[Federal Register Volume 72, Number 111 (Monday, June 11, 2007)]
[Notices]
[Pages 32079-32081]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-2878]


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COMMODITY FUTURES TRADING COMMISSION


Order Exempting the Trading and Clearing of Certain Credit 
Default Products Pursuant to the Exemptive Authority in Section 4(c) of 
the Commodity Exchange Act (``CEA'')

AGENCY: Commodity Futures Trading Commission

ACTION: Final order.

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SUMMARY: On May 14, 2007, the Commodity Futures Trading Commission 
(``CFTC'' or the ``Commission'') published for pubic comment in the 
Federal Register \1\ a proposal to exempt for the CEA \2\ the trading 
and clearing of certain products called credit default options 
(``CDOs'') and credit default basket options (``CDBOs'') that are 
proposed to be traded on the Chicago Board Options Exchange (``CBOE''), 
a natioal securities exchange registered under Section 6 of the 
Securities Exchange Act of 1934 (``1934 Act''),\3\ and cleared through 
the Options Clearing Corporation (``OCC''), a registered securities 
clearing agency registered under Section 17A of the 1934 Act,\4\ and 
Derivatives Clearing Organization registered under Section 5b of the 
CEA.\5\ The proposed order was preceded by a request from OCC to 
approve rules that would permit it to clear these CDOs and CDBOs in its 
capacity as a registered securities clearing agency. OCC's request 
presented novel and complex issues of jurisdiction and the Commission 
determined that an order exempting the trading and clearing of such 
instruments from pertinent requirements of the CEA may be appropriate. 
The Commission has reviewed the comments made in response to its 
proposal and the entire record in this matter and has determined to 
issue an order exempting the trading and clearing of these contracts 
from the CEA.
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    \1\ 72 FR 27091 (May 14, 2007).
    \2\ 7 U.S.C. 1 et seq.
    \3\ 15 U.S.C. 78f.
    \4\ 15 U.S.C. 78q-1.
    \5\ 7 U.S.C. 7a-1.
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    Authority for this exemption is found in Section 4(c) of the 
CEA.\6\
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    \6\ 7 U.S.C. 6(c).

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DATES: Effective Date: June 5, 2007.

FOR FURTHER INFORMATION CONTACT: John C. Lawton, Deputy Director and 
Chief Counsel, 202-418-5480; [email protected], Robert B. Wasserman, 
Associate Director, 202-418-7719, lgregory*@cftc.gov, Division of 
Clearing and Intermediary Oversight, Commodity Futures Trading 
Commission, Three

[[Page 32080]]

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

SUPPLEMENTARY INFORMATION: 

Introduction

    The OCC is both a Derivatives Clearing Organization (``DCO'') 
registered pursuant to Section 5b of the CEA,\7\ and a securities 
clearing agency registered pursuant to Section 17A of the 1934 Act.\8\ 
The CBOE is a national securities exchange registered as such under 
Section 6 of the 1934 Act.\9\
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    \7\ 7 U.S.C. 7a-1.
    \8\ 15 U.S.C. 78q-1.
    \9\ 15 U.S.C. 78f.
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    CBOE has filed with the Securities and Exchange Commission 
(``SEC'') proposed rule changes to provide for the listing and trading 
on CBOE of cash-settled products characterized by CBOE as options based 
on credit events in one or more debt securities of specified 
``Reference Entities.'' \10\ These products are referred to as Credit 
Default Options (``CDOs''), and would pay the holder a specified amount 
upon the occurrence, as determined by CBOE, of a ``Credit Event,'' 
defined to mean an ``Event of Default'' on any debt security issued or 
guaranteed by a specified ``Reference Entity.''
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    \10\ See Release No. 34-55251, 72 FR 7091 (Feb. 14, 2007).
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    CBOE has also filed with the SEC proposed rule changes to provide 
for the listing and trading on CBOE of products called Credit Default 
Basket Options (``CDBOs'').\11\ These are similar in concept to CDOs, 
except that a CDBO covers more than one Reference Entity. For each 
individual Reference Entity, a notional value (a fraction of the 
aggregate Notional Face Value of the basket) and a recovery rate is 
specified. CDBOs may be of the multiple-payout variety, or of the 
single-payout variety, where a payout occurs only the first time a 
Credit Event is confirmed with respect to a Reference Entity prior to 
expiration.
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    \11\ See SR-CBOE-2007-026.
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    OCC has filed with the CFTC, pursuant to Section 5c(c) of the CEA 
and Commission Regulations 39.4(a) and 40.5 thereunder,\12\ requests 
for approval of rules and rule amendments that would enable OCC to 
clear and settle these CDOs and CDBOs in its capacity as a registered 
securities clearing agency (and not in its capacity as a DCO).\13\ 
Section 5c(c)(3) provides that the CFTC must approve any such rules and 
rule amendments submitted for approval unless it finds that the rules 
or rule amendments would violate the CEA.
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    \12\ 7 U.S.C. 7a-2(c), 17 CFR Sec. Sec.  39.4(a), 40.5.
    \13\ See SR-OCC-2007-01 A-1; SR-OCC-2007-06. OCC has filed 
identical proposed rule changes with the SEC.
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    The request for approval concerning the CDO product was filed 
effective March 8, 2007. On April 23, 2007, the review period was 
extended pursuant to Regulation 40.5(c) until June 6, 2007, on the 
ground that the CDOs ``raise novel or complex issues, including the 
nature of the contract, that require additional time for review.'' The 
request for approval concerning the CDBO product was filed effective 
April 23, 2007.

