THE LONDON CLEARING HOUSE LIMITED PETITION FOR EXEMPTION PURSUANT TO SECTION 4(c) OF THE COMMODITY EXCHANGE ACT
THE LONDON CLEARING HOUSE LIMITED PETITION FOR EXEMPTION PURSUANT TO SECTION 4(c) OF THE COMMODITY EXCHANGE ACT TABLE OF CONTENTS
I. RELIEF SOUGHT 1
II. ORGANIZATION OF THIS PETITION 3
III. STATUTORY BACKGROUND 4
A. Section 4(c)(1) of the Act 4
B. The Part 35 Swap Exemption 5
IV. SWAPCLEAR CONCEPT 7
A. SwapClear Functions 8
B. SwapClear Design Standards 10
1. Admission Standards 11
2. Product Eligibility 11
3. Risk Management 11
4. Operational Systems 11
5. Financial Resources 11
6. Regulatory Oversight 11
7. Policy Decisions and Governance 12
C. Standards for Participation in SwapClear 12
1. SwapClear Clearing Member ("SCM") 12
2. SwapClear Dealer ("SD") 13
D. Product Eligibility 14
E. SwapClear Risk Management, and Operational and Financial Integrity 15
F. Regulatory Oversight of SwapClear, SCMs and SDs 17
1. Regulation of SwapClear 17
2. Regulation of SDs and SCMs 18
G. SwapClear Governance 19
V. STANDARDS FOR EXEMPTIVE RELIEF 20
VI. THE SWAPCLEAR PETITION SATISFIES THE STATUTORY
STANDARDS FOR RELIEF 21
A. The Exchange Trading Requirements Should Not Apply to Swap
Agreements Cleared Through SwapClear Because SwapClear Will
Not Impact Current OTC Trading Arrangements 21
B. Swap Agreements Cleared Through SwapClear Will Be Entered
into Solely by Wholesale Market Participants Whose Qualifications
Exceed Congressional Standards Regarding Appropriate Persons 23
C. The Proposed Relief Is Consistent with the Public Interest and
the Purposes of the Act. 23
1. The Exemption Is Consistent with the Prevention of Fraud 24
2. The Exemption Will Preserve the Financial Integrity of
the Markets and Participants 25
a. SwapClear Will Reduce Systemic Risks 26
b. SwapClear Will Be a Prudent and Sound Central Counterparty 27
c. Risk Diversification Will Enhance LCH's Financial Integrity 29
d. Legal Certainty Will Contribute to the
Financial Integrity of the Markets 30
3. The Exemption Will Promote Responsible Economic and
Financial Innovation 31
D. The Proposed Relief Will Have No Material Adverse Effect on
CFTC or Contract Market Regulatory or Self-Regulatory Responsibilities 34
1. The Exemption Will Not Impact Market Surveillance 34
2. The Exemption Will Enhance the Financial Integrity of Participants 34
3. The Exemption Will Not Impact the Protection of Customers or Trade Practice Enforcement 35
a. The Protection of SwapClear Participants 35
b. Protection of Customers of Exchange Markets
Clearing Through LCH 37
4. Regulatory Cooperation 38
E. The Proposed Exemption Is Pro-Competitive 39
VII. CONCLUSION 42
APPENDIX I - SwapClear Risk Management, and Operational
and Financial Integrity A-1
A. Credit Monitoring, Trade Registration, and Netting Arrangements A-1
B. Swap Agreement Valuation and Variation Margin A-2
C. Initial Margin A-3
D. Margin Cover and Banking Procedures A-4
E. Financial Backing A-4
F. Default Procedures A-5
G. Operational Reliability A-7
APPENDIX II - LCH Default Rules
APPENDIX III - Market Protections
VOLUME OF EXHIBITS
June 15, 1998
Ms. Jean A. Webb
Office of the Secretariat
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW, 4th Floor
Washington, DC 20581
Re: Petition for Exemption from the Commodity Exchange Act
Dear Ms. Webb:
On behalf of our client, The London Clearing House Limited ("LCH"), a Recognized Clearing House ("RCH") in the United Kingdom ("UK") under the UK's Financial Services Act 1986 ("FSAct"), we respectfully request that the Commodity Futures Trading Commission ("Commission" or "CFTC") grant the exemptive relief requested herein pursuant to Section 4(c) of the Commodity Exchange Act ("Act"). The information contained herein has been provided by LCH and its staff members.
I. RELIEF SOUGHT
LCH believes that there are significant benefits to be gained from the establishment of an appropriately structured clearing facility for privately negotiated forward rate agreements ("FRAs")/ and interest rate swaps/ (such FRAs and interest rate swaps are collectively referred to herein as "swap agreements"). LCH's view is based upon extensive investigation, including discussions with principal dealers in swap agreements, as well as consultations with representatives of relevant regulatory and banking authorities. As a result of its research LCH determined that there is considerable interest in, and support for, such a clearing facility among market participants and regulators. Accordingly, in July 1997, the LCH Board authorized the development of a clearing facility for swap agreements ("SwapClear"), which is scheduled to commence operations in mid-1999.
LCH has received support for SwapClear from some of the largest global participants in the over-the-counter ("OTC") derivatives markets. However, concerns have been expressed regarding regulatory and legal uncertainties that currently exist in the United States ("US") pertaining to the clearing of swap agreements by a central counterparty as proposed by SwapClear.
In order to alleviate the legal and regulatory uncertainty faced by US entities that desire to clear swap agreements through SwapClear, LCH hereby respectfully requests that the CFTC, pursuant to Section 4(c) of the Act, grant an exemption from all provisions of the Act (except for Sections 2(a)(1)(B), 4b, and 4o of the Act, and the provisions of Sections 6(c) and 9(a)(2) of the Act to the extent these provisions prohibit manipulation of the market price of any commodity in interstate commerce or for future delivery on or subject to the rules of any contract market and Section 32.9 of the CFTC's Rules) to qualified U.S. entities that utilize SwapClear to clear transactions in "swap agreements" (as such term is defined in CFTC Rule 35.1(b)).
The submission by LCH of this petition for exemption to the CFTC does not imply, and no inference should be drawn or presumption made, that swap agreements that are cleared through SwapClear, or that SwapClear participants, are subject to regulation under the Act. As set forth in Section 4(c)(5) of the Act and in the Congressional Record, the Commission is permitted to issue an exemption that is applicable to the extent that the exempted transaction may have been subject to the Act, i.e., without requiring a determination of whether the transaction actually was, in fact, subject to the Act./
II. ORGANIZATION OF THIS PETITION
This petition is organized as follows. Section III. discusses the statutory background of exemptions from the Act, specifically, the role of Section 4(c) of the Act in promoting legal certainty with respect to OTC transactions (see Section III.A., below), the scope of the previous regulatory relief granted thereunder by the Commission with respect to swap transactions, and the possible need for an exemption of swap agreements cleared through SwapClear (see Section III.B., below).
Section IV. describes the SwapClear concept: the functions performed by SwapClear (see Section IV.A., below) and its design standards (see Section IV.B., below); the eligibility standards for participation in SwapClear (see Section IV.C., below); the nature of the OTC products cleared through SwapClear (see Section IV.D., below); the risk management procedures utilized by SwapClear, including credit monitoring, trade registration, netting arrangements, swap valuation methodologies, variation margin and initial margin requirements, margin cover and banking procedures, financial backing, and default procedures (see Section IV.E. and Appendix I., below); the regulatory regime applicable to SwapClear (see Section IV.F., below); and SwapClear's governance structure (see Section IV.G., below).
The statutory standards for exemptive relief under Section 4(c) of the Act are outlined in Section V. below. Section VI. establishes that SwapClear's function and design satisfy the applicable statutory standards because swap agreements cleared through SwapClear, having no effect on current OTC arrangements, should not be subject to the exchange-trading requirement of the Act (see Section VI.A., below); swap agreements will be entered into solely by appropriate persons (see Section VI.B., below); the proposed relief is consistent with the public interest and the purposes of the Act (see Section VI.C., below); the proposed relief will not have any material adverse effect on the CFTC or any contract market regulatory or self-regulatory responsibilities (see Section VI.D., below); and the proposed exemption will not adversely affect fair competition (see Section VI.E., below).
