Publications

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Last November, shortly after the President's Working Group on Financial Markets declared that the implementation of central counterparty services for credit default swaps (CDS) was a top priority, the Board of Governors of the Federal Reserve System (the FRB), the Securities and Exchange Commission (the SEC) and the Commodity Futures Trading Commission (the CFTC) signed a Memorandum of Understanding and began working together and sharing information on issues related to clearing CDS and regulating central counterparties (CCPs) for that purpose.

As a result, working in close consultation with the FRB and the CFTC, as well as the Federal Reserve Bank of New York and the UK Financial Services Authority (the FSA), the SEC has issued the following series of temporary rules and exemptions to facilitate the operation of central counterparties and enable their participants to begin centralized clearing of CDS as soon as possible:

General Rules Exempting Eligible CDS

On January 14, 2009, the SEC adopted interim final temporary rules, effective until September 25, 2009, providing exemptions under the Securities Act of 1933, the Securities Exchange Act of 1934 and the Trust Indenture Act of 1939 for Eligible CDS (as defined below) to allow them to be cleared by one or more central counterparties.

Exemptions for Specific Central Counterparties

LCH.Clearnet

On December 23, 2008, the SEC granted temporary exemptions, effective until September 25, 2009, to LIFFE Administration and Management (LIFFE A&M) and LCH.Clearnet Ltd. to operate LCH.Clearnet as a central counterparty to clear Index CDS (as defined below).

ICE US Trust LLC

On March 6, 2009, the SEC approved temporary exemptions, effective until December 7, 2009, to allow the Intercontinental Exchange and The Clearing Corporation to operate ICE US Trust LLC as a central counterparty for clearing CDS.

Chicago Mercantile Exchange

On March 13, 2009, the SEC approved similar exemptions, effective until December 14, 2009, permitting the Chicago Mercantile Exchange Inc. (CME) to operate as a central counterparty for clearing CDS, using the CMDX trading and processing platform developed by a joint venture of the CME and Citadel Investment Group LLC.

Final Regulatory Hurdle to Launch

Obtaining an exemption from the SEC was the final regulatory approval that each of the CCPs needed before it could begin clearing CDS in the US. Each CCP is registered with and under the jurisdiction of one or more regulators other than the SEC: the FSA and the CFTC for LCH.Clearnet; the FRB and the New York State Banking Department for ICE Trust; and the CFTC and the FSA for CME. Although all three CCPs already had the requisite approval for clearing CDS from their primary regulators, they could not practically launch operations in the US and invite the participation of US entities without the SEC’s assurance that such activities would not violate US securities laws.

Early Results in the Race To Clear CDS

To date neither LCH.Clearnet nor the CME has cleared any CDS. ICE, however, began clearing CDS the first week after receiving its exemption from the SEC. ICE Trust reported that it cleared over 613 CDS transactions totaling $71 billion of notional value during its first four weeks of operation, resulting in $12.7 billion of open interest on April 6.

Summary of SEC Orders Granting Exemptions

The following summary of the four releases published in the Federal Register to announce the SEC actions listed above focuses on the principles, characteristics and analyses common to all three CCPs, including brief descriptions of:

• credit default swaps;
• how central counterparties would operate and the services they would provide;
• the conditions that the SEC imposed on the eligibility of CDS for clearing and the operation of the CCPs; and
• the status of CCPs and their participants under the US securities laws.

Following the summary of the common elements are more specific descriptions of each CCP, including details of its margining requirements and risk management procedures.

What Is a Credit Default Swap?

A credit default swap is a bilateral contract between two parties, known as counterparties. The value of this financial contract is based on underlying obligations (reference obligations) of a single entity (a reference entity), or on a particular security or other debt obligation (reference security), or an index of several such entities, securities or obligations (an Index CDS). The obligation of a seller to make payments under a CDS contract is triggered by a default of, or other credit event occurring to, such reference entity, security or index. Investors may use CDS for a variety of reasons, including to offset or insure against risk in their fixed-income portfolios, to take synthetic positions in bonds or in segments of the debt market as represented by an index, or to speculate on the volatility in credit spreads. CDS market volumes increased dramatically during the past several years as the types and number of entities participating in the CDS market multiplied.

