March 6, 2013
Today the Commission approved CME Rule 1001, which was submitted to the Commission for review pursuant to Section 40.5 of the Commission’s regulations. Although I agree with the policy outcome of allowing CME to choose which Swap Data Repository (SDR) will receive data on cleared swaps, I am abstaining from the vote on this rule because approval of this rule without an amendment to the Commission’s Part 45 regulations will lead to further confusion with respect to reporting requirements for cleared swaps. My preferred approach, an approach that was not presented to the Commission as an option on which to vote, would have been to re-propose the internally inconsistent Part 45 of the Commission’s regulations in compliance with the Administrative Procedure Act (APA). Instead the Commission has embarked on this suspect approach.
Under Section 40.5 of the Commission’s regulations, a registered entity may submit a new rule, rule amendment or dormant rule to the Commission for approval prior to the rule’s implementation.1 Section 40.5(b) sets out the standard by which the Commission will review the submission. The Commission shall approve the rule, rule amendment or dormant rule unless it is inconsistent with the Commodity Exchange Act (CEA) or the Commission’s regulations.2 As part of its review, the Commission accepted comments from the public as to the advisability of approving CME’s proposed rule. The comments received highlighted the multiple interpretations one could draw from the Commission’s existing regulations, particularly Part 45. Despite the commenters’ concern regarding the legal sufficiency of Part 45, the Commission chose to ignore the commenters’ concerns and has approved the rule without initiating the process to amend Part 45.
Part 45’s Internal Inconsistencies Require Re-proposal
Part 45 sets forth recordkeeping and reporting obligations for Swap Execution Facilities (SEFs), Designated Contract Markets (DCMs), Derivatives Clearing Organizations (DCOs), SDRs, Swap Dealers (SDs), Major Swap Participants (MSPs), and all other swap participants.3 The statutory basis for promulgating Part 45 was CEA § 4r(a), which calls for all uncleared swaps, and only uncleared swaps, to be reported to an SDR to satisfy recordkeeping and reporting requirements.4 In setting out the reporting requirements for swap transactions however, the Commission failed to make any meaningful distinction between swap transactions that have been submitted for clearing and those that were entered into on a bilateral basis and not cleared through a DCO. As a result, Part 45 expressly requires all swaps, both cleared and uncleared, to be submitted to an SDR to satisfy the regulatory reporting requirements established by §4r(a).5
Section 45.8 of the Commission’s regulations, titled “Determination of which counterparties must report,” sets out a hierarchy of counterparties responsible for reporting swap transactions. It states, among other things, that: (1) if a counterparty to a swap transaction is either a SD or a MSP, then such SD or MSP must report; (2) if a transaction is executed on a SEF or a DCM, then the counterparties must agree which counterparty shall carry the reporting obligation and (3) if a transaction is an off-facility swap, then the counterparties must agree on the reporting counterparty.6 Section 45.8 does not identify a DCO as a party with a reporting obligation.
However, §45.3, titled “Swap data reporting: creation data,” completely ignores the reporting obligations of the relevant counterparties mentioned in § 45.8 and instead identifies SEFs and DCMs as the parties responsible for reporting creation data for swaps executed on a SEF or DCM. More importantly, §45.3(b)(2) requires that DCOs report all transactions subject to mandatory clearing. Does this mean a DCO must report swaps that have been executed on a SEF or DCM after the swap has already been reported by the SEF/DCM? This, despite the fact that §45.8 does not list DCOs, SEFs or DCMs as reporting parties that are required to submit swap data pursuant to Part 45. The answers to these questions remain unclear to me.
To make matters worse, instead of clarifying and providing further meaning to the rule text, the preamble only serves to add even more confusion. For example, in the preamble to the final Part 45 rule, the Commission mentions a comment submitted by CME in which the company states that cleared swaps need not be reported to an SDR since the DCO at which the swap was cleared will already have that data on record.7 In the alternative, CME argued that the clearing house should be able to report to an SDR of its choosing as that would be less costly than establishing data links with numerous SDRs.8 The Commission rejected this argument and instead made clear that while the final rule does not prohibit reporting parties from submitting data to DCOs registered as SDRs (or to SDRs chosen by the DCO), such a choice may be made by the reporting party or registered entities for business purposes.9
While the preamble and rule leave open the possibility that reporting parties and registered entities may decide to have DCOs choose which SDR will receive swap data, the rule does not definitively state which party has the authority to make that decision. With reporting parties and DCOs both claiming the right to choose the SDR, and pointing to Part 45 as the source of their authority, the Commission cannot now claim that CME Rule 1001 is not inconsistent with the Commission's regulations. DCOs will point to §45.3 to support their claim, while reporting parties may rely on §45.8. Another fact making this determination more problematic is that although the Commission’s action today theoretically applies only to CME, the practical result is that the Commission’s statement is an interpretation that applies to the entire industry.10 The ambiguity in Part 45 is unacceptable and highlights the necessity to re-write the rule.
Part 45 Must be Amended to Reconcile its Requirements with Existing Commission Regulations and Industry Practice
Part 45 fails to provide the clarity necessary to inform the public that the reporting obligations it creates are consistent with Part 39 and the process for clearing swaps. Section 39.12(b)(6) codifies a long-standing industry practice which holds that once a contract is accepted for clearing by a DCO, that contract is extinguished and replaced by two equal and opposite swaps between the DCO and each clearing member.11 This long-standing practice is consistent with the policy outcome of CME Rule 1001. Section 45.3 however, fails to specify how the termination of the original swap affects the continuing reporting obligations of the original counter parties or the DCO. For example, §45.3 states that a DCO creates two equal and opposite swaps during the clearing process. It further states that the DCO, when reporting swaps that are subject to mandatory clearing, must include with the reported swap data, the new internal identifiers assigned by the automated clearing system to the two swaps resulting from the clearing process.12
Where Part 45 falls short, is that it never specifically states what reporting obligations remain with respect to the initial swap once clearing has taken place. Nor does Part 45 provide enough detail on how the two new swaps are related to the original swap. A better approach would be to amend Part 45 so that it makes clear, as Part 39 does that once a swap is submitted for clearing, that swap no longer exists and two new equal and opposite swaps take its place. Likewise, Part 45 should be amended to make clear what the reporting obligations are for the DCO and original counterparties once the two new swaps have been created, as provided through CME Rule 1001.
