2013-26479

Federal Register, Volume 78 Issue 215 (Wednesday, November 6, 2013)[Federal Register Volume 78, Number 215 (Wednesday, November 6, 2013)]

[Rules and Regulations]

[Pages 66621-66637]

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

[FR Doc No: 2013-26479]

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Rules and Regulations

Federal Register

________________________________________________________________________

This section of the FEDERAL REGISTER contains regulatory documents

having general applicability and legal effect, most of which are keyed

to and codified in the Code of Federal Regulations, which is published

under 50 titles pursuant to 44 U.S.C. 1510.

The Code of Federal Regulations is sold by the Superintendent of Documents.

Prices of new books are listed in the first FEDERAL REGISTER issue of each

week.

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Federal Register / Vol. 78, No. 215 / Wednesday, November 6, 2013 /

Rules and Regulations

[[Page 66621]]

COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 23 and 190

RIN 3038-AD28

Protection of Collateral of Counterparties to Uncleared Swaps;

Treatment of Securities in a Portfolio Margining Account in a Commodity

Broker Bankruptcy

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (the ``Commission'')

is issuing final rules implementing new statutory provisions enacted by

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection

Act (the ``Dodd-Frank Act''). Specifically, the final rule contained

herein imposes requirements on swap dealers (``SDs'') and major swap

participants (``MSPs'') with respect to the treatment of collateral

posted by their counterparties to margin, guarantee, or secure

uncleared swaps. Additionally, the final rule includes revisions to

ensure that, for purposes of subchapter IV of chapter 7 of the

Bankruptcy Code, securities held in a portfolio margining account that

is a futures account or a Cleared Swaps Customer Account constitute

``customer property''; and owners of such account constitute

``customers.''

DATES: Effective date: This rule is effective January 6, 2014.

Compliance dates: For uncleared swap transactions that are entered

into with ``new counterparties,'' \1\ all persons shall be in

compliance with the requirements set forth in Subpart L of Part 23 not

later than May 5, 2014. For uncleared swap transactions that are

entered into with ``existing counterparties,'' \2\ all persons shall be

in compliance with the requirements set forth in Subpart L of Part 23

not later than November 3, 2014. All parties must comply with the Part

190 rules by January 6, 2014.

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\1\ A ``new counterparty'' is a counterparty with whom, at the

time of the effective date of this final rule, no agreement exists

between the SD or MSP and that counterparty concerning uncleared

swaps.

\2\ An ``existing counterparty'' is a counterparty with whom, at

the time of the effective date of this final rule, an agreement

exists between the SD or MSP and that counterparty concerning

uncleared swaps.

FOR FURTHER INFORMATION CONTACT: Robert B. Wasserman, Chief Counsel,

Division of Clearing and Risk (DCR), at 202-418-5092 or

[email protected]; Laura Astrada, Associate Chief Counsel, DCR, at

202-418-7622 or [email protected]; Thomas Smith, Deputy Director,

Division of Swap Dealer and Intermediary Oversight at 202-418-5495 or

[email protected]; or Martin White, Assistant General Counsel, Office of

the General Counsel at 202-418-5129 or [email protected]; in each case,

also at the Commodity Futures Trading Commission, Three Lafayette

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Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

A. Statutory Background

B. Section 4s(l) of the CEA

C. Section 20(c) of the CEA

II. Margin Segregation for SD or MSP Counterparties With Respect to

Uncleared Swaps

A. Regulation 23.700: Definitions

B. Regulation 23.701: Notification of Right to Segregation

C. Regulation 23.702: Requirements for Segregated Margin

D. Regulation 23.703: Investment of Segregated Margin

E. Regulation 23.704: Requirements for Non-Segregated Margin

F. Compliance Date

III. Portfolio Margining

IV. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

C. Cost-Benefit Considerations

I. Background

A. Statutory Background

On July 21, 2010, President Obama signed the Dodd-Frank Act.\3\

Title VII of the Dodd-Frank Act \4\ amended the Commodity Exchange Act

(``CEA'') \5\ to establish a comprehensive new regulatory framework for

swaps and certain security-based swaps. The legislation was enacted to

reduce risk, increase transparency, and promote market integrity within

the financial system by, among other things: (i) Providing for the

registration and comprehensive regulation of SDs and MSPs; (ii)

imposing mandatory clearing and trade execution requirements on

clearable swap contracts; (iii) creating recordkeeping and real-time

reporting regimes; and (iv) enhancing the rulemaking and enforcement

authorities of the Commission with respect to, among others, all

registered entities and intermediaries subject to the oversight of the

Commission.

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\3\ Public Law 111-203, 124 Stat. 1376 (2010). The text of the

Dodd-Frank Act may be accessed at http:www.cftc.gov/idc/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf.

\4\ Pursuant to section 701 of the Dodd-Frank Act, Title VII may

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

2010''.

\5\ 7 U.S.C. 1 et seq.

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Section 724(c) of the Dodd-Frank Act amended the CEA to add section

4s(l), which includes provisions concerning the rights of

counterparties to SDs and MSPs with respect to the treatment of such

counterparty's margin for uncleared swaps. As discussed further in Part

II of this preamble, these changes are implemented in new Subpart L to

Part 23 of Title 17, Sec. Sec. 23.700 through 23.704.\6\

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\6\ The Commission notes that these rules were proposed as

Sec. Sec. 23.600 through 23.604. Because other rulemakings use

these sections, this final rulemaking will use and reference

Sec. Sec. 23.700 through 23.704 throughout, notwithstanding the

numbering in the proposal.

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Section 713(c) of the Dodd-Frank Act amends the CEA to add, as

section 20(c) thereof, a provision that requires the Commission to

exercise its authority to clarify the legal status, in the event of a

commodity broker bankruptcy, of (i) securities in a portfolio margining

account held as a futures account, and (ii) an owner of such account.

B. Section 4s(l) of the CEA

Section 4s(l) of the CEA sets forth certain requirements concerning

the rights of counterparties of SDs and MSPs with respect to the

segregation of money, securities, or other property used to margin,

guarantee, or otherwise secure uncleared swaps. These requirements

apply only to initial margin. Section 4s(l) requires that:

[[Page 66622]]

An SD or MSP notify each counterparty at the beginning of

a swap transaction that the counterparty has the right to require

segregation of the funds or other property supplied to margin,

guarantee, or secure the counterparty's obligations; \7\ and

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\7\ In a separate rulemaking, the Commission proposed ``minimum

initial and variation margin requirements'' for each SD or MSP for

which there is no prudential regulator as a way to ``help ensure the

safety and soundness of the [SD or MSP].'' See Margin Requirements

for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76

FR 23732 (Apr. 28, 2011). Among other things, the Commission

proposed to require SDs and MSPs to segregate margin for uncleared

swaps that such SD or MSP receives from other SDs and MSPs

(hereinafter known as the ``SD/MSP Specific Segregation

Requirements''). See id. at 23748. Thus, under that proposal, even

if an SD or MSP did not exercise its right to require segregation of

the funds or other property that it supplies to margin, guarantee,

or secure its obligation, such funds or other property would

nonetheless be segregated.

The U.S. banking regulators have proposed similar segregation

requirements for those SDs and MSPs that are prudentially regulated

and that will be subject to their margin rules. See Margin and

Capital Requirements for Covered Swap Entities, 76 FR 27564 (May 11,

2011). The Commission is continuing to consider this proposal in

light of this related work by U.S. banking regulators and related

efforts by regulators in other countries. The Commission is aware of

the importance of developing consistent SD/MSP Specific Segregation

Requirements where possible in order to address systemic risk issues

and to avoid regulatory arbitrage concerns. See also section 752 of

the Dodd-Frank Act.

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at the request of the counterparty, the SD or MSP shall

segregate such funds or other property with an independent third party

custodian. The funds or other property of the counterparty must be kept

in a segregated account with an independent third party, designated for

and on behalf of that counterparty, separate from the assets and other

interests of the SD or MSP.

C. Section 20(c) of the CEA

Section 713(c) of the Dodd-Frank Act, codified as section 20(c) of

the CEA, directs the Commission to exercise its authority to ensure

that securities held in a portfolio margining account carried as a

futures account are customer property and the owners of those accounts

are customers for the purposes of subchapter IV of chapter 7 of title

11.

II. Margin Segregation for SD or MSP Counterparties With Respect to

Uncleared Swaps

The Commission sought public comment on customer collateral

protection with respect to money, securities, or other property used to

margin, guarantee, or otherwise secure uncleared swaps. First, on

October 22, 2010, the Commission, through its staff, held a roundtable

to discuss individual customer collateral protection with respect to

cleared and uncleared swaps.\8\ Following consideration of the comments

made during the roundtable, on December 3, 2010, the Commission issued

a Notice of Proposed Rulemaking (``NPRM''),\9\ and sought comment on

all aspects of the NPRM, including the definition of initial margin,

counterparty notification, the nature of the custodian, and the

investment of segregated collateral.\10\ The Commission received

comments from twenty-two different commenters regarding the proposed

regulations in the NPRM.\11\ The Commission, through its staff, also

met extensively with market participants both prior to and following

issuance of the NPRM.

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\8\ The transcript from the roundtable is available at: http://www.cftc.gov/idc/groups/public/@swaps/documents/dfsubmission/dfsubmission6_102210-transcrip.pdf.

\9\ See Protection of Collateral of Counterparties to Uncleared

Swaps; Treatment of Securities in a Portfolio Margining Account in a

Commodity Broker Bankruptcy, 75 FR 75432 (Dec. 3, 2010).

\10\ The comment period closed on February 1, 2011, and was

reopened for 30 days on May 4, 2011. See Reopening and Extension of

Comment Periods for Rulemakings Implementing the Dodd-Frank Wall

Street Reform and Consumer Protection Act, 76 FR 25274 (May 4,

2011).

\11\ Letters were received from Alternative Investment

Management Association Limited (AIMA), American Gas Association

(AGA), the Asset Management Group (AMG) of Securities Industry and

Financial Markets Association (SIFMA), Edison Electric Institute

(EEI), Federal Home Loan Banks (FHLB), Federated Investors, Inc.

(Federated), Fidelity Investments (Fidelity), Intercontinental

Exchange, Inc. (ICE), International Swaps and Derivatives

Association (ISDA), Investment Company Institute (ICI), Managed

Funds Association (MFA), MetLife Inc. (MetLife), National Rural

Electric Cooperative Association (NRECA), New York City Bar

Association (NYCBA), Norges Bank Investment Management (Norges),

State Street Corporation (State Street), SIFMA, SIFMA and ISDA

(SIFMA/ISDA), and the Working Group of Commercial Energy Firms

(Working Group). NYCBA's letter was a pre-NRPM letter dated November

29, 2010. SIFMA's letter was a pre-NPRM letter dated October 27,

2010. Federated submitted two letters, both of which focused on the

investment of segregated funds. The Commission also received letters

from the following individuals: Chris Barnard, Leigh Mckeirnan, and

Bill Granberry.

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A. Regulation 23.700: Definitions

1. ``Segregate''

In the NPRM, the Commission proposed to define ``segregate''

according to its commonly-understood meaning: To keep two or more items

in separate accounts, and to avoid combining them in the same transfer

between two accounts.

One commenter agreed with the Commission's proposed definition of

``segregate.'' \12\ Another commenter requested clarification regarding

the definition of the term segregate and whether it requires that

collateral be held in an individual customer account or whether such

term permits an SD or MSP to hold segregated customer collateral in an

omnibus customer account.\13\ The Commission notes that section

4s(l)(3)(B) requires that a segregated account be ``designated as a

segregated account for and on behalf of the counterparty.'' \14\

Moreover, regulation 23.702(b) of the final rules requires initial

margin that is segregated pursuant to a counterparty's election to be

held in an account for and on behalf of the counterparty.\15\ Thus,

regulation 23.702(b) requires initial margin to be held in an

individual customer account. As such, the Commission is adopting the

definition of ``segregate'' as proposed.

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\12\ See AIMA letter at 2.

\13\ Working Group letter at 3.

\14\ 7 U.S.C. 6s(l)(3)(B).

\15\ See discussion in section C.1 infra.

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2. ``Variation Margin''

The Commission proposed to define ``variation margin'' (for which a

counterparty does not have the right to segregation as section

4s(l)(2)(B)(i) prescribes) as an amount calculated to cover the current

exposure arising from changes in the market value of the position since

the trade was executed or the previous time the position was marked to

market.

Six commenters discussed the ``variation margin'' definition.\16\

SIFMA/ISDA wrote that the concept of variation margin is different in

the over-the-counter swaps market than it is in the futures market.\17\

In particular, SIFMA/ISDA noted that parties to swaps do not ``pay''

margin to each other based on mark-to-market prices; rather they post

and grant a security interest in collateral based on estimated payment

amounts derived from current market conditions.\18\ SIFMA/ISDA

recommended replacing the term ``variation margin'' with the term

``exposure collateral,'' and defining ``exposure collateral'' to mean

``money, securities or property posted by a party to secure its

obligations pursuant to the terms of a swap agreement, the amount of

which is based on an estimate of the net mark-to-market exposure of all

transactions under the master swap agreement.'' \19\ AIMA wrote that

the

[[Page 66623]]

proposed definition of ``variation margin'' was appropriate.\20\

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\16\ SIFMA/ISDA, ISDA, FHLB, NRECA, AIMA, AMG.

\17\ SIFMA/ISDA letter at 2. See also ISDA letter at 2.

\18\ SIFMA/ISDA letter at 2. See also ISDA letter at 2.

\19\ SIFMA/ISDA letter at 3. See also ISDA letter at 3.

\20\ AIMA letter at 1.