Limits on SEC Authority over Swap Agreements

The SEC noted that its authority over “swap agreements” as defined in the Gramm-Leach-Bliley Act is limited by Section 2A of the Securities Act and Section 3A of the Exchange Act. Section 206A of the Gramm-Leach-Bliley Act defines a swap agreement as “any agreement, contract, or transaction between eligible contract participants (as defined in section 1a(12) of the Commodity Exchange Act) the material terms of which (other than price and quantity) are subject to individual negotiation.” For those CDS that are swap agreements, the exclusion from the definition of security in Section 2A of the Securities Act and Section 3A of the Exchange Act and related provisions will continue to apply, and therefore they are not affected by the SEC’s interim final temporary rules. For those CDS that are not swap agreements (non-excluded CDS), the SEC’s temporary rules provide certain conditional exemptions from the provisions of the Securities Act, the Exchange Act and the Trust Indenture Act and are designed to foster the development and operation of one or more exchanges and CCPs for trading and clearing CDS.

Eligibility of CDS for Exemptions

Interim final temporary Securities Act Rule 239T (Rule 239T) provides the eligibility criteria by which CDS would qualify for the exemption from the registration requirements of the Securities Act. Rule 239T specifies that an “Eligible CDS” must be a bilateral executory derivative contract, not subject to individual negotiation, in which a buyer makes payments to the seller and, in return, receives a payout if there is a default or other credit event involving the reference obligation or the reference entity within a certain time, and the agreement for which includes the:

1. Specification of the reference obligation or obligor; or, in the case of a reference group or index thereof, all of the reference obligations or obligors comprising any such group or index);
2. Term of the agreement;
3. Notional amount upon which payment obligations are calculated;
4. Credit-related events that trigger a settlement obligation; and
5. Obligations to be delivered if there is a credit-related event or, if it is a cash settlement, the obligations whose value is to be used to determine the amount of settlement obligation under the eligible credit default swap.

To complete its qualifications for the exemptions from registration, Rule 239T further requires that the Eligible CDS must be (i) be issued or cleared by a CCP satisfying the conditions set forth in the companion exemptions or registered as a clearing agency under Section 17A of the Exchange Act (a Registered or Exempt CCP) and (ii) offered and sold only to an “eligible contract participant” (as defined in Section 1a(12) of the Commodity Exchange Act, other than a person who is an eligible contract participant under Section 1a(12)(C) of such Act).

Eligibility Standards for Reference Securities

Rule 239T will permit the offer and sale of Eligible CDS that are or will be issued or cleared by a Registered or Exempt CCP without requiring compliance with Section 5 of the Securities Act, while assuring the availability of information to buyers and sellers of CDS due to certain information conditions in the companion exemptive orders and preserving anti-fraud liability under Section 17(a) of the Securities Act, which currently applies to securities-based swap agreements.

The SEC conditioned the exemptions from clearing registration upon representations in the exemptive requests that: (a) information is available about the terms of the CDS, the creditworthiness of the CCP or any guarantor and the clearing and settlement process for the CDS; and (b) the reference entity, the issuer of the reference security or the reference security is one of the following:

1. an entity (i) reporting under the Exchange Act, (ii) providing Securities Act Rule 144A(d)(4) information, or (iii) about which financial information is otherwise publicly available;
2. a foreign private issuer that has securities listed outside the United States and has its principal trading market outside the United States;
3. a foreign sovereign debt security;
4. an asset-backed security, as defined in Regulation AB, issued in a registered transaction with publicly available distribution reports;
5. an asset-backed security issued or guaranteed by Fannie Mae, Freddie Mac or the Government National Mortgage Association (Ginnie Mae); or
6. an index in which 80 percent or more of the index's weight is comprised of the reference entities or reference securities described in clauses (1) to (5) above (Index CDS).

Eligible Participants

The Securities Act exemption is intended to limit investor involvement in Eligible CDS issued or cleared by a Registered or Exempt CCP for eligible contract participants. As noted above, the term “eligible contract participant” is defined in Section 1a(12) of the Commodity Exchange Act and generally includes various regulated financial institutions, business enterprises that meet certain tests relating to total assets or net worth, certain pension funds, state and local governments and certain wealthy individuals.

