[Federal Register Volume 64, Number 190 (Friday, October 1, 1999)]
[Notices]
[Pages 53346-53364]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-25605]
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COMMODITY FUTURES TRADING COMMISSION
Order Granting the London Clearing House's Petition for an
Exemption Pursuant to Section 4(c) of the Commodity Exchange Act
AGENCY: Commodity Futures Trading Commission.
ACTION: Final order.
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SUMMARY: In response to a Petition for Exemption Pursuant to Section
4(c) of the Commodity Exchange Act (``CEA'' or ``Act'') submitted by
the London Clearing House Limited (``LCH''), the Commodity Futures
Trading Commission (``CFTC'' or ``Commission'') is adopting an order
that exempts certain swap agreements submitted for clearing through
LCH's newly-developed swaps clearing operation (``SwapClear'') from
most provisions of the Act and Commission regulations. The order
provides a similar exemption to specified persons who engage in certain
activities with respect to such agreements. This order is being adopted
pursuant to the exemptive authority granted to the Commission by the
Futures Trading Practices Act of 1992. The Commission believes that the
relief provided by this order is appropriate because a centralized
swaps clearing operation may provide substantial benefits to the over-
the-counter (``OTC'') derivatives market and because the SwapClear
operation satisfies the statutory criteria for an exemption pursuant to
Section 4(c) of the Act.
EFFECTIVE DATE: September 23, 1999.
FOR FUTHER INFORMATION CONTACT: John C. Lawton, Acting Deputy Director;
Thomas E. Joseph, Special Counsel; or Jocelyn B. Barone, Attorney-
Advisor, Division of Trading and Markets, Commodity Futures Trading
Commission, Three Lafayette Center, 1155 21st Street, N.W., Washington,
D.C. 20581. Telephone: (202) 418-5450.
Table of Contents
I. Introduction
II. Statutory and Regulatory Background
III. LCH and SwapClear
A. LCH
B. SwapClear
1. Participants
2. Products
3. Clearing Procedures
4. Treatment of Client Funds
5. Risk Management Procedures
6. Default Rules and Procedures
7. Operational Safeguards
IV. Regulatory Oversight in the United Kingdom and Information-
Sharing between Regulators
A. Applicable Regulations in the United Kingdom
B. Information-Sharing between the FSA and the CFTC
V. Summary of Comments
VI. Determinations Required for Exemption
A. Exchange Trading Requirement
B. The Public Interest and the Purposes of the Act
1. Potential Benefits of SwapClear
2. Financial Safeguards
3. Potential for Fraud or Manipulation
C. Appropriate Persons
D. Adverse Effects on Regulatory or Self-Regulatory Duties
VII. Explanation of the Order
VIII. Conclusion
The Order
SUPPLEMENTARY INFORMATION:
I. Introduction
By a petition dated June 15, 1998, LCH requested that the
Commission
[[Page 53347]]
grant an exemption pursuant to Section 4(c) of the CEA \1\ to qualified
persons using ``SwapClear,'' a proposed facility for clearing swap
transactions that satisfy specified criteria (``LCH Petition''). The
LCH Petition specifically requested that the Commission exempt such
persons from all provisions of the CEA and Commission regulations,
except for Sections 2(a)(1)(B);\2\ 4b and 4o of the Act; \3\ the
provisions of Sections 6(c) and 9(a)(2) of the Act \4\ to the extent
that such provisions prohibit the 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 Rule 32.9.\5\ The
Commission published a notice of the LCH Petition and a request for
public comment in the Federal Register on July 7, 1998.\6\ The comment
period was originally sixty days, but it was extended until September
23, 1998, in response to a request by the International Swaps and
Derivatives Association, Inc. (``ISDA'').\7\ The Commission received
four letters in response to its request for comments. Two of these
letters were from futures exchanges, and two were from trade
associations.\8\ The comments are summarized in Section V below.
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\1\ 7 U.S.C. 6(c).
\2\ Section 4(c) of the CEA expressly prohibits the Commission
from exempting any transaction from Section 2(a)(1)(B) of the Act.
Section 2(a)(1)(B) sets forth the division of the jurisdiction
between the CFTC and the Securities and Exchange Commission
(``SEC'') over specified instruments and restricts or prohibits
certain types of securities derivatives. 7 USC 2a.
\3\ Sections 4b and 4o of the Act prohibit fraudulent conduct
with respect to futures and option transactions. 7 USC 6b and 6o.
\4\ 7 U.S.C. 9 and 13(a)(2).
\5\ Rule 32.9 prohibits fraud in connection with commodity
option transactions. 17 CFR 32.9.
\6\ Petition of the London Clearing House Limited for an
Exemption Pursuant to Section 4(c) of the Commodity Exchange Act, 63
FR 3665 (July 7, 1998)(Request for Comments).
\7\ Petition of the London Clearing House Limited for an
Exemption Pursuant to Section 4(c) of the Commodity Exchange Act, 63
FR 49094 (Sept. 14, 1998)(Extension of Comment Period).
\8\ The Commission received comments from the Chicago Board of
Trade (``CBOT''), the New York Mercantile Exchange (``NYMEX''),
ISDA, and the OTC Derivatives Products Committee of the Securities
Industry Association (``SIA'').
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Based upon the Commission's review and consideration of the LCH
Petition, as supplemented by correspondence from counsel for LCH, the
comments received in response to the LCH Petition, and the Commission's
independent analysis, the Commission is adopting an order pursuant to
the authority granted in Section 4(c) of the Act that exempts specified
swap agreements submitted for clearing to SwapClear and specified
persons who engage in certain activities with respect to those
agreements from most provisions of the CEA to the extent that such
persons and agreements are subject to the Act and the Commission's
regulations. The exemptive relief provided by the order is subject to
the terms and conditions set forth therein.
II. Statutory and Regulatory Background
Section 2(a)(1)(A) of the CEA grants the Commission exclusive
jurisdiction over ``accounts, agreements (including any transaction
which is of the character of * * * `an option'), and transactions
involving contracts of sale of a commodity for future delivery traded
or executed on a contract market or any other board of trade, exchange,
or market.'' \9\ The term ``commodity'' is not limited to tangible
products, but rather has been defined broadly to include ``all
services, rights, and interests in which contracts for future delivery
are presently or in the future dealt in.'' \10\
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\9\ 7 U.S.C. 2(i).
\10\ 7 U.S.C. 1a(3).
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The CEA and Commission regulations require that transactions in
futures contracts and commodity option contracts, with narrowly defined
exceptions, occur on or subject to the rules of a contract market
designated by the Commission.\11\ Specifically, Section 4(a) of the CEA
provides, inter alia, that it is unlawful to enter into a futures
contract that is not made on or subject to the rules of a board of
trade which has been designated by the Commission as a ``contract
market.'' \12\ Pursuant to Sections 4c(b) and 4c(c) of the Act, the
trading of commodity options is permitted only in accordance with
Commission regulations.\13\ Part 33 of the regulations prohibits
persons from entering into, offering to enter into, or executing any
commodity option transaction unless the transaction occurs on a
contract market designated by the Commission to trade commodity
options, subject to certain exceptions set forth elsewhere in
Commission rules.\14\
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\11\ 7 U.S.C. 6(a), 6c(b), and 6c(c).
\12\ 7 U.S.C. 6(a). This prohibition does not apply to contracts
made on or subject to the rules of a board of trade, exchange, or
market located outside of the United States, its territories, or
possessions.
\13\ 7 U.S.C. 6c(b) and 6c(c). Section 4c(b) provides, inter
alia:
No person shall offer to enter into, enter into or confirm the
execution of, any transaction involving any commodity regulated
under this Act which is of the character of, or is commonly known to
the trade as, an ``option'' * * * contrary to any rule, regulation
or order of the Commission prohibiting any such transaction or
allowing any such transaction under such terms and conditions as the
Commission shall prescribe.
Section 4c(c) directs the Commission to issue regulations that,
inter alia, ``permit the trading of such commodity options under
such terms and conditions that the Commission from time to time may
prescribe.''
\14\ 17 CFR Part 33.
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The Futures Trading Practices Act of 1992 (``1992 Act'') added
subsections (c) and (d) to Section 4 of the CEA.\15\ Section 4(c)(1)
authorizes the Commission, by rule, regulation, or order, to exempt any
agreement, contract or transaction, or class thereof, from the
exchange-trading requirement of Section 4(a) or any other requirement
of the Act other than Section 2(a)(1)(B).\16\ The Commission is
authorized to grant an exemption either: (i) On its own initiative or
on the application of any person; (ii) retroactively or prospectively;
and (iii) unconditionally or on stated terms or conditions.\17\
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\15\ Pub. L. No. 102-546 (1992), 106 Stat. 3590, 3629.
\16\ Section 4(c) provides that:
\17\ 7 U.S.C. 6(c)(1).
In order to promote responsible economic or financial innovation
and fair competition, the Commission by rule, regulation, or order,
after notice and opportunity for hearing may (on its own initiative
or on application of any person, including any board of trade
designated as a contract market for transactions for future delivery
in any commodity under section 5 of this Act) exempt any agreement,
contract, or transaction (or class thereof) that is otherwise
subject to subsection (a) (including any person or class of persons
offering, entering into, rendering advice or rendering other
services with respect to, the agreement, contract or transaction),
either unconditionally or on stated terms or conditions or for
stated periods and or from any other provision of the Act (except
section 2(a)(1)(B)), if the Commission determines that the exemption
would be consistent with the public interest.
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The Commission may grant an exemption from the exchange trading
requirement of Section 4(a) or any other requirement of the Act other
than Section 2(a)(1)(B) ``to promote responsible economic or financial
innovation and fair competition'' if it determines that ``the exemption
would be consistent with the public interest.'' \18\ Prior to issuing
an exemption under Section 4(c) from the exchange trading requirement
of Section 4(a), the Commission must find that: (i) 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;'' (ii) the exempted transaction ``will be entered into solely
between the `appropriate persons' '' delineated in Section 4(c)(3);
\19\ and (iii) the
[[Page 53348]]
agreement, contract, or transaction in question ``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.'' \20\
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\18\ Id.
\19\ The Act defines the term ``appropriate person'' to include:
(A) A bank or trust company (acting in an individual or
fiduciary capacity).
(B) A savings association.
(C) An insurance company.
(D) An investment company subject to regulation under the
Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.).
(E) A commodity pool formed or operated by a person subject to
regulation under [the] Act.
(F) A corporation, partnership, proprietorship, organization,
trust, or other business entity with a net worth exceeding
$1,000,000 or total assets exceeding $5,000,000, or the obligations
of which under the agreement, contract or transaction are guaranteed
or otherwise supported by a letter of credit or keepwell, support or
other agreement by any such entity or by an entity referred to in
subparagraph (A), (B), (C), (H), (I), or (K) of this paragraph.
(G) An employee benefit plan with assets exceeding $1,000,000,
or whose investment decisions are made by a bank, trust company,
insurance company, investment adviser registered under the
Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.), or a
commodity trading advisor subject to regulation under the Act.
(H) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof,
or any multinational or supranational entity or any instrumentality,
agency, or department of any of the foregoing.
(I) A broker-dealer subject to regulation under the Securities
Exchange Act of 1934 (15 U.S.C. 78a et seq.) acting on its own
behalf or on behalf of another appropriate person.
(J) A futures commission merchant, floor broker, or floor trader
subject to regulation under [the] Act acting on its own behalf or on
behalf of another appropriate person.
(K) Such other persons that the Commission determines to be
appropriate in light of their financial or other qualifications, or
the applicability of appropriate regulatory protections. 7 U.S.C.
6(c)(3).
\20\ Specifically, Section 4(c) states:
The Commission shall not grant any exemption under [Section
4(c)] from any of the requirements of subsection (a) [the exchange
trading requirement] unless the Commission determines that--
(A) the 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
purposes of this Act; and
(B) the agreement, contract, or transactions--
(i) will be entered into solely between appropriate persons; and
(ii) 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 this Act.
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Section 4(c)(5) of the Act authorized the Commission ``promptly''
to exercise the exemptive authority granted in Section 4(c)(1) by
providing an exemption for swap agreements that are not part of a
fungible class of agreements that are standardized as to their material
economic terms.\21\ The Commission did so by adopting Part 35 of the
Commission's regulations in January 1993. These rules exempt swap
agreements satisfying specified criteria and any person who offers,
enters into, or renders advice or other services with respect to such
transactions from all provisions of the Act and the Commission's
regulations except for Sections 2(a)(1)(B), 4b and 4o, Rule 32.9, and
the antimanipulation provisions in Sections 6(c) and 9(a)(2).\22\ The
Part 35 swaps exemption became effective retroactively as of October
23, 1974, the date of the enactment of the Commodity Futures Trading
Commission Act of 1974.
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\21\ Section 4(c)(5)(B) states, in part, that the Commission may
[P]romptly following the enactment of this subsection, or upon
application by any person, exercise the exemptive authority granted
under paragraph (1) * * * with respect to classes of swap agreements
* * * that are not part of a fungible class of agreements that are
standardized as to their material economic terms, to the extent that
such agreements may be regarded as subject to the provisions of this
Act.
\22\ 17 CFR Part 35. In enacting the swaps exemption, the
Commission also acted pursuant to its plenary authority to regulate
commodity options under Section 4c(b) of the CEA with respect to
swap agreements that are commodity options. Id. at 5589.
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To be eligible for exemptive treatment under Part 35, a transaction
must: (i) Be a ``swap agreement'' as defined in Rule 35.1(b)(1); \23\
(ii) be entered into solely between ``eligible swap participants'' as
defined in Rule 35.1(b)(2); \24\ (iii) not be part of a fungible class
of agreements that are standardized as to their material economic
terms; \25\ (iv) include the creditworthiness of a party having an
obligation under the agreement as a material consideration in entering
into or determining the terms of the swap agreement; and (v) not be
entered into and traded on or through a multilateral transaction
execution facility. These criteria were designed to ensure that the
exempted swap agreements met the requirements set forth by Congress in
Section 4(c) of the CEA and ``to promote domestic and international
market stability, reduce market and liquidity risks in financial
markets, including those markets (such as futures exchanges) linked to
swap markets and eliminate a potential source of systemic risk.'' \26\
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\23\ Rule 35.1(b)(1) defines a swap agreement as:
(i) An agreement (including terms and conditions incorporated by
reference therein) which is a rate swap agreement, basis swap,
forward rate agreement, commodity swap, interest rate option,
forward foreign exchange agreement, rate cap agreement, rate floor
agreement, rate collar agreement, currency swap agreement, cross-
currency rate swap agreement, currency option, any other similar
agreement (including an option to enter into any of the foregoing);
(ii) Any combination of the foregoing; or
(iii) A master agreement for any of the foregoing together with
all supplements thereto. 17 CFR 35.1(b)(1).
