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2012-18382

  • Federal Register, Volume 77 Issue 152 (Tuesday, August 7, 2012)[Federal Register Volume 77, Number 152 (Tuesday, August 7, 2012)]

    [Proposed Rules]

    [Pages 47169-47222]

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

    [FR Doc No: 2012-18382]

    [[Page 47169]]

    Vol. 77

    Tuesday,

    No. 152

    August 7, 2012

    Part II

    Commodity Futures Trading Commission

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    17 CFR Part 50

    Clearing Requirement Determination Under Section 2(h) of the CEA;

    Proposed Rule

    Federal Register / Vol. 77 , No. 152 / Tuesday, August 7, 2012 /

    Proposed Rules

    [[Page 47170]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 50

    RIN 3038-AD86

    Clearing Requirement Determination Under Section 2(h) of the CEA

    AGENCY: Commodity Futures Trading Commission.

    ACTION: Notice of proposed rulemaking.

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

    is proposing regulations to establish a clearing requirement under new

    section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted

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

    Protection Act (Dodd-Frank Act). The regulations would require that

    certain classes of credit default swaps (CDS) and interest rate swaps

    (IRS), described herein, be cleared by a derivatives clearing

    organization (DCO) registered with the Commission. The Commission also

    is proposing regulations to prevent evasion of the clearing requirement

    and related provisions.

    DATES: Comments must be received on or before September 6, 2012.

    ADDRESSES: You may submit comments, identified by RIN number 3038-AD86,

    by any of the following methods:

    The agency's Web site, at http://comments.cftc.gov. Follow

    the instructions for submitting comments through the Web site.

    Mail: David A. Stawick, Secretary of the Commission,

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

    Street NW., Washington, DC 20581.

    Hand Delivery/Courier: Same as mail above.

    Federal eRulemaking Portal: http://www.regulations.gov.

    Follow the instructions for submitting comments.

    Please submit your comments using only one method.

    All comments must be submitted in English, or if not, accompanied

    by an English translation. Comments will be posted as received to

    http://www.cftc.gov. You should submit only information that you wish

    to make available publicly. If you wish the Commission to consider

    information that you believe is exempt from disclosure under the

    Freedom of Information Act, a petition for confidential treatment of

    the exempt information may be submitted according to the procedures

    established in Sec. 145.9 of the Commission's regulations.\1\

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    \1\ 17 CFR 145.9. Commission regulations referred to herein are

    found on the Commission's Web site.

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    The Commission reserves the right, but shall have no obligation, to

    review, pre-screen, filter, redact, refuse or remove any or all of your

    submission from http://www.cftc.gov that it may deem to be

    inappropriate for publication, such as obscene language. All

    submissions that have been redacted or removed that contain comments on

    the merits of the rulemaking will be retained in the public comment

    file and will be considered as required under the Administrative

    Procedure Act and other applicable laws, and may be accessible under

    the Freedom of Information Act.

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

    202-418-5684, sjosephson@cftc.gov; Brian O'Keefe, Associate Director,

    202-418-5658, bokeefe@cftc.gov; or Erik Remmler, Associate Director,

    202-418-7630, eremmler@cftc.gov, Division of Clearing and Risk,

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

    Street NW., Washington, DC 20581.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Background

    A. Financial Crisis

    B. Central Role of Clearing in the Dodd-Frank Act

    C. G-20 and International Commitments on Clearing

    D. Overview of Section 2(h) and Sec. 39.5

    E. Submissions From DCOs

    II. Review of Swap Submissions

    A. General Description of Information Considered

    B. Commission Processes for Review and Surveillance of DCOs

    C. Credit Default Swaps

    D. Proposed Determination Analysis for Credit Default Swaps

    E. Interest Rate Swaps

    F. Proposed Determination Analysis for Interest Rate Swaps

    III. Proposed Rule

    A. Proposed Sec. 50.1 Definitions

    B. Proposed Sec. 50.2 Treatment of Swaps Subject to a Clearing

    Requirement

    C. Proposed Sec. 50.3 Notice to the Public

    D. Proposed Sec. 50.4 Classes of Swaps Required To Be Cleared

    E. Proposed Sec. 50.5 Clearing Transition Rules

    F. Proposed Sec. 50.6 Delegation of Authority

    G. Proposed Sec. 50.10 Prevention of Evasion of the Clearing

    Requirement and Abuse of an Exception or Exemption to the Clearing

    Requirement

    IV. Implementation

    V. Cost Benefit Considerations

    A. Statutory and Regulatory Background

    B. Overview of Swap Clearing

    C. Consideration of the Costs and Benefits of the Commission's

    Action

    D. Costs and Benefits of the Rule as Compared to Alternatives

    E. Section 15(a) Factors

    VI. Related Matters

    A. Regulatory Flexibility Act

    B. Paperwork Reduction Act

    I. Background

    A. Financial Crisis

    In the fall of 2008, a series of large financial institution

    failures triggered a financial and economic crisis that threatened to

    freeze U.S. and global credit markets. As a result of these failures,

    unprecedented governmental intervention was required to ensure the

    stability of the U.S. financial system.\2\ These failures revealed the

    vulnerability of the U.S. financial system and economy to wide-spread

    systemic risk resulting from, among other things, poor risk management

    practices of financial firms and the lack of supervisory oversight for

    a financial institution as a whole.\3\

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    \2\ On October 3, 2008, President Bush signed the Emergency

    Economic Stabilization Act of 2008, which was principally designed

    to allow the U.S. Department of the Treasury and other government

    agencies to take action to restore liquidity and stability to the

    U.S. financial system (e.g., the Troubled Asset Relief Program--also

    known as TARP--under which the U.S. Department of the Treasury was

    authorized to purchase up to $700 billion of troubled assets that

    weighed down the balance sheets of U.S. financial institutions). See

    Public Law 110-343, 122 Stat. 3765 (2008).

    \3\ See Financial Crisis Inquiry Commission, ``The Financial

    Crisis Inquiry Report: Final Report of the National Commission on

    the Causes of the Financial and Economic Crisis in the United

    States,'' Jan. 2011, at xxviii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

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    The financial crisis also illustrated the significant risks that an

    uncleared, over-the-counter (OTC) derivatives market can pose to the

    financial system. As the Financial Crisis Inquiry Commission explained:

    The scale and nature of the [OTC] derivatives market created

    significant systemic risk throughout the financial system and helped

    fuel the panic in the fall of 2008: millions of contracts in this

    opaque and deregulated market created interconnections among a vast

    web of financial institutions through counterparty credit risk, thus

    exposing the system to a contagion of spreading losses and

    defaults.\4\

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    \4\ See id. at 386.

    Certain OTC derivatives, such as CDS, played a prominent role

    during the crisis. According to a white paper by the U.S. Department of

    the Treasury, ``the sheer volume of these [CDS] contracts overwhelmed

    some firms that had promised to provide payment of the CDS and left

    institutions with losses that they believed they had been

    [[Page 47171]]

    protected against.'' \5\ In particular, AIG reportedly issued uncleared

    CDS transactions covering more than $440 billion in bonds, leaving it

    with obligations that it could not cover as a result of changed market

    conditions.\6\ As a result of AIG's CDS exposure, the Federal

    government bailed out the firm with over $180 billion of taxpayer money

    in order to prevent AIG's failure and a possible contagion event in the

    broader economy.\7\

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    \5\ Financial Regulatory Reform: A New Foundation, June 2009,

    available at: http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf and cited in S. Rep. 111-176 at 29-30 (Apr. 30,

    2010).

    \6\ Adam Davidson, ``How AIG fell apart,'' Reuters, Sept. 18,

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

    \7\ Hugh Son, ``AIG's Trustees Shun `Shadow Board,' Seek

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

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    More broadly, the President's Working Group (PWG) on Financial

    Policy noted shortcomings in the OTC derivative markets as a whole

    during the crisis. The PWG identified the need for an improved

    integrated operational structure supporting OTC derivatives,

    specifically highlighting the need for an enhanced ability to manage

    counterparty risk through ``netting and collateral agreements by

    promoting portfolio reconciliation and accurate valuation of trades.''

    \8\ These issues were exposed in part by the surge in collateral

    required between counterparties during 2008, when the International

    Swaps and Derivatives Association (ISDA) reported an 86% increase in

    the collateral in use for OTC derivatives, indicating not only the

    increase in risk, but also circumstances in which positions may not

    have been collateralized.\9\

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    \8\ The President's Working Group on Financial Markets, ``Policy

    Statements on Financial Market Developments,'' Mar. 2008, available

    at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.

    \9\ ISDA, ISDA Margin Survey, 2009, available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.

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    With only limited checks on the amount of risk that a market

    participant could incur, great uncertainty was created among market

    participants. A market participant did not know the extent of its

    counterparty's exposure, whether its counterparty was appropriately

    hedged, or if its counterparty was dangerously exposed to adverse

    market movements. Without central clearing, a market participant bore

    the risk that its counterparty would not fulfill its payment

    obligations pursuant to a swap's terms (counterparty credit risk). As

    the financial crisis deepened, this risk made market participants wary

    of trading with each other. As a result, markets quickly became

    illiquid and trading volumes plummeted. The dramatic increase in ``TED

    spreads'' evidenced this mistrust.\10\ These spreads increased from a

    long-term average of approximately 30 basis points to 464 basis

    points.\11\

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    \10\ The TED spread measures the difference in yield between

    three-month Eurodollars as represented by London Interbank Offered

    Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit

    risk while T-bills do not. As the spread got larger, it meant that

    lenders demanded more return to compensate for credit risk then they

    would need if they loaned the money to the U.S. Department of the

    Treasury without any credit risk.

    \11\ The U.S. Financial Crisis: Credit Crunch and Yield Spreads,

    by James R. Barth et al., page 5, available at: http://apeaweb.org/confer/bei08/papers/blp.pdf.

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    The failure to adequately collateralize the risk exposures posed by

    OTC derivatives, along with the contagion effects of the vast web of

    counterparty credit risk, led many to conclude that OTC derivatives

    should be centrally cleared. For instance, in 2008, the Federal Reserve

    Bank of New York (FRBNY) began encouraging market participants to

    establish a central counterparty to clear CDS.\12\ For several years

    prior, the FRBNY had led a targeted effort to enhance operational

    efficiency and performance in the OTC derivatives market by increasing

    automation in processing and by promoting sound back office practices,

    such as timely confirmation of trades and portfolio reconciliation.

    Beginning with CDS in 2008, the FRBNY and other primary supervisors of

    OTC derivatives dealers increasingly focused on central clearing as a

    means of mitigating counterparty credit risk and lowering systemic risk

    to the markets as a whole. Both regulators and market participants

    alike recognized that risk exposures would have been monitored,

    measured, and collateralized through the process of central clearing.

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    \12\ See Federal Reserve Bank of New York, Press Release, ``New

    York Fed Welcomes Further Industry Commitments on Over-the-Counter

    Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which

    references documents prepared by market participants describing the

    importance of clearing. See also Ciara Linnane and Karen Brettell,

    ``NY Federal Reserve pushes for central CDS counterparty,'' Reuters,

    Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.

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    B. Central Role of Clearing in the Dodd-Frank Act

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

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

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

    a comprehensive new regulatory framework for swaps, and the requirement

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

    reform. The CEA, as amended by Title VII, now requires a swap: (1) To

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

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

    cleared, unless an exception to the clearing requirement applies; (2)

    to be reported to a swap data repository (SDR) or the Commission; and

    (3) if the swap is subject to a clearing requirement, to be executed on

    a designated contract market (DCM) or swap execution facility (SEF),

    unless no DCM or SEF has made the swap available to trade.\13\

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    \13\ The Commission has proposed rules that would establish a

    separate process for determining whether a swap has been made

    ``available to trade'' by a DCM or SEF. Those rules, and any

    determinations made under those rules, will be finalized separately

    from the proposed clearing requirements discussed herein. See

    Process for a Designated Contract Market or Swap Execution Facility

    to Make a Swap Available to Trade Under Section 2(h)(8) of the

    Commodity Exchange Act, 76 FR 77728 (Dec. 14, 2011).

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    Clearing is at the heart of the Dodd-Frank financial reform.

    According to the Senate Report:\14\

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    \14\ S. Rep. 111-176, at 32 (April 30, 2010). See also Letter

    from Senators Christopher Dodd and Blanche Lincoln to Congressmen

    Barney Frank and Collin Peterson (June 30, 2010) (``Congress

    determined that clearing is at the heart of reform--bringing

    transactions and counterparties into a robust, conservative, and

    transparent risk management framework.'').

    As a key element of reducing systemic risk and protecting

    taxpayers in the future, protections must include comprehensive

    regulation and rules for how the OTC derivatives market operates.

    Increasing the use of central clearinghouses, exchanges, appropriate

    margining, capital requirements, and reporting will provide

    safeguards for American taxpayers and the financial system as a

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    whole.

    The Commission believes that a clearing requirement will reduce

    counterparty credit risk and provide an organized mechanism for

    collateralizing the risk exposures posed by swaps. According to the

    Senate Report:\15\

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    \15\ S. Rep. 111-176, at 33.

    With appropriate collateral and margin requirements, a central

    clearing organization can substantially reduce counterparty risk and

    provide an organized mechanism for clearing transactions. * * *

    While large losses are to be expected in derivatives trading, if

    those positions are fully margined there will be no loss to

    counterparties and the overall financial system and none of the

    uncertainty about potential exposures that contributed to the panic

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    in 2008.

    [[Page 47172]]

    Notably, Congress did not focus on just one asset class, such as CDS;

    rather, Congress determined that all swaps that a DCO plans to accept

    for clearing must be submitted to the Commission for a determination as

    to whether or not those swaps are required to be cleared pursuant to

    section 2(h)(2)(D) of the CEA.

    C. G-20 and International Commitments on Clearing

    The financial crisis generated international consensus on the need

    to strengthen financial regulation by improving transparency,

    mitigating systemic risk, and protecting against market abuse. As a

    result of the widespread recognition that transactions in the OTC

    derivatives market increased risk and uncertainty in the economy and

    became a significant contributor to the financial crisis, a series of

    policy initiatives were undertaken to better regulate the financial

    markets.

    In September 2009, leaders of the Group of 20 (G-20)--whose

    membership includes the United States, the European Union, and 18 other

    countries--agreed that: (1) OTC derivatives contracts should be

    reported to trade repositories; (2) all standardized OTC derivatives

    contracts should be cleared through central counterparties and traded

    on exchanges or electronic trading platforms, where appropriate, by the

    end of 2012; and (3) non-centrally cleared contracts should be subject

    to higher capital requirements.

    In June 2010, the G-20 leaders reaffirmed their commitment to

    achieve these goals. In its October 2010 report on Implementing OTC

    Derivatives Market Reforms (the October 2010 Report), the Financial

    Stability Board (FSB) made twenty-one recommendations addressing

    practical issues that authorities may encounter in implementing the G-

    20 leaders' commitments.\16\ The G-20 leaders again reaffirmed their

    commitments at the November 2011 Summit, including the end-2012

    deadline. The FSB has issued three implementation progress reports. The

    most recent report urged jurisdictions to push forward aggressively to

    meet the G-20 end-2012 deadline in as many reform areas as possible. On

    mandatory clearing, the report observed that ``[j]urisdictions now have

    much of the information they requested in order to make informed

    decisions on the appropriate legislation and regulations to achieve the

    end-2012 commitment to centrally clear all standardised OTC

    derivatives.'' \17\

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    \16\ See ``Implementing OTC Derivatives Market Reforms,''

    Financial Stability Board, Oct. 25, 2010, available at http://www.financialstabilityboard.org/publications/r_101025.pdf.

    \17\ OTC Derivatives Working Group, ``OTC Derivatives Market

    Reforms: Third Progress Report on Implementation,'' Financial

    Stability Board, June 15, 2012, available at http://www.financialstabilityboard.org/publications/r_120615.pdf.

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    Specifically with regard to required clearing, the Technical

    Committee of the International Organization of Securities Commissions

    (IOSCO) has published a final report, Requirements for Mandatory

    Clearing, outlining recommendations that regulators should follow to

    carry out the G-20's goal of requiring standardized swaps to be

    cleared.\18\

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    \18\ IOSCO's report, published in February 2012, is available at

    https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf.

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    D. Overview of Section 2(h) and Sec. 39.5

    The Commission has promulgated Sec. 39.5 of its regulations to

    implement procedural aspects section 2(h) of the CEA.\19\ Regulation

    39.5 establishes procedures for: (1) Determining the eligibility of a

    DCO to clear swaps; (2) the submission of swaps by a DCO to the

    Commission for a clearing requirement determination; (3) Commission

    initiated reviews of swaps; and (4) the staying of a clearing

    requirement.

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    \19\ See 76 FR 44464 (July 26, 2011); 17 CFR 39.5.

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    This determination and rule proposed today would require that

    certain swaps submitted by Commission-registered DCOs are required to

    be cleared under section 2(h) of the CEA. Under section 2(h)(1)(A),

    ``it shall be unlawful for any person to engage in a swap unless that

    person submits such swap for clearing to a [DCO] that is registered

    under [the CEA] or a [DCO] that is exempt from registration under [the

    CEA] if the swap is required to be cleared.'' \20\

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    \20\ See section 2(h) of the CEA. A clearing requirement

    determination also may be initiated by the Commission. Section

    2(h)(2)(A)(i) of the CEA requires the Commission on an ongoing basis

    to ``review each swap, or any group, category, type, or class of

    swaps to make a determination as to whether the swap, category, type

    or class of swaps should be required to be cleared.'' As previously

    noted, the Commission intends to consider swaps submitted by DCOs

    prior to undertaking any Commission-initiated reviews.

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    A clearing requirement determination may be initiated by a swap

    submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to ``submit

    to the Commission each swap, or any group, category, type or class of

    swaps that it plans to accept for clearing, and provide notice to its

    members of the submission.'' In addition under section 2(h)(2)(B)(ii)

    of the CEA, ``[a]ny swap or group, category, type, or class of swaps

    listed for clearing by a [DCO] as of the date of enactment shall be

    considered submitted to the Commission.''

    E. Submissions From DCOs

    On February 1, 2012, Commission staff sent a letter requesting that

    DCOs submit all swaps that they were accepting for clearing as of that

    date, pursuant to Sec. 39.5.\21\ The Commission received submissions

    relating to CDS and IRS clearing from: the International Derivatives

    Clearinghouse Group (IDCH) on February 17, 2012; the CME Group (CME),

    ICE Clear Credit, ICE Clear Europe, each dated February 22, 2012, and a

    submission from LCH.Clearnet Limited (LCH) on February 24, 2012.\22\

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    \21\ The letter made it clear that DCOs should submit both pre-

    enactment swaps and swaps for which DCOs have initiated clearing

    since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to

    those swaps that DCOs were accepting for clearing as of July 21,

    2010, the date of enactment of the Dodd-Frank Act.

    \22\ Other swaps submissions were received from Kansas City

    Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and

    NGX do not accept any CDS or IRS for clearing.

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    This proposal's clearing requirement determination would cover

    certain CDS and IRS currently being cleared by a DCO. The Commission

    intends subsequently to consider other swaps submitted by DCOs, such as

    agricultural, energy, and equity indices.

    The decision to focus on CDS and IRS in the initial clearing

    requirement determination is a function of both the market importance

    of these swaps and the fact that they already are widely cleared. In

    order to move the largest number of swaps to required clearing in its

    initial determination, the Commission believes that it is prudent to

    focus on those swaps that have the highest market shares and market

    impact. Further, for these swaps there is already a blueprint for

    clearing and appropriate risk management. CDS and IRS fit these

    considerations and therefore are well suited for required clearing

    consideration.\23\

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    \23\ The Commission will consider all other swaps submitted

    under Sec. 39.5(b) as soon as possible after this proposal is

    published. These other swaps include certain CDS that were submitted

    to the Commission subsequent to the initial February 2012

    submissions discussed above. If the Commission determines that

    additional swaps should be required to be cleared such determination

    likely will be proposed as a new class under proposed Sec. 50.4, as

    discussed below.

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    Significantly, market participants have recommended that the

    Commission take this approach. In their joint comment letter to the

    Commission's proposed Compliance and Implementation Schedule for the

    clearing requirement, the Futures Industry Association (FIA), ISDA, and

    the Securities Industry and Financial Markets Association (SIFMA)

    opined

    [[Page 47173]]

    that CDS and IRS should be required to be cleared first because they

    are already being cleared.\24\ FIA, ISDA, and SIFMA commented further

    that it would make sense for the Commission to require commodity and

    equity swaps to be cleared later because fewer of these swaps are

    currently being cleared. Similarly, the letter sent by the Alternative

    Investment Management Association (AIMA) in response to Commissioner

    O'Malia's request for comment concerning the implementation of the

    clearing requirement \25\ argues that the Commission should first

    review those swaps currently being cleared and then swaps that

    currently trade in large numbers.

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    \24\ FIA/ISDA/SIFMA comment letter to the Notice of Proposed

    Rulemaking, Swap Transaction Compliance and Implementation Schedule:

    Clearing and Trade Execution Requirements under Section 2(h) of the

    CEA, 76 FR 58186 (Sept. 20, 2011). This comment letter is available

    on the Commission's Web site at: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093&ctl00--ctl00--

    cphContentMain--MainContent--gvCommentListChangePage=2.

    \25\ On July 28, 2011, Commissioner O'Malia released a letter

    seeking public comment on the manner in which the Commission should

    determine (i) which swaps would be subject to the clearing

    requirement and (ii) whether to grant a stay of a clearing

    requirement. Commissioner O'Malia's letter, as well as AIMA's

    letter, are available on the Commission's Web site at: http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.

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    IRS accounts for about $500 trillion of the $650 trillion global

    OTC swaps market, in notional dollars--the highest market share of any

    class of swaps.\26\ LCH claims to clear about $302 trillion of those--

    meaning that, in notional terms, LCH clears approximately 60% of the

    IRS market.\27\ While CDS indices do not have as prominent a market

    share as IRS, CDS indices are capable of having a sizeable market

    impact, as they did during the 2008 financial crisis. Overall, the CDS

    marketplace has almost $29 trillion in notional outstanding across both

    single and multi-name products.\28\ CDS on standardized indices

    accounts for about $10 trillion of the global OTC market in notional

    dollar amount outstanding.\29\ Since March 2009, the ICE Clear Credit

    and ICE Clear Europe have combined to clear over $30 trillion in gross

    notional for all CDS.\30\ Because of the market shares and market

    impacts of these swaps, and because these swaps are currently being

    cleared, the Commission decided to review CDS and IRS in its initial

    clearing requirement determination. The Commission recognizes that

    while this is an appropriate basis for this initial proposal, swap

    clearing is likely to evolve and clearing requirement determinations

    made at later times may be based on a variety of other factors beyond

    the extent to which the swaps in question are already being cleared.

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    \26\ Bank of International Settlements (BIS) data, December

    2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.

    \27\ Id.; LCH data.

    \28\ BIS data, December 2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.

    \29\ Id.

    \30\ ICE Clear Credit data, as of the April 26, 2012 clearing

    cycle.

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    II. Review of Swap Submissions

    A. General Description of Information Considered

    The Commission reviewed each of the submissions in detail. Based on

    these submissions, the Commission was able to consider the ability of

    an individual DCO to clear a given swap, as well as to consider the

    information supplied cumulatively across all submissions for a given

    swap. The analysis included reviews of the DCOs' existing rule

    frameworks and their risk management policies. The Commission relied on

    industry data as available, such as publicly available Depository Trust

    and Clearing Corporation (DTCC) data from the Trade Information

    Warehouse (TIW) on CDS transactions. Other publicly available data

    sources, such as data from the Bank of International Settlements (BIS)

    on the OTC derivatives markets are analyzed and cited throughout this

    notice of proposed rulemaking. The Commission also was able to review

    letters from market participants directly related to the clearing

    requirement.\31\ Other market input on the clearing requirement could

    be taken from comments received with regard to rules relating to the

    proposed Swap Transaction Compliance and Implementation Schedule:

    Clearing and Trade Execution Requirements under Section 2(h) of the CEA

    \32\ and the Process for Review of Swaps for Mandatory Clearing.\33\

    This notice of proposed rulemaking also reflects consultation with the

    staff of the Securities and Exchange Commission (SEC), prudential

    regulators, and international regulatory authorities. As Sec. 39.5

    provides for a 30-day comment period for any clearing determination,

    the final clearing requirement will be informed by public feedback.

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    \31\ See responses to Commissioner O'Malia's letter of June 28,

    2011 requesting input on the clearing determination available on the

    Commission's Web site, available at http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.

    \32\ See comment file for Swap Transaction Compliance and

    Implementation Schedule: Clearing and Trade Execution Requirements

    under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011),

    available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093.

    \33\ See comment file for Process for Review of Swaps for

    Mandatory Clearing, 75 FR 67277 (Nov. 2, 2010), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=890.

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

    B. Commission Processes for Review and Surveillance of DCOs

    i. Part 39 Regulations Set Forth Standards for Compliance

    Section 2(h)(2)(D)(i) of the CEA provides that the Commission shall

    review whether the submissions are consistent with section 5b(c)(2) of

    the CEA. Section 5b(c)(2) of the CEA sets forth eighteen core

    principles with which DCOs must comply to be registered and to maintain

    registration. The core principles address numerous issues, including

    financial resources, participant and product eligibility, risk

    management, settlement procedures, default management, system

    safeguards, reporting, recordkeeping, public information, and legal

    risk.

    All of the DCOs that submitted swaps for review are registered with

    the Commission and their submissions identify swaps that they are

    already clearing. Consequently, the Commission has been reviewing and

    monitoring compliance by the DCOs with the core principles for the

    submitted swaps. For purposes of reviewing whether the submissions are

    consistent with section 5b(c)(2) of the CEA, the Commission will rely

    on both the information received in the submissions themselves and on

    its ongoing review and risk surveillance programs. These processes are

    summarized below to provide a better understanding of the information

    the Commission uses in its review of consistency of the submissions

    with the core principles. The Commission believes this overview is

    particularly helpful for this rulemaking because the clearing

    requirement proposed herein is the first such undertaking by the

    Commission under the provisions of the Dodd-Frank Act.

    The primary objective of the CFTC supervisory program is to ensure

    compliance with applicable provisions of the CEA and implementing

    regulations, and in particular, the core principles applicable to DCOs.

    A primary concern of the program is to monitor and mitigate potential

    risks that can arise in derivatives clearing activities for the DCO,

    its members, and entities using the DCO's services. Accordingly, the

    CFTC supervisory program takes a risk-based approach.

    In addition to the core principles set forth in section 5b(c)(2) of

    the CEA, section 5c(c) of the CEA governs the procedures for review and

    approval of new products, new rules, and rule amendments submitted to

    the

    [[Page 47174]]

    Commission by DCOs. Part 39 of the CFTC's regulations implements

    sections 5b and 5c(c) of the CEA by establishing specific requirements

    for compliance with the core principles as well as procedures for

    registration, for implementing DCO rules, and for clearing new

    products. Part 40 of the CFTC's regulations sets forth additional

    provisions applicable to a DCO's submission of rule amendments and new

    products to the CFTC.

    The Commission has means to enforce compliance, including the

    Commission's ability to sue the DCO in federal court for civil monetary

    penalties,\34\ issue a cease and desist order,\35\ or suspend or revoke

    the registration of the DCO.\36\ In addition, any deficiencies or other

    compliance issues observed during ongoing monitoring or an examination

    are frequently communicated to the DCO and various measures are used by

    the Commission to ensure that the DCO appropriately addresses such

    issues, including escalating communications within the DCO management

    and requiring the DCO to demonstrate, in writing, timely correction of

    such issues.

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

    \34\ See section 6c of the CEA.

    \35\ See section 6b of the CEA.

    \36\ See section 5e of the CEA.

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

    ii. Initial Registration Application Review and Periodic In-Depth

    Reviews

    Section 5b of the CEA requires a DCO to register with the

    Commission. In order to do so, an organization must submit an

    application demonstrating that it complies with the core principles.

    During the review period, the Commission generally conducts an on-site

    review of the prospective DCO's facilities, asks a series of questions,

    and reviews all documentation received. The Commission may ask the

    applicant to make changes to its rules to comply with the CEA and the

    Commission's regulations.

    After registration, the Commission conducts examinations of DCOs to

    determine whether the DCO is in compliance with the CEA and Commission

    regulations. The examination consists of a planning phase where staff

    reviews information the Commission has on hand to determine whether the

    information raises specific issues and to develop an examination plan.

    The examination team participates in a series of meetings with the DCO

    at its facility. Commission staff also communicates with relevant DCO

    staff, including senior management, and reviews documentation. Data

    produced by the DCO is independently tested. Finally, when relevant,

    walk-through testing is conducted for key DCO processes.

    iii. Commission Daily Risk Surveillance

    Commission risk surveillance staff monitors the risks posed to and

    by DCOs, clearing members, and market participants, including market

    risk, liquidity risk, credit risk, and concentration risk. This

    analysis includes reviews of daily, large trader reporting data

    obtained from market participants, clearing members, and DCOs, which is

    available at the trader, clearing member, and DCO levels. Relevant

    margin and financial resources information is also included within the

    analysis.

    Commission staff regularly conducts back-testing to review margin

    coverage at the product level and follows up with the relevant DCO

    regarding any exceptional results. Independent stress testing of

    portfolios is conducted on a daily, weekly, and ad hoc basis. The

    independent stress tests may lead to individual trader reviews and/or

    futures commission merchant (FCM) risk reviews to gain a deeper

    understanding of a trading strategy, risk philosophy, risk controls and

    mitigants, and financial resources at the trader and/or FCM level. The

    traders and FCMs that have a higher risk profile are then reviewed

    during the Commission's on-site review of a DCO's risk management

    procedures.

    C. Credit Default Swaps

    i. Submissions Provided Information per Sec. 39.5

    Pursuant to Sec. 39.5, the Commission received filings with

    respect to CDS from CME, ICE Clear Credit, and ICE Clear Europe.\37\

    The CME and ICE Clear Credit submissions included the CDS that each

    clear on North American corporate indices, covering various tenors and

    series. The ICE Clear Europe submission includes, among other swaps,

    the CDS contracts on European corporate indices that they clear, with

    information on each of the different tenors and series. Each of the

    submissions contained information relating to the five statutory

    factors set forth in section 2(h)(2)(D) of the CEA and other

    information required under Sec. 39.5.

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

    \37\ In the case of CME and ICE Clear Europe, the submissions

    also included other swaps beyond those in the CDS and IRS

    categories. These submissions, including a description of the

    specific swaps covered, are available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm.

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

    CME, ICE Clear Credit, and ICE Clear Europe provided notice of

    their Sec. 39.5 swap submissions to their members by posting their

    submissions on their respective Web sites.\38\ The submissions also are

    published on the Commission's Web site.

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

    \38\ Available at: http://www.cmegroup.com/market-regulation/rule-filings.html and https://www.theice.com/publicdocs/regulatory_filings/ICEClearCredit_022212.pdf. ICE Clear Europe did not provide

    a link to its relevant Web page.

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

    Regulation 39.5(b)(3)(viii) also directs a DCO's submission to

    include a summary of any views on the submission expressed by members.

    CME's submission did not address this. In their submissions, ICE Clear

    Credit and ICE Clear Europe stated that neither has solicited nor

    received any comments to date and will notify the Commission of any

    such comments. The Commission expects that DCOs will provide any

    feedback they receive regarding their submissions to the Commission for

    consideration.

    ii. Background on Market

    A credit default swap is a bilateral contract that allows the

    counterparties to trade or hedge the risk that an underlying entity

    will default--in most cases, either a corporate or a sovereign

    borrower. The protection buyer makes a quarterly premium payment until

    a pre-defined credit event occurs or until the swap agreement matures.

    In return, the protection seller assumes the financial loss in case the

    reference borrower becomes insolvent or an underlying security

    defaults. In addition to such ``single name'' CDS described above, the

    market also developed CDS to cover multi-name baskets of entities.

    While these baskets can be specifically created by the parties in a

    bespoke swap transaction, the large majority of multi-name baskets are

    based on both standardized indices and standardized swap agreements.

    These index CDS can cover up to 125 reference entities. Each of these

    entities may be weighted equally within the index or have different

    weightings depending on the terms of the specific index. Unlike a

    single name CDS, these contracts generally continue until the swap

    agreement reaches its scheduled termination date. Under the contract,

    the protection seller would assume the financial loss associated with,

    and make payment to the protection buyer on, each of the individual

    entities in the index that suffers a credit event until the swap's

    maturity. Those entities suffering a credit event would be removed from

    the index. The swap would continue on the remaining names, with the

    protection buyer making reduced quarterly premium

    [[Page 47175]]

    payments based upon the now smaller index covered by the swap.

    The most recent BIS study\39\ found that, as of December 2011, the

    size of the overall CDS marketplace exceeded $28.6 trillion in notional

    amount outstanding. Of that amount, $11.8 trillion was in multi-name

    CDS agreements. Within this sub-category of CDS, CDS on indices

    accounted for more than 89% of the total notional amount outstanding.

    This continues a trend as CDS on standardized indices have seen

    increasing volumes relative to other multi-name instruments such as

    synthetic collateralized debt obligations and other bespoke products.

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

    \39\ See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.

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

    Multiple providers have established CDS indices to be used by

    market participants. These providers typically establish an index's

    constituents, as well as standard terms and tenors. They also may

    provide on-going pricing services for their indices. The CDS indices

    owned and managed by Markit have the dominant market share within this

    class of CDS. There are other providers of CDS indices, though to date,

    those indices have not been widely used. Currently none of the indices

    are the basis for any CDS cleared by a DCO.\40\ The Markit CDX family

    of indices is the standard North American credit default swap family of

    indices, with the primary corporate indices being the CDX North

    American Investment Grade (consisting of 125 investment grade corporate

    reference entities \41\) (CDX.NA.IG) and the CDX North American High

    Yield (consisting of 100 high yield corporate reference entities)

    (CDX.NA.HY). The standard currency for CDS on these indices is the U.S.

    dollar.

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

    \40\ S&P/ISDA have, for example, co-branded additional indices

    for use in the CDS marketplace. These indices cover similar classes

    of reference entities as the Markit indices. To date, however, the

    use of these indices by market participants has been limited. With

    insufficient data regarding outstanding notional amounts and trading

    volumes, the Commission does not believe it appropriate to include

    these indices in the mandatory clearing determination. To the extent

    other providers establish indices with demonstrable open interest,

    trading volumes and pricing sources, the Commission will consider

    them for inclusion either within the current proposed classes of

    swaps, or within a separate class of swaps. Exclusion for the

    proposed classes only means that the CDS on such indices are not

    subject to a clearing requirement, and has no other impact on the

    use of such indices by market participants.

    \41\ The term ``reference entities'' refers to those entities

    that form the basis of an index. For the indices discussed in this

    proposal, all of the reference entities are corporate entities. For

    example, when one of those corporate entities declares bankruptcy,

    it may trigger a credit event under the terms of the index. A credit

    event also may be declared when a reference entity fails to pay on

    an outstanding debt.

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

    Additionally, Markit owns and manages the iTraxx indices covering

    reference entities in the European and Asia/Pacific markets. The

    primary indices for the European markets are the iTraxx Europe which

    covers 125 European investment grade corporate reference entities, the

    iTraxx Europe Crossover covering 50 European high yield reference

    entities and the iTraxx Europe High Volatility, which is a 30-entity

    subset of the European investment grade index. These indices are

    generally denominated in euro.

    Beyond those discussed above, Markit provides more granular indices

    covering specific corporate sectors in both the United States and

    Europe. Markit also provides indices that cover non-corporate reference

    entities, including indices of sovereign reference entities from around

    the world, U.S. municipal issuers and structured finance issuers. Some

    of the sector specific CDS, particularly those based on indices in the

    iTraxx family have significant volumes. For example, the iTraxx Europe

    Senior Financials referencing European financial institutions has over

    $13 billion in net notional and 3,711 open contracts for Series 17

    according to DTCC data.\42\ Those contracts are not currently cleared

    by a DCO and thus have not been submitted to the Commission. Therefore,

    these contracts are not being considered as part of the proposed

    clearing requirement determination discussed herein. To the extent

    these contracts were to be cleared by a DCO in the future, the DCO

    would be required to submit those contracts to the Commission for

    review pursuant to Sec. 39.5. If those contracts were not cleared by

    any DCO, they may still be subject to a Commission-initiated review

    pursuant to Sec. 39.5(c) in the future.

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

    \42\ See www.dtcc.com. Data as of May 21, 2012.

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

    As administrator of these indices, Markit reviews the composition

    of underlying reference entities in the indices every six months. Once

    Markit establishes the constituents to be included within the indices,

    a new series of the respective index is created. Additionally, each

    time one of the reference entities within an index suffers a credit

    event, a new version of an existing series of the index is created. In

    addition to the series and version variations that may exist on the

    index, the parties can choose the tenor of the CDS on a given index.

    While the 5-year tenor is the most common, and therefore most liquid,

    other standard tenors may include 1-, 2-, 3-, 7-, and 10-year swaps.

