[Federal Register Volume 78, Number 38 (Tuesday, February 26, 2013)]
[Notices]
[Pages 13130-13132]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-04357]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-68955; File No. SR-ICEEU-2012-11]


Self-Regulatory Organizations; ICE Clear Europe Limited; Order 
Approving Proposed Rule Change, as Modified by Amendment No. 1 Thereto, 
Relating to Enhanced Margin Methodology

February 20, 2013.

I. Introduction

    On December 28, 2012, ICE Clear Europe Limited (``ICE Clear 
Europe'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change SR-ICEEU-2012-11 pursuant to 
Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\ 
and Rule 19b-4 thereunder.\2\ The proposed rule change was published 
for comment in the Federal Register on January 8, 2013.\3\ On February 
14, 2013, ICE Clear Europe filed Amendment No. 1 to the proposed rule 
change.\4\ The Commission received one comment regarding this 
proposal.\5\ For the reasons discussed below, the Commission is 
granting approval of the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 68563 (January 2, 2013), 
78 FR 1281 (January 8, 2013).
    \4\ In Amendment No. 1, ICE Clear Europe clarified the 
description of the current and proposed approaches to its 
concentration charge calculations.
    \5\ See Comment from Mark Sokolow dated January 17, 2013, 
available at http://www.sec.gov/comments/sr-iceeu-2012-11/iceeu201211.shtml.
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II. Description

    ICE Clear Europe proposes to implement an enhanced margin 
methodology (``Decomp Model'') that addresses the risk of both index 
and single-name credit default swaps (``CDS'') cleared by ICE Clear 
Europe and permits appropriate portfolio margining between related 
index and single-name CDS positions. ICE Clear Europe believes that the 
Decomp Model will enhance its own risk management, as discussed below, 
and thereby facilitate the prompt and accurate settlement and risk 
management of swaps and contribute to the safeguarding of securities 
and funds associated with CDS transactions.
    A fundamental aspect of the Decomp Model is the recognition that 
index CDS instruments cleared by ICE Clear Europe are essentially a 
composition of specific single-name CDS. The Decomp Model includes the 
following enhancements to the ICE Clear Europe margin methodology 
(``Margin Methodology Enhancements'') for index CDS instruments (which 
are already in place for single-name CDS): Replacing standard deviation 
with mean absolute deviation (MAD) as a measure of credit spread 
variability, use of an auto regressive process to obtain multi-horizon 
risk measures, an increased number of spread response scenarios, and 
introduction of liquidity requirements. These enhancements and the 
enhancements referenced below have been reviewed and/or recommended by 
the ICE Clear Europe risk management personnel, risk and model review 
working groups and committees, the ICE Clear Europe Risk Committee and 
an independent third-party risk expert (Finance Concepts). 
Implementation of these enhancements to the ICE Clear Europe risk 
methodology will result specifically in a better measurement of the 
risk associated with clearing index CDS.
    As a result of the decomposition of the index CDS, ICE Clear Europe 
also will be able to (1) incorporate jump-to-default risk as a 
component of the risk margin associated with index CDS (which is 
already in place for single-name CDS) and (2) provide appropriate 
portfolio margin treatment between index CDS and offsetting single-name 
CDS positions. Incorporating jump-to-default risk as a component of the 
Decomp Model will result in a better measurement of the risk associated 
with clearing index CDS (as is already the case for single-name CDS). 
Recognizing the highly correlated relationship between long-short 
positions in index CDS and the underlying single-name CDS constituents 
of an index CDS will provide for fundamental and appropriate portfolio 
margin treatment.
    Upon approval of the Decomp Model, ICE Clear Europe would initially 
make appropriate portfolio margining available with respect to its 
Clearing Members' proprietary positions. ICE Clear Europe does not 
currently clear CDS positions of customers of its Clearing Members, but 
it plans to introduce customer clearing for CDS upon receipt of 
applicable regulatory approvals.\6\ The Commission has granted an 
exemptive order permitting ICE Clear Europe to commingle customer 
positions in index CDS and single-name CDS carried through FCM/BD 
Clearing Members in a single account; \7\ in addition, ICE Clear Europe 
has petitioned the Commodity Futures Trading Commission (``CFTC'') to 
permit such commingling.\8\ Following the commencement of customer 
clearing for CDS, and upon receipt of all necessary regulatory 
approvals, ICE Clear Europe would make appropriate portfolio margining 
available to commingled customer positions in index and single-name CDS 
using the Decomp Model. Accordingly, the Decomp Model is an important 
component of ICE Clear Europe's planned customer clearing offering.
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    \6\ The Commission recently approved proposed rule changes by 
ICE Clear Europe to implement customer clearing for CDS. See 
Securities Exchange Act Release No. 68812 (February 1, 2013), 78 FR 
9088 (February 7, 2013).
    \7\ See Securities Exchange Act Release No. 68433 (December 14, 
2012), 77 FR 75211 (December 19, 2012).
    \8\ See letter from Paul Swann, President & Chief Operating 
Officer, ICE Clear Europe to Mr. David Stawick, Secretary, CFTC, 
dated May 31, 2012, available at http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/icecleareurope4dfrequest.pdf.
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    ICE Clear Europe has stated that it does not believe that the 
expected phased implementation of the portfolio margining element of 
the proposed Decomp Model (commencing with proprietary positions) 
raises an issue of unfair discrimination. ICE Clear Europe believes the 
portfolio margining aspect of the Decomp Model does not unfairly 
discriminate with respect to similarly situated participants because it 
is available to any participant for whom ICE Clear Europe is currently 
able to provide portfolio margin treatment. Once ICE Clear Europe makes 
customer clearing available and obtains all necessary regulatory 
approvals, ICE Clear Europe will offer portfolio margining with respect 
to its Clearing Members' customer positions. ICE Clear