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The fact that the statute refers to ``variation margin'' indicates

that Congress was contemplating the use of the term ``variation

margin'' as opposed to ``exposure collateral.'' For the sake of

consistency with other regulations, the Commission is amending the

definition of ``variation margin'' to add the phrase ``or collateral

posted by'' after the phrase ``a payment made by''. However, the

Commission agrees with SIFMA/ISDA's comments regarding the fact that in

the uncleared OTC derivatives markets, parties do not necessarily

``pay'' variation margin to each other, and instead post

collateral.\21\ The Commission therefore notes that although the

definition of variation margin will include payments, where a payment

is made, there would not be any collateral to be segregated. The

definition is otherwise being adopted as proposed.

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\21\ SIFMA/ISDA letter at 2. See also ISDA letter at 2.

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3. ``Initial Margin''

The Commission proposed to define ``initial margin'' (for which a

counterparty has the right to segregation pursuant to CEA section

4s(l)) as an amount calculated based on anticipated exposure to future

changes in the value of a swap.

Ten commenters addressed the definition of ``initial margin.'' \22\

ICI wrote that the proposed definition of initial margin was too broad,

and might be interpreted to also include variation margin.\23\ By

contrast, Fidelity suggested that ``the proposed definition of `initial

margin' may be too narrow and could exclude `upfront' deliveries of

collateral that should properly be treated as initial margin.'' \24\

FHLB recommended that the term ``independent amount'' be used instead

of ``initial margin.'' \25\ However, if the Commission elects to use

the term ``initial margin,'' FHLB argued that the definition of

``initial margin'' should, at the very least, track and reference

``independent amount'' as it appears in the ISDA documentation.\26\

SIFMA/ISDA also recommended that the term ``independent amount'' be

used in the place of ``initial margin,'' and suggested that

``independent amount'' be defined to mean ``money, securities or

property posted by a party to secure its obligations pursuant to the

terms of a swap agreement and that is either (i) specified as an

[`independent amount'] in the relevant agreement of the parties or (ii)

calculated based upon terms agreed between the parties (in either case,

in addition to and separately from any [exposure collateral]

requirement).'' \27\ Chris Barnard suggested that the Commission

clarify that initial margin is posted at the commencement or outset of

a swap transaction as a way to distinguish initial margin from

variation margin.\28\ AIMA and MetLife wrote that the proposed

definition of initial margin was appropriate.\29\

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\22\ ICI, Fidelity, FHLB, AMG, ISDA, Chris Barnard, AIMA, NRECA,

MetLife, SIFMA/ISDA.

\23\ ICI letter at 2.

\24\ Fidelity letter at 2.

\25\ FHLB letter at 6.

\26\ FHLB letter at 6. See also AMG letter at 5.

\27\ SIFMA/ISDA letter at 2-3. See also ISDA letter at 2-3.

\28\ Chris Barnard letter at 1.

\29\ AIMA letter at 1. See also MetLife letter at 3, stating

that for purposes of the proposed rule, the definition of initial

margin was sufficient, although noting it would request more

specific guidance for calculating initial margin in the event of

``future use or expanded definition.''

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The Commission has considered the comments and understands that

some commenters prefer the traditional practice of using the term

``independent amount.'' However, the statute uses the term ``variation

margin'' and the obvious complimentary term to ``variation margin''

would be ``initial margin.'' Moreover, a reference to ``independent

amount,'' by itself, would not be effective, since the definition of

``independent amount'' in the ISDA ``Credit Support Annex'' directs the

reader to a form.\30\ A reference to a form would not be desirable as a

definition both because it is ambiguous and because the substance of

the form is subject to change. Therefore, the Commission is adopting

the definition of initial margin as proposed.

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\30\ See Paragraph 13 of the ISDA Credit Support Annex. See also

definition of ``Independent Amount'' in the ISDA Credit Support

Annex.

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B. Regulation 23.701: Notification of Right to Segregation

1. Required Notification

Proposed regulation 23.601(a) \31\ implemented the statutory

requirement set forth in section 4s(l)(1)(A) of the CEA. Specifically,

with respect to an uncleared swap, proposed regulation 23.601(a) would

have required an SD or MSP to notify each of its counterparties that a

counterparty has the right to require any initial margin posted by it

to be segregated in accordance with Commission regulations.\32\ The

Commission also stated that it interpreted the language of CEA section

4s(l)(1)(A) as a segregation right that can be elected or renounced by

the SD's or MSP's counterparty in its discretion.\33\ As stated in the

NPRM, Congress's description as a ``right'' of what would otherwise be

a simple matter for commercial negotiation suggests that this decision

is an important one, with a certain degree of favor given to an

affirmative election.\34\ As such, in implementing section 4s(l)(1)(A)

the Commission is requiring SDs and MSPs to offer their counterparties

segregation that meets the minimum standards set forth in these rules.

However, SDs, MSPs and counterparties may negotiate alternative

arrangements for the handling of collateral if all parties agree.

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\31\ As discussed above, section numbers in the NPRM are

slightly different from those in this final rulemaking. See supra n.

6. Proposed regulation 23.601(a) is being finalized herein as

regulation 23.701(a).

\32\ 75 FR at 75433 (Dec. 3, 2010).

\33\ See also CEA section 4s(l)(4) (referring to cases where the

counterparty ``does not choose to require segregation'' of margin).

7 U.S.C. 6s(l)(4).

\34\ 75 FR at 75433 (Dec. 3, 2010).

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In the NPRM, the Commission did not propose specific disclosure

requirements with respect to this notification. Instead, the Commission

requested comment as to whether the SD or MSP should be required to

disclose the price of segregation, the price of fees to be paid to the

custodian (if the SD or MSP is aware of the amount of such fees), or

differences in the terms of the swap that the SD or MSP is willing to

offer to the counterparty (e.g., differences in the fixed interest rate

for an interest rate swap) if the counterparty elects or renounces the

right to segregation.\35\

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\35\ Id.

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Thirteen commenters discussed the costs associated with

segregation,\36\ with most expressing concern about proper price

disclosures by the SDs and MSPs. Two commenters indicated that price

disclosure was not particularly important.

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\36\ AMG, MFA, State Street, AGA, Fidelity, ICI, SIFMA/ISDA,

ISDA, FHLB, Chris Barnard, AIMA, MetLife, EEI.

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Several commenters expressed concern that an SD or MSP would not

make counterparties aware of the price associated with segregation and

might impose higher prices or offer less attractive terms to

counterparties electing segregation.\37\ MFA recommended ``that the

Commission require SDs and MSPs to provide counterparties with robust

disclosure of all costs that the SD or MSP will charge to the

counterparty if the counterparty elects to segregate its initial

margin.'' \38\ State Street suggested that ``the Commission should . .

. provide that, although the pricing of the same

[[Page 66624]]

transaction with and without a segregated account may differ, the

pricing difference should be reflective of actual out-of-pocket costs

expected to be incurred by the [SD/MSP] as a result of use of the

segregated account, and that the nature and amounts of those costs

should be fully disclosed.'' \39\ AGA argued that, without proper

disclosure, counterparties will be forced ``to exercise in a vacuum

their right to seek segregation of initial margin for an uncleared

swap'' and suggested that each SD or MSP be required to notify each

counterparty as to the price of having a third party hold

collateral.\40\

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\37\ AMG letter at 8.

\38\ MFA letter at 4.

\39\ State Street letter at 3.

\40\ AGA letter at 4. See also Fidelity letter at 3.

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ICI sought to distinguish between fees charged by the custodian--

which ICI does not believe need be disclosed by the SD or MSP--and fees

embedded in the SD's swaps pricing for not having access to the

customer's collateral.\41\ SIFMA/ISDA do not believe that mandating

disclosure is necessary or desirable because ``a counterparty can

always, in accordance with current market practice, request the

disclosures it considers necessary from its SD/MSP . . . [and]

mandatory disclosure by the SD/MSP is impractical because much of the

material costs are within the control of a third party: the

custodian.'' \42\

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\41\ ICI letter at 3.

\42\ SIFMA/ISDA letter at 3, ISDA letter at 3-4.

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Finally the FHLB wrote that ``it is very important for SDs/MSPs to

respond to requests for information regarding the additional costs that

may be imposed on end-user counterparties that elect to have initial

margin segregated with an independent custodian.'' \43\

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\43\ FHLB letter at 7.

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In light of the concerns expressed by commenters, the Commission

has determined that a limited set of disclosures should be required.

First, the SD or MSP must inform the counterparty of the price

associated with segregation, including custodial fees, to the extent

the SD or MSP has such information. It is the Commission's view that

the price of segregation is a material term in any segregation package

offered by the SD or MSP. Further, where the custodian is an affiliate

of, or a regular custodian for, the SD or MSP, the SD or MSP may be

better positioned to know the amount of any such custody costs.\44\ In

addition, in order for counterparties to make an informed decision as

to whether to exercise the right of segregation, the identity of an

acceptable custodian(s) is a material aspect of the notification so

that counterparties may make informed decisions as to the degree of

independence of such custodian(s).\45\ As described in more detail in

section C.1, below, this notification must include at least one credit-

worthy non-affiliate as an option for custodian of segregated initial

margin. The Commission has amended regulation 23.701 accordingly.

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\44\ However, if the counterparty selects to use an independent

custodian (e.g., a non-affiliate of the SD or MSP or a custodian

with which the SD or MSP does not have a pre-existing relationship),

the SD or MSP may not be required to inform the counterparty of the

price of custodianship because the SD or MSP may not have that

information.

\45\ Several commenters highlighted the importance of have the

choice of at least one custodian who is not affiliated with the SD

or MSP. See generally EEI letter at 2, AIMA at 2, MFA letter at 4,

and Fidelity letter at 5.

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The Commission notes that certain entities have developed or are in

the process of developing electronic platforms through which

counterparties could access account information regarding the status of

their collateral. The Commission may consider, in a future rulemaking,

whether the notification required pursuant to regulation 23.701 should

include information from the SD or MSP regarding such platforms.

2. Limitation of Right--Variation Margin

Proposed regulation 23.601(b) \46\ incorporated the limitation in

section 4s(l)(2)(B)(i) of the CEA that the right to segregation does

not apply to variation margin. Fidelity recommended that the final rule

require that SDs and MSPs ``segregate variation margin posted by a

counterparty at the counterparty's request.'' \47\ Fidelity requested

that, at a minimum, the rule clarify that ``no change will be necessary

to collateral agreements [not in conflict with the rule] . . . that

involve segregation of all margin, initial and variation. . . .'' \48\

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\46\ Proposed regulation 23.601(b) is being finalized herein as

regulation 23.701(b).

\47\ Fidelity letter at 4. See also AMG letter at 6.

\48\ Fidelity letter at 3-4.

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The statute clearly excludes variation margin from the 4s(l)

segregation requirements.\49\ Thus, the request for such a requirement

is not supported by the statute. However, the Commission confirms that

this rule governs collateral arrangements for swaps entered into on and

subsequent to the compliance date and does not affect collateral

arrangements agreed to for swaps that are entered into prior to the

compliance date. In addition, the Commission notes that this rulemaking

does not restrict parties from negotiating segregation arrangements for

variation margin.

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\49\ See section 4s(l)(2)(B)(i) of the CEA.

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3. Counterparty Notification

The Commission regards the inclusion of the term ``right to require

segregation'' in section 4s(l) of the CEA as requiring that the

segregation decision is made by appropriate decision-makers within the

counterparty organization. Proposed regulation 23.601(c) \50\ would

require that the ``right to require segregation'' notification be made

to certain senior decision-makers, in descending order of preference.

Notification would be made to the Chief Risk Officer, or the Chief

Executive Officer, or to the highest level decision-maker for the SD's

or MSP's counterparty. The Commission sought comment as to whether this

list of decision-makers would be appropriate.

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\50\ Proposed regulation 23.601(c) is being finalized herein as

23.701(c).

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Eleven commenters opposed the requirement that the Chief Risk

Officer receive the segregation notification.\51\ EEI wrote that this

requirement ``fails to take into account existing governance and

compliance structures and processes developed and implemented by

entities for the express purpose of meeting compliance and risk

management objectives.'' \52\ ICI suggested that notices go to ``an

authorized person to avoid the disruption that would be associated with

a [Chief Risk Officer] or other `high-level decision-maker' making an

election to each SD or MSP before a trade can settle.'' \53\ AGA

recommended that the notification ``be made to the officer in the

counterparty responsible for the management of collateral.'' \54\ ISDA

suggested that the counterparty should identify the proper party to

receive notice from the SD or MSP.\55\ Similarly, Fidelity wrote that

the ``final rule should allow the counterparty to select the notice

recipient.'' \56\

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\51\ SIFMA/ISDA, NRECA, EEI, ICI, AGA, ISDA, AMG, Fidelity,

Working Group, AIMA, FHLB.

\52\ EEI letter at 3.

\53\ ICI letter at 3.

\54\ AGA letter at 5.

\55\ ISDA letter at 5 and SIFMA/ISDA letter at 4. See also AMG

letter at 7, suggesting that notice be made to any party authorized

by the counterparty.

\56\ Fidelity letter at 3. See also Working Group letter at 5.

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A counterparty's decision to elect its segregation right is a

financial decision that is heavily dependent on such counterparty's

risk assessments. It would seem appropriate, therefore, for a

counterparty employee who is involved in the assessment of risk and/or

collateral management to receive this notification. However, after

consideration of the comments, it is clear that such person does not

necessarily need to be the Chief Risk Officer. The Commission agrees

with AGA's comment that a notification should be sent to the ``officer

in the

[[Page 66625]]

counterparty responsible for the management of collateral.'' \57\ If

such a person is not identified by the counterparty to the SD or MSP,

then the notification should be sent to the Chief Risk Officer and so

on, as described in the proposed rule. Regulation 23.701(c) has been

amended accordingly.