    Beyond these administrative functions, Markit, in conjunction with

    ISDA, has established standardized transaction terms and legal

    documentation in the form of standard terms supplements and

    confirmations for their indices. In the vast majority of cases,

    transactions using the indices are executed using these standard terms,

    although the indices also may be used in connection with non-standard

    transactions. A particular CDS index agreement will only be eligible to

    be cleared by a DCO to the extent the agreement is based upon the

    standard terms. Consistent with the movement of the CDS market to

    standardized contracts and spreads, cleared contracts all use

    standardized spreads of 100 or 500 basis points on the cost of

    protection, with the use of the upfront payments to accurately capture

    the cost of the credit protection on the indices.\43\

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

    \43\ ISDA's Big Bang Protocol in April 2009, in addition to

    providing the ``hardwiring'' necessary for Auction Settlement and

    the establishment of the Credit Derivatives Determination

    Committees, also created a new standardized North American corporate

    CDS contract with fixed scheduled termination dates, fixed payment

    and accrual dates, and standardized coupons. See http://www.isda.org/companies/auctionhardwiring/auctionhardwiring.html.

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

    The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that

    were submitted to the Commission are standardized contracts providing

    credit protection on an untranched basis, meaning that settlement is

    not limited to a specific range of losses upon the occurrence of credit

    events among the reference entities included within an index. Besides

    single name CDS, these untranched CDS on indices are the only type of

    CDS being cleared by these DCOs. Other swaps like credit index

    tranches, options, and first- or Nth-to-default baskets on these

    indices are not currently cleared.

    Both CME and ICE Clear Credit have submitted standard untranched

    CDS on the CDX.NA.IG and the CDX.NA.HY indices that they clear. CME

    offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for each

    series going back to Series 9 for those contracts that have not reached

    their termination date. For the North American high yield index, CME

    offers clearing for Series 11 and each subsequent series at the 5-year

    tenure.

    ICE Clear Credit offers CDX.NA.IG Series 8 and all subsequent

    series of that index that are still outstanding at the 5- and 10-year

    tenors. Additionally, Series 8 to Series 10 are cleared at the 7-year

    tenor. For the high yield index, ICE Clear Credit clears all series

    from the current series through the CDX.NA.HY Series 9 at the 5-year

    tenor.

    [[Page 47176]]

    In addition to these indices, ICE Clear Credit has also cleared the

    CDX North American Investment Grade High Volatility (consisting 30

    names from the CDX.NA.IG) (CDX.NA.IG.HVOL). ICE Clear Credit is not

    however clearing Series 18, the most recently established series of the

    CDX.NA.IG.HVOL or Series 17, given the limited trading volumes for this

    swap. ICE Clear Credit only clears the CDX.NA.IG.HVOL for Series 9

    through Series 16, and only at the 5-year tenor.

    ICE Clear Europe, another registered DCO, made a submission

    covering the index CDS that it clears. Similar to the other

    submissions, the contracts that ICE Clear Europe clears are focused on

    corporate reference entities, though in this case, the entities are

    based in Europe. Also, similar to the CME and ICE Clear Credit

    submissions, the swaps cleared by ICE Clear Europe are indices owned

    and administered by Markit. ICE Clear Europe clears the euro-

    denominated contracts referencing the iTraxx Europe, the iTraxx Europe

    Crossover, and the iTraxx Europe High Volatility. For the iTraxx Europe

    and Crossover, ICE Clear Europe clears outstanding contracts in the

    Series 7 and 8, respectively, through the current series. For the High

    Volatility index, ICE Clear Europe clears outstanding contracts in the

    Series 9 through the current series. In terms of tenors, ICE Clear

    Europe clears the 5-year tenor for all swaps, as well as the 10-year

    tenor for the iTraxx Europe index.

    Based upon those portions of the CME, ICE Clear Credit, and ICE

    Clear Europe swap submissions relating to the cleared CDS contracts

    discussed above, as well as the analysis conducted by the Commission

    pursuant to Sec. 39.5(b) and set forth below, the Commission is

    reviewing the following classes of swaps for purposes of the clearing

    requirement.

    iii. CDS Trading and Risk Management

    The indices were created in the mid-2000s. Parties to these OTC

    contracts could use the indices to express their bullish or bearish

    sentiments on credit as an asset class, or to actively manage their

    credit exposures.\44\ As standardized contracts and indices, they had

    increased liquidity and were cheaper and easier to enter into than a

    customized transaction. Following the financial crisis, the popularity

    of such bespoke transactions like synthetic collateral debt obligations

    decreased and the standardized indices continued to grow.

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

    \44\ Generally the market for all CDS is driven by dealers.

    Recent estimates found that about 74% of CDS trading takes place

    among 20 dealer-banks worldwide, according to data from DTCC., which

    runs a central registry for credit derivatives. See http://www.bloomberg.com/news/2011-11-01/selling-more-insurance-on-shaky-european-debt-raises-risk-for-u-s-banks.html.

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

    Markit licenses its indices to market making financial

    institutions. Notwithstanding that these contracts trade as OTC

    products, the standardization of the contracts has allowed for them to

    be completed and confirmed electronically by a number of service

    providers. The 5-year tenor is the most liquid of the tenors.

    Similarly, the current ``on-the-run'' series tend to see the most

    liquidity, while the older ``off-the-run'' series tend to see less

    liquidity.\45\ Many investors exit positions in an existing series when

    a new series ``rolls,'' explaining increased liquidity in the ``on-the-

    run'' series. As noted above, the pricing for the contract is generally

    set at a standardized rate of 100 or 500 basis points, with upfront

    payments exchanged to compensate for the actual price of the credit

    protection being provided.

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

    \45\ The term ``on-the-run'' refers to current series of an

    index, while older series are referred to ``off-the-run.'' Each six

    months when a new series is created (or ``rolls'' using market

    terminology), the new series is considered the ``on-the-run'' index,

    and all others are considered ``off-the-run.''

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

    For the DCOs clearing these swaps, the key factors in managing the

    risk of CDS portfolios that they clear are changes in the price of the

    swaps, the idiosyncratic risk related to the default of a reference

    entity, and the liquidity risk associated with unwinding a portfolio of

    a defaulting clearing member. While differing in the specific margin

    methodologies, each of the DCOs uses methodologies designed to capture

    99% of potential portfolio losses over a five-day period. The DCOs will

    stress CDS portfolios with shifts both up and down in the price of the

    CDS, as well as with changes to the slope of the term structure of the

    CDS pricing curve. Idiosyncratic risk will be captured by a ``jump-to-

    default'' analysis in which widely held reference entities are assumed

    to default with limited or no recovery. Liquidity risk seeks to capture

    the cost of liquidating a portfolio, with assumed higher costs

    associated with concentrated portfolios.

    The DCOs conduct end-of-day settlement on the CDS, using prices

    submitted by clearing members that hold a cleared position in that

    swap. According to DCO rules, the submitted prices may be traded

    against, such that members are incentivized to submit accurate pricing

    data. The DCOs analyze the submitted data to remove any outliers.\46\

    The DCOs then calculate a composite spread or price by aggregating all

    the prices individually submitted, after deleting the outliers.\47\ The

    more liquid a particular swap, the more price submissions will be made.

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

    \46\ Clearing rules generally provide for a mechanism for DCOs

    to levy fines against clearing members for failure to submit

    accurate prices across the full term structure for a given product.

    \47\ The theoretical spread/price of the index may be calculated

    by looking at the spread/price of each of the individual

    constituents in the index, though this may not account for the

    actual demand to buy or sell protection based on the index itself.

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

    In the event of a default of a clearing member, the DCOs have the

    ability to conduct an auction for other members to bid on all or a

    portion of the defaulting member's portfolio of CDS positions. To the

    extent that the DCO was unable to sell the entire portfolio, the

    clearing rules require the non-defaulting clearing members to accept an

    apportionment of such portfolio if required by the DCO. To the extent

    the market for a swap is more liquid, the chances for a successful

    auction would likely be increased. Further, to the extent an auction is

    unsuccessful, a more liquid market would give the clearing member

    receiving such an apportionment a better opportunity to successfully

    sell or otherwise offset the risk associated with the CDS it accepted.

    In addition to the CDS indices, ICE Clear Credit and ICE Clear

    Europe also offer single name CDS \48\ for clearing. Of the $29

    trillion in CDS notional outstanding, approximately $17 trillion is in

    single name swaps according to the latest market survey of BIS.\49\ As

    part of their margining methodology, DCOs are seeking approval to offer

    portfolio margining for the single name CDS and the CDS indices held

    within a given portfolio.\50\ Given that the single name reference

    entities will likely also be constituents of a given index within a

    portfolio, the Commission generally believes that such portfolio

    margining initiatives are consistent with the sound risk management

    policies for DCOs that are required under Sec. 39.13(g)(4). Moreover,

    DCOs such as ICE Clear Credit already use margining methodologies that

    provide for appropriate portfolio margining treatment with regard to

    clearing

    [[Page 47177]]

    members' proprietary positions.\51\ The Commission is committed to

    working toward establishing similar portfolio margining programs for

    DCOs clearing customer positions in CDS indices and single name CDS.

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

    \48\ Such single name CDS are defined as ``security-based

    swaps'' under section 721(a) of the Dodd-Frank Act.

    \49\ See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.

    \50\ See ICE Clear Credit's petitions to the Commission and SEC,

    dated October 4, 2011. The petition to the Commission is available

    at http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/iceclearcredit100411public.pdf.

    \51\ See ICE Clear Credit's certification to the Commission,

    dated as of November 25, 2011. The certification is available at

    http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul112511icecc001.pdf.

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

    iv. CDS Classes Based on Key Specifications

    Under Sec. 39.5, the decision of the Commission to require that a

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

    informed by a number of factors. As an initial matter, the Commission

    looks to the submissions of the DCO themselves with regard to the swaps

    they submit. After analyzing the key attributes of the swaps submitted,

    the Commission is proposing to establish two classes of CDS subject to

    the clearing requirement. The first class is based on the North

    American untranched indices and the second class is based on the

    European untranched indices.

    Given the different markets that the CDS indices cover, the

    different currencies and other logistical differences in how the CDS

    markets and documentation work, the Commission believes this is an

    appropriate basis for separate classes. In the case of the submissions

    received to date, the U.S. dollar-denominated CDS covering North

    America corporate credits would be a separate class of CDS from a euro-

    denominated CDS referencing European obligations.

    The nature of the underlying reference entities for the CDS serve

    to establish the another specification. Each index referenced was a

    broad-based pool of corporate entities. These indices included both

    investment grade and high yield corporate entities and they were not

    limited by a specific sector type. The data available for corporate CDS

    transactions, including the CDS indices, is substantial. As new swaps

    are cleared and considered by class, the nature of the underlying index

    will continue to be a factor in the establishment of such classes.

    As noted above, the regional differences in the way CDS indices are

    traded and cleared warrant a separate specification based upon common

    market standards established within the regions. Beyond different

    currencies, the key terms of the underlying CDS, including the relevant

    credit events, may differ with direct impact on the clearing and risk

    management of these products by DCOs.

    The actual indices included within a class are also specified. As

    only certain indices for a type of reference entity may have

    significant trading volumes and be cleared within a particular region,

    it is necessary to identify those specific indices within the classes.

    The classes are also being defined by particular tenors for the

    various indices included within the class. Given varying outstanding

    notional amounts and trading volumes on different tenors of existing

    indices, the Commission has analyzed the impact of including all or

    only select tenors within a given class. In addition, applicable series

    are identified within each tenor so that market participants can

    identify whether a particular series of given index is required to be

    cleared.

    Finally, the nature of the CDS itself referencing the underlying

    indices will be a factor as well. Each of the submissions dealt only

    with untranched CDS on the indices. There is a significant market for

    tranched swaps using the indices, where parties to the CDS contract

    agree to address only a certain range of losses along the entire loss

    distribution curve. Other swaps such as first or ``Nth'' to default

    baskets, and options, also exist on the indices.

    v. Identification of Specifications

    The Commission is proposing two classes of CDS contracts subject to

    the clearing requirement. The first class would be untranched CDS

    contracts referencing corporate entities in North America via Markit's

    CDX.NA.IG and CDX.NA.HY indices. The second class would include

    untranched CDS referencing European corporate entities via Markit's

    iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High

    Volatility. The following table sets forth the specific specifications

    of each class:

    Table 1

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

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

    North American Untranched CDS Indices Class

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

    Specification

    1. Reference Entities............. Corporate.

    2. Region......................... North America.

    3. Indices........................ CDX.NA.IG.

    CDX.NA.HY.

    4. Tenor.......................... CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.

    CDX.NA.HY: 5Y.

    5. Applicable Series.............. CDX.NA.IG 3Y: Series 15 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.IG 5Y: Series 11 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.IG 7Y: Series 8 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.IG 10Y: Series 8 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.HY 5Y: Series 11 and all

    subsequent Series, up to and

    including the current Series.

    6. Tranched....................... No.

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

    European Untranched CDS Indices Class

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

    Specification

    1. Reference Entities............. Corporate.

    2. Region......................... Europe.

    3. Indices........................ iTraxx Europe.

    iTraxx Europe Crossover.

    iTraxx Europe HiVol.

    4. Tenor.......................... iTraxx Europe: 5Y, 10Y.

    iTraxx Europe Crossover: 5Y.

    iTraxx Europe HiVol: 5Y.

    5. Applicable Series.............. iTraxx Europe 5Y: Series 10 and all

    subsequent Series, up to and

    including the current Series.

    [[Page 47178]]

    iTraxx Europe 10Y: Series 7 and all

    subsequent Series, up to and

    including the current Series.

    iTraxx Europe Crossover 5Y: Series

    10 and all subsequent Series, up to

    and including the current Series.

    iTraxx Europe HiVol 5Y: Series 10

    and all subsequent Series, up to

    and including the current Series.

    6. Tranched....................... No.

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

    The Commission is proposing to separate the classes of corporate

    swaps between the North American contracts and European contracts. The

    Commission believes that indices based on other types of entities would

    be viewed as a separate class and would be subject to a separate

    determination by the Commission. For example, given the differences

    that exist with regard to volumes and risk management of indices based

    on sovereign issuers, it is likely that such CDS would represent their

    own class of swaps. Similarly, to the extent indices from other regions

    were submitted by a DCO, it is likely that the Commission would take

    the view that they are part of their own class of swaps as well.

    The Commission believes it appropriate to define the classes of

    swaps as untranched CDS contracts referencing the broad-based corporate

    indices of Markit. These corporate indices have the most net notional

    outstanding, the most trading volumes, and the best available pricing.

    The risk management frameworks for the corporate index swaps are the

    most well-established, and have the most available data in terms of CDS

    spreads and corporate default studies for analysis of the underlying

    constituents of the indices. Agreements based on these indices also are

    widely accepted and use standardized terms.\52\

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

    \52\ To the extent other vendors successfully develop similar

    indices, the Commission would conduct the analysis required by Sec.

    39.5, either on its own initiative or based on a DCO submission. If

    based on that analysis the Commission issued a clearing requirement

    determination, it is likely that such indices would be considered to

    be part of an existing class of CDS that are required to be cleared.

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

    Both of the CDS classes presented herein assume that the relevant

    CDS agreement will use the standardized terms established by Markit/

    ISDA with regard to the specific index and be denominated in a currency

    that is accepted for clearing by DCOs. To the extent that a CDS

    agreement on an index listed within the classification is not accepted

    for clearing by any DCO because it uses non-standard terms or is

    denominated in a currency that makes it ineligible for clearing, that

    CDS would not be subject to the requirement that it be cleared,

    notwithstanding that the CDS is based on such index.

    With regard to the specific indices, the Commission has not

    included the CDX.NA.IG.HVOL within the North American swap class. While

    older series of this swap were cleared at the 5-year tenor by ICE Clear

    Credit, neither of the two most recent series has been cleared, given

    the lack of trading volume in this swap. The swap is not offered for

    clearing by CME. To the extent that any DCO decides to clear future

    series of this particular indice, it would need to be submitted

    pursuant to Sec. 39.5, at which time, the Commission would be able to

    revisit the profile of the underlying index and determine whether swap

    contracts associated with this index should be subject to a clearing

    requirement.

    ICE Clear Europe continues to clear the iTraxx Europe High

    Volatility through the current series at the 5-year tenor,

    notwithstanding declines in the volume for the recent series. Overall,

    the outstanding notional amounts and trading volumes are substantially

    less than those of the other iTraxx swaps. Recent DTCC data indicates

    that the gross notional amounts on contracts on the iTraxx Europe High

    Volatility index was $1.8 billion, representing less than 1% of those

    volumes for the European investment grade index and approximately 2.5%

    of the European high yield index for the same series.\53\

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

    \53\ See www.dtcc.com. Data as of May 21, 2012.

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

    Notwithstanding the relatively small volumes, the Commission is

    proposing to include the iTraxx Europe High Volatility index within the

    class of European corporate indices subject to required clearing at

    this time. Because the current on-the-run series of this particular

    index is cleared, unlike the similar North American contract, the

    Commission believes the contract should be included within the class of

    European corporate swaps that is required to be cleared.

    With regard to tenors, Markit, as administrator of the indices,

    publishes the initial spreads on the roll for each of the tenors

    offered for a given indice. For the CDX.NA.IG, it publishes spreads for

    the 1-, 2-, 3-, 5-, 7-, and 10-year tenors. For the CDX.NA.HY, the

    spreads are set for the 3-, 5-, 7-, and 10-year tenors. For the iTraxx

    Europe, Crossover and High Volatility, spreads are similarly set for

    the 3-, 5-, 7-, and 10-year tenors.

    Notwithstanding these various tenor offerings, the 5-year tenor for

    all indices is by far the most liquid tenor in the CDS marketplace. As

    a result, each DCO clears the 5-year tenor of the CDS index swaps that

    they clear. CME additionally offers clearing for 3-, 7-, and 10-year

    tenors on the CDX.NA.IG. ICE Clear Credit offers clearing on the 10-

    year tenor for the North American investment grade swap in addition to

    the 5-year contract. In the past, ICE Clear Credit has cleared the 7-

    year tenor of that index, but has not offered that tenor since Series

    10. For the iTraxx indices, ICE Clear Europe offers the 10-year tenor

    on the investment grade index, in addition to the 5-year tenor.

    Based upon its analysis of the Sec. 39.5 factors, the Commission

    is proposing that each of the 3-, 5-, 7-, and 10-year tenors be

    included within the class of swaps subject to the clearing requirement

    determination for CDX.NA.IG. While the DCO submissions indicate varying

    degrees of trading volumes among the indices at tenors other than the

    5-year tenor, there are clearly large notional volumes and trading

    activity across the products as a whole. The risk management frameworks

    and methodologies employed by the DCOs should not be substantially

    impacted or can be adjusted to accommodate additional tenors. The

    remaining factors should be unchanged.

    The Commission is proposing to exclude the 1- and 2-year tenors of

    the CDX.NA.IG from the class at this point. The Commission would like

    to see more data on the volumes of these tenors. Importantly, these

    tenors of swaps have not been submitted to the Commission by a DCO, so

    the Commission could review them when submitted by a DCO or on its own

    initiative pursuant to the Sec. 39.5(c). Because many investors use

    the 5-year tenor to take a view on credit as an asset class, and then

    exit the position when the new index rolls rather than hold a less

    liquid position in an off-the-run swap, the Commission is concerned

    that those seeking to avoid clearing may shift to the 1- or 2-year

    tenor to take a position on credit. The Commission will monitor volumes

    in the swaps at these tenors and evaluate

    [[Page 47179]]

    whether a change in the class of swaps to include these tenors is

    warranted.

    With regard to the CDX.NA.HY, the Commission's proposal will be

    limited to the 5-year tenor, the predominant tenor in this

    contract.\54\ Similarly, the Commission's proposal with regard to the

    iTraxx indices will capture only those tenors that are currently

    offered for clearing--the 5- and 10-year tenors for the iTraxx Europe,

    and the 5-year tenors for the iTraxx Crossover and the iTraxx High

    Volatility.

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

    \54\ After its initial submission, ICE Clear Credit added the

    CDX.NA.HY, Series 15, 3-year contract to its list of CDS contracts

    eligible for clearing. The Commission has reviewed this contract,

    but is not including this particular contract within its proposed

    determination. The Commission will monitor volumes in the product at

    these tenors and evaluate whether a change in the class of swaps to

    include additional tenors is warranted.

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

    The Commission's proposed clearing determination will be limited to

    only those series of a given index, which are currently being cleared.

    Therefore, no swaps referencing a series prior to Series 8 for the

    CDX.NA.IG and CDX.NA.HY would be required to be cleared. For the iTraxx

    Europe and iTraxx Europe Crossover, no contracts referencing a series

    prior to Series 7 would be required to be cleared, and in the case of

    the iTraxx Europe High Volatility, no series prior to Series 9 would be

    required to be cleared.\55\

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

    \55\ As discussed in further detail below, the clearing

    requirement would not require existing swaps in the older series to

    be cleared. The requirement is prospective, only requiring newly

    executed swaps in these older series to be cleared.

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

    Further, to the extent that any contract is of a tenor such that it

    is scheduled to terminate prior to July 1, 2013, such contract would

    not be part of this proposed clearing determination. Given the

    implementation periods provided for under Sec. 50.25, discussed below

    in Section IV, the Commission does not want to create a situation where

    certain market participants would be required to clear a contract based

    upon their status under the implementation provisions, but other

    parties would never be required to clear that same contract before its

    scheduled termination.

    The Commission also is proposing that the classes be limited to

    untranched CDS agreements on the aforementioned indices where the

    contract covers the entire index loss distribution of the index and

    settlement is not linked to a specified number of defaults. Tranched

    swaps, first- or ``Nth'' to-default, options, or any other product

    variations on these indices are excluded from these classes. These

    other swaps based on the indices, such as tranches, have very different

    profiles in terms of the Sec. 39.5 analysis. Besides very different

    notional and trading volumes, the risk management processes and

    operations may be significantly different. The Commission believes it

    appropriate to consider tranched swaps and other variations on the

    indices as outside of the classes of swaps proposed herein. Such swaps,

    if submitted, likely would be viewed as a separate class.

    D. Proposed Determinations Analysis for Credit Default Swaps

    Section 2(h)(2)(D)(i) of the CEA requires the Commission to review

    whether a swap submission under section 2(h)(2)(B) is consistent with

    section 5b(c)(2) of the CEA. Section 2(h)(2)(D)(ii) of the CEA also

    requires the Commission to consider five factors in a determination

    based on a Commission initiated review or a swap submission: (1) The

    existence of significant outstanding notional exposures, trading

    liquidity, and adequate pricing data; (2) the availability of rule

    framework, capacity, operational expertise and resources, and credit

    support infrastructure to clear the contract on terms that are

    consistent with the material terms and trading conventions on which the

    contract is then traded; (3) the effect on the mitigation of systemic

    risk, taking into account the size of the market for such contract and

    the resources of the DCO available to clear the contract; (4) the

    effect on competition, including appropriate fees and charges applied

    to clearing; and (5) the existence of reasonable legal certainty in the

    event of the insolvency of the relevant DCO or one or more of its

    clearing members with regard to the treatment of customer and swap

    counterparty positions, funds, and property.

    i. Consistency With Core Principles for Derivatives Clearing

    Organizations

    Section 2(h)(2)(D)(i) of the CEA requires the Commission to review

    whether a submission is consistent with the core principles for DCOs.

    Each of the DCO submissions relating to CDS provided data to support

    the Commission's analysis of the five factors under section 2(h)(2)(D)

    of the CEA. The Commission also was able to call upon independent

    analysis conducted with regard to CDS market, as well as its knowledge

    and reviews of the registered DCOs' operations and risk management

    processes, covering items such as product selection criteria, pricing

    sources, participant eligibility, and other relevant rules. The

    discussion of all of these factors is set forth below.

    The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe

    pursuant to Sec. 39.5(b) are currently being cleared by those

    organizations. As discussed above, the risk management, rules, and

    operations used by each DCO to clear these swaps are subject to review

    by the Commission risk management, legal, and examinations staff on an

    on-going basis.

    Additionally, each of the DCOs has established procedures for the

    review of any new swaps offered for clearing. Before the indices

    referenced herein were accepted for clearing by any of the DCOs, they

    were subject to review by the risk management functions of those

    organizations. Such analysis generally focuses on the ability to risk

    manage positions in the potential swaps and on any specific operational

    issues that may arise from the clearing of such swaps. In the case of

    the former, this involves ensuring that adequate pricing data is

    available, both historically and on a ``going forward'' basis, such

    that a margining methodology could be established, back-tested, and

    used on an on-going basis. Operational issues may include analysis of

    additional contract terms for new swaps that may require different

    settlement procedures. Each of the contracts submitted by CME, ICE

    Clear Credit, and ICE Clear Europe and discussed herein has undergone

    an internal review process by the respective DCO and has been

    determined to be within their product eligibility standards.

    As part of their rule frameworks, each of the DCOs also maintains

    participant eligibility requirements. On April 20, 2012, CME filed its

    amended rule concerning CDS Clearing Member Obligations and

    Qualifications (Rule 8H04). Pursuant to the amended rule, published to

    comply with Commission Regulation 39.12(a)(2), a CDS clearing member

    would have to maintain at least $50 million of capital. The amended

    rule would also require a CDS clearing member's minimum capital

    requirement to be ``scalable'' to the risks it poses. Further, CME

    already has client clearing available for its CDS index contracts.

    Similarly, on March 23, 2012, ICE Clear Credit filed its amended

    Rule 201(b) to incorporate the $50 million minimum capital requirement

    for clearing members. ICE Clear Credit also has client clearing

    available for its CDX index contracts.

    ICE Clear Europe has adopted similar rules to comply with Sec.

    39.12(a)(2), and has instituted changes to its rules to permit client

    clearing of its iTraxx contracts.

    In their submissions, CME and ICE Clear Credit enclosed their risk

    management procedures. In its submission, ICE Clear Europe references

    [[Page 47180]]

    its risk management procedures, which it had previously submitted to

    the Commission in connection with its application to register as a DCO.

    As part of its risk management and examination functions, the

    Commission reviews each DCO's risk management procedures, including its

    margining methodologies.

    ICE Clear Credit uses a multi-factor model to margin the indices

    discussed herein, as well as single name CDS. The margining methodology

    is designed to capture the risk of movements in credit spreads,

    liquidation costs, jump-to-default risk for those names on which credit

    protection has been sold, large position concentration risks, interest

    rate sensitivity, and basis risk associated with offsetting index

    derived single names and opposite ``outright'' single names. These

    factors are similarly used by ICE Clear Europe to calculate the

    margining requirements for their iTraxx swap listings and the

    underlying single name constituents. The CME's CDS model also weighs a

    number of factors to calculate the initial margin for a portfolio of

    CDS positions. These include macro-economic risk factors, such as

    movements associated with systematic risk resulting in large shifts in

    credit spreads across a portfolio, shifts in credit spreads based on

    tenors and changes in relative spreads between investment grade and

    high yield spreads. Additional factors include specific sector risks,

    the idiosyncratic risk of extreme moves in particular reference

    entities and the liquidity risk associated with unwinding the

    portfolio. In all cases, the methodologies are designed to protect

    against any 5-day move in the value of the given CDS portfolio, with a

    99% confidence level.

    In addition to initial margin, each of the clearinghouses collects

    variation margin on a daily basis to capture changes in the mark-to-

    market value of the positions. To do this, the clearinghouses calculate

    end-of-day settlement prices using clearing member price submissions

    for cleared swaps. Each of the clearinghouses maintains processes for

    ensuring the quality of member price submissions, including the ability

    to compel trades at quoted prices on a random basis and to enforce

    fines on incomplete or incorrect submissions. ICE Clear Credit and ICE

    Clear Europe also use Markit services for CDX and iTraxx submissions.

    CME uses other third party data providers for pricing support as

    necessary on its cleared CDS products.

    In addition to the end-of-day settlement, each of the

    clearinghouses monitors positions throughout the day and maintains the

    ability to require margin on an intraday basis. Triggers may be set

    based upon the erosion of margin to a specific level or a call may be

    made at the discretion of the clearinghouse. When necessary, DCOs apply

    concentration charges to a clearing member's house or customer account

    in order to address situations where the DCO believes a given position

    may be under-collateralized because the size of the position relative

    to the size of the market may increase the cost of liquidating the

    position.

    In addition to the initial margin and variation margin collected by

    each DCO, each of the clearinghouses maintains a separate guaranty fund

    for its CDS clearing business. Using a combination of factors from

    their margining methodologies, positions are stressed to replicate

    extreme but plausible market conditions. Using these stressed results,

    each of the clearinghouses sizes its guaranty fund to cover the

    positions of its two largest debtor clearing members. Clearing members

    are required to contribute to the guaranty fund based on their relative

    positions.

    To the extent a clearing member was unable to meet a margin call,

    or otherwise violated clearinghouse rules, each of the clearinghouses

    has the ability to find a clearing member in default. In such cases,

    each of the clearinghouses has established procedures by which it

    attempts to minimize the risk associated with a defaulting member's

    positions. A clearinghouse would activate its default committee,

    seconding traders from clearing participants, to work to partition the

    portfolio for sale and for hedging purposes. The clearinghouse would

    then conduct an auction among its clearing participants for the sale of

    the portfolio. To the extent certain positions were unsold, each of the

    clearinghouses has the ability to allocate such positions to the

    remaining clearing members.

    While other resources of the clearinghouse would be available in

    the event of a default of a clearing member, including clearinghouse

    contributions, the initial margin and guaranty fund contributions make

    up the primary financial resources of the clearinghouses. In total,

    CFTC-registered DCOs are currently holding more than $20 billion in

    aggregate in initial margin to cover cleared CDS positions.\56\

    Additionally, publicly available data shows that CME's CDS guaranty

    fund has approximately $629 million; ICE Clear Credit has a guaranty

    fund equal to $4.4 billion; and ICE Clear Europe has a guaranty fund

    [euro]2.7 billion for its CDS business.\57\ In addition to the guaranty

    fund contributions made by clearing members, each of the clearinghouses

    also makes contributions to their respective funds, ranging in amounts

    from $50 to $100 million.\58\

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

    \56\ Based on Commission data for registered DCOs as of May 10,

    2012.

    \57\ See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME's guaranty fund, as of May

    10, 2012; https://www.theice.com/clear_credit.jhtml for data on the

    size of ICE Clear Credit's guaranty fund; and https://www.theice.com/clear_europe_cds.jhtml for data on the size of ICE

    Clear Europe's guaranty fund for CDS, as of May 10, 2012.

    \58\ Many DCOs also have rules allowing for an assessment of the

    remaining clearing members in the event of a default.

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

    Based upon the Commission's on-going risk management and rule

    reviews, and its annual examinations of the DCOs, the Commission

    believes that the submissions of CME, ICE Clear Credit, and ICE Clear

    Europe are consistent with section 5b(c)(2) of the CEA and the related

    Commission regulations. In analyzing the CDS products submissions

    discussed herein, the Commission does not believe that a clearing

    determination with regard to the specified CDS products would be

    inconsistent with CME, ICE Clear Credit, or ICE Clear Europe's

    continued ability to maintain such compliance with the DCO core

    principles.

    ii. Consideration of the Five Statutory Factors for Clearing

    Requirement Determinations

    a. Outstanding Notional Exposures, Trading Liquidity, and Adequate

    Pricing Data

    Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to

    take into account the existence of outstanding notional exposures,

    trading liquidity, and adequate pricing data. As discussed earlier, the

    most recent BIS data has shown significant growth in the use of CDS on

    index products, with notional amounts growing by 40% over the most

    recent annual reporting period. Overall, CDS on index products account

    for 37% of all notional amounts of CDS contracts outstanding, with over

    $10 trillion in notional outstanding.

    The predominant provider of CDS indices is Markit. Markit has

    indices covering corporate and sovereign entities, among others, in the

    United States, Europe, and Asia. Recent Markit data shows daily

    transaction volumes of 1,561 transactions using its licensed family of

    CDX indices, and 1,266 daily transactions using its European iTraxx

    index swaps.\59\ Further, it shows a rolling monthly average of $663

    billion in gross notional amount for the CDX family of indices and

    [euro]499 billion for

    [[Page 47181]]

    the iTraxx family. Nearly all of the CDX contracts and volumes come

    from indices that would be subject to the proposed clearing requirement

    determination. For the iTraxx, more than 79% of those daily contract

    volumes and 82% of the daily gross notional volumes come from the

    iTraxx investment grade and high yield indices contemplated by the

    proposed clearing requirement determination.

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

    \59\ Based on data published on www.markit.com as of May 23,

    2012.

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

    One point highlighted by this data, however, is the declining

    trading liquidity in the off-the-run series that can occur. Of the

    volumes noted by Markit, nearly 60% was in the current on-the-run

    series, as compared to all other outstanding series combined. The

    submissions of ICE Clear Credit, ICE Clear Europe, and CME also note

    the decline in average weekly gross notional amounts and contracts for

    benchmark tenors for off-the-run indices. The decline however can be

    more precipitous among older off-the-run indices. While many market

    factors can contribute to the actual volumes for a specific off-the-run

    contract, subject to certain exceptions, the trend is generally toward

    lower volumes.

    Set forth below is a table of data taken from DTCC as of May 22,

    2012, highlighting the net notional amounts and outstanding contracts

    across all tenors available for each series in the proposed

    determination.\60\

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

    \60\ Data available at www.dtcc.com. In 2006, DTCC began

    providing warehouse services for confirmed CDS trades through its

    Trade Information Warehouse (TIW). With the commitment of global

    market participants in 2009 to ensure that all OTC derivatives

    trades are recorded by a central repository, TIW has become a global

    repository for all CDS trades. With all major market participants

    submitting their trades to the TIW, it is estimated that 98% of all

    CDS trades are included within the warehouse, making it the primary

    source of CDS transaction data.

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

    BILLING CODE 6351-01-P

    [[Page 47182]]

    [GRAPHIC] [TIFF OMITTED] TP07AU12.000

    Notwithstanding the declining volumes that occur when an index is

    no longer on-the-run, the Commission does not believe that is

    sufficient reason to exclude the older series from the classes of CDS.

    As the DTCC data indicates, there are still significant volumes of

    outstanding notional amounts in each of these series. From the

    perspective of the clearinghouse, the risk management of the older

    series of swaps should not provide significant additional challenges.

    With the significant notional and contract volumes still outstanding at

    DTCC, many clearing members already have these positions on their books

    and are meeting their risk management requirements, even in the face of

    declining trading volumes. Finally, while the volumes may decline, the

    data included in the submissions indicates that volume still does

    exist, and parties should be able trade as necessary. Additionally, as

    discussed further below, the clearing requirement would apply only to

    new swaps executed in the off-the-run indices.

    Given the contract and notional volumes listed above, there is

    adequate data available on pricing. The pricing for the CDS on these

    indices is fairly consistent across clearinghouses. The clearinghouses

    generally require a clearing member with open interest in a particular

    index to provide a price on that index for end of day settlement

    purposes. After applying a process to remove clear outliers, a

    composite price is calculated using the remaining prices. To ensure the

    integrity of the submissions, clearing members' prices may be

    ``actionable,'' meaning that they may form the basis of an actual trade

    that the member will be forced to enter. Clearinghouses also have

    compliance programs that may result in fines for clearing members that

    fail to submit accurate pricing data.

    Beyond clearing member submissions, there are a number of third-

    party vendors that provide pricing services on these swaps. Third-party

    vendors typically source their data from a broader range of dealers.

    The data includes both direct contributions as well as feeds to

    automated trading systems. This data is reviewed for outliers and

    aggregated for distribution.

    [[Page 47183]]

    b. Availability of Rule Framework, Capacity, Operational Expertise and

    Resources, and Credit Support Infrastructure

    Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to

    take into account the availability of rule framework, capacity,

    operational expertise and resources, and credit support infrastructure

    to clear the contract on terms that are consistent with the material

    terms and trading conventions on which the contract is then traded. The

    Commission preliminarily has determined that this factor is satisfied

    by each of CME, ICE Clear Credit, and ICE Clear Europe.

    CME, ICE Clear Credit, and ICE Clear Europe, respectively,

    currently are clearing the swaps each submitted under Sec. 39.5. As

    such, they have developed respective rule frameworks, capacity,

    operational expertise and resources, and credit support infrastructure

    to clear the contracts on terms that are consistent with the material

    terms and trading conventions on which the contracts currently are

    trading. The Commission believes that these are scalable and that CME,

    ICE Clear Credit, and ICE Clear Europe would be able to risk manage the

    additional swaps that might be submitted due to the clearing

    requirement determination.

    Following the financial crisis, the major market participants

    committed in 2009 to the substantial reforms to the OTC derivatives

    markets.\61\ Among the commitments from CDS dealers and buy side

    participants was to actively engage with central counterparties to

    broaden the range of cleared swaps and market participants. These

    changes were in addition to those generated through organizations like

    ISDA and their protocols impacting CDS. For broadly traded swaps like

    the CDS indices, the ultimate impact of these initiatives was

    operational platforms, rule frameworks, and other infrastructure

    initiatives that replicated the bilateral market and supported the move

    of these CDS to a centrally cleared environment. In this way, the CDS

    clearing services offered by DCOs, including CME, ICE Clear Credit, and

    ICE Clear Europe, were designed to be cleared in a manner that is

    consistent with the material terms and trading conventions of a

    bilateral, uncleared market.

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

    \61\ See the June 2, 2009 letter to The Honorable William C.

    Dudley, President of the Federal Reserve Bank of New York, available

    at http://www.newyorkfed.org/newsevents/news/markets/2009/060209letter.pdf.