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

    Section 4(c)(1) of the CEA empowers the CFTC to ``promote 
responsible economic or financial innovation and fair competition'' by 
exempting any transaction or class of transactions from any of the 
provisions of the CEA (subject to exceptions not relevant here) where 
the Commission determines that the exemption would be consistent with 
the public interest. The Commission may grant such an exemption by 
rule, regulation or order, after notice and opportunity for hearing, 
and may do so on application of any person or on its own initiative. In 
enacting Section 4(c), Congress noted that the goal of provision ``is 
to give the Commission a means of providing certainty and stability to 
existing and emerging markets so that financial innovation and market 
development can proceed in an effective and competitive manner.'' \14\ 
As noted in the proposing release,\15\ In granting an exemption, the 
CFTC need not find that the CDOs and CDBOs are (or are not) subject to 
the CEA.
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    \14\ HOUSE CONF. REPORT ON NO. 102-978, 1992 U.S.C.C.A.N. 3179, 
3213 (``4(c) Conf. Report'').
    \15\ 72 FR 27091 (May 14, 2007).
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    Section 4(c)(2) provides that the Commission may grant exemptions 
only when it determines that the requirements for which an exemption is 
being provided should not be applied to the agreements, contracts or 
transactions at issue, and the exemption is consistent with the public 
interest and the purposes of the CEA; that the agreements, contracts or 
transactions will be entered into solely between appropriate persons; 
and that the exemption will not have a material adverse effect on the 
ability of the Commission or any contract market to discharge its 
regulatory or self-regulatory responsibilities under the CEA.
    In the May 14, 2007 Federal Register release, the Commission 
requested public comment on the matters discussed above and all issues 
raised by its proposed exemptive order.

III. Comment Letters

    The Commission received four comment letters. The Chicago 
Mercantile Exchange (``CME'') stated that it ``applauds'' the 
Commission's proposal to promote innovation but that it believed some 
issues should be addressed before a final order is issued. CME argued 
that: (1) It would be unfair for OCC and CBOE to receive exemptive 
relief yet continue to oppose CME's efforts to list competitive 
products; (2) the Commission should not accept OCC's and CBOE's 
characterization of the products as options; (3) there are strong 
arguments that the products are based on commodities, not securities; 
and (4) it is not proper to define ``appropriate persons'' in terms of 
the status of the person's intermediary.
    OCC focused on the ``appropriate persons'' issue. OCC argued that 
in light of the customer suitability rules and the overall federal 
securities regulatory framework, the products would be limited to 
``appropriate persons.''
    The Chicago Board of Trade ``CBOTS'') suggested that characterizing 
the CDOs and CDBOs as ``novel instruments'' should be repudiated or 
clarified because it could have implications under the patent laws.

IV. Findings and Conclusions

    After considering the complete record in this matter, including the 
comments received, the Commission has determined that the requirements 
of Section 4(c) have been met.\16\ First, the exemption is consistent 
with the public interest and with the purposes of the CEA. The purposes 
of the CEA include ``promot[ing] responsible innovation and fair 
competition among boards of trade, other markets and market 
participants.'' \17\ With respect to the competitive issue raised by 
CME in its comment letter, the Commission believes that an exemptive 
order in response to OCC's request for rule approval is the best way to 
promote responsibile innovation and fair competition among futures 
markets and securities markets. In cases such as this one where 
innovative products come close to the jurisdictional line between 
commodities and securities, rather than attempting to draw that line 
with precision with regard to the CBOE products and thereby potentially

[[Page 32081]]