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\57\ AGA letter at 5.

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4. Required Confirmation

Before the terms of an uncleared swap are confirmed, proposed

regulation 23.601(d) \58\ would require that the SD or MSP obtain from

the counterparty (1) confirmation of receipt of the segregation

notification by a specified decision-maker, and (2) whether the

counterparty has elected to exercise its section 4s(l) segregation

rights. The SD or MSP must maintain records of such confirmation and

election as business records in accordance with regulation 1.31.\59\

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\58\ Proposed regulation 23.601(d) is being finalized herein as

regulation 23.701(d).

\59\ 17 CFR 1.31.

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ICI's comment letter alone addressed this point.\60\ ICI agreed

with the proposal that ``confirmation of receipt of the notification

and election to require segregation or not should occur prior to

confirming the terms of the uncleared swap.'' \61\ The Commission

believes that requiring the SD or MSP to obtain confirmation of receipt

of the segregation notification and the counterparty's decision whether

to elect segregation prior to confirming the terms of the swaps will

provide greater certainty for both parties regarding the counterparty's

segregation election. The Commission also agrees that such confirmation

should be obtained prior to confirming the terms of the uncleared swap.

Therefore, the Commission is adopting paragraph (d) as proposed.

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

\60\ ICI letter at 3.

\61\ ICI letter at 3. See also discussion in section C.1 infra.

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5. Limitation of Responsibility To Notify

Section 4s(l)(1)(A) of the CEA states that an SD or MSP must notify

its counterparty of the right to require segregation of funds or other

property supplied to margin, guarantee or secure the obligations of the

counterparty ``at the beginning of a swap transaction.'' While this

language could be read to require transaction-by-transaction

notification, where the parties have a preexisting or on-going

relationship, such repetitive notification could be redundant, costly

and needlessly burdensome. On the other hand, the importance of the

segregation decision, as discussed above, suggests that some periodic

reconsideration might be appropriate. Proposed regulation 23.601(e)

\62\ sought to balance these considerations by providing that

notification to a particular counterparty by a particular SD or MSP

need only be made once in any calendar year.

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\62\ Proposed regulation 23.601(e) is being finalized herein as

regulation 23.701(e).

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Twelve commenters discussed issues surrounding the substance and

timing of segregation notification,\63\ with the primary concern being

whether the notification of the right to segregation had to be done on

a transaction-by-transaction basis or merely once per year.

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\63\ NRECA, Working Group, FHLB, MetLife, EEI, AGA, SIFMA/ISDA,

ISDA, AIMA, AMG, Fidelity, ICI.

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The Working Group requested that the rule require notification on

segregation no more often than once a year, rather than a transaction-

by-transaction notification.\64\ Fidelity supported the proposal that

notification be required at least annually, stating that this could

``prompt a counterparty to reconsider its elections in light of

[changes that could occur during the life of a swap transaction].''

\65\ FHLB and MetLife characterized transaction-by-transaction

notification as repetitive and redundant.\66\ AGA believes that once a

year is an appropriate notification frequency, unless the price of

segregation has changed in which case another notice should be

delivered.\67\

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\64\ Working Group letter at 4.

\65\ Fidelity letter at 3. See also ICI letter at 3.

\66\ FHLB letter at 6, MetLife letter at 2. See also EEI letter

at 3.

\67\ AGA letter at 5-6.

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Several commenters requested that the Commission loosen the once-

per-year notification in the Commission's proposed rule. NRECA, SIFMA/

ISDA, AIMA and AMG each wrote that an initial notification is all that

should be required--a counterparty's initial choice should be deemed to

apply to all future swaps unless the counterparty seeks to change its

election.\68\ SIFMA/ISDA proposed ``that an [SD or MSP] should only be

required to deliver a single notification of the right to segregate,

and the counterparty should be deemed to have elected not to require

segregation of its [independent amount] until such time as the

counterparty duly notifies the [SD or MSP] of its election to require

segregation.'' \69\

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\68\ NRECA letter at 13, SIFMA/ISDA letter at 4, ISDA letter at

4, AIMA letter at 2 and AMG letter at 7.

\69\ SIFMA/ISDA letter at 4. See also ISDA letter at 4.

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After careful consideration of the comments, the Commission agrees

that requiring notification on a transaction-by-transaction basis may

be overly costly and burdensome. In addition, the Commission notes the

difficulty associated with identifying material changes in the cost of

segregation and the burden that would be created should the Commission

require that additional notices be delivered upon such event. However,

the Commission notes that Congress emphasized the importance of the

ability of a counterparty to elect to have its collateral segregated,

describing segregation as a ``right.'' Moreover, the statute does not

merely grant counterparties the legal right to segregation; it

specifically requires that the existence of this right be communicated

to them. The Commission therefore believes that this notification

requirement is met when an SD or MSP provides notification to a

counterparty, at least once, in each calendar year. Where an SD or MSP

does not enter into any swap with the counterparty during a calendar

year, the notification requirement would not apply. The Commission

believes that such notification requirement would not be overly

burdensome, particularly when one considers the importance of the

counterparty's decision to require segregation. Thus, the Commission

has decided to adopt the final rule language as proposed.

6. Power To Change Election With Regard to Segregation

In the NPRM, the Commission proposed regulation 23.601(f),\70\

which makes clear that a counterparty's election with respect to the

segregation of initial margin may be changed at the discretion of the

counterparty upon delivery of written notice, and such decision shall

be applicable with respect to swaps entered into between the parties

after such delivery. Rather than grant the counterparty an absolute

right to change its election, the Working Group recommended that the

counterparty must expressly reserve such right: ``[if] a party makes an

election under the Proposed Rule and does not expressly reserve the

right to change that election in the relevant swap trading relationship

documentation, then they cannot do so.'' \71\

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\70\ Proposed regulation 23.601(f) is being finalized herein as

regulation 23.701(f).

\71\ Working Group letter at 5.

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The Commission does not believe that the commenter's clarification

is appropriate. The Commission notes that the rule clearly states that

any change to the counterparty's segregation election would only apply

to ``swaps entered into between the parties after . . . delivery'' of

written notice to the SD or

[[Page 66626]]

MSP. Therefore, if a counterparty sought to change its segregation

election, such election would not have retroactive effect (unless both

the counterparty and the SD or MSP so agreed). In other words, the

proposed rule leaves changes in terms for pre-existing swaps--including

with respect to segregation of collateral--as matters for negotiation

between the parties. The counterparty should retain its rights, under

the statute, to change its election as to swaps entered into after the

notice is delivered. As such, the Commission is adopting the final rule

language as proposed.

C. Regulation 23.702: Requirements for Segregated Margin

1. Independent Custodian and Separate Account

Pursuant to section 4s(l)(3) of the CEA, the Commission proposed

regulation 23.602(a)(1),\72\ which required that initial margin,

segregated in accordance with an election under regulation 23.601, be

held with a custodian that is independent of both the SD or MSP and the

counterparty. Proposed regulation 23.602(a)(2) \73\ required such

initial margin to be held in an account designated as a segregated

account for and on behalf of the counterparty.\74\ While, as noted, the

right to segregation does not apply to variation margin, the proposed

regulation provided that the SD or MSP and the counterparty may agree

that collateral falling within the definition of variation margin may

also be held in such segregated account. The Commission requested

comment on, among other things, whether an affiliate of the SD, MSP or

the counterparty should be considered an independent custodian. In

addition, the Commission requested comment on whether either party

could choose a custodian and, if so, what restrictions, if any, should

be placed on that choice.

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\72\ Proposed regulation 23.602(a)(1) is being finalized herein

as regulation 23.702(a).

\73\ Proposed regulation 23.602(a)(2) is being finalized herein

as regulation 23.702(b).

\74\ See discussion in section A.1 supra.

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Fourteen commenters discussed the choice of custodian for

segregation.\75\ The topics discussed by commenters included the

freedom of negotiation between the SD or MSP and counterparty, the use

of a custodian affiliated with an SD or MSP, the right of the

counterparty to choose the custodian, and qualifying criteria for a

custodian.

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\75\ MFA, SIFMA/ISDA, ISDA, ICI, Working Group, NRECA, AMG,

MetLife, EEI, Fidelity, AIMA, FHLB, Norges, State Street.

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

Four commenters argued that the custodian should be determined

purely by negotiation between the counterparty and SD or MSP. ICI

opined that ``the choice of custodian should be left to the agreement

of the parties.'' \76\ AIMA wrote that ``[t]he parties should be free

to negotiate which custodian is used, and it may be useful for the [SD]

or MSP to let the customer know which custodians it has relationships

with and has conducted appropriate due diligence on, including

affiliates and non-affiliates, and thus its preferred choices of

custodian.'' \77\ Similarly, the Working Group suggested ``that outside

the election to segregate collateral, which is the right of a [SD's or

MSP's] counterparty, all other terms and parameters of a custodial

relationship should be left to negotiation between counterparties. . .

.'' \78\ The NRECA wrote that it ``see[s] no benefit to the Commission

making [the choice of custodian] by regulation, rather than leaving

them to arm's length negotiations between contract counterparties.''

\79\

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

\76\ ICI letter at 3-4.

\77\ AIMA letter at 2.

\78\ Working Group letter at 2.

\79\ NRECA letter at 14.

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

However, AMG stated that while both the counterparty and the SD or

MSP have an interest in the selection of the custodian, the

counterparty is likely the party with the greatest interest and should

therefore have the right to select the custodian.\80\

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\80\ AMG letter at 3.

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

Several commenters discussed whether an affiliate of the SD or MSP

would qualify as an independent custodian. MetLife suggested ``that a

custodial arrangement with an affiliate of the SD or MSP would satisfy

the requirements for the use of an Independent Custodian. . . .'' \81\

AMG wrote that ``the CFTC should not limit the choice of custodian

solely to those unaffiliated with the relevant SD/MSPs and Customer

Counterparties but should provide the flexibility to use a custodian

who may also be affiliated with any SD/MSP or Customer Counterparty.''

\82\ Fidelity expressed concern that an ``unintended and undesirable

consequence of banning affiliates from acting as third-party custodians

could be to prevent counterparties from entering into swaps with [SD/

MSPs], where an affiliate of the [SD/MSP] already serves as a

depository or custodian of the counterparty.'' \83\

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

\81\ MetLife letter at 2.

\82\ AMG letter at 2. See also MFA letter at 3-4, EEI letter at

2.

\83\ Fidelity letter at 5.

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

Other commenters were receptive to the idea of an affiliate

custodian, but advised that the SD or MSP should be required to present

options to the counterparty on this issue. For example, AIMA

recommended that the Commission require SDs and MSPs to ``offer a

choice of . . . five custodians on whom they have conducted [a] due

diligence examination, including both an affiliate (if applicable) and

a non-affiliate.'' \84\ Similarly, FHLB urged the Commission to

condition allowing an affiliate of the SD or MSP to act as custodian

upon mutual agreement of the counterparty and the SD or MSP, and

suggested that ``the SD/MSP [should be] required to offer segregation

with at least one non-affiliated custodian.'' \85\ SIFMA/ISDA wrote

that an SD or MSP ``should be required, upon counterparty request, to

propose at least one creditworthy non-affiliated custodian that the SD/

MSP is willing to use, as an option.'' \86\ AMG noted that the

regulations should be flexible enough to allow the use of a custodian

affiliated with an SD, MSP, or the counterparty.\87\

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

\84\ AIMA letter at 2.

\85\ FHLB letter at 8.

\86\ SIFMA/ISDA letter at 5. See also ISDA letter at 7.

\87\ AMG letter at 2.

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

Three other commenters suggested that counterparties should have

the right to designate a non-affiliate custodian. State Street

recommended that the proposed rules be revised to provide that a

``counterparty has the right to designate the independent custodian, if

that custodian is a U.S. bank . . . and otherwise serves as a usual

depository for assets of the counterparty.'' \88\ Fidelity wrote that

while affiliates of the SD or MSP can be appropriate custodians, ``a

counterparty should have the right to require that a third-party

custodian be independent from the [SD or MSP].'' \89\ Norges proposed

that the final rule should provide the ``non-dealer/MSP counterparties

the option to require that initial margin . . . be held with a

custodian that is in fact independent of any affiliate of the swap

dealer or MSP.'' \90\

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

\88\ State Street letter at 2.

\89\ Fidelity letter at 5. See also FHLB letter at 8,

recommending that if parties cannot agree on a custodian then the

counterparty should be able to designate the custodian.

\90\ Norges letter at 2.

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

Two commenters offered qualifying criteria for a custodian. The MFA

suggested that a custodian ought to be ``regulated by a federal or

state bank regulator, be authorized under federal or state laws to

exercise corporate trust powers, and have equity of at least

[[Page 66627]]

[$200 million].'' \91\ MetLife suggested that an affiliate custodian

could satisfy the requirements for an independent custodian where it,

inter alia, ``maintains a minimum asset value [of at least $2 billion]

under custodial management.'' \92\

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

\91\ MFA letter at 4.

\92\ MetLife letter at 2.

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

The Commission also received one comment regarding the timing of

the requirement to segregate. SIFMA/ISDA requested that, due to the

amount of time required to fully negotiate a custodial arrangement,

parties ``be permitted to enter into new swaps pending completion of

custodial documentation satisfactory to both parties for so long as the

parties are negotiating in good faith to complete such custodial

documentation.'' \93\ SIFMA/ISDA also argued that the requirement to

segregate the initial margin ``with respect to all swaps entered into

after delivery of an election to require segregation . . . unless

otherwise agreed, become effective only upon the completion of

custodial documentation.'' \94\

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

\93\ SIFMA/ISDA letter at 5. See also ISDA letter at 5.