III. STATUTORY BACKGROUND
A. Section 4(c)(1) of the Act
On October 28, 1992, the Futures Trading Practices Act of 1992 (the "1992 Act") was signed into law./ The 1992 Act added new Section 4(c)(1) to the Act and authorized the Commission, by rule, regulation or order, to exempt any agreement, contract or transaction, or class thereof, from the exchange-trading requirements of Section 4(a) or any other requirement of the Act other than Section 2(a)(1)(B) of the Act./ In granting exemptive authority to the CFTC under Section 4(c), the Congressional Conferees "recognize[d] the need to create legal certainty for a number of existing categories of instruments which trade today outside the forum of a designated contract market."/ The CFTC has exercised its exemptive powers pursuant to Section 4(c) of the Act on several occasions, specifically with respect to: swap transactions;/ hybrid transactions;/ energy contracts;/ and "professional" contract market transactions./
B. The Part 35 Swap Exemption
Part 35 of the rules of the CFTC ("Part 35"), which was adopted by the CFTC at the behest of Congress/ pursuant to the exemptive authority set forth in Section 4(c) of the Act, provides a safe harbor from most CFTC regulatory requirements for swap transactions meeting specified criteria. The exemption is limited to "swap agreements" (as defined in CFTC Rule 35.1(b)) entered into by "eligible swap participants," which include various categories of institutional and commercial entities and natural persons with substantial assets./ In addition, Part 35 imposes conditions upon the design and execution of swap transactions that are intended to distinguish them from exchange-traded futures contracts. To qualify for exemption the swap transaction may not be "part of a fungible class of agreements that are standardized as to their material economic terms."/ Additionally, the creditworthiness of any party having an actual or potential obligation under the swap agreement must be a material consideration in entering into or determining the terms of the swap agreement./ Finally, the swap agreement may not be entered into or traded on a "multilateral transaction execution facility."/
The Commission has taken the position that the clearing of swaps is not permitted under Part 35./ Although Part 35 contemplates arrangements for bilateral netting of both obligations and payments and for multilateral netting of payment flows, the Commission did not extend the coverage of Part 35 to include swap transactions that are cleared through a system that mutualizes performance obligations among its members. In the Part 35 Adopting Release the Commission concluded that "at this time, the exemption does not extend to transactions that are subject to a clearing system where the credit risk of individual members of the system to each other in a transaction to which each is a counterparty is effectively eliminated and reduced by a system of mutualized risk of loss that binds members generally whether or not they are counterparties to the original transaction."/ The Commission took this position, in part, because no such clearing facilities were in existence at the time that Part 35 was adopted./ U.S. entities, therefore, that wish to clear swap agreements through SwapClear will be faced with the same regulatory and legal uncertainty with respect to such swap transactions that Part 35 was intended to alleviate.
When the Commission promulgated Part 35 however, the CFTC, along with other US regulators and market participants, acknowledged the significant benefits that a swap clearing facility could provide, stating, "The Commission shares the goal of financial system risk reduction as expressed in the comment letters from the Department of the Treasury, the Board of Governors of the Federal Reserve System ('Board'), and the Office of the Comptroller of the Currency ('OCC'). The Commission understands these letters to generally support the promulgation of part 35 but to express concern that Commission rules should go further to promote the reduction of systemic risk. In this regard, while the OCC and the Board endorsed the development of appropriately structured multilateral payment netting for swaps, the Board also observed that the Commission should permit multilateral settlement (or clearing) so risk of loss could be mutualized. The Commission believes that a clearing house system for swap agreements could be beneficial to participants and the public generally."/
In recognition of these benefits, the Commission stated that it would consider regulatory relief for swap transactions that are cleared through clearing facilities by evaluating the design of proposed facilities that are submitted to it for review, noting, "as such mechanisms are not yet in existence, and may take many forms and raise different regulatory concerns depending upon their structure or participants or whether another regulatory regime is applicable, the Commission will consider the terms and conditions of such an exemption from swap clearing houses in the context of specific proposals from exchanges, other regulators or others."/ Further, in its 1993 Report to Congress the CFTC reiterated its recognition of the benefits of swap clearing facilities and outlined some of the factors that it would look to in evaluating proposals for such facilities, stating: "The CFTC's exemptive provision for swaps...does not pose a bar to such arrangements [clearing facilities for swaps]. It does however, require that proposals for multilateral netting facilities, other than those limited to netting of payment flows, be submitted for review by the CFTC. In requiring that multilateral facilities be limited to netting of payments, absent specific exemption, the Commission nonetheless recognized the potential benefits of clearing systems that mutualize risk and that a clearing mechanism for swaps could further the interests of the public as well as swap participants. However, the Commission also recognizes that the regulatory issues presented by such a facility would depend materially upon the facility's design, such as, for example, the extent to which the construction of such facility is consistent with the minimum standards for netting systems recommended by the Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries ('Lamfalussy Report'). Therefore, swap clearing mechanisms would be most appropriately evaluated in the context of specific proposals."/
In the adopting release, the Commission suggested that such proposals should take the form of a petition for relief under Section 4(c), stating that: "[t]o the extent that market participants wish to use or establish...clearing systems involving mutualized risk or multiparty netting of payment obligations, the Commission will evaluate the terms and conditions, if any, that would be appropriate under Section 4(c) of the Act in connection with any request for exemptive relief involving such a facility."/
IV. SWAPCLEAR CONCEPT
In light of the Commission's clearly articulated view that it will evaluate requests for exemption for swap clearing facilities by examining the design of specific proposals, this Section IV. provides detailed information regarding SwapClear's concept and design.
A. SwapClear Functions
SwapClear represents a significant innovation in the risk management of OTC interest rate derivatives. By offering multilateral clearing for swap agreements, SwapClear will permit participants to replace current bilateral arrangements with more efficient multilateral netting.
Interest rate swaps and FRAs are generally transacted between banks, financial institutions, governmental entities, and other commercial entities in order to manage interest rate exposure or obtain more desirable financing in connection with the business or financial transactions of such entities. Such swaps and FRAs are privately negotiated on a principal basis or via interdealer brokers over the telephone. Currently, such transactions are settled by the counterparties on a bilateral basis.
Under a bilateral agreement, each party is exposed to the risk that its counterparty will fail to perform, which, in the context of an interest rate swap or FRA, is essentially a credit risk. Over the past few years, participants in OTC transactions have taken various measures in an attempt to reduce their counterparty risk. These include: the development of master agreements incorporating netting provisions; clauses providing for the termination of contracts in the event that a counterparty is downgraded, certain exposure thresholds are reached, or other adverse changes occur in a firm's financial condition; the imposition of collateral requirements on outstanding OTC positions; periodic marking to market and settlement of open positions; the reduction of credit lines to lower-rated counterparties and the capping of exposure to better-rated ones; and the establishment of separately capitalized derivatives subsidiaries. Negotiating credit provisions, monitoring financial conditions, making payments, and maintaining collateral with multiple counterparties are time consuming, costly and limit the ability of market participants to make efficient use of collateral, credit lines and capital. SwapClear will allow participants to replace current bilateral credit, netting and payment arrangements with more efficient multilateral netting of swap agreements./
Only banks or other financial institutions that meet LCH's stringent financial and eligibility criteria for designation as a SwapClear Dealer ("SD") will be permitted to register their swap agreements with SwapClear (see subsection C.2. below). Each SD will enter into a clearing arrangement with a SwapClear Clearing Member ("SCM") who will clear all of the swap agreements such SD chooses to submit for clearing (see subsection C.1. below). SCMs will also be required to satisfy rigorous financial and operational standards and will be assigned an intra-day credit limit by LCH. (An SCM may also act as an SD provided it meets LCH's SD eligibility requirements.) LCH and the SCMs will perform the same clearing and settlement functions with respect to swap agreements that are cleared through SwapClear, as LCH and its Exchange Clearing Members currently perform with respect to the various futures, options and equity contracts that are cleared through LCH.
SwapClear will have no impact on the way counterparties currently negotiate or effect swap agreements. It will not provide any facility for arranging or executing such transactions. Rather, SwapClear will perform credit enhancement, risk management, and position administration functions with respect to those swap agreements that qualified participants choose to submit for clearing. SDs will not be under any obligation to present transactions in swap agreements to LCH for registration. If the SDs elect to do so with respect to a particular transaction, however, it will be the responsibility of such SDs to ensure that the trade details match. Between the time a transaction is effected and the time it takes the SDs to match and present the details of the transaction for registration, which may take the SDs several days to accomplish, the parties will keep the transactions on their own books, and will be subject to full counterparty credit risk during such period.
Confirmations between the two original counterparty SDs will be exchanged and matched through Accord/, Londex/ or another operationally compatible matching system. When a swap agreement that is to be submitted for clearing has matched, the relevant details of the swap agreement will be transmitted to SwapClear to verify that: (1) the SDs are in good standing with LCH, (2) the swap agreement meets SwapClear's product eligibility parameters (see subsection C. below), and (3) the transaction does not exceed the SCMs' respective intra-day credit limits with LCH. Provided these criteria are satisfied, LCH will register the swap agreement and confirm the transaction to the SDs and their respective SCMs./
Upon registration by LCH of a swap agreement, the original bilateral swap agreement between the SDs will be replaced with four new swap agreements: one each between each SD and their respective SCMs, contracting as principals, and one each between each SCM and LCH, contracting as principals. The two SDs will become counterparties to their respective SCMs, and the two SCMs will become the counterparties of LCH. As a multilateral netting system, LCH will be counterparty, and contract as principal, in respect of each swap agreement cleared through SwapClear. Thus, LCH will be responsible for the performance of the swap agreement obligations to the SCMs, who in turn will be responsible for performance to their respective SDs and to LCH. Netting by novation will occur immediately upon registration of the transaction in the SCM's name. All swap agreements will be replaced by one consolidated contract under which payment obligations for the same value date and in the same currency will have been "novated" into a new, single consolidated payment obligation. The registration process will thus convert a series of separate transactions (between the SDs) into a set of payment obligations (between LCH and the SCMs), the exact amounts due being ascertainable at a future date if not immediately, in each currency for each payment date.