How Central Counterparties Work

A central counterparty novates bilateral trades by entering into separate contractual arrangements with both counterparties, replacing the buyer to one and the seller to the other. CDS agreements typically have been negotiated and entered into bilaterally, but both parties may agree that either party may novate the agreement and substitute a third party to take responsibility for performance, by acting as the new counterparty, under the swap agreement. In a CCP arrangement, both parties entering into a CDS would novate their trades to the CCP, and the CCP would be substituted as the counterparty to all parties of the CDS it clears. Through this novation process, the counterparty risk of a CDS would be effectively concentrated in the CCP.

Risk Management and Margin Requirements

A CCP would reduce the systemic risk of CDS and the credit exposure of each CDS participant through multilateral netting of trades. By netting positions in similar instruments and netting gains and losses across different instruments, a CCP would reduce the notional and net exposure of each participant to the CCP and vice versa, thereby reducing the overall risk in the system. Through uniform margining and other risk controls, such as concentration or position limits, a CCP can provide the means of monitoring and managing CDS positions to reduce the destabilizing impact and the potential “domino effect” that the failure of one participant may have on other participants and conceivably the entire financial system.

Like most futures clearinghouses, a CCP may impose initial and variation margin requirements on the CDS it accepts for clearance and establish a clearing fund. The CCP may also protect against the insolvency or default of a participant by mutualizing the risk through a loss-sharing arrangement among its remaining participants. In addition to reducing the counterparty risks of CDS throughout global financial markets, CCPs are designed to promote operational efficiencies and transparency currently lacking in the over-the-counter market for CDS. The margin policies and procedures for each of the CCPs are described below under “Specific Central Counterparties.”

Information Dissemination and Other Conditions to Exemptions

In its petition to the SEC requesting an exemption for clearing CDS, each CCP undertook to collect and process information about CDS transactions and positions from all of its participants and, in particular, to calculate and disseminate current values for open positions to set appropriate margin levels. The SEC noted that the availability of such information concerning cleared CDS would improve the fairness, efficiency and competitiveness of the CDS market and would enable market participants to derive information about the underlying securities and indices.

As conditions to the exemptions granted to each CCP, the SEC also required each CCP to:

1. make available to the public on terms that are fair and reasonable and not unreasonably discriminatory (i) all end-of day settlement prices and any other prices for cleared CDS that the CCP may establish to calculate mark-to-market margin requirements for the CCP’s participants and (ii) any other pricing or valuation information in respect of the cleared CDS that is published or distributed by the CCP;
2. make its annual financial statements available on its website;
3. preserve records related to its CDS clearing services for at least five years and for the first two years in an easily accessible place;
4. supply information and periodic reports related to its CDS clearing services as may be requested by the SEC;
5. provide access to the SEC to conduct on-site inspections of all facilities, records and personnel related to the CDS clearing services, subject to coordination with the CCP’s primary regulator;
6. notify the SEC of any material disciplinary action, including without limitation involuntary termination, against its participants using the CDS clearing service;
7. notify the SEC of all changes to its rules and procedures related to clearing CDS and its risk management practices;
8. provide the SEC with reports prepared by independent auditors with respect to certain automated systems used in connection with the CDS clearing services and the CCP’s annual audited financial statements; and
9. notify the SEC of any suspension of service, security breach or systems outage.

How Temporary Rules and Exemptions Affect Securities Laws

To facilitate the operation of CCPs for the CDS market, the SEC issued the interim final temporary rules to exempt:

(i) a clearing agency, acting solely as a CCP for Eligible CDS transactions, from the requirement to register as a clearing agency under Section 17A of the Exchange Act;

(ii) certain eligible contract participants and others from certain Exchange Act requirements with respect to Eligible CDS;

(iii) any exchange that effects transactions in Eligible CDS from the requirements under Sections 5 and 6 of the Exchange Act to register as a national securities exchange; and

(iv) any broker or dealer that effects transactions on an exchange in Eligible CDS from the requirements of Section 5 of the Exchange Act.

Why Rules and Exemptions Are Temporary

The SEC determined that the interim final temporary rules and temporary exemptive orders would facilitate the operation of one or more CCPs that will clear and settle CDS transactions while facilitating the SEC’s oversight of the CDS market. The SEC anticipated that the operation of one or more CCPs in accordance with its exemptions would (i) improve the efficiency and effectiveness of the CDS market, (ii) provide for increased transparency of exposures to particular reference entities or reference securities and (iii) increase available information about reference entities or reference securities. In the exemptive orders, the SEC imposed conditions that would enable it to oversee the development of CDS CCPs and exchanges as they evolve and to take any additional action it deems necessary to promote the public interest and to protect investors. The rules and exemptions are temporary, to provide the SEC with a reasonable opportunity to review the CDS clearing operations after one or more CCPs and CDS exchanges are actively engaged, evaluate whether registrations or permanent exemptions should be granted in the future and consider the public comments solicited by its releases.