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

    In addition, CME, ICE Clear Credit, and ICE Clear Europe are

    registered DCOs. To be registered as such, CME, ICE Clear Credit, and

    ICE Clear Europe have, on an on-going basis, demonstrated to the

    Commission that they are each in compliance with the core principles

    set forth in the CEA and Commission regulations, as discussed above. As

    a general matter, any DCO that does not have the rule framework,

    capacity, operational expertise and resources, and credit support

    infrastructure to clear the swaps that are subject to mandatory

    clearing is not in compliance with the core principles or the

    Commission regulations promulgating these principles.

    The Commission requests comment on all aspects of this factor,

    including whether or not commenters agree that an applicant's status as

    a registered DCO is sufficient for meeting the factor's requirements.

    c. Effect on the Mitigation of Systemic Risk

    Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to

    take into account the effect on the mitigation of systemic risk, taking

    into account the size of the market for such contract and the resources

    of the DCO available to clear the contract. The Commission agrees with

    the Sec. 39.5 swap submissions of the CME, ICE Clear Credit, and ICE

    Clear Europe that requiring certain classes of CDS to be cleared would

    reduce systemic risk in this sector of the swaps market. As CME noted,

    the 2008 financial crisis demonstrated the potential for systemic risk

    arising from the interconnectedness of OTC derivatives market

    participants and the limited transparency of bilateral, i.e. uncleared,

    counterparty relationships. According to the Quarterly Report (Third

    Quarter 2011) on Bank Trading and Derivatives Activities of the Office

    of the Comptroller of the Currency (OCC Report),\62\ CDS index products

    account for a significant percentage of the notional value of swaps

    positions held by financial institutions. According to ICE Clear

    Credit, the CDS indices it offers for clearing are among the most

    actively traded swaps with the largest pre-clearing outstanding

    positions, and ICE Clear Credit's clearing members are among the most

    active market participants. ICE Clear Credit also noted that its

    clearing members clear a significant portion of their clearing-eligible

    portfolio.

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

    \62\ Available at: http://occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq311.pdf.

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

    Clearing the CDS indices subject to this proposal will reduce

    systemic risk in the following ways: Mitigating counterparty credit

    risk because the DCO would become the buyer to every seller of CDS

    indices subject to this proposal and vice versa; providing

    counterparties with daily mark-to-market valuations and exchange of

    variation margin pursuant to a risk management framework; posting

    initial margin with the clearinghouse in order to cover potential

    future exposures in the event of a default; achieving multilateral

    netting, which substantially reduces the number and notional amount of

    outstanding bilateral positions; reducing swap counterparties'

    operational burden by consolidating collateral management and cash

    flows; and eliminating the need for novations or tear-ups because

    clearing members may offset opposing positions.

    As discussed previously, the clearinghouses collect substantial

    amounts of collateral in the form of initial margin and guaranty fund

    contributions to cover potential losses on CDS portfolios. The

    methodologies for calculating these amounts are based on covering 5-day

    price movements on a portfolio with a 99% confidence level for initial

    margin, and longer liquidation periods and higher confidence levels

    under ``extreme but plausible'' conditions in the case of guaranty fund

    requirements. Beyond these financial resources, the clearinghouses have

    in place established risk monitoring processes, system safeguards, and

    default management procedures, which are subject to testing and review,

    to address potential systemic shocks to the financial markets.

    The Commission requests comment on all aspects of this factor,

    including the risk mitigation associated with proposed clearing

    determination.

    d. Effect on Competition

    Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to

    take into account the effect on competition, including appropriate fees

    and charges applied to clearing. Of particular concern to the

    Commission is whether this proposed determination would harm

    competition by creating, enhancing, or entrenching market power in an

    affected product or service market, or facilitating the exercise of

    market power.\63\ Under U.S. Department of Justice guidelines, market

    power is viewed as the ability ``to raise price [including clearing

    fees and charges], reduce output, diminish innovation, or otherwise

    harm customers as a result of

    [[Page 47184]]

    diminished competitive constraints or incentives.'' \64\

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

    \63\ See U.S. Department of Justice and the Federal Trade

    Commission, Horizontal Merger Guidelines [hereinafter ``Horizontal

    Merger Guidelines''] at Sec. 1(Aug. 19, 2010), available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.

    \64\ Id.; see also U.S. Department of Justice (DOJ) and the

    Federal Trade Commission (FTC), Antitrust Guidelines for

    Collaborations Among Competitors at Sec. 1.2 (April 2000),

    available at http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf

    (``The central question is whether the relevant agreement likely

    harms competition by increasing the ability or incentive profitably

    to raise price above or reduce output, quality, service, or

    innovation below what likely would prevail in the absence of the

    relevant agreement'').

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

    The Commission has identified the following putative product and

    service markets as potentially affected by this proposed clearing

    determination: A DCO service market encompassing those clearinghouses

    that currently (or with relative ease in the future could) clear the

    CDS subject to this proposal, and a CDS product market or markets

    encompassing the CDS that are subject to this determination.\65\

    Without defining the precise contours of these markets at this

    time,\66\ the Commission recognizes that, depending on the interplay of

    several factors, this proposed swap determination potentially could

    impact competition within the affected markets. Of particular

    importance to whether any impact is, overall, positive or negative, is:

    (1) Whether the demand for these clearing services and swaps is

    sufficiently elastic that a small but significant increase above

    competitive levels would prove unprofitable because users of the CDS

    products and DCO clearing services would substitute other products/

    clearing services co-existing in the same market(s), and (2) the

    potential for new entry into these markets. The availability of

    substitute products/clearing services to compete with those encompassed

    by this proposed determination, and the likelihood of timely,

    sufficient new entry in the event prices do increase above competitive

    levels, each operate independently to constrain anticompetitive

    behavior.

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

    \65\ Included among these could be a separate product market for

    CDS indices licensing.

    \66\ The federal antitrust agencies, the DOJ and FTC, use the

    ``hypothetical monopolist test'' as a tool for defining antitrust

    markets for competition analysis purposes. The test ``identif[ies] a

    set of products that are reasonably interchangeable with a

    product,'' and thus deemed to reside in the same relevant antitrust

    product or service market. ``[T]he test requires that a hypothetical

    profit-maximizing firm, not subject to price regulation, that was

    the only present and future seller of those products (`hypothetical

    monopolist') likely would impose at least a small but significant

    and non-transitory increase in price (`SSNIP') on at least one

    product in the market.'' In most cases, a SSNIP of five percent is

    posited. If consumers would respond to the hypothesized SSNIP by

    substituting alternatives to a significant degree to render it

    unprofitable, those alternative products/services are included

    within the relevant market. This methodological exercise is repeated

    until it has been determined that consumers have no further

    interchangeable products/services available to them. Horizontal

    Merger Guidelines at Sec. 4.1.

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

    Any competitive import would likely stem from the fact that

    proposed determination would (1) remove the alternative of not clearing

    the CDS subject to this proposal, and/or (2) single out Markit indices

    and certain tenors for determination. The proposed determination would

    not specify what CDS products (or products that compete with the

    proposed CDS classes) may or may not be offered, traded, or voluntarily

    cleared; or who may or may not compete to provide clearing services for

    the CDS subject to this proposal (as well as those not required to be

    cleared). With respect to the first potential area of competitive

    import, to the extent that parties to the CDS subject to this proposal

    consider clearing the transactions reasonably interchangeable with not

    clearing them, the proposed determination would eliminate at least one

    competitive substitute within the clearinghouse services market for the

    CDS subject to this proposal. Given the risk-mitigation purpose and

    benefit of migration to voluntary CDS clearing, however, the Commission

    sees some basis to doubt that, under the ``hypothetical monopolist''

    methodology,\67\ counterparties to cleared swaps would consider the

    alternative of not clearing CDS under this proposal as a reasonable

    substitute to a degree sufficient that they should be viewed as

    populating the same relevant market.\68\ And, if the alternative of not

    clearing the proposed classes of CDS falls outside of the relevant

    services market that includes clearing, the proposed clearing

    determination should not impact competition in the clearing services

    market. The Commission requests comment on the extent to which

    foregoing clearing is considered reasonably interchangeable with

    clearing the CDS subject to this proposal and, in particular, if

    parties transacting cleared swaps in these classes would forego

    clearing if clearinghouses raised the price of clearing five percent.

    The Commission also requests comment on whether a different percentage

    than five percent should be used.

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

    \67\ See id.

    \68\ In other words, the Commission questions that, faced with a

    five percent non-transitory increase in the price of clearing the

    identified CDS classes, including fees and other charges, that the

    parties to these CDS transactions would forego clearing in

    sufficient volume to render the price increase unprofitable.

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

    Moreover, even if cleared and non-cleared transactions in the

    proposed CDS clearing requirement are now within the same relevant

    market, removing the uncleared option through this proposed rulemaking

    is not determinative of negative competitive impact. Other factors--

    including the availability of other substitutes within the market or

    potential for new entry into the market--may constrain market power.

    The Commission recognizes that currently no DCO clears CDS indices

    licensed by any other provider than Markit, suggesting the possibility

    that currently the clearing service market may be limited to the three

    providers (CME, ICE Clear Credit, and ICE Clear Europe) now clearing

    CDS indices licensed by Markit. This could be indicative, but is not

    dispositive, of whether a concentrated clearing services market

    susceptible to exercises of market power exists. The possibility

    remains that uncleared transactions on other indices, as well as

    cleared and uncleared transactions on Markit indices of tenors not

    included within the proposed determination, may also populate the

    affected clearing services market to constrain CME, ICE Clear Credit,

    and ICE Clear Europe from exercising market power.\69\ The Commission

    requests comment on the extent to which uncleared transactions on non-

    Markit indices, and cleared and uncleared transactions on Markit

    indices of tenors not included within the proposed determination, are

    considered reasonably interchangeable with clearing the CDS subject to

    this proposal; and, in particular, if parties transacting cleared CDS

    subject to this proposal would substitute uncleared transactions on

    non-Markit indices and/or transactions on Markit CDS tenors not subject

    to this proposal if clearinghouses raised the price of clearing the CDS

    required to be cleared five percent.

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

    \69\ Stated another way, competitive or potentially competitive

    CDS indices other than Markit, or for Markit CDS tenors other than

    those subject to this proposal, may offer a reasonably

    interchangeable substitute for cleared transactions in the proposed

    classes proposed, particularly if the price of clearing the required

    classes increased five percent.

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

    Additionally, the potential for new entry may constrain market

    power in an otherwise concentrated clearing services market. The

    Commission does not foresee that the proposed determination constructs

    barriers that would deter or impede new entry into a clearing services

    market.\70\ Indeed, there is some

    [[Page 47185]]

    basis to expect that the determination could foster an environment

    conducive to new entry. For example, the proposed clearing

    determinations, and the prospect that more may follow, is likely to

    reinforce, if not encourage, growth in demand for clearing services.

    Demand growth, in turn, can enhance the sales opportunity, a condition

    hospitable to new entry.\71\ Further, this proposed determination may

    increase the incentive of competing indices providers (for illustration

    purposes, Standard & Poor's) to support a new clearing services entrant

    through some form of partnership or other sponsorship effort. The

    Commission requests comment on the extent to which (1) entry barriers

    currently do or do not exist with respect to a clearing services market

    for the identified CDS classes; (2) the proposed determinations may

    lessen or increase these barriers; and (3) the proposed determinations

    otherwise may encourage, discourage, facilitate, and/or dampen new

    entry into the market.

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

    \70\ That said, the Commission recognizes that (1) to the extent

    the clearing services market for the CDS subject to this proposal,

    after foreclosing uncleared swaps, would be limited to a

    concentrated few participants with highly aligned incentives, and

    (2) the clearing services market is insulated from new competitive

    entry through barriers--e.g., high sunk capital cost requirements;

    high switching costs to transition from embedded, incumbents; and

    access restrictions, the proposed determination could have a

    negative competitive impact by increasing market concentration.

    \71\ See, e.g., Horizontal Merger Guidelines at Sec. 9.2 (entry

    likely if it would be profitable which is in part a function of

    ``the output level the entrant is likely to obtain'').

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

    Also, while the proposed rule does single out Markit indices and

    certain CDS tenors for required clearing, for reasons similar to those

    discussed above, this does not foreclose competition from CDS on other

    indices or tenors, and may in fact encourage it. For example, the

    Commission anticipates that an attempt by Markit to increase indices

    licensing fees would present a competitive opportunity for current and

    potential future indices providers to capture market share and/or

    entrants to leverage from market entry. The Commission requests comment

    on the extent to which competition in identified Markit CDS product

    markets may be impacted, including any expected impact on the price of

    Markit indices licenses, cost of swaps in the required classes, and

    entry conditions.

    In addition to what is noted above, the Commission requests

    comment, and quantifiable data, on whether the required clearing of any

    or all of these swaps will create conditions that create, increase, or

    facilitate an exercise of (1) clearing services market power in CME,

    ICE Clear Credit, ICE Clear Europe, and/or any other clearing service

    market participant, including conditions that would dampen competition

    for clearing services and/or increase the cost of clearing services,

    and/or (2) market power in any product markets for Markit indices and

    CDS tenors, including conditions that would dampen competition for

    these product markets and/or increase the cost of CDS involving the

    proposed clearing requirement. The Commission seeks comment, and

    quantifiable data, on the likely cost increases associated with

    clearing, particularly those fees and charges imposed by DCOs, and the

    effects of such increases on counterparties currently participating in

    the market. The Commission also seeks comment regarding the effect of

    competition on risk management by DCOs. The Commission welcomes comment

    on any other aspect of this factor.

    e. Legal Certainty in the Event of the Insolvency

    Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to

    take into account the existence of reasonable legal certainty in the

    event of the insolvency of the relevant DCO or one or more of its

    clearing members with regard to the treatment of customer and swap

    counterparty positions, funds, and property. The Commission is

    proposing this clearing requirement based on its view that there is

    reasonable legal certainty with regard to the treatment of customer and

    swap counterparty positions, funds, and property in connection with

    cleared swaps, namely the CDS indices subject to this proposal, in the

    event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or

    ICE Clear Europe) or one or more of the DCO's clearing members.

    The Commission concludes that, in the case of a clearing member

    insolvency at CME or ICE Clear Credit, subchapter IV of Chapter 7 of

    the U.S. Bankruptcy Code (11 U.S.C. 761-767) and Part 190 of the

    Commission's regulations would govern the treatment of customer

    positions.\72\ Pursuant to section 4d(f) of the CEA, a clearing member

    accepting funds from a customer to margin a cleared swap, must be a

    registered FCM. Pursuant to 11 U.S.C. 761-767 and Part 190 of the

    Commission's regulations, the customer's CDS positions, carried by the

    insolvent FCM, would be deemed ``commodity contracts.'' \73\ As a

    result, neither a clearing member's bankruptcy nor any order of a

    bankruptcy court could prevent either CME or ICE Clear Credit from

    closing out/liquidating such positions. However, customers of clearing

    members would have priority over all other claimants with respect to

    customer funds that had been held by the defaulting clearing member to

    margin swaps, such as the customers' positions in CDS indices subject

    to this proposal.\74\ Thus, customer claims would have priority over

    proprietary claims and general creditor claims. Customer funds would be

    distributed to swaps customers, including CDS customers, in accordance

    with Commission regulations and section 766(h) of the Bankruptcy Code.

    Moreover, the Bankruptcy Code and the Commission's rules thereunder (in

    particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of

    customer positions and collateral to solvent clearing members.

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

    \72\ The Commission observes that an FCM or DCO also may be

    subject to resolution under Title II of the Dodd-Frank Act to the

    extent it would qualify as covered financial company (as defined in

    section 201(a)(8) of the Dodd-Frank Act).

    \73\ If an FCM is also registered as a broker-dealer, certain

    issues related to its insolvency proceeding would also be governed

    by the Securities Investor Protection Act.

    \74\ Claims seeking payment for the administration of customer

    property would share this priority.

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

    Similarly, 11 U.S.C. 761-767 and Part 190 would govern the

    bankruptcy of a DCO, in conjunction with DCO rules providing for the

    termination of outstanding contracts and/or return of remaining

    clearing member and customer property to clearing members.

    With regard to ICE Clear Europe, the Commission understands that

    the default of a clearing member of ICE Clear Europe would be governed

    by the rules of that DCO. ICE Clear Europe, a DCO based in the United

    Kingdom, has represented that under English law its rules would

    supersede English insolvency laws. Under its rules, ICE Clear Europe

    would be permitted to close out and/or transfer positions of a

    defaulting clearing member that is an FCM pursuant to the U.S.

    Bankruptcy Code and Part 190 of the Commission's regulations. According

    to ICE Clear Europe's submission, the insolvency of ICE Clear Europe

    itself would be governed by both English insolvency law and Part 190.

    ICE Clear Europe has obtained legal opinions that support the

    existence of such legal certainty in relation to the protection of

    customer and swap counterparty positions, funds, and property in the

    event of the insolvency of one or more of its clearing members. In

    addition, ICE Clear Europe has obtained a legal opinion from U.S.

    counsel regarding compliance with the protections afforded to FCM

    customers under New York law.

    The Commission requests comment on its conclusions with regard to

    legal certainty in the event of an insolvency of CME, ICE Clear Credit,

    ICE Clear

    [[Page 47186]]

    Europe, or one of such DCOs' clearing members.

    Request for Comment

    The Commission requests comment on all aspects of the proposed

    classes of CDS to be included within the clearing requirement and the

    proposed determination. The Commission may consider alternatives to the

    proposed CDS classes and is requesting comment on the following

    questions:

    Should the Commission include all tenors, such as the 1-

    or 2-year tenor for Markit indices, for each index included within the

    class, notwithstanding the fact that those are tenors not currently

    cleared by a DCO? Will market participants be incentivized to use such

    contracts to avoid the clearing requirement?

    Should the Commission limit its determination to the most

    liquid tenors of the CDX.NA.IG such as the 5- and 10-year tenors, and

    exclude other tenors such as the 3- and 7-year tenors, which are less

    liquid?

    Is the Commission correct in believing that risk

    management frameworks and methodologies supporting existing cleared

    offerings can be adjusted to address additional tenors with limited

    changes?

    Should the Commission structure its clearing requirement

    such that indices that become older off-the-run indices are no longer

    subject to the requirement? In such a proposal, how should the

    Commission treat those off-the-run indices, such CDX.NA.IG Series 9,

    that have remained extremely active notwithstanding being off-the-run?

    Should the Commission establish some type of threshold of trading to

    exclude off-the-run indices from the requirement? How would the

    Commission construct a rule to indicate that an off-the-run index is no

    longer subject to clearing?

    To the extent off-the-run indices were excluded from the

    clearing requirement, would market participants be incentivized to

    trade in older off-the-run indices, as opposed to current on-the-run

    indices?

    The CDS indices proposed to be included within the

    clearing requirement are currently offered by DCOs and are among the

    most liquid CDS. Is there any factor within the five statutory that do

    not support inclusion with the clearing requirement? Are there other

    factors outside of those five factors with regard to these particular

    offerings that weigh against inclusion in a clearing determination?

    E. Interest Rate Swaps

    i. Introduction

    Interest rate swaps are agreements wherein counterparties agree to

    exchange payments based on a series of cash flows over a specified

    period of time typically calculated using two different rates

    multiplied by a notional amount. As of June 2011, the BIS estimated

    that over $500 trillion in notional amount of single currency interest

    rate swaps were outstanding \75\ representing 75 to 80%of the total

    estimated notional amount of derivatives outstanding.\76\ Based on

    these factors and on the swap submissions received under Sec. 39.5(b),

    the Commission believes that interest rate swaps represent a

    substantial portion of the swaps market and warrant consideration by

    the Commission for required clearing.

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

    \75\ BIS, OTC Derivatives Market Activity in the First Half of

    2011, November 2011, Table 1 [hereinafter ``BIS data'']. The BIS

    data provides the broadest market-wide estimates of interest rate

    swap activity available to the Commission.

    \76\ Id.

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

    The Commission's consideration of the interest rate swap

    submissions (IRS submissions) is presented in two parts. The first

    part, this Section II.E, discusses the Commission's rationale for

    determining how to classify and define the interest rate swaps

    identified in the DCO submissions to be considered for the clearing

    requirement. The second part, Section II.F, presents the Commission's

    consideration of the IRS submissions in accordance with section

    2(h)(2)(D) of the CEA.

    Unlike certain CDS or futures contracts, there are a large number

    of different, variable contract specifications available and used in

    interest rate swap transactions. As an indication of this variability,

    the Commission notes that over 10,500 different combinations of

    significant interest rate swap terms were identified for trades

    executed in a single three month period in 2010.\77\ This variability

    creates a challenge for DCOs to specify the interest rate swaps for

    which clearing services are available and for the Commission to define

    what kinds of interest rate swaps will be subject to the clearing

    requirement. Notwithstanding this variability in swap terms, parties

    generally seek common economic results when entering into interest rate

    swaps, and there are common contract definitions and conventions that

    make classifying and clearing interest rate swaps possible. Identifying

    and analyzing these commonalities is necessary for effective

    classification of the swaps that will be subject to a proposed clearing

    requirement determination for interest rate swaps. Accordingly, a

    summary of the DCO submissions received by the Commission is followed

    by a discussion of how interest rate swaps are traded and risk managed

    and an analysis of the primary interest rate swap classes that are

    cleared and the product specifications used to identify interest rate

    swap products within each class. Thereafter, in Section II.F the

    Commission considers each of the interest rate swap classes and the

    primary specifications that are identified in the IRS submissions using

    the five factors identified in section 2(h)(2)(D) of the CEA to

    determine which interest rate swaps shall be required to be cleared.

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

    \77\ Federal Reserve Bank of New York Staff Reports, ``An

    Analysis of OTC Interest Rate Derivatives Transactions: Implications

    for Public Reporting'' (March 2012) at 3 [hereinafter ``NY Fed

    Analysis''], available at http://www.newyorkfed.org/research/staff_reports/sr557.pdf.

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

    ii. Submissions Received

    The Commission received submissions from three DCOs eligible to

    clear interest rate swaps (IRS submissions): LCH.Clearnet Limited

    (LCH), the clearing division of the Chicago Mercantile Exchange Inc.

    (CME), and International Derivatives Clearinghouse, LLC (IDCH).\78\

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

    \78\ The IRS submissions received by the Commission are

    available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm. Submission materials marked by the submitting DCO for

    confidential treatment pursuant to Sec. Sec. 39.5(b)(5) and

    145.9(d) are not available for public review.

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

    The following table summarizes the interest rate swap classes and

    significant specifications identified in the IRS submissions as

    currently available for clearing by each DCO. The classes and swap

    specifications are described in more detail below.

    [[Page 47187]]

    Table 3--Interest Rate Swap Submissions Summary

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

    LCH CME IDCH

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

    Swap Classes...................... Fixed-to-floating, basis, Fixed-to-floating......... Fixed-to-floating,

    forward rate agreements basis, FRAs, OIS.

    (FRAs), overnight index

    swaps (OIS).

    Currencies \79\................... USD, EUR, GBP, JPY, AUD, USD, EUR, GBP, JPY, CAD, USD.

    CAD, CHF, SEK, CZK, DKK, and CHF.

    HKD, HUF, NOK, NZD, PLN,

    SGD, and ZAR.

    Rate Indexes...................... For Fixed-to-floating, USD-LIBOR, CAD-BA, CHF- USD-LIBOR.

    basis, FRAs: LIBOR in LIBOR, GBP-LIBOR, JPY-

    seven currencies, BBR- LIBOR, and EURIBOR.

    BBSW, BA-CDOR, PRIBOR,

    CIBOR-DKNA13, CIBOR2-

    DKNA13, EURIBOR-Telerate,

    EURIBOR-Reuters, HIBOR-

    HIBOR, HIBOR-HKAB, HIBOR-

    ISDC, BUBOR-Reuters,

    NIBOR, BBR-FRA, BBR-

    Telerate, PLN-WIBOR, PLZ-

    WIBOR, STIBOR, SOR-

    Reuters, JIBAR.

    For OIS: FEDFUNDS, SONIA,

    EONIA, TOIS.

    Maximum Stated Termination Dates.. For Fixed-to-floating, USD, EUR, GBP out to 50 For Fixed-to-

    basis, FRAs: USD, EUR, years, and CAD, JPY, CHF, floating: 30 years.

    and GBP out to 50 years, AUD out to 30 years.

    AUD, CAD, CHF, SEK and

    JPY out to 30 years and

    the remaining nine

    currencies out to 10

    years.

    For OIS: USD, EUR, GBP, .......................... For OIS, and FRAs:

    and CHF out to two years. two years.

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

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

    \79\ In this proposal, currencies are identified either by their

    full name or by the three letter ISO currency designation for the

    currency.

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

    Each of the IRS submissions provided information specified under

    Sec. 39.5(b) for such swap submissions or provided references to Web

    sites or other sources for such information, including, for example,

    information previously provided to the Commission for other purposes.

    Each submitter also has described how it provided notice to its members

    as required by Sec. 39.5(b)(3)(viii).

    LCH has been clearing OTC interest rate swaps since 1999 through

    its SwapClear service. In its IRS submission, LCH indicates that it

    clears more than 50% of the interest rate swap market by notional

    amount.\80\ As of its submission date, February 24, 2012, LCH reported

    that it had cleared and held outstanding about one million trades with

    an aggregate notional amount over $283 trillion. LCH accepted for

    clearing fixed-to-floating and basis swaps in seventeen currencies

    (including variable notional swaps in three currencies), overnight

    index swaps in four currencies, and forward rate agreements in 10

    currencies. Swaps accepted for clearing must have certain product

    specifications identified by LCH, which help it administer clearing and

    manage risk appropriately.\81\ Of the three interest rate swap

    submitters, LCH has been clearing the longest, clears the broadest

    range of interest rate swaps, and clears the largest portion of the

    interest rate swap market at this time. As of March 2011, LCH

    implemented client clearing in both Europe and the U.S. Prior to that

    date, both parties to a swap had to be LCH members to be able to clear

    a swap with LCH.

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

    \80\ LCH letter, dated February 24, 2012, at 1, stating that the

    market share percentage estimate is based upon BIS statistics and

    SwapClear volumes as of January 31, 2012.

    \81\ These specifications can be found on LCH's Web site at

    http://www.lchclearnet.com/Images/General%20Regulations_tcm6-43737.pdf.

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

    CME began clearing interest rate swaps on October 18, 2010. CME's

    IRS submission indicates that CME is currently clearing fixed-to-

    floating swaps in six currencies with an identified set of product

    specifications and has open interest in three currencies. In its

    submission, CME recommended a clearing requirement determination for

    all non-option interest rate swaps denominated in a currency cleared by

    any qualified DCO.

    In September 2010, IDCH amended its rule book to provide for

    clearing interest rate swaps. IDCH is eligible to clear U.S. dollar

    denominated fixed-to-floating swaps, overnight index swaps, and forward

    rate agreements, which have certain product specifications as

    identified in its submission. IDCH had no outstanding cleared positions

    for these swaps as of the date of this proposal.

    Furthermore, the interest rate swaps identified in the three IRS

    submissions are all single currency swaps with no optionality, as

    defined by the applicable DCO.

    iii. Interest Rate Swap Market Conventions and Risk Management

    Unlike certain CDS for which highly standardized terms have been

    developed, or futures, the terms of which are set by the exchanges,

    interest rate swaps are broad in scope and present a wide range of

    variable product classes and product specifications within each class.

    A data set of interest rate swaps electronically recorded over a three

    month period in 2010 by 14 large dealers for which one of those dealers

    was a party to each swap, contained over 10,500 different combinations

    of product classes, currencies, tenors, and forward periods.\82\ The

    data set also included eight different general product classes (e.g.,

    fixed-to-floating, basis, forward rate agreements, swaptions, etc.), 28

    currencies, 53 different rate indexes, and stated termination dates

    from one month to 55 years. In addition, dozens of different contract

    term conventions were identified.

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

    \82\ See ``ODSG data'' described below. The ODSG data set, while

    the broadest available providing trade-by-trade details, is limited

    in that it excludes trades that needed to be manually confirmed or

    that did not include a G14 Dealer.

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

    Notwithstanding the large variety of contracts, there are

    commonalities that make it possible to categorize interest rate swaps

    for clearing purposes. Firstly, the vast majority of interest rate

    swaps use the ISDA definitions and contract conventions that allow

    market participants to agree quickly on common terms for each

    transaction. In fact, the three DCOs clearing interest rate swaps all

    use ISDA definitions in their product specifications.

    Secondly, counterparties enter into swaps to achieve particular

    economic results. While the results desired may differ in small ways

    depending on each

    [[Page 47188]]

    counterparty's specific circumstances and goals, there are certain

    common swap conventions that are used to identify and achieve commonly

    desired economic results when entering into interest rate swaps. For

    example, a party that is trying to hedge variable interest rate risk

    may enter into a fixed rate to floating rate swap, or a party that is

    seeking to fix interest rates for periods in the future may enter into

    a forward rate agreement.

    The IRS submissions classify interest rate swaps on this basis by

    identifying commonly known classes of swaps that they clear including:

    fixed rate to floating rate swaps, that are sometimes referred to as

    plain vanilla swaps (fixed-to-floating swaps); floating rate to

    floating rate swaps, also referred to as basis swaps (basis swaps);

    overnight index swaps (OIS); and forward rate agreements (FRAs).\83\

    These class terms are also being used in industry efforts to develop a

    taxonomy for interest rate swaps.\84\

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

    \83\ These are sometimes also referred to as ``types,''

    ``categories,'' or ``groups.'' For purposes of this determination,

    the Commission is using the term ``class,'' in order to be

    consistent with the approach taken by the European Securities and

    Markets Authority (ESMA) in its Discussion Paper, ``Draft Technical

    Standards for the Regulation on OTC Derivatives, CCPs, and Trade

    Repositories,'' (Feb. 16, 2012), available at http://www.esma.europa.eu/system/files/2012-95.pdf. It is also noted that

    other categorizations are sometimes used for certain purposes.

    However, these four classes are common terms used by the DCOs and

    are common terms used in industry taxonomies.

    \84\ See, e.g., ISDA Swap Taxonomies, available at http://www2.isda.org/identifiers-and-otc-taxonomies/; Financial Products

    Markup Language, available at http://www.fpml.org/; and the NY Fed

    Analysis.

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

    Furthermore, within these general classes, certain specifications

    such as currency, reference interest rate index, and stated termination

    date (also referred to as maturity date), are essential for defining

    the economic result that will be achieved. For example, a party located

    in the United States who seeks to hedge interest rate risk that is in

    U.S. dollars will most likely enter into a U.S. dollar swap as opposed

    to a swap in different currency. The party will also enter into a swap

    whose interest rate index correlates with the floating rate the party

    is trying to hedge and will specify a termination date that coincides

    with when the subject interest rate risk terminates. Each of the IRS

    submissions naturally use these common specifications when identifying

    the swaps that the DCO clears. Within each of those specifications,

    there are common terms used by the DCOs, which allows for further

    classification of the full range of interest rate swaps that are

    executed.

    Accordingly, while there are a wide variety of interest rate swaps

    when taking into account all possible contract specifications, certain

    specifications are commonly used by the DCOs and market participants.

    This allows for the identification of classes of swaps and primary

    specifications within each class that reflect the economic goals market

    participants seek to achieve and that are based on market conventions

    used by the DCOs to define which interest rate swap products they will

    clear. For example, fixed-to-floating swaps comprise roughly 50% of

    interest rate swaps, U.S. dollar denominated swaps account for

    approximately 35% of the total outstanding notional amount of swaps,

    and U.S. dollar LIBOR is the floating rate index used for approximately

    80% of U.S. dollar swaps traded.\85\

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

    \85\ See below for a discussion of available market sources.

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

    The DCOs also risk manage interest rate swaps collectively on a

    portfolio basis rather than on a transaction or product specific basis.

    All three DCOs primarily assess risk at the portfolio-level. In other

    words, when looking at the risk posed by an interest rate swap

    portfolio, DCOs do not assess the risk of any one particular swap or

    swap class within the portfolio. Instead, the DCOs analyze the

    cumulative risk of a position's components. This concept of risk

    aggregation is also used within the context of the DCOs' margining

    methodologies. All three DCOs use margin methodologies based on

    portfolio margining as opposed to margining individual swaps or swap

    categories and subsequently developing offsets and charges across

    different swaps or classes of swaps.

    By looking at risk on a portfolio basis, the DCOs take into account

    how swaps with different attributes, such as underlying currency,

    stated termination dates, underlying floating rate indexes, swap

    classes, etc., are correlated and thus can offset risk across

    attributes. This is possible because, although individual transactions

    may have unique contract terms, given the commonalities of transactions

    as discussed above, swap portfolios can be risk managed on a cumulative

    value basis taking into account correlations among the cleared swaps.

    Consequently, DCOs can be expected to fairly, rapidly, and efficiently

    manage the risk of interest rate swaps in a default scenario through a

    small number of large hedging transactions that hedge large numbers of

    similarly correlated positions held by the defaulting party.\86\ As

    such, liquidity for specific, individual swaps is not the focus of DCOs

    from a risk management perspective. Rather, liquidity is viewed as a

    function of whether a portfolio of swaps has common specifications that

    are determinative of the economics of the swaps in the portfolio such

    that a DCO can price and risk manage the portfolio through block

    hedging and auctions in a default situation.

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

    \86\ After putting on these hedging positions, the DCO has the

    time needed to address any residual risk of the defaulted portfolio

    through auctioning off the defaulted portfolio together with the

    hedging transactions.

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

    A real life example of how this works is provided by LCH's

    management of the Lehman Brothers cleared interest rate swap portfolio

    following Lehman's bankruptcy in September 2008. Upon Lehman's default,

    LCH needed to risk manage a portfolio of approximately 66,000 interest

    rate swaps, which it hedged with approximately 100 new trades in less

    than five days. Once LCH executed these initial hedges, it was left

    with a relatively risk neutral portfolio. However, some risk still

    remained given that the hedges did not match the original trades

    exactly. Once the portfolio was hedged, LCH asked clearing members to

    price and bid on all, or subdivided portions, of the original Lehman

    portfolio with the hedging trades. For example, clearing members with

    live open positions in U.S. dollar swaps were asked to bid for the

    relatively hedged U.S. dollar portfolio. Through the bidding process,

    LCH was able to hedge and auction off all risk related to Lehman's

    interest rate swap portfolio existing at the time of its bankruptcy and

    only used approximately 35% of the initial margin Lehman had

    posted.\87\

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

    \87\ See LCH IRS submission, at 4.

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

    iv. Interest Rate Swap Classification for Clearing Requirement

    Determinations

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

    review each swap, or any group, category, type, or class of swaps to

    make a determination as to whether'' any thereof shall be required to

    be cleared. In reviewing the IRS submissions, the Commission has

    considered whether its clearing requirement determination should

    address individual swaps, or categories, types, classes, or other

    groups of swaps.

    Based on the market conventions as discussed above, and the DCO

    recommendations in the IRS submissions, the Commission is proposing a

    clearing requirement for four classes of interest rate swaps: fixed-to-

    floating swaps, basis swaps, OIS, and

    [[Page 47189]]

    FRAs. According to the IRS submissions, LCH offers all four classes for

    clearing, IDCH offers three of them for clearing, and CME offers one of

    them for clearing.\88\

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

    \88\ LCH clears all four classes of swap products; IDCH is

    eligible to clear fixed-to-floating swaps, OIS, and FRAs; and CME

    clears fixed-to-floating swaps.

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

    These four classes represent a substantial portion of the interest

    rate swap market. The following table provides an indication of the

    outstanding positions in each class.

    Table 4--Interest Rate Swaps Notional and Trade Count by Class \89\

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

    Notional Gross notional Total trade

    Swap class amount (USD percent of Total trade count percent

    BNs) total count of total

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

    Fixed-to-Floating............................... $299,818 52 3,239,092 75

    FRA............................................. 67,145 12 202,888 5

    OIS............................................. 43,634 8 109,704 3

    Basis........................................... 27,593 5 119,683 3

    Other........................................... 132,162 23 617,637 14

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

    Total....................................... 570,352 100 4,289,004 100

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

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

    \89\ TriOptima data, as of March 16, 2012. See Section II.F

    below for a description of the TriOptima Data. The TriOptima data

    provides information on nine other classes of swaps, none of which

    is included in the IRS submissions. Notably, one other type,

    swaptions, exceeded FRAs and basis swaps in terms of number of

    transactions completed in the sample. On a notional amount basis,

    swaptions represented less than half the notional amount of FRAs

    traded and a little less than the notional amount of basis swaps.

    Regardless, because swaptions are not being cleared by any DCOs at

    this time, they are not being considered in this proposal.

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

    At this time, there are no standard definitions in federal statutes

    or existing Commission regulations for these interest rate swap

    classes. In addition, while various class definitions are used in the

    derivatives literature, there are no commonly used definitions in the

    market. Accordingly, for purposes of discussing the clearing

    requirement determination in this proposal, the Commission has

    developed the following class definitions based on information provided

    by the submitting DCOs and market conventions.

    To define the four interest rate swap classes in a manner that

    works across all three DCOs making IRS submissions and for the interest

    rate swap market generally, it is useful first to summarize how

    interest rate swaps work. As noted above, in an interest rate swap, the

    parties exchange payments based on a series of cash flows over a

    specified period of time calculated using two different interest rates

    multiplied by a notional amount. One party to the swap agrees to pay

    the amount equal to one of the interest rates specified multiplied by

    the notional amount and the other party agrees to pay the amount equal

    to the other interest rate specified times the notional amount.\90\

    Each such payment stream is typically referred to as one ``leg'' or

    ``side'' of the swap transaction.

