respect to the annual reporting option described in Sec.

    50.52(d), the Commission stated in the NPRM that it anticipated that at

    least 90% of MNCs would choose to file an annual report in lieu of

    reporting each swap separately. The Commission estimated in the NPRM

    that it would take an average of 30 to 90 minutes to complete and

    submit the filing, resulting in an annual aggregate cost for submitting

    the annual report of approximately $195 to $585.\169\

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

    \169\ NPRM at 50441.

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

    In addition to the specific reporting obligations described in the

    rules, the NPRM also noted that reporting counterparties may need to

    update established reporting systems to comply with the reporting

    requirement, and non-reporting affiliate counterparties may need to

    transmit information to reporting counterparties after entering into a

    swap subject to the rules. In the NPRM, the Commission stated that it

    anticipated that reporting counterparties may have to modify their

    established reporting systems in order to accommodate the additional

    data fields required by Sec. 50.52(c) (proposed Sec. 39.6(g)(4)), and

    estimated that the modifications would create a one-time cost of

    between $341 and $3,410 per entity.\170\ The Commission further stated

    in the NPRM that it anticipated that an affiliate who is not the

    reporting counterparty may need to communicate information to the

    reporting counterparty after executing an inter-affiliate swap, and

    estimated the cost of, among other things, providing

    [[Page 21783]]

    information to facilitate any due diligence that the reporting

    counterparty may conduct, to be between $33 and $3,900.\171\

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

    \170\ Id.

    \171\ Id.

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

    Using these figures, the Commission estimated that the inter-

    affiliate exemption could result in an average total annual burden of

    1,758,369 hours and average total annual costs of $685,309,281, or

    approximately 1.8 minutes and $10.48 per inter-affiliate swap.

    2. Information Collection Comments

    The Commission invited public comment on the proposed PRA analysis

    and estimates and on any aspect of the reporting burdens resulting from

    proposed Sec. 39.6(g) (now Sec. 50.52(c)). One commenter submitted

    comments in relation to the Commission's estimate of the number of

    eligible affiliates seeking to claim the exemption. No commenters

    submitted comments to OMB, and OMB itself did not submit any comments

    to the Commission pertaining to the proposed rule.\172\

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

    \172\ See 5 CFR 1320.11(f).

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

    In the context of its comments pertaining to the costs and benefits

    of the reporting requirements of the proposed rule, EEI claimed that

    the Commission's estimation of 22 eligible affiliates per MNC was ``far

    too low'' for many U.S. energy companies. Although EEI commented that

    the Commission's estimate of the number of affiliates per MNC was too

    low in the context of U.S. energy companies, EEI did not provide an

    alternative estimate or point to any other sources of information that

    might provide an alternative source for estimating the average number

    of subsidiaries per MNC.

    The Commission has considered EEI's comment and declines to revise

    its estimate of the number of affiliates of an MNC.\173\ As described

    in the NPRM, the Commission estimated that a total of 53,195 affiliates

    might elect the inter-affiliate clearing exemption. The Commission's

    estimation of the number of affiliates of an MNC was based on the most

    recent data collected by the BEA, which indicated that there are 2,347

    MNCs in the U.S. and 25,424 foreign subsidiaries that are majority

    owned by such MNCs.\174\ To account for the number of majority-owned

    U.S. subsidiaries of MNCs, the Commission doubled the BEA's foreign

    subsidiaries, and determined that there are an estimated 50,848 U.S.

    and foreign subsidiaries, or approximately 22 subsidiaries per MNC.

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

    \173\ The Commission further notes that EEI's comments were made

    exclusively with respect to U.S. energy companies and not the

    broader spectrum of potential MNCs that are included within the

    estimation.

    \174\ See Table I.A 2., ``Selected Data for Foreign Affiliates

    and U.S. Parents in All Industries,'' located at http://www.bea.gov/international/pdf/usdia_2009p/Group%20I%20tables.pdf. The BEA

    defines a U.S. Parent of a MNC as a person that is a resident in the

    United States and owns or controls 10 percent or more of the voting

    securities, or the equivalent, of a foreign business enterprise. A

    Guide to BEA Statistics on U.S. Multinational Companies, available

    at http://www.bea.gov/scb/pdf/internat/usinvest/1995/0395iid.pdf.

