[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]


=======================================================================
-----------------------------------------------------------------------

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.

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

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.
---------------------------------------------------------------------------

    \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'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \9\ 7 U.S.C. 2(i).
    \10\ 7 U.S.C. 1a(3).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \27\ See id. at 5591.
    \28\ Id. at 5591, n.30.
    \29\ Id.
    \30\ Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \38\ Id. at 26122.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \42\ 58 FR 5587 at 5591.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \46\  LCH Petition at 17.
    \47\ Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \50\ LCH Petition at 1-2.
    \51\ Id. at 38.
    \52\ Id. at 2.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \163\ Id. at 18.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.''
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \182\ 58 FR 5587, 5592.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \184\ LCH Petition at Appendix I, A-2 and A-6-A-7.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.

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

[[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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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