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

    \90\ By contract, the two parties to an OTC swap often (but not

    always) agree that only one payment is due and owing on each payment

    date equal to the net positive amount equal to the excess amount of

    the larger amount due from one party over the smaller amount due

    from the other party. For cleared swaps, generally speaking, the

    amount payable to or by a party on any given day is determined based

    on the aggregate net amount due from or owed to the party for all of

    its positions that are cleared.

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

    Using this background, the four classes of swaps are defined as

    follows, for purposes of this proposal:

    1. ``Fixed-to-floating swap'': A swap in which the payment or

    payments owed for one leg of the swap is calculated using a fixed rate

    and the payment or payments owed for the other leg are calculated using

    a floating rate.

    2. ``Floating-to-floating swap'' or ``basis swap'': A swap in which

    the payments for both legs are calculated using floating rates.

    3. ``Forward Rate Agreement'' or ``FRA'': A swap in which payments

    are exchanged on a pre-determined date for a single specified period

    and one leg of the swap is calculated using a fixed rate and the other

    leg is calculated using a floating rate that is set on a pre-determined

    date.

    4. ``Overnight indexed swap'' or ``OIS'': A swap for which one leg

    of the swap is calculated using a fixed rate and the other leg is

    calculated using a floating rate based on a daily overnight rate.

    The LCH and CME IRS submissions addressed issues of classification

    for purposes of the interest rate swap clearing requirement. In its

    submission, LCH discussed the classification of interest rate swaps and

    recommended establishing clearing requirements for classes of interest

    rate swaps. LCH stated:

    We believe that it is counterproductive to define every single

    attribute and combination that could be found in an [interest rate]

    swap, and furthermore it would always be possible to create

    additional attributes that would move a swap outside of the mandate.

    We do not believe that the Commission should define the almost

    limitless combination of swap attributes currently used by the

    market. We recommend defining a subset of easily identifiable

    features that determine a swap subject to mandatory clearing if that

    swap is cleared by a registered DCO that satisfies the five factors

    in the Act and the Commission's regulations.

    More specifically, LCH recommended that the Commission use the

    following specifications to classify interest rate swaps for purposes

    of making a clearing determination: (i) Swap class (i.e., what the two

    legs of the swap are (fixed-to-floating, basis, OIS, etc.)), (ii)

    floating rate definitions used, (iii) the currency in which the

    notional and payment amounts are specified, (iv) stated final term of

    the swap (also known as maturity), (v) notional structure over the life

    of the swap (constant, amortizing, roller coaster, etc.), (vi) floating

    rate frequency, (vii) whether optionality is included, and (viii)

    whether a single currency or more than one currency is used for

    denominating payments and notional amount. In effect, LCH recommended

    the use of a set of basic product specifications to identify and

    describe each class of swaps subject to the clearing requirement.

    CME recommended a clearing determination for all non-option

    interest rate swaps denominated in a currency cleared by any qualified

    DCO. CME's request is similar to LCH's recommendation in that CME

    identifies currency and optionality as factors to consider. In

    addition, CME's request focuses on defining swaps subject to the

    [[Page 47190]]

    clearing requirement in a manner that can be used by all DCOs and not

    by reference to a specific DCO. IDCH did not recommend a particular

    approach for structuring the clearing determination.

    The Commission agrees with the general approach suggested by LCH

    and is proposing to establish a clearing requirement for classes of

    swaps, rather than for individual swap products.

    As an alternative, the Commission considered whether to establish

    clearing requirements on a product-by-product basis. Such a

    determination would need to identify the multitude of legal

    specifications of each product that would be subject to the clearing

    requirement. Although the industry uses standardized definitions and

    conventions, the product descriptions would be lengthy and require

    counterparties to compare all of the legal terms of their particular

    swap against the terms of the many different swaps that would be

    included in a clearing requirement. In this regard, LCH stated that the

    clearing requirement ``would be sub-optimal for the overall market if

    participants are forced to read pages of rules to decipher whether or

    not a swap is required to be cleared, or to have to make complex and

    time consuming decisions at the point of execution.'' \91\ The

    Commission shares this view and believes that for interest rate swaps,

    a product-by-product determination could be unnecessarily burdensome

    for market participants in trying to assess whether each swap

    transaction is subject to the requirement. A class-based approach would

    allow market participants to determine quickly whether they need to

    submit their swap to a DCO for clearing by checking initially whether

    the swap has the basic specifications that define each class subject to

    the clearing requirement.\92\

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

    \91\ LCH IRS submission, at 6.

    \92\ In addition, as noted by LCH, a product-by-product

    requirement may be evaded more easily because the specifications of

    a particular swap contract would need to match the specifications of

    each product subject to a clearing requirement. The clearing

    requirement could be evaded by adding, deleting, or modifying one or

    more of the contract's specifications, including minor

    specifications that have little or no impact on the economics of the

    swap. By using a class-based approach that allows for ranges of

    contract specifications established by the DCOs within each class,

    the Commission is reducing the potential for evasion in accordance

    with section 2(h)(4)(A) of the CEA, which directs the Commission to

    prescribe rules necessary to prevent evasion of the clearing

    requirements.

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

    A product-by-product designation also would be difficult to

    administer because the Commission would be required to consider each

    and every product submitted. On the other hand, designating classes of

    interest rate swaps for the clearing requirement provides a cost

    effective, workable method for the Commission to review new swap

    products that DCOs will submit for clearing determinations on a going

    forward basis without undertaking a full Commission review of each and

    every swap product. For each new swap, or group, class, type, or

    category of swap submitted, the DCO can identify whether it believes

    the submission falls within a class of swaps already subject to the

    clearing requirement. For such swaps, as described in greater detail

    below, the Commission is proposing to delegate to the Director of the

    Division of Clearing and Risk, with the consultation of the General

    Counsel, the authority to confirm whether the swap fits within the

    identified class and is therefore subject to the clearing requirement.

    In this way, DCOs will not be required to submit lengthy submissions,

    and the Commission need not review swaps that are already part of a

    class of swaps that the Commission has determined are subject to a

    clearing requirement pursuant to section 2(h)(2) of the CEA. Only swaps

    that are in a new swap class that has not previously been reviewed,

    because it contains one or more class level specifications that are not

    contained within a class that has previously been reviewed, would be

    subject to full Commission review.

    Request for Comment

    The Commission invites comment on the interest rate swaps class

    definitions.

    Are the definitions in harmony with industry practice?

    Should the Commission establish a clearing requirement for

    classes of swaps or for individual swap products?

    Would a product-by-product determination impose a greater

    burden on market participants than the proposed class-based approach?

    v. Interest Rate Swap Specifications

    After consideration of the IRS submissions received, the practical

    considerations of classifying swaps as described in the preceding

    section, the portfolio-based risk management approaches used by DCOs,

    and existing market practice for classifying and trading swap products

    based on common economic results, the Commission has analyzed the IRS

    submissions received pursuant to section 2(h)(2)(D) of the CEA and

    Sec. 39.5, and is proposing to classify the interest rates swaps

    submitted using the following affirmative specifications for each

    class: (i) Currency in which the notional and payment amounts are

    specified; (ii) rates referenced for each leg of the swap; and (iii)

    stated termination date of the swap. The Commission also is proposing

    three ``negative'' specifications for each class: (i) No optionality

    (as specified by the DCOs); (ii) no dual currencies; and (iii) no

    conditional notional amounts.\93\

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

    \93\ The term ``conditional notional amount'' refers to notional

    amounts that can change over the term of a swap based on a condition

    established by the parties upon execution such that the notional

    amount of the swap is not a known number or schedule of numbers, but

    may change based on the occurrence of some future event. This term

    does not include what are commonly referred to as ``amortizing'' or

    ``roller coaster'' notional amounts for which the notional amount

    changes over the term of the swap based on a schedule of notional

    amounts known at the time the swap is executed. Furthermore, it

    would not include a swap containing early termination events or

    other terms that could result in an early termination of the swap if

    a DCO clears the swap with those terms.

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

    The Commission has chosen these three affirmative specifications

    because it believes that they are fundamental specifications used by

    counterparties to determine the economic result of a swap transaction

    for each party. Counterparties enter into swaps to achieve particular

    economic results. For example, counterparties may enter into interest

    rate swaps to hedge an economic risk, to facilitate a purchase, or to

    take a view on the future direction of an interest rate. The

    counterparties enter into a swap that they believe will best achieve

    their desired economic result at a reasonable cost.

    The classes of swaps reflect general categories of desired economic

    results. As noted above, the IRS submissions identified four different

    classes of swap contracts that are being cleared at this time: Fixed-

    to-floating swaps, basis swaps, OIS, and FRAs. These classes of

    interest rates swaps reflect industry categorization and allow

    counterparties to achieve a particular economic result. For example, a

    fixed-to-floating swap may be used by a counterparty to hedge interest

    rate risk related to bonds it has issued or which it owns. Because the

    categorization of interest rate swaps into one of these basic classes

    reflects fundamental characteristics of a particular swap,

    counterparties can immediately assess whether a particular swap they

    are considering might be of a class that is subject to required

    clearing.

    All three submitters also identified currency as a specification

    for distinguishing swaps that are subject to clearing.\94\ A swap that

    requires

    [[Page 47191]]

    calculation or payment in a currency different than the currency of the

    related underlying purposes of the swap would introduce currency

    risk.\95\ Thus, the currency designated for the swap is a basic factor

    in precisely achieving the economic results of the swap desired by each

    party. For example, if a party wants to hedge a commercial business

    risk denominated in dollars, then the party is likely to enter into a

    swap calculated and payable in dollars. Entering into a swap in a

    currency that is different from the currency in which the risk to be

    hedged is denominated would unnecessarily introduce currency risk and

    reduce the effectiveness of the swap.

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

    \94\ As noted above, the notional amount of the swap is a

    critical element to pricing every swap because it is the amount by

    which the interest rate for each leg is multiplied by to calculate

    the payment streams for each counterparty. However, the notional

    amount is not really a specification that differentiates one class

    of swaps from another because every swap has a notional amount. By

    contrast, the currency in which the notional and payment amounts are

    specified does distinguish one class of swaps from others.

    \95\ For example, parties seeking to hedge interest rate risk in

    connection with bonds or to invest funds using swaps are more likely

    to enter into swaps that designate the same currency in which the

    bonds are payable or that the funds to be invested are held.

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

    The swaps listed by all three DCOs in their IRS submissions all

    identified the interest rates used for each leg of the swap as a basic

    term that defines the swap. The rates are basic determinants of the

    economic value of each stream of payments of an interest rate swap. It

    is therefore an important determinant for achieving each party's

    desired economic result. For example, if a party wants to hedge a loan

    obligation for which the interest rate is based on the London Interbank

    Offered Rate (commonly referred to as LIBOR), then the party can

    accurately hedge that risk by entering into a swap for which it

    receives LIBOR to offset its variable LIBOR risk. Using a different

    variable rate index would unnecessarily add basis risk to the swap and

    inhibit the party's desired result of hedging the risk inherent in

    changes in LIBOR over the life of its loan.

    Finally, the stated termination date, or maturity, of a swap is a

    basic specification for establishing the value of a swap transaction

    because interest rate swaps are based on an exchange of payments over a

    specified period of time ending on the stated termination date. The

    value of a swap at any one point in time depends in part on the value

    of each payment stream over the remaining life of the swap. For

    example, if a party wants to hedge variable interest rate risk for

    bonds it has issued that mature in ten years, it will generally enter

    into a swap with a stated termination date that matches the final

    maturity date of the bonds being hedged.\96\ To terminate the swap

    prior to such date would result in only a partial hedge and to execute

    a swap with a stated termination date that is later than the final bond

    maturity date would simply create exposed rate risk during the extended

    period beyond the final maturity date of the bonds.

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

    \96\ Although hedging an economic risk expected to remain

    outstanding for ten years with a matching ten year swap may

    generally be the most efficient and precise approach, the Commission

    recognizes that parties may achieve a similar result by using swaps

    with different stated termination dates. However, such substitution

    generally provides a less precise hedge.

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

    As a general matter, the four class-defining specifications

    identified by the Commission are used by all three submitters when

    identifying the swaps they clear. By using these basic specifications

    to identify the swaps subject to the clearing requirement,

    counterparties contemplating entering into a swap can determine quickly

    as a threshold matter whether the particular swap may be subject to a

    clearing requirement. If the swap has the basic specifications of a

    class of swaps subject to a clearing requirement, the parties will know

    that they need to verify whether a DCO will clear that particular swap.

    This will reduce the burden on swap counterparties related to

    determining whether a particular swap may be subject to the clearing

    requirement.

    The Commission also considered whether to define classes of swaps

    on the basis of other product specifications. Other potential

    specifications are numerous because of the nearly limitless alternative

    interest rate swaps that are theoretically possible. These alternative

    specifications fall into two general categories: Specifications that

    are commonly used to address mechanical issues for most swaps, and

    specifications that are less common and address idiosyncratic issues

    related to the particular needs of a counterparty. Examples of

    specifications that are commonly used to address mechanical issues for

    most swaps considered by the Commission include: Floating rate reset

    tenors, floating rate reset dates, reference city for business days,

    business day convention, day count fraction, spread added or subtracted

    from the variable rate, compounding method, effective date, averaging

    method, payment dates, period end dates, upfront payments, and consent

    to legal jurisdiction. These specifications are specifically identified

    for most swap transactions executed today. While these specifications

    may affect the value of the swap in a mechanical way, they are not,

    generally speaking, fundamental to determining the economic result the

    parties are trying to achieve. For example, the day count fraction

    selected affects calculation periods and therefore the amounts payable

    for each payment period. However, the parties, and the DCOs, can make

    mechanical adjustments to period pricing at the time a swap is cleared

    based on the day count fraction alternative selected by the parties and

    the day count fraction does not drive the economic result the parties

    are trying to achieve.

    Furthermore, DCOs can provide clearing for the standard

    alternatives of each of these specifications without affecting risk

    management. Using the same day count fraction example, LCH will accept

    U.S. dollar-LIBOR trades for clearing with nine alternative day count

    fractions based on the common day count fractions used in the

    market.\97\ While this specification, and other specifications of this

    kind, may affect the amounts owed on a swap, they can be accounted for

    mechanically in the payment amount calculations and do not change the

    substantive economic result the parties want to achieve.

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

    \97\ Each DCO identifies the standard term or range of terms it

    will accept for each specification. Accordingly, swap counterparties

    can review the DCO's product specifications to determine whether a

    swap will satisfy the DCO's requirements for these specifications.

    Additionally, DCOs are likely to develop a screening mechanism by

    which a party can enter the terms of a specific swap and determine

    whether the DCO will clear it. It is also likely that third-party

    vendors will develop or are developing similar screeners to apply to

    multiple DCOs. If counterparties want to enter into a swap that is

    in a class subject to required clearing and no DCO will clear the

    swap because it has other specifications that the DCOs will not

    accept, then the parties can still enter into that transaction on an

    uncleared basis.

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

    Examples of the latter are special representations added to address

    particular legal issues, unique termination events, special fees, and

    conditions tied to events specific to the parties. None of the DCOs

    clear interest rate swaps with terms in the second group. Accordingly,

    such specifications are not included in the classes of swaps subject to

    the clearing requirement proposed by this rule, and the Commission

    considered only the first group of more common specifications that are

    identified by the submitting DCOs in their product specifications.

    In short, the Commission recognizes that these other specifications

    may have an effect on the economic result to be achieved with the

    swap.\98\ However, it

    [[Page 47192]]

    believes that counterparties may account for the effects of such

    specifications with adjustments to other specifications or in the price

    of the swap. Furthermore, DCOs account for various alternatives or

    range of alternatives for these terms without impairing risk

    management. Finally, as described above in more detail, including these

    specifications in the description of the swaps subject to a clearing

    requirement could increase the burden on counterparties when checking

    whether a swap may be subject to required clearing. Accordingly, the

    Commission has determined not to include other, non-class defining

    specifications in the swap class definition.

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

    \98\ LCH recommended in its submission that floating rate tenor

    (also known as frequency) also be a class level specification and

    the Commission acknowledges that floating rate tenor can, in some

    cases, be a fundamental specification for achieving the economic

    benefits of an interest rate swap. However, it is the Commission's

    preliminary view that floating rate tenor is more akin to the other

    non-class specifications in that it is not fundamental to all

    economic results that may be considered by parties when

    contemplating a swap and it is a specification for which the DCOs

    can fairly easily offer all of the standard tenors that parties may

    consider.

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

    The Commission also considered whether there are product

    specifications that the Commission should explicitly exclude from the

    initial clearing requirement determination. In this regard, the

    Commission considered swaps with optionality, multiple currency swaps,

    and swaps with conditional notional amounts. The Commission determined

    that these three specifications should be included as so-called

    ``negative'' specifications.

    Optionality and swaps referencing more than one currency for

    calculation or payment purposes, raise concerns regarding adequate

    pricing measures and consistency across swap contracts that make them

    difficult for DCOs to effectively risk manage. LCH, CME, and IDCH

    currently do not clear interest rate swaps with such specifications.

    Furthermore, LCH and CME indicated that interest rate swaps with

    optionality or that reference multiple currencies should not be

    included for consideration of a clearing requirement at this time. LCH

    noted that, at this time, there is a lack of reliable market data and

    no market consensus on valuation models for swaps with these

    specifications, which significantly impairs a DCO's ability to set

    margin levels effectively for such products. Given these factors, the

    Commission is proposing to exclude swaps with optionality or that

    reference multiple currencies from this clearing requirement

    determination.

    Finally, LCH recommended that the Commission exclude from the

    clearing requirement swaps whose notional amount over the term of the

    swap is conditional, and therefore, at the time of execution, cannot be

    definitively identified by a number or schedule of numbers for the term

    of the swap. For example, the parties may agree to a formula for

    calculating the notional amount based on an index or the occurrence of

    future events such as prepayments on a pool of mortgages. The IRS

    submissions indicated that all three submitters would clear swaps with

    constant notional amounts through the final termination date. LCH also

    clears amortizing and roller coaster notional schedules for certain

    classes of swaps so long as the notional amounts for the contract are

    known at the time the swap is cleared. None of the DCOs clears swaps

    for which the notional amount throughout the term of the swap is not

    specifically known at the time the swap is executed. The Commission

    understands that conditional notional amount swaps are, at this time,

    difficult for DCOs to price effectively and risk manage. Accordingly,

    while this may change over time if certain market conventions develop

    in this area, conditional notional amount swaps cannot be subject to

    the clearing requirement determination.

    To reach a determination as to which interest rate swaps shall be

    subject to the clearing requirement, the Commission will consider in

    the following section the IRS submissions received pursuant to section

    2(h)(2)(D) of the CEA and Sec. 39.5 within the framework of the

    classes and specifications identified. In summary, the Commission will

    consider four classes of interest rate swaps for the clearing

    requirement: Fixed-to-floating swaps, basis swaps, FRAs, and OIS.

    Within each class, the Commission will further consider the following

    product specifications to define which swaps shall be required to be

    cleared: Currency, floating rate indexes referenced, stated termination

    dates, use of dual currencies, optionality, and notional amount

    certainty.

    Request for Comments

    The Commission invites comment on the six principle swap

    specifications identified by the Commission as being used by

    counterparties to determine the economic result of a swap transaction

    within each class.

    Should more specifications be added? If so, what are they

    and how are they fundamental to determining the economic result of a

    swap? Should any of the specifications be eliminated?

    F. Proposed Determination Analysis for Interest Rate Swaps

    i. Consistency With Core Principles for Derivatives Clearing

    Organizations

    Section 2(h)(2)(D)(i) of the CEA requires the Commission to review

    whether a swap submission is consistent with the core principles for

    DCOs in making its clearing determination. LCH, CME, and IDCH already

    clear all swaps identified in their respective IRS submissions and

    therefore each is subject to the Commission's review and surveillance

    procedures summarized above. Accordingly, the three DCOs already are

    required to comply with the core principles set forth in section

    5b(c)(2) of the CEA with respect to the swaps being considered by the

    Commission for the clearing requirement.

    To monitor compliance, the Commission has conducted periodic

    examinations of LCH, CME, and IDCH. During an examination, the

    Commission requests certain data regarding cleared transactions, fund

    transfers, margin requirement calculations, risk management testing and

    other issues that is provided as of a specific review date. In this

    manner, the Commission gets a snap-shot of information that the

    Commission staff uses to reconcile selected accounts and other

    information. Subsequently, the Commission goes onsite, typically for

    several days, to interview relevant parties and to test whether various

    policies and procedures established by the DCOs in their respective

    rule books comply with the CEA's core principles for DCOs and other

    regulatory requirements.

    As discussed above, following the review of data and the onsite

    visits, the Commission undertakes extensive analysis and discusses any

    questions and potential deficiencies with staff and management of the

    DCO to address any deficiencies and improvements that can be

    implemented by the DCO. To ensure that the DCOs are in compliance with

    the core principles, a detailed analysis is done to assess the DCO's

    policies and procedures regarding pricing, margining, back-testing, and

    their IRS portfolio risk management procedures. Furthermore, the

    Commission assesses the DCOs' procedures and policies regarding: (1)

    Onboarding new clearing members; (2) establishing the financial

    resources available to the DCOs and testing the sufficiency of those

    resources; and (3) assessing the default management and settlement

    procedures.

    More specifically, the DCOs give the Commission documentation that

    details relevant official policies and

    [[Page 47193]]

    procedures. The DCOs also provide evidence (such as margining, pricing

    data, and back-testing results) that confirms that the policies and

    methodologies are effective. Finally, the Commission goes onsite to the

    DCOs and interviews relevant parties and observes the procedures real-

    time to confirm that the DCOs are in effect following their stated

    policies. Additionally, the Commission, if feasible, will independently

    verify the analysis of any data provided by the DCOs.

    The Commission's Risk Surveillance Group (RSG) conducts daily risk

    management surveillance of all DCOs.\99\ If any issues arise, the RSG

    and the DCOs work in concert to understand and quickly address those

    issues. CME, LCH, and IDCH have worked collaboratively with the

    Commission in this regard and have provided accessible points of

    contact within the DCOs' respective organizations to expedite

    information flow.

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

    \99\ The only exception is IDCH. At this time, RSG does not

    actively monitor the risk posed by IDCH and its participants because

    IDCH does not have any open interest.

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

    All three submitting DCOs have asserted that they are capable of

    maintaining compliance with the core principles following a clearing

    requirement determination for the swaps that they clear, and the

    Commission has no reason to believe such assertions are not accurate at

    this time. The Commission does not believe that subjecting any of the

    interest rates swaps identified in the IRS submissions to a clearing

    requirement would alter compliance by the respective DCOs with the core

    principles. Accordingly, the Commission believes that each of the IRS

    submissions are consistent with section 5b(c)(2) of the CEA.

    Request for Comment

    The Commission requests comment on whether the proposed

    interest rate swaps clearing requirement determination would alter any

    DCO's ability to comply with the DCO core principles.

    ii. Consideration of the Five Statutory Factors for Clearing

    Requirement Determinations

    As explained above, section 2(h)(2)(D)(ii) of the CEA identifies

    five factors the Commission shall take into account in making a

    clearing requirement determination. The process for submission and

    review of swaps for a clearing requirement determination is further

    detailed in Sec. 39.5. This section provides the Commission's

    consideration of the five factors in the context of the requirements of

    Sec. 39.5 for interest rate swaps.

    a. Outstanding Notional Exposures, Trading Liquidity, and Adequate

    Pricing Data

    Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to

    take into account the existence of outstanding notional exposures,

    trading liquidity, and adequate pricing data. For purposes of this

    factor, the Commission considered the market data regarding outstanding

    notional amounts, trade liquidity, and pricing. Unlike CDS for which

    substantially all of the trading data has been collected and is stored

    in one place, there is no single data source for notional exposures and

    trading liquidity for the entire interest rate swap market.\100\

    However, the Commission considered several sources of data on the

    interest rate swap market that collectively provides the information

    the Commission needs to make a clearing requirement determination. The

    data sources considered include: general quarterly estimates published

    by the Bank for International Settlements (BIS data); market data

    published weekly by TriOptima (TriOptima data) covering swap trade

    information submitted voluntarily by 14 large derivatives dealers (G14

    Dealers); trade-by-trade data provided voluntarily by the G14 Dealers

    to the OTC Derivatives Supervisors Group for a three month period

    between June and August 2010 (ODSG data); and trade-by-trade data

    provided by LCH for the first calendar quarter of 2012 and summary

    cleared swap open interest information (LCH data).\101\ The G14 Dealers

    and LCH trade-by-trade data was provided to the Commission on a

    confidential basis and consent was granted for publication of the

    summary information in this proposal.

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

    \100\ See Bank of England, ``Thoughts on Determining Central

    Clearing Eligibility of OTC Derivatives,'' Financial Stability Paper

    No. 14, March 2012, at 11, available at http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper14.pdf.

    \101\ All DCOs are required to begin providing daily trade-by-

    trade data to the Commission as of November 8, 2012. CME also

    provided some information in this area, but because CME clears a

    small set of interest rate swaps for a relatively short period of

    time, CME's data is considered too limited to provide any indication

    of the complete interest rate swap market. The Commission recognizes

    that the LCH data also has limited value for its consideration of

    the first factor because it includes only cleared swaps, and not

    uncleared swaps. However, because LCH clears a large portion of the

    swaps products it offers clearing for (based on available

    information, LCH has cleared approximately 50 to 90 percent of the

    dealer open interest in the different interest rate swap products

    that it clears), its data provides some indication of the possible

    notional exposures and liquidity in the products submitted by LCH

    that the Commission is considering. Given the limitations on other

    available data, the Commission believes it is useful to consider the

    LCH data along with the market-wide BIS data, ODSG data, and

    TriOptima data.

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

    Each of these data sources has a number of limitations that are

    important to understand when considering the data. The following is a

    brief discussion of these limitations and how the data sets, when

    considered together, provide a more complete picture of outstanding

    notional amounts, trade liquidity, and pricing for the Commission's

    consideration of the swaps submitted.

    The BIS data set covers the largest portion of the interest rate

    swap market over time and therefore is useful for reaching general

    conclusions regarding full market size and longer term market trends.

    However, the BIS data provides only summary information that is not

    granular enough to inform the clearing requirement considerations at

    the proposed class level.

    TriOptima's data set updates are published weekly and provide more

    detail than the BIS data covering most of the class level

    specifications considered by the Commission. The TriOptima data is

    limited to the extent it only contains information gathered by

    TriOptima and therefore does not include all OTC interest rate swaps.

    Also, the TriOptima data shows outstanding notional and trade numbers

    as of a set date and does not provide an indication of trade liquidity

    over time.\102\

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

    \102\ The TriOptima data does not indicate how many trades are

    new for each reporting period rather than carry-over trades from the

    prior period. Accordingly, it is not possible to determine the

    amount of new trading activity from one reporting period to the

    next.

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

    The ODSG data provided detailed information on a trade-by-trade

    basis, thereby providing sufficient information for class-level

    consideration. This information is useful for considering trading

    liquidity. However, the ODSG data set is limited in several ways that

    can skew analysis of the data. The ODSG data covered transactions

    confirmed on the MarkitWire platform, a trade confirmation service

    offered by MarkitSERV, between June 1, 2010 and August 31, 2010, where

    at least one party was a G14 Dealer. The dataset does not include

    transactions that took place between two non-G14 Dealer parties, with

    such parties representing an estimated 11% of the notional volume

    activity in MarkitSERV.\103\ The number of non-G14 Dealer swap trades

    that are not entered on MakitSERV has not been estimated and could be

    significant. The omission of certain classes of participants and trades

    in the

    [[Page 47194]]

    sample will bias transaction and notional volume statistics downward.

    It may also distort the proportions of products seen relative to each

    other.

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

    \103\ NY Fed Analysis at 6.

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

    The ODSG dataset also does not include transactions that were

    manually confirmed either by choice or necessity. It is estimated that

    the data set represents roughly 78% of G14 Dealer interest rate

    transaction activity.\104\ The three-month time frame in 2010 also

    introduces limitations into analysis of the data set. This time frame

    represented a period in the midst of historically low central bank

    interest rate policy across major currencies and novel liquidity

    measures taken in response to the 2008 financial crisis. The short

    period also could be affected by seasonal patterns, and the possibility

    exists that the markets have fundamentally changed since the data was

    gathered. The lack of manually confirmed trades in the data suggests an

    overrepresentation of standardized transactions such as OIS and plain

    vanilla interest rate swaps and underrepresentation of non-standard

    classes such as exotics and basis swaps. For instance, exotic product

    structures not eligible for electronic matching are estimated to make

    up 2% of the OTC interest rate derivative market.\105\

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

    \104\ Id. at 6.

    \105\ Id. at 5.

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

    The LCH data provides summary data on outstanding notional amounts

    for different classes of swaps and the first quarter 2012 data provide

    detailed information on a trade-by-trade basis thereby providing

    sufficient information for class-level consideration. The LCH data is

    limited in that it only includes swaps cleared by LCH. It is noted,

    however, that LCH has cleared about 50% of the interest rate swap

    market and higher levels of certain kinds of swaps indicating a

    reasonably high inclusion rate. This data set also has the advantage of

    being more current than the ODSG data and BIS data and is specific to

    the swaps that are under consideration in this Commission

    determination.

    The TriOptima data and ODSG data are both based, in large part, on

    data provided by the G14 Dealers. Additionally, the TriOptima data is

    published by TriOptima in formats that, for the class specifications

    considered by the Commission, can be analyzed in a manner similar to

    the analysis of the ODSG data. In fact, the Commission has found the

    TriOptima data and the ODSG data to be complementary in some ways. The

    TriOptima data is current and provides fairly detailed information

    about the gross notional amounts and total trade numbers for each class

    specification considered in this proposal. However, the TriOptima data

    does not provide enough information to assess periodic trade liquidity

    for each specification. Because the ODSG data is provided on a trade-

    by-trade basis, the Commission and other regulators have been able to

    make more granular assessments of this information, particularly for

    purposes of considering trading liquidity. Accordingly, although the

    ODSG data is nearly two years old, it is useful for confirming whether

    observations based on the current TriOptima data are consistent with

    historical trends and also to indicate trading liquidity.

    For this proposal, the Commission is considering only the swaps

    identified in the DCOs' IRS submissions. Accordingly, where possible,

    the Commission presents and discusses only the data for swaps

    identified in the submissions. For example, although the ODSG data

    identifies twenty-eight different currencies in which swaps were traded

    during the period covered by the data set, only the seventeen

    currencies identified in the submissions were considered. In addition,

    the ODSG data shows all transactions recorded on MarkitServ including

    not only new, price-forming transactions, but also administrative

    transactions such as amendments, assignments, compression trades, and

    internal, inter-affiliate trades that may not be price forming.\106\

    Because the Commission is considering notional amounts and trading

    liquidity, non-price-forming trades have been removed from the ODSG

    data presented below.

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

    \106\ The NY Fed Analysis noted that for the ODSG interest rate

    swap data set the number and volume of non-price-forming trades were

    significantly greater than the number and volume of trades that were

    new economic activity. NY Fed Analysis, at 8.

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

    The following analysis of interest rate swap data is presented

    based on the four swap classes and class specifications discussed

    above. This information is used by the Commission to determine whether

    there exists significant outstanding notional amounts, trading

    liquidity, and pricing data to include each class and specification

    identified in the IRS submissions.

    1. Interest Rate Swap Class

    The Commission first considered data relevant to the different

    interest rate swap classes included in the IRS submissions starting

    with the BIS data.

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

    \107\ BIS data.

    \108\ This row excludes FRAs and options.

    Table 5--Bank for International Settlements Interest Rate Swaps Outstanding Notional by Class \107\

    [Amounts in billions of U.S. dollars]

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

    June 2009 Dec. 2009 June 2010 Dec. 2010 June 2011 Dec. 2011

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

    All Derivatives......................................... $594,553 $603,900 $582,685 $601,046 $706,884 $647,762

    Interest Rate Swaps \108\............................... 341,903 349,288 347,508 364,377 441,201 402,611

    FRAs.................................................... 46,812 51,779 56,242 51,587 55,747 50,576

    Options................................................. 48,513 48,808 48,081 49,295 56,291 50,911

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

    Total interest rate swaps........................... 437,228 449,875 451,831 465,260 553,240 504,098

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

    The BIS data shows only notional amounts for three large

    categories: FRAs, swaps with options, and other interest rate swaps. It

    does not provide information on daily trading liquidity or break out

    other kinds of interest rate swaps such as basis swaps, OIS, or

    inflation swaps.

    However, the BIS data is useful in providing certain big picture

    information. It indicates that interest rate swaps in total constitute

    nearly 80% of the derivatives market and interest rate swap notional

    amounts generally increased for all three kinds of swaps between 2008

    and 2011. Additionally, all three classes of swaps identified by the

    BIS data have substantial notional amounts outstanding. As of December

    2011, FRAs had about $50.5 trillion outstanding, options had about $51

    trillion outstanding, and other interest rate swaps had about $403

    trillion

    [[Page 47195]]

    outstanding. Furthermore, the BIS data shows that over the three year

    period covered in Table 5, total interest rate swaps reported grew by

    about 15%. Given this information, none of the kinds of swaps

    identified by the BIS should be eliminated from consideration by the

    Commission for a clearing requirement based on the BIS data alone.

    However, the BIS data does not provide enough detail to reach further

    determinations regarding the swaps identified in the IRS submissions.

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

    \109\ TriOptima data, as of March 16, 2012. The TriOptima data

    provides information on nine other classes of swaps, none of which

    is included in the submissions. Notably, one other type, swaptions,

    exceeded FRAs and basis swaps in terms of number of transactions

    completed in the sample. On a notional amount basis, swaptions

    represented less than half the notional amount of FRAs traded and a

    little less than the notional amount of basis swaps. Regardless,

    because swaptions were not included in the list of swaps cleared in

    the IRS submissions, swaptions are not being considered for the

    clearing requirement determination because no DCO is clearing

    swaptions at this time.

    \110\ NY Fed Analysis at 7. The ODSG data includes swaps entered

    into between June and August, 2010 as voluntarily reported by the

    G14 Dealers. The ODSG data provides information on other classes of

    swaps, none of which is included in the submissions.

    Table 6--TriOptima Data Interest Rate Swaps Outstanding Notional and Trade Count by Class \109\

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

    Notional Percent of

    Swap class amount (USD Percent of Total trade total trade

    BNs) total notional count count

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

    Fixed-to-Floating............................... $299,818 52 3,239,092 75

    FRA............................................. 67,145 12 202,888 5

    OIS............................................. 43,634 8 109,704 3

    Basis Swap...................................... 27,593 5 119,683 3

    Other........................................... 132,162 23 617,637 14

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

    Total....................................... 570,352 100.00 4,289,004 100

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

    Table 7--ODSG Data Interest Rate Swaps Trading Activity by Class \110\

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

    Average

    Notional weekly Average

    Swap class amount traded Trade count in notional weekly number

    in quarter quarter traded (USD of trades

    (USD BNs) BNs)

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

    Fixed-to-Floating............................... $15,858 123,337 $1,201 9,344

    OIS............................................. 16,563 12,792 1,255 969

    FRA............................................. 6,931 5,936 525 450

    Basis Swap...................................... 2,307 3,173 175 240

    Other........................................... 2,820 16,073 214 1,218

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

    Total....................................... 44,479 161,311 3,370 12,221

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

    The TriOptima data and the ODSG data identify notional amounts and

    trade counts for all four classes of swaps identified in the IRS

    submissions. Outstanding notional amounts are provided in the TriOptima

    data and BIS data. Trading liquidity as an indication of how

    effectively DCOs can risk manage a portfolio of swaps can be evidenced

    in several ways. The data available for this purpose includes total

    notional amount outstanding, total number of swaps outstanding, and the

    average number of transactions over a given period of time. The

    TriOptima data indicates liquidity through the total notional amount

    outstanding and total number of trades outstanding at a given time. The

    ODSG data provides an indication of liquidity in terms of the number of

    trades during the calendar quarter covered by the data and the average

    weekly number of trades during the period.

    The TriOptima data shows that all four classes have significant

    outstanding notional amounts with basis swaps being the lowest at about

    $27.6 trillion and the highest being fixed-to-floating swaps at $288.8

    trillion. Total trade counts for each type are also significant with

    the lowest being 109,704 for OIS and the highest being fixed-to-

    floating swaps at 3,239,092. The ODSG data confirms these observations

    historically.

    The average number of swap trades per week for each class of swaps

    is shown in the last column of Table 7. According to the ODSG data set,

    basis swaps were traded at the lowest frequency compared to the other

    three classes at 240 times on average each week during the ODSG data

    period. Because the ODSG data is from the summer of 2010 and gross

    notional amounts and trading activity in interest rate swaps have both

    increased generally, the Commission believes that trading activity has

    likely increased for all classes.

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

    \111\ The data covers swaps cleared by LCH during the first

    calendar quarter, 2012. Total Notional Outstanding Cleared is as of

    March 31, 2012.