\94\ SIFMA/ISDA letter at 5, ISDA letter at 5.

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

The language of the statute does not require that affiliates of a

counterparty be prohibited from serving as the custodian for segregated

funds. Affiliates are third-parties in that they are separate legal

entities, and therefore fall within the terms of the statute. However,

in light of the correlated insolvency risk wherein if an SD or MSP

becomes insolvent its affiliates will have an elevated risk of also

becoming insolvent, the Commission has determined that an SD or MSP

should be required to provide the counterparty with at least one credit

worthy non-affiliate as an option to serve as the custodian. The final

rule text has been amended to incorporate the requirement that SDs and

MSPs must provide their counterparties with at least one credit worthy

non-affiliate as an option to serve as the custodian.\95\

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

\95\ See regulation 23.701(a)(2).

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Regarding SIFMA/ISDA's question relating to the timing of

segregation, waiting until the completion of custodial documentation

for an election to require segregation to become effective would likely

create difficulties where an insolvency occurs in the time period

between agreement and documentation. Thus, it is the Commission's

position that protection of initial margin is best achieved by

requiring customer segregation to become effective upon election, not

upon completion of custodial documentation. In addition, the Commission

notes that compliance with SIFMA/ISDA's suggested ``good faith''

requirement would be impracticable to assess and is not amending the

rule as suggested.

2. Requirements for Custody Agreement

In the NPRM, the Commission proposed regulation 23.602(b),\96\

which imposed certain requirements on agreements for the segregation of

margin. Regulation 23.602(b) was intended to provide a balance between

the minimum interests of (i) the counterparty posting the margin, (ii)

the SD or MSP for whom the margin is posted, and (iii) the custodian,

while avoiding the necessity for time-consuming and expensive

interpleader proceedings.\97\ Under the proposal, an agreement for the

segregation of margin would have to be in writing, and must include the

custodian as a party. In addition, to ensure that the SD or MSP

receives the margin promptly in case it is entitled to do so, and that

the margin is returned to the counterparty in case it is entitled to

such return, the agreement must also provide that turnover of control

shall be made promptly upon presentation of a statement in writing,

signed by an authorized person under penalty of perjury, that one party

is entitled to such turnover pursuant to an agreement between the

parties.\98\ Otherwise, withdrawal of collateral may only be made

pursuant to the agreement of both the counterparty and the SD or MSP,

with the non-withdrawing party also receiving immediate notice of such

withdrawal.\99\

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\96\ Proposed regulation 23.602(b) is being finalized herein as

regulation 23.702(c).

\97\ If the SD or MSP and the counterparty were to make

competing claims to the collateral, and if the custodian did not

have a means under the agreement among the parties to decide between

such claims without risking legal liability, the custodian would

likely choose to interplead the collateral.

\98\ See 28 U.S.C. 1746. See also 18 U.S.C. 1621 (Perjury

Generally).

\99\ The importance of taking steps to ensure that unauthorized

withdrawals are not made is enhanced by the findings of the

Commission's Division of Clearing and Intermediary Oversight in

Financial and Segregation Interpretation 10-1, 20 FR 24768, 24770

(May 11, 2005) (``Findings by both Commission audit staff and the

SROs of actual releases of customer funds [from third-party

custodial accounts], without the required knowledge or approval of

the FCMs, further demonstrate that the risks associated with third-

party custodial accounts are real and material, not merely

theoretical.'').

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

Nine commenters argued against imposing a perjury standard on any

written statements by either the counterparty or the SD or MSP

informing the custodian to turn over of control of margin.\100\ For

example, ICI wrote that it ``believe[s] that it is unnecessary to

introduce the specter of criminal prosecution into custodial account

documentation. . . .'' \101\

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

\100\ ICI, Working Group, AMG, Fidelity, SIFMA/ISDA, MFA, ISDA,

FHLB, MetLife.

\101\ ICI letter at 4. See also Working Group letter at 4, AMG

letter at 6, Fidelity letter at 4-5, SIFMA/ISDA letter at 6, MFA

letter at 5, ISDA letter at 7, MetLife letter at 2.

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

The Commission believes that a perjury standard is appropriate

because it mitigates the tradeoff between speed and accuracy in stress

situations. In circumstances where one party to a swap needs expedient

turnover of segregated margin (for example, in order to meet margin

calls on positions hedging the swap) and is unable to obtain timely

approval from the counterparty (e.g., if margin is being taken from the

account because the counterparty is in financial trouble), it is

important for a depository to be able to respond to a unilateral

request for collateral without having to take the time to independently

investigate the legitimacy of the request.\102\ At the same time,

circumstances of market stress may also create incentives for parties

to illegitimately withdraw collateral from a segregated account.\103\

The perjury standard acts as a check on the legitimacy of a demand for

collateral without requiring the time needed for an independent inquiry

by the depository. At the same time, an SD, MSP or counterparty making

a demand for collateral can avoid criminal liability if it does not

engage in purposeful fraud.

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

\102\ In times of significant market stress, any unnecessary

impediments or restrictions on a counterparty's ability to obtain

immediate access to posted margin when such access is legitimate

could impair the operations of the counterparty, impair the

liquidity of other market participants and magnify the impact of a

market disruption.

\103\ A party facing insolvency or fearing imminent insolvency

on the part of its counterparty might be tempted to demand transfer

of margin without fully ensuring they were entitled to it, to take

the margin without plans to return it, or take the margin for the

purpose of covering an unrelated debt in the expectation of saving

their business and returning the margin shortly thereafter.

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

The Commission has decided to adopt the rule substantively as

proposed. However, the Commission points out that it has re-organized

the rule and modified certain language to provide greater clarity.

Specifically, the Commission combined the language in paragraphs (a)

and (a)(1) into paragraph (a). The Commission also renumbered paragraph

(a)(2) as paragraph (b). The Commission then renumbered paragraph (b)

as paragraph (c) and switched the text in subparagraphs (1) and (2).

The Commission also added

[[Page 66628]]

clarifying language to paragraphs (a),(b) and (c) to facilitate this

reorganization.

D. Regulation 23.703: Investment of Segregated Margin

1. Limitations on Investments

Proposed regulation 22.603(a) \104\ provides that segregated

initial margin may only be invested consistent with the standards for

investment of customer funds that the Commission applies to exchange-

traded futures and cleared swaps, regulation 1.25.\105\

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\104\ Proposed regulation 23.603(a) is being finalized herein as

regulation 23.703(a).

\105\ Section 4s(l)(2)(B)(ii)(I) of the CEA refers to

``commercial arrangements regarding the investment of segregated

funds or other property that may only be invested in such

investments as the Commission may permit by rule or regulation.''

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

Eight commenters expressed the view that imposing the standards of

regulation 1.25 on the investment of collateral for uncleared swaps was

overly restrictive.\106\

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

\106\ MetLife, Federated, ICI, AMG, Fidelity, SIFMA/ISDA, ISDA,

FHLB.

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

Fidelity suggested that ``custodians under tri-party custody

arrangements may limit the types of collateral that it will permit

under such arrangements to those investments permitted pursuant to

[regulation] 1.25.'' \107\ Fidelity further proposed that the

Commission require not only segregation of initial margin but also

variation margin, explaining that ``the right to require segregation of

variation margin . . . would reduce systemic risk for the same reasons

that segregation of initial margin reduces systemic risk.'' \108\

Similarly, AMG argued that the Commission should ``confirm the right of

Customer Counterparties to require segregation of both initial margin

and variation margin,'' explaining that the current practice in the OTC

market is to require all collateral to be segregated and held by a

third-party custodian.\109\

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

\107\ Fidelity letter at 5-6.

\108\ Fidelity letter at 4.

\109\ AMG letter at 6.

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

MetLife wrote that such a restriction is ``outside the scope of

normal market practice'' and that counterparties ``should be able to

negotiate the terms for investment of Initial Margin consisting of cash

within [their] own established investment guidelines.'' \110\ FHLB

added that ``Congress appropriately did not seek to limit how margin

for uncleared swaps would be invested,'' asserting that Congress had

assumed that ``both the end-user counterparty and the SD/MSP would

necessarily be involved in the decision as to how such funds would be

invested.'' \111\ Federated warned that this proposal will cause a loss

of investment returns.\112\

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

\110\ MetLife letter at 3. See also Federated letter at 3-7, ICI

letter at 4-6, AMG letter at 3-5, Fidelity letter at 5-6, SIFMA/ISDA

letter at 6, ISDA letter at 8, FHLB letter at 12.

\111\ FHLB letter at 13.

\112\ Federated letter at 7, 11.

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

In contrast, AIMA wrote that ``[t]he requirements of Regulation

1.25 of the CFTC Regulations . . . likely strike[ ] the right balance

between flexibility and the protection of the value of the

collateral.'' \113\

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

\113\ AIMA letter at 3.

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

Regulation 1.25 establishes a general prudential standard used in

the futures and cleared swaps markets that requires all permitted

investments of customer segregated funds to be consistent with the

objectives of preserving principal and maintaining liquidity.\114\ As

stated by the Commission in regulation 1.25's adopting release, ``[i]n

finalizing amendments to Regulation 1.25, the Commission seeks to

impose requirements on the investment of customer segregated funds with

the goal of enhancing the preservation of principal and maintenance of

liquidity consistent with Section 4d of the Act.''

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

\114\ See Investment of Customer Funds and Funds Held in an

Account for Foreign Futures and Foreign Options Transactions, 76 FR

78776 (Dec. 19, 2011).

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

Similarly, the Commission believes that applying the requirements

of regulation 1.25 to uncleared swaps will increase the safety and

maintain the liquidity of counterparty funds held by the custodian.

Regulation 1.25 establishes a general prudential standard by requiring

that all permitted investments be ``consistent with the objectives of

preserving principal and maintaining liquidity.'' \115\ While such a

standard may lead to lower investment returns, lower investment returns

correlate to decreased investment risk and must be viewed in the

context of the importance of protecting counterparties' collateral and

mitigating systemic risk that could result from the loss of access to

such collateral and, in turn, adversely impact the stability of the

U.S. financial markets. After considering the comments, the Commission

has decided to adopt the rule as proposed. The Commission believes that

the rule achieves the appropriate balance between the goals of

protecting counterparties' collateral and mitigating systemic risk, on

the one hand, and the goals of retaining an appropriate degree of

investment flexibility and opportunities for attaining capital

efficiency for DCOs and FCMs investing customer segregated funds, on

the other hand.'' \116\

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

\115\ Id. at 78776.

\116\ Id. at 78778.

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

It should be noted that Sec. 23.703(a) only restricts the manner

in which an SD or MSP may invest margin that is segregated pursuant to

an election under Sec. 23.701. This rule does not in any way restrict

the types of collateral that a counterparty may post to an SD or MSP,

nor does it require an SD or MSP to convert, in any way, posted

collateral.\117\

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

\117\ But cf. Margin Requirements for Uncleared Swaps for Swap

Dealers and Major Swap Participants, 76 FR 23732 (Apr. 28, 2011)

(proposing to limit the forms of acceptable initial margin to a

specified list of eligible collateral for transactions between a

swap dealer or major swap participant for which there is no

prudential regulator and a counterparty that is a swap dealer, a

major swap participant or a financial entity).

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

In addition, as discussed above, the Commission notes that

requiring the segregation of variation margin would be beyond the scope

of section 4s(l) of the statute and what Congress prescribed

therein.\118\ However, the Commission believes that it would be

consistent with that statute to allow the parties to agree to have

segregation arrangements for variation margin. Moreover, the Commission

acknowledges that where a counterparty and its SD or MSP have agreed to

segregate both initial margin and variation margin, such margin may be

commingled and held in the same account. But, to the extent that the

parties agree to commingle segregated initial and variation margin, the

Commission clarifies that the requirements set forth in Subpart L to

this Part 23, including the investment restrictions in regulation

23.703(a), would apply to all margin held (both initial margin and

variation margin) in such account.

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

\118\ See discussion in section B.2 supra.

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

2. Commercial Arrangements Regarding Investments and Allocations

As required by section 4s(l)(2)(B)(ii) of the CEA and subject to

the limitations set forth in regulation 23.603(a), proposed regulation

22.603(b) provided that the SD or MSP and the counterparty may enter

into any written commercial arrangement regarding the terms of the

investment of segregated margin and the related allocation of gains and

losses resulting from such investment. The Commission is adopting this

aspect of the rule as proposed.\119\

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

\119\ Proposed regulation 23.603(b) is being finalized herein as

regulation 23.703(b).

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E. Regulation 23.704: Requirements for Non-Segregated Margin

Section 4s(l)(4) of the CEA mandates that, if the counterparty does

not choose to require segregation, the SD or MSP shall report to the

counterparty, on a

[[Page 66629]]

quarterly basis, ``that the back office procedures of the swap dealer

or major swap participant relating to margin and collateral

requirements are in compliance with the agreement of the

counterparties.'' \120\ Proposed regulation 23.604(a) \121\ implemented

this provision and required that such reports be made no later than the

fifteenth (15th) business day of each calendar quarter for the

preceding calendar quarter. Proposed regulation 23.604(a) made the

Chief Compliance Officer of the SD or MSP responsible for such report.

In addition, proposed regulation 23.604(b) provided that this

obligation shall apply no earlier than the 90th calendar day after the

date on which the first swap is transacted between the counterparties.

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

\120\ 7 U.S.C. 6s(l)(4).

\121\ Proposed regulation 23.604 is being finalized herein as

regulation 23.704.

