[Federal Register Volume 74, Number 101 (Thursday, May 28, 2009)]
[Notices]
[Pages 25586-25593]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-12342]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-59955; File No. SR-FINRA-2009-012]
Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Notice of Filing and Order Granting Accelerated
Approval of Proposed Rule Change, as Modified by Amendment No. 1, To
Implement an Interim Pilot Program With Respect to Margin Requirements
for Certain Transactions in Credit Default Swaps
May 22, 2009.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on March 11, 2009, Financial Industry Regulatory Authority, Inc.
(``FINRA'') (f/k/a National Association of Securities Dealers, Inc.
(``NASD'')) filed with the Securities and Exchange Commission (``SEC''
or ``Commission'') the proposed rule change as described in Items I and
II below, which Items substantially have been prepared by FINRA. On May
19, 2009, FINRA submitted Amendment No. 1 to the proposed rule change.
The Commission is publishing this notice to solicit comments on the
proposed rule change from interested persons and is simultaneously
approving the proposed rule change as amended on an accelerated basis
to establish an interim pilot program.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
FINRA is proposing to adopt FINRA Rule 4240 (Margin Requirements
for Credit Default Swaps). The proposed rule would implement an interim
pilot program (the ``Interim Pilot Program'') with respect to margin
requirements for transactions in credit default swaps (``CDS'')
executed by a member (regardless of the type of account in which the
transaction is booked), including those in which the offsetting
matching hedging transactions (``matching transactions'') are effected
by the member in CDS contracts that are cleared through the central
counterparty clearing services of the Chicago Mercantile Exchange (the
``CME''). The proposed rule would expire on September 25, 2009.
The text of the proposed rule change is available on FINRA's Web
site at http://www.finra.org, at the principal office of FINRA and at
the Commission's Public Reference Room.
[[Page 25587]]
In addition, the text of the proposed rule change is set forth below.
New language is in italics.
* * * * *
4000. FINANCIAL AND OPERATIONAL RULES
* * * * *
4200. MARGIN
* * * * *
4240. Margin Requirements for Credit Default Swaps
(a) Effective Period of Interim Pilot Program
This Rule establishes an interim pilot program (``Interim Pilot
Program'') with respect to margin requirements for any transactions in
credit default swaps executed by a member (regardless of the type of
account in which the transaction is booked), including those in which
the offsetting matching hedging transactions (``matching
transactions'') are effected by the member in contracts that are
cleared through the central counterparty clearing services of the
Chicago Mercantile Exchange (``CME''). The Interim Pilot Program shall
automatically expire on September 25, 2009. For purposes of this Rule,
the term ``credit default swap'' (``CDS'') shall mean any ``eligible
credit default swap'' as defined in Securities Act Rule 239T(d), as
well as any other CDS that would otherwise meet such definition but for
being subject to individual negotiation, and the term ``transaction''
shall include any ongoing CDS position.
(b) Central Counterparty Clearing Arrangements
Any member, prior to establishing any clearing arrangement with
respect to CDS transactions that makes use of any central counterparty
clearing services provided by any clearing agency, pursuant to
Securities Act Rule 239T(a)(1), must notify FINRA in advance in
writing, in such manner as may be specified by FINRA in a Regulatory
Notice.
(c) Margin Requirements
(1) CDS Cleared on the Chicago Mercantile Exchange
Members shall require as a minimum for computing customer or
broker-dealer margin, with respect to any customer or broker-dealer
transaction in CDS with a member in which the member executes a
matching transaction that makes use of the central counterparty
clearing facilities of the CME (``CME matching customer-side
transaction''), the applicable margin pursuant to CME rules (sometimes
referred to in such rules as a ``performance bond'') regardless of the
type of account in which the transaction in CDS is booked. Members
shall, based on the risk monitoring procedures and guidelines set forth
in paragraph (d) of this Rule, determine whether the applicable CME
requirements are adequate with respect to their customer and broker-
dealer accounts and the positions in those accounts and, where
appropriate, increase such margin in excess of such minimum margin. For
this purpose, members are permitted to use the margin requirements set
forth in Supplementary Material .01 of this Rule.
The aggregate amount of margin the member collects from customers
and broker-dealers for transactions in CDS must equal or exceed the
aggregate amount of margin the member is required to post at CME with
respect to those customer and broker-dealer transactions.
CME matching customer-side transactions are not subject to the
provisions of paragraph (c)(2) of this Rule.
(2) CDS That Are Cleared on Central Counterparty Clearing Facilities
Other Than the CME or That Settle Over-the-Counter (``OTC'')
Members shall require, with respect to any transaction in CDS that
makes use of central counterparty clearing facilities other than the
CME or that settle OTC, the applicable minimum margin as set forth in
Supplementary Material .01 of this Rule regardless of the type of
account in which the transaction in CDS is booked. However, members
shall, based on the risk monitoring procedures and guidelines set forth
in paragraph (d) of this Rule, determine whether such margin is
adequate with respect to their customer and broker-dealer accounts and,
where appropriate, increase such requirements.