\24\ 17 CFR 35.1(b)(2). The definition of ``eligible swap
participants'' in Part 35 was patterned after the definition of
``appropriate persons'' in Section 4(c) of the Act with certain
adjustments to ensure that both foreign and United States entities
could qualify for treatment as eligible swap participants and to
establish minimal financial requirements for some participants.
Exemption for Certain Swap Agreements, 58 FR 5587, 5589 (Jan. 22,
1993). This approach is consistent with Congressional intent that
the Commission may limit the terms of an exemption granted pursuant
to Section 4(c) to some, but not all, of the listed categories of
appropriate persons. H.R. Rep. No. 978, 102d Cong., 2nd Sess. 79
(1992); 58 FR 5587 at 5589. The determination as to whether a
counterparty qualifies as an eligible swap participant must be made
at the time the counterparties enter into the swap agreement, but it
is sufficient that a party have a reasonable basis to believe that
the other party is an eligible swap participant at such time. 17 CFR
35.2; 58 FR 5587 at 5589.
\25\ The phrase ``material economic terms'' was intended ``to
encompass terms that define the rights and obligations of the
parties under the swap agreement and that, as a result, may affect
the value of the transaction.'' 58 FR 5587 at 5590. This condition
was designed to ensure ``that the exemption does not encompass the
establishment of a market in swaps agreements, the terms of which
are fixed and are not subject to negotiation, that functions
essentially in the same manner as an exchange but for the bilateral
execution of transactions.'' Id.
\26\ Id. at 5588.
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The Part 35 swaps exemption does not extend to transactions that
are subject to a clearing system, such as SwapClear, where the credit
risk of individual counterparties to each other is mitigated.\27\ The
Commission excluded centralized swaps clearing facilities from the Part
35 rules because ``such mechanisms [were] not yet in existence, and
[might] take many forms and raise different regulatory concerns
depending upon their structure or participants or whether another
regulatory regime is applicable'' and because the Commission believed
that ``the design of swaps clearing facilities and the services that
such facilities will offer should be driven by the needs and desires of
swaps market participants.'' \28\ The Commission stated that ``a
clearing house system for swap agreements could be beneficial to
participants and the public generally.'' \29\ Accordingly, the
Commission stated that it would ``consider the terms and conditions of
[an] exemption for swaps clearing houses in the context of specific
proposals from exchanges, other regulators and others.'' \30\
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\27\ See id. at 5591.
\28\ Id. at 5591, n.30.
\29\ Id.
\30\ Id.
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On May 12, 1998, the CFTC published a Concept Release on OTC
Derivatives (``OTC Concept Release'').\31\ Therein, the Commission
generally recognized that ``the OTC derivatives market [had] grown
dramatically in both volume and variety of products offered'' since the
Commission's last major regulatory
[[Page 53349]]
action involving such products.\32\ The Commission specifically
observed that the swaps exemption provided by Part 35 of the
Commission's regulations reflects ``the circumstances in the relevant
market at the time of their adoption'' and that the Commission should
review the exemption ``in light of current market conditions.'' \33\
The increased ``interest in developing clearing mechanisms for swaps
and other OTC derivatives'' was among the recent market changes
explicitly noted by the Commission.\34\ The Commission stated that it
believed that such efforts had reached a stage where it was necessary
``to consider and to formulate a program for the appropriate oversight
and exemption of swaps clearing.'' \35\ Accordingly, it requested
comment on the extent to which the Commission should continue to
require that the creditworthiness of a counterparty be a material
consideration for relief under the Part 35 rules.\36\ The Commission
also requested comment on the type of functions that an OTC derivatives
clearing facility would perform, the products it would clear, the
standards it would impose upon participants, and the risk management
tools it would employ.\37\
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\31\ 63 FR 26114.
\32\ Id.
\33\ Id. at 26120.
\34\ Id. at 26122.
\35\ Id.
\36\ Id. at 26120.
\37\ Id. at 26122-23.
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As discussed in the OTC Concept Release and in Section VI.B below,
a swaps clearing operation may reduce counterparty credit risk and the
transaction and administrative costs associated with the swaps market
while increasing liquidity and price transparency in that market.\38\
Accordingly, the Commission is approving the LCH Petition, pursuant to
Section 4(c) of the Act, subject to the terms and conditions contained
in the Commission's order. As set forth in Section VI below, the
Commission believes that the representations made in the LCH Petition,
as supplemented by its counsel, support the findings required by that
provision of the Act.
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\38\ Id. at 26122.
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The Commission has reviewed the SwapClear operation as presented in
the LCH Petition and has decided to extend exemptive relief only to
those transactions and market participants set forth in its order.
Because Section 4(c) expressly authorizes the Commission to furnish the
exemptive relief described therein by order, as well as by rule or
regulation, the Commission believes that there is no legal impediment
to providing individualized relief to LCH for SwapClear.
The Commission has chosen this approach for several reasons. First,
LCH, SwapClear, and SwapClear participants will be subject to a
comprehensive regulatory regime in the United Kingdom, including
oversight by the Financial Services Authority (``FSA''). In adopting
the Part 35 exemption, the Commission stated that it was ``mindful of
the costs of duplicative regulation'' and indicated that it would
consider ``the applicability of other regulatory regimes'' in
addressing petitions for further exemptive relief relating to swaps
facilities.\39\ It reiterated this intention in the OTC Concept
Release.\40\ The FSA, as the regulator in SwapClear's home
jurisdiction, has primary responsibility for implementing regulatory
requirements and enforcement procedures that are sufficient to protect
against credit concentration and other risks associated with a swaps
clearing facility that interposes a central counterparty to the
transactions it clears and provides for payment netting across
exchange-traded and OTC instruments.\41\ Because the Commission is
deferring to the applicable regulatory body in the United Kingdom in
this case, the Commission is not presented with certain issues that
would otherwise arise if a petition were submitted by a domestic
clearing organization or by a foreign clearing organization subject to
a less comprehensive regulatory structure. Accordingly, the Commission
believes that the LCH Petition is not necessarily a basis from which to
develop a regulatory framework for other swaps clearing facilities.
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\39\ 58 FR 5587 at 5591, n. 30.
\40\ 63 FR 26114 at 26123.
\41\ In its OTC Concept Release, the Commission acknowledged
that the benefits that might accrue from a swaps clearing service
might come at the cost of increased credit concentration and its
attendant risks. 63 FR 26114 at 26122. The Commission notes,
however, that LCH represents that it has adopted several risk
management procedures to address such risks. LCH's risk management
program is discussed in Section III.B below.
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Second, the LCH Petition is the first of its kind. An
individualized course will afford the Commission an opportunity to gain
greater experience with swaps clearing operations prior to formulating
and proposing more generalized exemptive relief. Finally, an
individualized approach is consistent with the Commission's previously
stated intention to review and to analyze petitions for swaps clearing
operations on a case-by-case basis in the context of specific
proposals.\42\
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\42\ 58 FR 5587 at 5591.
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The Commission's decision to provide specific relief to LCH does
not preclude the Commission from issuing exemptive relief to additional
parties that submit petitions to the Commission at a later date. Nor
does it prevent the Commission from granting exemptive relief of
broader applicability should circumstances or experience warrant.
III. LCH and SwapClear
A. LCH
LCH is a recognised clearing house (``RCH'') under the United
Kingdom's Financial Services Act 1986 (``FSAct'') and is subject to the
FSAct and other relevant laws, rules and regulations in the United
Kingdom.\43\ Under the FSAct, as supplemented by the Companies Act 1989
(``U.K. Companies Act''), a clearing house may be ``recognised'' if it
appears to the FSA \44\ that the clearing house, among other things:
(i) Has sufficient financial resources; (ii) has adequate arrangements
and resources for the effective monitoring and enforcement of its
rules; (iii) is able and willing to promote and maintain high standards
of integrity and fair dealing and to cooperate by the sharing of
information and otherwise, with the Secretary of State and any other
authority, body or person having responsibility for the supervision or
regulation of investment business or other financial services; and (iv)
has default rules which enable action to be taken to close out a
member's position in relation to all unsettled market contracts to
which such member is a party, where that member appears to be unable to
meet its obligation.\45\
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\43\ LCH Petition at 17-18.
\44\ The FSA is authorized to ``recognise'' clearing houses in
the United Kingdom pursuant to FSAct (Delegation) Order 1987. Id. at
17, n. 33.
\45\ Id. See also FSAct Pt. 1, 39 (1986) (Eng.). According to
LCH, the FSAct requires that persons who intend to engage in
``investment business'' in the United Kingdom be either
``authorised'' or ``exempted'' persons, as those terms are defined
in the FSAct. RCHs qualify as ``exempted persons'' and, thus, are
exempt from the authorisation requirement and the conduct of
business rules for the activities associated with their recognition
status, as long as they continue to satisfy the recognition
criteria. These criteria were established to take into account an
RCH's ``special regulatory position within the financial system''
and an RCH's expertise in the operation of such markets.
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Subject to its continuing compliance with the RCH recognition
requirements, LCH is permitted to clear both exchange-traded and OTC
instruments.\46\ LCH currently performs clearing and settlement
functions for futures and option contracts traded on the London
International Financial Futures and Options Exchange
[[Page 53350]]
(``LIFFE''), the London Metal Exchange, and the International Petroleum
Exchange and for United Kingdom equity transactions effected on
Tradepoint, an electronic stock exchange.\47\ LCH states that it
cleared and settled 279 million exchange-traded futures and option
contracts in 1997.
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\46\ LCH Petition at 17.
\47\ Id.
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As discussed more particularly in Section IV.A below, LCH, as an
RCH, is subject to direct regulatory oversight by the FSA and is
subject to reporting, recordkeeping, and other regulatory
obligations.\48\ Among other things, the FSA monitors LCH's continuing
compliance with the RCH qualifying criteria and its own annual
statement of objectives and requires that LCH furnish the FSA with
information regarding its governance, personnel, members, business
entities, and rule changes.\49\
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\48\ Id. at 18. See also FSAct Pt. 1, 39 (1986) (Eng.).
\49\ Letter from Jane Lowe, FSA, to Michael Greenberger,
Director, Division of Trading and Markets, CFTC (Nov. 17, 1998) (on
file with the Division of Trading and Markets, CFTC) at 4.
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B. SwapClear
SwapClear is a newly-developed LCH operation that will provide
multilateral clearing, settlement, and payment netting services to
qualified participants for forward rate agreements (``FRAs'') and
interest rate swap agreements that satisfy SwapClear's product
eligibility criteria.\50\ SwapClear is neither a separately organized
corporation nor an affiliated entity or branch of LCH. As an extension
of an RCH's activities, SwapClear will be subject to the regulatory
authority of the FSA and to applicable United Kingdom law.\51\
SwapClear is scheduled to commence operation in the summer of 1999.\52\
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\50\ LCH Petition at 1-2.
\51\ Id. at 38.
\52\ Id. at 2.
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1. Participants
LCH will restrict participation in SwapClear to those persons who
are eligible for designation by LCH as SwapClear Dealers (``SDs'') \53\
and/or SwapClear Clearing Members (``SCMs'').\54\ A swap agreement will
not be eligible for clearing through SwapClear unless both
counterparties to the transaction have been approved as SDs and the SDs
submit transactions to SwapClear for clearing through a qualified
SCM.\55\ End-users and members of the general public will not be
permitted to participate.\56\
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\53\ To qualify as an SD, an entity must be: (i) An institution
that enters into transactions that are equivalent to the swap
agreements cleared through SwapClear as a dealer in the ``wholesale
market'' in the United Kingdom or its equivalent elsewhere; (ii) at
all times such person is carrying on ``investment business'' in the
United Kingdom, as that term defined in the FSAct, either: (a) An
authorised or exempted person under the FSAct or (b) a ``European
investment firm'' as that term is defined in the United Kingdom's
Investment Services Regulations 1995 (``U.K. Investment Services
Regulations''); (iii) of investment grade caliber (i.e., an entity
having a Standard and Poor's credit rating of BBB or better) or a
fully guaranteed subsidiary of an investment grade parent; (iv) use
the Society for International Financial Telecommunications
communications network (``SWIFT'') (SWIFT is a bank-owned
cooperative which operates a network that processes and transmits
financial messages among its users worldwide); and (v) either a
swaps clearing member (``SCM'') or an entity that has a clearing
arrangement with an SCM. Id. at 13-14, 23. See also Letter from
Michael M. Philipp, Katten Muchin & Zavis, counsel to LCH, to
Jocelyn B. Barone, Staff Attorney, Division of Trading and Markets,
CFTC 1 (Nov. 10, 1998) (on file with the Division of Trading and
Markets, CFTC).
LCH will usually regard transactions as being in the wholesale
market where, for example, the institution enters into such
transactions as a ``listed institution'' under Section 43 of the
FSAct or otherwise meets the eligibility criteria for such listing.
LCH Petition at 13, n. 28. If the institution is not undertaking
such transactions in the United Kingdom, LCH will usually regard the
transactions as being in the wholesale market if the eligibility
criteria for Section 43 listing would be met by the institution if
it were undertaking such transactions in the United Kingdom. Id. LCH
will not usually regard the wholesale market dealer criterion as
being satisfied where the institution is generally regarded as a
customer or end-user of the interbank wholesale market. Id. at 13.
\54\ Id. at 8-9 and 12-13. To qualify as an SCM, an entity must:
(i) At all times such person is carrying on ``investment business''
in the United Kingdom, as that term is defined in the FSAct, be
either: (a) An authorised or exempt person under the FSAct or (b) a
``European investment firm,'' as that term is defined in the U.K.
Investment Services Regulations; (ii) be an LCH shareholder; (iii)
contribute a minimum of 2 million to LCH's Default Fund;
(iv) submit regular financial reports to LCH; (v) maintain a back-
office with adequate systems and records and a staff with expertise
in the swaps market; and (vi) satisfy minimum financial resource
requirements. Id. at 12-13.
An SCM's financial requirements will be satisfied if an SCM: (i)
is an SD; (ii) has a parent who is an SD and who provides a guaranty
of the SCM's liabilities to LCH; or (iii) has financial resources of
250 million. Id. An SCM's financial resources will be
calculated by subtracting its current liabilities from its current
assets. Id. at 13, n.27. For purposes of this calculation,
intangible fixed assets, investments in subsidiaries or other group
companies, other long term assets, shares in LCH, and the value of
exchange memberships will not be included as current assets. Id. LCH
has indicated that long term assets include debts or debits that
will be due in more than twelve months.
\55\LCH Petition at 8-9, 12-13, and 23. An SCM may also act as
an SD if it satisfies LCH's SD admission standards. Id. at 9.
\56\ Id. at 22-23 and 35.