imposing litigation costs on both the private sector and the public 
sector, it may be more efficient and is a proper use of Section 4(c) 
exemptive authority to permit, without compromising the public 
interest, the products to trade on both sides of the line and let 
competitive forces determine which venue is successful.
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    \16\ In this regard, consistent with the legislative history to 
Section 4(c) of the CEA, the Commission is not making a finding that 
CDOs and CDBO are (or are not) subject to the CEA.
    \17\ CEA Section 3(b), 7 U.S.C. 5(b) (emphasis added. See also 
CEA Section 4(c)(1), 7 U.S.C. 6(c)(1) (purpose of exemptions is ``to 
promote responsible economic or financial innovation and fair 
competition.'')
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    Second, the CDOs and CDBOs would be entered into solely between 
appropriate persons. This issue was discussed by both CME and OCC in 
their respective comment letters. Section 4(c)(3) includes within the 
term ``appropriate persons'' a number of specified categories of 
persons, but also in subparagraph (K), ``such other persons that the 
Commission determines to be appropriate in light of * * * the 
applicability of appropriate regulatory protections.'' (Emphasis 
added.) These products will be traded on a regulated exchange. CBOE, 
OCC, and their members who will intermediate these transactions, are 
subject to extensive and detailed oversight by the SEC and, in the case 
of the intermediaries, the securities self-regulatory organizations. It 
should be noted that CME has listed or will list comparable products 
and has not limited access to its markets to specified categories of 
persons. In light of where the products will be traded, the regulatory 
protections available under the securities laws, and the goal of 
promoting fair competition, these products will be traded by 
appropriate persons.
    Third, the exemption would not have a material adverse effect on 
the ability of the Commission or any designated contract market to 
carry out their regulatory responsibilities under the CEA. There is no 
reason to believe that granting an exemption here would interfere with 
the Commission's or a designated contract market's ability to oversee 
the trading of similar products on a designated contract market or 
otherwise to carry out their duties. None of the comment letters 
received addressed this issue.\18\
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    \18\ Under Section 4(c) of the CEA, the Commission need not 
resolve whether, as CME argues in its comment letter, these products 
are based on commodities and not securities, or, as CBOE argues in 
its comment letter, these products are securities subject to the 
securities laws. Nor need the Commission determine, as CME urges, 
whether the products are properly characterized as options. Finally, 
the Commission notes that its references to the novelty of the 
issues raised by these products refer to issues under the CEA and 
were not intended to be applicable in any matter relating to patent 
or intellectual property law.
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    Therefore, upon due consideration, pursuant to its authority under 
Section 4(c) of the CEA, the Commission hereby issues this Order and 
exempts the trading and clearing of CDOs and CDBOs to be listed and 
traded on CBOE and cleared through OCC as a securities clearing agency 
from the CEA. This Order is contingent upon the approval by the SEC, 
pursuant to Section 19(b) of the 1934 Act, of CBOE and OCC rules to 
permit the listing and trading of CDOs and CDBOs on CBOE. This Order is 
subject to termination or revision, on a prospective basis, if the 
Commission determines upon further information that this exemption is 
not consistent with the public interest. If the commission believes 
such exemption becomes detrimental to the public interest, the 
Commission may revoke this Order on its own motion.

V. Related Matters

A. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \19\ imposes certain 
requirements on federal agencies (including the Commission) in 
connection with their conducting or sponsoring any collection of 
information as defined by the PRA. The order would not require a new 
collection of information from any entities that would be subject to 
the order.
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    \19\ 44 U.S.C. 3507(d).
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B. Cost-Benefit Analysis

    Section 15(a) of the CEA, as amended by Section 119 of the 
Commodity Futures Modernization Act of 2000 (``CFMA''),\20\ requires 
the Commission to consider the costs and benefits of its action before 
issuing an order under the CEA. By its terms, Section 15(a) as amended 
does not require the Commission to quantify the costs and benefits of 
an order or to determine whether the benefits of the order outweigh its 
costs. Rather, Section 15(a) simply requires the Commission to 
``consider the costs and benefits'' of its action.
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    \20\ 7 U.S.C. 19(a).
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    Section 15(a) of the CEA further specifies that costs and benefits 
shall be evaluated in light of five broad areas of market and public 
concern: protection of market participants and the public; efficiency, 
competitiveness, and financial integrity of futures markets; price 
discovery; sound risk management practices; and other public interest 
considerations. Accordingly, the Commission could in its discretion 
give greater weight to any one of the five enumerated areas and could 
in its discretion determine that, notwithstanding its costs, a 
particular order was necessary or appropriate to protect the public 
interest or to effectuate any of the provisions or to accomplish any of 
the purposes of the CEA.
    The order issued today is expected to facilitate market 
competition. The commission has considered the costs and benefits of 
the order in light of the specific provisions of Section 15(a) of the 
CEA, as follows:
    1. Protection of market participants and the public. Protections 
for market participants and the public exist in that CBOE, OCC and 
their members who will intermediate CDOs and CDBOs are subject to 
extensive oversight by the SEC and, in the case of intermediaries, 
securities self-regulatory organizations.
    2. Efficiency, competition, and financial integrity. The exemptive 
order may enhance market efficiency and competition since it could 
encourage potential trading of CDOs and CDBOs on markets other than 
designated contract markets. Financial integrity will not be impaired 
since the CDOs and CDBOs will be cleared by OCC, a DCO and SEC-
registered clearing agency, and intermediated by SEC-registered broker-
dealers.
    3. Price discovery. Price discovery may be enhanced through market 
competition.
    4. Sound risk management practices. OCC has described appropriate 
risk-management practices that it will follow in connection with the 
clearing of CDOs and CDBOs.
    5. Other public interest considerations. The exemptive order may 
encourage development of credit derivative products through market 
competition without unnecessary regulatory burden.
    The Commission requested comment on its application of these 
factors in the proposing release. No comments were received.
    After considering these factors, the Commission has determined to 
issue this Order.
* * * * *

    Issued in Washington, DC, on June 5, 2007 by the Commission.
Eileen A. Donovan,
Acting Secretary of the Commission.
[FR Doc. 07-2878 Filed 6-8-07; 8:45 am]
BILLING CODE 6351-01-M