(d) Risk Monitoring Procedures and Guidelines
Members shall monitor the risk of any customer or broker-dealer
accounts with exposure to CDS and shall maintain a comprehensive
written risk analysis methodology for assessing the potential risk to
the member's capital over a specified range of possible market
movements over a specified time period. For purposes of this Rule,
members must employ the risk monitoring procedures and guidelines set
forth in paragraphs (d)(1) through (8) of this Rule. The member must
review, in accordance with the member's written procedures, at
reasonable periodic intervals, the member's credit extension activities
for consistency with the risk monitoring procedures and guidelines set
forth in this Rule, and must determine whether the data necessary to
apply the risk monitoring procedures and guidelines is accessible on a
timely basis and information systems are available to adequately
capture, monitor, analyze and report relevant data, including:
(1) obtaining and reviewing the required account documentation and
financial information necessary for assessing the amount of credit to
be extended to customers and broker-dealers;
(2) assessing the determination, review and approval of credit
limits to each customer and broker-dealer, and across all customers and
broker-dealers, engaging in CDS transactions;
(3) monitoring credit risk exposure to the member from CDS,
including the type, scope and frequency of reporting to senior
management;
(4) the use of stress testing of accounts containing CDS contracts
in order to monitor market risk exposure from individual accounts and
in the aggregate;
(5) managing the impact of credit extended related to CDS contracts
on the member's overall risk exposure;
(6) determining the need to collect additional margin from a
particular customer or broker-dealer, including whether that
determination was based upon the creditworthiness of the customer or
broker-dealer and/or the risk of the specific contracts;
(7) monitoring the credit exposure resulting from concentrated
positions within both individual accounts and across all accounts
containing CDS contracts; and
(8) maintaining sufficient margin in each customer and broker-
dealer account to protect against the default of the largest individual
exposure in the account as measured by computing the largest maximum
possible loss.
(e) Concentrations
Where the maximum current and potential exposure with respect to
the largest single name CDS across all accounts exceeds the member's
tentative net capital, the member must take a capital charge equal to
the aggregate margin requirement for such accounts on the positions in
such single name CDS in accordance with the tables set forth in
Supplementary Material .01 of this Rule. This capital charge may be
reduced by the amount of excess margin held in all customer and broker-
dealer accounts.
[[Page 25588]]
* * * Supplementary Material:
.01 Margin Requirements for CDS. The following customer and broker-
dealer margin requirements shall apply, as appropriate, pursuant to
paragraph (c) of this Rule.
(a) Customer and Broker-Dealer Accounts That Are Short a CDS
The following table shall be used to determine the margin that a
member must collect from a customer or broker-dealer that is short a
single name debt security CDS contract (sold protection). The margin is
to be collected based upon the basis point spread over LIBOR of the CDS
contract as well as the maturity of that contract as a percentage of
the notional amount, shall be as follows:
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Length of time to maturity of CDS contract (in
percent)
Basis point spread ---------------------------------------------------
7 years &
1 year 3 years 5 years longer
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0-100....................................................... 1 2 4 7
100-300..................................................... 2 5 7 10
300-500..................................................... 5 10 15 20
500-700..................................................... 10 15 20 25
700 and above............................................... 15 20 25 30
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For those CDS contracts where the underlying obligation is a debt
index, rather than a single name bond, the margin requirement as a
percentage of the notional amount shall be as follows:
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Length of time to maturity of CDS contract (in percent)
Index ----------------------------------------------------------------
1 year 3 years 5 years 7 years 10 years
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CDX.IG......................................... 1 1 2 4 5
CDX.HY......................................... 3 5 10 12 15
CDX.HVOL....................................... 2 3 4 5 7
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(b) Accounts That Are Long a CDS
For customer or broker-dealer accounts that are long the CDS
contracts (purchased protection), the margin to be collected shall be
50% of the above amounts.
(c) Accounts That Maintain Both Long and Short CDS
In instances where the customer or broker-dealer maintains both
long and short CDS, the member may elect to collect 50% of the above
margin requirements on the greater of the long or short position within
the same Bloomberg CDS sector, provided those long and short positions
are in the same spread and maturity bucket.
If a customer or broker-dealer is long the bond and long a CDS
contract on the same underlying obligor, margin needs to be collected
only on the long bond position, provided that bond can be delivered
against the long CDS contract, as prescribed pursuant to applicable
FINRA margin rules.
In instances where the customer or broker-dealer is short the bond
and short the CDS on the same underlying obligor, margin need only be
collected on the short bond, as prescribed pursuant to applicable FINRA
margin rules.
* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, FINRA included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. FINRA has prepared summaries, set forth in sections A,
B, and C below, of the most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
FINRA is proposing to adopt FINRA Rule 4240 (Margin Requirements
for Credit Default Swaps). The proposed rule would implement an Interim
Pilot Program with respect to margin requirements for transactions in
CDS executed by a member (regardless of the type of account in which
the transaction is booked), including those in which matching
transactions are effected by the member in CDS contracts that are
cleared through the central counterparty clearing services of the CME.
