[Federal Register: June 11, 2007 (Volume 72, Number 111)]


[Page 32079-32081]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]





Order Exempting the Trading and Clearing of Certain Credit

Default Products Pursuant to the Exemptive Authority in Section 4(c) of

the Commodity Exchange Act (``CEA'')

AGENCY: Commodity Futures Trading Commission

ACTION: Final order.


SUMMARY: On May 14, 2007, the Commodity Futures Trading Commission

(``CFTC'' or the ``Commission'') published for pubic comment in the

Federal Register \1\ a proposal to exempt for the CEA \2\ the trading

and clearing of certain products called credit default options

(``CDOs'') and credit default basket options (``CDBOs'') that are

proposed to be traded on the Chicago Board Options Exchange (``CBOE''),

a natioal securities exchange registered under Section 6 of the

Securities Exchange Act of 1934 (``1934 Act''),\3\ and cleared through

the Options Clearing Corporation (``OCC''), a registered securities

clearing agency registered under Section 17A of the 1934 Act,\4\ and

Derivatives Clearing Organization registered under Section 5b of the

CEA.\5\ The proposed order was preceded by a request from OCC to

approve rules that would permit it to clear these CDOs and CDBOs in its

capacity as a registered securities clearing agency. OCC's request

presented novel and complex issues of jurisdiction and the Commission

determined that an order exempting the trading and clearing of such

instruments from pertinent requirements of the CEA may be appropriate.

The Commission has reviewed the comments made in response to its

proposal and the entire record in this matter and has determined to

issue an order exempting the trading and clearing of these contracts

from the CEA.


\1\ 72 FR 27091 (May 14, 2007).

\2\ 7 U.S.C. 1 et seq.

\3\ 15 U.S.C. 78f.

\4\ 15 U.S.C. 78q-1.

\5\ 7 U.S.C. 7a-1.


Authority for this exemption is found in Section 4(c) of the



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


DATES: Effective Date: June 5, 2007.

FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director and

Chief Counsel, 202-418-5480; [email protected], Robert B. Wasserman,

Associate Director, 202-418-7719, lgregory*@cftc.gov, Division of

Clearing and Intermediary Oversight, Commodity Futures Trading

Commission, Three

[[Page 32080]]

Lafayette Centre, 1151 21st, NW., Washington, DC 20581.



The OCC is both a Derivatives Clearing Organization (``DCO'')

registered pursuant to Section 5b of the CEA,\7\ and a securities

clearing agency registered pursuant to Section 17A of the 1934 Act.\8\

The CBOE is a national securities exchange registered as such under

Section 6 of the 1934 Act.\9\


\7\ 7 U.S.C. 7a-1.

\8\ 15 U.S.C. 78q-1.

\9\ 15 U.S.C. 78f.


CBOE has filed with the Securities and Exchange Commission

(``SEC'') proposed rule changes to provide for the listing and trading

on CBOE of cash-settled products characterized by CBOE as options based

on credit events in one or more debt securities of specified

``Reference Entities.'' \10\ These products are referred to as Credit

Default Options (``CDOs''), and would pay the holder a specified amount

upon the occurrence, as determined by CBOE, of a ``Credit Event,''

defined to mean an ``Event of Default'' on any debt security issued or

guaranteed by a specified ``Reference Entity.''


\10\ See Release No. 34-55251, 72 FR 7091 (Feb. 14, 2007).


CBOE has also filed with the SEC proposed rule changes to provide

for the listing and trading on CBOE of products called Credit Default

Basket Options (``CDBOs'').\11\ These are similar in concept to CDOs,

except that a CDBO covers more than one Reference Entity. For each

individual Reference Entity, a notional value (a fraction of the

aggregate Notional Face Value of the basket) and a recovery rate is

specified. CDBOs may be of the multiple-payout variety, or of the

single-payout variety, where a payout occurs only the first time a

Credit Event is confirmed with respect to a Reference Entity prior to



\11\ See SR-CBOE-2007-026.


OCC has filed with the CFTC, pursuant to Section 5c(c) of the CEA

and Commission Regulations 39.4(a) and 40.5 thereunder,\12\ requests

for approval of rules and rule amendments that would enable OCC to

clear and settle these CDOs and CDBOs in its capacity as a registered

securities clearing agency (and not in its capacity as a DCO).\13\

Section 5c(c)(3) provides that the CFTC must approve any such rules and

rule amendments submitted for approval unless it finds that the rules

or rule amendments would violate the CEA.


\12\ 7 U.S.C. 7a-2(c), 17 CFR Sec. Sec. 39.4(a), 40.5.

\13\ See SR-OCC-2007-01 A-1; SR-OCC-2007-06. OCC has filed

identical proposed rule changes with the SEC.