Finally, Part 45 must also be amended so that continuation data (life cycle event data and valuation data) is only required to be provided for uncleared swaps. According to §45.4, both counterparties to the swap and the DCO that clears a swap must submit continuation data on a daily basis. At best, this requirement serves no regulatory purpose, and at worst it may also lead to uncertainty in the market. Each clearing house will maintain daily valuation data for swaps cleared through its organization in order to properly carry out its clearing and risk mitigation functions. Sending that same information to an SDR serves no additional benefit and will most likely contribute to uncertainty in the marketplace. What will happen if the daily valuation data provided by the DCO is different from that which is provided by swap counterparties? Which data set will take priority?
In an emergency default situation, the Commission and clearing houses should be able to look to one centralized database from which they can calculate market exposures. Historically that source of information has been the clearing house. The last thing we need during a period of market disruption is various market participants claiming different values for their portfolios based on conflicting data sets at SDRs and clearing houses. For purposes of consistency and market stability, we should amend Part 45 to remove the continuation data reporting requirement for cleared swaps.
The Commission has Ignored Administrative Due Process when Interpreting the Requirements of Part 45
The APA requires federal agencies to publish a notice of proposed rulemaking and give interested persons an opportunity to participate in the rule making process through submission of written data, views, or arguments.13 A Federal agency may only dispense with notice and comment in one of two situations. First, when an agency issues an interpretive rule, general statement of policy, or rules of agency organization, procedure, or practice.14 This interpretive rule exception applies to agency statements that “explain ambiguous language, or remind parties of existing duties, not those that create new law.”15 Second, an agency may dispense with notice and comment if it is able to demonstrate “Good Cause” that notice and comment is not necessary because it would be “impracticable, unnecessary, or contrary to the public interest.”16
In this case, the Commission has failed to meet either of the exceptions from the notice and comment requirement; instead, it is providing a new legal interpretation of Part 45, a rule that was already promulgated after a period of public notice and comment. A complete re-interpretation of the agency position with respect to the reporting requirements in Part 45 can hardly be classified as “a reminder to parties of its existing duties” or a simple clarification of ambiguous language. Thus, such re-interpretation must be expressed in the form of an agency rulemaking. Market participants should have once again been afforded a notice and comment period to specifically address the rules as they are set out in Part 45, not just the advisability of approving CME Rule 1001.
The Commission has similarly failed to provide a “Good Cause” showing for why notice and comment may be dispensed with prior to the new interpretation of Part 45 issued today. For example, a court could find “Good Cause” present when an agency must have regulations in place in order to meet a specific deadline imposed by Congress.17 Here, Part 45 was published in its final form in January of 2012. The Commission received comments from the industry, both before and after publication of the final rule, indicating that there were inconsistencies in the rule that called for the Commission to reconsider its original proposal. The Commission cannot now claim an emergency when presented with a new rule proposal from one of its registrants. The Commission has been on notice of the problems with Part 45 for more than a year.
The Commission’s overall rule writing process in implementing Dodd-Frank has proceeded at a breathtaking pace. This frenetic schedule resulted in the Commission implementing rules that did not work in harmony with each other as required in order to establish a new regulatory framework. The Commission must acknowledge the errors in the current rule and correct them now. For the reasons I have detailed above, I am abstaining from participating in the Commission’s approval of CME Rule 1001. I have often spoken about the need for good government. The action taken by the Commission today falls well short of the standards by which a federal agency should regulate an industry.
1 17 CFR §40.5.
3 77 Fed. Reg. 2136.
4 CEA §4r (Reporting and Recordkeeping for Uncleared Swaps) implementing §729 of Dodd-Frank, commonly referred to as “Regulatory Reporting.”
5 17 CFR §45.3.
6 17 CFR §45.8.
7 77 Fed. Reg. 2136, 2146.
8 Reporting to one SDR of its choosing would relieve the DCO of having to pay for IT connectivity to each of the SDRs selected by various reporting entities for trade reporting.
9 Id at 2184.
10 It seems likely that following approval of this rule all other DCOs registered with the Commission would soon follow suit and file similar rules with the Commission. The end result being that all swaps submitted for clearing would be reported to the SDR affiliated or owned by the DCO that cleared the transaction.
11 17 CFR §39.12.(b)(6).
12 17 CFR §45.3(a)(2).
13 5 U.S.C. §553(b) & (c). The Commission codified this rule into its regulations at 17 CFR §13.5.
14 Id §553(b)(A).
15 Sentara-Hampton Gen. Hosp. v. Sullivan, 980 F.2d 749, 759 (D.C.Cir. 1992).
16 5 U.S.C. §553(b)(3)(B).
17 Coalition for Parity, INC. v. Sebelius, 709 F.Supp. 2d 10 (2010), finding that the deadline imposed by a new regulatory regime, the need for regulatory certainty, Congress’ express authorization for the agency to publish interim final rules and the temporary nature of the interim final rules justified an agency’s decision to forego notice and comment in implementing interim final rules.
Last Updated: March 6, 2013