The proposed rule would expire on September 25, 2009.
(A). Background
On March 13, 2009, the Commission issued an Order granting
temporary exemptions under the Exchange Act in response to a request by
CME and Citadel Investment Group, LLC with respect to their proposal
for CME to provide clearance and settlement services as a central
counterparty for certain transactions in CDS.\3\ The Commission issued
similar Orders to LCH.Clearnet Ltd \4\ and ICE U.S. Trust LLC.\5\ The
Commission also recently enacted interim final temporary rules
providing enumerated exemptions under the federal securities laws for
certain CDS to facilitate the operation of one or more central clearing
counterparties in such CDS.\6\ Finally,
[[Page 25589]]
the Commission has provided temporary exemptions in connection with
Sections 5 and 6 of the Exchange Act for transactions in non-excluded
CDS \7\ (these Commission actions are hereinafter referred to
collectively as the ``Commission's CDS Relief''). The Commission noted
that these measures were intended to address concerns arising from
systemic risk posed by CDS, including, among others, risks to the
financial system arising from the lack of a central clearing
counterparty to clear and settle CDS.\8\
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\3\ See Securities Exchange Act Release No. 59578 (Mar. 13,
2009), 74 FR 11781 (Mar. 19, 2009).
\4\ See Securities Exchange Act Release No. 59164 (Dec. 24,
2008), 74 FR 139 (Jan. 2, 2009).
\5\ See Securities Exchange Act Release No. 59527 (Mar. 6,
2009), 74 FR 10791 (Mar. 12, 2009).
\6\ See Securities Act Release No. 8999 (Jan. 14, 2009), 74 FR
3967 (Jan. 22, 2009) (Temporary Exemptions for Eligible Credit
Default Swaps To Facilitate Operation of Central Counterparties To
Clear and Settle Credit Default Swaps). Generally, as noted by the
Commission, a CDS is a bilateral contract between two parties, known
as counterparties. The value of this contract is based on underlying
obligations of a single entity or on a particular security or other
debt obligation, or an index of several such entities, securities,
or obligations. The obligation of a seller to make payments under a
CDS contract is triggered by a default or other credit event as to
such entity or entities or such security or securities.
\7\ See Securities Exchange Act Release No. 59165 (Dec. 24,
2008), 74 FR 133 (Jan. 2, 2009).
\8\ See supra, notes 3, 4, 5, 6, and 7.
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Historically, in the absence of a central clearing counterparty,
CDS transactions entered into by U.S. investment banks have not been
booked in the member, but rather in the affiliated entities. In light
of the rapid growth of the CDS market, and the potential inability of
parties to meet their obligations as counterparties, the lack of a
central clearing counterparty poses risks not only to the two parties
to a CDS transaction, but also to the financial system overall because
of the resulting chain of significant economic loss when one or more
parties default on their obligations under a CDS transaction.
As discussed above, the Commission has issued exemptive Orders to
allow three entities to act as CDS central clearing counterparties. Of
these, the CME has requested that FINRA adopt customer margin rules for
CDS and suggested a specific customer margin methodology that could be
employed.\9\ FINRA performed an analysis of the margin methodology
suggested by CME, as well as the alternative methodology for CDS \10\
prior to proposing Rule 4240. FINRA believes it is appropriate to adopt
the proposed customer margin rule for CDS transactions during a limited
pilot period for the reasons described below; however, FINRA represents
that it will consider proposals it receives from other CDS central
clearing counterparties to amend its customer margin rules for CDS and,
if appropriate, will propose changes to its customer margin rules for
CDS.\11\
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\9\ The methodology CME proposed was amended based on FINRA's
analysis. FINRA's proposed rule sets forth additional requirements.
See Proposed FINRA Rule 4240(c)(1).
\10\ See Proposed FINRA Rule 4240(c)(2).
\11\ Based on communications on or about April 22, 2009 between
Bonnie Gauch of the Commission's Division of Trading and Markets and
Grace Vogel of FINRA.
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Accordingly, FINRA proposes to adopt Proposed FINRA Rule 4240,
which would impose margin rules for certain CDS transactions. The
Interim Pilot Program is intended to be coterminous with the
Commission's CDS Relief and would expire on September 25, 2009.
FINRA requests comment on the proposed rule during the period of
the Interim Pilot Program. Among other matters that commenters may wish
to address, FINRA is particularly interested in the following
questions:
1. Since historically CDS transactions have not been undertaken in
broker-dealers and therefore have not exposed broker-dealers to the
risks of such transactions, is the advent of broker-dealer
participation in these transactions, which entails greater individual
risks to broker-dealers but which fosters less systemic risk because of
the existence of a central clearing party for the matching transaction,
a correct balancing of risks as a matter of public policy?
2. Do commenters believe that different or amended margin
provisions would be superior to those set forth in the proposed rule?