LCH will, upon each payment date, also net the payment amounts due to or from an SCM in each currency, in respect of the consolidated obligation under the swap transactions registered in the SCM's name, with other payments due to or from the SCM. SwapClear will determine all reset rates and calculate reset amounts. Coupon payments will be netted with other payments such as margin and amounts from SCMs' other LCH activities wherever possible, (e.g., margin payments, payments of fees or settlement payments due on exchange traded business) resulting in a single pay/receive per currency each day between LCH and each SCM. Upon each payment date the amount payable or receivable in each currency will be settled by means of LCH's Protected Payment System ("PPS"). SwapClear will provide detailed reporting facilities to enable SCMs to reconcile coupon and other payments.
B. SwapClear Design Standards
In designing SwapClear to carry out the foregoing functions, LCH has been guided by certain risk management and regulatory principles and the best practices that it has identified from a number of sources. Specifically, LCH has drawn on the Lamfalussy Report (Exhibit 13), the Financial Integrity Recommendations relating to clearing houses published in June 1995 by the Futures Industry Association Global Task Force on Financial Integrity (Exhibit 14), Clearing Arrangements For Exchange-Traded Derivatives (a report of the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries, 1997, the "Parkinson Report") (Exhibit 15) and LCH's 110 years of experience as a clearing house.
The core principles that have informed LCH's design of SwapClear are:
1. Admission Standards. SwapClear should have rigorous admission standards, addressing financial and operational considerations. All participants should have a clear understanding of the financial risks involved in participating in SwapClear. Participation criteria should be objective, reasonable and non-discriminatory.
2. Product Eligibility. SwapClear should permit SwapClear participants to negotiate all material economic terms of swap agreements consistent with current OTC practices. SwapClear should not change the way in which SwapClear participants currently arrange transactions. Product eligibility parameters should ensure that there will be sufficient market liquidity for swap agreements cleared through SwapClear to permit LCH to calculate accurate daily mark-to-market values and enter into replacement transactions in the event of a default by an SCM.
3. Risk Management. SwapClear should exercise, at all levels of its operations, robust management of risk. SwapClear should monitor the financial and operational capabilities of participants on an ongoing basis to ensure compliance with its regulations, rules and procedures. SwapClear should utilize risk measurement and collateralization practices that are rigorous and disciplined. SwapClear should have a clear and reliable method of calculating mark-to-market values of swap agreements on a daily basis and a means of controlling LCH's exposure intraday. SwapClear's netting arrangements should be enforceable in all relevant jurisdictions.
4. Operational Systems. SwapClear should ensure that its clearing system and its banking and treasury functions are efficient and secure. SwapClear should provide accurate and timely processing capabilities and ensure comprehensive back-up and business recovery facilities.
5. Financial Resources. LCH should ensure that its core financial resources are sufficient to meet operational needs and that it maintains appropriate supplementary financial backing. SwapClear should have access to reasonable levels of liquidity to ensure the timely settlement of all of LCH's obligations in the event of a default by an SCM.
6. Regulatory Oversight. SwapClear should be subject to an appropriate form of regulation, consistent with the role undertaken by LCH, the type of instruments being cleared, the type of market participants, and the nature of the relationship among market participants. LCH is currently regulated by the UK's Financial Services Authority ("FSA", formerly known as the Securities and Investments Board, or "SIB") as an RCH under the FSAct, and SwapClear, as an extension of LCH's current activities as an RCH, will be subject to oversight by FSA. SwapClear should not change the way in which parties to swap agreements are currently regulated (except, possibly, with respect to changes in regulatory capital requirements pertaining to SwapClear participants). LCH should confer with and cooperate fully with FSA and other regulatory authorities as appropriate for the fulfillment of their regulatory duties.
7. Policy Decisions and Governance. LCH should possess a decision making and governance structure that provides direct involvement for those participants who provide the financial resources that support LCH's settlement guarantee. Such a structure will help to ensure that SwapClear benefits from the knowledge, experience and risk aversion of those with the keenest interest in the preservation of the highest standards of risk management and will help to diminish the "moral hazard" of participants expecting or relying on a government bailout. Such a structure should retain the necessary independence for the executives of LCH in relation to risk management decisions.
The following subsections describe the integration of these design principles into SwapClear's operations.
C. Standards for Participation in SwapClear
LCH has established predefined admission standards for SwapClear participants, addressing both operational and financial considerations, and will provide access to its services to qualified applicants, on equal terms.
1. SwapClear Clearing Member
Each swap agreement cleared through SwapClear will be registered by LCH in the names of two SCMs (for example, in the case of an interest rate swap, one as floating-rate payer and the other as fixed-rate payer). LCH requires that the two SCMs deal with LCH as principal, even where the original swap agreement was entered into by separate SDs and the SCMs are only providing a clearing service for the SDs. Each SCM will be fully liable for ensuring performance to LCH in respect of each swap agreement registered in its name.
SCMs will be required to meet rigorous financial, prudential and operational standards. LCH's Risk Management Department will monitor compliance with these criteria on an ongoing basis. The criteria require each SCM to: (1) be an LCH shareholder (requiring the purchase of one member share at a cost of just under ,300,000, although an SCM that is already an LCH member will not be required to purchase an additional share); (2) contribute to LCH's Member Default Fund ("MDF"); (3) meet minimum financial resource requirements (which would be satisfied by (a) being an SD, or (b) having a parent who is an SD and who provides a guaranty of the SCM's liabilities to LCH, or (c) having ,250 million in financial resources/); (4) make regular financial reports to LCH; and (5) maintain a back office with adequate systems, records and staff with expertise in the swap agreement markets.
2. SwapClear Dealer
For a trade to be cleared through SwapClear, both counterparties to the transaction must be approved by LCH as SDs. SDs will not be counterparties to LCH in respect of any swap transaction (unless the SD is also an SCM). LCH will, however, want to be satisfied that permitting an entity to become an SD will not introduce any unacceptable risks into the clearing system. Accordingly, LCH will require SDs to satisfy certain financial and operational standards. LCH's Risk Management Department will monitor compliance with these criteria on an ongoing basis. The requirements provide that an SD must be: (1) an institution entering into transactions that are equivalent to swap agreements cleared through SwapClear as a dealer in the "wholesale market"/ in the UK or its equivalent elsewhere (LCH will not usually regard this criterion as being satisfied where the institution is generally regarded as a customer or end-user of the interbank wholesale market); (2) investment grade caliber (Standard & Poors' credit rating of BBB or better) or a fully guaranteed subsidiary of an investment grade parent; (3) a SWIFT user; and (4) either an SCM, or have a clearing arrangement with an SCM. The foregoing criteria will help to ensure that all SDs have the appropriate financial and operational capabilities to deal in swap agreements and the sophistication to understand and manage the risks of such transactions, which will help to safeguard the integrity of LCH and its SCMs.
D. Product Eligibility
LCH will not establish or impose any requirement that there be standard contract specifications for swap agreements. SDs will continue to negotiate privately the essential economic terms of each swap agreement that is cleared through SwapClear. All material economic terms of a swap agreement will be subject to negotiation between the SDs, including: the Notional Amount, Trade Date, Effective Date, Fixed Rate, Fixed Rate Payer, Fixed Rate Payment Dates, Floating Rate, Floating Rate Payer, Floating Rate Payment Dates, Reset Dates, Termination Date, and Business Day Convention./
SwapClear will accept for registration swap agreements privately negotiated between SDs whose terms comply with the SwapClear product eligibility parameters. The parameters, which are described below, have been designed by LCH to assure that there is sufficient market liquidity for the swap agreements cleared through SwapClear so as to permit LCH to accurately calculate daily mark-to-market prices, and, in the event of a default by an SCM, to enter into replacement transactions.
SwapClear's product eligibility parameters provide that interest rate swaps will be fixed versus floating rate in a single currency. Interest rate swaps and FRAs may be transacted in the following currencies: US Dollars, Japanese Yen, Euros (and the eleven currencies that have elected to enter the Euro) and British Pounds. Additionally, Canadian Dollars will be listed if there is sufficient participation in SwapClear by Canadian Dollar market-makers. Interest rate swaps will have a constant notional principal amount throughout the term of the agreement, with no reset in arrears. FRAs will be settled on a discounted basis. Interest rate swaps may be for any maturity up to ten years. FRAs may be for any gap period up to one year.
SwapClear will not require that swap agreements be submitted for registration within a specified period of time after trade date, or that transactions be at current market prices when submitted for registration. SDs may, therefore, choose to register their current book of swap agreements through SwapClear if they so desire. Moreover, swap agreements that may be ineligible for registration on trade date may be submitted for clearing if they subsequently become eligible for registration. For example, a swap agreement with a 15 year maturity would become eligible for registration after 5 years, or a swap agreement that results from the exercise of a swaption would also be eligible for registration.