    Table 8--LCH Data Interest Rate Swaps Notional Outstanding and Trade Count Cleared by Classes \111\

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

    Average

    Notional Number of weekly Average Total notional

    Swap class cleared in swaps cleared notional weekly number outstanding

    Quarter (USD in quarter traded (USD of trades (USD BNs)

    BNs) BNs)

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

    Fixed-to-Floating............... $17,022 117,780 $1,309 9,060 $226,016

    FRA............................. 11,271 31,630 867 2,433 27,707

    OIS............................. 8,731 6,848 672 527 36,510

    [[Page 47196]]

    Basis........................... 1,610 2,940 124 226 11,378

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

    Total....................... 38,634 159,198 2,972 12,246 301,612

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

    The LCH data generally confirms the assessment of market-wide data.

    There is substantial outstanding notional volumes and trade liquidity

    for each of the four classes already being cleared at LCH.

    LCH cleared the following percentage of each class of swap as

    reported by TriOptima: \112\

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

    \112\ Percentages are calculated based on total notional amount

    cleared by LCH divided by total notional outstanding as reported by

    TriOptima. The TriOptima data is used because it is the most current

    data set that provides data broken out according to the classes

    currently being cleared.

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

    75% of the Fixed-to-Floating swaps,

    41% of FRAs,\113\

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

    \113\ LCH started clearing FRAs in December 2011 and cleared

    volumes have increased significantly each month since the start

    date.

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

    84% of OIS, and

    41% of Basis Swaps.

    Accordingly, a substantial portion of each class is already being

    cleared voluntarily.

    Swap Class Conclusion

    The Commission concludes that the four classes of swaps currently

    being cleared have significant outstanding notional amounts and trading

    liquidity. The Commission further notes that a substantial percentage

    of each of the four classes is already cleared by DCOs.

    2. Currency

    As discussed above in Section II.E, the currency in which the

    notional and payment amounts are specified is a primary product

    specification and all four data sources provide interest rate swap data

    by currency.

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

    \114\ BIS data.

    Table 9--Bank for International Settlements: Interest Rate Swaps Notional by Currency \114\

    (Amounts Outstanding in Billions of U.S. Dollars)

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

    June 2009 Dec 2009 June 2010 Dec 2010 June 2011 Dec 2011

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

    EUR..................................................... $160,668 $175,790 $161,515 $177,831 $219,094 $184,702

    USD..................................................... 154,174 153,373 164,119 151,583 170,623 161,864

    JPY..................................................... 57,452 53,855 55,395 59,509 65,491 66,819

    GBP..................................................... 32,591 34,257 36,219 37,813 50,109 43,367

    CAD..................................................... 3,227 3,427 4,411 4,247 6,905 6,397

    SEK..................................................... 5,294 4,696 4,461 5,098 5,832 5,844

    CHF..................................................... 4,713 4,807 4,650 5,114 6,170 5,395

    Other................................................... 19,108 19,669 21,061 24,064 29,017 29,709

    All Currencies.......................................... 437,228 449,875 451,831 465,260 553,240 504,098

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

    The BIS data addresses seven of the seventeen currencies identified

    in the submissions individually. All seven currencies have substantial

    outstanding notional amounts as of December 2011, ranging from nearly

    $5.4 trillion for the Swiss franc to about $185 trillion in euro.

    Although several currencies showed decreases in total notional

    outstanding from one reporting period to the next, most such decreases

    were around ten percent or less, and, after such decreases, total

    notional amounts for those currencies generally rebounded.\115\ For all

    currencies, the outstanding notional amounts were higher at the end of

    the most recent three-year period as compared to the beginning of the

    period.

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

    \115\ To some extent, such decreases may have resulted from

    increased trade compression exercises during the subsequent

    reporting period.

    \116\ TriOptima data, as of March 16, 2012.

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

    The Commission believes that the BIS data supports the conclusion

    that there exists significant outstanding notional amounts in each

    currency identified in the BIS data and that there is no indication

    that notional amounts in those currencies are decreasing at a rate that

    would warrant elimination of those currencies from consideration for a

    clearing requirement.

    Table 10--TriOptima Data Interest Rate Swaps Outstanding Notional and Trade Count by Currency \116\

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

    Notional Percent of

    Currency amount (USD Percent of Total trade total trade

    BNs Eqv.) total notional count count

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

    Euro............................................ $176,481 36 1,115,504 28

    US Dollar....................................... 175,777 35 1,300,862 33

    Yen............................................. 64,083 13 568,871 14

    British Pound................................... 43,337 9 419,611 11

    Other \117\..................................... 36,4905 7 536,887 14

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

    [[Page 47197]]

    Total....................................... 496,168 100 3,941,735 100

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

    Table 11--ODSG Data Interest Rate Swaps Notional Trading Activity by Currency \118\

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

    Average

    Notional weekly Average

    Currency traded in Trade count in notional weekly number

    quarter (USD quarter traded (USD of trades

    BNs) BNs)

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

    EUR............................................. $18,410 45,114 $1,395 3,418

    USD............................................. 11,013 48,876 834 3,703

    GBP............................................. 7,248 16,282 549 1,233

    JPY............................................. 4,263 18,799 323 1,424

    Other \119\..................................... 3,048 20,412 231 1,546

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

    Total....................................... 43,982 149,483 3,332 11,324

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

    The TriOptima data shows that total outstanding notional amounts as

    of March 16, 2012, ranged from $400 billion for Czech koruna to over

    $176 trillion notional amount for euros.\120\ While there may be

    sufficient outstanding notional amounts in all seventeen currencies,

    the Commission takes note that there is a clear demarcation between the

    four currencies with the highest outstanding notional amounts: euro,

    U.S. dollar, British pound, and yen, and all other currencies. As Table

    10 shows, the four top currencies range from about 9% to 36% of the

    total notional amount of all interest rate swaps outstanding and 11%to

    33% of the total number of trades. The remaining currencies range from

    about 2% down to 0.1% of the total notional amount traded and 3% down

    to 0.2%of total number of trades. In fact, the four major currencies

    accounted for about 93% of the total notional amount outstanding in the

    TriOptima data set.

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

    \117\ Thirteen other currencies are cleared by LCH: AUD, CHF,

    SEK, CAD, ZAR, NZD, NOK, HKD, PLN, SGD, HUF, DKK, and CZK.

    \118\ The ODSG data includes swaps entered into between June and

    August 2010 as voluntarily reported by the G14 Dealers.

    \119\ Includes the 13 other currencies cleared by LCH identified

    in its IRS submission. The ODSG data identified an additional 11

    other currencies that were not cleared by any of the submitters.

    \120\ TriOptima data, as of March 16, 2012.

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

    The ODSG data provides an indication of trading liquidity in terms

    of average weekly notional amount traded and number of new trades

    completed during the period covered by the data set. Of the four major

    currencies, Japanese yen had the lowest weekly average notional at $323

    billion and the British pound had the lowest average number of trades

    each week at 1,233.

    The TriOptima data provides an overall, more current view of trades

    outstanding, which provides a broader picture of the trading potential

    for each currency for purposes of DCO risk management. As of March 16,

    2012, all but one of the seventeen currencies had outstanding trade

    counts in excess of 14,000 with the exception being the Danish krone at

    6,849. Again, the four highest currencies by trade count: euro, U.S.

    dollar, British pound, and yen, accounted for about 85% of the total

    number of trades recorded and outstanding at the time the data was

    collected.

    Table 12--LCH Data Interest Rate Swaps Notional Outstanding and Trade Count Cleared by Currency \121\

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

    Notional cleared Number of swaps Average weekly Average weekly Total notional

    Currency in quarter cleared in notional traded number of outstanding

    (USD BNs) quarter (USD BNs) trades (USD BNs)

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

    EUR........................................................... $19,207 61,039 $1,477 4,695 $115,695

    USD........................................................... 12,111 51,710 932 3,978 107,734

    GBP........................................................... 2,801 12,976 216 998 25,339

    JPY........................................................... 2,799 12,374 215 952 37,696

    Other......................................................... 1,716 21,099 132 1,623 15,146

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

    Total..................................................... 38,634 159,198 2,972 12,246 301,612

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

    The LCH data shows that the relative notional amount and number of

    swaps in each currency cleared is generally correlated with the

    notional amount and number of swaps of each currency reported by the

    more general market data sets. As a percentage of the total notional

    amount outstanding as reported by TriOptima, LCH cleared the following

    percentages: \122\

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

    \121\ The data covers swaps cleared by LCH during the first

    calendar quarter, 2012. Total Notional Outstanding is as of March

    31, 2012.

    \122\ The TriOptima data is used for this calculation because it

    is the most current data set that provides data broken out according

    to the classes currently being cleared.

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

    66% of euro,

    61% of U.S. dollars,

    [[Page 47198]]

    58% of British pounds,

    59% of Japanese yen, and

    42% of other currencies.

    Of the interest rate swaps identifying U.S. dollars, euro, British

    pounds or yen as the applicable currency, significantly more than half

    are already being cleared by LCH. While the level of clearing of other

    currencies is, on a combined basis reasonably high at 42%, the

    Commission notes the level is noticeably lower than the percentage of

    swaps being cleared for the top four currencies.

    Currency Specification Conclusion

    The Commission believes that all of the data sets demonstrate the

    existence of significant outstanding notional amounts and trading

    liquidity in the seventeen currencies identified in the submissions.

    However, the Commission notes that swaps using the four currencies with

    the highest outstanding notional amounts and trade frequency: euro,

    U.S. dollar, British pound, and yen, account for an outsized portion of

    both notional amounts outstanding and trading volumes. Furthermore, the

    Commission notes that these four currencies are already being cleared

    more than the other currencies generally.

    While it is important that this determination include a substantial

    portion of the interest rate swaps traded to have a substantive,

    beneficial impact on systemic risk, the Commission also recognizes that

    the proposed rule is the Commission's first swap clearing requirement

    determination. As noted in the phased implementation rules for the

    clearing requirement, the Commission believes that introducing too much

    required clearing too quickly could unnecessarily increase the burden

    of the clearing requirement on market participants. In recognition of

    these considerations, the Commission will focus the remainder of this

    initial clearing requirement determination analysis on swaps

    referencing the four most heavily traded currencies. The Commission

    notes that the decision not to include the other thirteen currencies at

    this time does not limit the Commission's authority to reconsider

    required clearing of those currencies in the future.

    The Commission requests comment on whether any of the other

    thirteen currencies identified above should be included in the initial

    clearing requirement determination for interest rate swaps.

    3. Floating Rate Index Referenced

    The ODSG data and LCH data provide an indication of the rate

    indices used on a transaction-by-transaction basis. Rate indexes are

    currency specific. However, the BIS data and the TriOptima data do not

    provide information on the different rate indices referenced in

    interest rate swaps. The following tables present trading activity data

    for each rate index identified in the IRS submissions as being cleared

    for each of the four currencies the Commission is proposing to include

    in the clearing requirement determination.

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

    \123\ The ODSG data includes swaps entered into between June and

    August, 2010 as voluntarily reported by the G14 Dealers. This table

    includes only rate indexes used for the G4 currencies and that are

    cleared by LCH.

    \124\ ``Eur-Euribor'' category includes both Eur-Euribor-Reuters

    and Eur-Euribor-Telerate, which are both cleared by LCH.

    * ``EONIA'', ``SONIA'', and ``FedFunds'' are floating rate

    indexes used to calculate OIS amounts only. The other indexes listed

    in the table are used for fixed-to-floating swaps, basis swaps, and

    FRAs.

    \125\ The data includes swaps cleared by LCH during the first

    calendar quarter, 2012.

    Table 13--ODSG Data Interest Rate Swaps Trading Activity by Rate Index \123\

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

    Notional traded Average weekly

    Rate Index in quarter (USD Trade count for notional traded Average weekly

    BNs) quarter (USD BNs) number of trades

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

    EUR-EURIBOR \124\................... $9,366 38,213 $710 2,895

    USD-LIBOR........................... 9,080 46,620 688 3,532

    EUR-EONIA *......................... 9,022 6,496 684 492

    GBP-SONIA *......................... 4,934 2,011 374 152

    JPY-LIBOR........................... 4,015 18,491 304 1,401

    GBP-LIBOR........................... 2,296 12,417 174 941

    USD-FedFunds *...................... 1,887 1,951 143 148

    EUR-LIBOR........................... 1 5 0 0

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

    Total........................... 40,602 126,204 3,076 9,561

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

    Table 14--LCH Data Interest Rate Swaps Notional Outstanding and Trade Count by Rate Index\125\

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

    Notional cleared Number of swaps Average weekly

    Rate index (by currency) in quarter (USD cleared in notional traded Average weekly

    BNs) quarter (USD BNs) number of trades

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

    EURO

    EURIBOR......................... $13,444 57,157 $1,034 4,397

    EONIA........................... 5,763 3,882 443 299

    US Dollar

    LIBOR........................... 10,905 50,197 839 3,861

    FEDFUND......................... 1,206 1,513 93 116

    GBP

    LIBOR........................... 1,067 11,550 82 888

    SONIA........................... 1,734 1,426 134 110

    Yen

    LIBOR........................... 2,799 12,374 215 952

    Other Indexes....................... 1,716 21,099 132 1,623

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

    Total....................... 38,634 159,198 2,972 12,246

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

    [[Page 47199]]

    The ODSG data shows minimal activity for EUR-LIBOR with about 1

    billion of notional amount and five trades made for the three-month

    period in 2010 that the ODSG data covers. EUR-LIBOR does not appear on

    the LCH data table because, although swaps referencing that index can

    be cleared at LCH, LCH had no open interest for that index as of March

    31, 2012. Given the minimal notional amounts and trade liquidity for

    the EUR-LIBOR index, the Commission has determined not to include EUR-

    LIBOR under the clearing requirement.

    The other rate indexes all show significant notional amounts and

    trading liquidity. The rates with the least activity, the U.S. dollar

    Fedfund index and British pound-LIBOR index, each have over one

    trillion dollars in notional outstanding already cleared at LCH and on

    a weekly basis, $93 billion and $82 billion in notional amount,

    respectively, were cleared per week on average. In terms of number of

    trades cleared at LCH, swaps referencing Fedfunds were cleared on

    average 116 times per week and swaps referencing British pound-LIBOR

    were cleared 888 times per week on average. All of the other indices

    currently cleared have similar or substantially higher number of trades

    and notional amounts cleared.\126\

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

    \126\ British pound-SONIA has about the same number of trades

    and per week trading average as Fedfunds, but has a higher

    outstanding notional amount at $1.734 trillion.

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

    The rate indexes used for OTC interest rate swaps and the interest

    rate swaps identified for clearing by the DCOs reference not only the

    generic index, but a reference definition for the index such as the

    ISDA definition or Reuters definition. These reference definitions

    refer to the generic index and in addition, typically identify

    specifically where the calculating party shall look up the index and

    sometimes at what time the calculating party shall look up the index

    for calculation purposes. Additionally, these reference indices provide

    a standard alternative if the index is not available from the

    designated source at the designated time. While the Commission

    recognizes the importance of these features of the reference

    definitions and that each swap, both cleared and uncleared, should have

    these features, such features need not be included in the index rate

    specification for the Commission's clearing requirement determination

    because they are not definitive for the economic result achieved.

    Rather, the generic index itself is. If the parties to a swap identify

    a specific reference definition for an index, they need only confirm

    whether the DCO accepts that reference definition. If it does not, then

    the swap in question is not accepted for clearing and it is not subject

    to the clearing requirement.

    Rate Index Specification Conclusion

    The Commission concludes that with the exception of the EURO-LIBOR

    index, all of the rate indexes identified in the IRS submissions have

    significant outstanding notional amounts and trading liquidity. The

    Commission further notes that significant notional amounts of these

    rate indexes are already cleared by DCOs.

    4. Stated Termination Dates

    Stated termination date (sometimes referred to as ``maturities'')

    data is often presented by aggregating stated termination dates for

    swaps into specified term periods or ``buckets.'' The IRS submissions

    show that the DCOs have been clearing interest rate swaps with final

    termination dates out to at least ten years for all seventeen

    currencies and out to 50 years for some classes and currencies cleared.

    The use of maturity buckets eases the discussion of the range of

    termination dates. As the tables below show, interest rate swaps can be

    multi-year contracts with termination dates out to fifty years or more

    depending on the class and currency of the swap. Also, stated

    termination dates can fall on any day of the year. Given this continuum

    of termination dates, the DCOs have indicated that they manage the

    cleared swap portfolio risk using a swap curve.\127\ Swap curves are

    also used by market participants to price interest rate swaps. By

    pricing swaps in this way, the economic results of an interest rate

    swap can be fairly closely approximated, and therefore hedged, using

    two or more other swaps with different maturities principally by

    matching the weighted average duration of those swaps with the duration

    of the swap being hedged.\128\ In the same manner, a large portfolio of

    interest rate swaps can be hedged fairly closely with a small number of

    hedging swaps that have the same duration as the entire portfolio or

    subsets of related swaps within the portfolio. In effect, for DCO risk

    management purposes, the termination dates of interest rate swaps are

    assessed based on how they affect the overall duration aspects of the

    portfolio of swaps cleared.\129\ Accordingly, the primary determination

    with respect to the stated termination date specification is, for each

    class and currency, at what point, if any, along the continuum of swap

    maturities is there insufficient notional outstanding and trading

    liquidity to structure the swap curve effectively for DCO risk

    management purposes.

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

    \127\ The ``swap curve'' is the term generally used by market

    participants for interest rate swap pricing and is similar to, and

    is sometimes established, in part, based on, ``yield curves'' used

    for pricing bonds.

    \128\ Other factors, such as convexity, may also be taken into

    account in determining the appropriate hedge ratio between the

    initial swap and the other swaps used to hedge its exposure.

    \129\ For further discussion of the use of portfolio risk

    management by DCOs, see the discussion of interest rate swap market

    conventions and risk management in Section II.E above.

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

    The TriOptima data provided sufficient detail to discern notional

    amounts and trade counts only for each swap class. The ODSG data

    provided sufficient detail to discern notional amounts and trade counts

    only for each currency. The LCH data provided enough detail for both

    swap class and currency.

    Regarding maturity buckets, the BIS data only provides information

    for interest rate swaps in three periods: up to one year, between one

    year and five years, and more than five years. Because the BIS data

    does not provide granular detail beyond the five year maturity date, it

    does not provide enough detail to inform the Commission's determination

    regarding the IRS submissions under consideration. Accordingly, the BIS

    data was not considered for the stated termination date specification.

    Table 15--TriOptima Data Interest Rate Swaps Notional by Maturity Period and Class \130\

    [U.S. dollar equivalent in billions]

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

    Maturity 0<=2 Maturity 2<=5 Maturity 5<=10 Maturity Maturity Maturity 30+

    Product type years years years 10<=20 years 20<=30 years Years

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

    Fixed-to-Floating:

    --Notional.......................................... $118,523 $80,101 $66,049 $19,872 $13,207 $2,067

    [[Page 47200]]

    --Trade Count....................................... 823,434 890,622 908,880 303,927 270,074 42,155

    FRA:

    --Notional.......................................... $66,040 $1,060 $45 $0 $0 $0

    --Trade Count....................................... 201,164 1,646 78 0 0 0

    OIS:

    --Notional.......................................... $41,783 $1,450 $258 $64 $74 $4

    --Trade Count....................................... 77,982 26,067 3,740 1,376 510 29

    Basis Swap:

    --Notional.......................................... $17,324 $6,032 $2,633 $950 $561 $94

    --Trade Count....................................... 39,632 34,080 24,590 12,638 8,197 546

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

    Table 16--LCH Data: Interest Rate Swaps Notional Outstanding Cleared by Maturity Period and Class\131\

    [U.S. dollar equivalent in billions]

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

    Maturity 0<=2 Maturity 2<=5 Maturity 5<=10 Maturity Maturity Maturity

    Product type years years years 10<=20 years 20<=30 years 30<=50 years

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

    Fixed-to-Floating:

    --Notional.......................................... $7,773 $4,448 $3,569 $747 $463 $52

    --Trade Count....................................... 22,431 34,930 40,086 8,551 10,701 1,127

    FRA:

    --Notional.......................................... $11,184 $0 $0 $0 $0 $0

    --Trade Count....................................... 31,584 0 0 0 0 0

    OIS:

    --Notional.......................................... $8,714 $0 $0 $0 $0 $0

    --Trade Count....................................... 6,848 0 0 0 0 0

    Basis Swap:

    --Notional.......................................... $1,423 $129 $37 $14 $5 $1

    --Trade Count....................................... 1,485 736 394 226 84 15

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

    The TriOptima data and LCH data presented above is useful in

    considering the distribution of final termination dates based on swap

    class. For fixed-to-floating swaps and basis swaps, there was

    significant outstanding notional amounts and number of trades for all

    maturity buckets.

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

    \130\ TriOptima data, as of March 16, 2012.

    \131\ The data covers swaps cleared by LCH during the first

    calendar quarter, 2012.

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

    For FRAs, the TriOptima data shows a steep drop off after two

    years, although there is still over $1 trillion dollars of outstanding

    notional amount in the 2<=5 year bucket and 1,646 trades. The notional

    amount outstanding falls below $50 billion after the five year

    maturity. The LCH data shows substantial outstanding notional amounts

    out to two years and none thereafter. The IRS submissions provide that

    the DCOs do not clear FRAs with payment dates beyond three years.

    Accordingly, the Commission need not consider FRAs with maturities

    beyond three years until such time as a DCO submits such swaps for

    clearing.

    For OIS, the TriOptima data shows notional amounts for all maturity

    buckets, but the drop off was steep beyond two years. After ten years,

    outstanding notional amounts drop below $100 billion for each maturity

    bucket. The LCH data shows no outstanding notional amounts cleared

    beyond two years. The IRS submissions provide that the DCOs do not

    accept for clearing OIS swaps beyond two years. Accordingly, the

    Commission is not considering OIS swaps beyond two years in this

    clearing requirement determination.

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

    \132\ The ODSG data includes swaps entered into between June and

    August, 2010 as voluntarily reported by the G14 Dealers. Only

    currencies and swap classes identified in the IRS submissions are

    included.

    Table 17--ODSG Data: Interest Rate Swaps Trading Activity by Maturity Period and Currency \132\

    [U.S. dollar equivalent in billions]

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

    Maturity 0<=2 Maturity 2<=5 Maturity Maturity Maturity Maturity

    Currency years years 5<=10 years 10<=20 years 20<=30 years 30<=50 years

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

    EUR..................................................... $14,596 $1,699 $1,510 $447 $287 $34

    USD..................................................... 6,796 1,991 1,999 247 220 5

    GBP..................................................... 6,521 348 263 72 54 17

    JPY..................................................... 2,970 782 448 91 16 0

    Other................................................... 2,597 325 142 16 3 0

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

    Total............................................... 33,480 5,143 4,362 872 580 56

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

    [[Page 47201]]

    Table 18--LCH Data Interest Rate Swaps Notional Outstanding Cleared by Maturity Period and Currency \133\

    [U.S. Dollar Equivalent in Billions]

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

    Maturity 0<=2 Maturity 2<=5 Maturity Maturity Maturity Maturity

    Currency years years 5<=10 years 10<=20 years 20<=30 years 30<=50 years

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

    EUR..................................................... $14,697 $1,922 $1,759 $477 $269 $35

    USD..................................................... 8,850 1,796 1,176 154 133 2

    GBP..................................................... 2,143 256 268 59 51 16

    JPY..................................................... 2,204 254 262 56 12 0

    Other................................................... 1,200 349 141 13 3 0

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

    Total............................................... 29,094 4,577 3,606 760 468 53

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

    The ODSG data and LCH data in the two preceding tables show

    notional amounts traded for maturity buckets by currency. As shown,

    there were traded and cleared notional amounts for euro, U.S. dollars

    and British pounds out to the 30 to 50 year bucket and for yen out to

    the twenty to thirty year bucket. The LCH data confirms that

    substantial notional amounts of euros, U.S. dollars and British pounds

    are being cleared out to fifty years and yen out to 30 years.

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

    \133\ The data covers swaps cleared by LCH during the first

    calendar quarter, 2012.

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

    Stated Termination Date Specification Conclusion

    For the classes of swaps, the TriOptima data show that there is

    significant outstanding notional amounts and number of trades out to 50

    years for fixed-to-floating swaps and basis swaps, out to three years

    for OIS, and out to two years for FRAs. With respect to currencies, the

    ODSG data set and LCH data show significant outstanding notional

    amounts and number of trades out to 50 years for U.S. dollars, euros,

    and British pounds and out to 30 years for yen.

    5. Adequate Pricing Data

    In reaching its proposed determination, the Commission also is

    taking into account the adequacy of the pricing data for the four

    classes of interest rate swaps. LCH submits there is adequate pricing

    data for its risk and default management. It explains that its risk and

    default management is based on the following factors under normal and

    stressed conditions:

    Outstanding notional, by maturity bucket and currency;

    Number of participants with live open positions, by

    maturity bucket and currency;

    Notional throughput of the market, by maturity bucket and

    currency;

    Size tradable by maturity bucket that would not adjust the

    market price;

    Number of potential direct clearing members clearing the

    products that are part of the mutualized default fund and default

    management process;

    Interplay between on-the-run and off-the-run contracts;

    and

    Product messaging components and structure.

    LCH carries out a fire drill of its default management procedures

    and readiness twice a year. According to LCH, the fire drill presents

    an opportunity to further benchmark market liquidity and behavior and

    for models and assumptions to be recalibrated based on practitioner

    input. LCH also tests liquidity assumptions from the outset when

    developing clearing capabilities for a new product and thereafter, on a

    daily basis. This testing informs how LCH develops and modifies its

    risk management framework to provide adequate risk coverage in

    compliance with the core principles applicable to DCOs. Based on this

    framework, LCH contends that there is adequate pricing data for the

    swaps offered for clearing.

    IDCH submits that there is adequate pricing data to produce the

    IDCH-generated discount curve (the IDCH Curve). IDCH values each open

    position at the end of each trading day by valuing each leg of the cash

    flows of the contract (fixed and floating) according to discount

    factors produced by the IDCH Curve. The IDCH Curve is a zero-coupon

    yield curve that is updated on a continual basis and includes a

    composite of swap rates. IDCH generates a unique IDCH Curve for each

    reference rate that is available for clearing and calibrates each of

    these IDCH Curves to the discount curve to value at-market instruments

    at par.

    CME publicly represents that its interest rate swap valuations are

    fully transparent and rely on pricing inputs obtained from wire service

    feeds. Further, CME uses conventional pricing methodologies, including

    OIS discounting, to produce its zero coupon curve. In addition,

    customers are provided with direct access to daily reports showing

    curve inputs, daily discount factors, and valuations for each cleared

    swap position.

    It is also worth noting that those interest rate swaps that are the

    subject of this proposal are capable of being priced off of deep and

    liquid debt markets. Because of the stability of access to pricing data

    from these markets, the pricing data for non-exotic interest rate swaps

    that are currently being cleared is generally viewed as non-

    controversial.

    Based on consideration of the existence of significant outstanding

    notional exposures, trading liquidity, and adequate pricing data, the

    Commission preliminarily has determined to include interest rate swaps

    with the following specifications in the clearing requirement rule.

    Table 19--Interest Rate Swap Determination

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

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

    Fixed-to-Floating Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30

    years. years. years. years.

    [[Page 47202]]

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Basis Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30

    years. years. years. years.

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Forward Rate Agreement Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Overnight Index Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP)....

    2. Floating Rate Indexes........ FedFunds.......... EONIA............. SONIA.............

    3. Stated Termination Date Range 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.

    4. Optionality.................. No................ No................ No................

    5. Dual Currencies.............. No................ No................ No................

    6. Conditional Notional Amounts. No................ No................ No................

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

    Request for Comments

    Should the Commission consider other data to determine

    whether there are outstanding notional exposures, trading liquidity, or

    adequate pricing data to support the proposed clearing requirements? If

    so, please provide or identify any additional data that may assist the

    Commission in this regard.

    Do the four classes of interest rate swaps that would be

    subject to the proposed clearing requirement have significant

    outstanding notional amounts and trading liquidity?

    Should the Commission include the other thirteen

    currencies currently being cleared in its initial clearing requirement

    determination?

    Should the Commission include stated termination dates

    that are shorter than those that are listed, particularly for the

    fixed-to-floating and basis swaps?

    If the option in an interest rate swaption is exercised

    and not cash settled, should the resulting swap be subject to the

    clearing requirement if it meets the specifications included in the

    proposed clearing requirement?

    Is there adequate pricing data for DCO risk and default

    management of the interest rate swaps that would be subject to the

    proposed rule?

    b. Availability of Rule Framework, Capacity, Operational Expertise

    and Resources, and Credit Support Infrastructure

    Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to

    take into account the availability of rule framework, capacity,

    operational expertise and resources, and credit support infrastructure

    to clear the proposed classes of swaps on terms that are consistent

    with the material terms and trading conventions on which they are now

    traded. The Commission believes that LCH, CME, and IDCH have developed

    rule frameworks, capacity, operational expertise and resources, and

    credit support infrastructure to clear the interest rate swaps they

    currently clear on terms that are consistent with the material terms

    and trading conventions on which those swaps are being traded. The

    Commission notes that LCH already clears more than half the global

    interest rate swaps in the four proposed classes of the clearing

    requirement and that CME and IDCH also already clear the more commonly

    traded swaps under this clearing requirement proposal.

    Importantly, the Commission notes that the three DCOs each

    developed their interest rate swap clearing offerings in conjunction

    with market participants and in response to the specific needs of the

    marketplace. In this manner, the clearing services of each DCO are

    designed to be consistent with the material terms and trading

    conventions of a bilateral, uncleared market.

    LCH submits that it has the capability and expertise to not only

    manage the risks inherent in the current book of interest rate swaps

    cleared, but also the capability to manage the increased volume that

    the clearing requirement for all of its currently clearable products

    could generate. LCH states that its clearing model seamlessly allows

    interest rate swaps to be cleared on identical terms for both new and

    existing, bilateral OTC swaps. Existing bilateral swaps are regularly

    back loaded into LCH's cleared swaps book. In order to be able to

    securely risk manage, and technologically and operationally process

    this volume of trades and diversity of underlying product (i.e., all of

    the unique underlying features of every single swap), LCH has developed

    operational models, controls, and risk algorithms to ensure that it can

    process trades, and is capable of calculating the level of risk it has

    with any counterparty--both direct clearing members and their

    customers. LCH believes its SwapClear service is proof that the

    interest rate swap market and all of its features can

    [[Page 47203]]

    be safely cleared with the right systems, controls, risk management,

    operational framework, and expertise, and it points to the orderly and

    successful close out of the Lehman Brothers International Europe's

    interest rate swap portfolio. LCH notes that in so doing, no other

    clearing member or clearing member's customer was harmed and, less than

    half of the defaulter's initial margin was used.

    CME's submission cites to its rule books to demonstrate the

    availability of rule framework, capacity, operational expertise and

    resources, and credit support infrastructure to clear qualified,

    interest rate swap contracts on terms that are consistent with the

    material terms and trading conventions on which the contracts are then

    traded.

    IDCH submits that its rule book provides a rule framework for

    clearing members and customers of clearing members to clear U.S. dollar

    interest rate swaps on terms that are consistent with the material

    terms and trading conventions on which they would trade interest rate

    swaps and forward rate agreements in the OTC market. The IDCH rule book

    also sets forth clearing member criteria and obligations, and

    descriptions of the clearing process, the settlement process (including

    the collection of performance bond and protection of customer

    collateral), and the default process.

    IDCH also claims that it has the capacity, operational expertise

    and resources, and credit support infrastructure to clear U.S. dollar

    interest rate swaps on terms that are consistent with the material

    terms and trading conventions on which interest rate swaps and forward

    rate agreements are traded in the OTC market. IDCH states that it has

    the financial capacity to clear such swaps as demonstrated by the

    financial resources backing its obligations under the cleared

    contracts, which includes initial margin posted by clearing members

    (for their proprietary account and customer accounts), guaranty fund

    deposits posted by clearing members, and assessment powers against

    clearing members. IDCH notes that it has been registered as a DCO since

    2008 and has dedicated tremendous resources to developing its

    operational capacity to clear interest rate swaps. It claims that the

    capacity of the IDCH clearing systems is scalable and has been tested

    to manage the anticipated volume of interest rate contracts. IDCH also

    says that its clearing systems presently have the capacity to manage

    the clearing of up to 220,000 contracts with 550 value-at-risk (VaR)

    scenarios being used for portfolio revaluation. The architecture of the

    systems is designed to be scalable with hardware and has been tested to

    manage the clearing of up to two million interest rate swaps using the

    same 550 VaR scenarios for revaluation.

    Having taken into account the three DCOs' availability of rule

    framework, capacity, operational expertise and resources, and credit

    support infrastructure, the Commission is proposing the determination

    and rules described below.

    Request for Comments

    The Commission requests comment on all aspects of this

    factor, including whether or not commenters agree that the three DCOs

    clearing interest rate swaps can satisfy the factor's requirements.

    Has the Commission sufficiently taken into account the

    three DCOs' availability of rule framework, capacity, operational

    expertise and resources, and credit support infrastructure? Are there

    additional or alternative considerations that should be reviewed by the

    Commission?

    c. Effect on the Mitigation of Systemic Risk

    Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to

    take into account the effect on the mitigation of systemic risk, taking

    into account the size of the market for such contract and the resources

    of the DCO available to clear the contract. CME, LCH, and IDCH submit

    that subjecting interest rate swaps to central clearing would help

    mitigate systemic risk. As noted above, the Commission believes that

    the market for these swaps is significant and mitigating counterparty

    risk through clearing likely would reduce systemic risk in that market

    and in the industry, generally.

    According to LCH, if all clearable swaps are required to be

    cleared, the inevitable result will be a less disparate marketplace

    from a systemic risk perspective. CME submits that the 2008 financial

    crisis demonstrated the potential for systemic risk arising from the

    interconnectedness of OTC derivatives market participants and submits

    that centralized clearing will reduce systemic risk.

    IDCH submits that, given the tremendous size of the interest rate

    derivatives market, the potential mitigation of systemic risk through

    centralized clearing of interest rate swaps is significant. IDCH argues

    that clearing such swaps brings the risk mitigation and collateral and

    operational efficiency afforded to cleared and exchange-traded futures

    contracts to bilaterally negotiated OTC interest rate derivatives. The

    submission of interest rate swaps for clearing affords the parties the

    credit, risk management, capital, and operational benefits of central

    counterparty clearing of such transactions, and facilitates collateral

    efficiency. Cleared swaps allow market participants to free up

    counterparty credit lines that would otherwise be committed to open

    bilateral contracts. Additionally, according to IDCH, an efficient

    system for centralized clearing allows parties to mitigate the risk of

    a bilateral OTC derivative. Instead of holding offsetting positions

    with different counterparties and being exposed to the risk of each

    counterparty, a party may enter into an economically offsetting

    position that is cleared. Although the positions are not offset, the

    initial margin requirement will be reduced to close to zero. To

    eliminate risk without using centralized clearing, the party must enter

    into a tear-up agreement with the counterparty, or enter into a

    novation.

    While the clearing requirement would remove a large portion of the

    interconnectedness of current OTC markets that leads to systemic risk,

    the Commission notes that central clearing, by its very nature,

    concentrates risk in a handful of entities. However, the Commission

    observes that central clearing was developed and designed to handle

    such concentration of risk.

    LCH has extensive experience risk managing very large volumes of

    interest rate swaps; as noted above, it is believed that about half of

    the interest rate swaps are cleared by LCH. CME submits that it has the

    necessary resources available to clear the swaps that are the subject

    of its submission. The Commission notes that CME or its predecessors

    have cleared futures since 1898 and is the largest futures

    clearinghouse in the world. CME has not defaulted during that time.

    IDCH submits that the IDCH framework provides IDCH with scalable

    financial resources sufficient to clear a large volume of interest rate

    swaps.

    Accordingly, the Commission believes that LCH, CME, and IDCH would

    be able to manage the risk posed by clearing swaps that are required to

    be cleared. In addition, the Commission believes that the central

    clearing of the interest rate swaps that are the subject of this

    proposal would serve to mitigate counterparty credit risk thereby

    having a positive effect on the reducing systemic risk. Having taken

    into account the effect on the mitigation of systemic risk, the

    Commission is proposing the determination and rules described below.

    [[Page 47204]]

    Request for Comments

    Would the proposed clearing requirement reduce systemic

    risk?

    Would the proposed clearing requirement increase the risk

    to LCH, CME, or IDCH? If so, please explain why.

    Are LCH, CME, and IDCH capable of handling any increased

    risk that would result from the proposed clearing requirement?

    d. Effect on Competition

    Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to

    take into account the effect on competition, including appropriate fees

    and charges applied to clearing. As discussed above, of particular

    concern to the Commission is whether this proposed determination would

    harm competition by creating, enhancing, or entrenching market power in

    an affected product or service market, or facilitating the exercise of

    market power. Market power is viewed as the ability to raise price,

    including clearing fees and charges, reduce output, diminish

    innovation, or otherwise harm customers as a result of diminished

    competitive constraints or incentives.\134\

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    \134\ See Section II.D above for more detailed discussion.