(B). Proposal
(1) Scope of the Proposed Rule
Proposed FINRA Rule 4240(a) provides that the Interim Pilot Program
would apply to margin requirements for any transactions in CDS executed
by a member (regardless of the type of account in which the transaction
is booked), including those in which the matching transactions are
effected by the member in contracts that are cleared through the
central clearing counterparty clearing services of the CME. FINRA notes
that matching transactions that are cleared through the CME as the
central clearing counterparty would be subject to margin requirements
pursuant to CME rules (sometimes referred to in such rules as
``performance bond''). Accordingly, with respect to these matching
transactions, the proposed rule is intended to apply to the side of the
CDS transaction--executed between a member and a customer or other
broker-dealer \12\--that is not cleared through the CME.\13\
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\12\ NASD Rule 0120(g) states that the term ``customer'' shall
not include a broker or dealer. For purposes of the proposed rule,
the terms ``customer or broker-dealer'' and ``customer and broker-
dealer'' are intended to include any party with which a member
executes a CDS transaction.
\13\ Under Proposed FINRA Rule 4240(c)(1), such transactions are
defined as ``CME matching customer-side transactions.'' See Section
(B)(3) under this Item. Under Proposed FINRA Rule 4240(c)(1), the
term ``CME matching customer-side transaction'' would include any
party, including a broker-dealer.
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Proposed FINRA Rule 4240(a) would define the term ``CDS'' for
purposes of the rule. Specifically, CDS would include any ``eligible
credit default swap'' as defined in Securities Act Rule 239T(d),\14\ as
well as any other CDS that would otherwise meet such definition but for
being subject to individual negotiation.\15\ In addition, the proposed
rule provides that, for purposes of the rule, the term ``transaction''
includes any ongoing CDS position.
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\14\ 17 CFR 230.239T(d).
\15\ FINRA notes that Rule 239T(d) excludes contracts that are
``subject to individual negotiation.'' The proposed FINRA rule would
reach CDS contracts, subject to the other criteria set forth in Rule
239T(d), without regard to whether they are individually negotiated.
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Proposed FINRA Rule 4240(a) provides that the Interim Pilot Program
would automatically expire on September 25, 2009.
(2) Central Counterparty Clearing Arrangements
Proposed FINRA Rule 4240(b) would provide that any member, prior to
establishing any clearing arrangement with respect to CDS transactions
that makes use of any central counterparty clearing services provided
by any clearing agency, pursuant to Securities Act Rule 239T(a)(1),\16\
must notify FINRA in advance in writing, in such manner as may be
specified by FINRA in a Regulatory Notice.
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\16\ 17 CFR 230.239T(a)(1).
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(3) Margin Requirements: CDS Cleared on the CME
Proposed FINRA Rule 4240(c)(1) provides that a member, as a minimum
for computing customer or broker-dealer margin, with respect to any
customer or broker-dealer transaction in CDS with a member in which the
member executes a CME matching customer-side transaction, must require
the applicable margin pursuant to CME rules regardless of the type of
account in which the transaction in CDS is booked. The proposed rule
would require that members must, based on the risk monitoring
procedures and guidelines set forth in paragraph (d) of the proposed
rule,\17\ determine whether the applicable CME requirements are
adequate with respect to their customer and broker-dealer accounts and
the positions in those accounts and, where appropriate, increase such
margin in excess of the minimum margin. For this purpose, the proposed
rule would
[[Page 25590]]
permit members to use the margin requirements set forth in the proposed
rule's Supplementary Material.\18\
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\17\ See Proposed FINRA Rule 4240(d).
\18\ See Proposed FINRA Rule 4240.01.
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It is FINRA's understanding that, after calculating margin on an
account-specific basis, CME performs stress tests to assess
concentration risk across a member's customer and house portfolios.\19\
Further, CME may require that a member post additional margin based on
the results of those concentration risk stress tests. Accordingly,
Proposed FINRA Rule 4240(c)(1) would require that the aggregate amount
of margin the member collects from customers and broker-dealers for
transactions in CDS must equal or exceed the aggregate amount of margin
the member is required to post at CME with respect to those customer
and broker-dealer transactions.
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\19\ See Letter from Adam Cooper, Senior Managing Director and
General Counsel, Citadel Investment Group, L.L.C., and Ann K.
Shulman, Managing Director and Deputy General Counsel, Chicago
Merchantile Exchange Inc., to Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission, dated March 12, 2009 (available
at http://www.sec.gov/rules/exorders/2009/cme-citadel-exreq.pdf).
Letter from Lisa A. Dunsky, Director & Associate General Counsel,
CME Group, to David Stawick, Secretary, Commodity Futures Trading
Commission, dated December 19, 2008, (available at: http://www.cftc.gov).
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CME matching customer-side transactions, being subject to the
margin guidelines set forth in Proposed FINRA Rule 4240(c)(1), are not
subject to the margin guidelines as set forth in paragraph (c)(2) of
the proposed rule. However, members are encouraged to apply higher
margin requirements where appropriate.