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Four commenters discussed this proposal.\122\ The Working Group

wrote that quarterly report of back office compliance for swaps with

non-segregated margin is unnecessarily burdensome.\123\ SIFMA and ISDA

also argued that the requirement for a Chief Compliance Officer

statement would be burdensome.\124\

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\122\ Working Group, AIMA, ISDA and SIFMA/ISDA.

\123\ Working Group letter at 5-6. See also SIFMA/ISDA letter at

7 and ISDA letter at 8.

\124\ SIFMA/ISDA letter at 7 and ISDA letter at 9.

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SIFMA and ISDA went further, suggesting that disclosure should not

be required especially where the relevant SD/MSP is permitted to freely

sell, pledge, rehypothecate, assign, invest, use, commingle, or

otherwise dispose of any independent amount that it holds, since any

such disclosure would be meaningless.\125\

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\125\ SIFMA/ISDA letter at 7 and ISDA letter at 8.

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The Working Group argued that an initial representation as to

compliance should be treated as renewed each quarter unless altered by

the SD or MSP.\126\ SIFMA and ISDA proposed giving the counterparty

permission to waive receipt of the quarterly disclosure.\127\

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

\126\ Working Group letter at 6.

\127\ SIFMA/ISDA letter at 7 and ISDA letter at 8.

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The Working Group also suggested that in addition to forgoing or

electing segregation under the rule, parties may choose to segregate

outside of the proposed rule.\128\ For example, the Working Group

stated that a counterparty may wish to have its collateral held in an

SD's omnibus customer account, and that such agreements should be

permitted.\129\

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

\128\ Working Group letter at 3.

\129\ Id.

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By contrast AIMA agreed with the proposal for reporting on a

regular basis and suggested that reporting also occur immediately

following entry of a swap agreement.\130\

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\130\ AIMA letter at 3.

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While quarterly reporting may impose certain administrative burdens

on SDs and MSPs, such quarterly reporting, as contemplated by

regulation 23.704, is expressly required by the statute.\131\ The

Commission agrees that since a counterparty may choose not to segregate

at all, it also may elect to segregate in some lesser manner than that

contemplated by regulation 23.702. However, the Commission notes that,

for counterparties who do not choose segregation, as contemplated by

section 4s(l)(1)(B) of the CEA, the purpose of section 4s(l)(4) of the

CEA is to confirm that the SD or MSP is adhering to the obligations of

their agreement. Therefore, the requirements of regulation 23.704 will

apply to all agreements relating to uncleared swaps for which the

counterparty does not elect to segregate initial margin pursuant to

regulation 23.702. Moreover, the Commission believes that placing

responsibility for the report with the chief compliance officer of the

SD or MSP required by Section 4s(k) of the CEA is appropriate in light

of the chief compliance officer's role in making sure the SD or MSP

complies with its statutory and regulatory obligations.\132\ The

Commission is adopting the rule as proposed.

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\131\ The reporting requirement found in section 4s(l)(4) of the

CEA states that if the counterparty does not choose to require

segregation of the funds or other property supplied to margin,

guarantee, or secure the obligations of the counterparty, the swap

dealer or major swap participant shall report to the counterparty of

the swap dealer or major swap participant on a quarterly basis that

the back office procedures of the swap dealer or major swap

participant relating to margin and collateral requirements are in

compliance with the agreement of the counterparties.

\132\ See generally section 4s(k)(2)(E) of the CEA (stating that

the chief compliance officer shall ``ensure compliance with the

[CEA] (including regulations) relating to swaps, including each rule

prescribed by the Commission under [section 4s].'')

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F. Compliance Date

In the NPRM, the Commission requested comment on the appropriate

timing of effectiveness for the final rules for Part 23. SIFMA/ISDA

recommended a 6 month implementation period for swaps that are entered

into with new counterparties and a 12 month implementation period for

swaps that are entered into with existing counterparties.\133\ The

Working Group recommended a 12 month implementation period.\134\ After

consideration of the comments, the Commission has decided to adopt

SIFMA/ISDA's suggestion, which would provide a 6 month implementation

period for swaps that are entered into with ``new counterparties'' and

a 12 month implementation period for swaps that are entered into with

``existing counterparties.''

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\133\ SIFMA/ISDA letter at 8. See also ISDA letter at 9.

\134\ Working Group letter at 7. See also ICI letter at 6.

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III. Portfolio Margining

The NRPM proposed changes to the definition of ``customer'' in

Sec. 190.01(k) \135\ and the definition of ``customer property'' in

Sec. 190.08(a)(1)(i)(F) \136\ to implement section 713(c) of the Dodd-

Frank Act, which added section 20(c) of the CEA and stated that the

Commission ``shall exercise its authority to ensure that securities

held in a portfolio margining account carried as a futures account are

customer property and the owners of those accounts are customers for

the purposes of'' subchapter IV of chapter 7 of the U.S. Bankruptcy

Code.

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\135\ The Commission proposed to define ``customer'' as follows:

``Customer shall have the same meaning as that set forth in section

761(9) of the Bankruptcy Code. To the extent not otherwise included,

customer shall include the owner of a portfolio margining account

carried as a futures account.''

\136\ The Commission proposed to include ``To the extent not

otherwise included, securities held in a portfolio margining account

carried as a futures account'' in the definition of ``customer

property.'' 75 FR at 75435 (Dec. 10, 2010).

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The Commission received three comments on these proposals.\137\ ICE

agreed with the proposed amendments to the definition of ``customer''

and ``customer property'' stating that the proposal was ``a necessary

step toward realizing the important benefits of portfolio margining for

market participants.'' \138\ ICE also expressed concern that the

reference to ``futures account'' while excluding swaps referred to in

4d(f) of the CEA would ``create artificial and unnecessary distinctions

between futures and other products regulated by the Commission,'' \139\

and would detract from the ``certainty for the treatment in insolvency

of portfolio margining arrangements that include both swaps and

securities.'' \140\ As such, ICE requested a technical clarification to

make clear that the treatment in insolvency of portfolio margining

arrangements includes arrangements

[[Page 66630]]

involving swaps.\141\ AIMA also indicated its approval of the proposed

amendments to the definition of ``customer'' and ``customer property,''

\142\ and ICI supported the proposed amendment as an implementation of

section 713(c) of the Dodd-Frank Act.\143\

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\137\ ICE, AIMA, ICI.

\138\ ICE letter at 2.

\139\ Id. at 3.

\140\ Id. at 2.

\141\ Id. at 2.

\142\ AIMA letter at 3.

\143\ ICI letter at 6-7.

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After careful consideration of the comments, the Commission agrees

that Congress, in directing the Commission to clarify the treatment of

``securities'' held in a ``futures account,'' did not mean to imply

that securities held in a Cleared Swaps Customer Account would not be

treated as customer property. Accordingly, the Commission will adopt a

technical clarification, as suggested by ICE's comments, to avoid the

implication that portfolio margining arrangements involving swaps do

not receive the same bankruptcy protection as portfolio margining

arrangements involving futures. Thus, where the Commission has referred

to a ``futures account'' in the definition of ``customer'' in Sec.

190.01(k) and the definition of ``customer property'' in Sec.

190.08(a)(1)(i)(F), the Commission is adding a reference to a ``Cleared

Swaps Customer Account.'' The Commission is otherwise adopting these

changes as proposed.

The Commission also proposed certain technical corrections to

sections 190.02 and 190.06. The Commission notes, however, that

substantively identical technical corrections were completed in a prior

rulemaking, and thus no further action is necessary in this regard

herein.\144\

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\144\ See Protection of Cleared Swaps Customer Contracts and

Collateral; Conforming Amendments to the Commodity Broker Bankruptcy

Provisions, 77 FR 6336 (Feb. 7, 2012).

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IV. Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (``RFA'') requires Federal agencies

to consider the impact of its rules on ``small entities.'' \145\ A

regulatory flexibility analysis or certification typically is required

for ``any rule for which the agency publishes a general notice of

proposed rulemaking pursuant to'' the notice-and-comment provisions of

the Administrative Procedure Act, 5 U.S.C. 553(b).\146\

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

\145\ 5 U.S.C. 601 et seq.

\146\ 5 U.S.C. 601(2), 603, 604 and 605.

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With respect to the proposed release, while the Commission provided

an RFA statement that the proposed rule would impose regulatory

obligations on SDs and MSPs and noted that SDs and MSPs were new

categories of registrants, the Commission determined that the SDs and

MSPs were like FCMs and large traders that have been determined not to

be small entities.\147\ Thus, in the proposal, the Commission certified

that the rulemaking would not have a significant economic effect on a

substantial number of small entities. Comments on that certification

were sought.

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\147\ 75 FR 75432, 75435-36 (Dec. 3, 2010).

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

As indicated in the NPRM, the final rule will impose regulatory

obligations on SDs and MSPs. The conclusion that the rule will not have

a significant economic impact on a substantial number of small entities

within the meaning of the RFA remains valid for the final rule, which

like the proposed rule, imposes duties only on SDs and MSPs. Subsequent

to the publication of the NPRM for this rule, the Commission has

determined in other rulemakings that SDs and MSPs should not be

considered small entities based on their size and characteristics

analogous to non-small entities that pre-dated the adoption of the

Dodd-Frank Act and has certified that these entities are not small

entities for RFA purposes.\148\ As stated in prior rules, because of

the SDs and MSPs size and characteristics and the ``de minimis''

requirements, SDs and MSPs should not be considered small entities for

purposes of the RFA and SBA regulations.\149\ Nevertheless, in the

``entities'' rule that further defined the terms SD and MSP,

supplementing the statutory definitions of those terms, the Commission

expected that if any small entity were to engage in the activities

covered by the definition, most such entities would be eligible for the

``de minimis'' exception from the definition.\150\ Also, the Commission

noted that the MSP participant definition applies only to persons with

very large swap positions, and therefore the definition of MSP is

incompatible with small entity status.\151\ Thus, the ``entities''

final rule concluded that the rule, insofar as it affected SDs and

MSPs, would not have a significant economic impact on a substantial

number of small entities.\152\ The same reasoning applies to the

present rule.

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\148\ See 77 FR 48208, 48306 (Aug. 13, 2012); Further Definition

of ``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap

Agreement''; Mixed Swaps; Security-Based Swap Agreement

Recordkeeping, citing 76 FR 29868-29869 (May 23, 2011). See also,

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 20128, 20193 (Apr. 3, 2012); Registration of Swap

Dealers and Major Swap Participants, 77 FR 2613, 2620 (Jan. 19,

2012), citing 75 FR 71379, 71385 (Nov. 23, 2010) (Registration of

Swap Dealers and Major Swap Participants).

\149\ The Small Business Administration (``SBA'') identifies (by

North American Industry Classification System codes) a small

business size standard of $7 million or less in annual receipts for

Subsector 523--Securities, Commodity Contracts, and Other Financial

Investments and Related Activities. 13 CFR 121.201 (1-1-11 Edition).

65 FR 30840 (May 15, 2000).

\150\ Further Definition of ``Swap Dealer,'' ``Security-Based

Swap Dealer,'' ``Major Swap Participant'' and ``Eligible Contract

Participant,'' 77 FR 30596, 30701 (May 23, 2012).

\151\ See id.

\152\ 77 FR at 30701 (May 23, 2012). See also ``Registration of

Swap Dealers and Major Swap Participants,'' 77 FR 2613, 2620 (Jan.

19, 2012) (``Registration Adopting Release'') (``In terms of

affecting a substantial number of small entities . . . the

Commission is statutorily required to exempt from designation as an

SD those entities that engage in a de minimis quantity of swaps

dealing.'').

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One commenter, representing a number of market participants in the

energy business, submitted a comment related to the RFA, stating that

``[e]ach of the complex and interrelated regulations currently being

proposed by the Commission has both an individual, and a cumulative,

effect on . . . small entities.'' \153\ Upon consideration of this

commenter's statements, the CFTC notes that it is not required to

consider the cumulative economic impact of the entire mosaic of rules

under the Dodd-Frank Act, since an agency is only required to consider

the impact of how it exercises its discretion to implement the statute

through a particular rule. In all rulemakings, the Commission performs

an RFA analysis for that particular rule. The observations of this

commenter therefore do not provide a reason to conclude that the rules

being promulgated in this rulemaking will have a significant economic

impact on a substantial number of small entities within the legal

meaning of the RFA. This is so because, as explained above, the rules

in question impose duties only on SDs and MSPs and not on other

entities, small or otherwise.

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\153\ NRECA letter at 16.

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Accordingly, the Chairman, on behalf of the Commission, hereby

certifies pursuant to 5 U.S.C. 605(b) that the final rules will not

have a significant economic impact on a substantial number of small

entities.

B. Paperwork Reduction Act

1. Introduction

Provisions of new regulation Part 23, specifically regulations

23.701 and 23.704, include information disclosure requirements that

constitute the collection of information within the meaning of the

Paperwork Reduction

[[Page 66631]]

Act of 1995 (``PRA'').\154\ The Commission therefore has submitted this

collection of information to the Office of Management and Budget

(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR

1320.11. Under the PRA, an agency may not conduct or sponsor, and a

person is not required to respond to, a collection of information

unless it displays a currently valid control number.\155\ The title for

this collection of information is ``Disclosure and Retention of Certain

Information Relating to Swaps Customer Collateral,'' OMB Control Number

3038-0075, which has been submitted to OMB for approval. The collection

of information will be mandatory. The information in question will be

held by private entities and, to the extent it involves consumer

financial information, may be protected under Title V of the Gramm-

Leach-Bliley Act as amended by the Dodd-Frank Act.\156\ An agency may

not conduct or sponsor, and a person is not required to respond to, a

collection of information unless it displays a currently valid OMB

control number.

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\154\ 44 U.S.C. 3501 et seq.

\155\ Id.