Initially, the following floating rate indices will be acceptable: LIBOR, PIBOR, EURIBOR. Other indices, such as Commercial Paper, Fed Funds, and Constant Maturity Treasuries are under consideration. The minimum notional amount will be one unit of currency. LCH will not impose any maximum notional amount, and SDs will be permitted to use forward starts, stub periods, and mismatched fixed/floating dates. They will also be able to select any start date that is a business day in the applicable currency center as well as any reset/fixing dates. LCH will also permit SDs to select any interest rate accrual basis, e.g., actual/360, actual/365, 30/360 fixed, and 30E/360.
LCH anticipates extending the product eligibility parameters in the future to include: additional currencies and indices; longer maturities; variable notional principal; basis swaps; cross currency swaps (subject to LCH being able to eliminate or margin for Herstatt Risk/); and caps, collars, floors and swaptions. All swap agreements eligible for clearing through SwapClear will meet the definition of "swap agreement" set forth in Part 35./
E. SwapClear Risk Management, and Operational and Financial Integrity
This sub-section briefly summarizes the principal features of LCH's risk management procedures (which are set forth in detail in Appendix I).
The starting point for LCH's risk management is assuring the quality of its members./ As set forth above, LCH has established stringent financial, operational and sophistication standards for SwapClear participants. LCH will impose appropriate reporting requirements on SwapClear participants. SDs and SCMs will have an ongoing duty to notify LCH if they no longer satisfy or may cease to satisfy any of the SwapClear eligibility criteria. If LCH has reason to believe that a participant may no longer satisfy its participant eligibility requirements, LCH will be entitled to call for any information to determine whether the firm still satisfies the eligibility requirements. Firms will be obligated to supply any such information requested by LCH. Additionally, SDs and SCMs will be required to notify LCH upon the occurrence of a number of events relating to their insolvency, dissolution, status as a registrant or licensee, or authorization to conduct investment business in the UK, any disciplinary or enforcement judgments, convictions of financial crimes, or any other material changes in business.
In addition, LCH will employ eight principal risk management tools in controlling the risks arising out of acting as a central counterparty for transactions that are registered through SwapClear.
First, LCH will establish intraday limits on credit exposure with respect to each SCM and will monitor its exposure to each SCM on an ongoing basis. LCH will have the ability to reject any transaction or impose liquidation orders with respect to transactions that exceed assigned credit limits. Second, all payment obligations for the same value date and in the same currency will be "novated" into a single payment obligation between each SCM and LCH. Third, LCH will establish a zero-coupon yield curve in each currency on each day and will employ a reliable method of calculating mark-to-market values of swap agreements on a daily basis that will facilitate collection of the appropriate amount of variation margin. SCMs will be required to pay to LCH SwapClear variation margin each day in cash, thereby preventing losses from accumulating in the system. Fourth, LCH will establish prudent initial margin requirements to protect itself from future price movements. Fifth, LCH will operate efficient and prudent treasury procedures relating to cash management and the valuation of collateral. Sixth, LCH will operate effective default management procedures, including close-out netting, and will take appropriate steps to assure the enforceability of its default and netting rights. Seventh, LCH will maintain adequate financial and liquidity resources to meet its daily operational needs and to satisfy its obligations in the event of a member's default. Eighth, LCH will assure the operational viability and security of its clearing, banking and treasury functions and will maintain comprehensive back-up and business recovery facilities.
F. Regulatory Oversight of SwapClear, SCMs and SDs
1. Regulation of SwapClear
LCH is subject to a comprehensive regulatory regime in the UK. As an RCH under the FSAct/, LCH is an exempted person in respect of any activities undertaken by it in providing clearing services for the transaction of investment business./ Thus, subject to its continuing compliance with the RCH recognition requirements under the FSAct, LCH may clear exchange traded products as well as OTC products such as swap agreements. Currently, LCH clears and settles futures and options contracts traded on The London International Financial Futures and Options Exchange ("LIFFE"), the London Metal Exchange ("LME"), and the International Petroleum Exchange ("IPE"). LCH also clears and settles UK equity transactions effected on Tradepoint, an electronic stock exchange.
LCH is subject to direct regulatory oversight by FSA, which monitors LCH's ongoing fulfillment of relevant FSAct requirements. LCH is required to have "financial resources sufficient for the proper performance of its functions."/ In that regard, LCH maintains the financial resources described in Sections D. and E. of Appendix I. LCH is required to submit to FSA its quarterly management accounts, annual audited reports and accounts, and annual budget, which permits FSA to satisfy itself that LCH maintains financial resources sufficient for the proper performance of its clearing functions.
In addition, LCH is subject to the UK's Criminal Justice Act 1993 and Money Laundering Requirements 1993, as are its UK regulated members and their regulator, the FSA. LCH is obliged, under the legislation, to report to the authorities any evidence of money laundering activity by its members and to make its records available for the investigation of money laundering. LCH staff are aware of these responsibilities, and reporting to the authorities is channelled through the Managing Director, Risk, who acts as LCH's Money Laundering Officer.
All arrangements LCH is making for SwapClear will ensure that it meets its recognition criteria for an RCH regulated by the FSA (please see footnote 33, above). LCH provides FSA with an annual regulatory plan that includes a statement of its objectives and annual targets against which LCH's performance may be judged. All arrangements LCH will be making for SwapClear are subject to approval by FSA.
LCH has consulted with HMT, the Bank of England and FSA regarding the direction and progress of SwapClear. Presentations regarding SwapClear have also been made by LCH to a Bank For International Settlements ("BIS") sub-committee on clearing, staff at the Federal Reserve Board in Washington, the Office of the Comptroller of the Currency, the Bank of Japan, the Japanese Ministry of Finance, the Bundesbank, the Bank of Italy, the Central Bank of Ireland and the Bank of Canada.
2. Regulation of SDs and SCMs
In LCH's view, clearing a swap agreement through SwapClear should not result in any additional regulatory requirements for SDs and SCMs that are otherwise currently conducting OTC transactions with wholesale market counterparties. In order to enter into swap agreements in the UK, authorization or exemption under the FSAct is required where such activity constitutes investment business in the UK within the meaning of the FSAct.
G. SwapClear Governance
Founded in 1888, LCH is a private limited company organized under the laws of the UK and operates on a not-for-profit basis. LCH is owned 75% by its 126 Members, which include most of the major dealer participants and their affiliates in the swaps market, and 25% by LIFFE Holdings plc, LME and IPE. In 1997, LCH settled and cleared 240 million contracts.
LCH possesses a governance structure that provides direct involvement by market participants who themselves provide the supplementary financial resources that support LCH's risk management controls and provide additional substance to LCH's clearing guarantee. LCH is governed by its Board, which is made up of its Chairman, the LCH Chief Executive, the Chief Executives of LIFFE, LME and IPE, and nine Clearing Member directors. The Clearing Member directors are elected by the membership, with three Clearing Member directors coming up for election each year. A Nominating Committee ensures that a balance of representation is achieved across LCH's markets and types of members. There are three main Board committees: Risk, Operations and Audit.
The Board will establish a new SwapClear committee, comprising SDs and SCMs, which will be responsible for overseeing the development and subsequent operation of the SwapClear facility. Until SwapClear commences operations, and for a period of six months thereafter, this committee will be composed of one representative from each of the SCMs and SDs that are the initial supporters of SwapClear. After six months of operation the committee will be elected by SwapClear participants. The SwapClear committee will elect a chairman and a deputy chairman. The chairman, and in his absence the deputy chairman, will be entitled to attend LCH Board meetings in a non-voting capacity. The SwapClear committee will also elect two representatives to attend in an advisory capacity the Operations committee and the Risk committee. These governance arrangements will be reviewed by the LCH Board two years after SwapClear has commenced operations. The foregoing governance structure is designed to ensure that there is sufficient input, advice and direction from those with knowledge and experience relevant to SwapClear.
The foregoing descriptions of SwapClear's functions, design, participant eligibility requirements, risk-management procedures, regulation and governance satisfy every element of the SwapClear design standards enumerated above in subsection B., and, as demonstrated below, will offer significant benefits to SDs, SCMs, LCH and the public generally. Wishing to make SwapClear and its benefits available to qualified US entities, LCH has undertaken the following analysis of the applicable statutory provisions under the Act.
V. STANDARDS FOR EXEMPTIVE RELIEF
Section 4(c)(1) of the Act provides that the Commission may exempt any agreement, transaction or contract from any provisions of the Act (except Section 2(a)(1)(B)) if the Commission determines that the exemption would be consistent with the public interest. In this regard, the conference report to the 1992 Act stated that the "public interest" under Section 4(c) includes the "national public interests noted in the Act, the prevention of fraud and the preservation of the financial integrity of the markets, as well as the promotion of responsible economic or financial innovation and fair competition."/
Section 4(c)(2) of the Act further provides that in order for the Commission to grant an exemption from the exchange-trading requirement contained in Section 4(a) of the Act, the Commission must determine that the exchange-trading requirement should not be applied to the agreement, contract or transaction for which the exemption is sought, and that the exemption would be consistent with the public interest and the purposes of the Act. The Conference Report noted that the reference to the purposes of the Act was intended "to underscore [the] expectation that the Commission will assess the impact of a proposed exemption on the maintenance of the integrity and soundness of markets and market participants."/
In addition the Commission must determine that the agreement, contract, or transaction being exempted will be entered into solely between "appropriate persons" as defined in Section 4(c)(3)/ and that the agreement, contract, or transaction will not have a material adverse effect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory duties under the Act/.