(4) Margin Requirements: CDS That Are Cleared on Central Counterparty
Clearing Facilities Other Than the CME or That Settle Over-the-Counter
(``OTC'')
Proposed FINRA Rule 4240(c)(2) would provide that a member, with
respect to any transaction in CDS that makes use of central
counterparty clearing facilities other than the CME or that settle OTC,
must require the applicable minimum margin as set forth in the proposed
rule's Supplementary Material regardless of the type of account in
which the transaction in CDS is booked.\20\ However, the proposed rule
provides that a member must, based on the risk monitoring procedures
and guidelines set forth in paragraph (d) of the proposed rule,
determine whether such margin is adequate with respect to their
customer and broker-dealer accounts and, where appropriate, increase
the requirements.
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\20\ See Proposed FINRA Rule 4240.01.
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(5) Risk Monitoring Procedures and Guidelines
Proposed FINRA Rule 4240(d) provides that members must monitor the
risk of any customer or broker-dealer accounts with exposure to CDS and
must maintain a comprehensive written risk analysis methodology for
assessing the potential risk to the member's capital over a specified
range of possible market movements over a specified time period. The
proposed rule would require that members must employ the risk
monitoring procedures and guidelines set forth in Proposed FINRA Rule
4240(d)(1) through (8).\21\ Further, the rule would require the member
to review, in accordance with the member's written procedures, at
reasonable periodic intervals, the member's credit extension activities
for consistency with the risk monitoring procedures and guidelines set
forth in the rule, and to determine whether the data necessary to apply
the risk monitoring procedures and guidelines is accessible on a timely
basis and information systems are available to adequately capture,
monitor, analyze and report relevant data (i.e., the data relevant for
purposes of the risk monitoring procedures and guidelines set forth in
Proposed FINRA Rule 4240(d)(1) through (8)).
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\21\ See Proposed FINRA Rule 4240(d)(1) through (8).
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(6) Concentrations
Proposed FINRA Rule 4240(e) would require that, where the maximum
current and potential exposure with respect to the largest single name
CDS across all accounts exceeds the member's tentative net capital, the
member must take a capital charge equal to the aggregate margin
requirement for such accounts on the positions in such single name CDS
in accordance with the tables set forth in the proposed rule's
Supplementary Material.\22\ This additional requirement for
concentrated positions reflects FINRA's concern for the possibility of
a sudden default in the largest single name CDS across all accounts in
respect of which a member has current or potential exposure. However,
the proposed rule would allow a member to reduce this capital charge by
the amount of the excess margin held in all customer and broker-dealer
accounts.
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\22\ See Proposed FINRA Rule 4240.01.
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(7) Proposed FINRA Rule 4240.01
Proposed FINRA Rule 4240.01, a Supplementary Material, sets forth
the customer and broker-dealer margin requirements that would apply
with respect to CDS, as appropriate, pursuant to paragraph (c) of the
proposed rule. The proposed rule addresses customer and broker-dealer
accounts that are short a CDS, accounts that are long a CDS and
accounts that maintain both long and short CDS. Paragraph (c) of the
Supplementary Material provides, with respect to accounts that maintain
both long and short CDS, that if a customer or broker-dealer is long
the bond and long a CDS contract on the same underlying obligor, margin
would need to be collected only on the long bond position, provided
that bond can be delivered against the long CDS contract, as prescribed
pursuant to applicable FINRA margin rules.\23\ In instances where the
customer or broker-dealer is short the bond and short the CDS on the
same underlying obligor, margin need only be collected on the short
bond, again as prescribed pursuant to applicable FINRA margin
rules.\24\ FINRA notes that, for purposes of the proposed rule, the
term ``applicable FINRA margin rules'' refers to requirements pursuant
to NASD Rule 2520 or Incorporated NYSE Rule 431, as applicable to the
member.\25\ FINRA plans to address NASD Rule 2520 and Incorporated NYSE
Rule 431 later as part of FINRA's rulebook consolidation process, and,
accordingly, will amend Proposed FINRA Rule 4240.01(c) as appropriate
to refer to the new, consolidated FINRA margin rule.\26\
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\23\ As originally proposed, the rule change would have stated,
``If a customer or broker-dealer is long the bond and long a CDS
contract on the same underlying obligor, margin needs to be
collected only on the long bond position, provided that bond can be
delivered against the short CDS contract, as prescribed pursuant to
applicable FINRA margin rules.'' Amendment No. 1 corrected this
sentence by changing the word ``short'' directly preceding the
second ``CDS'' to ``long.''
\24\ As originally proposed, the rule change would have stated,
``In instances where the customer or broker-dealer is short the bond
and short the CDS, margin need only be collected on the short bond,
as prescribed pursuant to applicable FINRA margin rules.'' Amendment
No. 1 clarified this sentence by adding the phrase ``on the same
underlying obligor'' directly following the word ``CDS.''
\25\ The current FINRA rulebook consists of: (1) FINRA Rules;
(2) NASD Rules; and (3) rules incorporated from NYSE (``Incorporated
NYSE Rules''). While the NASD Rules generally apply to all FINRA
members, the Incorporated NYSE Rules apply only to those members of
FINRA that are also members of the NYSE (``Dual Members''). The
FINRA Rules apply to all FINRA members, unless such rules have a
more limited application by their terms.