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

    The Commission further notes that the estimate of the number of

    affiliates per MNC proposed in the NPRM and adopted in this release for

    purposes of the PRA, is an averaged approximation based on publically

    available information collected by the BEA, and acknowledges that the

    number of affiliates of an MNC may be higher or lower than 22. However,

    there is no basis for concluding that the use of a different source for

    estimating the average number of affiliates per MNC would result in a

    higher number estimate, nor did the Commission receive comments to that

    effect. Accordingly, the Commission believes that its estimation is

    reasonable in light of the information that is publicly available at

    this time, and that its original proposed estimates remain appropriate

    for purposes of the PRA.

    List of Subjects in 17 CFR Part 50

    Business and industry, Clearing, Swaps.

    For the reasons stated in the preamble, amend 17 CFR part 50 as

    follows:

    PART 50--CLEARING REQUIREMENT AND RELATED RULES

    0

    1. The authority citation for part 50 continues to read as follows:

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

    124 Stat. 1376.

    0

    2. The heading for part 50 is revised to read as set forth above.

    0

    3. Add Sec. 50.52 to subpart C to read as follows:

    Sec. 50.52 Exemption for swaps between affiliates.

    (a) Eligible affiliate counterparty status. Subject to the

    conditions in paragraph (b) of this section:

    (1) Counterparties to a swap may elect not to clear a swap subject

    to the clearing requirement of section 2(h)(1)(A) of the Act and this

    part if:

    (i) One counterparty, directly or indirectly, holds a majority

    ownership interest in the other counterparty, and the counterparty that

    holds the majority interest in the other counterparty reports its

    financial statements on a consolidated basis under Generally Accepted

    Accounting Principles or International Financial Reporting Standards,

    and such consolidated financial statements include the financial

    results of the majority-owned counterparty; or

    (ii) A third party, directly or indirectly, holds a majority

    ownership interest in both counterparties, and the third party reports

    its financial statements on a consolidated basis under Generally

    Accepted Accounting Principles or International Financial Reporting

    Standards, and such consolidated financial statements include the

    financial results of both of the swap counterparties.

    (2) For purposes of this section:

    (i) A counterparty or third party directly or indirectly holds a

    majority ownership interest if it directly or indirectly holds a

    majority of the equity securities of an entity, or the right to receive

    upon dissolution, or the contribution of, a majority of the capital of

    a partnership; and

    (ii) The term ``eligible affiliate counterparty'' means an entity

    that meets the requirements of this paragraph.

    (b) Additional conditions. Eligible affiliate counterparties to a

    swap may elect the exemption described in paragraph (a) of this section

    if:

    (1) Both counterparties elect not to clear the swap;

    (2)(i) A swap dealer or major swap participant that is an eligible

    affiliate counterparty to the swap satisfies the requirements of Sec.

    23.504 of this chapter; or

    (ii) If neither eligible affiliate counterparty is a swap dealer or

    major swap participant, the terms of the swap are documented in a swap

    trading relationship document that shall be in writing and shall

    include all terms governing the trading relationship between the

    eligible affiliate counterparties;

    (3) The swap is subject to a centralized risk management program

    that is reasonably designed to monitor and manage the risks associated

    with the swap. If at least one of the eligible affiliate counterparties

    is a swap dealer or major swap participant, this centralized risk

    management requirement shall be satisfied by complying with the

    requirements of Sec. 23.600 of this chapter; and

    (4)(i) Each eligible affiliate counterparty that enters into a

    swap, which is included in a class of swaps identified in Sec. 50.4,

    with an unaffiliated counterparty shall:

    [[Page 21784]]

    (A) Comply with the requirements for clearing the swap in section

    2(h) of the Act and this part;

    (B) Comply with the requirements for clearing the swap under a

    foreign jurisdiction's clearing mandate that is comparable, and

    comprehensive but not necessarily identical, to the clearing

    requirement of section 2(h) of the Act and this part, as determined by

    the Commission;

    (C) Comply with an exception or exemption under section 2(h)(7) of

    the Act or this part;

    (D) Comply with an exception or exemption under a foreign

    jurisdiction's clearing mandate, provided that:

    (1) The foreign jurisdiction's clearing mandate is comparable, and

    comprehensive but not necessarily identical, to the clearing

    requirement of section 2(h) of the Act and this part, as determined by

    the Commission; and

    (2) The foreign jurisdiction's exception or exemption is comparable

    to an exception or exemption under section 2(h)(7) of the Act or this

    part, as determined by the Commission; or

    (E) Clear such swap through a registered derivatives clearing

    organization or a clearing organization that is subject to supervision

    by appropriate government authorities in the home country of the

    clearing organization and has been assessed to be in compliance with

    the Principles for Financial Market Infrastructures.