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LCH designed the SD and SCM eligibility criteria to ensure that
SwapClear participants \57\ possess the financial and operational
capability and experience to deal in swap agreements and the
sophistication to understand and to manage the risks of such
transactions.\58\ Its admission standards will limit participation in
SwapClear to persons whose qualifications exceed those of the
``appropriate persons'' set forth in Section 4(c) of the Act and the
``eligible swap participants'' delineated in Rule 35.1.\59\ LCH
represents that its participant eligibility standards will be publicly
disclosed and that it will provide access to SwapClear's services to
all qualified SDs and SCMs on equal terms.\60\
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\57\ SDs and SCMs are referred to collectively throughout this
release as ``SwapClear participants.''
\58\ Id. at 13-14, 28, and Appendix I, A-1.
\59\ Id. at 23 and 42.
\60\ Id. at 12, 23, and 29.
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LCH further represents that its Risk Management Department will
monitor the compliance of SDs and SCMs with SwapClear's admission
standards on an ongoing basis \61\ and that all SDs and SCMs will be
bound by LCH rules, regulations, and procedures (collectively, ``LCH
Rules'').\62\ Any SD who fails to comply with LCH Rules will no longer
satisfy SwapClear's participant eligibility criteria. An SCM's failure
to comply with LCH Rules will constitute an event of default by the
SCM.\63\ LCH will establish formal limits on its intraday credit
exposure to each SCM.\64\ SCMs will be notified of their respective
credit limits.\65\
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\61\ Id. at 12-13 and 23.
\62\ Id. at 37. LCH represents that all SwapClear participants
will receive a copy of LCH's regulations and default rules. Id. at
28.
\63\ Id. at 37.
\64\ Id. at 28 and Appendix I, A-1. LCH has indicated that
intraday credit limits will be established on a ``net'' basis.
\65\ Id. at 16 and Appendix I, A-1.
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2. Products
Only those swap agreements whose terms comply with certain product
eligibility requirements will be accepted for registration and clearing
by SwapClear. The product eligibility criteria were designed to ensure
that there is sufficient market liquidity in the swap agreements that
are cleared through SwapClear to allow LCH to calculate daily mark-to-
market prices accurately and to enter into replacement transactions in
the event of an SCM's default.\66\ Initially, the SwapClear operation
will be restricted to clearing FRAs \67\ and interest rate swap
agreements \68\ that contain specified
[[Page 53351]]
characteristics. To be eligible for clearing by SwapClear, an interest
rate swap transaction must: (i) Be fixed versus floating rate in a
single currency; \69\ (ii) be in acceptable currencies; \70\ (iii) use
acceptable floating rate indices; \71\ (iv) be for a maturity of up to
ten years; \72\ and (v) have a constant notional principal amount
throughout the term of the agreement, with no reset in arrears.\73\ An
FRA must also be transacted in acceptable currencies and use an
acceptable floating rate to be eligible for clearing through
SwapClear.\74\ LCH will impose a minimum acceptable notional amount of
one unit of currency on eligible FRAs and interest rate swaps, but will
not impose a maximum notional amount.\75\ SDs will be permitted to use
forward starts,\76\ stub periods,\77\ and mismatched fixed/floating
dates.\78\ LCH anticipates broadening the classes of transactions
acceptable for clearing through SwapClear in the future, but represents
that it will only register and clear those transactions within the
definition of a ``swap agreement'' as set forth in Part 35 of the
Commission rules.\79\
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\66\ Id. at 14.
\67\ The LCH Petition defines an FRA as ``a privately negotiated
contract in which two counterparties agree on the interest rate to
be paid on a notional amount of a specified currency, of specified
maturity, at a specific future time.'' Id. at 1. The principal is
not exchanged. Rather, ``the difference between the contracted rate
and the prevailing rate is settled in cash.'' Id. FRAs may be for
any gap period up to one year and will be settled on a discounted
basis. Id. at 14.
\68\ The LCH Petition defines an interest rate swap agreement as
``a privately negotiated agreement between counterparties to make
periodic payments to each other for a specified period'' where
``[o]ne party makes payments based on a fixed interest rate, while
the counterparty makes payments on a variable (e.g., floating) rate.
The contractual payments are based on a notional amount that is not
actually exchanged.'' Id. at 1.
\69\ Id. at 14.
\70\ SwapClear will accept FRAs and interest rate swaps that
have been transacted in United States Dollars, Japanese Yen, Euros,
British Pounds, and if there is sufficient participation in
SwapClear by Canadian Dollar market-makers, Canadian Dollars. Id.
\71\ Currently, SwapClear will accept transactions using the
following floating rate indices: LIBOR, PIBOR, and EURIBOR. Id. at
15. LCH is contemplating expanding the list of acceptable indices to
include Commercial Paper, Fed Funds, and Constant Maturity
Treasuries. Id.
\72\ Id. at 14.
\73\ Id. During the life of a swap agreement, the floating rate
is ``reset'' at an agreed frequency (e.g., 6 months). In the case of
swap agreements traded on the interbank market, this is typically
done in advance. A swap agreement has ``reset in arrears'' where the
rate is applied at the end of the prevailing period with payment
being made on the period end date. Letter from Michael M. Philipp,
Katten Muchin & Zavis, counsel to LCH, to Jocelyn B. Barone, Staff
Attorney, Division of Trading and Markets, CFTC 1 (Nov. 13, 1998)
(on file with the Division of Trading and Markets, CFTC).
\74\ LCH Petition at 14-15.
\75\ Id. at 15.
\76\ LCH defines a ``forward start'' as a swap agreement that
starts at an agreed date in the future. Letter from Michael M.
Philipp, Katten Muchin & Zavis, counsel to LCH, to Jocelyn B.
Barone, Staff Attorney, Division of Trading and Markets, CFTC 1
(Nov. 13, 1998) (on file with the Division of Trading and Markets,
CFTC).
\77\ LCH explains that a swap agreement contains a ``stub
period'' when either the time period between the start of the swap
agreement and the first reset or the time period between the last
reset and the end of a swap agreement is not a commonly quoted
interval (i.e., 2.5 months, rather than 3 months). Id.
\78\ LCH Petition at 15.
\70\ Id.
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Some of the material economic terms of transactions eligible to be
cleared by SwapClear will be subject to private negotiation between
SDs.\80\ LCH will neither establish nor impose any requirement (other
than those described above) that the swap agreements contain standard
contract specifications, nor will it provide any facility for arranging
or executing swap agreements.\81\ LCH will not obligate an SD to submit
swap agreements to LCH for registration and clearing, will not mandate
that an SD submit a swap transaction for registration and clearing
within a specified period of time after the trade date, and will not
require that a swap agreement be at current market prices when
submitted for registration.\82\ Swap agreements that are ineligible for
registration on the trade date may be submitted for clearing on a later
date, if they subsequently become eligible.\83\ No swap agreement to be
cleared through SwapClear will be traded on a multilateral transaction
execution facility.\84\
---------------------------------------------------------------------------
\80\ Id. at 14, 22, and 42. Within the parameters set by LCH,
the SD may negotiate 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, as
defined in ISDA's 1991 definitions. Id. at 14.
\81\ Id. at 9 and 14.
\82\ Id.
\83\ Id. at 14. For example, a swap agreement with a fifteen
year maturity initially would not satisfy SwapClear's product
eligibility criteria because such criteria do not allow for
transactions with maturities in excess of ten years. However, such a
transaction would become eligible for registration after five years.
Id.
\84\ Id. at 22.
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3. Clearing Procedures
Confirmations of swap agreements between SDs to be submitted for
clearing through SwapClear will be exchanged and matched through
Accord,\85\ Londex,\86\ or another operationally compatible matching
system.\87\ After the agreement has been confirmed, the relevant
details of the transaction will be transmitted to SwapClear.\88\ SDs
will be required to submit transactions to SwapClear for clearing
through a registered SCM.\89\ Upon submission, SwapClear will verify
that: (i) Both original counterparty SDs satisfy LCH's participant
eligibility criteria and are in good standing with LCH; (ii) the swap
agreement satisfies SwapClear's product eligibility requirements; and
(iii) the transaction does not exceed the SCMs' respective intra-day
credit limits with LCH.\90\ If these criteria are satisfied, LCH will
register the swap agreement and confirm the transaction to the SDs and
their respective SCMs.\91\ If a transaction does not satisfy these
criteria, or LCH otherwise rejects the trade, the SwapClear system will
send a rejection message to each original SD counterparty.\92\ In the
latter case, the transaction between the original SD counterparties
will remain in existence and will remain subject to the relevant master
agreement between them, but the transaction will not be cleared through
SwapClear.\93\ 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, the parties will keep the transactions on their own
books and will be subject to full counterparty credit risk.\94\
---------------------------------------------------------------------------
\85\ Accord is a service offered to the users of SWIFT that
facilitates the matching of transaction confirmations. Id. at 9, n.
24.
\86\ Londex is an OTC confirmation matching system that is
currently being developed by SNS Systems, Inc. Id. at 9, n. 25.
\87\ Id. at 9. SDs will maintain responsibility for ensuring
that the trade details of all swap agreements submitted to SwapClear
for registration and clearing match. Id.
\88\ Id.
\89\ Id. at 8-9.
\90\ Id. at 8-9 and Appendix I, A-1.
\91\ Id. at 9.
\92\ Id. at Appendix I, A-2.
\93\ Id.
\94\ Id. at 9.
---------------------------------------------------------------------------
LCH will register swap agreements for clearing only in the names of
the SCMs, and the SCMs will be required to deal with LCH as
principals.\95\ Each SCM will be fully liable to LCH for ensuring
performance with respect to each swap agreement registered in its
name.\96\ When LCH registers a swap agreement, it automatically will
send a message to the applicable SCMs via SWIFT \97\ confirming that
their transaction has been registered. At the time of registration, the
original, bilateral transaction between the SDs will be replaced with
four new swap agreements: one between each SD and its SCM, contracting
as principals, and one between each SCM and LCH, contracting as
principals.\98\ LCH will become the central counterparty with respect
to all swap agreements to be
[[Page 53352]]
cleared through SwapClear and, as such, will be responsible to the SCMs
for the performance of the obligations thereunder.\99\ The SCMs, in
turn, will be responsible for performance to their respective SDs and
to LCH.\100\ The new contracts between the SDs and the SCMs will
contain the same terms to which the original counterparties
agreed.\101\ The new contracts between LCH and each SCM will contain
the same terms as the contracts they replaced, but will also contain
LCH's standard contract terms (e.g., margin payment requirements, rules
regarding what constitutes acceptable collateral, and choice of law
provisions).\102\
---------------------------------------------------------------------------
\95\ Id. at 12.
\96\ Id.
\97\ Because all SDs must be SWIFT users to acquire and maintain
their SD designation, SCMs that also qualify as SDs necessarily will
have access to the SWIFT network. LCH anticipates that most other
SCMs will utilize the SWIFT system in order to obtain automatic
confirmation. However, an SCM who is not SWIFT user will be able to
access, through LCH, a real time listing of the registered trades
for that SCM's customers.
\98\ Id. at 10 and Appendix I, A-2.
\99\ Id. at 10.
\100\ Id.
\101\ Id. at Appendix I, A-1-A-2.
\102\ Id.
---------------------------------------------------------------------------
Immediately upon registration of a swap agreement, LCH will net the
payment amounts due to or from each SCM under the terms of all of the
swap transactions registered in the SCM's name for the same value date
and in the same currency.\103\ In addition, LCH will net these payments
with other payments due to or from the SCM as a result of any exchange-
traded instruments that it clears with LCH on each payment date.\104\
This will result in a net single pay or receive amount per currency per
day between LCH and each SCM.\105\ SwapClear will determine all reset
rates and calculate reset amounts.\106\ Upon each payment date, the
amount payable or receivable in each currency will be settled by means
of LCH's Protected Payment System (``PPS'').\107\
---------------------------------------------------------------------------
\103\ Id. at 10 and Appendix I, A-2. These payments may include
margin payments, fees, interest, settlement payments, and other
payments associated with the SCM's LCH-cleared transactions. Id. at
Appendix I, A-2.
\104\ Id. at 10 and Appendix I, A-2.
\105\ Id. at 10.
\106\ Id.
\107\ Id. LCH requires SCMs to maintain accounts for each
currency type with at least one of the twenty-three banks it uses
under its PPS. Id. at Appendix I, A-4. Settlement takes place via
book entry transfer between the accounts of the SCM and LCH. Id.
---------------------------------------------------------------------------
4. Treatment of Client Funds
LCH represents that United Kingdom law would permit LCH to
commingle segregated client funds relating to an SCM's exchange-traded
business in the United Kingdom and client funds relating to an SCM's
SwapClear business.\108\ However, LCH represents further that it
anticipates that LCH clearing members who are also SCMs will carry
their non-proprietary futures positions and associated margin funds in
their ``client'' account at LCH, but likely will carry their non-
proprietary SwapClear positions and associated margin funds in their
``house'' account at LCH.\109\ Accordingly, LCH believes that United
States persons who do not engage in SwapClear transactions, but who
clear their exchange-traded futures through the ``client'' account of a
member of LCH who is also an SCM are unlikely to be exposed to a
greater likelihood of loss in the event of a default by a SwapClear
participant than would exist prior to the implementation of a SwapClear
facility.
---------------------------------------------------------------------------
\108\ Letter from Michael M. Philipp, Katten Muchin & Zavis,
counsel to LCH, to Jocelyn B. Barone, Staff Attorney, Division of
Trading and Markets, CFTC 2 (Feb. 9, 1999) (on file with the
Division of Trading and Markets, CFTC).
\109\ Letter from Michael M. Philipp, Katten Muchin & Zavis,
counsel to LCH, to Jocelyn B. Barone, Staff Attorney, Division of
Trading and Markets, CFTC (Mar. 2, 1999) (on file with the Division
of Trading and Markets, CFTC). LCH's expectation that SCMs will
carry their respective SwapClear positions in their ``house''
account is based upon three assumptions. First, LCH believes that
most SDs will submit swap transactions for clearing through an
affiliated SCM. Second, LCH anticipates that most SCMs will not be
required under relevant United Kingdom law to segregate an SD's
SwapClear-related funds into a ``client'' account and will not, in
fact, do so. Third, to the extent that the segregation requirement
would otherwise apply, relevant United Kingdom law permits most SDs
to ``opt out'' of that requirement and to consent to the placement
of their funds in the SCM's ``house'' account.
---------------------------------------------------------------------------
5. Risk Management Procedures
LCH represents that it will employ several risk management tools to
control the risks arising from its acting as a central counterparty for
swap transactions that are registered and cleared through
SwapClear.\110\ In addition to the mechanisms already discussed--
participant admission standards and payment netting arrangements--these
risk management tools include participant reporting requirements,
initial margin requirements, daily marking-to-market of all positions,
variation margin requirements, intraday credit limits, back-up
financial resources, and stress testing.