\26\ For more information about the rulebook consolidation
process, see FINRA Information Notice, March 12, 2008 (Rulebook
Consolidation Process).
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FINRA will announce the effective date of the proposed rule change
in a Regulatory Notice to be published no later than 60 days following
Commission approval, but FINRA does
[[Page 25591]]
intend to issue such Regulatory Notice as soon as practicable in the
event of SEC approval of the proposed rule change given the limited
time period of the proposed Interim Pilot Program.
2. Statutory Basis
FINRA believes that the proposed rule change is consistent with the
provisions of Section 15A(b)(6) of the Act,\27\ which requires, among
other things, that FINRA rules must be designed to prevent fraudulent
and manipulative acts and practices, to promote just and equitable
principles of trade, and, in general, to protect investors and the
public interest. FINRA believes that the proposed rule change would
further the purposes of the Act because, consistent with goals set
forth by the Commission when it provided the Commission's CDS Relief
with respect to the operation of central counterparties to clear and
settle CDS, the margin requirements set forth by the proposed rule
change will help to stabilize the financial markets.
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\27\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition
FINRA does not believe that the proposed rule change will result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
Written comments were neither solicited nor received.
III. Commission's Findings and Order Granting Accelerated Approval of a
Proposed Rule Change
Pursuant to Section 19(b)(2) of the Act,\28\ the Commission may not
approve any proposed rule change, or amendment thereto, prior to the
30th day after the date of publication of notice of the filing thereof,
unless the Commission finds good cause for so doing and publishes its
reasons for so finding. FINRA also has requested that the Commission
find good cause for approving the proposed rule change prior to the
30th day after publication in the Federal Register. For the Commission
to approve rule changes proposed by a registered securities association
(e.g., FINRA) the proposed rule changes must be consistent with the
requirements of the Exchange Act, including Section 15A(b)(6) of the
Act,\29\ and the rules and regulations thereunder. Section 15A(b)(6)
requires that the rules of a registered securities association be,
``designed to prevent fraudulent and manipulative acts and practices,
to promote just and equitable principles of trade, to foster
cooperation and coordination with persons engaged in regulating,
clearing, settling, processing information with respect to, and
facilitating transactions in securities, to remove impediments to and
perfect the mechanism of a free and open market and a national market
system, and, in general, to protect investors and the public interest;
and are not designed to permit unfair discrimination between customers,
issuers, brokers, or dealers, to fix minimum profits, to impose any
schedule or fix rates of commissions, allowances, discounts, or other
fees to be charged by its members, or to regulate by virtue of any
authority conferred by [Section 15A] matters not related to the
purposes of [Section 15A] or the administration of the association.''
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\28\ 15 U.S.C. 78s(b)(2).
\29\ 15 U.S.C. 78o-3(b)(6).
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The over-the-counter (``OTC'') market for CDS has been a source of
concerns to the Commission and other financial regulators.\30\ These
concerns include the systemic risk posed by CDS, highlighted by the
possible inability of parties to meet their obligations as
counterparties and the potential resulting adverse effects on other
markets and the financial system.\31\ Recent credit market events have
demonstrated the seriousness of these risks in a CDS market operating
without meaningful regulation, transparency,\32\ or central clearing
counterparties.\33\ These events have emphasized the need for central
clearing counterparties as mechanisms to help control such risks.\34\
Establishment of central clearing counterparties for CDS is expected to
reduce the counterparty risks inherent in the CDS market, and thereby
help mitigate potential systemic impacts. As we have stated
previously,\35\ given the continued uncertainty in this market, taking
action to help foster the prompt development of central clearing
counterparties is in the public interest.
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\30\ See Securities Exchange Act Releases Nos. 59164, p. 1 (Dec.
24, 2008), 74 FR 139 (Jan. 2, 2009), 59165, p. 1 (Dec. 24, 2008), 74
FR 133 (Jan. 2, 2009), 59527, p. 1 (Mar. 6, 2009), 74 FR 10791 (Mar.
12, 2009), 59578, p. 1 (Mar 13, 2009), 74 FR 11781, at 11782 (Mar.
19, 2009), and Securities Act Release No. 8999, p. 4 (Jan. 14,
2009), 74 FR 3967 (Jan. 22, 2009).
\31\ Id. In addition to the potential systemic risks that CDS
pose to financial stability, we are concerned about other potential
risks in this market, including operational risks, risks relating to
manipulation and fraud, and regulatory arbitrage risks.
\32\ See Policy Objectives for the OTC Derivatives Market, The
President's Working Group on Financial Markets, November 14, 2008,
available at http://www.ustreas.gov/press/releases/reports/
policyobjectives.pdf (``Public reporting of prices, trading volumes
and aggregate open interest should be required to increase market
transparency for participants and the public.'').