The request for approval concerning the CDO product was filed

effective March 8, 2007. On April 23, 2007, the review period was

extended pursuant to Regulation 40.5(c) until June 6, 2007, on the

ground that the CDOs ``raise novel or complex issues, including the

nature of the contract, that require additional time for review.'' The

request for approval concerning the CDBO product was filed effective

April 23, 2007.

II. Section 4(c) of the Commodity Exchange Act

Section 4(c)(1) of the CEA empowers the CFTC to ``promote

responsible economic or financial innovation and fair competition'' by

exempting any transaction or class of transactions from any of the

provisions of the CEA (subject to exceptions not relevant here) where

the Commission determines that the exemption would be consistent with

the public interest. The Commission may grant such an exemption by

rule, regulation or order, after notice and opportunity for hearing,

and may do so on application of any person or on its own initiative. In

enacting Section 4(c), Congress noted that the goal of provision ``is

to give the Commission a means of providing certainty and stability to

existing and emerging markets so that financial innovation and market

development can proceed in an effective and competitive manner.'' \14\

As noted in the proposing release,\15\ In granting an exemption, the

CFTC need not find that the CDOs and CDBOs are (or are not) subject to

the CEA.


\14\ HOUSE CONF. REPORT ON NO. 102-978, 1992 U.S.C.C.A.N. 3179,

3213 (``4(c) Conf. Report'').

\15\ 72 FR 27091 (May 14, 2007).


Section 4(c)(2) provides that the Commission may grant exemptions

only when it determines that the requirements for which an exemption is

being provided should not be applied to the agreements, contracts or

transactions at issue, and the exemption is consistent with the public

interest and the purposes of the CEA; that the agreements, contracts or

transactions will be entered into solely between appropriate persons;

and that the exemption will not have a material adverse effect on the

ability of the Commission or any contract market to discharge its

regulatory or self-regulatory responsibilities under the CEA.

In the May 14, 2007 Federal Register release, the Commission

requested public comment on the matters discussed above and all issues

raised by its proposed exemptive order.

III. Comment Letters

The Commission received four comment letters. The Chicago

Mercantile Exchange (``CME'') stated that it ``applauds'' the

Commission's proposal to promote innovation but that it believed some

issues should be addressed before a final order is issued. CME argued

that: (1) It would be unfair for OCC and CBOE to receive exemptive

relief yet continue to oppose CME's efforts to list competitive

products; (2) the Commission should not accept OCC's and CBOE's

characterization of the products as options; (3) there are strong

arguments that the products are based on commodities, not securities;

and (4) it is not proper to define ``appropriate persons'' in terms of

the status of the person's intermediary.

OCC focused on the ``appropriate persons'' issue. OCC argued that

in light of the customer suitability rules and the overall federal

securities regulatory framework, the products would be limited to

``appropriate persons.''

The Chicago Board of Trade ``CBOTS'') suggested that characterizing

the CDOs and CDBOs as ``novel instruments'' should be repudiated or

clarified because it could have implications under the patent laws.

IV. Findings and Conclusions

After considering the complete record in this matter, including the

comments received, the Commission has determined that the requirements

of Section 4(c) have been met.\16\ First, the exemption is consistent

with the public interest and with the purposes of the CEA. The purposes

of the CEA include ``promot[ing] responsible innovation and fair

competition among boards of trade, other markets and market

participants.'' \17\ With respect to the competitive issue raised by

CME in its comment letter, the Commission believes that an exemptive

order in response to OCC's request for rule approval is the best way to

promote responsibile innovation and fair competition among futures

markets and securities markets. In cases such as this one where

innovative products come close to the jurisdictional line between

commodities and securities, rather than attempting to draw that line

with precision with regard to the CBOE products and thereby potentially

[[Page 32081]]

imposing litigation costs on both the private sector and the public

sector, it may be more efficient and is a proper use of Section 4(c)

exemptive authority to permit, without compromising the public

interest, the products to trade on both sides of the line and let

competitive forces determine which venue is successful.


\16\ In this regard, consistent with the legislative history to

Section 4(c) of the CEA, the Commission is not making a finding that

CDOs and CDBO are (or are not) subject to the CEA.

\17\ CEA Section 3(b), 7 U.S.C. 5(b) (emphasis added. See also

CEA Section 4(c)(1), 7 U.S.C. 6(c)(1) (purpose of exemptions is ``to

promote responsible economic or financial innovation and fair



Second, the CDOs and CDBOs would be entered into solely between

appropriate persons. This issue was discussed by both CME and OCC in

their respective comment letters. Section 4(c)(3) includes within the

term ``appropriate persons'' a number of specified categories of

persons, but also in subparagraph (K), ``such other persons that the

Commission determines to be appropriate in light of * * * the

applicability of appropriate regulatory protections.'' (Emphasis

added.) These products will be traded on a regulated exchange. CBOE,

OCC, and their members who will intermediate these transactions, are

subject to extensive and detailed oversight by the SEC and, in the case

of the intermediaries, the securities self-regulatory organizations. It

should be noted that CME has listed or will list comparable products

and has not limited access to its markets to specified categories of

persons. In light of where the products will be traded, the regulatory

protections available under the securities laws, and the goal of

promoting fair competition, these products will be traded by

appropriate persons.