---------------------------------------------------------------------------
\110\ LCH Petition at 15-17 and Appendix I, A-1-A-8.
---------------------------------------------------------------------------
LCH also will impose both routine and event-based reporting
requirements upon SwapClear participants.\111\ For example, SCMs will
be required to submit regular financial statements and audited accounts
to LCH. SCMs and SDs will have an ongoing duty to notify LCH if they
cease to satisfy any of the SwapClear participant eligibility criteria
and will be required to furnish LCH, upon request, with any information
LCH deems necessary to determine their participant eligibility status
if LCH reasonably doubts their continued eligibility.\112\ SDs and SCMs
will be required to notify LCH upon the occurrence of specified events
relating to their status as a registrant or licensee; their
authorization to conduct investment business in the United Kingdom;
their insolvency, dissolution, or conviction of a financial crime;
disciplinary or enforcement judgments involving them; and material
changes in their business.\113\ LCH will maintain records of SCM
transactions for six years, and such records will be available to
SwapClear participants and to their auditors upon request.\114\
---------------------------------------------------------------------------
\111\ Id. at 16 and 37. The specific reporting requirements LCH
will impose upon SwapClear participants will vary depending upon the
type of SwapClear participant and the regulatory regime to which the
participant is subject. Letter from Michael M. Philipp, Katten
Muchin & Zavis, counsel to LCH, to Jocelyn B. Barone, Staff
Attorney, Division of Trading and Markets, CFTC 1 (Nov. 20, 1998)
(on file with the Division of Trading and Markets, CFTC). For
instance, a SwapClear participant that is regulated as a bank will
be required to provide LCH with a copy of its annual report and
audited accounts; a participant that is regulated by the FSA or the
Securities and Futures Authority (``SFA'') will be required to
provide copies of the monthly financial reports that it files with
its respective regulator; a participant that is regulated by the
CFTC or the SEC will be required to provide copies of the quarterly
financial reports that it files with its respective regulator; and
an unregulated participant will be required to provide quarterly
financial reports, including the balance sheets and profit and loss
statements prepared by the participant for its management's use. Id.
at 37.
\112\ Id. at 16.
\113\ Id.
\114\ Id. at 37. LCH is also subject to certain reporting and
recordkeeping regulations imposed by the FSA. These requirements are
discussed in Section IV.
---------------------------------------------------------------------------
To protect against potential adverse future market movements and
the cost of liquidating the portfolio in the event of an SCM's default,
LCH will require SCMs to post initial margin.\115\ The initial margin
required of SCMs will be established using a scenario-based margin
methodology analogous to London SPAN, the futures margining
system currently in use at LCH.\116\ In determining the definition and
scale of the scenarios, LCH will use: (i) its experience in setting
margin rates for LIFFE interest rate contracts; (ii) an analysis of
historic, implied, and modeled term structure volatility; (iii)
modeling of extreme events; \117\ and (iv) conservative assumptions
regarding the time necessary to close out.\118\ The
[[Page 53353]]
amount of initial margin required of any SCM will be affected by the
market volatility of the SCM's portfolio, the liquidity of the
instruments in the portfolio, and the relative size of the
portfolio.\119\ LCH will distribute its margin model to SCMs and will
publish its margin parameters.\120\ In its discretion, LCH's Risk
Management Department may require an SCM to post initial margin in
excess of that calculated using its margin methodology.\121\ LCH will
accept initial margin in the form of: (i) Cash; (ii) securities of the
following types--United Kingdom gilts and treasury bills, United States
government bills, notes, and bonds, German government bonds, French,
Dutch, Italian, and Spanish government bonds and treasury bills, and
certain certificates of deposit; and (iii) bank guarantees, in a form
determined by LCH.\122\
---------------------------------------------------------------------------
\115\ Id. at 16 and Appendix I, A-1 and A-3.
\116\ Id. at Appendix I, A-3. SwapClear's margin methodology is
subject to approval by the FSA. Id.
\117\ The LCH Petition cites the United Kingdom leaving the ERM
in 1992 and the bond crisis in February of 1994 as examples of such
events. Id.
\118\Id. LCH's yield curve scenarios used in calculating
SwapClear initial margin requirements assume a time to close out of
five days, although LCH would seek to offset the positions of a
defaulting SCM by liquidating, hedging, or transferring such
positions in a shorter period of time. Letter from Michael M.
Philipp, Esquire, Katten Muchin & Zavis, counsel to LCH, to Jocelyn
B. Barone, Staff Attorney, Division of Trading and Markets, CFTC 1
(Mar. 3, 1998) (on file with the Division of Trading and Markets,
CFTC).
\119\ LCH Petition at Appendix I, A-3.
\120\ Id.
\121\ Id. LCH represents that its governance structure reserves
margin rate setting to LCH's Chief Executive to ensure LCH's
decisions regarding margin are made independently and to avoid
conflicts of interest. Id. at 28. LCH has indicated that neither the
Chief Executive nor members of his staff will be associated with
SwapClear participants.
\122\ Id. at Appendix I, A-4. Bank guarantees from an SCM or
from an SCM's parent company would not be accepted. LCH is currently
considering whether to extend its arrangements to include
Euroclear's Collateral Management Service in order to facilitate the
provision of additional margin cover after transfers are no longer
possible through the United Kingdom banking system. Id.
---------------------------------------------------------------------------
To prevent losses from accumulating in the system, LCH will mark-
to-market all SwapClear positions on a daily basis and will require
SCMs to pay any change in the value of those positions from the
previous day's value in cash as variation margin.\123\ LCH will
establish a zero-coupon yield curve in each currency on each day and
calculate mark-to-market values of the swap agreements cleared through
SwapClear to facilitate the collection of the appropriate amount of
variation margin.\124\
---------------------------------------------------------------------------
123 Id. at 16, 28, and Appendix I, A-3.
124 Id. at 16 and Appendix I, A-1-A-2. One feature of
SwapClear's margining process that distinguishes it from an exchange
margining procedure is that SwapClear sets no separate maintenance
margin level. Daily margin flows must meet initial margin
requirements, so that all margin payments are essentially
``variation margin'' because there is no daily settlement or mark-
to-market flows that adjust margin accounts above the maintenance
level, but below the initial margin level.
---------------------------------------------------------------------------
As discussed above, SCMs will be subject to intraday credit limits
set by LCH.\125\ LCH intends to monitor its exposure to each SCM
throughout the day and to call for additional margin cover in advance
of the SCM's exceeding its credit limit.\126\ LCH will reject
transactions involving an SCM that has reached its limit unless
additional margin is provided.\127\ LCH also has extensive emergency
intervention powers under its regulations to impose liquidation orders
when an SCM exceeds its credit limit.\128\
---------------------------------------------------------------------------
125 Id. at 16 and Appendix I, A-1.
126 Id. at Appendix I, A-1.
127 Id. at 9, 16, and Appendix I, A-1.
128 Id. at Appendix I, A-1.
---------------------------------------------------------------------------
LCH asserts that it will ensure that SwapClear will have access to
financial resources of sufficient size and liquidity to satisfy its
settlement obligations.\129\ As of the date of the LCH Petition, LCH
had cash margin cover for its futures and option business in excess of
2 billion.\130\ LCH represents that these funds are held on
short-term deposit with acceptable bank depositories, as determined by
minimum credit rating criteria and limits according to credit rating
and shareholder funds.\131\ Should additional funds be needed, LCH
maintains bank lines of credit in the amount of 40.5
million and $10 million.\132\ LCH also maintains a Default Fund
(``DF'') to cover situations where the costs to LCH of standing behind
and closing out and/or transferring a defaulting member's positions
exceed the margin collected by LCH from the defaulting member.\133\ The
DF currently consists of 150 million contributed by LCH's
exchange clearing members.\134\ The DF contributions are in the form of
cash-backed indemnities, with LCH holding the cash.\135\ Upon
commencement of the SwapClear operation, LCH intends to increase the DF
by an additional 100 million to be contributed by
SCMs.\136\ It is likely that each SCM initially will contribute to the
DF at a minimum flat rate of 2 million.\137\ As registered
positions increase, LCH intends to implement risk-based
contributions.\138\ The adequacy of the SCMs' additional
100 million contribution to the DF and the aggregate size
of the DF will be reassessed once SwapClear becomes operational on the
basis of actual exposures and stress test results.\139\
---------------------------------------------------------------------------
129 Id. at 16 and Appendix I, A-4.
130 Id. at Appendix I, A-4.
131 Id.
132 Id. LCH does not believe that it will be necessary to
establish additional credit lines with respect to its SwapClear
business. LCH asserts that it does not need to maintain the large
credit lines held by clearing houses whose initial margin cover
principally takes the form of securities because LCH's margin cover
is highly liquid. Id.
133 Id.
134 Id.
135 Id.
136 Id. at Appendix I, A-5.
137 Id.
138 Id.
139 Id. Both the transitional DF increase of 100
million and LCH's approach to measuring the adequacy of the DF and
making necessary adjustments to it are subject to further refinement
and discussion with the FSA. Changes to the rules governing the DF
are also subject to approval by LCH's membership. Id.
---------------------------------------------------------------------------
LCH currently conducts internal stress tests on the initial margin
cover it holds from each member on a daily basis to assess the adequacy
of its daily funding level in the event a member default coincides with
extreme market movements.\140\ The stress tests employ, for all
contracts, extreme historical price movements recorded in the exchange
markets cleared by LCH.\141\ LCH examines the results of the stress
testing daily and reports the results on a quarterly basis to the Risk
Committee of LCH's Board so that the Risk Committee may make
recommendations to the Board if the ongoing adequacy of the DF is
placed in doubt.\142\ LCH also makes the results of the stress testing
available to the FSA.\143\
---------------------------------------------------------------------------
140 Id. at Appendix I, A-4-A-5.
141 Id. at 28 and Appendix I, A-4.
142 Id. at Appendix I, A-4-A-5.
143 Id. at Appendix I, A-5.
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6. Default Rules and Procedures
SCMs will be subject to LCH's default rules.\144\ LCH is authorized
by these rules to declare an SCM in default in a number of
circumstances, including: (i) The failure of the SCM to satisfy its
payment obligations on time or the likelihood that it will have
difficulty in doing so; (ii) the insolvency of the SCM or a related
company; and (iii) certain regulatory action.\145\ LCH will have the
discretion to take a variety of actions with respect to a defaulting
SCM's transactions, including: (i) closing out the transactions; (ii)
entering into replacement transactions; \146\ (iii) setting off any
losses that result from the SCM's
[[Page 53354]]
default against its gains; (iv) applying margin held against any net
loss; \147\ and (iv) if the margin held by LCH is insufficient to cover
the net loss, applying additional resources against the net loss in
accordance with its default rules.\148\ Additional resources would be
applied in the following order: (i) The defaulting SCM's DF
contribution; (ii) any pre-tax, pre-rebate earnings LCH has generated
in the financial year in which the default occurs as a loss borne by
LCH for its own account, up to a maximum of 10 million per
financial year; (iii) LCH's insurance backing or analogous
arrangements; (iv) the DF contributions of non-defaulting members;
\149\ and (v) LCH's own capital.\150\
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144 Id. at Appendix I, A-2.
145 Id. at Appendix I, A-5. Regulatory actions that might
constitute an event of default include: (i) The SCM is in breach of
the terms of membership of a regulatory body, is refused an
application for membership in a regulatory body or is suspended or
expelled from membership in a regulatory body; (ii) the SCM is in
breach of the rules of a regulatory body to which it is subject;
(iii) the SCM's authorisation by a regulatory body is suspended or
withdrawn; or (iv) a regulatory body takes or threatens to take
action against or in respect of the SCM under any statutory
provision or process of law. LCH Default Rules.
146 The replacement costs would be part of the loss that LCH
could claim from the defaulting SCM. LCH Petition at Appendix I, A-
6.
147 LCH would return any surplus margin to the defaulting SCM's
administrator or liquidator or to the defaulting SCM itself, as
appropriate. Id.
148 Id. at Appendix I, A-5-A-6.
149 LCH's default rules permit LCH to use a non-defaulter's DF
contribution unless insurance is available. Letter from Michael M.
Philipp, Katten Muchin & Zavis, counsel to LCH, to Jocelyn B.
Barone, Staff Attorney, Division of Trading and Markets, CFTC 1
(Nov. 19, 1998) (on file with the Division of Trading and Markets,
CFTC). The terms of LCH's insurance contract provide for coverage
for default losses totaling in excess of 150 million
over a rolling three year period rather than a loss incurred on any
individual default. Id. To the extent that LCH has used any of its
profits, or if there has been a previous call on the DF after which
LCH has required members to ``top-up'' the DF, the insurance may be
available before all of the DF has been depleted. Id.
150 LCH Petition at Appendix I, A-5-A-6; LCH Default Fund Rules;
and Letter from Michael M. Philipp, Katten Muchin & Zavis, counsel
to LCH, to Jocelyn B. Barone, Staff Attorney, Division of Trading
and Markets, CFTC 1 (Nov. 19, 1998) (on file with the Division of
Trading and Markets, CFTC). Such procedures would not preclude LCH
from pursuing contractual and other legal remedies against the SCM
in the event of a default.
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7. Operational Safeguards
LCH will implement certain safeguards to ensure the reliability and
security of its operations.\151\ Specifically, LCH will internally test
and will participate in third party testing of the systems upon which
it relies (e.g., CGO II, CREST, and SWIFT).\152\ LCH will also maintain
comprehensive back-up and business recovery facilities.\153\ In
addition, LCH has implemented a comprehensive year 2000 (``Y2K'')
program to avoid disruptions that could be caused by the use of
computer technology that is not Y2K compliant.\154\
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151 LCH Petition at 16, 28, and Appendix I, A-1 and A-7.
152 Id. at Appendix I, A-8.
153 Id. at Appendix I, A-1 and A-7.
154 Id.
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IV. Regulatory Oversight in the United Kingdom and Information-
Sharing Between Regulators
A. Applicable Regulations in the United Kingdom
LCH, SwapClear, and SwapClear participants are subject to a
comprehensive regulatory regime in the United Kingdom. The Commission
reviewed the United Kingdom's regulatory framework in connection with a
petition submitted by the FSA's predecessor in interest, the Securities
and Investment Board (``SIB''), that requested an exemption from the
application of certain Commission foreign futures and options rules
pursuant to Rule 30.10 (``SIB Petition'').\155\ The SIB Petition
requested exemptive relief on the grounds that the applicable
regulatory and self-regulatory framework in the United Kingdom was
comparable to that imposed by the CEA and the Commission's regulations.