\156\ See generally Notice of Proposed Rulemaking, Privacy of

Consumer Financial Information; Conforming Amendments Under Dodd-

Frank Act 75 FR 66014 (Oct. 27, 2010).

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2. Comments Received on Collection of Information Proposed in NPRM

Estimates of the expected information collection burden related to

regulations 23.701 and 23.704 were published for comment in the

NPRM.\157\ General comments on these regulations and the Commission's

response are discussed in a previous section of this preamble. The

Commission received two comments specifically addressing the

Commission's numerical PRA burden estimate for regulation 23.701.\158\

A comment from ISDA stated that the annual burden estimate of 0.3 hours

per counterparty for this requirement appeared insufficient. The

comment stated:

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\157\ In the NPRM these provisions were numbered as regulation

23.601 and 23.604.

\158\ The comments referred to regulation 23.601, reflecting the

numbering in the NPRM.

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Specifically, the following documentation-related functions would

be necessary: Scheduling, drafting, issuing, tracking, receipt,

validation, classification and storage. As a result, we believe that

the process contemplated by the Proposed Rules would entail multiple

hours of staff time per counterparty.\159\

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\159\ ISDA letter at 5.

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The second comment made substantially the same point.\160\ In

response to these comments, and certain other considerations, the

Commission has reevaluated the per-disclosure burden estimate for

regulation 23.701 and has modified the estimate as discussed below.

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

\160\ SIFMA/ISDA letter at 4.

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3. Adjustments to Estimate of Information Collection Burden Based on

New Estimate of Expected Total Number of Swap Dealers and Major Swap

Participants

The Commission has determined to adjust the burden estimate for

Regulations 23.701 and 23.704 based on a number of considerations. Both

regulations apply to SDs and MSPs. At the time the NPRM was published,

it was estimated, for purposes of the PRA burden estimate, that the

total number of SDs and MSPs would be about 300 entities. Based on

information developed since that time, the Commission now estimates

that the total number of SDs and MSPs, and thus the total number of

entities required to engage in information collection pursuant to these

rules, will be about 125 entities.\161\

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\161\ See discussion in Registration of Swap Dealers and Major

Swap Participants, 77 FR 2613, 2622 (Jan. 19, 2012).

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For the disclosure required by regulation 23.701 the Commission is

also adjusting its estimate of the per disclosure burden, for a number

of reasons. First, the final regulation requires that the disclosure

(a) identify one or more custodians for segregated initial margin

acceptable to the SD or MSP, at least one of which must be legally

independent of the parties to the transactions and (b) provide

information on the price of segregation for each identified custodian

to the extent that the SD or MSP has such information. As a result of

these changes, it is expected that part of the disclosure required by

the regulation will be standardized, with accompanying efficiencies in

drafting and making disclosure, but that part of the disclosure may be

specific to particular transactions. Second, as noted above, commenters

suggested that the burden estimate in the NPRM was insufficient to

cover all of the tasks necessary to make the required disclosure.

In the NPRM, the Commission estimated that disclosure required by

regulation 23.701 would require 0.3 hours of work per disclosure, which

could be performed by staff with a salary level of approximately $20

per hour. The Commission has adjusted this time estimate to 2 hours per

disclosure based on the considerations discussed immediately above. The

Commission further estimates that the average dollar cost of the

disclosure per hour will be $50, giving a cost of $100 for 2 hours of

work.\162\ In addition, for purposes of the NPRM, the Commission

estimated that each SD and MSP would make the disclosure once per year

to an average of between 433 and 666 counterparties.\163\ The

Commission is adjusting the estimate of number of disclosures per SD or

MSP per year based on the reduction, noted above, in the estimate of

the total number of SDs and MSPs from about 300 to about 125. Assuming

a roughly similar total number of counterparties will be doing business

with SDs and MSPs, this implies that the number of counterparties doing

business with each individual SD or MSP in a year will probably be

higher on average than was estimated at the time of the NPRM. To

account for this likely effect, the Commission now estimates that each

SD and MSP will, on average, make the disclosure to approximately 1300

counterparties each year. As at the time of the NPRM, the Commission

expects that the number of counterparties per SD or MSP per year is

likely to be considerably higher than this average figure for the

largest SDs and MSPs, and smaller than this average figure for some

other SDs and MSPs. Given the absence of experience with this newly

promulgated rule, these estimates are subject to an inherent degree of

uncertainty.

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\162\ This estimate is based on the assumption that about three

quarters of the work will be done by junior level staff with a

salary of approximately $25 per hour and that about one quarter of

the work will be done by senior level staff with a salary of

approximately $100 per hour. Compare SIFMA, Report on Management and

Professional Earnings in the Securities Industry-2011 at 4 (national

average total compensation for a junior level compliance specialist

in the survey equaled $50,998 per year, an hourly equivalent of

approximately $25), 8 (national average total compensation for a

compliance attorney in the survey equaled $131,304 per year, an

hourly equivalent of approximately $65).

\163\ The estimate in the NPRM assumed that the largest SDs and

MSPs would make the required disclosure to an average of 5,000-

10,000 counterparties per year and that smaller SDs and MSPs would

make the required disclosure to an average of about 200

counterparties per year. See 75 FR at 75436 (Dec. 3, 2010) and n.

29.

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The Commission, in the NPRM, estimated that regulation 23.701 would

require a total of approximately 130,000-200,000 disclosures per year,

generating an estimated total annual information collection burden of

approximately 40,000-60,000 hours and $800,000-$1,200,000. Based on the

adjustments described above the

[[Page 66632]]

Commission estimates that regulation 23.701 will require a total of

approximately 162,500 disclosures per year, generating an estimated

total annual information collection burden of approximately 325,000

hours and cost of $16,250,000.

The Commission, in the NPRM, estimated that regulation 23.704 would

require a total of approximately 260,000-400,000 disclosures per year,

generating an estimated total annual information collection burden of

approximately 80,000-120,000 hours and $2,400,000-$3,500,000.\164\ The

Commission is adjusting this estimate based on the reduced estimate of

the number of affected SDs and MSPs from 300 to 125, and the increased

estimate of 1300 counterparties per SD or MSP. In the absence of more

specific information, the Commission continues to assume for purposes

of this calculation that half of counterparties will elect not to

segregate, and will receive the required quarterly disclosure. The

Commission notes that the cost per counterparty can be divided into two

costs: An initial cost and an on-going, annual cost. In respect of the

initial cost, the Commission estimates a total of twenty hours of the

Chief Compliance Officer's time to prepare and design the SD or MSP's

compliance procedures for its 23.704 disclosure requirements. In

respect of ongoing costs, the Commission recognizes that, while the

degree of disclosure to particular counterparties may differ (e.g.,

agreements may require no disclosure, high-level disclosure only or

more in-depth disclosure), it is likely that the levels of disclosures

may coalesce around certain intervals such that efficiencies may be

observed in respect of analysis and preparation of current disclosures

and ongoing updates to the same. The Commission estimates that the

Chief Compliance Officer will spend five hours, on an annual basis,

updating the existing procedures and reviewing compliance with such

procedures as well as an additional hour, on a non-regular basis in

perhaps 2% of the cases, addressing non-routine issues that may arise

in respect of a particular disclosure to a counterparty. The Commission

further estimates that a junior compliance officer will spend, on

average, approximately 0.3 hours per counterparty on a quarterly basis,

analyzing the procedures followed and preparing the disclosure to be

sent.

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\164\ This estimate in the NPRM was based on the requirement of

regulation 23.704 that SDs and MSPs make the required disclosure

four times each year to each of their uncleared swaps counterparties

that does not choose to require segregation of initial margin. It

was further based on estimates that each disclosure would require,

on average, approximately 0.3 hours of staff time by staff with a

salary level of approximately $30 per hour although, per the terms

of the rule, this would vary depending on the specifics of the

agreement of the parties with regard to the back-office procedures

of the SD or MSP and the extent to which such procedures were

standardized. The estimate further assumed that about half of all

uncleared swaps counterparties would not choose segregation of

initial margin and that, as a result, the largest SDs and MSPs would

make the required disclosure to an average of 2,500-5,000

counterparties four times per year and that smaller SDs and MSPs

would make the required disclosure to an average of about 100

counterparties four times per year. See 75 FR at 75436 (Dec. 3,

2010) and n. 30; SIFMA, Report on Management and Professional

Earnings in the Securities Industry-2011 at 4 (national average

total compensation for a junior level compliance specialist in

survey equaled $50,998 per year, an hourly equivalent of

approximately $25).

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Based on these adjustments, the Commission now estimates that

regulation 23.704 will require initial costs of approximately $280,000

and, on an ongoing basis, a total of approximately 325,000 disclosures

per year generating an estimated total annual information collection

burden of approximately $3.7 million, based on the following: An annual

cost of $29,300 per SD/MSP comprising eighteen hours for the Chief

Compliance Officer with a salary level of approximately $110.97 per

hour and the annual cost of 780 hours for junior compliance staff with

a salary level of approximately $35 per hour, multiplied by an

estimated 125 SD/MSPs.

C. Cost-Benefit Considerations

1. Background

Prior to the passage of the Dodd-Frank Act, the decision to

segregate and the mechanics of such segregation were unregulated and

left to the negotiation of the parties to the swap. Under new CEA

section 4s(l)(1)(A), an SD or MSP is required to notify the

counterparty of its right to segregation. Upon request by the

counterparty, the SD or MSP must segregate the funds for the benefit of

the counterparty, among other requirements under section 4s(l)(1)(B).

Other paragraphs of section 4s(l) outline the applicability of the

segregation notification, the nature of the custodian and the reporting

requirement for unsegregated initial margin.

This legislative act is indicative of Congress's broad intent to

increase the safety of the swaps market. While many aspects of Title

VII of the Dodd-Frank Act promote the increased clearing of swaps,

section 4s(l) indicates Congress' intent to increase the safety in the

market for uncleared swaps by creating a self-effectuating requirement

for the segregation of counterparty initial margin in an entity legally

separate from the SD or MSP.

In the NPRM, the Commission invited the public ``to submit any data

or other information that they may have quantifying or qualifying the

costs and benefits of the proposal with their comment letters.'' \165\

The Commission received no such quantitative data or information with

respect to these rules. While the Commission did not receive comments

directly on the costs and benefit analysis, it did receive comments

that alluded to costs, as discussed in more detail in the sections

below. For example, some commenters believed that the notification of

counterparties of their right to segregation would create an

administrative cost (although no commenters attempted to quantify such

costs). FHLB, MetLife and EEI characterized transaction-by-transaction

notification as repetitive and redundant.\166\ Some commenters believed

that even yearly notification was unnecessary.\167\ On the topic of

investing initial margin only as allowed under regulation 1.25,

Federated directly stated that this would cause a loss of investment

returns.\168\ Finally, the Working Group wrote that requiring quarterly

reporting for non-segregated margin would be unnecessarily burdensome,

indicating that producing such reports might create a needless

administrative cost.\169\

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\165\ 75 FR at 75437 (Dec. 3, 2010).

\166\ FHLB letter at 6, MetLife letter at 2, EEI letter at 3.

\167\ SIFMA/ISDA letter at 4, ISDA letter at 4, AMG letter at 7.

\168\ Federated letter at 7, 11.

\169\ Working Group letter at 6.

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2. Statutory Mandate To Consider Costs and Benefits

Section 15(a) of the CEA requires the Commission to consider the

costs and benefits of its action before promulgating a regulation.\170\

In particular, costs and benefits must be evaluated in light of five

broad areas of market and public concern: (1) Protection of market

participants and the public; (2) efficiency, competitiveness, and

financial integrity of futures markets; (3) price discovery; (4) sound

risk management practices; and (5) other public interest

considerations. Accordingly, the Commission considers the costs and

benefits resulting from its own discretionary determinations with

respect to the section 15(a) factors.

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\170\ 7 U.S.C. 19(a).

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In issuing these final rules, the Commission has considered the

costs and benefits of each aspect of the rules, as well as alternatives

to them. In addition, the Commission has evaluated

[[Page 66633]]

comments received regarding costs and benefits in response to its

proposal. Where quantification has not been reasonably estimable due to

lack of necessary underlying information, the Commission has considered

the costs and benefits of the final rules in qualitative terms.

3. Benefits and Costs of the Final Rule

A discussion of the costs and benefits of this rule and the

relevant comments is set out immediately below and continues in the

discussion of the section 15(a) factors. The discussion of costs and

benefits here should be read in conjunction with the discussion of rule

provisions and comments in the remainder of the preamble, which was

also taken into account in the Commission's overall consideration of

costs and benefits as part of its decision to promulgate the rule.

The major provisions of this final rule reflect specific

requirements compelled by the CEA, as amended by the Dodd-Frank Act.

This discussion of costs and benefits focuses on the areas in which the

Commission used its discretion to introduce standards or requirements

beyond those which were required by statute.

a. Benefits

The final rule, in regulation 23.701(e), requires notification of

the right to segregation once per each year that a new swap is entered

into rather than, e.g., at the beginning of a swap transaction or

notification only when a counterparty first does business with the SD

or MSP. Annual notification offers the benefit of ensuring that the

right to segregation is called to the attention of counterparties

reasonably close in time to the point at which decisions are made with

respect to the handling of collateral for particular swaps transactions

without requiring excessive or repetitive notification in cases where a

counterparty engages in multiple swaps with a particular SD or MSP over

the course of a year. Annual notification also reduces the likelihood

that required information regarding custodians and pricing will become

obsolete, which would be a significant possibility if notification were

given only at the beginning of a multi-year business relationship

between a counterparty and the SD or MSP.