Third, the exemption would not have a material adverse effect on

the ability of the Commission or any designated contract market to

carry out their regulatory responsibilities under the CEA. There is no

reason to believe that granting an exemption here would interfere with

the Commission's or a designated contract market's ability to oversee

the trading of similar products on a designated contract market or

otherwise to carry out their duties. None of the comment letters

received addressed this issue.\18\


\18\ Under Section 4(c) of the CEA, the Commission need not

resolve whether, as CME argues in its comment letter, these products

are based on commodities and not securities, or, as CBOE argues in

its comment letter, these products are securities subject to the

securities laws. Nor need the Commission determine, as CME urges,

whether the products are properly characterized as options. Finally,

the Commission notes that its references to the novelty of the

issues raised by these products refer to issues under the CEA and

were not intended to be applicable in any matter relating to patent

or intellectual property law.


Therefore, upon due consideration, pursuant to its authority under

Section 4(c) of the CEA, the Commission hereby issues this Order and

exempts the trading and clearing of CDOs and CDBOs to be listed and

traded on CBOE and cleared through OCC as a securities clearing agency

from the CEA. This Order is contingent upon the approval by the SEC,

pursuant to Section 19(b) of the 1934 Act, of CBOE and OCC rules to

permit the listing and trading of CDOs and CDBOs on CBOE. This Order is

subject to termination or revision, on a prospective basis, if the

Commission determines upon further information that this exemption is

not consistent with the public interest. If the commission believes

such exemption becomes detrimental to the public interest, the

Commission may revoke this Order on its own motion.

V. Related Matters

A. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (``PRA'') \19\ imposes certain

requirements on federal agencies (including the Commission) in

connection with their conducting or sponsoring any collection of

information as defined by the PRA. The order would not require a new

collection of information from any entities that would be subject to

the order.


\19\ 44 U.S.C. 3507(d).


B. Cost-Benefit Analysis

Section 15(a) of the CEA, as amended by Section 119 of the

Commodity Futures Modernization Act of 2000 (``CFMA''),\20\ requires

the Commission to consider the costs and benefits of its action before

issuing an order under the CEA. By its terms, Section 15(a) as amended

does not require the Commission to quantify the costs and benefits of

an order or to determine whether the benefits of the order outweigh its

costs. Rather, Section 15(a) simply requires the Commission to

``consider the costs and benefits'' of its action.


\20\ 7 U.S.C. 19(a).


Section 15(a) of the CEA further specifies that costs and benefits

shall be evaluated in light of five broad areas of market and public

concern: protection of market participants and the public; efficiency,

competitiveness, and financial integrity of futures markets; price

discovery; sound risk management practices; and other public interest

considerations. Accordingly, the Commission could in its discretion

give greater weight to any one of the five enumerated areas and could

in its discretion determine that, notwithstanding its costs, a

particular order was necessary or appropriate to protect the public

interest or to effectuate any of the provisions or to accomplish any of

the purposes of the CEA.

The order issued today is expected to facilitate market

competition. The commission has considered the costs and benefits of

the order in light of the specific provisions of Section 15(a) of the

CEA, as follows:

1. Protection of market participants and the public. Protections

for market participants and the public exist in that CBOE, OCC and

their members who will intermediate CDOs and CDBOs are subject to

extensive oversight by the SEC and, in the case of intermediaries,

securities self-regulatory organizations.

2. Efficiency, competition, and financial integrity. The exemptive

order may enhance market efficiency and competition since it could

encourage potential trading of CDOs and CDBOs on markets other than

designated contract markets. Financial integrity will not be impaired

since the CDOs and CDBOs will be cleared by OCC, a DCO and SEC-

registered clearing agency, and intermediated by SEC-registered broker-


3. Price discovery. Price discovery may be enhanced through market


4. Sound risk management practices. OCC has described appropriate

risk-management practices that it will follow in connection with the

clearing of CDOs and CDBOs.

5. Other public interest considerations. The exemptive order may

encourage development of credit derivative products through market

competition without unnecessary regulatory burden.

The Commission requested comment on its application of these

factors in the proposing release. No comments were received.

After considering these factors, the Commission has determined to

issue this Order.

* * * * *

Issued in Washington, DC, on June 5, 2007 by the Commission.

Eileen A. Donovan,

Acting Secretary of the Commission.

[FR Doc. 07-2878 Filed 6-8-07; 8:45 am]


Last Updated: June 29, 2007