Specific Central Counterparties

LCH.Clearnet

LCH.Clearnet is a Recognised Clearing House under UK law, and LIFFE A&M, a subsidiary of NYSE Euronext, is a Recognised Investment Exchange. Both entities are therefore subject to regulatory supervision of the FSA. LCH.Clearnet has also been approved as a derivatives clearing organization by the CFTC.

LIFFE A&M developed a post-trade processing service for OTC derivatives, called Bclear, that can be used as a conduit for submitting completed transactions for Index CDS to LCH.Clearnet for centralized clearing. Bclear does not serve as a trade execution facility or a matching system, but only accepts and processes Index CDS transactions negotiated by counterparties on a bilateral basis. LIFFE A&M represented to the SEC that it would maintain and make available on its website: (i) contract specifications for each Index CDS that may be cleared through Bclear and (ii) a description of the Bclear processing and clearing services and rules for using such services.

Through Bclear, LCH.Clearnet would accept Index CDS transactions only from clearing members of LIFFE A&M and would serve as the CCP only to clearing firms, each acting as principal in an Index CDS transaction. LCH.Clearnet would have no contractual relationship with, or knowledge of, non-clearing members of LIFFE A&M or customers on whose behalf a transaction was executed.

Margin and Risk Management: LCH.Clearnet collects initial and variation margin for all positions, including Index CDS submitted through Bclear, in its members’ clearing accounts and revalues (mark to market) the margin positions of its members at least daily to account for changes or volatility in the market price of the underlying index and in the valuation of margin collateral. A default by a clearing member will be dealt with under the rules of LCH.Clearnet and, as the legal counterparty to each clearing member, LCH.Clearnet will bear the risk of any loss arising out of such default, drawing first from its mutualized default fund and then its capital and reserves pursuant to its prescribed procedures. To protect the credit of the CCP, LCH.Clearnet requires its members to (i) meet specific capital adequacy standards, (ii) provide audited annual financial statements and (iii) notify LCH.Clearnet upon the occurrence of events that could materially affect the capital or credit of the member.

ICE US Trust

ICE US Trust LLC is organized as a New York State trust company and is a member of the Federal Reserve System. Therefore it is subject to direct supervision by the New York State Banking Department (the NYSBD) and the FRB, specifically the Federal Reserve Bank of New York.

All trades submitted by ICE participants for clearing through ICE Trust will be recorded in the Deriv/SERV Trade Information Warehouse of The Depository Trust & Clearing Corporation (DTCC). Initially, ICE Trust will accept matched trades from DTCC that have been recorded in the Deriv/SERV Trade Information Warehouse on a weekly basis. Within two months of launch, ICE Trust intends to accept matched trades from DTCC on a daily basis.

ICE Trust rules provide that each bilateral CDS contract between two ICE Trust participants accepted by ICE Trust for clearing will be novated. Pursuant to such novation, the terms and conditions governing the bilateral CDS contract negotiated by the counterparties will be superseded by the provisions of the ICE Trust rules applicable to such CDS transaction.

Margin and Risk Management: ICE Trust will mitigate counterparty risk through its margin, guaranty fund and credit support framework under ICE Trust rules. ICE Trust has undertaken to maintain strict risk-based margin and guaranty fund requirements, subject to ongoing regulation and oversight by the FRB and the NYSBD. Pursuant to ICE Trust rules, each ICE Trust participant will be required to deposit: (1) initial margin, reflecting a risk-based calculation of potential loss on outstanding CDS positions in the event of a significant adverse market movement and (2) mark-to-market margin based upon marking to market outstanding positions at the end of each day. Initially, ICE Trust will accept only cash (in specified currencies) and G-7 government debt to satisfy initial margin requirements and only cash for mark-to-market margin.