Finally, Section 15 of the Act provides, in pertinent part, that the CFTC must consider the public interest to be protected by the antitrust laws and endeavor to take the least anticompetitive means of achieving the objectives, policies, and purposes of the Act in adopting any exemption under Section 4(c) of the Act. As set forth below, the relief requested by this petition clearly is in accordance with the standards enumerated in the Act and should be granted.
VI. THE SWAPCLEAR PETITION SATISFIES THE STATUTORY STANDARDS FOR RELIEF
A. The Exchange Trading Requirements Should Not Apply to Swap Agreements Cleared Through SwapClear Because SwapClear Will Not Impact Current OTC Trading Arrangements.
The exchange trading requirement of Section 4(a) was premised on the Congressional findings in 1922 that the regulation of futures contracts is necessary because "futures transactions are carried on in large volume by the public generally", that "[t]he prices involved in such transactions are generally quoted and disseminated", and that "transactions . . . can be manipulated, controlled, cornered, or squeezed"./ Thus, some seventy-plus years ago, in the context of transactions involving futures contracts in agricultural commodities, Congress enacted the original version of what later became the Act in order to protect farmers and other merchandisers of certain agricultural commodities from the perceived abuses involving futures contracts. Congress deemed exchange-trading necessary to provide orderly and fair markets for participants in futures contracts and to provide price discovery for the public at large. In adopting Section 4(c) of the Act in 1992, Congress recognized that OTC instruments "may contain some features similar to those of regulated exchange-traded products, but are sufficiently different in their purpose, function, design or other characteristics, that as a matter of policy, traditional futures regulation and the limitation of trading to the floor of an exchange may be unnecessary to protect the public interest and may create an inappropriate burden on Commerce."/ The CFTC has also recognized that transactions in swap agreements occur outside the forum of exchange trading./ In addition, the Commission has recognized that swap transactions are privately negotiated between banks and financial institutions and do not involve the general public./
The Commission has rightly concluded that "all markets are not the same and the appropriate regulatory framework must depend on an analysis of the characteristics of the specific market."/ The Commission has also "recognized that differences between exchange-traded markets and the OTC derivatives market warrant differences in regulatory treatment."/ OTC swap transactions are not engaged in by the general public and do not perform a primary price discovery function./ Moreover, the interest rate markets and indices underlying OTC swap agreements are not susceptible to manipulation. Thus, the rationale underlying the exchange-trading requirement for futures contracts is not applicable to OTC swap agreements entered into between SwapClear participants and cleared through SwapClear.
If, under Part 35, eligible swap participants are currently permitted to engage in privately negotiated bilateral swap transactions free of regulation under the Act, the addition of a clearing mechanism to that same transaction should not subject the transaction to the exchange-trading requirement. All swap agreements cleared through SwapClear will continue to be individually negotiated transactions and will not be traded on a multilateral trade execution facility. SwapClear participants will be limited to banks and financial institutions and, thus, will not involve the general public. SwapClear will not standardize the material economic terms of swap agreements or perform a primary price discovery function. Therefore, just as the Commission previously concluded that the exchange-trading requirement should not apply to swap agreements that meet the criteria of Part 35 (because, such agreements are not standardized as to their material economic terms and are not entered into or traded on a multilateral trade execution facility), the Commission should determine that the exchange-trading requirement should not apply to swap agreements cleared through SwapClear.
B. Swap Agreements Cleared Through SwapClear Will Be Entered into Solely by Wholesale Market Participants Whose Qualifications Exceed Congressional Standards Regarding Appropriate Persons.
LCH has established rigorous financial, operational and market sophistication standards for SDs and SCMs. LCH's admission criteria far exceed the standards specified by Congress in its definition of "appropriate person" set forth in Section 4(c)(3) of the Act and the CFTC's definition of "eligible swap participant" contained in CFTC Rule 35.1(a)(2). LCH's admission standards address both operational and financial considerations. Access conditions will be objective, reasonable and non-discriminatory.
Specifically, SDs must be investment grade caliber or guaranteed by an investment grade parent and be a "wholesale market" counterparty, and SCMs must have financial resources of at least ,250 million or be able to quality as an SD. Only well capitalized, creditworthy and experienced institutions such as banks and large financial institutions will be able to qualify as SwapClear participants. LCH will monitor the financial condition of SDs and SCMs on an ongoing basis.
Every SD and SCM will qualify as an "appropriate person"/ as that term is defined by the statute and Part 35. LCH, will, of course, qualify as an "appropriate person" by virtue of its own capital.
As set out in Section IV.C.2., above, a swap agreement will only be eligible to be settled through SwapClear if both counterparties are SDs. SwapClear will not provide a facility for clearing transactions between an SD and its clients; thus there is no way that an end-user can participate in SwapClear. Given the limited and discrete universe of SwapClear participants and LCH's rigorous participant eligibility criteria, the CFTC should find that swap agreements cleared through SwapClear will be entered into solely by appropriate persons.
C. The Proposed Relief Is Consistent with the Public Interest and the Purposes of the Act.
As noted above, the Conference Report states that the "public interest" under Section 4(c) includes "the national public interests noted in the Act, the prevention of fraud and the preservation of the financial integrity of markets, as well as the promotion of responsible economic or financial innovation and fair competition." The Conference Report goes on to state that "the Conferees intend for this reference to the `purposes of the Act' to underscore their expectation that the Commission will assess the impact of a proposed exemption on the maintenance of the integrity and soundness of markets and market participants."/
1. The Exemption Is Consistent with the Prevention of Fraud
In general, fraud does not appear to be a particular problem in the interbank swap or FRA markets. A governmental regulatory framework, such as the Act, designed to protect retail investors from fraud would appear to be inapplicable to large and sophisticated institutional parties transacting swap agreements on a principal basis. Banks and financial institutions that are participants in the "wholesale market" and that qualify as SDs do not need, and are not seeking, the protection of the Act with respect to swap agreements cleared through SwapClear. Such banks and financial institutions have demonstrated their ability to protect themselves from fraud relating to OTC derivatives transactions without the assistance of CFTC regulation. SDs can protect themselves from fraud by carefully selecting their counterparties. Such sophisticated parties can also protect themselves from fraud by seeking restitution in court or by simply threatening to do so./ Moreover, US banks are already subject to federal bank regulatory oversight and federal civil laws prohibiting fraud and price manipulation with respect to their OTC market activities.
Because SwapClear will not change the way in which swap agreements are negotiated or transacted between parties, SwapClear will not provide market participants with any greater incentive or opportunity to engage in fraudulent transactions than may currently exist when OTC products are settled on a bilateral basis. Moreover, clearing OTC transactions through a regulated clearing house will assist the internal controls and risk management of banks and financial institutions, which should act as a deterrent to fraud. For example, by subjecting OTC swap transactions to LCH's daily mark-to-market and variation margin collection procedures, it will be more difficult for "rogue traders" to deceive their management as to the value of positions or to hide unprofitable positions. Independent pricing and daily calls for margin should alert management to the existence of a problem.
Finally, it should be noted that this petition specifically excludes from its request for exemption the antifraud provisions of Sections 4b and 4o of the Act, and the provisions of Sections 6(c) and 9(a)(2) of the Act to the extent these provisions prohibit price manipulation. In light of these considerations the Commission should find that the requested exemption is consistent with the public interest in preventing fraud.
2. The Exemption Will Preserve the Financial Integrity of the Markets and Participants
The proposed exemption will help to maintain the integrity and soundness of the market and market participants. First, by providing multilateral netting and daily margining, SwapClear will promote the financial integrity of the swaps market by reducing systemic risk. Second, SwapClear's design, which incorporates the Lamfalussy Report standards for multilateral netting systems,/ will ensure that LCH, as a central counterparty, will contribute to the financial integrity of the markets and will be resilient in extreme market conditions. Third, by adding OTC interest rate products to its current mix of exchange-traded futures contracts, LCH will diversify its risks, reducing the likelihood of LCH suffering a loss in the event of a default by one of its members. Fourth, by alleviating the legal and regulatory uncertainty regarding the participation of US entities in SwapClear, the proposed exemption will reduce legal and regulatory risk, permitting the swap markets to function more effectively.
a. SwapClear Will Reduce Systemic Risks
Because LCH will become the counterparty to every registered swap agreement, counterparty exposure will be reduced. The current bilateral netting arrangements between swap counterparties would be replaced with more efficient multilateral netting, reducing the risk for SDs. Portfolio tests have demonstrated significant reductions in both current net exposure and future counterparty exposure through the introduction of multilateral netting. In other words, the introduction of a central counterparty such as LCH is not merely changing the counterparty on cleared transactions but, by facilitating the netting of offsetting transactions, is reducing systemic risk./
Not only is overall risk reduced by the introduction of SwapClear, but the remaining counterparty risk is better controlled. LCH's prudent risk management policies and collateralization practices (intraday exposure limits, initial margin, daily mark-to-market, and no margin thresholds) will help prevent losses from accumulating within the financial system.