[[Page 13131]]

Europe believes the proposed rule amendments are therefore not designed 
to permit unfair discrimination among participants in the use of ICE 
Clear Europe's clearing services.
    In addition, as part of the implementation of the proposed Decomp 
Model, ICE Clear Europe proposes to (1) reduce the current level of 
risk mutualization among ICE Clear Europe's CDS Clearing Members 
through the default resources held in the mutualized CDS Guaranty Fund 
and significantly increase the level of resources held as initial 
margin for CDS Contracts (the ``Guaranty Fund/IM Modification''), (2) 
modify the initial margin risk model approach in a manner that will 
make it easier for market participants to measure their risks, by 
removing the conditional recovery rate stress scenarios and adding a 
new recovery rate sensitivity component (the ``IM Recovery Rate 
Modification''), (3) modify the concentration charge calculation by 
introducing the net notional amount (``NNA'') per single-name/index 
calculation and applying the more conservative concentration charge 
based on the 5-Year equivalent notional amount (``5Y ENA'') or NNA (the 
``IM Concentration Charge Modification''), (4) add a new basis risk 
component from single-name CDS positions that are offset by index-
derived single-name CDS positions (the ``IM Basis Risk Modification'') 
and (5) combine a single guaranty fund calculation for index CDS and 
single-name CDS positions (the ``Guaranty Fund Modification'').
    Currently, ICE Clear Europe maintains a high percentage of its 
default resources for CDS Contracts in the CDS Guaranty Fund, as 
compared to initial margin for CDS Contracts. This reflects the fact 
that the current CDS Guaranty Fund model is designed to cover the 
uncollateralized losses that would result from the three single names 
that would cause the greatest losses when entering a state of default. 
The Guaranty Fund/IM Modification incorporates into the initial margin 
risk model \9\ the single name that causes the greatest loss when 
entering a state of default (i.e., the single name that results in the 
greatest amount of loss when stress-tested to undergo a credit event). 
This change effectively collateralizes the loss that would occur from 
this single name upon default. Consequently, the amount of 
uncollateralized loss that would result from the three single names 
causing the greatest losses when entering a state of default is 
reduced, thereby reducing the amount of required contributions to the 
CDS Guaranty Fund.
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    \9\ The modification applies to the jump-to-default requirements 
component of IM.
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    ICE Clear Europe notes that the decrease in the CDS Guaranty Fund 
and the increase in initial margin requirements are not equivalent in 
terms of magnitudes. Instead, based on current portfolios, it is 
expected that for every $1 decrease in the CDS Guaranty Fund 
requirement there will be a corresponding increase of approximately $5 
in initial margin requirements.
    The IM Recovery Rate Modification modifies the initial margin risk 
model by removing the conditional recovery rate stress scenarios and 
adding a new recovery rate sensitivity component that is computed by 
considering changes in the recovery rate assumptions and their impact 
on the net asset value of the CDS portfolio. This modification will 
make it easier for market participants to replicate their initial 
margin requirements.
    The IM Concentration Charge Modification defines concentration 
charge thresholds in terms of NNA as well as 5Y ENA and takes the more 