\33\ See The Role of Credit Derivatives in the U.S. Economy
Before the H. Agric. Comm., 110th Cong. (2008) (Statement of Erik
Sirri, Director of the Division of Trading and Markets, Commission).
\34\ See id.
\35\ See Securities Exchange Act Release Nos. 59164 (Dec. 24,
2008), 74 FR 139 (Jan. 2, 2009), 59527 (Mar. 6, 2009), 74 FR 10791
(Mar. 12, 2009), and 59578 (Mar. 13, 2009), 74 FR 11781 (Mar. 19,
2009).
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The Commission believes that using well-regulated central clearing
counterparties to clear transactions in CDS helps promote efficiency
and reduce risk in the CDS market and among its participants.\36\ These
benefits can be particularly significant in times of market stress, as
central clearing counterparties can mitigate the potential for a market
participant's failure to destabilize other market participants, and
reduce the effects of misinformation and rumors\.37\ Central clearing
counterparty-maintained records of CDS transactions may also aid the
Commission's efforts to prevent and detect fraud and other abusive
market practices.\38\
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\36\ See Securities Exchange Act Releases Nos. 59164, p. 4 (Dec.
24, 2008), 74 FR 139, at 140 (Jan. 2, 2009), 59527, p. 4 (Mar. 6,
2009), 74 FR 10791, at 10792 (Mar. 12, 2009), and 59578, p. 4 (Mar.
13, 2009), 74 FR 11781, at 11782 (Mar. 19, 2009).
\37\ Id.
\38\ Id.
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Well-regulated central clearing counterparties also are expected to
address concerns about counterparty risk by substituting the
creditworthiness and liquidity of the central clearing counterparties
for the creditworthiness and liquidity of the counterparties to a
CDS.\39\ In the absence of central clearing counterparties,
participants in the OTC CDS market must carefully manage their
counterparty risks because a default by a counterparty can render
worthless, and payment delay can reduce the usefulness of, the credit
protection that has been bought by a CDS purchaser.\40\ Firms that
trade CDS OTC attempt to manage counterparty risk by carefully
selecting and monitoring their counterparties, entering into legal
agreements that permit them to net gains and losses across contracts
with a defaulting counterparty, and often requiring counterparty
exposures to be collateralized.\41\ Central clearing
[[Page 25592]]
counterparties are expected to allow participants to avoid the risks
specific to individual counterparties because central clearing
counterparties generally ``novate'' bilateral trades by entering into
separate contractual arrangements with both counterparties--becoming
buyer to one and seller to the other.\42\ Through novation, it is the
central clearing counterparty that assumes the counterparty risks. For
this reason, central clearing counterparties for CDS are expected to
contribute generally to the goal of market stability.\43\ As part of
its risk management, a central clearing counterparty may subject
novated contracts to initial and variation margin requirements and
establish a clearing fund.\44\ A central clearing counterparty also may
implement a loss-sharing arrangement among its participants to respond
to a participant insolvency or default.\45\
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\39\ Id.
\40\ Id.
\41\ See generally R. Bliss and C. Papathanassiou, ``Derivatives
clearing, central counterparties and novation: The economic
implications,'' http://www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_final.pdf (Mar. 8, 2006), at 6. See also ``New
Developments in Clearing and Settlement Arrangements for OTC
Derivatives,'' Committee on Payment and Settlement Systems, BIS, at
25 (Mar. 2007), available at http://www.bis.org/pub/cpss77.pdf;
``Reducing Risks and Improving Oversight in the OTC Credit
Derivatives Market,'' Before the Sen. Subcomm. On Secs., Ins. and
Investments, 110th Cong. (2008) (Statement of Patrick Parkinson,
Deputy Director, Division of Research and Statistics, FRB).
\42\ See Securities Exchange Act Releases Nos. 59164, p. 4 (Dec.
24, 2008), 74 FR 139, at 140 (Jan. 2, 2009), 59527, p. 4 (Mar. 6,
2009), 74 FR 10791, at 10792 (Mar. 12, 2009), and 59578, p. 4 (Mar.
13, 2009), 74 FR 11781, at 11782 (Mar. 19, 2009). ``Novation'' is a
``process through which the original obligation between a buyer and
seller is discharged through the substitution of the central
clearing counterparty as seller to buyer and buyer to seller,
creating two new contracts.'' Committee on Payment and Settlement
Systems, Technical Committee of the International Organization of
Securities Commissioners, Recommendations for Central Counterparties
(November 2004) at 66.
\43\ See Securities Exchange Act Releases Nos. 59164, p. 5 (Dec.
24, 2008), 74 FR 139, at 140 (Jan. 2, 2009), 59527, p. 5 (Mar. 6,
2009), 74 FR 10791, at 10792 (Mar. 12, 2009), and 59578, p. 5 (Mar.
13, 2009), 74 FR 11781, at 11782 (Mar. 19, 2009).
\44\ Id.
\45\ Id.