By an order that became effective on July 19, 1989,\156\ the Commission
granted the SIB Petition, stating that the Commission had concluded
that the standards for relief relevant to a determination that a
particular regulatory program is ``comparable'' to that in the United
States, as set forth in Commission rules, had ``generally been
satisfied'' and that ``compliance with applicable United Kingdom Law
and SIB rules may be substituted for compliance with [certain] sections
of the Act * * *'' \157\
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155 Appendix A to Rule 30.10 permits specified persons located
outside of the United States and subject to a comparable regulatory
structure in the jurisdiction in which they are located to petition
the Commission for exemption from the application of certain Part 30
rules based upon substituted compliance with comparable regulatory
requirements imposed by the foreign jurisdiction. 17 CFR 30.10. The
Part 30 rules authorize the Commission to grant such an exemption if
the action would not be otherwise contrary to the public interest or
to the purposes for which the exemption is sought. Id.
156 Foreign Futures and Option Transactions, 54 FR 21599 (May
19, 1989).
157 Id. at 21600.
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Pursuant to applicable United Kingdom law, LCH, as an RCH, is
subject to oversight by the FSA. The FSA will monitor LCH's ongoing
compliance with relevant regulatory requirements. In order to uphold
its RCH status, LCH is required to maintain specified financial
resources and to adhere to certain reporting and recordkeeping
requirements. For example, LCH must furnish the FSA with the
information set forth in the Financial Services Notification by
Recognised Bodies Regulations 1996 (``Notification Regulations'').\158\
LCH must also provide the FSA with an annual regulatory plan that
includes a statement of its objectives and annual targets against which
LCH's performance may be judged.\159\ The FSA monitors LCH's progress
against its regulatory plan on an annual basis.\160\
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\158\ FSAct, Section 39. Section 41 of the FSAct authorizes the
FSA to promulgate regulations so that it may acquire the information
necessary to carry out its supervisory and other regulatory
functions.
Among other things, LCH is required to provide the FSA with
information relating to its governance, personnel, business
activities, members and changes to its rules. LCH Petition at 18;
Letter from Jane Lowe, Financial Services Authority, to Michael
Greenberger, Director, Division of Trading and Markets, CFTC (Nov.
17, 1998) (on file with the Division of Trading and Markets, CFTC)
at 3. Governance and personnel information would include information
relating to changes to its constitution, changes to key personnel,
and events relating to key personnel (e.g., the presentation of a
petition for bankruptcy); a change in its independent arbitrator,
ombudsman, or complaints investigator; or the dismissal of, or any
disciplinary actions relating to, any of its officers or employees).
Id. at 6-7. With respect to its business activities, LCH must
provide the FSA with certain financial information (e.g., annual
audited reports and accounts and the quarterly and annual budgets)
and notification of the following: a change in its auditors, fees,
or charges; the presentation of a petition for winding up; the
appointment of a receiver or liquidator; the making of a voluntary
arrangement with creditors; the institution of legal proceedings
against it; the delegation of regulatory functions of another body
regulated by the FSA; the undertaking of any regulatory functions of
another body regulated by the FSA; a change in the name of the
persons to whom it provides clearing services; and admissions and
deletions from its membership. Id. With respect to its members, LCH
is required to advise the FSA of any disciplinary action it takes
against a member or an employee of a member; persons appointed by
another regulatory body to investigate the affairs of a member or
its clearing services; evidence indicating that any person has been
carrying on unauthorized investment business or has committed a
criminal offense under the FSAct; and the open positions, margin
liability, and cash and collateral balances of a defaulting member's
accounts. Id.
\159\ LCH Petition at 18.
\160\ Letter from Jane Lowe, Financial Services Authority, to
Michael Greenberger, Director, Division of Trading and Markets, CFTC
(Nov. 17, 1998) (on file with the Division of Trading and Markets,
CFTC) at 4.
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Representatives of the FSA meet with senior clearing house risk
managers and LCH's Chief Executive on a regular basis to discuss
regulatory issues. The FSA also conducts various site projects, as
necessary, in response to specific regulatory concerns.\161\
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\161\ Id. at 4-5. The FSA anticipates that the existing
regulatory framework applicable to LCH will be substantially
retained in the United Kingdom's Financial Services Reform Bill. Id.
at 5.
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As an extension of LCH's activities as an RCH, the SwapClear
operation will be subject to regulatory oversight by the FSA. The FSA
anticipates requiring regular reporting regarding SwapClear, but has
not determined definitively the specific reporting requirements that it
[[Page 53355]]
will impose with respect to the SwapClear operation. The FSA expects to
receive, among other things, product reporting (e.g., the range in
mark-to-market values of the FRAs and swap agreements it clears and
information regarding counterparty positions); risk management
reporting (e.g., margining levels, changes in the credit standing of
SCMs, LCH's counterparty exposure, and stress testing results); and
exception reporting (e.g., same day reporting on matters being reported
regularly, where developments extend beyond predetermined levels).\162\
---------------------------------------------------------------------------
\162\ Id. at 8.
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SwapClear participants will also be subject to regulation in the
United Kingdom. SwapClear participants will be required to be
authorised or exempt under the FSAct where entering into swap
agreements cleared by SwapClear would constitute ``investment business
in the United Kingdom,'' as that phrase is defined in the FSAct.\163\
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\163\ Id. at 18.
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B. Information-Sharing Between the CFTC and the FSA
The FSA and the CFTC have reached an understanding concerning the
form and content of a Bilateral Side Letter (``Side Letter'') to the
Memorandum of Understanding dated September 25, 1991 on the Mutual
Assistance and Exchange of Information between the SEC, the CFTC, the
United Kingdom's Department of Trade and Industry, HMT, and the FSA
(formerly the Securities and Investments Board)(''US/UK MOU''). The
Commission believes that an exchange of information concerning
SwapClear should help provide LCH, the FSA, and the Commission with
notice of potential problems arising from the operation of SwapClear or
the activities of SDs and SCMs and thus permit regulatory or self-
regulatory bodies to react to such conditions at an earlier stage.
V. Summary of Comments
Most of the commenters viewed the establishment of a swaps clearing
operation as an important and positive development in the OTC
derivatives market and affirmed that a clearing mechanism may provide
significant benefits to swap market participants, including a reduction
of the counterparty credit risk associated with swap transactions.
However, the commenters' views diverged on the approach that the
Commission should take in approving a swaps clearing operation and the
appropriate timing of Commission action on the LCH Petition.
CBOT questioned the suitability of any Commission action on the LCH
Petition prior to the completion of Commission consideration of the
comments regarding swaps clearing organizations it solicited in the OTC
Concept Release.\164\ It further suggested that the Commission subject
the LCH Petition itself to the concept release process consistent with
its recent treatment of similar market initiatives.\165\ The Commission
notes that there is no legal requirement for the Commission to issue a
concept release prior to granting an exemption pursuant to the
authority provided by that provision. Furthermore, the Commission has
had the benefit of the public comments submitted in response to the OTC
Concept Release as well as the public comments submitted in response to
its request for comment on the LCH Petition.
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\164\ 63 FR 26115.
\165\ CBOT cited the placement of the electronic computer
terminals of foreign boards of trade in the United States for the
purpose of trading products available through those boards of trade
as an example of a recent market innovation that the Commission has
subjected to the concept release process. Concept Release on the
Placement of a Foreign Board of Trade's Computer Terminals in the
United States, 63 FR 39779 (July 24, 1998). CBOT also cited the
Commission's decision to postpone its deliberation of CBOT's
proposal regarding the exchange of agricultural futures for OTC
options and NYMEX's proposal to adopt a new rule that would permit
an exchange of futures contracts for qualifying swap agreements
(``EFS Transactions'') until the Commission examined the issues
raised in its Concept Release on the Regulation of Noncompetitive
Transactions Executed on or Subject to the Rules of a Contract
Market, 63 FR 3708 (Jan. 28, 1998). The Commission notes that it has
since approved NYMEX's EFS Transactions proposal, pursuant to the
terms and conditions of a three year pilot program. CFTC Approves
[NYMEX's] Proposal to Permit EFS Transactions, CFTC Press Release
No. 4228-99 (Jan. 11, 1999).
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Both CBOT and NYMEX recommended that, in lieu of granting piecemeal
exemptions, the Commission should adopt a generic regulatory framework
that would permit the centralized clearing of swap agreements in
accordance with standards that would apply equally to foreign and
domestic clearing organizations. CBOT and NYMEX urged the Commission to
defer action upon the LCH Petition until generally applicable rules
could be proposed and published. NYMEX maintained that publishing
proposed standards for broad prospective application would be more
compatible with the Commission's prior practice in issuing Section 4(c)
exemptions than providing isolated relief to one applicant.\166\ It
also argued that a generalized rulemaking would provide the Commission
with an opportunity to acquire and consider the perspectives of several
segments of the derivatives markets and would provide a level of due
process more appropriate to the contemplated degree of regulatory
change.
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\166\ NYMEX cited the Commission's publication of the proposed
order granting exemptive relief for certain contracts involving the
deferred purchase or sale of energy products. See Exemptions for
Certain Contracts Involving Energy Products, 58 FR 6250 (Jan. 27,
1998)(Proposed Order).
---------------------------------------------------------------------------
As discussed above, the Commission is authorized to examine and
assess petitions for exemptive relief pursuant to Section 4(c) of the
Act on a case-by-case basis and to issue orders granting or denying
such relief. It has elected to do so because (i) such an approach is
consistent with its formerly stated intention to evaluate proposals for
swaps clearing operations in this way; (ii) this is the first such
petition that has been submitted to the Commission; (iii) swaps
clearing services are a novel addition to the OTC market and, thus,
there is little experience upon which the Commission might draw in
developing an exemption of general applicability; and (iv) SwapClear
and SwapClear participants will be subject to extensive regulation
abroad. The Commission also notes that the comment letters received by
the Commission support the conclusion that the public was sufficiently
informed of the LCH Petition to enable meaningful comment on the
proposal.
NYMEX also recommended that the Commission use 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, known as the ``Lamfalussy Report,'' as a
starting point in developing standards for a swaps clearing facility.
NYMEX specifically proposed that the Commission establish qualifying
criteria for participation in a swaps clearing operation that consider
the financial integrity, commercial standing, and swaps transaction
experience of the prospective participants.\167\ It further suggested
that the Commission require swaps clearing facilities to, inter alia,
collect original and variation margin in cash or cash equivalents,
mark-to-market and settle cleared swap agreements on a daily
basis,\168\ segregate customer funds from
[[Page 53356]]
proprietary funds,\169\ and maintain certain records of the essential
terms of cleared swap transactions and of all exchanges of payments,
including margin flows, associated with the such transactions. NYMEX
also recommended that the Commission reserve the right periodically to
review any exemption it provides pursuant to Section 4(c) of the Act
and prospectively to modify or terminate the exemption as circumstances
warrant. The Commission notes that NYMEX acknowledged that the LCH
Petition incorporated many of the financial and operational safeguards
suggested by NYMEX. For example, SwapClear's risk management features
include participant reporting requirements, the collection of initial
and variation margin, and daily marking-to-market of all positions.
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\167\ NYMEX objected to SwapClear's admission standards as
unnecessarily restrictive and anticompetitive because they would
prohibit an entity that is not a swaps dealer in the interbank
wholesale market from using SwapClear, regardless of the entity's
size, financial integrity, or experience in swap transactions.
\168\ NYMEX recommended that the Commission accept the prices of
Commission-approved contracts with sufficient levels of trading
volume and open interest as safe and reliable sources of price data
for use in marking swaps positions to market, but that it formulate
standards for the use of alternative sources of price data as well.
NYMEX suggested that such standards should take into account the
reliability of the data sources, the frequency with which the data
are disseminated, and the degree of acceptance of the data sources
by market participants.
\169\ NYMEX contended that centralized swaps clearing operations
would raise fiduciary concerns because they would collect and hold
money from many parties. NYMEX conceded, however, that it would be
appropriate to provide an exception to the segregation requirement
where the customer knowingly and willingly opts out of the
protection afforded by it. LCH represents that it will permit SCMs
to establish separately designated ``client'' accounts that are
separately margined, if they so desire, even though the United
Kingdom Client Money Rules that generally require the segregation of
proprietary and client funds will not apply to most SCMs.
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CBOT and NYMEX also expressed concern regarding the competitive
effects on the United States industry of approving the LCH Petition in
the absence of generally applicable exemptive relief. CBOT explicitly
noted that approving the LCH Petition absent generalized relief would
enable a foreign entity to begin clearing swap agreements in the United
States before a United States-based clearing organization would have an
opportunity to develop a competing facility. These commenters contended
that the likelihood that swap agreements cleared by LCH will directly
compete with products traded on regulated domestic futures exchanges
necessitates consistency both between the regulatory treatment of
clearing facilities for swap agreements and clearing facilities for
futures contracts and between foreign and domestic clearing operations.
CBOT remarked, for example, that the terms of LCH-cleared swap
agreements were likely to become standardized over time to qualify for
clearing and indicated that this increasing standardization might
facilitate secondary trading in swaps contracts among swap market
participants, SDs, and SCMs, thereby creating a new and competitive
futures-like market in swap transactions. To ensure even-handed
regulation and fair competition between OTC markets and futures
exchanges, NYMEX proposed that the Commission undertake a broad review
of its current regulations and consider applying its Section 4(c)
exemptive authority to exchange-traded instruments.
The Commission notes that its order expressly conditions the
exemptive relief provided therein upon the requirement that the swap
transactions to be cleared by SwapClear not be part of a fungible class
of agreements that are standardized as to their material economic
terms. The Commission also notes that its approval of the LCH Petition
does not preclude other entities that may wish to operate a swaps
clearing facility from submitting a similar request for relief.
ISDA and SIA questioned the Commission's ability to exercise
jurisdiction over LCH and the transactions to be cleared by SwapClear.
In ISDA's view, individually negotiated swap transactions subject to
clearing arrangements are excluded from the exemption of Part 35, but
are not within the ambit of the CEA and the Commission's regulations.
Accordingly, ISDA maintained that LCH was not required to submit a
petition for exemptive relief under Section 4(c) of the CEA. ISDA
asserted that Commission action on the LCH Petition should be
restricted to: (i) stating that LCH does not require an exemption
pursuant to Section 4(c) of the Act or (ii) issuing an exemption
pursuant to Section 4(c) that specifies that the exemption should not
be construed to imply that the exempted transactions are futures
contracts under the CEA. SIA similarly urged the Commission to grant
the requested exemptive relief only to the extent, and without any
determination that, the swap transactions submitted for clearance by
LCH constitute futures contracts or commodity options subject to the
Commission's jurisdiction. The Commission notes that the order grants
an exemption from the CEA only to the extent that the CEA is applicable
to the instruments covered by SwapClear and that the Commission need
not analyze each such instrument to determine that issue.