Clearing related futures contracts and swap agreements through the same clearing facility provides efficient netting, which not only reduces the cost of providing margin, but also reduces the number of payments. By netting across products rather than requiring separate settlement, SwapClear will assist in maintaining the integrity of the financial system in times of crisis by helping to reduce payment gridlock.
Moreover, if a member default occurs, use of a central counterparty, such as LCH, serves to prevent other market counterparties from experiencing losses on positions cleared through LCH, thus isolating the default and preventing a domino effect./
Finally, by increasing the financial backing of LCH, SwapClear will enhance the financial integrity of LCH with respect to its ability to cover any losses in excess of margin which may arise from the default on one of the exchange-markets that currently clear through LCH.
b. SwapClear Will Be a Prudent and Sound Central Counterparty
The gains that will result from SwapClear's reducing systemic risks, as outlined above, would be negated if, by acting as a central counterparty, LCH were to introduce a significant point of weakness or uncertainty into the financial system. However, SwapClear has been designed in accordance with prudent and sound regulatory practice and consistent with the recommendations of various financial services industry and regulatory bodies to avoid this problem. (Please see Section IV.B., above, for SwapClear's design standards and Sections IV. C. through G., above, for a discussion of the incorporation of the design standards into SwapClear's operations).
In its OTC Report the CFTC stated that the regulatory issues presented by a swaps clearing facility would depend in part on the extent to which the design of such facility is consistent with the Lamfalussy Report./ As set forth below, SwapClear's design satisfies all of the principal elements of the Lamfalussy Report, described above in footnote 50.
i. Legal Arrangements. LCH will satisfy itself that its regulations, netting arrangements and its ability to enforce its security interest in collateral are legally enforceable in all relevant jurisdictions. (See Appendix I., Section F. for a description of the protections afforded to LCH under Part VII of the UK's Companies Act 1989.)
ii. Understanding of Risks. All SwapClear participants will have a clear understanding of the financial risks associated with SwapClear's netting procedures and will be provided with a copy of LCH's Regulations and LCH's Default Rules (see Appendix II.). LCH also publishes a booklet entitled "Market Protection" (see Appendix III.) which sets out the various risks associated with clearing through LCH in accordance with the framework set out in the "Report of the Sub-committee on Information Statements" by the FIA Global Taskforce on Financial Integrity in June 1996./ The booklet will be revised to include the clearing of swap agreements by LCH in conjunction with the introduction of SwapClear.
In addition, SwapClear's admission standards will help to safeguard the integrity of LCH and market participants by requiring that all SwapClear participants have an appropriate level of product and market knowledge and financial and operational capabilities. Accordingly, every SwapClear participant will be expected to have a thorough understanding of the credit and liquidity risks associated with the obligations to be netted.
iii. Risk Management. SwapClear will have clearly defined procedures for the management of risk by LCH. LCH will manage the credit risk resulting from SwapClear transactions by having high financial resource requirements for SCMs and monitoring firms' continuing compliance with these standards. It will set explicit credit limits on the amount of uncollateralized exposure it is prepared to accept with respect to each SCM and transactions in excess of these limits will not be registered by LCH. SwapClear will monitor exposure to SCMs in real-time and LCH will collect intraday margin cover when existing positions are showing additional exposures as a result of market moves. SwapClear's requirement for variation margin to be paid in cash will prevent risks from accumulating within the system. SwapClear's initial margin methodology will allow LCH to manage the market exposure, including liquidity risks, to which LCH would become exposed on the default of a member. LCH's governance structure, while allowing members to control the strategic direction of their clearing house, explicitly reserves certain key powers, including margin rate setting, to the Chief Executive in order to maintain LCH's ability to act independently and to avoid conflicts of interest. LCH applies prudent risk management policies in the acceptance of collateral as margin cover and the investing of cash margin, where money-market exposures are kept within Board-approved credit limits. Finally, LCH conducts daily stress testing to ensure the adequacy of its financial backing arrangements in the event of member defaults coinciding with extreme market price moves.
LCH does not prescribe procedures for the management of risk by SwapClear participants, (which would be inappropriate and unenforceable); however, SwapClear's variation and initial margin calculations will ensure that accurate and timely signals about the size and risk associated with a firm's cleared transactions are sent to the firm. It is LCH's policy to ensure that senior management independent from day-to-day trading activities of a member firm is informed if such member firm's margin appears consistently high in relation to its financial resources or normal trading pattern.
iv. Ability To Complete Daily Settlements. SwapClear's SCM credit limits, prudent initial margin requirements, accurate daily mark-to-market calculations, and variation margin procedures ensure that SwapClear will be protected in the event of a default by an SCM. LCH's Treasury Department carefully monitors its daily liquidity requirements so that a minimum of $300 million of money-market deposits mature each day. Additionally, should the need arise, LCH maintains bank lines of credit in the amount of ,40.5 million and US$10 million. LCH's lines of credit and careful analysis of its cash requirements help to assure that SwapClear will have access to sufficient sources of liquidity to meet its settlement obligations.
v. Fair Admissions Criteria. SwapClear has established objective and publicly-disclosed admission criteria which permit fair and open access. These criteria, along with all SwapClear regulations and procedures, will be publicly available.
vi. Operational Reliability. LCH will ensure the operational reliability of SwapClear's technical systems and will provide for back-up facilities capable of completing daily processing requirements. LCH has extensive business recovery procedures in place for both office and systems environments, as described in Appendix I, Section G.
c. Risk Diversification Will Enhance LCH's Financial Integrity
By adding OTC interest rate products to the current mix of exchange traded products that it clears, LCH is diversifying its risk portfolio. Portfolio analysis demonstrates that diversification of risk reduces the likelihood of LCH's incurring a loss in the event of a default by any of its members. Finally, the clearinghouse, its members, and their customers benefit from the clearing of swap agreements because there will now be a greater pool of assets, in the form of initial margin deposits associated with the defaulting member's swap agreement positions and an enlarged MDF, for LCH to draw on in the event of a default by an Exchange Clearing Member. LCH firmly believes that clearing exchange-traded products and OTC products in the same clearing entity is beneficial from a risk management perspective.
Some have questioned whether a single clearinghouse should clear exchange-traded products and OTC derivative products (i.e, margin and capital supporting exchange-traded futures positions should not be commingled with margin and capital supporting OTC products)./ There is nothing inherent in swap agreements that creates more risk to LCH than any other exchange-traded interest rate product cleared through LCH. The real question is whether LCH is appropriately monitoring the risk of the swap agreement. To the extent that it is, there is no reason to require the separate clearing of OTC swap agreements from exchange-traded products. Assuming a clearinghouse collects sufficient initial margin, properly calculates the daily mark-to-market, and collects variation margin, it is beneficial to the overall financial integrity of the clearing system to clear exchange traded and OTC products in the same system./ Moreover, a central counterparty such as SwapClear, that clears both exchange-traded and OTC interest rate derivatives, and that also has in place appropriate margining and collateral procedures, will assist market integrity by sending clear signals about the size and risk of a significant portion of a firm's proprietary trading to the senior management of the firm. SwapClear's requirement for cash variation margin will not allow losses to go unnoticed or to be concealed. As losses cannot be rolled forward, risk is not allowed to accumulate within the system. LCH is not aware of any valid economic or regulatory reason for separating the clearing of OTC and exchange-traded products.
d. Legal Certainty Will Contribute to the Financial Integrity of the Markets
By granting this exemption, the CFTC would reduce the legal risk that a SwapClear transaction would be unenforceable, and thereby reduce financial risk and contribute to the preservation of the financial integrity of the markets.
SwapClear will issue standard forms of agreement with respect to the non-economic terms of swap agreements./ Standardized forms of agreement will not change the current bilateral negotiation process, as discussions between traders are generally confined to the economic terms of the swap, none of which is being standardized by SwapClear. SDs will continue to require a bilateral master agreement, normally an ISDA agreement, to be in place with a counterparty before a swap agreement is transacted, even if the swap agreement is to be cleared through SwapClear. SwapClear's standardized forms of agreement will, however, reduce the operational costs and risks associated with the confirmation process and the subsequent handling of exceptions during the life of the swap agreement. SwapClear will also encourage the faster production of trade confirmations because a swap agreement will be registered with LCH only when the transaction has been agreed in a confirmation between the parties.
3. The Exemption Will Promote Responsible Economic and Financial Innovation
The Group of Thirty framed this issue as follows: "Financial economists have identified three ways in which financial innovation can increase the efficiency of the overall financial system and thereby improve performance of the overall economy. These are: by meeting investor and issuer demands for new securities and financial risk products, expanding the opportunities for risk-sharing, risk-pooling, hedging and intertemporal or spatial transfers of resources; by lowering transaction costs or increasing the liquidity of the markets; and by helping to solve costly contractual and informational problems."/ SwapClear will contribute to increasing financial efficiency in all three areas.
First, the potential for the freeing up of credit lines and reduction in regulatory capital requirements could expand the opportunities for many banks and other financial institutions to use the OTC swaps market for efficient management of their interest rate liabilities.