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Central clearing counterparties also are expected to reduce CDS
risks through multilateral netting of trades.\46\ Trades cleared
through a central clearing counterparty would limit a participant's
exposure to an OTC market dealer, permitting the participant to accept
the best bid or offer in the OTC market regardless of the
creditworthiness of the dealer.\47\ In addition, by allowing netting of
positions in similar instruments, and netting of gains and losses
across different instruments, central clearing counterparties are
expected to reduce redundant notional exposures and promote the more
efficient use of resources for monitoring and managing CDS
positions.\48\ Through risk controls, including controls on market-wide
concentrations that cannot be implemented effectively when counterparty
risk management is decentralized, central clearing counterparties are
expected to help prevent a single market participant's failure from
destabilizing other market participants and, ultimately, the broader
financial system.\49\
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\46\ See Securities Exchange Act Releases Nos. 59164, p. 5 (Dec.
24, 2008), 74 FR 139, at 140 (Jan. 2, 2009), 59527, p. 5 (Mar. 6,
2009), 74 FR 10791, at 10792 (Mar. 12, 2009), and 59578, p. 5 (Mar.
13, 2009), 74 FR 11781, at 11782 (Mar. 19, 2009). See also, ``New
Developments in Clearing and Settlement Arrangements for OTC
Derivatives,'' supra note 11, at 25. Multilateral netting of trades
would permit multiple counterparties to offset their open
transaction exposure through the central clearing counterparty,
spreading credit risk across all participants in the clearing system
and more effectively diffusing the risk of a counterparty's default
than could be accomplished by bilateral netting alone.
\47\ Id.
\48\ Id.
\49\ Id.
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After careful consideration, the Commission finds that FINRA's
proposed rule change to establish a pilot program implementing minimum
customer margin requirements for transactions in CDS is consistent with
the requirements of the Exchange Act,\50\ including Section 15A(b)(6)
of the Act.\51\ In particular, the Commission finds that FINRA's
proposed rule is consistent with Section 15A(b)(6) of the Act \52\ in
that it is designed to perfect the mechanism of a free and open market
and to protect investors and the public interest. The Commission notes
that the proposed rule is intended to promote greater accuracy and
efficiency with respect to Exchange margin requirements. The proposed
rule is intended to align a customer's total margin requirement for CDS
positions with the actual risk associated with those positions taken as
a whole. FINRA's proposed rule also is consistent with 15A(b)(6) of the
Act \53\ because it is designed to limit the amount of leverage a
customer can obtain though CDS positions and decreases the risk that a
broker-dealer will fail because its customers are unable to fulfill
their obligations to the firm.
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\50\ In approving this proposed rule change, the Commission has
considered its impact on efficiency, competition, and capital
formation. See 15 U.S.C. 78c(f).
\51\ 15 U.S.C. 78o-3(b)(6).
\52\ Id.
\53\ Id.
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The Commission also finds that accelerated approval is appropriate.
More specifically, accelerated approval will allow the pilot program,
which will expire on September 25, 2009, to be in effect for a
sufficient period of time to permit FINRA to properly evaluate the
performance of the margin rule so that it can propose suitable
permanent margin rules for CDS. Further, accelerated approval is
appropriate because it will enable the CME to immediately begin
clearing customer, in addition to proprietary, CDS positions, and
therefore, enable market participants to receive more quickly the
benefits described above, such as increased market stability, arising
from the existence of a well-regulated central clearing counterparty.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Act. Comments may be submitted by any of
the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
Send an e-mail to [email protected]. Please include
File Number SR-FINRA-2009-012 on the subject line.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number SR-FINRA-2009-012. This
file number should be included on the subject line if e-mail is used.
To help the Commission process and review your comments more
efficiently, please use only one method. The Commission will post all
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). Copies of the submission, all subsequent amendments,
all written statements with respect to the proposed rule change that
are filed with the Commission, and all written communications relating
to the proposed rule change between the Commission and any person,
other than those that may be withheld from the public in accordance
with the provisions of 5 U.S.C. 552, will be available for inspection
and copying in the Commission's Public Reference Room, 100 F Street,
NE., Washington, DC 20549, on official business days between the hours
of 10 a.m. and 3 p.m. Copies of such filing also will be available for
inspection and copying at the principal office of FINRA. All comments
received will be posted
[[Page 25593]]
without change; the Commission does not edit personal identifying
information from submissions. You should submit only information that
you wish to make available publicly. All submissions should refer to
File Number SR-FINRA-2009-012 and should be submitted on or before June
18, 2009.
V. Conclusion
For the foregoing reasons, pursuant to Section 19(b)(2) of the
Act,\54\ the Commission finds good cause to approve the proposed rule
change on an accelerated basis.
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\54\ 15 U.S.C. 78s(b)(2).
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It is hereby ordered, pursuant to Section 19(b)(2) of the Act, that
the proposed rule change (SR-FINRA-2009-012) be, and it hereby is,
approved on an accelerated basis to establish an interim pilot program
expiring on September 25, 2009.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. E9-12342 Filed 5-27-09; 8:45 am]
BILLING CODE 8010-01-P