SIA further suggested that the Commission limit the scope of the
transactions that are eligible for the requested exemptive relief to
transactions that satisfy the requirements for an exemption under Part
35 of Commission rules, except for the requirement that the credit-
worthiness of a party with an obligation under the transaction be a
material consideration in entering into the swap transaction. The
Commission notes that the exemptive relief provided by the order is
restricted to transactions and participants that satisfy such
requirements as well as the other terms and conditions set forth in the
order.
SIA also questioned the Commission's authority to oversee the
operations of a clearing house such as LCH. Specifically, it asserted
that the Commission may only regulate a clearing organization in the
limited context of its oversight of the futures and option clearing
activities of boards of trade designated as contract markets. SIA also
argued that the Commission's assertion of jurisdiction over LCH would
be inconsistent with Section 4(b) of the Act.\170\ The Commission
recognizes that LCH and SwapClear are subject to an extensive
regulatory scheme in the United Kingdom and notes that it is not
adopting any rules or regulations of the type prohibited by Section
4(b) of the CEA. Rather, the Commission is issuing an order as
authorized by Section 4(c) of the Act to extend the exemption already
granted in Part 35 of the Commission's Rules by permitting swaps
clearing.
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\170\ Section 4(b) of the Act, inter alia, prohibits the
Commission from adopting a rule or regulation that:
(1) Requires Commission approval of any contract, rule,
regulation, or action of any foreign board of trade, exchange, or
market or clearinghouse for such board of trade, exchange, or
market, or (2) governs in any way any rule or contract term or
action of any foreign board of trade, exchange, or market, or
clearing house for such board of trade, exchange, or market. 7
U.S.C. 6(b).
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In sum, the Commission has carefully considered each of the
comments and believes that the order is generally responsive to the
commenters' concerns.
VI. Determinations Required for Exemption
Section 4(c) of the CEA authorizes the Commission, by rule,
regulation, or order, to exempt any agreement, contract or transaction,
or class thereof from the exchange trading requirement or Section 4(a)
of the Act or any other requirement of the Act other than Section
2(a)(1)(B), if the Commission determines that the exemption would be
consistent with the public interest. Furthermore, Section 4(c)(2) of
the Act provides that the Commission may not grant an exemption from
the exchange trading requirement of Section 4(a) of the Act unless the
Commission finds
[[Page 53357]]
that: (i) The exchange-trading requirement should not be applied to the
agreement, contract, or transaction for which the exemption is
requested and the exemption would be consistent with the public
interest and the purposes of the Act; (ii) the exempted transaction
will be entered into solely between ``appropriate persons''; and (iii)
the agreement, contract or transaction in question 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.\171\ For the reasons stated below, the Commission
believes that issuing the exemptive relief as set forth in the order is
consistent with those determinations.
---------------------------------------------------------------------------
\171\ 7 U.S.C. 6(c)(2).
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A. Exchange-Trading Requirement
The Commission believes that the exchange trading requirement
contained in Section 4(a) of the CEA should not be applied to swap
transactions that satisfy the terms and conditions set forth in this
order. First, the Commission has recognized that the OTC swaps market
does not serve the same price discovery function \172\ as the exchange-
traded market because prices in the OTC swaps market are privately
negotiated between individual market participants.\173\ LCH represents
that some of the material economic terms of the transactions to be
cleared by SwapClear will be bilaterally negotiated between the SDs.
Accordingly, SwapClear will not likely perform a ``primary price
discovery function.'' \174\
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\172\ By this statement, the Commission does not intend to
suggest that a price discovery process is absent from the OTC swaps
market. It merely notes that the difference between the price
discovery functions of the exchange and OTC markets may warrant
diverse regulatory treatment.
\173\ Accordingly, participants in the OTC market may trade
``off-market.''
\174\ LCH Petition at 22.
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In addition, when adopting the Part 35 rules,\175\ the Commission
found that it was not necessary to apply the exchange trading
requirement to swap agreements satisfying the conditions of the
exemption provided therein because ``one of the prerequisites for the
exemption [was] that the swaps agreement not be standardized like
exchange products or entered into or traded on a [multilateral
transaction execution facility].'' \176\ Allowing transactions to be
cleared through SwapClear, under the conditions enumerated in the
order, will not alter the validity of this determination. The swaps
market currently exists outside the exchange trading forum pursuant to
Part 35, and LCH represents that ``[a]ll swap agreements cleared
through SwapClear will continue to be individually negotiated
transactions and will not be traded on a multilateral trade execution
facility.'' \177\
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\175\ As discussed above, Part 35 of the Commission's
regulations exempts specified persons who offer, enter into or
render advice or services with respect to specified swap agreements
from certain provisions of the CEA.
\176\ 58 FR 5587 at 5592.
\177\ LCH Petition at 22.
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The Commission has expressly excluded transactions that are part of
a fungible class of agreements standardized as to their material
economic terms or are traded on a multilateral transaction execution
facility from the scope of the order. It has further restricted the
exemptive relief to ``swap agreements'' that have been entered into by
``eligible swap participants,'' as those terms are defined in Rule
35.1.\178\ The order, therefore, does not significantly expand the
class of transactions or class of participants already afforded
exemptive relief pursuant to Part 35 of Commission rules because the
transactions to be cleared by SwapClear satisfy all of the conditions
for an exemption under those rules, with the exception of one. Because
LCH will interpose itself as a counterparty to each transaction it
clears, the requirement that the creditworthiness of the counterparties
be a material consideration in entering into or determining the terms
of the agreements is not satisfied. In adopting the Part 35 Rules,
however, the Commission indicated its willingness to expand the
exemption to include centralized swaps clearing facilities under
appropriate conditions and stated that such a facility may prove
beneficial to participants and the public.\179\
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\178\ Only the particular FRAs and interest rate swap agreements
described in the LCH Petition are eligible for exemptive relief
under the terms of the order granted herein. Accordingly, the
exemption that would be provided would be applicable to fewer types
of agreements than are covered by the Part 35 exemption.
\179\ 58 FR 5587, 5591, n.30.
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Based upon the above, the Commission determines that the exchange
trading requirement of Section 4(a) of the CEA should not be applied to
transactions meeting the terms and conditions of this order.
B. The Public Interest and the Purposes of the Act
When considering previous Section 4(c) exemptive actions, the
Commission has measured the action's consistency with ``the public
interest and the purposes of the Act'' against the ``template of its
over-all regulatory scheme'' and the guidance set forth in the
Conference Report accompanying the 1992 Act.\180\ In this respect, the
Conference Report states that the term ``public interest'' as used in
Section 4(c) is intended ``to include 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.''
\181\ The Conference Report also states that the reference in Section
4(c) to the ``purposes of the Act'' is intended to ``underscore [the
Conferees'] 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.''
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\180\ Exemption for Certain Contracts Involving Energy Products,
58 FR 21286, 21292 (Apr. 20, 1993)(Final Order). See also Regulation
of Hybrid Instruments, 58 FR 5580, 5582 (Jan. 22, 1993); 58 FR 5587
at 5592.
\181\ H.R. Rep. No. 978, supra n.24 at 78.
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As the Commission stated when it adopted the Part 35 swaps
exemption, ``swap agreements are important tools that are used by
[market participants] to hedge or manage financial risk and accomplish
other financial objectives.'' \182\ The Commission believes that a
centralized swaps clearing facility such as SwapClear may reduce the
risks and costs of participation in the swap market and increase
transparency in that market without increasing the risk of fraud or
market manipulation.
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\182\ 58 FR 5587, 5592.
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1. Potential Benefits of SwapClear
The Commission believes that a properly managed and adequately
capitalized or otherwise secured clearing facility that includes a
performance guarantee by a central counterparty, the multilateral
netting of payments, positions, and credit exposure, and the other
innovative features offered by SwapClear may significantly benefit the
OTC derivatives marketplace by diminishing certain risks and costs
associated with that market.\183\
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\183\ Similarly, the Bank for International Settlements
concluded that a clearing house for OTC derivatives has the
potential to mitigate counterparty risk and to reduce systemic risk
if the clearing house manages risk effectively. See, Bank for
International Settlements, OTC Derivatives: Settlement Procedures
and Counterparty Risk Management 36 (Sept. 1998).
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For example, by interposing a central counterparty to each swap
transaction it clears and by offering LCH's performance guarantee,
SwapClear effectively substitutes the credit of a highly capitalized
clearing system as a
[[Page 53358]]
whole for the credit of an individual counterparty, thereby mitigating
counterparty credit risk. SwapClear's use of a multilateral payment
netting system may lessen the risks associated with multiple, redundant
settlement payments by potentially reducing the number and the amount
of payments that must be made. SwapClear also offers a default
procedure designed to permit positions to be closed out with limited
impact on other, non-defaulting counterparties. In this way, the
effects of a single member default will be isolated, and a chain
reaction of consequential defaults by other market counterparties that
may, in turn, cause widespread risk to the financial system may be
prevented. Moreover, LCH's default rules take precedence over the
rights of a liquidator or other insolvency office-holder under relevant
insolvency law in the United Kingdom.\184\
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\184\ LCH Petition at Appendix I, A-2 and A-6-A-7.
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The market innovations offered by SwapClear may also reduce the
costs of participation in the swaps market. For example, the
multilateral clearing offered by SwapClear may reduce the costs of
negotiating credit provisions and monitoring the financial condition of
multiple counterparties. Multilateral payment netting may reduce the
costs of providing margin, collateralizing payment obligations, and
transferring several repetitive settlement payments to multiple
counterparties. By decreasing these costs, SwapClear may enable swaps
market participants to make more efficient use of their capital,
collateral, and credit lines.
SwapClear may also benefit the swaps industry by increasing
transparency in the marketplace. LCH will have knowledge of each
SwapClear participant's transactions and will set daily credit limits
to restrict this exposure accordingly. This may send a clear signal
regarding the size and risk of a portion of a individual participant's
proprietary trading. By requiring positions to be marked-to-market on a
daily basis and by requiring variation margin, SwapClear may reduce a
trader's ability to maintain large positions without alerting its
senior management to the size or risk exposure of those positions.
Finally, by granting this exemptive relief, the Commission clearly
establishes the legality of SwapClear and the swap instruments to be
cleared through it under the CEA insofar as they comply with the terms
and conditions of the Commission's order.
2. Financial Safeguards
The Commission has previously indicated that the benefits that
might result from the centralized clearing of OTC derivative
transactions may come ``at the cost of concentrating risk in the
clearing organization.'' \185\ Similarly, NYMEX asserted that the
centralized clearing of swap agreements would entail concentration of
financial and credit risks in one facility and that clearing members
would not be privy to or be able to assess the risk being undertaken by
the clearing entity. LCH has developed a risk management program
designed to control the credit concentration risks associated with its
SwapClear operation. SwapClear's risk management program includes the
following: imposing admissions standards intended to restrict
participation to financially and operationally sophisticated entities;
requiring that SCMs post initial margin for each cleared transaction in
an amount that has been calculated in accordance with a margin
methodology that is fundamentally similar to that successfully in use
at LCH with respect to its exchange-traded derivatives; \186\
calculating the marked-to-market values of swap agreements on a daily
basis; collecting variation margin, in cash, from SCMs each day; and
establishing formal intra-day credit exposure limits for each SCM and
calculating the effect of each new transaction on an SCM's credit
exposure. LCH also has established clearly prescribed procedures
governing a member's default and has substantial financial resources to
protect it against the consequences of such a default. The adequacy of
LCH's member-backed default fund will be tested in daily stress tests.
This risk management plan, as detailed in Section III.B above,
incorporates the criteria set forth in the Lamfalussy Report,\187\ a
report that the Commission has indicated may serve as an appropriate
touchstone for reviewing a swaps clearing service.\188\ NYMEX also
recommended that the Commission look to this report for guidance in
developing standards for a prudently-managed swaps clearing facility.
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\185\ 63 FR 26114 at 26122.
\186\ The differences between the margin methodology applicable
to LCH's exchange-traded and OTC derivatives business may be
attributed to the features which distinguish the trading and pricing
of non-fungible from fungible derivatives. LCH has requested Freedom
of Information Act Confidential Treatment of its margin
methodologies pursuant to Rule 145.9. SCMs will have access to
SwapClear's margin methodologies.
\187\ The Lamfalussy standards include:
1. Netting schemes should have a well-founded legal basis under
all relevant jurisdictions;
2. Netting scheme participants should have a clear understanding
of the impact of the particular scheme on each of the financial
risks affected by the netting process;
3. Multilateral netting systems should have clearly-defined
procedures for the management of credit risks and liquidity risks
which specify the respective responsibilities of the netting
provider and the participants. These procedures should also ensure
that all parties have both the incentives and the capabilities to
manage and contain each of the risks they bear and that limits are
placed on the maximum level of credit exposure that can be produced
by each participant;
4. Multilateral netting systems should, at a minimum, be capable
of ensuring the timely completion of daily settlements in the event
of an inability to settle by the participant with the largest single
net-debit position;
5. Multilateral netting systems should have objective and
publicly-disclosed criteria for admission which permit fair and open
access; and
6. All netting schemes should ensure the operational reliability
of technical systems and the availability of back-up facilities
capable of completing daily processing requirements. CFTC, OTC
Derivatives Report 136-37 (Oct. 1993).
\188\ Id.
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Payment netting may also reduce the amount of capital held in
reserve by clearing members. Capital reserves act as a buffer against
shocks to the market and price volatility. However, the introduction of
centralized swaps clearing should result in a reduction in counterparty
credit risk and participation costs and a concomitant reduction in the
need for capital reserves to address those factors.
3. Potential for Fraud or Manipulation
The Commission does not believe that the LCH Petition raises any
particular concerns with respect to fraud, nor did any commenter
suggest that the SwapClear operation might increase the opportunity for
fraud in the swaps market. LCH will only clear transactions that are
entered into by large, sophisticated financial institutions which have
dealt with each other on a bilateral basis and have the ability and the
resources to judge the overall fairness of the price and contract terms
for each transaction.\189\ Nevertheless, in its order, the Commission
has reserved its authority to act against fraud under the antifraud
provisions of Section 4b and 4o of the CEA and Rule 32.9. The
Commission also believes that it will be able to obtain information
needed to investigate any complaints of fraud that are within its
jurisdiction involving SwapClear transactions or participants under the
terms of the US/UK MOU and the Side Letter between the Commission and
the FSA.
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\189\ In fact, by calculating daily mark-to-market prices, LCH
may decrease potential fraud by reducing the chances that a party,
including a ``rogue'' employee, could mislead its counterparty or
other person about the current value of a transaction.