Second, SwapClear will reduce the costs of swap transactions by:
! Reducing the costs of collateralizing payment obligations through multilateral netting. As assets dedicated to collateral purposes often can be put to better uses, maintaining redundant collateral imposes significant costs. SDs with an extensive gross contract position (many contracts with different counterparties) are likely to realize a significant cost reduction;
! Enabling offsetting trades for the reduction of exposure on a particular swap agreement to be transacted with any SD, not just the original counterparty. This will eliminate the need to "tear up" or assign swap agreements to free up credit lines, and should generally make it easier for SDs to manage credit lines;
! Reducing regulatory capital requirements for SDs/SCMs that are subject to regulatory capital requirements. Changes in EU Directives under the Expanded Matrix Directive ("EMD") and Capital Adequacy Directive II ("CAD II") have been agreed at the finance minister level and allow OTC products that are cleared through a clearing house to be treated like exchange-traded and cleared instruments in respect of counterparty risk requirements. The effect of the changes would be that an SD/SCM would not be required to calculate counterparty risk requirements in respect of its exposure to LCH. It is expected that other regulators will follow this treatment which recognizes that counterparty exposures of firms in relation to cleared OTC products will be the same as in relation to their exchange-traded derivatives, i.e., it is eliminated by the clearing house's prudent margining and collateral requirements. The problems associated with the current regulatory capital regime are well known;/ SwapClear will provide a means of alleviating these problems in respect of a significant part of the derivatives market in a simple, yet prudent, manner;
! Reducing the cost of providing margin through margin offsets against certain exchange traded products that are cleared by LCH. For example, short-term interest rate futures and options and government bond futures and options traded on LIFFE and cleared by LCH would be available for margin offset against swap agreements registered through SwapClear. Portfolio analysis has indicated margin savings of over 50% for well hedged portfolios, reflecting the low market risk of the combined portfolios;
! Reducing operational and administrative costs. SwapClear should reduce the significant costs associated with trade confirmation by encouraging the automation of confirmation matching and the faster production of trade confirmations because a swap agreement will be registered with LCH only when it has been agreed in a confirmation between the parties. SwapClear will perform much of the administration of swaps that currently must be performed and reconciled by both counterparties: it will mark-to-market swap agreements and collateral and determine reset rates and amounts. It will also reduce the number of payments required through netting into a single pay/receive by currency per day/. The relative efficiency of futures back-offices compared to OTC back-office operations is well known. The introduction of clearing for OTC products will extend the benefits of settlement with a central clearing house to the OTC markets.
Third, contractual and informational issues will be simplified by SwapClear. As described above, legal and documentation risk will be reduced through the use of standard non-economic terms which will reduce the operational issues caused by the handling of exceptions. The provision of independent, reliable mark-to-market prices will assist SwapClear participants in the valuation of swap agreement positions.
As demonstrated above, SwapClear will offer numerous benefits to SDs, SCMs, LCH and the public generally through systemic risk reduction and greater efficiency for SwapClear participants. The Commission should find that the exemption would promote market integrity and responsible financial innovation in this important market sector./
D. The Proposed Relief Will Have No Material Adverse Effect on CFTC or Contract Market Regulatory or Self-Regulatory Responsibilities.
Congress indicated that the Commission is to consider such regulatory concerns as "market surveillance, financial integrity of participants, protection of customers and trade practice enforcement."/ In the five years since the Commission adopted Part 35 the record does not support a conclusion that the purposes of the Act or the Commission's regulatory efforts have been adversely affected by exempt swap transactions. Swap agreements have been entered into by appropriate persons in the OTC market and carried on a bilateral basis without any apparent adverse impact on market surveillance, financial integrity of participants, protection of customers and trade practice enforcement of regulated markets. Nor have transactions in swap agreements affected the ability of futures exchanges to fulfill their self-regulatory duties. There is no reason to believe that simply adding a clearing facility to such otherwise exempt swap transactions will have a material adverse effect on the regulatory and self-regulatory responsibilities of the CFTC or contract markets.
1. The Exemption Will Not Impact Market Surveillance.
Market surveillance concerns should not be applicable to a clearing facility that is providing clearing and settlement services with respect to OTC transactions in interest rate instruments. The interest rate markets underlying swap agreements are very deep and are generally quite difficult, if not impossible, to manipulate./ LCH is not aware of any reported concerns of market manipulation regarding the interest rate swap market. SwapClear will not provide any greater opportunities to manipulate markets than may currently exist in the OTC market.
2. The Exemption Will Enhance the Financial Integrity of Participants.
As detailed in Section VI.C.2. above, SwapClear will enhance the financial integrity of market participants by providing the benefits of multilateral netting, permitting more efficient use of credit lines and reducing counterparty risk. Moreover, the centralization of information at the clearing house level regarding transactions and mutualization of risks should reduce systemic risks, as well as reduce the likelihood that systemic risks will cause a systemic crisis. SwapClear should have no adverse impact on the ability of the CFTC or contract markets to monitor or protect the financial integrity of market participants.
3. The Exemption Will Not Impact the Protection of Customers or Trade Practice Enforcement.
In evaluating the impact of this exemption on the protection of customers, one must consider two different categories of customers: (i) SwapClear participants, and (ii) the customers of the exchanges for whom LCH clears.
a. The Protection of SwapClear Participants
The CFTC's customer protection regime consists of essentially seven elements: (i) registration, fitness, and qualification of individuals and entities that handle customer orders and funds; (ii) minimum capital requirements for firms that accept customer funds; (iii) segregation requirements with respect to customer funds; (iv) sales practice standards, including required disclosure of risks; (v) recordkeeping and reporting requirements; (vi) audit and enforcement procedures with respect to violators of regulatory requirements; and (vii) dispute resolution procedures in the form of reparations or self-regulatory organization arbitration proceedings.
Either the elements of the CFTC's customer protection regime are not applicable to SwapClear participants, or comparable protections are provided by the regulatory system under which LCH operates.
SwapClear participants will be limited to a group of highly sophisticated, well capitalized and creditworthy banks and financial institutions that have extensive experience in the swap market, are aware of the risks arising out of swap transactions, and are able to take steps to protect themselves from such risks. No end-user business will be cleared through SwapClear, thus, the CFTC's customer protection regime is not relevant to SwapClear.
SwapClear participants will not need the protections of the Act relating to registration, fitness and qualification of intermediaries. Similarly, because all SDs must be participants in the "wholesale market," sales practice standards are not relevant; there should be no need to provide such OTC market participants with disclosure statements regarding the risks of OTC swap transactions that they choose to negotiate privately./ SwapClear will have no impact on the manner in which swap agreements are currently negotiated or transacted between counterparties and thus, trade practice enforcement concerns should not be applicable to the proposed exemption.
The CFTC currently does not impose capital requirements on participants in OTC derivative markets./ SwapClear participants will not be looking to SwapClear to provide them with protection against counterparty default through the imposition of higher regulatory capital standards than may currently exist. Given the sophistication of SwapClear participants, the principal-to-principal nature of the relationship between SDs and SCMs and the applicability of other regulatory capital requirements to many SwapClear participants, there should be no need for the CFTC to impose regulatory capital requirements with respect to swap agreements cleared through SwapClear.
UK client money rules promulgated under the FSAct do not apply to banks and other entities that are listed institutions regulated by the Bank of England. Approved banks that are authorized persons under the FSAct are not required under the UK client money rules to segregate client funds that they hold. These rules permit firms that are not banks and who are subject to the rules to agree with certain non-private customers that their funds should not be segregated. Because it is expected that most SCMs will be listed institutions, approved banks or firms as discussed above, it is not expected that SCMs will be required to segregate SDs' funds in respect of business cleared by them through SwapClear and in such case such business will be recorded in the SCM's "House" account. However, SCMs will be permitted to establish separately designated accounts that are separately margined if they so desire. If an SCM establishes separate "House" and "Client" accounts, LCH will treat those accounts on an entirely separate basis in all situations involving the default of the member in whose name the two accounts are maintained, with no offset being allowed between the accounts./ It would be duplicative and inappropriate, therefore, for the CFTC to apply its segregation regime to funds associated with SwapClear transactions.
LCH will maintain appropriate reporting and recordkeeping requirements for SwapClear participants and transactions. (Please see Section IV.E., above.) Moreover, SCMs will be required to provide regular financial statements as well as audited accounts. LCH will maintain records of SwapClear transactions for six years and such records will be available to Swapclear participants and their auditors upon request.
In addition to the foregoing, SDs and SCMs will be bound by LCH rules. Failure to comply with LCH's rules, regulations or procedures will constitute an event of default by an SCM and, with respect to an SD, would mean that the SD no longer meets the SwapClear eligibility criteria. LCH will offer a dispute resolution mechanism with respect to LCH-registered SwapClear transactions.
Due to the fact that the transactions will be conducted in the OTC market, the financial and market sophistication of SwapClear participants, and the existence of a comparable regulatory regime in the UK, there is no need for the CFTC to extend its futures customer protection regulations to SwapClear participants.
b. Protection of Customers of Exchange Markets Clearing Through LCH
Customers of the exchange-traded futures markets that clear through LCH will not be adversely affected by SwapClear and will be afforded significant protections.
SwapClear will have no impact on Customers that clear their exchange-traded futures positions through LCH members that are not SCMs in the event of a default by such LCH clearing member.