    (ii)(A) Except as provided in paragraph (b)(4)(ii)(B) of this

    section, if one of the eligible affiliate counterparties is located in

    the European Union, Japan, or Singapore, the following may satisfy the

    requirements of paragraph (b)(4)(i) of this section until March 11,

    2014:

    (1) Each eligible affiliate counterparty, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, pays and collects full variation margin daily

    on all swaps entered into between the eligible affiliate counterparty

    located in the European Union, Japan, or Singapore and an unaffiliated

    counterparty; or

    (2) Each eligible affiliate counterparty, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, pays and collects full variation margin daily

    on all of the eligible affiliate counterparties' swaps with other

    eligible affiliate counterparties.

    (B) If one of the eligible affiliate counterparties is located in

    the European Union, Japan, or Singapore, the requirements of paragraph

    (b)(4)(i) of this section shall not apply to the eligible affiliate

    counterparty located in the European Union, Japan, or Singapore until

    March 11, 2014, provided that:

    (1) The one counterparty that directly or indirectly holds a

    majority ownership interest in the other counterparty or the third

    party that directly or indirectly holds a majority ownership interest

    in both counterparties is not a ``financial entity'' as defined in

    section 2(h)(7)(C)(i) of the Act; and

    (2) Neither eligible affiliate counterparty is affiliated with an

    entity that is a swap dealer or major swap participant, as defined in

    Sec. 1.3.

    (iii) If an eligible affiliate counterparty located in the United

    States enters into swaps, which are included in a class of swaps

    identified in Sec. 50.4, with eligible affiliate counterparties

    located in jurisdictions other than the United States, the European

    Union, Japan, and Singapore, and the aggregate notional value of such

    swaps, which are included in a class of swaps identified in Sec. 50.4,

    does not exceed five percent of the aggregate notional value of all

    swaps, which are included in a class of swaps identified in Sec. 50.4,

    in each instance the notional value as measured in U.S. dollar

    equivalents and calculated for each calendar quarter, entered into by

    the eligible affiliate counterparty located in the United States, then

    such swaps shall be deemed to satisfy the requirements of paragraph

    (b)(4)(i) of this section until March 11, 2014, provided that:

    (A) Each eligible affiliate counterparty, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, pays and collects full variation margin daily

    on all swaps entered into between the eligible affiliate counterparties

    located in jurisdictions other than the United States, the European

    Union, Japan, and Singapore and an unaffiliated counterparty; or

    (B) Each eligible affiliate counterparty, or a third party that

    directly or indirectly holds a majority interest in both eligible

    affiliate counterparties, pays and collects full variation margin daily

    on all of the eligible affiliate counterparties' swaps with other

    eligible affiliate counterparties.

    (c) Reporting requirements. When the exemption described in

    paragraph (a) of this section is elected, the reporting counterparty,

    as determined in accordance with Sec. 45.8 of this chapter, shall

    provide or cause to be provided the following information to a

    registered swap data repository or, if no registered swap data

    repository is available to receive the information from the reporting

    counterparty, to the Commission, in the form and manner specified by

    the Commission:

    (1) Confirmation that both eligible affiliate counterparties to the

    swap are electing not to clear the swap and that each of the electing

    eligible affiliate counterparties satisfies the requirements in

    paragraph (b) of this section applicable to it;

    (2) For each electing eligible affiliate counterparty, how the

    counterparty generally meets its financial obligations associated with

    entering into non-cleared swaps by identifying one or more of the

    following categories, as applicable:

    (i) A written credit support agreement;

    (ii) Pledged or segregated assets (including posting or receiving

    margin pursuant to a credit support agreement or otherwise);

    (iii) A written guarantee from another party;

    (iv) The electing counterparty's available financial resources; or

    (v) Means other than those described in paragraphs (c)(2)(i), (ii),

    (iii) or (iv) of this section; and

    (3) If an electing eligible affiliate counterparty is an entity

    that is an issuer of securities registered under section 12 of, or is

    required to file reports under section 15(d) of, the Securities

    Exchange Act of 1934:

    (i) The relevant SEC Central Index Key number for that

    counterparty; and

    (ii) Acknowledgment that an appropriate committee of the board of

    directors (or equivalent body) of the eligible affiliate counterparty

    has reviewed and approved the decision to enter into swaps that are

    exempt from the requirements of section 2(h)(1) and 2(h)(8) of the Act.