conservative concentration requirement based on either notional amount. 
The current concentration charge approach only takes into account 5Y 
ENA. This modification captures the risk of large directional CDS 
positions that may not be captured by the calculation based on the 5Y 
ENA. For example, a set of large NNA positions, whose maturity date is 
close to the current date, may not be subject to concentration charges 
based on 5Y ENA if the estimated 5Y ENA is below the established 
threshold. The alternative NNA-based concentration charge computations 
may yield significant additional initial margin requirements as the NNA 
exceeds the established threshold.
    As index-derived single-name positions and outright single-name 
positions are offset, an additional basis risk requirement is 
introduced to account for the fact that the index instruments are more 
actively traded than single-name instruments and thus are the preferred 
instruments to express changing views about the credit market as a 
whole, or even about specific single-name components of the indices. 
The IM Basis Risk Modification captures the risk associated with 
differences between outright single-name CDS positions and index-
derived single-name CDS positions. In other words, a ``perfectly 
hedged'' portfolio consisting of an index CDS position and opposite 
index replicating single-name CDS positions will still attract an 
initial margin requirement due to the basis risk that exists.
    Currently, ICE Clear Europe estimates separate guaranty fund sizes 
for index CDS positions and single-name positions. The Guaranty Fund 
Modification takes into account the portfolio benefits between index 
and single-name positions, and incorporates the worst 2-member 
uncollateralized losses coming from the jump-to-default, spread 
response, basis and interest rate stress scenario considerations. As 
noted above, the Decomp Model also extends the jump-to-default 
calculation to index CDS as well as single-name CDS.

III. Comments

    The Commission received one comment on the proposed rule 
change.\10\ The commenter queried whether the Commission's exemptive 
order permitting ICE Clear Europe to commingle customer positions in 
index CDS and single-name CDS carried through FCM/BD Clearing Members 
in a single account is in compliance with generally accepted accounting 
principles and is in the best interest of customers.\11\ The commenter 
also queried whether customers are aware of the commingling and whether 
such commingling is industry standard.\12\ The comment is not directly 
applicable to the proposed rule change, which relates to ICE Clear 
Europe's implementation of an enhanced margin methodology designed to 
address the risk of clearing both index and single-name credit default 
swaps.\13\
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    \10\ See supra note 5.
    \11\ See supra note 7.
    \12\ Id.
    \13\ The Commission notes that such commingled positions would 
be held in a segregated account established and maintained in 
accordance with Section 4d(f) of the Commodity Exchange Act, and the 
CFTC has adopted rules requiring that cleared swaps customer 
collateral be held separately from the FCM's own property and be 
accounted for on a customer-by-customer basis (i.e., the collateral 
of one cleared swaps customer may not be used to satisfy the losses 
of the FCM or any other customer). See Protection of Cleared Swaps 
Customer Contracts and Collateral; Conforming Amendments to the 
Commodity Broker Bankruptcy Provisions, Final Rule, 77 FR 6336 
(February 7, 2012).
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IV. Discussion