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[[Page 53359]]
The Commission is also unaware of any concerns that use of the
SwapClear operation will enable parties to manipulate prices more
easily, and no such concerns were raised by the commenters. Swap
transactions typically do not raise the same market manipulation
concerns under the CEA as do certain exchange-traded contracts because
swap prices are not generally widely disseminated or used by persons
engaged in buying or selling the underlying commodities to determine
prices. Nevertheless, the order granted herein will specifically
reserve the Commission's authority under the Act to take action against
market manipulation.\190\ The Commission believes it will be able to
acquire information needed to investigate any market manipulation
complaints that are within its jurisdiction involving SwapClear
transactions and participants under the terms of the US/UK MOU and the
Side Letter between the CFTC and the FSA.
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\190\ Manipulative activity involving the trading of OTC
derivative instruments can have a detrimental impact on commerce in
the United States for at least three basic reasons. First, like
their exchange-traded counterparts, OTC derivative contracts allow
end users to hedge against adverse commodity price fluctuations,
changing currency and interest rates, and other marketplace
uncertainties. As a consequence, OTC markets are playing an
increasingly important role in risk management. If they are to
continue to fulfill this vital function, OTC derivative instruments
must not be subject to manipulation by unscrupulous traders. Second,
the very nature of the participants in the OTC derivatives markets--
major investment banks, publicly held companies, pension and hedge
funds, and government agencies--dictates that the impact of any
distortion in the price of OTC derivative instruments could be
widespread, harming many more persons than just the aggrieved party
to the contract. Given the enormous size of many derivative
transactions in the OTC markets and the high degree of leverage
often involved in those transactions, price manipulation could
result in significant individual counterparty failures and even
generate systemic risk. Finally, the interrelated nature of prices
in many cash, futures, and OTC derivative markets makes it likely
that price movements in one market will have a corresponding effect
on prices in related markets. As a consequence, if the value of an
OTC derivative instrument were, for example, based on the closing
price of futures traded on a Commission-designated contract market,
an unscrupulous trader could seek to enhance the value of his or her
OTC derivatives position by attempting to manipulate the price of
the relevant futures contract.
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Accordingly, the Commission determines that the exemptive relief
granted by this order is consistent with the public interest and the
purposes of the Act.
C. Appropriate Persons
The Commission must also determine that a transaction exempted
under Section 4(c) of the Act will be entered into only by
``appropriate persons.'' The term ``appropriate person'' is
specifically limited to certain persons defined in the Act which are
generally institutional investors but may include ``such other persons
that the Commission determines to be appropriate in light of their
financial or other qualifications, or the applicability of appropriate
regulatory protections.'' \191\ The Conference Report states that
``[d]etermining whether particular categories of participants are
appropriate for particular instruments will be part of the Commission's
responsibility to determine that a proposed exemption is consistent
with the public interest.'' \192\
---------------------------------------------------------------------------
\191\ 7 U.S.C. 6(c)(3).
\192\ H.R. Rep. No. 978, supra, n. 24 at 79.
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LCH will impose minimum financial and operational admissions
criteria intended to ensure that all SDs and SCMs who participate in
SwapClear will possess the financial sophistication and resources to
understand and to withstand the risks of participation in the swaps
market. While LCH represents that every SD and SCM will qualify as an
``appropriate person,'' as that term is defined by the CEA,\193\ LCH's
eligibility standards will in fact result in all SwapClear participants
exceeding that standard because all SwapClear participants will qualify
as ``eligible swap participants'' as that term is defined in Commission
regulations.\194\ The Commission believes that the ``appropriate
person'' requirement of Section 4(c) is met by LCH's admission
criteria.
---------------------------------------------------------------------------
\193\ LCH Petition at 23.
\194\ 17 CFR 35.1.
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LCH will monitor compliance with its participant qualifications on
an ongoing basis. To ensure that participation is so limited, the
Commission's order explicitly limits the relief provided to
transactions in which both the original counterparties and the clearing
SCMs are ``eligible swap participants'' as defined in Part 35 of the
Commission's regulations.\195\
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\195\ Since the Part 35 swaps exemption was adopted pursuant to
Section 4(c) of the Act, persons who are ``eligible swap
participants'' have already been determined by the Commission to be
``appropriate persons'' as defined in the CEA. See 58 FR 5587 at
5589 (the Part 35 adopting release's discussion of ``eligible swap
participants'').
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Thus, the Commission determines that the transactions granted
relief pursuant to this order will be entered into solely by
appropriate persons.
D. Adverse Effects on Regulatory or Self-Regulatory Duties
In determining that an exemption granted under Section 4(c) of the
Act 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, the Conference Report states that the Commission
``should consider the potential impact of the new product on such
regulatory concerns as market surveillance, financial integrity of
participants, protection of customers, and trade practice
enforcement.''\196\ However, the Conference Report also states that
``this provision [is not intended] to allow an exchange or any other
existing market to oppose the exemption of a new product solely on
grounds that it may compete with or draw market share away from that
existing market.'' \197\
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\196\ H.R. Rep. No. 978, supra n.24 at 79.
\197\ Id.
---------------------------------------------------------------------------
As discussed above, the Commission has recognized that regulatory
protections related to price discovery, financial integrity, and
customer protection may differ between OTC swaps markets and exchange
markets because the OTC swap transactions in most markets do not appear
to perform the same price discovery function as exchange-traded markets
since the prices of OTC instruments are subject to private, bilateral
negotiation and because OTC swap transactions are generally conducted
on a principal-to-principal basis between financially sophisticated
counterparties. For example, in adopting its Part 35 swap exemption,
the Commission determined that regulatory concerns regarding financial
integrity and customer protection were addressed in large part by the
requirement that exempt transactions be carried out by eligible swap
participants.\198\ The Commission has included compliance with this
requirement as a condition of the exemption provided by the order. At
the same time, LCH's eligibility
[[Page 53360]]
requirements for SDs and SCMs limit participation in SwapClear to a
still smaller subset of institutions that should possess the financial
sophistication and resources to engage in and bear the risks associated
with the transactions in question.
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\198\ 58 FR 5587 at 5592. In this respect, the Commission also
noted that, in order to qualify for the Part 35 swaps exemption, the
creditworthiness of the counterparty must be a material
consideration in entering into the exempt transaction. The
Commission concluded that the Part 35 criteria as a whole would
preclude anonymous transactions and ensure that qualifying swap
transactions would be limited to persons who are sophisticated or
financially able to bear the risks associated with those
transactions. Id. While swaps clearing effectively eliminates
counterparty creditworthiness as a material consideration in
entering into a swap transaction, LCH's admission criteria ensure
that parties eligible to use SwapClear will be sophisticated and
financially able to bear the risks of the underlying swap
transaction, and LCH's risk management procedures and default
reserve ensure that LCH will be a highly creditworthy central
counterparty to the cleared transactions. In addition, each SD in
any LCH-cleared transaction will know its counterparty and its SCM
(and LCH will know both the SDs and SCMs involved) so that
transactions cleared through SwapClear will not be anonymous at the
point where the parties enter into the transaction.
---------------------------------------------------------------------------
The types of swaps transactions that LCH proposes to clear are
already being executed in the OTC derivatives market. The approval of
LCH's Petition will potentially reduce certain risks now associated
with OTC swaps transactions and add to the soundness and transparency
of the OTC swaps market.
Moreover, it is widely acknowledged that the exchange-traded
futures and OTC swaps markets are linked, with swaps market
participants using certain exchange-traded futures as hedging vehicles.
Developments that add to the soundness of the swaps market will also
potentially add to the financial security and soundness displayed by
the exchange-traded futures markets. In addition, the Side Letter
between the FSA and the CFTC will enable the Commission to acquire
information regarding LCH, SwapClear, SCMs, and SDs that may allow it
to learn of and to respond to financial, operational, and other
problems that may negatively affect United States contract markets and
market participants on a more timely basis. Finally, no commenter
indicated that any self-regulatory organization's ability to fulfill
its obligations would be adversely affected by Commission approval of
SwapClear.
Accordingly, the Commission determines that issuance of this order
will not have a material adverse affect on the ability of the
Commission or any contract market to discharge its regulatory or self-
regulatory duties under the Act.
VII. Explanation of the Order
The order grants an exemption from most provisions of the CEA and
the Commission's regulations with respect to any swap agreement
submitted for clearing through SwapClear and any person offering,
entering into, or rendering advice or other services with respect to
such agreements, subject to certain terms and conditions set forth
therein. The exemption extends to all provisions of the Act and
Commission regulations except for Sections 2(a)(1)(B), 4b and 4o of the
Act, Rule 32.9, and the provisions of Sections 6(c) and 9(a)(2) of the
Act to the extent that 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. Exemptive
relief provided by the order will not become effective until the FSA
and the CFTC have executed the Side Letter, and the Commission has
received confirmation that the FSA has completed its review of
SwapClear and has granted LCH approval to commence SwapClear
operations.
The Commission notes that the order specifically enumerates several
aspects of SwapClear that it considers relevant to its decision to
approve the LCH Petition, regarding SwapClear's admissions criteria,
product eligibility requirements, margining system, and other risk
management procedures; the applicable regulatory regime; and the
reporting, recordkeeping, and information-sharing arrangements. These
factors are illustrative of those elements of a swaps clearing
operation that the Commission deems pertinent to a request for
exemptive relief. The Commission will examine all future petitions
based on the circumstances presented.
The Commission has limited the exemptive relief by imposing certain
conditions. Section 4(c) of the Act expressly empowers the Commission
to issue exemptions subject to terms and conditions. The Commission has
included these restrictions to ensure that the participant base,
products, and activities of SwapClear are not expanded without
Commission consideration of whether the exemption should be so
extended. If any of the conditions set forth in the order is not
satisfied when a transaction is submitted for clearing through LCH
(e.g., LCH is no longer an RCH or the swap agreement is not of the type
set forth in the order), the transaction will fall outside the
exemption.
The exemptive relief is restricted to those FRAs and interest rate
swap agreements described in the LCH Petition that fall within the
definition of ``swap agreements'' as set forth in Rule 35.1(b)(1). The
Commission intends that the order will provide LCH with flexibility to
expand its product eligibility criteria to include, for example,
interest rate swaps using currencies, floating rate indices, or
maturity dates other than those that will be immediately available.
However, the Commission recognizes that transactions other than FRAs
and interest rate swap agreements that qualify as ``swap agreements''
under the Commission's rules may raise additional regulatory concerns.
Accordingly, it is declining to extend relief to instruments other than
those set forth in the order.
In addition, the exemptive relief extends only to those agreements
that would already be entitled to exemption under Part 35 of the
Commission's regulations except for the fact that they are subject to
clearing. Thus, the agreements must have been entered into by
``eligible swap participants'' as that term is defined in Rule
35.1(b)(2). This stricture is intended to ensure that participation is
limited to the ``appropriate persons'' pursuant to Section 4(c) of the
Act and, more particularly, to those persons possessing the financial
sophistication, experience, and resources sufficient for participation
in the swaps market.
The Commission is further restricting its relief to non-fungible
transactions the material economic terms of which have been
individually negotiated and which have not been traded on or through a
multilateral transaction execution facility. Once SwapClear receives
FSA's regulatory approval, this order contemplates that parties will be
allowed to submit to SwapClear previously transacted swap agreements
and still claim the relief granted herein as long as such transactions
met the terms and conditions of Part 35 at the time that they were
first entered into.
Finally, the order expressly conditions the exemptive relief
provided upon the requirement that LCH be an RCH with respect to
SwapClear at the time the swap agreement for which exemptive relief is
sought is submitted for clearing to LCH. This condition is being
imposed because the Commission has deferred, in large part, to the
FSA's regulation of LCH as an RCH. Thus, parties could not claim the
exemption for transactions that were submitted for clearing at a time
when LCH did not have RCH status. Swap agreements submitted to
SwapClear prior to LCH's loss of status as an RCH would not be
affected, however, as long as all other conditions set forth in this
order were satisfied.
The Commission recognizes that it may be appropriate to review,
revise, or revoke the exemptive relief provided should circumstances or
further experience with swaps clearing warrant, and it expressly
reserves the power to take such action. The Commission reviewed LCH's
request for exemptive relief in its totality with due regard for all
representations made in support thereof. Because a change in any one of
these representations, in whole or in part, may have led the Commission
to reach a different conclusion, the Commission believes it must
reserve the right to review, modify and/or revoke its order if it
discovers that a material fact or circumstance regarding LCH or
SwapClear has been misrepresented, has been found to be untrue, or has
ceased to be true. As to the representations outlined in the order, the
Commission
[[Page 53361]]
believes that LCH possesses an affirmative obligation to notify the
Commission in the event it discovers that such information is
misleading or untrue. The Commission believes that the reservation of
its right to modify or revoke the order will provide an incentive to
all parties who may submit petitions for exemptive relief to the
Commission to furnish complete and accurate information in support of
their respective requests.
The activities of LCH and SwapClear are subject to a comprehensive
regulatory regime in the United Kingdom, including capital, reporting,
and other regulatory requirements designed to ensure their financial
and operational integrity and to ensure that the FSA would receive
timely notice of any financial or operational difficulties involving
them. In the event that LCH and/or SwapClear are not so regulated or in
the event that the FSA or any other relevant authority in the United
Kingdom no longer authorizes the operation of SwapClear, the exemptive
relief requested may not be appropriate. Accordingly, the order
provides that the Commission may modify or revoke the order should
either of those events occur.
The Commission believes that an adequate exchange of information
between it and the FSA concerning SwapClear and its operations is
important to the CFTC's ability to fulfill its domestic regulatory
functions. Accordingly, the Commission is reserving the right to revise
or revoke the exemption should it be unable to acquire the information
it views as necessary to enforce the order, to provide adequate
protection to United States contract markets or United States market
participants, or otherwise to carry out its regulatory functions.
Finally, LCH has agreed to file a valid, effective, and binding
appointment of an agent in the United States for purposes of accepting
delivery and service of communications issued by or on behalf of the
CFTC, the United States Department of Justice, any self-regulatory
organization, or any SwapClear participant. Such communications include
any summons, complaint, order, subpoena, request for information, or
notice, as well as any other written document or correspondence. As the
Commission believes that such an agency arrangement is essential to
proper communications between LCH and agencies of the United States or
United States participants, it is specifically reserving the right to
revise or to revoke the order should such an arrangement become
ineffective or cease to exist.
The Commission notes that any revision or revocation of its order
will apply prospectively only and will not affect the legal certainty
of any swap transaction entered into prior to the revision or
revocation.
IX. Conclusion
As demonstrated above, the Commission believes that its order is
supported by the appropriate determinations made in accordance with the
standards set forth in Section 4(c) of the Act for granting exemptions
and that a centralized swap clearing operation such as SwapClear may
provide substantial benefits to the OTC derivatives industry.