    (d) Annual reporting. An eligible affiliate counterparty that

    qualifies for the exemption described in paragraph (a) of this section

    may report the information listed in paragraphs (c)(2) and (3) of this

    section annually in anticipation of electing the exemption for one or

    more swaps. Any such reporting by a reporting counterparty under this

    paragraph will be effective for purposes of paragraphs (c)(2) and (3)

    of this section for 365 days following the date of such reporting.

    During the 365-day period, the reporting counterparty shall amend the

    report as necessary to reflect any material changes to the information

    reported. Each reporting counterparty shall have a reasonable basis to

    believe that the eligible affiliate counterparties meet the

    requirements for the exemption under this section.

    [[Page 21785]]

    Issued in Washington, DC, on April 1, 2013, by the Commission.

    Melissa D. Jurgens,

    Secretary of the Commission.

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

    Federal Regulations.

    Appendices to Clearing Exemption for Swaps Between Certain Affiliated

    Entities--Commission Voting Summary and Statements of Commissioners

    Appendix 1--Commission Voting Summary

    On this matter, Chairman Gensler and Commissioners Chilton,

    O'Malia, and Wetjen voted in the affirmative; Commissioner Sommers

    voted in the negative.

    Appendix 2--Statement of Chairman Gary Gensler

    I support the final rule to exempt swaps between certain

    affiliated entities within a corporate group from the clearing

    requirement in the Dodd-Frank Wall Street Reform and Consumer

    Protection Act.

    Since the late 19th century, clearinghouses have lowered risk

    for the public and fostered competition in the futures market.

    Clearing also has democratized the market by fostering access for

    farmers, ranchers, merchants and other participants.

    The Commission approved the first clearing requirement for swaps

    last November, following through on the U.S. commitment at the 2009

    G-20 meeting that standardized swaps be cleared by the end of 2012.

    Following Congress' direction, end-users are not required to bring

    swaps into central clearing.

    A key milestone was reached on March 11 with the requirement

    that swap dealers and the largest hedge funds begin clearing the

    vast majority of interest rate and credit default index swaps.

    Compliance will continue to be phased in throughout this year. Other

    financial entities begin clearing June 10. Accounts managed by third

    party investment managers and ERISA pension plans have until

    September 9.

    The final rule allows for an exemption from clearing for swaps

    between affiliates under the following limitations:

    First, the exemption covers swaps between majority-

    owned affiliates whose financial statements are reported on a

    consolidated basis.

    Second, the rule requires documentation of such

    exempted swaps, centralized risk management, and reporting

    requirements for such swaps.

    Third, the exemption requires that each swap entered

    into by the affiliated counterparties with unaffiliated

    counterparties must be cleared. This approach largely aligns with

    the Europeans' approach to an exemption for inter-affiliate

    clearing.

    In order to promote international harmonization regarding

    mandatory clearing, the final rulemaking provides for two time-

    limited alternative compliance frameworks for swaps entered into

    with unaffiliated counterparties in jurisdictions outside of the

    United States.

    With regard to affiliated counterparties located in the European

    Union, Japan and Singapore--jurisdictions that have adopted swap

    clearing regimes and are currently in the process of

    implementation--the Commission is phasing compliance with the

    requirement to clear swaps with unaffiliated counterparties until

    March 11, 2014. During the phase-in period affiliated counterparties

    located in these jurisdictions will be able to pay and collect

    variation margin in lieu of clearing. Affiliated counterparties that

    are located in these jurisdictions (that are not affiliated with

    swap dealers or major swap participants) will not have to pay or

    collect such variation margin during the phase-in period, provided

    they are not directly or indirectly majority-owned by a financial

    entity.

    With regard to affiliated counterparties located in other

    foreign jurisdictions, the Commission is phasing compliance with the

    requirement to clear swaps with unaffiliated counterparties until

    March 11, 2014. Until that date, an affiliated counterparty located

    outside the United States, the European Union, Japan and Singapore

    does not have to clear its swaps with unaffiliated counterparties so

    long as the aggregate notional value of such swaps does not exceed

    five percent of the notional value of all swaps entered into by the

    affiliated counterparty located in the United States.

    This phasing in of the inter-affiliate exemption provides a

    transition period for foreign jurisdictions to implement comparable

    and comprehensive clearing regimes.

    [FR Doc. 2013-07970 Filed 4-10-13; 8:45 am]

    BILLING CODE 6351-01-P

    Last Updated: April 11, 2013



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