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

    The Commission has identified one putative service market as

    potentially affected by this proposed clearing determination: A DCO

    service market encompassing those clearinghouses that currently (or

    with relative ease in the future could) clear the interest rate swaps

    subject to this proposal. Without defining the precise contours of this

    market at this time, the Commission recognizes that, depending on the

    interplay of several factors, this proposed clearing requirement

    potentially could impact competition within the affected market. Of

    particular importance to whether any impact is, overall, positive or

    negative, is: (1) Whether the demand for these clearing services and

    swaps is sufficiently elastic that a small but significant increase

    above competitive levels would prove unprofitable because users of the

    interest rate swap products and DCO clearing services would substitute

    other clearing services co-existing in the same market(s); and (2) the

    potential for new entry into this market. The availability of

    substitute clearing services to compete with those encompassed by this

    proposed determination, and the likelihood of timely, sufficient new

    entry in the event prices do increase above competitive levels, each

    operate independently to constrain anticompetitive behavior.

    Any competitive import would likely stem from the fact that the

    proposed determination would remove the alternative of not clearing for

    interest rate swaps subject to this proposal. The proposed

    determination would not specify who may or may not compete to provide

    clearing services for the interest rate swaps subject to this proposal

    (as well as those not required to be cleared).

    To the extent that parties to interest rate swaps subject to this

    proposal consider clearing the swaps reasonably interchangeable with

    not clearing them, the proposed determination would eliminate at least

    one competitive substitute within the clearinghouse services market for

    the interest rate swaps identified in this proposal. Given the risk-

    mitigation purpose and benefit of migration to voluntary interest rate

    swap clearing, however, the Commission sees some basis to doubt that

    counterparties to cleared swaps would consider the alternative of not

    clearing interest rate swaps subject to this proposal as a reasonable

    substitute to a degree sufficient that they should be viewed as

    populating the same relevant market.\135\ Furthermore, if the

    alternative of not clearing the interest rate swaps subject to this

    proposal falls outside of the relevant services market that includes

    clearing, the proposed clearing determination should not impact

    competition in the clearing services market. The Commission requests

    comment on the extent to which foregoing clearing is considered

    reasonably interchangeable with clearing the interest rate swaps

    subject to this proposal and, in particular, if parties transacting

    interest rate swaps subject to this proposal would forego clearing if

    clearinghouses raised the price of clearing five percent. The

    Commission also requests comment on whether a different percentage than

    five percent should be used.

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

    \135\ In other words, the Commission questions that, faced with

    an assumed five percent non-transitory increase in the price of

    clearing the identified interest rate swaps, including fees and

    other charges, that the parties to these interest rate swap

    transactions would forego clearing in sufficient volume to render

    the price increase unprofitable.

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

    Moreover, even if cleared and non-cleared transactions of the type

    subject to this proposal are now within the same relevant market,

    removing the uncleared option through this proposed rulemaking is not

    determinative of negative competitive impact. Other factors--including

    the availability of other substitutes within the market or potential

    for new entry into the market--may constrain market power.

    Additionally, the potential for new entry may constrain market

    power in an otherwise concentrated clearing services market. The

    Commission does not foresee that the proposed determination constructs

    barriers that would deter or impede new entry into a clearing services

    market.\136\ Indeed, there is some basis to expect that the

    determination could foster an environment conducive to new entry. For

    example, the proposed clearing determinations, and the prospect that

    more may follow, is likely to reinforce, if not encourage, growth in

    demand for clearing services. Demand growth, in turn, can enhance the

    sales opportunity, a condition hospitable to new entry.\137\ The

    Commission requests comment on the extent to which: (1) Entry barriers

    currently do or do not exist with respect to a clearing services market

    for the interest rate swaps subject to this proposal; (2) the proposed

    determinations may lessen or increase these barriers; and (3) the

    proposed determinations otherwise may encourage, discourage,

    facilitate, and/or dampen new entry into the market.

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

    \136\ That said, the Commission recognizes that (1) to the

    extent the clearing services market for the interest rate swaps

    identified in this proposal, after foreclosing uncleared swaps,

    would be limited to a concentrated few participants with highly

    aligned incentives, and (2) the clearing services market is

    insulated from new competitive entry through barriers--e.g., high

    sunk capital cost requirements; high switching costs to transition

    from embedded, incumbents; and access restrictions--the proposed

    determination could have a negative competitive impact by increasing

    market concentration.

    \137\ See, e.g., Horizontal Merger Guidelines at Sec. 9.2

    (entry likely if it would be profitable which is in part a function

    of ``the output level the entrant is likely to obtain'').

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

    Request for Comments

    In addition to what is noted above, the Commission requests

    comment, and quantifiable data, on whether the required clearing of any

    or all of these swaps will create conditions that create, increase, or

    facilitate an exercise of: (1) Clearing services market power in LCH,

    CME, and IDCH, and/or any other clearing service market participant,

    including conditions that would dampen competition for clearing

    services and/or increase the cost of clearing services; and/or (2)

    market power in any product markets for interest rate swaps, including

    conditions that would dampen competition for these product markets and/

    or increase the cost of interest rate swaps involving the interest rate

    swaps identified in this proposal. The Commission seeks comment, and

    quantifiable data, on the likely cost increases associated with

    clearing, particularly those fees and charges

    [[Page 47205]]

    imposed by DCOs, and the effects of such increases on counterparties

    currently participating in the market. The Commission also seeks

    comment regarding the effect of competition on DCO risk management. The

    Commission also welcomes comment on any other aspect of this factor.

    e. Legal Certainty in the Event of the Insolvency

    Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to

    take into account the existence of reasonable legal certainty in the

    event of the insolvency of the relevant DCO or one or more of its

    clearing members with regard to the treatment of customer and swap

    counterparty positions, funds, and property. The Commission is

    proposing this clearing requirement based on its view that there is

    reasonable legal certainty with regard to the treatment of customer and

    swap counterparty positions, funds, and property in connection with

    cleared swaps, namely the interest rate swaps subject to this proposal,

    in the event of the insolvency of the relevant DCO (CME, LCH, or IDCH)

    or one or more of the DCO's clearing members.

    The Commission concludes that, in the case of a clearing member

    insolvency at CME or IDCH, subchapter IV of Chapter 7 of the U.S.

    Bankruptcy Code (11 U.S.C. 761-767) and Part 190 of the Commission's

    regulations would govern the treatment of customer positions.\138\

    Pursuant to section 4d(f) of the CEA, a clearing member accepting funds

    from a customer to margin a cleared swap, must be a registered FCM.

    Pursuant to 11 U.S.C. 761-767 and Part 190 of the Commission's

    regulations, the customer's interest rate swap positions, carried by

    the insolvent FCM, would be deemed ``commodity contracts.'' \139\ As a

    result, neither a clearing member's bankruptcy nor any order of a

    bankruptcy court could prevent either CME or IDCH from closing out/

    liquidating such positions. However, customers of clearing members

    would have priority over all other claimants with respect to customer

    funds that had been held by the defaulting clearing member to margin

    swaps, such as the interest rate swaps subject to this proposal.\140\

    Thus, customer claims would have priority over proprietary claims and

    general creditor claims. Customer funds would be distributed to swap

    customers, including interest rate swap customers, in accordance with

    Commission regulations and section 766(h) of the Bankruptcy Code.

    Moreover, the Bankruptcy Code and the Commission's rules thereunder (in

    particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of

    customer positions and collateral to solvent clearing members.

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

    \138\ The Commission observes that an FCM or DCO also may be

    subject to resolution under Title II of the Dodd-Frank Act to the

    extent it would qualify as covered financial company (as defined in

    section 201(a)(8) of the Dodd-Frank Act).

    \139\ If an FCM is also registered as a broker-dealer, certain

    issues related to its insolvency proceeding would also be governed

    by the Securities Investor Protection Act.

    \140\ Claims seeking payment for the administration of customer

    property would share this priority.

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

    Similarly, 11 U.S.C. 761-767 and Part 190 would govern the

    bankruptcy of a DCO, in conjunction with DCO rules providing for the

    termination of outstanding contracts and/or return of remaining

    clearing member and customer property to clearing members.

    With regard to LCH, the Commission understands that the default of

    a clearing member of LCH would be governed by the rules of that DCO.

    LCH, a DCO based in the United Kingdom, has represented that under

    English law its rules would supersede English insolvency laws. Under

    its rules, LCH would be permitted to close out and/or transfer

    positions of a defaulting clearing member that is an FCM pursuant to

    the U.S. Bankruptcy Code and Part 190 of the Commission's regulations.

    According to LCH's submission, the insolvency of LCH itself would be

    governed by both English insolvency law and Part 190.

    LCH has obtained legal opinions that support the existence of such

    legal certainty in relation to the protection of customer and swap

    counterparty positions, funds, and property in the event of the

    insolvency of one or more of its clearing members. In addition, LCH has

    obtained a legal opinion from U.S. counsel regarding compliance with

    the protections afforded to FCM customers under New York law.

    Request for Comments

    The Commission invites comment regarding whether there is

    reasonable legal certainty in the event of an insolvency of a DCO or

    one or more of its clearing members with regard to the treatment of

    customer and swap counterparty positions, funds, and property.

    III. Proposed Rule

    The Commission is proposing the following rules under section

    2(h)(2), as well as its authority under sections 5b(c)(2)(L) and 8a(5)

    of the CEA. In issuing a determination regarding whether a swap or

    class of swaps is required to be cleared, ``the Commission may require

    such terms and conditions to the requirement as the Commission

    determines to be appropriate.'' \141\

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

    \141\ Section 2(h)(2)(D)(iii) of the CEA.

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

    A. Proposed Sec. 50.1 Definitions

    Proposed Sec. 50.1 sets forth two defined terms: ``business day''

    and ``day of execution.'' The definition of business day would exclude

    Saturdays, Sundays, and legal holidays. This definition is being

    proposed as a means of addressing situations where executing

    counterparties are located in different time zones. It is intended to

    avoid difficulties associated with end-of-day trading by deeming swaps

    executed after 4:00pm, or on a day other than a business day, to have

    been executed on the immediately succeeding business day. The

    Commission recognizes that market participants should not be required

    to maintain back-office operations 24 hours a day or 7 days a week in

    order to meet the proposed deadline for submitting swaps that are

    required to be cleared to a DCO. The Commission also is attempting to

    be sensitive to possible concerns about timeframes that may discourage

    trade execution late in the day. To account for time-zone issues, the

    ``day of execution'' has been defined to be the calendar day of the

    party to the swap that ends latest, giving the parties the maximum

    amount of time to subject their swaps to a DCO while still requiring

    such submission on a same-day basis.

    B. Proposed Sec. 50.2 Treatment of Swaps Subject to a Clearing

    Requirement

    Proposed Sec. 50.2(a) would require all persons, other than those

    who elect the exception for non-financial entities in accordance with

    Sec. 39.6, to submit a swap that is part of the class described in

    Sec. 50.4 for clearing by a DCO as soon as technologically practicable

    and no later than the end of the day of execution. The objective of

    this provision is to ensure that swaps subject to a clearing

    requirement are submitted to DCOs for clearing in a timely manner. The

    Commission notes that this proposal regarding timing of submission to a

    DCO is consistent with the real-time public reporting rules and the

    rules mandating deadlines for the reporting of swap data to SDRs, both

    of which use ``as soon as technologically practicable'' as the

    applicable standard.\142\

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    \142\ See 17 CFR 43.2, Real-Time Public Reporting of Swap

    Transaction Data, 77 FR 1182, 1243-44 (Jan. 9, 2012); and 17 CFR

    45.3, Swap Data Recordkeeping and Reporting Requirements, 77 FR

    2136, 2199-2200 (Jan. 13, 2012).

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

    For purposes of this rule, the Commission clarifies that submission

    of a swap by a market participant to its FCM clearing member would be

    deemed

    [[Page 47206]]

    to meet the requirements for submitting the swap to a DCO. Once a

    customer submits a swap to its FCM, the timeliness considerations are

    governed by other straight-through-processing rules recently finalized

    by the Commission.\143\ Under Sec. 1.74(a), FCMs that are clearing

    members of DCOs shall coordinate with DCOs to establish systems that

    enable the FCM or DCO to accept or reject each trade submitted for

    clearing by a customer of the FCM as quickly as would be

    technologically practicable if fully automated systems were used.

    Similarly, under Sec. 1.74(b), FCM clearing members must accept or

    reject each trade submitted to it by a customer as quickly as would be

    technologically practicable if fully automated systems were used. Those

    market participants that clear on their own behalf would be required to

    submit their swaps to a DCO directly and pursuant to the proposed

    timeframe.

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

    \143\ Customer Clearing Documentation, Timing of Acceptance for

    Clearing, and Clearing Member Risk Management, 77 FR 21278, 21307

    (Apr. 9, 2012).

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

    Proposed Sec. 50.2(b) would require persons subject to Sec.

    50.2(a) to undertake reasonable efforts to determine whether a swap is

    required to be cleared. The Commission would consider such reasonable

    efforts to include checking the Commission's Web site or the DCO's Web

    site for verification of whether a swap is required to be cleared.

    Similarly, market participants could consult third-party service

    providers for such verification. This reasonable efforts standard is

    intended to provide market participants with clarity as to what is

    expected of them when they enter into a swap that has the

    specifications of one of the classes identified in proposed Sec. 50.4.

    Ideally, DCOs will design and develop systems that will enable

    market participants and trading platforms to check whether or not their

    swap is subject to a clearing requirement and be provided with an

    answer within seconds (or faster). This technology would provide a

    single-stop solution for the market with regard to checking eligibility

    under a required clearing regime.

    C. Proposed Sec. 50.3 Notice to the Public

    Proposed Sec. 50.3(a) would require each DCO to post on its Web

    site a list of all swaps that it will accept for clearing and clearly

    indicate which of those swaps the Commission has determined are

    required to be cleared pursuant to part 50 of the Commission's

    regulations and section 2(h)(1) of the CEA. The proposed rule builds

    upon the requirements of Sec. 39.21(c)(1), which requires each DCO to

    disclose publicly information concerning the terms and conditions of

    each contract, agreement, and transaction cleared and settled by the

    DCO. Proposed Sec. 50.3(b) would require the Commission to post on its

    Web site a list of those swaps it has determined are required to be

    cleared and all DCOs that are eligible to clear such classes of swaps.

    The Commission believes that this will provide market participants with

    sufficient notice regarding which swaps are subject to a clearing

    requirement.

    D. Proposed Sec. 50.4 Classes of Swaps Required To Be Cleared

    As discussed at length above, proposed Sec. 50.4 sets forth the

    classes of interest rate swaps and CDS that the Commission has

    determined are required to be cleared. Proposed Sec. 50.4(a) includes

    a table listing those types of interest rate swaps the Commission would

    require to be cleared; proposed Sec. 50.4(b) includes a table listing

    those types of CDS indices the Commission would require to be cleared.

    The Commission believes that this format provides market participants

    with a clear understanding of which swaps are required to be cleared.

    By using basic specifications to identify the swaps subject to the

    clearing requirement, counterparties contemplating entering into a swap

    can determine quickly as a threshold matter whether or not the

    particular swap may be subject to a clearing requirement. If the swap

    has the basic specifications of a class of swaps determined to be

    subject to a clearing requirement, the parties will know that they need

    to verify whether a DCO will clear that particular swap. This will

    reduce the burden on swap counterparties related to determining whether

    a particular swap may be subject to the clearing requirement.

    E. Proposed Sec. 50.5 Clearing Transition Rules

    Proposed Sec. 50.5 would codify section 2(h)(6) of the CEA. Under

    proposed Sec. 50.5(a), swaps that are part of a class described in

    Sec. 50.4 but were entered into before the enactment of the Dodd-Frank

    Act would be exempt from clearing so long as the swap is reported to an

    SDR pursuant to Sec. 44.02 and section 2(h)(5)(A) of the CEA.

    Similarly, under proposed Sec. 50.5(b), swaps entered into after the

    enactment of the Dodd-Frank Act but before the application of the

    clearing requirement would be exempt from the clearing requirement if

    reported pursuant to Sec. 44.03 and section 2(h)(5)(B) of the Act.

    F. Proposed Sec. 50.6 Delegation of Authority

    Proposed Sec. 50.6(a) would delegate to the Director of the

    Division of Clearing and Risk, or the Director's designee, with the

    consultation of the General Counsel or the General Counsel's designee,

    the authority to determine whether a swap falls within a class of swaps

    described in Sec. 50.4 and to communicate such a determination to the

    relevant DCOs. The Commission believes that the Division of Clearing

    and Risk has the requisite expertise to make such a determination and

    that the most expeditious way for the marketplace to be apprised of a

    such a determination would be for the Division of Clearing and Risk to

    make the determination itself and to communicate it directly to the

    relevant DCOs.

    Swaps that contain the specifications described in Sec. 50.4 would

    be presumed to fall within a class of swaps already subject to a

    clearing requirement. In this manner, the Commission hopes to

    facilitate DCOs' ability to add new swaps to particular classes without

    undue burden.

    G. Proposed Sec. 50.10 Prevention of Evasion of the Clearing

    Requirement and Abuse of an Exception or Exemption to the Clearing

    Requirement

    The Commission is proposing Sec. 50.10 to prevent evasion of the

    clearing requirement and prevent abuse of any exemption or exception to

    the clearing requirement under the Commission's new rulemaking

    authority provided in the Dodd-Frank Act amendments to sections

    2(h)(4)(A) \144\ (Prevention of Evasion) and 2(h)(7)(F) \145\ (Abuse of

    the End-User Exception) of the CEA and under the Commission's existing

    rulemaking authority in section 8a(5) \146\ (General Rulemaking

    Authority) of the CEA. Proposed Sec. 50.10 would prohibit (a) evasions

    of the requirements of section 2(h), (b) abuse of the end-user

    exception to the clearing requirement, and (c) abuse of any exemption

    or exception to the requirements of section 2(h), including any

    exemption or exception that the Commission may provide by rule,

    regulation, or order.

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    \144\ Section 2(h)(4) of the CEA, 7 U.S.C. 2(h)(4).

    \145\ Section 2(h)(7)(F) of the CEA, 7 U.S.C. 2(h)(7)(F).

    \146\ Section 8a(5) of the CEA, 7 U.S.C. 12a(5).

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

    Section 2(h) of the CEA provides two express rulemaking provisions

    specifically addressing prevention of evasion and prevention of abuse

    of the clearing requirement. Section 2(h)(4)(A) states that the

    Commission shall prescribe rules and issue interpretations

    [[Page 47207]]

    of rules as determined by the Commission to be necessary to prevent

    evasions of the clearing requirements under section 2(h) of the CEA.

    Section 2(h)(7)(F) provides that the Commission may prescribe such

    rules or issue interpretations of the rules as the Commission

    determines to be necessary to prevent abuse of the exceptions to the

    clearing requirement. The Commission preliminarily views evasion of the

    clearing requirement and abuse of an exemption or exception to the

    clearing requirement, including the end-user exception, to be related

    concepts and are informed by new enforcement authority under the Dodd-

    Frank Act, which added new sections 6(e)(4)-(5) \147\ and 9(a)(6) \148\

    to CEA.

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

    \147\ Section 6(e)(4)-(5) of the CEA, 7 U.S.C. 9a(4)-(5).

    \148\ Section 9(a)(6) of the CEA, 7 U.S.C. 13(a)(6).

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

    Proposed Sec. 50.10(a) would make it unlawful for any person to

    knowingly or recklessly evade, participate in, or facilitate an evasion

    of any of the requirements of section 2(h) of the CEA. Proposed Sec.

    50.10(a) is informed by and consistent with section 6(e)(4) and (5) of

    the CEA, which states that any DCO, SD, or MSP that ``knowingly or

    recklessly evades or participates in or facilitates an evasion of the

    requirements of section 2(h) shall be liable for a civil monetary

    penalty in twice the amount otherwise available for a violation of

    section 2(h).'' Proposed Sec. 50.10(a), however, would apply to any

    person. In addition, proposed Sec. 50.10(a) would apply to any

    requirement under section 2(h) of the CEA or any Commission rule or

    regulation promulgated thereunder. These requirements include the

    clearing requirement under section 2(h)(1), reporting of data under

    section 2(h)(5), and the trade execution requirement under section

    2(h)(8), among other requirements.\149\

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

    \149\ For example, it would be a violation of proposed Sec.

    50.10(a) for a SEF to knowingly or recklessly evade or participate

    in or facilitate an evasion of the trade execution requirement under

    section 2(h)(8).

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

    The Commission notes, however, that section 2(h)(1)(A) \150\ of the

    CEA provides that it ``shall be unlawful for any person to engage in a

    swap unless that person submits such swap for clearing'' to a DCO if

    the swap is required to be cleared. Unlike the knowing or reckless

    standard under proposed Sec. 50.10(a), section 2(h)(1)(A) imposes a

    non-scienter standard on swap market participants. Therefore, any

    person engaged in a swap that is required to be cleared under section

    2(h) and proposed Part 50 of the Commission's Regulations, and such

    person did not submit the swap for clearing, absent an exemption or

    exception, would be subject to a Commission enforcement action

    regardless of whether the person knowingly or recklessly failed to

    submit the swap for clearing.

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

    \150\ Section 2(h)(1)(A) of the CEA, 7 U.S.C. 2(h)(1)(A).

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

    Proposed Sec. 50.10(b) makes it unlawful for any person to abuse

    the end-user exception to the clearing requirement as provided under

    section 2(h)(7) of the CEA and Sec. 39.6.\151\ Proposed Sec. 50.10(b)

    is adopted under the authority in both section 2(h)(4)(A) and section

    2(h)(7)(F). The Commission preliminarily believes that an abuse of the

    end-user exception to the clearing requirement may also, depending on

    the facts and circumstances, be an evasion of the requirements of

    section 2(h). The Commission's view is informed by section 9(a)(6) of

    the CEA, which cross-references both the prevention of evasion

    authority in section 2(h)(4) and prevention of abuse of the exception

    to the clearing requirement in section 2(h)(7)(F). Section 9(a)(6)

    states that it ``shall be a felony punishable by a fine of not more

    than $1,000,000 or imprisonment for not more than 10 years, or both,

    together with the costs of prosecution, for * * * [a]ny person to abuse

    the end user clearing exemption under section 2(h)(4), as determined by

    the Commission.'' Therefore, the Commission is proposing to interpret a

    violation of section 9(a)(6) of the CEA to also be a violation of

    proposed Sec. 50.10(b).

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

    \151\ See End-User Exception to the Clearing Requirement for

    Swaps, adopted by the Commission on July 10, 2012, available at

    www.cftc.gov.

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

    Proposed Sec. 50.10(c) makes it unlawful for any person to abuse

    any exemption or exception to the requirements of section 2(h) of the

    CEA, including any exemption or exception, as the Commission may

    provide by rule, regulation, or order. This provision is informed by

    the Dodd-Frank Act amendments in section 2(h)(4)(A) to prescribe rules

    necessary to prevent evasions of the clearing requirements, section

    2(h)(7)(F) to prescribe rules necessary to prevent abuse of the

    exceptions to the clearing requirements, and the Commission's general

    rulemaking authority in section 8a(5) to promulgate rules that, in the

    judgment of the Commission, are reasonably necessary to accomplish any

    purposes of the CEA. Therefore, the Commission preliminarily believes

    that proposed Sec. 50.10(c) is necessary to prevent abuses of any

    exemption or exception to the requirements of section 2(h).

    The Commission believes a ``principles-based'' approach to proposed

    Sec. 50.10 is appropriate. The Commission is not proposing to provide

    a bright-line test of non-evasive or abusive conduct, because such an

    approach may be a roadmap for engaging in evasive or abusive conduct or

    activities. Nevertheless, the Commission is proposing additional

    guidance regarding evasion and abuse in order to provide clarity to

    market participants.\152\

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

    \152\ Examples described in the guidance are illustrative and

    not exhaustive of the transactions, instruments, or entities that

    could be considered evasive. In considering whether a transaction,

    instrument, or entity is evasive, the Commission will consider the

    facts and circumstances of each situation.

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

    The Commission proposes to interpret these rules in a manner

    similar to its interpretation of the anti-evasion rules that it

    recently adopted in its rulemaking to further define the term

    swap.\153\ The Commission proposes to determine on a case-by-case

    basis, whether particular transactions or other activities constitute

    an evasion of the requirements of section 2(h) of the CEA or the

    regulations promulgated thereunder or an abuse of any exemption or

    exception to the requirements of section 2(h). Each such transaction or

    activity would be evaluated on a case-by-case basis with consideration

    given to all the facts and circumstances.

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

    \153\ See Further Definition of ``Swap,'' ``Security-Based

    Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;

    Security-Based Swap Agreement Recordkeeping, Section VII, adopted by

    the Commission on July 10, 2012, available at www.cftc.gov.

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

    Similar to its approach in the rules further defining the term

    ``swap,'' the Commission proposes that it would not consider

    transactions or other activities structured in a manner solely

    motivated by a legitimate business purpose to constitute evasion or

    abuse. Additionally, when determining whether particular conduct is an

    evasion of the requirements of section 2(h) or an abuse of any

    exemptions or exceptions to those requirements, the Commission will

    consider the extent to which the conduct involves deceit, deception, or

    other unlawful or illegitimate activity.

    The Commission recognizes that market participants may engage in

    conduct or activities, such as structuring a transaction in a

    particular way, for legitimate business purposes, without any intention

    to evade the requirements of section 2(h) of the CEA or abuse any

    exemptions or exceptions thereunder. Thus, in evaluating whether a

    person has evaded such requirements or abused

    [[Page 47208]]

    an exemption or exception, the Commission proposes to consider the

    extent to which a person has a legitimate business purpose in

    connection with the relevant conduct or activities. This proposed

    analytical method will be useful in the overall analysis of potentially

    knowingly or recklessly evasive conduct or abusive conduct. The

    Commission proposes to view legitimate business purpose considerations

    on a case-by-case basis in conjunction with all other relevant facts

    and circumstances.

    Moreover, the Commission recognizes that it is possible that a

    person intending to evade the requirements of section 2(h) or abuse an

    exemption or exception thereunder may attempt to justify its actions by

    claiming that such actions are legitimate business practices in its

    industry. Therefore, the Commission proposes to retain the flexibility,

    via an analysis of all relevant facts and circumstances, to confirm not

    only the legitimacy of the business purpose of those actions but

    whether the actions could still be determined to be evasive or abusive.

    Because market participants engage in conduct and activities, such as

    structuring transactions and instruments, in a particular way for

    various reasons, it is essential that all relevant facts and

    circumstances be considered, including legitimate business purposes,

    before reaching any conclusion as to evasion or abuse.

    When determining whether a particular activity constitutes an

    evasion of the requirements of section 2(h) or an abuse of any

    exemption or exception to such requirements, the Commission proposes to

    consider the extent to which the activity involves deceit, deception,

    or other unlawful or illegitimate activity. The Commission believes

    that although it is likely that fraud, deceit, or unlawful activity

    will be present where evasion or abuse has occurred, these factors are

    not prerequisites to finding a violation of proposed rule Sec. 50.10.

    Rather, fraud, deceit, or unlawful activity is one circumstance the

    Commission proposes to consider when evaluating a person's conduct or

    activities.

    Finally, when considering all the relevant facts and circumstances

    under a potential violation of proposed rule Sec. 50.10, the

    Commission would not consider the form, label, or written documentation

    of any relevant agreement, contract or transaction to be dispositive.

    This approach is intended to prevent evasion and abuse through clever

    draftsmanship of a form, label, or other written documentation.

    Therefore, the Commission proposes to look beyond the form of the

    agreement, contract or transaction to examine its actual substance and

    purpose to prevent any evasion or abuse through clever draftsmanship.

    In addition to the prohibitions under proposed Sec. 50.10, the

    Commission notes that additional provisions of the CEA may also be

    applicable to evasive or abusive practices. For example, the Commission

    notes that swaps, whether cleared or uncleared, must be reported to a

    registered SDR, or if no SDR will accept the swap, to the

    Commission.\154\ In that regard, the Commission has proposed that to be

    eligible to qualify for certain exceptions or to be able to rely on

    certain exemptions, at least one party to the swap must report certain

    information to an SDR or to the Commission. Regulation 39.6(b)(4), for

    example, requires at least one party to a swap that has elected to use

    the end-user exception to the clearing requirement to report whether

    the swap is used to hedge or mitigate commercial risk.\155\

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

    \154\ See section 2(a)(13)(G) of the CEA, 7 U.S.C. 2(a)(13)(G),

    and section 4r(a)(1) of the CEA, 7 U.S.C. 6r(a)(1).

    \155\ See End-User Exception to the Clearing Requirement for

    Swaps, adopted by the Commission on July 10, 2012, available at

    www.cftc.gov.

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

    Considering this regulatory regime, certain evasive or abusive

    practices, such as making false statements or submission in connection

    with the clearing requirement, may also violate other provisions of the

    CEA. For example, section 6(c)(2) \156\ of the CEA, which makes it

    unlawful for any person to make any false or misleading statement of

    material fact to the Commission, including in any report filed with the

    Commission or any other information relating to a swap. Furthermore,

    section 9(a)(4) \157\ of the CEA makes it a felony for any person to

    willfully falsify a material fact, make any false or fraudulent

    statements or representations, or make or use any false writing or

    document or fraudulent statement or entry to an SDR. Thus, the

    Commission may bring enforcement actions under proposed Sec. 50.10,

    section 6(c)(2), and section 9(a)(4), among other statutory provisions

    and rules, to prevent evasions of the requirements of section 2(h) and

    abuses of any exemption or exception to such requirements.

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

    \156\ Section 6(c)(2) of the CEA, 7 U.S.C. 9(c)(2).

    \157\ Section 9(a)(4) of the CEA, 7 U.S.C. 13(a)(4). See also

    section 9(a)(3) of the CEA, 7 U.S.C. 13(a)(3).

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

    Request for Comment

    The Commission requests comment on all aspects of the proposed

    rules and specifically on:

    Should the Commission clarify in the proposed rules that

    the clearing requirement applies to all new swaps and all changes in

    the ownership of a swap, such as assignment, novation, exchange,

    transfer, or conveyance?

    Is proposed Sec. 50.10 and the guidance set forth in this

    section sufficient to address concerns of evasion of the requirements

    of section 2(h) or an abuse of any exemption or exception to such

    requirements? Is further guidance necessary? If so, what further

    guidance would be appropriate?

    Should the Commission prohibit certain specific practices

    that would be evasions of the requirements of section 2(h)?

    Should the Commission prohibit certain specific practices

    that would be an abuse of the end-user exception?

    Should the Commission prohibit certain specific practices

    that would be an abuse of any other exemption or exception to the

    requirements of section 2(h)?

    IV. Implementation

    The Commission is proposing to require compliance with the clearing

    requirement for the classes of swaps identified in proposed Sec. 50.4

    according to the compliance schedule contained in Sec. 50.25.\158\

    Under this schedule, compliance with the clearing requirement will be

    phased by type of market participant entering into a swap subject to

    the clearing requirement.

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

    \158\ The Commission proposed a compliance schedule for the

    clearing requirement in September 2011, 76 FR 58186 (Sept. 20,

    2011), and is finalizing 17 CFR 50.25 concurrently.

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

    V. Cost Benefit Considerations

    A. Statutory and Regulatory Background

    The regulations contained in this proposal identify certain classes

    of swaps that are required to be cleared pursuant to the Dodd-Frank

    Act's \159\ clearing requirement incorporated within amended section

    2(h)(1)(A) of the CEA.\160\ This clearing requirement is designed to

    standardize and reduce counterparty risk associated with swaps, and, in

    turn, mitigate the potential

    [[Page 47209]]

    systemic impact of such risks and reduce the likelihood for swaps to

    cause or exacerbate instability in the financial system. It reflects a

    fundamental premise of the Dodd-Frank Act: the use of properly

    functioning central clearing can reduce systemic risk.

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

    \159\ Dodd-Frank Wall Street Reform and Consumer Protection Act,

    Public Law 111-203, 124 Stat. 1376 (2010).

    \160\ This section states: ``It shall be unlawful for any person

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

    clearing to a derivatives clearing organization that is registered

    under this Act or a derivatives clearing organization that is exempt

    from registration under this Act if the swap is required to be

    cleared.''

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

    Regulation 39.5 provides an outline for the Commission's review of

    swaps for required clearing.\161\ Regulation 39.5 allows the Commission

    to review swaps submitted by DCOs or those swaps that the Commission

    opts to review on its own initiative.\162\ Under section 2(h)(2)(D) of

    the CEA, in reviewing swaps for required clearing, the Commission must

    take into account the following factors: (1) Significant outstanding

    notional exposures, trading liquidity and adequate pricing data, (2)

    the availability of rule framework, capacity, operational expertise and

    credit support infrastructure, (3) the effect on the mitigation of

    systemic risk, (4) the effect on competition and (5) the existence of

    reasonable legal certainty in the event of the insolvency of the DCO or

    one or more of its clearing members.\163\ Regulation 39.5 also directs

    DCOs to provide to the Commission other information, such as product

    specifications, participant eligibility standards, pricing sources,

    risk management procedures, a description of the manner in which the

    DCO has provided notice of the submission to its members and any

    additional information requested by the Commission. This information is

    designed to assist the Commission in identifying those swaps that are

    required to be cleared.

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

    \161\ 76 FR 44464 (July 26, 2011).

    \162\ See Sec. 39.5(b), Sec. 39.5(c). Under section

    2(h)(2)(B)(ii) of the CEA, ``[a]ny swap or group, category, type, or

    class of swaps listed for clearing by a [DCO] as of the date of

    enactment shall be considered submitted to the Commission.''

    \163\ Section 2(h)(2)(D) of the CEA and Sec. 39.5(b)(ii).

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

    B. Overview of Swap Clearing

    i. How Clearing Reduces Risk

    When a bilateral swap is cleared, the clearinghouse becomes the

    counterparty to each of the original participants in the swap. This

    standardizes counterparty risk for the original swap participants in

    that they each bear the same risk--i.e., the risk attributable to

    facing the clearinghouse as counterparty. In addition, clearing

    mitigates counterparty risk to the extent that the clearinghouse is a

    more creditworthy counterparty relative to the original swap

    participants. Clearinghouses have demonstrated resilience in the face

    of past market stress. Most recently, they remained financially sound

    and effectively settled positions in the midst of turbulent events in

    2007-2008 that threatened the financial health and stability of many

    other types of entities.

    Given the variety of effective clearinghouse tools to monitor and

    manage counterparty risk, the Commission believes that DCOs will

    continue to be some of the most creditworthy counterparties in the swap

    markets. These tools include the contractual right to: (1) Collect

    initial and variation margin associated with outstanding swap

    positions; (2) mark positions to market regularly (usually one or more

    times per day) and issue margin calls whenever the margin in a

    customer's account has dropped below predetermined levels set by the

    DCO; (3) adjust the amount of margin that is required to be held

    against swap positions in light of changing market circumstances, such

    as increased volatility in the underlying product; and (4) close out

    the swap positions of a customer that does not meet margin calls within

    a specified period of time.

    Moreover, in the event that a clearing member defaults on their

    obligations to the DCO, the latter has a number of remedies to manage

    associated risks, including transferring the swap positions of the

    defaulted member, and covering any losses that may have accrued with

    the defaulting member's margin on deposit. In order to transfer the

    swap positions of a defaulting member and manage the risk of those

    positions while doing so, the DCO has the ability to: (1) Hedge the

    portfolio of positions of the defaulting member to limit future losses;

    (2) partition the portfolio into smaller pieces; (3) auction off the

    pieces of the portfolio, together with their corresponding hedges, to

    other members of the DCO; and (4) allocate any remaining positions to

    members of the DCO. In order to cover the losses associated with such a

    default, the DCO would typically draw from (in order): (1) The initial

    margin posted by the defaulting member; (2) the guaranty fund

    contribution of the defaulting member; (3) the DCO's own capital

    contribution; (4) the guaranty fund contribution of non-defaulting

    members; and (5) an assessment on the non-defaulting members. These

    mutualized risk mitigation capabilities are largely unique to

    clearinghouses, and help to ensure that they remain solvent and

    creditworthy swap counterparties even when dealing with defaults by

    their members or other challenging market circumstances.

    ii. Movement of Swaps Into Clearing

    There is significant evidence that some parts of the OTC swap

    markets (the IRS and CDS markets in particular) have been migrating

    into clearing over the last few years in response to natural market

    incentives as well as in anticipation of the Dodd-Frank Act's clearing

    requirement. LCH Clearnet data, for example, shows that the outstanding

    volume of interest rate swaps cleared by LCH has grown steadily since

    at least November 2007, as has the monthly registration of new trade

    sides. Data provided to the Commission shows that the notional amount

    of cleared IRS is approximately $72 trillion as of January 2007, and

    just over $236 trillion in September 2010, an increase of 228% in three

    and a half years.\164\ Together, those facts indicate increased demand

    for LCH clearing services related to interest rate swaps, a portion of

    which preceded the Dodd-Frank Act.\165\ Data available through CME and

    TriOptima indicate similar patterns of growing demand for interest rate

    swap clearing services, though their publically available data does not

    provide a picture of demand prior to the passage of the Dodd-Frank

    Act.\166\

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

    \164\ Data provided to the Commission by LCH.

    \165\ See http://www.lchclearnet.com/swaps/volumes/.

    \166\ See http://www.cmegroup.com/trading/interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical-reports.html.