The final rule, in regulation 23.701(a)(2), requires the SD or MSP

to identify, in the notification, at least one creditworthy non-

affiliate acceptable to the SD or MSP as a custodian. As discussed

above, there are benefits to requiring that the counterparty have the

option of using a non-affiliate custodian for collateral because of the

likely higher correlation of default risk between an affiliate

custodian and the SD or MSP. There are also benefits to requiring the

identity of such a custodian acceptable to the SD or MSP to be

specifically disclosed because the identity of the custodian is a

material aspect of any segregation package.

The final rule also requires, in regulation 23.701(a)(3), the SD or

MSP to provide the counterparty with the price of segregation to the

extent that the SD or MSP has such information (e.g., where the

custodian is an affiliate of, or a regular custodian for, the SD or

MSP). Requiring the SD or MSP to disclose price information that it has

available is beneficial because knowledge of the price of segregation

is essential in order for the counterparty to determine the net value

of choosing segregation. In transactions in which the parties have

agreed that a withdrawal of segregated margin may be made without the

written consent of both the counterparty and the SD or MSP, the final

rule, in regulation 23.702(c)(2), includes a perjury standard for a

party unilaterally representing to the custodian that it is entitled to

segregated initial margin. The benefit of a perjury standard for

unilateral requests for collateral is that it provides a disincentive

to parties who might otherwise be inclined to fraudulently request

collateral, particularly in circumstances where financial distress may

create incentives to cut corners.

The final rule requires, in regulation 23.703(a), that any

investments of segregated initial margin given to an SD or MSP conform

to regulation 1.25. While not required by statute, this aspect of the

final rule is beneficial because it will serve to safeguard segregated

initial margin in the same way that regulation 1.25 safeguards futures

and cleared swaps customer collateral. Without this requirement, there

exists a possible moral hazard concern that an SD or MSP may engage in

excessive risk taking with the funds of a counterparty. This moral

hazard arises out of either (i) lack of customer awareness, (ii) agency

costs facing the customer that make it difficult to contract around

issues of collateral use (e.g., monitoring costs of the SD's or MSP's

activities by the customer), or (iii) existence of a potential

government backstop, which lessens the incentive of either SDs or MSPs

or their customers to impose restrictions on collateral investment.

The final rule, in regulation 23.704(a), also makes the Chief

Compliance Officer of the SD or MSP required by section 4s(k) of the

CEA responsible for the report to each counterparty that elects not to

require segregation whether or not the back office procedures relating

to margin and collateral requirements of the SD or MSP were out of

compliance with the agreement between the SD or MSP and the

counterparty, consistent with the Chief Compliance Officer's

section4s(k)(2)(D) of the CEA duties. This provision should enhance

compliance by SDs and MSPs with these aspects of their agreements with

their counterparties by highlighting breaches and by incentivizing SDs

and MSPs to avoid breaches that would have to be reported. Compliance

by SDs and MSPs with provisions concerning margin and collateral

requirements should lead to better protection of counterparties in the

event of the insolvency of the SD or MSP.

b. Costs

As noted previously, the final rule, in regulation 23.701(e),

requires yearly notification of the right to segregation. This is less

costly than a requirement that such notification be given with each

swap transaction, which would result from a more literal reading of the

statute.\171\

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\171\ See CEA section 4s(l)(1)(A) (A swap dealer or major swap

participant shall be required to notify the counterparty of the swap

dealer or major swap participant at the beginning of a swap

transaction that the counterparty has the right to require

segregation.).

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An estimate of the cost of the required yearly notification is

given in the Paperwork Reduction Act section of this preamble, above.

The Commission believes that the cost of requiring SDs and MSPs to

deliver one notification per year to each counterparty is not overly

burdensome, particularly when one considers the importance of the

counterparty's decision to require segregation and the large dollar

volume of business that is typically done by SDs and MSPs.\172\ The

increased cost associated with an annual notification requirement, as

compared to a requirement that notification only be required at the

beginning of a swap relationship between the parties as was urged by

some commenters, is the difference in the administrative costs of

sending each additional yearly notification as opposed to just one

initial notification. Commenters who favored less-than-annual

notification did not provide specific estimates of this cost

difference. Based on its assessment of the cost of annual notification,

the Commission does not

[[Page 66634]]

believe that this cost difference would impose an unreasonable

burden.\173\

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\172\ See generally Further Definition of ``Swap Dealer,''

``Security-Based Swap Dealer,'' ``Major Swap Participant,'' ``Major

Security-Based Swap Participant'' and ``Eligible Contract

Participant,'' 77 FR 30596 (May 23, 2012).

\173\ For the Commission's analysis and estimate of the costs of

annual notification, please see the discussion in the Paperwork

Reduction Act section of this preamble, above.

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The requirement that SDs or MSPs reveal to counterparties the

identity of one or more potential custodians (one of which must be

unaffiliated), and their respective prices of segregation, should

impose minimal costs. It is likely that both the identities of

custodians and related pricing information would, in the ordinary

course, be included in any negotiation between an SD or MSP and a

counterparty. In any event, the SD's or MSP's own custodial and pricing

decisions are known (or certainly readily knowable) by the SD or MSP,

and thus requiring them to be disclosed should introduce minimal cost

upon the SD or MSP. There may be an administrative cost to the SD or

MSP in initially selecting an unaffiliated custodian, if the SD or MSP

did not previously have a relationship with such an entity. This

administrative expense need only be a one-time cost and should not be

overly burdensome.

The perjury standard introduces a heightened punishment for the

inappropriate seizure of customer collateral based on false

representations. The primary cost of such a standard is the exercise of

excessive caution by SDs or MSPs in asserting their right to this

collateral, even in instances where that right is warranted.

The requirement that investments of segregated margin given to an

SD or MSP adhere to regulation 1.25 may impose costs. The primary cost

would be a loss of investment returns to SDs and MSPs under the rule as

opposed to investment returns that would have been permitted without

the regulation's restriction. Regulation 1.25 requires that investments

of customer collateral by an SD or MSP adhere to a list of enumerated

investments, concentration limits and other restrictions because

certain investments may not adequately meet the statute's paramount

goal of protecting customer funds.\174\ Nonetheless, the Commission

recognizes that restricting the type and form of permitted investments

could result in certain SDs and MSPs earning less income from their

investments of customer funds. The Commission has (conservatively)

estimated the excess return (or spread) of investing without

restrictions, as compared to investing according to regulation 1.25

guidelines, to be between 0% and 4%.\175\ The associated cost of

imposing regulation 1.25, which needs to also consider the (risk-based)

preferences of counterparties over the set of foregone investment

opportunities, exists somewhere within this range. Secondarily, there

may be administrative costs to SDs and MSPs in ensuring compliance with

regulation 1.25 limitations. However, the Commission notes that parties

are free to negotiate arrangements outside of the final rule.

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\174\ See generally 7 U.S.C. 6d.

\175\ This range is based on an average yield on 10-year T-bonds

between 4% and 6% and a long-run annualized return on equities

between 6% and 8%.

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An estimate of the cost of the quarterly reporting required

pursuant to regulation 23.704 is given in the Paperwork Reduction Act

section of this preamble, above. As noted above, the Chief Compliance

Officer and junior compliance officers' time may result in an added

cost to the implementation of regulation 23.704. The Chief Compliance

Officer's involvement with design and implementation of these

procedures, however, is commensurate with its section 4s(k)(2)(D) CEA

responsibilities for ``administrating each policy and procedure that is

required to be established pursuant to [section 4s].'' In addition,

this cost is outweighed by the relative benefit of the design and

implementation of effective recordkeeping procedures for the large

number of counterparties served by each SD or MSP.

c. Consideration of Alternatives

In arriving at the final rules, in areas in which the Commission

exercised its discretion, the Commission has considered a number of

alternatives suggested by commenters.

The Commission asked in the NPRM whether the SD or MSP should be

required to disclose the price of segregation, the fees to be paid to

the custodian (if the SD or MSP was aware of such costs) or differences

in the terms of the swap that the SD or MSP is willing to offer to the

counterparty if the counterparty elects or renounces the right to

segregation. SIFMA/ISDA wrote that mandating disclosure is not

necessary or desirable because ``a counterparty can always, in

accordance with current market practice, request disclosures it

considers necessary from its SD/MSP [hellip] [and] mandatory disclosure

by the SD/MSP is impractical because much of the material costs are

within the control of a third party: The custodian.'' \176\ ICI sought

to distinguish between fees charged by the custodian--which ICI does

not believe need to be disclosed by the SD or MSP--and fees embedded in

the SD's or MSP's pricing.\177\ State Street suggested that ``the

Commission should [hellip] provide that, although the pricing of the

same transaction with and without a segregated account may differ, the

pricing difference should be reflective of actual out-of-pocket costs

expected to be incurred by the [SD or MSP] as a result of use of the

segregated account, and that the nature and amounts of those costs

should be fully disclosed.'' \178\

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\176\ SIFMA/ISDA letter at 3 and ISDA letter at 3-4.

\177\ ICI letter at 3.

\178\ State Street letter at 3.

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The Commission could have chosen to take the path requested by

SIFMA/ISDA, in which no disclosures are mandated by the regulation, or

the path requested by ICI, in which only fees embedded in the SD's or

MSP's pricing for segregated margin are disclosed. However, as

discussed by several commenters, what is relevant to the counterparty

in determining whether to segregate (and with which custodian) is the

sum of all associated costs; \179\ both those directly associated with

the custodian, and any additional charges imposed by the SD or MSP.

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\179\ See generally MFA Letter at 4 and State Street letter at

3.

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The SD or MSP will typically be in a better position to know the

fees charged by the custodian than the counterparty. In such instances,

the alternatives suggested by SIFMA/ISDA and ICI could result in a lack

of pricing information for the counterparty, or at best, a more

difficult path for a counterparty to obtain such information. The SD or

MSP is responsible for segregation and for using an independent third-

party custodian, and providing price information about the total cost

of segregation to the counterparty is a key component of evaluating a

custodian's service.

The Commission notes State Street's argument, but believes that

mandating that the difference in prices charged by the SD or MSP should

only reflect the SD's or MSP's out-of-pocket costs would be excessively

proscriptive. To the extent that this rule promotes price transparency,

it will foster more competitive pricing.

In addition, several commenters requested the Commission eliminate

the once-per-year notification in the Commission's proposed rule.

SIFMA/ISDA and AMG each wrote that an initial notification is all that

should be required. The Commission considered requiring only an initial

notification, however it opted for a yearly notification. Yearly

notification serves

[[Page 66635]]

as an appropriate means for calling attention to the importance of the

right to segregate collateral, and offers a number of benefits,

relative to one-time-only disclosure, as has been discussed above.

Similarly, the Commission has concluded that any difference in

administrative costs should not be excessively burdensome.

The alternative to a perjury standard for unilateral requests to

withdraw collateral from segregation is not to have one. However, it is

the Commission's view that heightening the penalty for fraudulently

requesting funds to which one is not entitled reduces the incidence of

such claims, and may serve the general intent of section 4s(l) to

increase the safety and financial integrity of the uncleared swap

market and to safeguard the initial margin of parties to uncleared

swaps, once segregated, while still providing the benefits of a

unilateral ability to withdraw collateral to parties who agree to such

an approach.\180\

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\180\ As discussed below, the perjury rule may in certain

instances lead to excess caution by SDs and MSPs in cases where they

do have a right to the collateral. In such instances, the perjury

rule could adversely affect sound risk management.

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The alternatives to subjecting the investment of segregated initial

margin to regulation 1.25 are to subject it to no restrictions at all

or to subject it to some other collateral investment regime. The

Commission notes that none of the commenters proposed an alternative

investment framework or detailed set of restrictions.\181\ It is the

Commission's view that the purpose of section 4s(l) is to increase the

safety of the uncleared swaps market and to protect initial margin,

once segregated. Regulation 1.25 is used by the Commission for both

futures and cleared swaps as a means by which to protect segregated

customer funds against risky investment. Having created a legal

standard for this purpose, it makes sense to apply it to uncleared

swaps transactions in which counterparties choose to have their

collateral segregated within a regulatory framework established by the

Commission under the authority of section 4s(l).

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\181\ While Federated provided some general suggestions, such as

setting concentration limits on investments with a particular fund

or family of funds, it argued that there ``should be no limits on

investment of collateral for uncleared or cleared swaps.'' See

Federated letter at 10-11.

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Alternatives to reporting requirements to non-segregated collateral

would be to require reports less frequently than quarterly and to not

place responsibility for such reports on the chief compliance officer.

The Commission notes that while quarterly reporting may impose certain

administrative burdens on SDs and MSPs, such quarterly reporting, as

contemplated by regulation 23.704, is expressly required by the

statute.\182\ In addition, under section 4s(k)(2)(D) of the CEA, the

chief compliance officer is ``responsible for administering each policy

and procedure that is required to be established pursuant to [section

4s].'' Thus, responsibility for compliance with the quarterly reporting

requirement, a procedure required by section 4s(l)(4) of the CEA,

properly rests with the chief compliance officer.

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\182\ The reporting requirement found in section 4s(l)(4) of the

CEA states that if the counterparty does not choose to require

segregation of the funds or other property supplied to margin,

guarantee, or secure the obligations of the counterparty, the swap

dealer or major swap participant shall report to the counterparty of

the swap dealer or major swap participant on a quarterly basis that

the back office procedures of the swap dealer or major swap

participant relating to margin and collateral requirements are in

compliance with the agreement of the counterparties.