Order Granting Relief
Order of the Commodity Futures Trading Commission Pursuant to
Section 4(c) of the Commodity Exchange Act Exempting Certain Swap
Agreements to be Cleared Through the London Clearing House Limited's
SwapClear Operation and Certain Persons Who Engage in Specified
Activities With Respect to Such Transactions From Specified
Provisions of the CEA.
By a petition dated June 15, 1998, the London Clearing House
Limited (``LCH'') requested that the Commodity Futures Trading
Commission (``CFTC'' or ``Commission'') grant an exemption pursuant to
Section 4(c) of the Commodity Exchange Act (``CEA'' or ``Act'') to
qualified persons using SwapClear, LCH's proposed service for the
centralized clearing of certain swap transactions (``LCH Petition'').
The LCH Petition requested that the Commission exempt such persons from
all provisions of the CEA and the Commission's regulations except for
Sections 2(a)(1)(B), 4b, and 4o of the Act, the provisions of Sections
6(c) and 9(a)(2) of the Act to the extent that such provisions prohibit
the 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 Rule 32.9.
LCH Representations
LCH has made a number of representations in support of its
Petition. The Commission has relied upon these representations in its
evaluation of the LCH Petition and in its decision to grant the
exemptive relief provided by this order. LCH's representations include,
but are not limited to, the following:
(1) LCH is a recognized clearing house (``RCH'') under the laws of
the United Kingdom and is authorized under United Kingdom law to clear
over-the-counter instruments. In order to obtain recognition as a
clearing house, LCH was required to demonstrate to the appropriate
regulatory authorities in the United Kingdom that it had, among other
things:
(a) Sufficient financial resources to carry out its business as a
clearing house;
(b) Adequate arrangements and resources for the effective
monitoring and enforcement of compliance with its rules;
(c) An ability and willingness to share information with its
regulators; and
(d) Default rules that enable action to be taken to close out a
member's position in relation to all unsettled contracts to which such
member is a party where a member appears unable to meet its obligations
to the clearing house.
(2) As an RCH, LCH is subject to direct regulatory oversight by the
Financial Services Authority (``FSA'') and is subject to reporting,
recordkeeping, and other regulatory requirements.
(3) Among other things, LCH is required to provide the FSA with an
annual regulatory plan that includes a statement of objectives and
targets. LCH is also required to provide the FSA with information
relating to its governance, personnel, and business activities and
changes in its rules. The information that LCH must provide to the FSA
includes information relating to:
(a) Its annual audited reports and accounts;
(b) Its quarterly and annual budgets;
(c) The presentation of a petition for winding up, the appointment
of a receiver or liquidator, or the making of a voluntary arrangement
with creditors;
(d) The institution of any legal proceedings against it;
(e) Changes in its constitution, fees and charges, key personnel,
independent arbitrator, ombudsman, complaints investigator, auditors,
and persons to whom it provides clearing services;
(f) The presentation of a petition for bankruptcy by any of its key
personnel;
(g) The dismissal of or any disciplinary actions taken against or
relating to any of its officers or employees;
(h) Admissions or deletions from membership;
(i) Any disciplinary action taken against a member or an employee
of a member;
(j) Persons appointed by another regulatory body to investigate the
affairs of a member or its clearing services;
(k) Evidence indicating any person has been carrying on
unauthorized investment business or has committed a criminal offense
under the Financial Services Act (``FSAct''); and
[[Page 53362]]
(l) The open positions, margin liability, and cash and collateral
balances of a defaulting member's account.
(4) The FSA will continually monitor LCH's compliance with its
annual regulatory plan and other regulatory requirements.
(5) As an extension of LCH's activities as an RCH, the SwapClear
operation will be subject to regulation and oversight by the FSA, and
LCH will be required to provide the FSA with certain information
regarding its SwapClear operation.
(6) Among other things, LCH will be required to provide the FSA
with information concerning:
(a) The range in mark-to-market values of the swap agreements it
clears;
(b) Counterparty positions;
(c) Counterparty margining levels;
(d) Changes in the credit standing of SwapClear Clearing Members
(``SCMs'');
(e) LCH's counterparty exposure; and
(f) The results of stress testing.
(7) Only transactions entered into by persons who have been
approved by LCH as SwapClear Dealers (``SDs'') will be eligible for
clearing through SwapClear. To qualify for designation as an SD under
LCH Rules, a person must:
(a) Be a financial institution that is active in the wholesale
market for the type of forward rate agreements and interest rate swap
agreements to be cleared by SwapClear;
(b) At all times such person is carrying on ``investment business''
in the UnitedKingdom, as that term defined in the FSAct, be either:
(i) An authorized or exempted person under the FSAct or
(ii) A ``European investment firm'' as that term is defined in the
United Kingdom's Investment Services Regulations 1995 (``U.K.
Investment Services Regulations'');
(c) Be of investment grade caliber or be guaranteed by an
investment grade parent; and
(d) Satisfy certain operational standards.
(8) LCH will require that all agreements to be cleared through
SwapClear be submitted through a person that has been approved by LCH
as an SCM. Accordingly, an SD must have a clearing arrangement in place
with a SCM or be approved as an SCM itself before it will be permitted
to participate in SwapClear. To qualify for designation as an SCM, a
person must:
(a) Be an LCH shareholder;
(b) At all times such person is carrying on ``investment business''
in the United Kingdom, as that term is defined in the FSAct, be either:
(i) An authorized or exempt person under the FSAct or
(ii) A ``European investment firm,'' as that term is defined in the
U.K. Investment Services Regulations;
(c) Satisfy minimum financial requirements;
(d) Contribute to LCH's Default Fund (``DF'');
(e) Submit regular financial reports to LCH; and
(f) Satisfy specified operational and staffing standards.
(9) LCH will not permit end-users or members of the general public
who do not satisfy LCH's criteria for designation as an SD or SCM to
participate in SwapClear.
(10) LCH will monitor the compliance of SDs and SCMs with
SwapClear's admission standards on an ongoing basis.
(11) All SDs and SCMs will be bound by LCH rules, regulations, and
requirements (collectively, ``LCH Rules'').
(12) LCH will permit only forward rate agreements and interest rate
swap agreements that satisfy the product eligibility standards set
forth in the LCH Petition to be cleared by SwapClear.
(13) Material economic terms of all transactions to be cleared by
SwapClear will be bilaterally negotiated between SDs.
(14) LCH will not provide counterparties with any form of
transaction execution facility.
(15) LCH will register agreements for clearing only after it has
verified that:
(a) Both counterparties satisfy LCH's participant eligibility
criteria;
(b) That the agreement satisfies SwapClear's product eligibility
requirements; and
(c) The transactions will not exceed the submitting SCM's
respective intra-day credit limit.
(16) LCH will register all agreements to be cleared by SwapClear in
the name of an SCM, and the SCM will be fully liable for ensuring
performance to LCH with respect to each swap agreement registered in
its name. An SD may clear an agreement for itself if it has also
received approval from the LCH to act as an SCM.
(17) Where the SCM is not the same party as the SD, back-to-back
transactions will also arise between the SD and the SCM. In these
cases, upon registration of those agreements for clearing by LCH, the
original bilateral forward rate agreements or interest rate swap
agreements between the SDs will be replaced by four new transactions:
one between each SD and its SCM, contracting as principals, and one
between each SCM and LCH, contracting as principals.
(18) LCH will become the central counterparty with respect to all
swap agreements to be cleared through SwapClear and, as such, will be
responsible to the SCMs for the performance of the obligations
thereunder.
(19) LCH represents that United Kingdom law would permit LCH to
commingle segregated client funds relating to an SCM's exchange-traded
business in the United Kingdom and client funds relating to an SCM's
SwapClear business. However, LCH represents further that it anticipates
that LCH clearing members who are also SCMs will carry their non-
proprietary futures positions and associated margin funds in their
``client'' account at LCH, but likely will carry their non-proprietary
SwapClear positions and associated margin funds in their ``house''
account at LCH. Accordingly, LCH believes that United States persons
who do not engage in SwapClear transactions, but who clear their
exchange-traded futures through the ``client'' account of a member of
LCH who is also an SCM are unlikely to be exposed to a greater
likelihood of loss in the event of a default by a SwapClear participant
than would exist prior to the implementation of a SwapClear facility.
(20) LCH will implement certain risk management mechanisms and
procedures to control the risks arising from its role as central
counterparty to all agreements cleared through SwapClear. LCH's risk
management program will include:
(a) A requirement that the terms of a swap agreement be confirmed
by the original counterparties before the agreement will be accepted
for clearing by SwapClear.
(b) A requirement that SDs and SCMs submit certain information to
LCH including information relating to:
(i) Their ongoing ability to satisfy SwapClear's participant
eligibility criteria;
(ii) Their status as a licensee;
(iii) Their authority to conduct investment business in the United
Kingdom;
(iv) Their solvency;
(v) Their dissolution;
(vi) Their conviction of a crime;
(vii) Disciplinary or enforcement judgment involving them; and
(viii) Material changes to their business.
(c) The establishment of intra-day limits on credit exposure with
respect to each SCM. LCH will monitor its credit exposure to each SCM
on an ongoing basis and will be able to reject any transaction for
registration or impose liquidation orders with respect to transactions
that exceed assigned credit limits.
[[Page 53363]]
(d) The establishment of initial margin requirements to cover
adverse market movements and the cost of liquidating positions in the
event of a default by an SCM. Subject to the approval of the FSA, the
initial margin requirements will be set using a scenario-based method
analogous to London SPAN. LCH will accept margin only in
cash, bank guarantees, and specified government securities. LCH will
retain the discretion to require a SwapClear participant to post
initial margin in excess of that calculated using its margin
methodology.
(e) The calculation of mark-to-market values for all cleared
agreements on a daily basis and a requirement that SCMs pay variation
margin equivalent to any change in the value of an SCM's position from
the previous day, each day, in cash.
(f) The maintenance of financial resources of sufficient size and
liquidity to cover the cost of closing out or transferring a defaulting
member's position where those costs exceed the initial margin collected
by LCH from the defaulting member, including cash, lines of credit, a
default fund to which each SCM must contribute, and the maintenance of
an insurance policy to cover any shortfall in the default fund.
(g) The maintenance of rules which permit LCH to declare an SCM in
default in appropriate circumstances and to take appropriate, clearly-
defined action in the event of an SCM default.
(h) Daily stress testing of the initial margin LCH holds from each
member to ensure the adequacy of its daily funding level in the event
of a member default and daily review of the stress testing results.
(i) Internal and third party testing of the operational systems
upon which LCH relies.
(j) The maintenance of back-up and business recovery facilities to
ensure the reliability and security of SwapClear's operations.
(21) LCH will forward a copy of the annual report that it is
required to file with the FSA to the CFTC upon submission of that
document to the FSA.
(22) LCH will provide a copy of the LCH Rules applicable to its
SwapClear operation to the CFTC, prior to the onset of SwapClear's
operations.
(23) LCH will maintain a valid, effective, and binding agency
agreement with a person located in the United States whereby it
authorizes that person to act as its agent for purposes of accepting
delivery and service of communications at all times during which this
order is in effect. Such communications include any summons, complaint,
order, subpoena, request for information, notice or any other written
document or correspondence issued by or on behalf of the CFTC, the
United States Department of Justice, any self-regulatory organization,
or any SwapClear participant. LCH will provide immediate, written
notice to the Commission of any change concerning the status of the
party identified as the agent for the service of process or the
effectiveness of any agreement with such party.
Terms and Conditions
Based upon the representations that have been made, the Commission
has determined that granting the Petition for Exemption Pursuant to
Section 4(c) of the Act dated June 15, 1998 submitted by LCH, subject
to the terms and conditions below, would be consistent with the
standards set forth in Section 4(c) of the CEA.
Accordingly, any swap agreement submitted for clearing to LCH
through its swap clearing facility known as SwapClear is exempt from
all provisions of the Act and any person or class of person offering,
entering into, rendering advice or rendering other services, including
clearing services, with respect to such agreement, is exempt for such
activity from all provisions of the Act (except in each case, sections
2(a)(1)(B), 4b and 4o of the Act, and Rule 32.9 of the Commission's
regulations, 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), provided that each of
the following terms and conditions is met:
(1) The transaction would constitute a ``swap agreement,'' as that
term is defined in Section 35.1(b)(1) of the Commission's regulations,
and the transaction is a forward rate agreement or interest rate swap
agreement as defined in the LCH Petition.
(2) The transaction has been entered into solely between ``eligible
swap participants,'' as that term is defined in Section 35.1(b)(2) of
the Commission's regulations, which have been approved as SDs by LCH.
(3) The transaction is not part of a fungible class of agreements
that are standardized as to their material economic terms.
(4) The transaction is not entered into and traded on or through a
multilateral transaction execution facility.
(5) At the time such agreement is submitted to LCH for registration
by SwapClear, LCH is an RCH under the applicable laws of the United
Kingdom with respect to the clearing services offered by SwapClear.
This order, and the exemption provided herein, shall not become
effective until the FSA and the Commission have executed the Bilateral
Side Letter to the Memorandum of Understanding dated September 25, 1991
on the Mutual Assistance and Exchange of Information between the SEC,
the CFTC, the United Kingdom's Department of Trade and Industry, HM
Treasury, and the FSA (formerly the Securities and Investments Board),
and the FSA has provided the Commission with written notification that
it has reviewed the SwapClear operation and has approved the
commencement of the SwapClear operation.
The Commission reserves the right to review and, prospectively, to
modify and/or to revoke this order and the exemption contained therein,
including the conditions imposed upon the exemptive relief, in certain
circumstances, including, but not limited to, the following:
(1) The Commission discovers that a material representation made by
LCH or its counsel or representatives is materially misleading, is
untrue, or has ceased to be true.
(2) LCH ceases to satisfy the criteria for designation as an RCH
under the applicable laws of the United Kingdom.
(3) The FSA or any relevant authority in the United Kingdom no
longer authorizes the operation of SwapClear.
(4) LCH fails to maintain a valid, effective, and binding agreement
appointing an agent in the United States for purposes of accepting
delivery and service of communications, as defined above, issued by or
on behalf of the CFTC, the United States Department of Justice, any
self-regulatory organization, or any SwapClear participant.
(5) The Commission determines that it is unable to obtain
sufficient information including, but not limited to, information that
the FSA and LCH have agreed to provide to the Commission or to which
the Commission believes it is entitled to receive under the terms of
the US/UK MOU, the Side Letter thereto or any other information-sharing
arrangement.
(6) Any revocation of this order or the exemption provided herein
by the Commission would be prospective only and would not affect the
status of any transaction entered into in reliance on this order prior
to the revocation.
[[Page 53364]]
Issued in Washington, DC on March 23, 1999, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 99-25605 Filed 9-30-99; 8:45 am]
BILLING CODE 6351-01-P