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

    In addition to IRS clearing, major CDS market participants are

    clearing their CDS indices and single names in significant volumes. As

    explained above, in 2008, the Federal Reserve Bank of New York (FRBNY)

    began encouraging market participants to establish a central

    counterparty to clear CDS.\167\ In the past four years, CDS clearing

    has grown significantly. In total, CFTC-registered DCOs are currently

    holding more than $20 billion in aggregate in initial margin to cover

    cleared CDS positions.\168\ Additionally, publicly available data shows

    that CME's CDS guaranty fund has approximately $629 million; ICE Clear

    Credit has a guaranty fund equal to $4.4 billion; and ICE Clear Europe

    has a

    [[Page 47210]]

    guaranty fund [euro]2.7 billion for its CDS business.\169\

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

    \167\ See Federal Reserve Bank of New York, Press Release, ``New

    York Fed Welcomes Further Industry Commitments on Over-the-Counter

    Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which

    references documents prepared by market participants describing the

    importance of clearing. See also Ciara Linnane and Karen Brettell,

    ``NY Federal Reserve pushes for central CDS counterparty,'' Reuters,

    Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.

    \168\ Based on Commission data for registered DCOs as of May 10,

    2012.

    \169\ See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME's guaranty fund, as

    of May 10, 2012; https://www.theice.com/clear_credit.jhtml for data

    on the size of ICE Clear Credit's guaranty fund; and https://www.theice.com/clear_europe_cds.jhtml for data on the size of ICE

    Clear Europe's guaranty fund for CDS, as of May 10, 2012.

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

    Notably, the move toward central clearing has been particularly

    pronounced during times of crisis, as market participants have

    voluntarily used central clearing as a way of protecting against

    counterparty credit risk. The bankruptcy of Enron, in 2001, led to the

    emergence of clearing for OTC energy swaps in the United States. After

    Enron's failure, many counterparties to energy swaps realized the

    benefits of substituting the creditworthiness of a clearing house for

    that of their bilateral counterparties. Much of the impetus for moving

    OTC energy swaps into clearing resulted from the credit crisis that

    developed following Enron's collapse.\170\ According, to CME, its

    ClearPort service ``filled a major void in the aftermath of the Enron

    collapse, particularly in the OTC market for natural gas, which was

    left without a central OTC marketplace.'' \171\

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

    \170\ ``Has OTC Energy Clearing Finally Taken Off?'' in Markets

    03, a publication from FIA available at: http://www.futuresindustry.org/downloads/Outlook/OTCenergy.pdf. See also,

    ``Energy: An example for regulators to study,'' Financial Times, Nov

    3, 2011, available at http://www.ft.com/intl/cms/s/0/c5bfba26-fb3e-11e0-8df6-00144feab49a.html#axzz1zkpvIkJd.

    \171\ CME Group, ``Stepping Out of Uncertainty,'' (2009),

    available at http://www.cmegroup.com/company/history/magazine/Summer2009/steppingout.html.

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

    iii. The Clearing Requirement and Role of the Commission

    In the Dodd-Frank Act, Congress directed that clearing shift from a

    voluntary practice to a mandatory practice for certain swaps and gave

    the Commission responsibility for determining which swaps would be

    required to be cleared. Therefore, the costs and benefits of required

    clearing are attributable, in part, to the Act itself, and, in part, to

    Commission action, taking the form of an exercise of discretion to

    determine which swaps are required to be cleared. Because the

    requirements of the Dodd-Frank Act and the discretion of the Commission

    operate in concert in this way, it is impossible to distinguish

    precisely between those costs and benefits that result from the Dodd-

    Frank Act's clearing requirement, considered in the abstract, and those

    that result from the Commission's determinations that particular types

    of swaps will be required to be cleared. Also, because voluntary

    clearing of swaps has increased over past years (may be due in part to

    anticipation of the clearing requirement to be imposed under the Dodd-

    Frank Act, but may also be due in part to a realization of the benefits

    of clearing after the financial crisis), it is impossible to determine

    precisely the extent to which any increased use of clearing would

    result from statutory or regulatory requirements, as compared to swap

    market participants' desires to use clearing to obtain its risk-

    reducing benefits.\172\

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

    \172\ It is also possible that some market participants would

    respond to the proposed rule's requirement that certain types of

    swaps be cleared by decreasing their use of such swaps. This

    possibility contributes to the uncertainty regarding how the

    proposed rule will affect the quantity of swaps that are cleared.

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

    The Commission also recognizes that there might not be a linear

    relationship between the quantity of swaps that are cleared (whether

    measured by number of swaps, the notional value of swaps or some other

    measure of swap quantity, such as the exposure resulting from the

    swaps) and the costs and benefits resulting from clearing. For example,

    if the Commission were to assume that the proposed rule would result in

    a doubling of the quantity of a certain type of swap that is cleared,

    it would not necessarily be the case that the costs and benefits of

    clearing that type of swap would double. Rather, the relationship could

    be non-linear for a variety of reasons (such as variations among the

    users of that type of swap). In fact, it may be reasonable to assume

    that where the costs of clearing are relatively low and the benefits

    are relatively high, market participants already voluntarily clear

    swaps even in the absence of a clearing requirement. The Commission

    requests comment on the relationship between the requirement that the

    swaps identified in the proposal be cleared and the costs and benefits

    of that requirement, including on whether that relationship is linear

    or non-linear.

    For all these reasons, the Commission has determined that the costs

    and benefits related to the required clearing of the classes of IRS and

    CDS subject to this proposal are attributable, in part to (1)

    Congress's stated goal of reducing systemic risk by, among other

    things, requiring clearing of swaps and (2) the Commission's discretion

    in selecting swaps or classes of swaps in order to achieve those ends.

    The Commission will discuss the costs and benefits of the overall move

    from voluntary clearing to required clearing for the swaps subject to

    this proposal.

    The Commission requests comment on this assumption, and in

    particular on the extent to which swap market participants' use of

    clearing results from a regulatory requirement that specific swaps be

    cleared (i.e., the rules proposed here), the Dodd-Frank Act's general

    clearing requirement, or other motivations for the use of clearing,

    including, among other things, independent business reasons and

    incentives from other regulators, such as prudential authorities.

    C. Consideration of the Costs and Benefits of the Commission's Action

    i. CEA Section 15(a)

    Section 15(a) of the CEA requires the Commission to consider the

    costs and benefits of its actions before promulgating a regulation

    under the CEA or issuing certain orders. Section 15(a) further

    specifies that the costs and benefits shall be evaluated in light of

    the following 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.

    In the sections that follow the Commission considers: (1) Costs and

    benefits of required clearing for the classes of swaps identified in

    this proposal; (2) alternatives contemplated by the commission and

    their costs and benefits relative to the approach proposed herein; (3)

    the impact of required clearing for the proposed classes of swaps on

    the 15(a) factors.

    ii. Costs and Benefits of Required Clearing Under the Proposal

    In order to clear swaps in the classes identified in this proposal,

    certain market participants are likely to face certain startup and

    ongoing costs relating to technology and infrastructure, new or updated

    legal agreements, ongoing fees from service providers, and costs

    related to collateralization of their positions. The per-entity costs

    related to changes in technology, infrastructure, and legal agreements

    are likely to vary widely, depending on each market participant's

    existing technology infrastructure, legal agreements, operations, and

    anticipated needs in each of these areas. For market participants that

    already use clearing, some of these costs may be expected to be lower,

    while the opposite would

    [[Page 47211]]

    likely be true for market participants that begin to use clearing only

    because of the requirement. The costs of collateralization, on the

    other hand, are likely to vary depending on whether an entity is

    subject to capital requirements or not, and the differential between

    the cost of capital for the assets they uses as collateral, and the

    returns they realize on those assets. Commenters are requested to

    address the extent to which factors such as these will affect the costs

    of clearing for various market participants.

    There are also significant benefits associated with increased

    clearing, including reducing and standardizing counterparty risk,

    increased transparency, and easier access to the swap markets. These

    effects together will contribute significantly to the stability and

    efficiency of the financial system. It is impossible, at this point, to

    quantify these benefits with any degree of precision. The Commission

    notes, however, that the extraordinary financial system turbulence of

    2008 has had profound and long-lasting adverse effects on the real

    economy, and therefore reducing systemic risk provides significant, if

    unquantifiable, benefits.\173\ Also, as is the case for the costs

    related to clearing, these benefits would be relatively less to the

    extent that market participants are already using clearing in the

    absence of a requirement. Commenters are requested to address this

    aspect of the analysis as well.

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

    \173\ For example, the PEW Economic Policy Group estimates total

    costs of the acute stage of the crisis for U.S. interests were

    approximately $12.04 trillion, including lost GDP, wages, real

    estate wealth, equity wealth, and fiscal costs. Their estimates

    include $7.4 trillion in losses in the equity markets between June

    2008 and March 2009, but do not include subsequent gains in equity

    markets that restored markets to their mid-2008 levels by the end of

    2009. In addition, their calculations do not include continued

    declines in real estate markets subsequent to March 2009. See Pew

    Economic Policy Group, ``The Cost of the Financial Crisis: The

    Impact of the September 2008 Economic Collapse,'' March 2010. The

    IMF estimated that the cost to the banking sector of the financial

    crisis through 2010 was approximately $2.2 trillion and reported a

    range of estimates for total cost to the taxpayer of GSE bailouts

    that ranged from $160 billion (Office of Management and Budget,

    February 2010) to $500 billion (Barclays Capital, December 2009).

    See IMF, ``Global Financial Stability Report: Responding to the

    Financial Crisis and Measuring Systemic Risks,'' October 2010. Both

    studies acknowledge that the estimates are subject to uncertainties.

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

    a. Technology, Infrastructure, and Legal Costs

    With respect to technology, for market participants that already

    use swap clearing or transact in futures, many of the backend

    requirements for technology that supports cleared swaps are likely to

    be quite similar, and therefore necessary changes to those systems are

    likely to require a relatively lower costs. Market participants that

    are not currently using clearing for swaps or transacting in futures,

    however, may need to implement appropriate middleware to connect with

    an FCM that will clear their transactions.

    Similarly for legal fees, the costs related to clearing the swaps

    that are subject to the proposed clearing requirement are likely to

    vary widely depending on whether market participants already use

    clearing or transact in futures. For those market participants that

    have not already engaged an FCM, it has been estimated that smaller

    financial institutions will spend between $2,500 and $25,000 reviewing

    and negotiating legal agreements when establishing a new business

    relationship with an FCM.\174\ The Commission does not have information

    necessary to confirm these estimates or determine to what degree these

    estimates would apply to larger entities establishing a relationship

    with an FCM. In addition, the Commission does not have information to

    determine costs associated with entities that already have established

    relationships with one or more FCMs but need to revise those

    agreements. In all cases such costs are likely to depend significantly

    on the specific business needs of each entity and therefore are

    expected to vary widely among market participants.

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

    \174\ See Chatham Financial letter at 2, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58077 and

    Webster Bank letter at 3, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58076.

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

    In addition, the Commission is exercising the anti-evasion

    rulemaking authority granted to it by the Dodd-Frank Act. Generally,

    proposed rule Sec. 50.10 states that it is unlawful for any person to

    knowingly or recklessly evade or participate in or facilitate an

    evasion of the requirements of section 2(h) of the CEA, to abuse the

    exception to the clearing requirement as provided under section 2(h)(7)

    of the CEA and Commission rule Sec. 39.6, or to abuse any exemption or

    exception to the requirements of section 2(h) of the CEA, including any

    exemption or exception as the Commission may provide by rule,

    regulation, or order.

    Although proposed rule Sec. 50.10 does not set forth a bright line

    test to define evasion or abuse, the proposed rule is expected to help

    ensure that would-be evaders cannot engage in conduct or activities

    that constitute an evasion of the requirements of section 2(h) or an

    abuse of any exemption or exception to such requirements. The

    Commission also proposes guidance as to how it would determine if such

    evasion or abuse has occurred, while at the same time preserving the

    Commission's ability to determine, on a case-by-case basis, with

    consideration given to all the facts and circumstances, that other

    types of transactions or activities constitute an evasion or abuse

    under proposed Sec. 50.10.

    The Commission proposes that participants in the markets should

    already have policies and procedures in place to ensure that their

    employees, affiliates, and agents will refrain from engaging in

    activities, including devising transactions, for the purpose of

    evading, or in reckless disregard of, the requirements of section 2(h)

    of the CEA and Commission rules and regulations promulgated thereunder

    or to abuse any exemption or exception to such requirements. Given that

    the proposed rule imposes no affirmative duties (i.e., reporting or

    recordkeeping), it is unlikely that it will impose any additional

    ongoing costs beyond the pre-existing costs associated with ensuring

    that the firm is not engaging in unlawful conduct. In that regard, the

    Commission believes that it will not be necessary for firms that

    currently have adequate compliance programs to hire additional staff or

    significantly upgrade their systems to comply with the proposed rule.

    Firms may, however, incur some one-time costs such as costs associated

    with training traders and staff on the proposed rule. In addition,

    market participants may incur costs when deciding whether particular

    conduct or activity could be construed as being an evasion of the

    requirements of section 2(h) or an abuse of any exemption or exception

    to such requirements. However, the proposed rules and proposed guidance

    explain what constitutes evasive or abusive conduct, which should serve

    to mitigate such costs.

    The Commission requests comment, including any quantifiable data

    and analysis, on the changes that market participants will have to make

    to their technological and legal infrastructures in order to clear the

    swaps that are subject to the proposed clearing requirement. How many

    market participants may have to establish new relationships with FCMs,

    or significantly upgrade those relationships? What updates to legal

    documentation are necessary, if any, for entities that already have an

    existing FCM relationship? If commenting on this subject, please

    clarify whether the comment relates to market participants that

    currently transact in: (1) Uncleared

    [[Page 47212]]

    swaps without margin agreements; (2) uncleared swaps with margin

    agreements; (3) cleared swaps; and/or (4) futures. If possible, please

    quantify costs and the specific platforms being implemented, or changes

    being made to existing platforms.

    b. Ongoing Costs Related to FCMs and Other Service Providers

    In addition to costs associated with technological and legal

    infrastructure, market participants transacting in swaps subject to the

    proposed clearing requirement will bear ongoing costs associated with

    fees charged by FCMs. Regarding fees, DCOs typically charge FCMs an

    initial transaction fee for each of the FCM's customers' IRS that are

    cleared, as well as an annual maintenance fee for each of their

    customers' open positions. Not including customer-specific and volume

    discounts, the transaction fees for IRS at the CME range from $1 to $24

    per million notional amount for IRS and the maintenance fees are $2 per

    year per million notional amount for open positions.\175\ LCH

    transaction fees for IRS range from $1-$20 per million notional amount,

    and the maintenance fee ranges from $5-$20 per swap per month,

    depending on the number of outstanding swap positions that an entity

    has with the clearinghouse.\176\ For CDS, ICE Clear Credit charges an

    initial transaction fee of $6 per million notional amount. There is no

    maintenance fee charged by ICE for maintaining open CDS positions.\177\

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

    \175\ See CME pricing charts at: http://www.cmegroup.com/trading/cds/files/CDS-Fees.pdf;

    http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Customer-Fee.pdf;

    and http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Self-Clearing-Fee.pdf [hereinafter ``CME Pricing Charts''].

    \176\ See LCH pricing for clearing services related to OTC IRS

    at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.

    \177\ See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.

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

    FCMs will also bear additional fees with respect to their house

    accounts at the DCO to the extent that they clear more swaps due to the

    clearing requirement. For example, for IRS that they clear through CME,

    clearing members are charged a transaction fee that ranges from $0.75

    to $18.00 per million notional, depending on the transaction

    maturity.\178\ Members, however, are not charged annual maintenance

    fees for their open house positions.\179\ For CDS, clearing members at

    ICE Clear Credit are charged $5 per transaction per million notional

    and there is no maintenance fee.\180\

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

    \178\ See CME Pricing Charts.

    \179\ See id.

    \180\ See LCH pricing for clearing services related to OTC IRS

    at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.

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

    As discussed above, it is difficult to predict precisely how the

    proposed requirement to clear the classes of swaps covered by this

    proposed rule will increase the use of swap clearing, as compared to

    the use of clearing that would occur in the absence of the requirement.

    However, the Commission expects that application of the clearing

    requirement to the swaps covered by the proposed rule will generally

    increase the use of clearing, leading to the ongoing transaction costs

    noted above.

    In addition, the Commission understands that FCM customers that

    only transact in swaps occasionally are typically required to pay a

    monthly or annual fee to each FCM that ranges from $75,000 to $125,000

    per year.\181\ Again, although it is impossible to predict precisely

    how many FCM customers would be subject to such fees based on the

    proposed clearing requirement for CDS and IRS, the Commission expects

    that some market participants that previously did not use clearing

    would be subject to the requirements of the proposed rule.

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

    \181\ See letters from Chatham and Webster Bank.

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

    The Commission requests comment on whether the cited fee

    information is accurate and typical, as well as, the extent to which

    such fees are expected to result from the requirement to clear the

    classes of swaps subject to the proposed rule. Comment is also

    requested on whether the increased use of clearing that may result is

    expected to change such fees, and if so, how. The Commission also

    requests additional comment, data, and analysis regarding the fee

    structures of FCMs in general, and in particular as they relate to the

    clearing of the types of swaps covered by the proposed rule.

    Specifically, the Commission requests comment on the following:

    Do the fees described above typically include fees charged

    by the DCO to the FCM for the FCM customer's swap positions?

    Do FCMs typically charge a similar fee to customers that

    are more active in trading swaps, and are such fees are generally

    greater, lesser, or similar to the fees charged to less active

    institutions?

    Do such maintenance fees exist for larger customers, and

    if so, approximately how much charged?

    c. Costs Related to Collateralization of Cleared Swap Positions

    As mentioned above, market participants that enter into the classes

    of swaps covered by the proposed rule will be required to post

    collateral at the DCO. Of course, the incremental cost of collateral

    resulting from the application of the proposed clearing requirement

    depends on the extent to which such swaps are already being cleared

    (even in the absence of the requirement) or otherwise collateralized.

    The incremental cost also depends on whether such swaps are, if not

    collateralized, priced to include implicit contingent liabilities and

    counterparty risk born by the counterparty to the swap.

    A conservative approach would be to assume that the swaps that

    would be covered by the proposed clearing requirement currently are

    uncleared, completely uncollateralized, and not priced to include

    implicit contingent liabilities and counterparty risk born by the

    counterparty. In this case, imposition of the clearing requirement for

    those types of swaps would create additional costs due to: (1) The

    spread between cost of capital and returns on that capital for assets

    posted to meet initial margin for the entire term of the swap; and (2)

    the spread between cost of capital and returns on that capital for

    assets posted to meet the variation margin to the extent a party is

    ``out of the money'' on each swap. Under the assumptions mentioned

    above, if every IRS and CDS that is not currently cleared were moved

    into clearing, the maximum additional initial margin that would need to

    be posted is approximately $19.2 billion for IRS and $53 billion for

    CDS. However, for the reasons described below, these numbers likely

    overestimate the amount of additional initial margin that would need to

    be posted.\182\

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

    \182\ There also is a possibility that the numbers calculated

    above under-estimate the amount of additional initial margin that

    will need to be posted under a required clearing regime for IRS and

    CDS. For instance, there may be numerous market participants with

    directional portfolios that will be unable to benefit from margin

    offsets. However, the Commission continues to believe that its

    estimates are more likely to overstate the required additional

    margin.

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

    The Commission calculated its estimated additional initial margin

    amounts based on the following assumptions. According to

    representations made to the Commission by LCH, they clear approximately

    51% of the IRS market. The total amount of initial margin on deposit at

    LCH for IRS is approximately $20 billion.\183\ Therefore, if all

    remaining IRS were moved into

    [[Page 47213]]

    clearing, approximately $19.2 billion ($20B/0.51-$20B = 19.2B) would

    have to be posted in initial margin.

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

    \183\ The total amount of initial margin on deposit at CME for

    IRS is $5 billion, but for purposes of this estimate, the Commission

    is not including that amount.

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

    Similarly, the initial margin related to CDS currently on deposit

    at CME, ICE Clear Credit, and ICE Clear Europe is approximately $21.4

    billion.\184\ This amount includes initial margin based on both index-

    based CDS and single-name CDS positions. BIS data indicates that

    approximately 36.6% of the CDS market comprises index-based CDS.\185\

    If we assume that approximately 36.6% of the overall portfolio-based

    CDS margin (i.e., CDS indices and single-name CDS margined together)

    currently held by DCOs for CDS positions is related to index-based CDS,

    and then add any margin held by DCOs attributable solely to index-based

    CDS, we can estimate that approximately $9.0 billion in margin

    currently held by those DCOs is related to index-based CDS. ISDA data

    indicates that 14.5% of the index-based CDS market is currently

    cleared.\186\ Therefore, if the entire index-based CDS market moved

    into clearing, $53 billion ($9.0/.145-$9.0 = $53) in initial margin

    would have to be posted at DCOs.\187\ Again, it is highly probable that

    these estimates significantly overstate the amount of additional

    capital that would be posted for a number of reasons described below.

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

    \184\ The total amount of initial margin on deposit only

    includes those amounts reported to the Commission by registered

    DCOs. Other clearinghouses, such as LCH.Clearnet.SA, clear the

    indices included in the proposed determination, however, the

    relative size of the open interest in the relevant CDS indices is

    substantially smaller than each of the DCOs included in this

    calculation.

    \185\ BIS estimates that the gross notional value of outstanding

    CDS contracts is $28.6 trillion, and that $10.5 trillion of that is

    index related CDS. See BIS data, available at http://www.bis.org/statistics/otcder/dt21.pdf.

    \186\ ISDA has estimated that 14.5% of the index-based CDS

    market is currently being cleared, whereas the total outstanding

    notional at CME, ICE Clear Europe, and ICE Clear Credit represents

    approximately 7.5% of the global index-based CDS market estimated by

    BIS. Such a discrepancy would be expected if one or more of the

    following occurred: (1) If ISDA overestimated the percentage of the

    index-based CDS that is currently being cleared; (2) if BIS

    overestimated the size of the global index-based swap market; (3) if

    a significant amount of compression occurs as index-based CDS are

    moved into clearing; and/or (4) if a significant portion of the

    cleared index-based CDS market is held at clearinghouses other than

    CME, ICE Clear Europe, and ICE Clear Credit. The Commission believes

    that the compression of CDS positions moving into clearing is the

    most likely explanation, and therefore has used the ISDA estimate.

    However, the Commission also requests comment from the public

    regarding the accuracy of ISDA and BIS estimates regarding index-

    based CDS markets, and requests from the public any additional data

    for purposes of determining with greater certainty how much of the

    index-based CDS market is currently being cleared.

    \187\ Both estimates assume that additional IRS brought into

    clearing would have similar margin requirements per unit of notional

    to those IRS that are already in clearing, and assumes that

    additional CDS brought into clearing would have similar margin

    requirements per unit of notional to those CDS that are already

    being cleared. These assumptions, in turn, imply similar levels of

    liquidity, compression, netting, and similar tenors for the swaps

    that are currently cleared and those that are not. While the

    Commission recognizes that these factors are not likely to be

    identical among both groups of products, adequate information to

    quantify the impact of each of these possible differences between

    the two groups of swaps on the amount of additional collateral that

    would have to be posted is not available.

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

    First, this analysis assumes that every IRS and index-based CDS not

    currently cleared is brought into clearing under the proposed rule.

    However, in this rule the Commission has proposed required clearing

    only for certain classes of IRS and CDS, and not for all IRS and CDS.

    Therefore, there will still be certain types of IRS, such as those

    related to the thirteen additional currencies cleared by LCH, that are

    not required to be cleared. Moreover, the clearing requirement will

    apply only to new swap transactions whereas market estimates include

    legacy transactions.

    In addition, non-financial entities entering into swaps for the

    purpose of hedging or mitigating commercial risk are not required to

    use clearing under section 2(h)(7) of the CEA. As a consequence, many

    entities will not be required to clear, even when entering into IRS or

    CDS that are otherwise required to be cleared. Third, some IRS and CDS

    involve cross-border transactions to which the Commission's clearing

    requirement will not apply.\188\ Fourth, collateral is already posted

    with respect to many non-cleared IRS and CDS. ISDA conducted a recent

    survey which reported that 93.4% of all trades involving credit

    derivatives, and 78.1% of all trades involving fixed income derivatives

    are subject to collateral agreements.\189\ Moreover, ISDA estimated

    that the aggregate amount of collateral in circulation in the non-

    cleared OTC derivatives market at the end of 2011 was approximately

    $3.6 trillion.\190\

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

    \188\ See Cross-Border Application of Certain Swaps Provisions

    of the Commodity Exchange Act, 77 FR 41213 (July 12, 2012).

    \189\ See ISDA Margin Survey 2012, at 15, available at: http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

    Although it is unclear exactly how many of the derivatives covered

    by this survey are swaps, it is reasonable to assume that a large

    part of them are.

    \190\ This estimate, however, does not adjust for double

    counting of collateral assets. The same survey reports that as much

    as 91.1% of cash used as collateral and 43.8% of securities used as

    collateral are being reused, and therefore are counted two or more

    times in the ISDA survey. See ISDA Margin Survey 2012, at 20 and 11,

    respectively.

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

    In any case, it is reasonable to assume that the requirement to

    clear the swaps covered by the proposed rule will result in increased

    use of clearing and increased posting of collateral with respect to

    such swaps. To calculate the additional collateral cost to market

    participants, we must estimate the difference between the cost of

    capital for the additional collateral and the returns on that capital.

    In comments regarding other Commission rules, commenters have often

    taken the view that the difference between the cost and returns on

    capital for funds that are used as collateral is substantial.

    In a study commissioned by the Working Group of Commercial Energy

    Firms, for example, NERA used an estimate of 13.08% for the pre-tax

    weighted average cost of capital for the firm, and an estimate of 3.49%

    for the pre-tax yield on collateral, for a difference as 9.59% which

    NERA used as the net pre-tax cost of collateral.\191\ However, these

    estimates use the borrowing costs for the entire firm, but only

    consider the returns on capital for one part of the firm, when

    determining the spread between the two. The result is an over-stated

    difference, and therefore a higher cost associated with collateral than

    would result if the costs of capital and returns of capital were

    compared on a consistent basis.\192\

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

    \191\ The NERA study is available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=50037 and their comments

    defending their cost of capital are available in their letter at

    http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=57015.

    \192\ This aspect of the NERA study has been described in

    greater detail by MIT professors John Parsons and Antonio Mello,

    available at: http://bettingthebusiness.com/2012/01/22/phantom-costs-to-the-swap-dealer-designation-and-otc-reform/ and http://bettingthebusiness.com/2012/03/19/nera-doubles-down/.

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

    However, the Commission notes that this cost is not only likely

    overstated, for the reasons mentioned above, but that it also may not

    be a new cost. Rather, it is a displacement of a cost that is embedded

    in uncleared, uncollateralized swaps. Entering into a swap is costly

    for any market participant because of the default risk posed by its

    counterparty, whether the counterparty is a DCO, swap dealer, or other

    market participant. When a market participant faces the DCO, the DCO

    accounts for that counterparty risk by requiring collateral to be

    posted, and the cost of capital for the collateral is part of the cost

    that is necessary in order to maintain the swap position. When a market

    participant faces a dealer or other counterparty in an uncleared swap,

    however, the uncleared swap contains an implicit line of credit upon

    which the market participant effectively draws when its swap position

    is out of

    [[Page 47214]]

    the money. Counterparties charge for this implicit line of credit in

    the spread they offer on uncollateralized, uncleared swaps. It can be

    shown that the cash flows of an uncollateralized swap (i.e., a swap

    with an implicit line of credit) are, over time, substantially

    equivalent to the cash flows of a collateralized swap with an explicit

    line of credit.\193\ And because the counterparty risk created by the

    implicit line of credit is the same as the counterparty risk that would

    result from an explicit line of credit provided to the same market

    participant, to a first order approximation, the charge for each should

    be the same as well.\194\ This means that the cost of capital for

    additional collateral posted as a consequence of requiring

    uncollateralized swaps to be cleared does not introduce an additional

    cost, but rather takes a cost that is implicit in an uncleared,

    uncollateralized swap and makes it explicit. This observation applies

    to capital costs associated with both initial margin and variation

    margin.

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

    \193\ Mello, Antonio S., and John E. Parsons, ``Margins,

    Liquidity, and the Cost of Hedging.'' MIT Center for Energy and

    Environmental Policy Research, May 2012, available at http://dspace.mit.edu/bitstream/handle/1721.1/70896/2012-005.pdf?sequence=1.

    \194\ See id., Mello and Parsons state in their paper, ``Hedging

    is costly. But the real source of the cost is not the margin posted,

    but the underlying credit risk that motivates counterparties to

    demand that margin be posted.'' Id. at 12. They go on to demonstrate

    that, ``To a first approximation, the cost charged for the non-

    margined swap must be equal to the cost of funding the margin

    account. This follows from the fact that the non-margined swap just

    includes funding of the margin account as an embedded feature of the

    package.'' Id. at 15-16.

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

    The Commission invites further comment regarding the total amount

    of additional collateral that would be posted due to required clearing

    of the classes of swaps designated in this proposal. Furthermore, the

    Commission invites comment regarding the cost of capital and returns on

    capital for that collateral, as well as on the cost of the implicit

    line of credit embedded in uncleared, uncollateralized swaps. The

    Commission, in particular, welcomes any quantifiable data and analysis

    that commenters are willing to share regarding these subjects.

    Another impact of the proposed rule may be that financial

    institutions are required to hold additional capital with respect to

    their swap positions pursuant to prudential regulatory capital

    requirements. Basel III standards are designed to incentivize central

    clearing of derivatives by applying a lower capital weighting to them

    than for similar uncleared derivatives positions. Therefore, the

    Commission expects that the capital that financial institutions are

    required to hold is likely to be reduced as a consequence of their

    increased use of swap clearing. The Commission invites comment on the

    effects of required clearing on the capital requirements for financial

    institutions. To the extent possible, please quantify the relevant

    costs and benefits and explain the effect of the relevant capital

    standards.

    In addition, operational costs may result from the collateral

    requirements that apply to the proposed clearing requirement. With

    uncleared swaps, counterparties may agree not to collect variation

    margin until certain thresholds of exposure are reached, thus reducing

    or perhaps entirely eliminating the need to exchange variation margin

    as exposure changes. DCOs, on the other hand, collect and pay variation

    margin on a daily basis and sometimes more frequently. As a

    consequence, increased required clearing may increase certain

    operational costs associated with moving variation margin to and from

    the DCO. On the other hand, increased clearing is also likely to lead

    to benefits from reduced operational costs related to valuation

    disputes, as parties to cleared swaps agree to abide by the DCO's

    valuation procedures. To the extent that the requirement to clear the

    types of swaps covered by the proposed rule leads to increased use of

    clearing, these costs and benefits are likely to result. The Commission

    invites further comment regarding the costs and benefits associated

    with operational differences related to the collateralization of

    uncleared versus cleared swaps.

    Increases in clearing as a result of the proposed clearing

    requirement also may result in additional costs for clearing members in

    the form of guaranty fund contributions. However, it also may be that

    increased clearing of swaps would decrease guaranty fund contributions

    for certain clearing members. Market participants that currently

    transact swaps bilaterally and do not clear such swaps must either

    become clearing members of an appropriate DCO or submit such swaps for

    clearing through an existing clearing member, once the clearing

    requirement applies to such swaps. A party that chooses to become a

    clearing member of a DCO must make a guaranty fund contribution. A

    party that chooses to clear swaps through an existing clearing member

    may have a share of the clearing member's guaranty fund contribution

    passed along to it in the form of fees. While the addition of new

    clearing members and new customers for existing clearing members may

    result in existing clearing members experiencing an increase in their

    guaranty fund requirements, it should be noted that if (1) new clearing

    members are not among the two clearing members used to calculate the

    guaranty fund and (2) any new customers trading through a clearing

    member do not increase the size of uncollateralized risks at either of

    the two clearing members used to calculate the guaranty fund, all else

    held constant, existing clearing members may experience a decrease in

    their guaranty fund requirement.\195\

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

    \195\ In order to calculate the size of their guaranty funds,

    clearinghouses for swaps generally stress their clearing members'

    portfolios under a number of extreme, but plausible, scenarios in

    order to identify the two clearing members with the largest losses.

    The resulting loss calculation of those two clearing members is used

    to size the guaranty fund. Once that amount is established, the

    clearinghouse will require contributions of all clearing members

    based on their relative ``losses'' under the stress scenarios.

    Assuming that the portfolios of new clearing members and new

    customers do not alter the overall sizing of the guaranty fund, but

    that the new clearing members are making contributions to the

    guaranty fund based on their relative potential losses, the overall

    guaranty fund contribution for existing clearing members may

    decrease.

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

    d. Benefits of Clearing

    As noted above, the benefits of swap clearing, in general, are

    significant. Thus, to the extent that the proposed clearing requirement

    for certain classes of IRS and CDS leads to increased use of clearing,

    these benefits are likely to result. As is the case for the costs noted

    above, it is impossible to predict the precise extent to which the use

    of clearing will increase as a result of the proposed rule, and

    therefore the benefits of the proposed rule cannot be precisely

    quantified. But the Commission believes that the benefits of increased

    clearing resulting from the proposed rule will be significant, because

    the classes of swaps required to be cleared by the proposed rule

    represent a substantial portion of the total swap markets. Currently

    outstanding IRS and CDS indices have notional amounts of about $504

    trillion and $10.4 trillion, respectively, which is a substantial part

    of the $648 trillion notional global swaps market.\196\ As noted above,

    the proposed rule requires that only certain classes of IRS and CDS

    indices be cleared, but such classes likely represent the most common

    swaps within those overall asset classes, and therefore are likely to

    constitute a relatively large portion of those asset classes. By

    requiring these particular swaps to be cleared, the benefits of

    clearing are expected to be realized across a relatively large portion

    of the

    [[Page 47215]]

    market. The Commission requests comment on whether such benefits will

    result from the proposed rule and, if so, the expected magnitude of

    such benefits.

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

    \196\ BIS data, December 2011, available at: http://www.bis.org/statistics/derstats.htm.

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

    The proposed rule's requirement that certain classes of swaps be

    cleared is expected to increase the number of swaps in which market

    participants will face a DCO, and therefore, will face a highly

    creditworthy counterparty. DCOs are some of the most creditworthy

    counterparties in the swap market because they have at their disposal a

    number of risk management tools that enable them to manage counterparty

    risk effectively. Those tools include contractual rights that enable

    them to use margin to manage current and potential future exposure, to

    close out and transfer defaulting positions while minimizing losses

    that result from such defaults, and to protect solvency during the

    default of one or more members through a waterfall of financial

    contributions from which they can draw, as outlined above. Also,

    clearing protects swap users from the risk of having to share in loss

    mutualization among FCMs if one DCO member defaults and such measures

    are necessary.

    This proposed rule requires that classes of swaps that are required

    to be cleared must be submitted to clearing ``as soon as

    technologically practicable after execution, but in any event by the

    end of the day of execution.'' \197\ This conforms to the requirements

    established in the recently finalized rule regarding timing of

    acceptance for clearing,\198\ which is designed to promote rapid

    submission of these swaps for clearing and reduce the unnecessary

    counterparty risk that can develop between the time of execution and

    submission to clearing.\199\

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

    \197\ See proposed Sec. 50.2(a).

    \198\ See Client Clearing Documentation, Timing of Acceptance

    for Clearing, and Clearing Member Risk Management, 77 FR 21278 (Apr.

    9, 2012).

    \199\ The Commission notes that if a market participant executed

    a swap that is required to be cleared on a SEF or DCM, then that

    market participant will be deemed to have met their obligation to

    submit the swap to a DCO because of the straight-through processing

    rules previously adopted by the Commission.

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

    The Commission expects that the requirement for rapid submission,

    processing, and acceptance or rejection of swaps for clearing will be

    beneficial in several respects. It is important to note that when two

    parties enter into a bilateral swap with the intention of clearing it,

    each party bears counterparty risk until the swap is cleared. Once the

    swap is cleared, the clearinghouse becomes the counterparty to each of

    the original parties, which minimizes and standardizes counterparty

    risk.

    Where swaps of the type covered by the proposed rule are not

    executed on an exchange, the proposed rule should significantly reduce

    the amount of time needed to process them. Although costs associated

    with latency-period counterparty credit risk cannot be completely

    eliminated in this context, the rules will reduce the need to

    discriminate among potential counterparties in off-exchange swaps, as

    well as the potential costs associated with rejected swaps. By reducing

    the counterparty risk that could otherwise develop during the latency

    period, these rules promote a market in which all eligible market

    participants have access to counterparties willing to trade on terms

    that approximate the best available terms in the market. This may

    improve price discovery and promote market integrity.

    In addition, absent proposed Sec. 50.10 and related

    interpretations, certain risks could increase in a manner that the

    Commission would not be able to measure accurately. Proposed Sec.

    50.10 and related interpretations are expected to bring the appropriate

    scope of swaps within the requirements of section 2(h), which will

    facilitate the achievement of the benefits of swap clearing and trade

    execution, among others. Activity conducted solely for a legitimate

    business purpose, absent other indicia of evasion or abuse, would not

    constitute a violation of proposed Sec. 50.10 as described in the

    Commission's proposed interpretation.

    D. Costs and Benefits of the Proposed Rule as Compared to Alternatives

    The Commission's proposal to apply the clearing requirement

    initially to certain CDS and IRS is a function of both the market

    importance of these products and the fact that they already are widely

    cleared. In order to move the largest number of swaps to required

    clearing in its initial determination, the Commission believes that it

    is prudent to focus on swaps that are widely used and for which there

    is already a blueprint for clearing and appropriate risk management.

    CDS and IRS that match these factors are therefore well suited for

    required clearing.