    Section 19(b)(2)(C) of the Act \14\ directs the Commission to 
approve a proposed rule change of a self-regulatory organization if it 
finds that such proposed rule change is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to such organization. Section 17A(b)(3)(F) of the Act \15\ 
requires, among other things, that the rules of a clearing agency be 
designed to assure the safeguarding of securities and funds

[[Page 13132]]

which are in the custody or control of the clearing agency or for which 
it is responsible.
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    \14\ 15 U.S.C. 78s(b)(2)(C).
    \15\ 15 U.S.C. 78q-1(b)(3)(F).
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    The Decomp Model would implement a number of Margin Methodology 
Enhancements for index CDS instruments, as described above, which are 
already in place for single-name CDS. The decomposition of index CDS 
also would permit ICE Clear Europe to incorporate jump-to-default risk 
as a component of the risk margin associated with index CDS. The 
Commission believes that the Margin Methodology Enhancements and the 
incorporation of jump-to-default risk as a component of the index CDS 
margin methodology would result in better measurement of the risk 
associated with clearing index CDS.
    The proposed rule change also includes modifications to ICE Clear 
Europe's initial margin and CDS Guaranty Fund methodologies. The 
Guaranty Fund/IM Modification would incorporate into the initial margin 
risk model the single name that causes the greatest loss when entering 
a state of default, thus requiring Clearing Members to collateralize a 
greater portion of the loss resulting from their default. The IM 
Recovery Rate Modification would facilitate the ability of market 
participants to replicate their initial margin requirements and 
evaluate the risk of their CDS clearing portfolio. The IM Concentration 
Charge Modification would allow for a potentially more conservative 
concentration requirement for large directional CDS positions. The IM 
Basis Risk Modification would capture the risk associated with 
differences between outright single-name CDS positions and index-
derived single-name CDS positions, such that even ``perfectly hedged'' 
portfolios will still attract an initial margin requirement due to the 
basis risk that exists. Finally, the Guaranty Fund Modification would 
combine a single guaranty fund calculation for index CDS and single-
name CDS positions, which takes into account the portfolio benefits 
between index and single-name positions and incorporates the worst 2-
member uncollateralized losses coming from the jump-to-default, spread 
response, basis and interest rate stress scenario considerations. The 
Commission believes that these modifications, and the enhancements 
described above, would facilitate the safeguarding of securities and 
funds in the custody or control of ICE Clear Europe or for which it is 
responsible.
    After considering the proposed changes, including each of the 
representations made by ICE Clear Europe in the filing, the Commission 
believes that these changes are consistent with the requirements of 
Section 17A(b)(3)(F) of the Act,\16\ including ICE Clear Europe's 
obligation to ensure that its rules are designed to assure the 
safeguarding of securities and funds in the custody or control of the 
clearing agency or for which it is responsible.
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    \16\ 15 U.S.C. 78q-1(b)(3)(F).
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V. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of the Act and in 
particular with the requirements of Section 17A of the Act \17\ and the 
rules and regulations thereunder.
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    \17\ 15 U.S.C. 78q-1.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\18\ that the proposed rule change (File No. SR-ICEEU-2012-11), as 
modified by Amendment No. 1, be, and hereby is, approved.\19\
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    \18\ 15 U.S.C. 78s(b)(2).
    \19\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\20\
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    \20\ 17 CFR 200.30-3(a)(12).
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Kevin M. O'Neill,
Deputy Secretary.
[FR Doc. 2013-04357 Filed 2-25-13; 8:45 am]
BILLING CODE 8011-01-P