ICE Trust will also maintain a guaranty fund to cover losses arising from a participant’s default on cleared CDS transactions that exceed the amount of margin collected from the defaulting participant. Each ICE Trust participant is required to contribute a minimum of $20 million to the guaranty fund when it joins ICE Trust and will be required to contribute additional amounts on an ongoing basis based on its CDS exposure. ICE Trust will monitor the adequacy of the guaranty fund daily and determine the need for additional contributions, at least monthly, so that the guaranty fund will grow in proportion to the position risk of the aggregate volume of CDS cleared by ICE Trust.

ICE Trust will also adopt rules that mutualize the risk of a default by one of its participants across all of its participants. In the event that an ICE Trust participant defaults, ICE Trust rules will ensure an orderly liquidation and unwinding of the open positions of such defaulting participant. As soon as it determines that a default has occurred, ICE Trust will be authorized to enter into replacement CDS transactions with other ICE Trust participants to mitigate the risk of the defaulting participant’s open positions.

ICE Trust has undertaken to calculate an end-of-day settlement price for each CDS cleared by ICE Trust based on prices submitted by ICE Trust participants. As part of this mark-to-market process, ICE Trust will periodically require its participants to execute certain CDS trades at the applicable end-of-day settlement price to help ensure that such prices submitted by each participant reflects its best assessment of the value of each of its open positions.

CME

Chicago Mercantile Exchange is a designated contract market for trading futures and options on futures contracts regulated by the CFTC. The CME operates its own clearing house as a division of CME which is regulated by the CFTC as a derivatives clearing organization. Therefore CME is required to comply with 18 CFTC core principles applicable to designated contract markets and 14 CFTC core principles applicable to derivatives clearing organizations. CME is also subject to regulation in the UK by the FSA as a Recognised Overseas Investment Exchange and a Recognised Overseas Clearing House.

As noted above, CME and Citadel Investment Group LLC formed a joint venture to develop the CMDX trading and processing platform for CDS. CMDX trading, booking and migration services will be available only to eligible contract participants. Each participant on the CMDX platform must be a clearing member of CME or have a clearing relationship with a CME clearing member.

CME would accept for clearing: (i) CDS trades that are matched on the CMDX platform, (ii) pre-existing non-standardized CDS trades that are submitted to clearing through the CMDX migration facility and (iii) new trades in standardized CDS products that are executed bilaterally and submitted to CME for clearing directly by the participants. Initially CMDX would offer standardized CDS that mirror the terms of existing over-the-counter CDS as closely as possible, but the coupons and maturities would be standardized to the extent necessary to permit centralized clearing. CME would accept the migration of non-standardized CDS trades only if both counterparties are CME clearing members or have a clearing relationship with a CME clearing member and they agree to convert the CDS to standardized terms that would permit clearing.

Risk Management: To clear CDS, CME would use its established systems, procedures and financial safeguards that operate its primary futures market, and such functions would be subject to CFTC oversight. CME has requirements for minimum capital contribution, contribution to the guaranty fund based on risk factors, maintenance margin and mark-to-market margining with immediate payment of losses applicable to clearing members. CME has adopted risk-based capital requirements, which are monitored by its audit department. CME would extend its current monitoring of customer accounts and positions to include CDS cleared by CME, which entails monitoring, investigating and reporting to CME management unusual trading patterns, significant losses due to market moves and significant changes in positions from day to day.

FINRA Pilot Program for Broker-Dealers Clearing CDS through CME

The Financial Industry Regulatory Authority (FINRA) filed with the SEC a proposed rule change, with a request for accelerated approval, to adopt FINRA Rule 4240 (Margin Requirements for Credit Default Swaps). The proposed rule would implement an interim pilot program to determine margin requirements for CDS transactions executed by broker-dealers who are FINRA members (regardless of the type of account in which the transaction is booked), including CDS transactions that are cleared through CME and other CCPs in which broker-dealers regulated by FINRA participate. Historically, US investment banks have not conducted CDS transactions through their broker-dealer affiliates. FINRA expects that the creation of CCPs for CDS will lead to an increase in the volume of CDS transactions executed through broker-dealers.

The FINRA proposal seeks comment on whether the drive to promote systemic stability by clearing CDS justifies the potential risk to the broker-dealer channel. The rule proposal also requires that a member firm notify FINRA before it begins to participate in trading and clearing CDS through a central counterparty. The proposed rule would expire on September 25, 2009, the same expiration date as the SEC’s interim final temporary rules for the establishment of CCPs for CDS.