    As noted above, IRS with a notional amount of $504 trillion are

    currently outstanding--the highest proportion of the $648 trillion

    global swaps market of any class of swaps.\200\ CDS indices with a

    notional amount of about $10.4 trillion are currently outstanding.\201\

    While CDS indices do not have as prominent a share of the entire swaps

    market as IRS, uncleared CDS is capable of having a sizeable market

    impact, as it did during the 2008 financial crisis. In addition, many

    of the swaps within each of the classes proposed for required clearing

    are already cleared by one or more clearinghouses. LCH claims to clear

    IRS with a notional amount of about $284 trillion--meaning that, in

    notional terms, LCH clears 51% of the interest rate swap market.\202\

    The swap market has made a smooth transition into clearing CDS on its

    own initiative. As a result, DCOs, FCMs, and many market participants

    already have experience clearing the types of swaps that have been

    proposed for required clearing. The Commission expects, therefore, that

    DCOs and FCMs are equipped to handle the increases in volume and

    outstanding notional amount in these swaps that is likely to be cleared

    as the result of the proposed rule. Because of the wide use of these

    swaps and their importance to the market, and because these swaps are

    already cleared safely, the Commission is proposing to subject certain

    types of IRS and CDS to the initial clearing requirement.

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

    \200\ BIS data, June 2011, available at http://www.bis.org/publ/otc_hy1111.pdf.

    \201\ See id.

    \202\ See id.

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

    The Commission is proposing certain key specifications for CDS and

    IRS that will inform whether a particular swaps falls within one of the

    classes of swaps that are required to be cleared. The two classes of

    CDS that are required to be cleared are (1) U.S. dollar-denominated CDS

    covering North America corporate credits and (2) euro-denominated CDS

    referencing European obligations. The four classes of IRS required to

    be cleared are (1) fixed-to-floating swaps, (2) basis swaps, (3) OIS,

    and (4) FRAs.

    Regarding CDS, the Commission has outlined three key specifications

    comprising (1) region and nature of reference entity, (2) the nature of

    the CDS itself, and (3) tenor. Each of these specifications will assist

    market participants in determining whether a swap falls within the CDS

    classes of swaps required to be cleared. For the first, a

    distinguishing characteristic is whether the reference entity is in

    North American or European and whether it is one of Markit's CDX.NA.IG,

    CDX.NA.HY, iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe

    High Volatility indices. The second key specification relates to

    whether the CDS is tranched or untranched. The classes that are

    required to be cleared include only untranched CDS where the contract

    covers the entire index loss

    [[Page 47216]]

    distribution of the indice and settlement is not linked to a specified

    number of defaults. Tranched swaps, first- or ``Nth'' to-default,

    options, or any other product variations on these indices are excluded

    from these classes. Finally, the third key specification entails

    whether a swap falls within a tenor, specific to an index, that is

    required to be cleared. The Commission has determined that each of the

    3-, 5-, 7-, and 10-year tenors be included within the class of swaps

    subject to the clearing requirement determination for CDX.NA.IG; the 5-

    year tenor be included for CDX.NA.HY; each of the 5- and 10-year for

    ITraxx Europe; the 5-year for ITraxx Europe Crossover; and, the 5-year

    for ITraxx Europe High Volatility. In addition, it should be noted that

    only certain series will be viewed as required to be cleared.

    The Commission had a number of alternatives to that proposed.

    First, the Commission could have used a narrower or broader group of

    reference entities. For example, the Commission has not included the

    CDX.NA.IG.HVOL within the North American swap class. While doing so

    would have increased the number of swaps required to be cleared, the

    Commission questions whether there is sufficient liquidity to justify

    required clearing at this time given that the recent series of

    CDX.NA.IG.HVOL have not been cleared by ICE (and are not offered at all

    by CME).

    The Commission could also have endeavored to include tranched CDS.

    The Commission recognizes that there is a significant market for

    tranched swaps using the indices. In these transactions, parties to the

    CDS contract agree to address only a certain range of losses along the

    entire loss distribution curve. Other swaps such as first or ``Nth'' to

    default baskets, and options, also exist on the indices. However, these

    swaps are not being cleared currently and were not submitted by a DCO

    for consideration under Sec. 39.5.

    Regarding tenor, the Commission could have included more of those

    offered within the classes of swaps required to be cleared. For

    example, the CDX.NA.IG has 1- and 2-year tenors and the CDX.NA.HY, has

    3-, 7-, and 10-year tenors that have not been included among the

    specified tenors. The iTraxx Europe has 3- and 7-year tenors and the

    Crossover and High Volatility each have 3-, 7-, and 10-year tenors that

    have not been included. In addition, the Commission could have included

    all series of active indices. The concern, regarding both tenors and

    series, is that certain tenors and series have lower liquidity and may

    be difficult for a DCO to adequately risk manage. While including more

    tenors and series would have increased the volume of swaps required to

    be cleared to some degree, the Commission proposes that doing so may

    have raised costs for DCOs and other market participants and been less

    desirable relative to the factors established in Sec. 39.5.

    With regard to IRS, as mentioned above, the Commission is proposing

    a clearing requirement for four classes of interest rate swaps: fixed-

    to-floating swaps, basis swaps, OIS, and FRAs. Within those four

    classes, the Commission is proposing three affirmative specifications

    for each class ((i) Currency used for in which the notional and payment

    amounts are specified, (ii) rates referenced for each leg of the swap,

    and (iii) stated termination date of the swap) and three ``negative''

    specifications for each class ((i) No optionality (as specified by the

    DCOs); (ii) no dual currencies; and (iii) no conditional notional

    amounts).

    The Commission considered whether to establish clearing

    requirements on a product-by-product basis. Such a determination would

    need to identify the multitude of legal specifications of each product

    that would be subject to the clearing requirement. Although the

    industry uses standardized definitions and conventions, the product

    descriptions would be lengthy and require counterparties to compare all

    of the legal terms of their particular swap against the terms of the

    many different swaps that would be included in a clearing requirement.

    The Commission believes that for interest rate swaps, a product-by-

    product determination could be unnecessarily burdensome for market

    participants in trying to assess whether each swap transaction is

    subject to the requirement. A class-based approach would allow market

    participants to determine quickly whether they need to submit their

    swap to a DCO for clearing by checking initially whether the swap has

    the basic specifications that define each class subject to the clearing

    requirement.

    As an alternative to the classes selected, LCH recommended that the

    Commission use the following specifications to classify interest rate

    swaps for purposes of making a clearing determination: (i) Swap class

    (i.e., what the two legs of the swap are (fixed-to-floating, basis,

    OIS, etc.)), (ii) floating rate definitions used, (iii) the currency

    designated for swap calculations and payments, (iv) stated final term

    of the swap (also known as maturity), (v) notional structure over the

    life of the swap (constant, amortizing, roller coaster, etc.), (vi)

    floating rate frequency, (vii) whether optionality is included, and

    (viii) whether a single currency or more than one currency is used for

    denominating payments and notional amount. CME recommended a clearing

    determination for all non-option interest rate swaps denominated in a

    currency cleared by any qualified DCO.

    These alternative specifications fall into two general categories:

    specifications that are commonly used to address mechanical issues for

    most swaps, and specifications that are less common and address

    idiosyncratic issues related to the particular needs of a counterparty.

    Examples of the latter are special representations added to address

    particular legal issues, unique termination events, special fees, and

    conditions tied to events specific to the parties. None of the DCOs

    clear interest rate swaps with terms in the second group. As for

    mechanical specifications, while the Commission recognizes that such

    specifications may affect the value of the swap, such specifications

    are not, generally speaking, fundamental to determining the economic

    result the parties are trying to achieve.\203\ The Commission has

    proposed the three affirmative specifications described above because

    it believes that they are fundamental specifications used by

    counterparties to determine the economic result of a swap transaction

    for each party.

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

    \203\ As noted in Section II.E above, mechanical specifications

    include characteristics such as floating rate reset tenors,

    reference city for business days, business day convention, and

    others that have some small impact on valuation but that do not

    fundamentally alter the economic consequence of the swap for the

    parties that enter into it.

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

    The Commission also could have avoided the negative specifications

    for IRS, which would have had the effect of potentially including more

    IRS swaps within the universe of those required to be cleared. However,

    the Commission believes that swaps with optionality, multiple currency

    swaps, and swaps with conditional notional amounts raise concerns

    regarding adequate pricing measures and consistency across swap

    contracts. Such contingencies make them difficult for DCOs to

    effectively risk manage. Additionally, at this time, no DCO is offering

    them for clearing.

    Another alternative considered by the Commission, but not proposed,

    was that of stating the clearing requirement in terms of a particular

    type of swap, rather than using broad characteristics to describe the

    type of swaps for which clearing would be required. For example, rather

    than requiring that all IRS that meet the six specifications in

    proposed Sec. 50.4(a) be cleared, the rule could have specified that

    only certain

    [[Page 47217]]

    sub-types of those IRS--such as all such IRS with a term of five

    years--are required to be cleared. Such an approach might permit the

    Commission to account for variation in liquidity and outstanding

    notional values among different sub-types of swap, and thereby focus

    the clearing requirement on very particular swaps to account for these

    differences within the same general class. Also, generally speaking,

    limiting the clearing requirement to fewer swaps could reduce some

    costs associated with clearing.

    However, this advantage was weighed against an important

    disadvantage of this approach. A highly focused clearing requirement

    could increase the ability for market participants to replicate the

    economic results of a swap that is required to be cleared by

    substituting a swap not required to be cleared; this greater latitude

    for clearing avoidance, in turn, could increase systemic risk and

    dampen the beneficial effects of clearing noted above.\204\ Under the

    approach proposed by the Commission, all swaps that fall within

    identified classes are covered by the clearing requirement, which

    reduces the risk of such avoidance and the associated reduction of

    benefits. Moreover, stating the clearing requirement in more general

    terms reduces the costs associated with determining whether or not a

    particular swap is subject to the clearing requirement.

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

    \204\ For instance, in the example noted above, swaps with a

    term of five years and one day would not be required to be cleared.

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

    The Commission invites comment on the costs and benefits of

    identifying classes of swaps for clearing in a more focused or more

    general manner. If possible, please quantify costs and benefits that

    result either from the approach proposed by the Commission or from

    alternatives that you believe the Commission should consider.

    The Commission also considered proposing required clearing for all

    seventeen currencies of IRS that are currently offered for clearing,

    but decided instead to propose required clearing at this time for IRS

    in four currencies (EUR, USD, GBP, and JPY). The Commission recognizes

    that requiring IRS in all seventeen currencies submitted by LCH

    Clearnet to be cleared would provide the benefit of some incremental

    reduction in overall counterparty, and thus systemic, risk attendant to

    clearing a greater portion of IRS. However, as noted above, the

    Commission proposes that initiating the clearing requirement in a

    measured manner with respect to IRS in the four specified currencies

    familiar to many market participants is the preferable approach at this

    time because it would give market participants an opportunity to

    identify and address any operational challenges related to required

    clearing. Moreover, the currencies included in the proposed classes

    constitute approximately 93% of cleared IRS, which suggests that

    significant reductions in counterparty risk and gains in systemic

    protection will be accomplished by limiting the clearing determination

    to them.

    Similarly, the Commission considered requiring clearing of all CDS

    that are currently being cleared, but decided not to include, in the

    initial clearing requirement, certain types of CDS that have a less

    significant role in the current market.\205\

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

    \205\ For instance, the Commission decided not to include

    CDX.NA.IG.HiVOL from the proposed determination given the lack of

    volume in the current on-the-run and recent off-the-run series. In

    addition, CME currently does not clear any HiVOL contracts, and ICE

    Clear Credit no longer clears the most recent series.

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

    The Commission invites further comment on its decision-making with

    regard to the classes of IRS and CDS that would be required to be

    cleared. Commenters are also invited 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.

    E. Section 15(a) Factors

    As noted above, the requirement to clear the classes of swaps

    covered by the proposed rule is expected to result in increased use of

    clearing, although it is impossible to quantify with certainty the

    extent of that increase. Thus, this section discusses the expected

    results from an overall increase in the use of swap clearing in terms

    of the factors set forth in section 15(a) of the CEA.

    i. Protection of Market Participants and the Public

    As described above, required clearing of the classes of swaps

    identified in this proposed rule is expected to reduce counterparty

    risk for market participants that clear those swaps because they will

    face the DCO rather than another market participant that lacks the full

    array of risk management tools that the DCO has at its disposal. This

    also reduces uncertainty in times of market stress because market

    participants facing a DCO are less concerned with the impact of such

    stress on the solvency of their counterparty for cleared trades.

    By proposing to require clearing of certain classes of swaps, all

    of which are already available for clearing, the Commission expects to

    encourage a smooth transition by creating an opportunity for market

    participants to work out challenges related to required clearing of

    swaps while operating in familiar terrain. More specifically, the DCOs

    will clear an increased volume of swaps that they already understand

    and have experience managing. Similarly, FCMs likely will realize

    increased customer and transaction volume as the result of the

    requirement, but will not have to simultaneously learn how to

    operationalize clearing for new types of swaps. And the experience of

    FCMs with these products is also likely to benefit customers that are

    new to clearing, as the FCM guides them through initial experiences

    with cleared swaps.\206\

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

    \206\ As discussed in Section II.C and II.E above, DCOs offering

    clearing for CDS and IRS have established extensive risk management

    practices, which focus on the protection of market participants. See

    also Sections II.D and II.F for a discussion of the effect on the

    mitigation of systemic risk in the CDS market and in the IRS market,

    as well as the protection of market participants during insolvency

    events at either the clearing member or DCO level.

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

    In addition, uncleared swaps subject to collateral agreements can

    be the subject of valuation disputes. These valuation disputes

    sometimes require several months, or longer, to resolve.

    Uncollateralized exposure can grow significantly during that time,

    leaving one of the two parties exposed to counterparty risk that was

    intended to be covered through a collateral agreement. DCOs reduce

    valuation disputes for cleared swaps as well as the risk that

    uncollateralized exposure can develop and accumulate during the time

    when such a dispute would have otherwise occurred, thus providing

    additional protection to market participants who transact in swaps that

    are required to be cleared.\207\

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

    \207\ See Sections II.D and II.F above for a further discussion

    of how DCOs obtain adequate pricing data for the CDS and IRS that

    they clear. Based on this pricing data, valuation disputes are

    minimized, if not eliminated for cleared swaps.

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

    As far as costs are concerned, market participants that do not

    currently have established clearing relationships with an FCM will have

    to set up and maintain such a relationship in order to clear swaps that

    are required to be cleared. As discussed above, market participants

    that conduct a limited number of swaps per year will likely be required

    to pay monthly or annual fees that FCM's charge to maintain both the

    relationship and outstanding swap positions belonging to the customer.

    In addition, the FCM is likely to pass along fees charged by the DCO

    for establishing and maintaining open positions.

    [[Page 47218]]

    ii. Efficiency, Competitiveness, and Financial Integrity of Swap

    Markets

    Swap clearing, in general, is expected to reduce uncertainty

    regarding counterparty risk in times of market stress and promote

    liquidity and efficiency during those times. Increased liquidity

    promotes the ability of market participants to limit losses by exiting

    positions effectively when necessary in order to manage risk during a

    time of market stress.

    In addition, to the extent that positions move from facing multiple

    counterparties in the bilateral market to being run through a smaller

    number of clearinghouses, clearing facilitates increased netting. This

    reduces the amount of collateral that a party must post in margin

    accounts.

    As discussed in Sections II.D and II.F above, in setting forth this

    proposal, the Commission took into account a number of specific factors

    that relate to the financial integrity of the swap markets.

    Specifically, the discussion above includes an assessment of whether

    the DCOs clearing CDS and IRS have the rule framework, capacity,

    operational expertise and resources, and credit support infrastructure

    to clear CDS and IRS on terms that are consistent with the material

    terms and trading conventions on which the contract is then traded. The

    proposal also considered the resources of DCOs to handle additional

    clearing, as well as the existence of reasonable legal certainty in the

    event of a clearing member or DCO insolvency.\208\

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

    \208\ See Section II.C and II.E.

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

    As discussed above, bilateral swaps create counterparty risk that

    may lead market participants to discriminate among potential

    counterparties based on their creditworthiness. Such discrimination is

    expensive and time consuming insofar as market participants must

    conduct due diligence in order to evaluate a potential counterparty's

    creditworthiness. Requiring certain types of swaps to be cleared

    reduces the number of transactions for which such due diligence is

    necessary, thereby contributing to the efficiency of the swap markets.

    In proposing a clearing requirement for both CDS and IRS, the

    Commission must consider the effect on competition, including

    appropriate fees and charges applied to clearing. As discussed in more

    detail in Sections II.D and II.F above, there are a number of potential

    outcomes that may result from required clearing. Some of these outcomes

    may impose costs, such as if a DCO possessed market power and exercised

    that power in an anticompetitive manner, and some of the outcomes would

    be positive, such as if the clearing requirement facilitated a stronger

    entry-opportunity for competitors.

    As far as costs are concerned, the markets for some swaps within

    the classes that are proposed to be required to be cleared may be less

    liquid than others. All other things being equal, swaps for which the

    markets are less liquid have the potential to develop larger current

    uncollateralized exposures after a default on a cleared position, and

    therefore will require posting of relatively greater amounts of initial

    margin.

    iii. Price Discovery

    Clearing, in general, encourages better price discovery because it

    eliminates the importance of counterparty creditworthiness in pricing

    swaps cleared through a given DCO. That is, by making the counterparty

    creditworthiness of all swaps of a certain type essentially the same,

    prices should reflect factors related to the terms of the swap, rather

    than the idiosyncratic risk posed by the entities trading it.\209\

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

    \209\ See Chen, K., et al. ``An Analysis of CDS Transactions:

    Implications for Public Reporting,'' September 2011, Federal Reserve

    Bank of New York Staff Reports, at 14, available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf.

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

    As discussed in sections II.D and II.F above, DCOs obtain adequate

    pricing data for the CDS and IRS that they clear. Each DCO establishes

    a rule framework for its pricing methodology and rigorously tests its

    pricing models to ensure that the cornerstone of its risk management

    regime is as sound as possible.

    iv. Sound Risk Management Practices

    If a firm enters into swaps to hedge certain positions and then the

    counterparty to those swaps defaults unexpectedly, the firm could be

    left with large outstanding exposures. As stated above, when a swap is

    cleared the DCO becomes the counterparty facing each of the two

    original participants in the swap. This standardizes and reduces

    counterparty risk for each of the two original participants. To the

    extent that a market participant's hedges comprise swaps that are

    required to be cleared, the requirement enhances their risk management

    practices by reducing their counterparty risk.

    In addition, from systemic perspective, required clearing reduces

    the complexity of unwinding/transferring swap positions from large

    entities that default. Procedures for transfer of swap positions and

    mutualization of losses among DCO members are already in place, and the

    Commission anticipates that they are much more likely to function in a

    manner that enables rapid transfer of defaulted positions than legal

    processes that would surround the enforcement of bilateral contracts

    for uncleared swaps.\210\

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

    \210\ As discussed in Sections II.C and II.E above, sound risk

    management practices are critical for all DCOs, especially those

    offering clearing for CDS and IRS. In the discussion above, the

    Commission considered whether each DCO submission under review was

    consistent with the core principles for DCOs. In particular, the

    Commission considered the DCO submissions in light of Core Principle

    D, which relates to risk management. See also Sections II.D and II.F

    for a discussion of the effect on the mitigation of systemic risk in

    the CDS market and in the IRS market, as well as the protection of

    market participants during insolvency events at either the clearing

    member or DCO level.

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

    v. Other Public Interest Considerations

    In September 2009, the President and the other leaders of the

    ``G20'' nations met in Pittsburgh and committed to a program of action

    that includes, among other things, central clearing of all standardized

    swaps.\211\ Together, IRS and CDS represent more than 75% of the

    notional amount of outstanding swaps, and therefore, requiring the most

    active, standardized classes of swaps within those groups to be cleared

    represents a significant step toward the fulfillment of that

    commitment.

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

    \211\ A list of the G20 commitments made in Pittsburgh can be

    found at: http://www.g20.utoronto.ca/analysis/commitments-09-pittsburgh.html.

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

    VI. Related Matters

    A. Regulatory Flexibility Act

    The Regulatory Flexibility Act (RFA) requires that agencies

    consider whether the rules they propose will have a significant

    economic impact on a substantial number of small entities and, if so,

    provide a regulatory flexibility analysis respecting the impact.\212\

    The clearing requirement determinations and rules proposed by the

    Commission will affect only eligible contract participants (ECPs)

    because all persons that are not ECPs are required to execute their

    swaps on a DCM, and all contracts executed on a DCM must be cleared by

    a DCO, as required by statute and regulation; not by operation of any

    clearing requirement.\213\

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

    \212\ See 5 U.S.C. 601 et seq.

    \213\ To the extent that this rulemaking affects DCMs, DCOs, or

    FCMs, the Commission has previously determined that DCMs, DCOs, and

    FCMs are not small entities for purposes of the RFA. See,

    respectively and as indicated, 47 FR 18618, 18619, Apr. 30, 1982

    (DCMs and FCMs); and 66 FR 45604, 45609, Aug. 29, 2001 (DCOs).

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

    [[Page 47219]]

    The Commission has previously determined that ECPs are not small

    entities for purposes of the RFA.\214\ However, in its proposed

    rulemaking to establish a schedule to phase in compliance with certain

    provisions of the Dodd-Frank Act, including the clearing requirement

    under section 2(h)(1)(A) of the CEA, the Commission received a joint

    comment (Electric Associations Letter) from the Edison Electric

    Institute (EEI), the National Rural Electric Cooperative Association

    (NRECA) and the Electric Power Supply Association (EPSA) asserting that

    certain members of NRECA may both be ECPs under the CEA and small

    businesses under the RFA.\215\ These members of NRECA, as the

    Commission understands, have been determined to be small entities by

    the Small Business Administration (SBA) because they are ``primarily

    engaged in the generation, transmission, and/or distribution of

    electric energy for sale and [their] total electric output for the

    preceding fiscal year did not exceed 4 million megawatt hours.''\216\

    Although the Electric Associations Letter does not provide details on

    whether or how the NRECA members that have been determined to be small

    entities use the IRS and CDS that are the subject of this rulemaking,

    the Electric Associations Letter does state that the EEI, NRECA and

    EPSA members ``engage in swaps to hedge commercial risk.'' \217\

    Because the NRECA members that have been determined to be small

    entities would be using swaps to hedge commercial risk, the Commission

    expects that they would be able to use the end-user exception from the

    clearing requirement and therefore would not be affected to any

    significant extent by this rulemaking.

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

    \214\ See 66 FR 20740, 20743 (Apr. 25, 2001).

    \215\ See joint letter from EEI, NRECA, and ESPA, dated Nov. 4,

    2011, (Electric Associations Letter), commenting on Swap Transaction

    Compliance and Implementation Schedule: Clearing and Trade Execution

    Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20,

    2011).

    \216\ Small Business Administration, Table of Small Business

    Size Standards, Nov. 5, 2010.

    \217\ See Electric Associations Letter, at 2. The letter also

    suggests that EEI, NRECA, and EPSA members are not financial

    entities. See id., at note 5, and at 5 (the associations' members

    ``are not financial companies'').

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

    Thus, because nearly all of the ECPs that may be subject to the

    proposed clearing requirement are not small entities, and because the

    few ECPs that have been determined by the SBA to be small entities are

    unlikely to be subject to the clearing requirement, the Chairman, on

    behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that

    the rules herein will not have a significant economic impact on a

    substantial number of small entities. The Commission invites public

    comment on this determination.

    B. Paperwork Reduction Act

    The Paperwork Reduction Act (PRA) \218\ imposes certain

    requirements on federal agencies (including the Commission) in

    connection with conducting or sponsoring any collection of information

    as defined by the PRA. Proposed Sec. 50.3(a), which would require each

    DCO to post on its Web site a list of all swaps that it will accept for

    clearing and clearly indicate which of those swaps the Commission has

    determined are required to be cleared, builds upon the requirements of

    Sec. 39.21(c)(1), which requires each DCO to disclose publicly

    information concerning the terms and conditions of each contract,

    agreement, and transaction cleared and settled by the DCO. Thus, this

    rulemaking will not require a new collection of information from any

    persons or entities. The Commission invites public comment on whether

    this rulemaking will require a new collection of information.

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

    \218\ 44 U.S.C. 3507(d).

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

    List of Subjects in 17 CFR Part 50

    Business and industry, Clearing, Swaps.

    In consideration of the foregoing, and pursuant to the authority in

    the Commodity Exchange Act, as amended, and in particular section 2(h)

    of the Act, the Commission hereby adopts an amendment to Chapter I of

    Title 17 of the Code of Federal Regulation by proposing to amend part

    50 as follows:

    PART 50--CLEARING REQUIREMENT AND RELATED RULES

    1. The authority citation for part 50 reads as follows:

    Authority: 7 U.S.C. 2(h), 7a-1 as amended by Pub. L. 111-203,

    124 Stat. 1376.

    2. Add new part 50 to read as follows:

    PART 50--CLEARING REQUIREMENT AND RELATED RULES

    Subpart A--Definitions and Clearing Requirement

    Sec.

    Sec. 50.1 Definitions.

    50.2 Treatment of swaps subject to a clearing requirement.

    50.3 Notice to the public.

    50.4 Classes of swaps required to be cleared.

    50.5 Swaps exempt from a clearing requirement.

    50.6 Delegation of Authority.

    50.7-9 [Reserved]

    50.10 Prevention of Evasion of the Clearing Requirement and Abuse of

    an Exception or Exemption to the Clearing Requirement.

    50.11-24 [Reserved]

    Subpart B--Compliance Schedule

    50.25 Clearing Requirement Compliance Schedule.

    50.26-49 [Reserved]

    Subpart C--Exceptions to Clearing Requirement

    Sec. 50.50-100 [Reserved]

    Sec. 50.1 Definitions.

    For the purposes of this part,

    Business day means any day other than a Saturday, Sunday, or

    [legal] holiday.

    Day of execution means the calendar day of the party to the swap

    that ends latest, provided that if a swap is (A) entered into after

    4:00 p.m. in the location of a party, or (B) entered into on a day that

    is not a business day in the location of a party, then such swap shall

    be deemed to have been entered into by that party on the immediately

    succeeding business day of that party, and the day of execution shall

    be determined with reference to such business day.

    Sec. 50.2 Treatment of swaps subject to a clearing requirement.

    (a) All persons executing a swap that (1) is not subject to an

    exception under section 2(h)(7) of the Act and Sec. 39.6, and (2) is

    included in a class of swaps identified in Sec. 50.4, shall submit

    such swap to a derivatives clearing organization for clearing as soon

    as technologically practicable after execution, but in any event by the

    end of the day of execution.

    (b) Each person subject to the requirements of paragraph (a) shall

    undertake reasonable efforts to verify whether a swap is required to be

    cleared.

    Sec. 50.3 Notice to the public.

    (a) In addition to its obligations under Sec. 39.21(c)(1), each

    derivatives clearing organization shall make publicly available on its

    Web site a list of all swaps that it will accept for clearing and

    identify which swaps on the list are required to be cleared under

    section 2(h)(1) of the Act and this part.

    (b) The Commission shall maintain a current list of all swaps that

    are required to be cleared and all derivatives clearing organizations

    that are eligible to clear such swaps on its Web site.

    [[Page 47220]]

    Sec. 50.4 Classes of swaps required to be cleared.

    (a) Interest rate swaps. Swaps that have the following

    specifications are required to be cleared under section 2(h)(1) of the

    Act, and shall be cleared pursuant to the rules of any derivatives

    clearing organization eligible to clear such swaps under Sec. 39.5(a)

    of this chapter.

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

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

    Fixed-to-Floating Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30

    years. years. years. years.

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Basis Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30

    years. years. years. years.

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Forward Rate Agreement Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.

    3. Stated Termination Date Range 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.

    4. Optionality.................. No................ No................ No................ No.

    5. Dual Currencies.............. No................ No................ No................ No.

    6. Conditional Notional Amounts. No................ No................ No................ No.

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

    Overnight Index Swap Class

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

    Specification

    1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).

    2. Floating Rate Indexes........ FedFunds.......... EONIA............. SONIA............. ..................

    3. Stated Termination Date Range 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.

    4. Optionality.................. No................ No................ No................ ..................

    5. Dual Currencies.............. No................ No................ No................ ..................

    6. Conditional Notional Amounts. No................ No................ No................ ..................

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

    (b) Credit default swaps. Swaps that have the following

    specifications are required to be cleared under section 2(h)(1) of the

    Act, and shall be cleared pursuant to the rules of any derivatives

    clearing organization eligible to clear such swaps under Sec. 39.5(a)

    of this chapter.

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

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

    North American Untranched CDS Indices Class

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

    Specification

    1. Reference Entities............. Corporate.

    2. Region......................... North America.

    3. Indices........................ CDX.NA.IG.

    CDX.NA.HY.

    4. Tenor.......................... CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.

    CDX.NA.HY: 5Y.

    5. Applicable Series.............. CDX.NA.IG 3Y: Series 15 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.IG 5Y: Series 11 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.IG 7Y: Series 8 and all

    subsequent Series, up to and

    including the current Series.

    [[Page 47221]]

    CDX.NA.IG 10Y: Series 8 and all

    subsequent Series, up to and

    including the current Series.

    CDX.NA.HY 5Y: Series 11 and all

    subsequent Series, up to and

    including the current Series.

    6. Tranched....................... No.

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

    European Untranched CDS Indices Class

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

    Specification

    1. Reference Entities............. Corporate.

    2. Region......................... Europe.

    3. Indices........................ iTraxx Europe.

    iTraxx Europe Crossover.

    iTraxx Europe HiVol.

    4. Tenor.......................... iTraxx Europe: 5Y, 10Y

    iTraxx Europe Crossover: 5Y.

    iTraxx Europe HiVol: 5Y.

    5. Applicable Series.............. iTraxx Europe 5Y: Series 10 and all

    subsequent Series, up to and

    including the current Series.

    iTraxx Europe 10Y: Series 7 and all

    subsequent Series, up to and

    including the current Series.

    iTraxx Europe Crossover 5Y: Series

    10 and all subsequent Series, up to

    and including the current Series.

    iTraxx Europe HiVol 5Y: Series 10

    and all subsequent Series, up to

    and including the current Series.

    6. Tranched....................... No.

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

    Sec. 50.5 Clearing Transition Rules.

    (a) Swaps entered into before July 21, 2010 shall be exempt from

    the clearing requirement under Sec. 50.2 if reported to a swap data

    repository pursuant to section 2(h)(5)(A) of the Act and Sec. 44.02 of

    this chapter.

    (b) Swaps entered into before the application of the clearing

    requirement for a particular class of swaps under Sec. 50.2 and Sec.

    50.4 shall be exempt from the clearing requirement if reported to a

    swap data repository pursuant to section 2(h)(5)(B) of the Act and

    Sec. 44.03 of this chapter.

    Sec. 50.6 Delegation of Authority.

    (a) The Commission hereby delegates to the Director of the Division

    of Clearing and Risk or such other employee or employees as the

    Director may designate from time to time, with the consultation of the

    General Counsel or such other employee or employees as the General

    Counsel may designate from time to time, the authority:

    (1) To determine whether one or more swaps submitted by a

    derivatives clearing organization under Sec. 39.5 falls within a class

    of swaps as described in Sec. 50.4; and

    (2) To notify all relevant derivatives clearing organizations of

    that determination.

    (b) The Director of the Division of Clearing and Risk may submit to

    the Commission for its consideration any matter which has been

    delegated in this section. Nothing in this section prohibits the

    Commission, at its election, from exercising the authority delegated in

    this section.

    Sec. 50.7-9 [Reserved].

    Sec. 50.10 Prevention of Evasion of the Clearing Requirement and

    Abuse of an Exception or Exemption to the Clearing Requirement.

    (a) It shall be unlawful for any person to knowingly or recklessly

    evade or participate in or facilitate an evasion of the requirements of

    section 2(h) of the Act or any Commission rule or regulation

    promulgated thereunder.

    (b) It shall be unlawful for any person to abuse the exception to

    the clearing requirement as provided under section 2(h)(7) of the Act

    and Sec. 39.6 of this chapter.

    (c) It shall be unlawful for any person to abuse any exemption or

    exception to the requirements of section 2(h) of the Act, including any

    exemption or exception as the Commission may provide by rule,

    regulation, or order.

    By the Commission.

    Issued in Washington, DC, on July 24, 2012.

    Sauntia S. Warfield,

    Assistant Secretary of the Commission.

    Appendices to Clearing Requirement Determination Under Section 2(h) of

    the CEA--Commission Voting Summary and Statements of Commissioners

    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 Sommers,

    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 proposal to require certain interest rate swaps

    and credit default swap (CDS) indices to be cleared as provided by

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

    Frank Act).

    For over a century, through good times and bad, central clearing

    in the futures market has lowered risk to the broader public. Dodd-

    Frank financial reform brings this effective model to the swaps

    market. One of the primary benefits of swaps market reform is that

    standard swaps between financial firms will move into central

    clearing, which will significantly lower the risks of the highly

    interconnected financial system.

    The Dodd-Frank Act requires the Commission to determine whether

    a swap is required to be cleared. For purposes of this first set of

    determinations, the Commission has looked to swaps that are

    currently cleared based upon submissions from eight derivatives

    clearing organizations (DCOs).

    This first proposed clearing determination would require that

    swaps within identified classes be cleared by a DCO. This first

    determination includes interest rate swaps in four currencies, as

    well as five CDS indices. The proposal addresses swaps that five

    DCOs are already clearing, including standard interest rate swaps in

    U.S. dollars, euros, British pounds and Japanese yen, as well as a

    number of CDS indices, including North American and European

    corporate names. Subsequently, the Commission will consider other

    swaps, such as agricultural, energy and equity indices.

    I believe that the Commission's proposed determination for each

    class satisfies the five factors provided for by Congress in the

    Dodd-Frank Act, including the first factor that addresses

    outstanding exposures, liquidity and pricing data.

    Under the proposal, a DCO would be required to post on its Web

    site a list of all swaps it will accept for clearing and must

    [[Page 47222]]

    indicate which swaps the Commission had determined are required to

    be cleared.

    I look forward to receiving public input on this proposed rule.

    Appendix 2--Statement of Commissioner Scott D. O'Malia

    I respectfully concur with the Commodity Futures Trading

    Commission's (``Commission'') proposal to establish a clearing

    requirement for certain classes of credit default swaps and interest

    rate swaps pursuant to the Commission's authority under new section

    2(h)(1)(A) of the Commodity Exchange Act (``CEA'').\1\ Centralized

    clearing is a vital part of the Dodd-Frank Act reforms and is

    expected to reduce counterparty credit risks, improve transparency

    and fairness around the setting of margin requirements, increase

    market liquidity, and reduce overall systemic risks.

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

    \1\ 7 U.S.C. 2(h). Congress amended section 2(h) of the CEA

    under section 723 of the Dodd-Frank Wall Street Reform and Consumer

    Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) (``Dodd-

    Frank Act'').

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

    I am pleased that the Commission's proposal thoughtfully

    incorporates comments received in response to my July 28, 2011

    letter \2\ to the public seeking comment on the five substantive

    criteria that the Commission is required to consider in making

    mandatory clearing determinations.\3\ The comments help provide the

    necessary clarity and guidance that the markets have sought

    regarding how the Commission will consider and weigh these criteria.

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

    \2\ My letter, and comments submitted in response thereto, can

    be found on the Commission's Web site at: http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.

    \3\ Specifically, section 2(h)(2)(D)(ii) requires the Commission

    consider the following five factors based on a Commission initiated

    review of a swap submission: (1) The existence of significant

    outstanding notional exposures, trading liquidity, and adequate

    pricing of data; (2) the availability of rule framework, capacity

    operational expertise and resources, and credit support

    infrastructure to clear the contract on terms that are consistent

    with the material terms and trading conventions on which the

    contract is then traded; (3) the effect on the mitigation of

    systemic risk, taking into account the size of the market for such

    contract and the resources of the derivatives clearing organization

    (``DCO'') available to clear the contract; (4) the effect on

    competition, including appropriate fees and charges applied to

    clearing; and (5) the existence of reasonable legal certainty in the

    event of the insolvency of the relevant DCO (or one or more of its

    clearing members) with regard to the treatment of customer and swap

    counterparty positions, funds, and property.

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

    Today's proposal also (1) includes a more reasoned cost-benefit

    analysis that is based on an appropriate pre-Dodd-Frank baseline,

    (2) discusses a variety of alternatives based on public comments,

    and (3) asks a series of questions in the absence of available data.

    Once again, I am encouraged that Commission staff is working with

    technical experts from the Office of Management and Budget (``OMB'')

    to improve our cost-benefit analyses. It is my hope that the

    Commission's final rule similarly benefits from our cooperative

    relationship with OMB.

    Once this proposal is published in the Federal Register, the 90-

    day clock will start. The Commission will review all comments, and

    discuss its final determination for clearing the majority of swaps

    in due course. I implore commenters to provide feedback and to

    submit data as soon as possible so that the Commission can account

    for the actual impact that today's rule will have on market

    liquidity, margining, and the reduction of risks.

    [FR Doc. 2012-18382 Filed 8-6-12; 8:45 am]

    BILLING CODE 6351-01-P

    Last Updated: August 7, 2012



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