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4. Section 15(a) Factors

As noted above, in this final rule, the Commission considers the

costs and benefits that result from the regulations issued herein

according to the requirements of section 15(a) of the CEA. Previous

sections identify four main issues for cost-benefit considerations: (1)

Notification of the right to segregate, (2) requirements to reveal the

price of segregation, (3) statements affirming the right to seize

collateral, and (4) adherence to regulation 1.25 in the investment of

segregated collateral. This section discusses those considerations in

light of the section 15(a) criteria described above.

a. Annual Notification of the Right to Segregate

This requirement ensures that the right to segregation is called to

the attention of counterparties reasonably close in time to the point

at which they make decisions regarding the handling of collateral for

particular swaps transactions and therefore increases the likelihood

that counterparties will make informed decisions on whether to elect

segregation. It thereby furthers the protection of market participants

and the public and promotes sound risk management practices.

b. Revealing the Price of Segregation and Identifying a Custodian

The statute requires the SD or MSP to notify the counterparty of

its right to segregation. The final regulation goes beyond the

statutory requirement by also requiring that the SD or MSP provide an

unaffiliated custodian that it would be willing to use as well as the

price associated with segregation. The Commission has determined that

the benefits for this requirements are compelling and do not entail any

significant costs.

The requirement also promotes the protection of market participants

and the public and promotes sound risk management practices. The

ability of a counterparty to know the custodian and the price

associated with segregation is important because it facilitates the

counterparty's decisions regarding whether to segregate initial margin

and with whom it wishes to transact swaps. In addition to benefitting

counterparties facilitating decisions regarding protection of

collateral in uncleared swaps transactions benefits the public.

Notwithstanding the movement towards clearing, a large number of swaps

will remain bilateral contracts. Congress has determined that systemic

risk will be reduced by offering counterparties the right to segregate

collateral to avoid losses brought about by default of an SD or MSP and

providing information on custodians and pricing promotes the exercise

of this right.

This requirement also promotes market efficiency, competitiveness

and financial integrity by facilitating counterparty comparison of

custodians, which may influence its choice of the SD or MSP with which

it wishes to transact swaps. To the extent that such price transparency

promotes competition among custodians, one can expect reductions in the

cost of segregation, which, in turn, may lead to increased use of the

segregation option, with the resultant positive implications for sound

risk management practices. Second, requiring that pricing information

be obtained by the party best positioned to know such information

eliminates a circumstance where a party at a comparative disadvantage

for obtaining such information has to do so.

c. Perjury Standard for Statements Affirming the Right to Unilaterally

Withdraw Collateral From a Custodian

The baseline for comparison of this requirement is typical market

practice, which may include civil and criminal actions against a party

falsely claiming that it is entitled to funds to which it, in fact, is

not.

Introducing a perjury standard for unilateral requests for

collateral will serve as an additional disincentive for parties who

might otherwise be inclined to fraudulently request collateral. To the

extent this standard reduces the incidence of such false claims, the

rule acts to promote the protection of market participants and the

public. In addition, fraudulent requests for collateral, if

[[Page 66636]]

honored, can shake victimized parties' confidence in the uncleared

segregation regime and damage public confidence in the safety of the

uncleared swap market. Heightening disincentives for fraudulent conduct

will therefore help to safeguard the financial integrity of the

uncleared swap market place. As previously mentioned, a primary cost of

this standard is the exercise of excessive caution by SDs or MSPs in

asserting their right to this collateral, even in instances where the

SD or MSP believes that the unilateral withdrawal of such collateral is

authorized, because of the costs and risks of exposure to a potential

criminal action. To the extent that this potential cost arises,

therefore, the requirement can negatively impact the practice of sound

risk management.

d. Adherence to Regulation 1.25

Absent this requirement, an SD or MSP's investment options for

collateral would be left up to the negotiation of the counterparties.

As discussed above, without this requirement, there exists a

possible moral hazard concern that an SD or MSP may engage in excessive

risk taking with the funds of a counterparty. The Commission agrees

with commenters who claim that this requirement may constrain the

investment returns of SDs and MSPs relative to those returns achievable

absent the enhanced safety criteria. Recognizing that there may be some

reduction in returns, applying regulation 1.25 standards to segregated

initial margin of uncleared swaps will benefit market participants and

the public by safeguarding such segregated funds.

This regulation also benefits the financial integrity of the market

place. A party who invests its customer's segregated funds is required

to replenish any losses in the customer account with its own funds.

During a period of market stress, such a party might be experiencing

losses in other areas, which may increase the difficulty of making the

customer whole. In that regard, even if there are not losses in the

customer account, strains on the SD's or MSP's sources of funds may

cause delays in a counterparty receiving funds to which it is entitled.

Regulation 1.25 requires that customer fund investments be made in an

enumerated list of instruments which preserve principal and maintain

liquidity.

Finally, requiring that investments of segregated initial margin

adhere to regulation 1.25 benefits sound risk management practices by

ensuring that segregated funds are invested in a safe manner. This

benefits the counterparty, whose initial margin is safeguarded, and the

market as a whole, because of the decreased likelihood of a market

shock causing a chain reaction which results in the loss of segregated

funds. While the Commission realizes that there may be administrative

costs in ensuring that regulation 1.25 requirements are followed, the

Commission expects that SDs and MSPs are sophisticated firms that

should be able to make the necessary adjustments without much delay or

expense. The overall benefits of safeguarding segregated funds and the

resultant reductions in risk to portfolios, as compared to those based

on a regulatory framework without such limitations, exceed those

costs.\183\

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\183\ Based on the subject matter of the rule and comments

received, the Commission does not expect the rule to have a

significant effect on price discovery or on other public interest

considerations not already discussed.

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List of Subjects

17 CFR Part 23

Consumer protection, Reporting and recordkeeping requirements,

Swaps.

17 CFR Part 190

Bankruptcy, Brokers, Commodity futures, Reporting and recordkeeping

requirements, Swaps.

For the reasons stated in the preamble, the Commodity Futures

Trading Commission amends 17 CFR parts 23 and 190 as follows:

PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS

0

1. The authority citation for part 23 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,

9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.

0

2. Add and reserve subpart K.

0

3. Add subpart L to read as follows:

Subpart L--Segregation of Assets Held as Collateral in Uncleared Swap

Transactions

Sec.

23.700 Definitions.

23.701 Notification of right to segregation.

23.702 Requirements for segregated margin.

23.703 Investment of segregated margin.

23.704 Requirements for non-segregated margin.

Subpart L--Segregation of Assets Held as Collateral in Uncleared

Swap Transactions

Sec. 23.700 Definitions.

As used in this subpart:

Initial Margin means money, securities, or property posted by a

party to a swap as performance bond to cover potential future exposures

arising from changes in the market value of the position.

Margin means both Initial Margin and Variation Margin.

Segregate. To segregate two or more items is to keep them in

separate accounts, and to avoid combining them in the same transfer

between two accounts.

Variation Margin means a payment made by or collateral posted by a

party to a swap to cover the current exposure arising from changes in

the market value of the position since the trade was executed or the

previous time the position was marked to market.

Sec. 23.701 Notification of right to segregation.

(a) Prior to the execution of each swap transaction that is not

submitted for clearing, a swap dealer or major swap participant shall:

(1) Notify each counterparty to such transaction that the

counterparty has the right to require that any Initial Margin the

counterparty provides in connection with such transaction be segregated

in accordance with Sec. 23.702 and Sec. 23.703;

(2) Identify one or more custodians, one of which must be a

creditworthy non-affiliate and each of which must be a legal entity

independent of both the swap dealer or major swap participant and the

counterparty, as an acceptable depository for segregated Initial

Margin; and

(3) Provide information regarding the price of segregation for each

custodian identified in paragraph (a)(2) of this section, to the extent

that the swap dealer or major swap participant has such information.

(b) The right referred to in paragraph (a) of this section does not

extend to Variation Margin.

(c) The notification referred to in paragraph (a) of this section

shall be made to an officer of the counterparty responsible for the

management of collateral. If no such party is identified by the

counterparty to the swap dealer or major swap participant, then the

notification shall be made to the Chief Risk Officer of the

counterparty, or, if there is no such Officer, the Chief Executive

Officer, or if none, the highest-level decision-maker for the

counterparty.

(d) Prior to confirming the terms of any such swap, the swap dealer

or major swap participant shall obtain from the counterparty

confirmation of receipt by the person specified in paragraph (c) of

this section of the notification specified in paragraph (a) of this

section, and an election to require such segregation or not. The swap

dealer or major swap participant shall maintain such

[[Page 66637]]

confirmation and such election as business records pursuant to Sec.

1.31 of this chapter.

(e) Notification pursuant to paragraph (a) of this section to a

particular counterparty by a particular swap dealer or major swap

participant need only be made once in any calendar year.

(f) A counterparty's election to require segregation of Initial

Margin, or not to require such segregation, may be changed at the

discretion of the counterparty upon written notice delivered to the

swap dealer or major swap participant, which changed election shall be

applicable to all swaps entered into between the parties after such

delivery.

Sec. 23.702 Requirements for segregated margin.

(a) The custodian of Margin, segregated pursuant to an election

under Sec. 23.701, must be a legal entity independent of both the swap

dealer or major swap participant and the counterparty.

(b) Initial Margin that is segregated pursuant to an election under

Sec. 23.701 must be held in an account segregated for and on behalf of

the counterparty, and designated as such. Such an account may, if the

swap dealer or major swap participant and the counterparty agree, also

hold Variation Margin.

(c) Any agreement for the segregation of Margin pursuant to this

section shall be in writing, shall include the custodian as a party,

and shall provide that:

(1) Any withdrawal of such Margin, other than pursuant to paragraph

(c)(2) of this section, shall only be made pursuant to the agreement of

both the counterparty and the swap dealer or major swap participant,

and notification of such withdrawal shall be given immediately to the

non-withdrawing party;

(2) Turnover of control of such Margin shall be made without the

written consent of both parties, as appropriate, to the counterparty or

to the swap dealer or major swap participant, promptly upon

presentation to the custodian of a statement in writing, made under

oath or under penalty of perjury as specified in 28 U.S.C. 1746, by an

authorized representative of either such party, stating that such party

is entitled to such control pursuant to an agreement between the

parties. The other party shall be immediately notified of such

turnover.

Sec. 23.703 Investment of segregated margin.

(a) Margin that is segregated pursuant to an election under Sec.

23.701 may only be invested consistent with Sec. 1.25 of this chapter.

(b) Subject to paragraph (a) of this section, the swap dealer or

major swap participant and the counterparty may enter into any

commercial arrangement, in writing, regarding the investment of such

Margin, and the related allocation of gains and losses resulting from

such investment.

Sec. 23.704 Requirements for non-segregated margin.

(a) The chief compliance officer of each swap dealer or major swap

participant shall report to each counterparty that does not choose to

require segregation of Initial Margin pursuant to Sec. 23.701(a), no

later than the fifteenth business day of each calendar quarter, on

whether or not the back office procedures of the swap dealer or major

swap participant relating to margin and collateral requirements were,

at any point during the previous calendar quarter, not in compliance

with the agreement of the counterparties.

(b) The obligation specified in paragraph (a) of this section shall

apply with respect to each counterparty no earlier than the 90th

calendar day after the date on which the first swap is transacted

between the counterparty and the swap dealer or major swap participant.

PART 190--BANKRUPTCY

0

4. The authority citation for part 190 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 4a, 6c, 6d, 6g, 7a, 12, 19, and 24,

and 11 U.S.C. 362, 546, 548, 556, and 761-766, unless otherwise

noted.

0

5. In Sec. 190.01, revise paragraph (l) to read as follows:

Sec. 190.01 Definitions.

* * * * *

(l) Customer shall have the same meaning as that set forth in

section 761(9) of the Bankruptcy Code. To the extent not otherwise

included, customer shall include the owner of a portfolio margining

account carried as a futures account or cleared swaps customer account.

* * * * *

0

6. In Sec. 190.08, redesignate paragraph (a)(1)(i)(F) as paragraph

(a)(1)(i)(G) and add new paragraph (a)(1)(i)(F) to read as follows:

Sec. 190.08 Allocation of property and allowance of claims.

* * * * *

(a) * * *

(1) * * *

(i) * * *

(F) To the extent not otherwise included, securities held in a

portfolio margining account carried as a futures account or a cleared

swaps customer account;

* * * * *

Issued in Washington, DC, on October 31, 2013, by the

Commission.

Melissa D. Jurgens,

Secretary of the Commission.

Appendices to Protection of Collateral of Counterparties to Uncleared

Swaps; Treatment of Securities in a Portfolio Margining Account in a

Commodity Broker Bankruptcy--Commission Voting Summary and Statement of

Chairman

Note: The following appendices will not appear in the Code of

Federal Regulations.

Appendix 1--Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Chilton,

O'Malia, and Wetjen voted in the affirmative; no Commissioner voted

in the negative.

Appendix 2--Statement of Chairman Gary Gensler

I support the final rule enhancing the protection of customer

funds when entering into uncleared swap transactions. Today's final

rule fulfills Congress' mandate that counterparties of swap dealers

be given a choice regarding whether or not they get the protections

that come from segregation of monies and collateral they post as

initial margin. These are important customer protections for

counterparties as they enter into customized swaps with swap

dealers.

Swap dealers will be required to give each of their

counterparties the choice with regard to segregation. The dealers

also will have to provide the prices for the various segregation

choices. Further, the dealers must give the customers at least one

custodial arrangement choice not affiliated with the swap dealer's

bank.

In addition, this rule provides clarifying changes to ensure

that if a counterparty chooses segregation for its funds, those

funds will not be tied up in the bankruptcy of its swap dealer.

These rules are critical to protecting insurance companies,

pension funds, community banks and municipal governments wishing to

hedge a risk in using the customized swaps market.

[FR Doc. 2013-26479 Filed 11-5-13; 8:45 am]

BILLING CODE 6351-01-P

Last Updated: November 6, 2013