Most customers clearing their futures positions through LCH members that are SCMs will carry their futures positions and associated margin funds in the clearing member's "Client" Account, whereas in most cases it is expected that SwapClear positions will be carried in the SCM's "House" Account. In such circumstances, futures customers will be protected because, in the event of the clearing member's default, under LCH's Default Rules there cannot be any offset across the "Client" and "House" Accounts. Thus, in the event an SCM incurs losses on SwapClear business, customers whose margin money is segregated will not be adversely affected, because such customer funds will be held subject to the UK's Client Money Rules. Similarly, SwapClear will not have an adverse effect on US futures customers of LCH members, because the futures margin deposits of such US customers will be held in segregation in accordance with the UK's client money rules.
Finally, in the situation where a clearing member that is an SCM clears the SwapClear business of an SD through the "Client" Account, the futures customers in the "Client" Account should be protected because it is expected that normally an SD will clear SwapClear positions through the "Client" Account of its SCM only where such SD desires to receive cross-margin treatment with respect to its futures positions that are also cleared in the "Client" Account. By clearing a hedged position, the clearing member is less likely to default due to client losses.
In addition, all futures market customers will benefit from SwapClear's reduction of systemic risk (see Section VI.C.2.a., above), which will make clearing members less likely to default and provide greater security for LCH itself.
The Commission should conclude that customers that transact exchange-traded futures contracts that are cleared through LCH will not be adversely affected by SwapClear.
4. Regulatory Cooperation
To the extent any of the foregoing regulatory responsibilities may be deemed to be implicated by SwapClear transactions, it is relevant to note that LCH is subject to a comprehensive and robust regulatory regime in the UK. In light of the fact that SwapClear will be regulated, in its home jurisdiction,/ under the regulatory oversight of FSA pursuant to the FSAct, there is no apparent benefit to be gained by duplicative regulation of LCH, or by imposing additional regulations on SwapClear participants./
US and UK regulators have previously "agreed on the importance of cooperation in this area [the regulatory framework for OTC derivatives transactions] between regulatory authorities in different jurisdictions and of different financial institutions."/ They also "recognize that a critical factor in a regulatory framework for addressing risk in international financial markets is the appropriate exchange of financial and operational information between regulators on a cross-border basis."/
LCH and FSA are parties to various memoranda of understanding ("MOUs") with the CFTC, US Securities and Exchange Commission and various clearing houses and exchanges that will facilitate the fulfillment by the Commission and contract markets of their regulatory and self-regulatory duties should regulatory issues arise. LCH anticipates that these arrangements will cover SwapClear. The sorts of issue that these information-sharing arrangements are intended to cover were set out in the Windsor Declaration in May 1995, as follows: "Mechanisms should be in place to ensure that enhanced co-operation and communication occurs as necessary between regulators and/or market authorities to minimize the adverse consequences of market disruptions caused by defaults or other failures...[R]ecent market developments require effective international co-ordination and timely communication of reliable information which is essential for supervisory purposes when a financial intermediary, a market member, or a market experiences material financial or operational difficulties."
Based upon the foregoing, the Commission should conclude that requested exemption will have no material impact on the CFTC's or any contract market's ability to fulfill its regulatory or self-regulatory duties under the Act./
E. The Proposed Exemption Is Pro-Competitive
Section 15 of the Act/ requires the Commission to consider the public interest to be protected by the antitrust laws and endeavor to take the least anticompetitive means of achieving the objectives, policies, and purposes of the Act in adopting any exemption under Section 4(c). As the Commission has stated repeatedly, it is not compelled to take the least anticompetitive course of action, but may weigh the regulatory objectives that would be served by the proposed exemption against the anticompetitive impact of the exemption./ In evaluating the impact of an exemption on fair competition, Congress expected that "the Commission will apply consistent standards based on the underlying facts and circumstances of the transactions and markets being considered and may make distinctions between the exchanges and other markets, taking into account the particular facts and circumstances involved . . . where such distinctions are not arbitrary and capricious."/
The Commission's consideration of this petition should lead it to conclude that any possible anticompetitive effects would be clearly outweighed by the proposed exemption's furtherance of the policies, purposes and objectives of the Act. This petition does not raise any significant competitive issues. Rather, the requested relief is pro-competitive because by improving the legal and regulatory certainty of US SwapClear participants, it will enable growth, competition and innovation in the interest rate swap and FRA markets by permitting US firms to compete with foreign banks and dealers on an equal basis. Thus, the exemption will further the fundamental objectives of Section 4(c) of the Act by promoting "responsible economic or financial innovation and fair competition." In addition, as set forth in Section VI.C.2. above, the exemption will further the fundamental objectives of Section 4(c) of the Act by preserving the financial integrity of the markets.
In the adopting release, the Commission stated that it was unaware of any anticompetitive practices or other discernible adverse effects arising during the evolution and development of the swaps market./ The addition of a clearing, settlement and credit enhancement facility to OTC swap agreements will not have an anticompetitive result in the swap market or in the exchange-traded futures market. SwapClear's admission standards are objective and publicly disclosed, which permits fair and open access for qualifying firms.
The OTC interest rate swaps market is complementary, and not in competition, with exchange-traded interest rate futures markets./ The growth of the exchange-traded and OTC markets has been parallel. Since the adoption of Part 35, the CME's Eurodollar futures contract has flourished. The addition of a clearing facility for swaps will not change the symbiotic relationship between swap agreements and exchange-traded futures contracts. Market participants do not choose between swaps and futures based upon their credit characteristics. Rather, users of swaps enjoy the ability to customize and structure products, whereas users of futures contracts enjoy the price transparency, competitive execution, liquidity, and fungibility that exchange-traded futures contracts offer. Typically, swap market participants utilize exchange-traded futures contracts to hedge the net exposure of their swap portfolio./ Because SwapClear will allow market participants to reduce the credit risk component of their OTC transactions, SDs that clear their swap agreements through SwapClear may be able to engage in a greater number of swap transactions, which in turn, will require more hedging with exchange-traded futures contracts.
SwapClear does not unfairly compete with regulated futures exchanges, because SwapClear will not standardize contracts, provide fungibility or offer a competitive price discovery mechanism. In addition, LCH does not enjoy an unfair regulatory advantage over CFTC regulated clearing houses, because, as described above, LCH is subject to a regulatory scheme under the FSAct that is comparable to the regulatory structure governing US clearing houses.
The proposed relief will remove a legal and regulatory uncertainty that is not present with respect to other international swap market participants, which will assist US banks and financial institutions in competing with foreign rivals in the highly competitive swap and FRA markets. By removing this uncertainty, the exemption will promote innovation in the swap and FRA markets and will permit US participants to benefit from the advantages of SwapClear on an equal footing with their foreign competitors. If the requested relief is not granted, US firms that are thereby inhibited from participating in SwapClear may find it difficult to compete with foreign firms who will, for example, have the ability to use SwapClear to free their credit lines and take on new business.
Finally, the requested exemption is not exclusive. There is nothing that would prevent a US clearing house from petitioning the Commission for permission to offer the same or similar services to OTC market participants.
Based upon the foregoing, the Commission must find that the proposed exemption's public benefits clearly outweigh any potential anticompetitive effects.
This petition has demonstrated in detail SwapClear's adherence to prudent and effective design principles, specifically: stringent admission standards; robust risk management through suitable mark-to-market and margin methodologies; secure operational facilities; sufficient financial backing; and oversight of its operations and procedures by its government regulator. SwapClear's design will allow it to provide the many benefits described herein. The public interest will be served through the reduction of systemic risk that multilateral netting will provide. SwapClear participants will benefit from the reduction of counterparty credit risk, regulatory capital, and operational costs.
Finally, as clearly demonstrated herein, the proposed exemption would satisfy the applicable statutory requirements. SwapClear is primarily a clearing, settlement and credit enhancement mechanism. It will not standardize the material economic terms of swap agreements, nor will it have any impact on current OTC trading arrangements. Thus, the exchange-trading requirements of the Act are inapplicable. All SwapClear participants will be "appropriate persons". SwapClear's services will expand the economic opportunities of its participants, reduce the costs of their operations and reduce legal uncertainty, thus promoting responsible financial innovation. SwapClear will not have any adverse effect on the regulatory or self-regulatory responsibilities of the CFTC or contract markets. Finally, the exemption should have an overall positive effect on competition by facilitating growth and innovation in the financial markets and enabling US firms to benefit from SwapClear on an equal footing with other non-U.S. banks and financial institutions.
On the basis of the foregoing, the Commission should find that the exemption is consistent with the public interest and should be granted.
If you have any questions regarding this petition, please call my associate, Michael Philipp at (312) 902-5367, or the undersigned at (312) 902-5241.
Very truly yours,
Arthur W. Hahn
Appendix I - SwapClear Risk Management, and Operational and Financial Integrity
Appendix II - LCH Default Rules
Appendix III - Market Protections
Volume of Exhibits
cc: David Hardy, Chief Executive
Michael Foot, Financial Services Authority
Note: Appendices I, II, and III are available by contacting the Commission's Office of the Secretariat, (202) 418-5100.