By Margaret Scullin
On December 2, 2013, the Commodity Futures Trading Commission (“CFTC”) published final regulations establishing additional standards for derivatives clearing organizations (“DCOs”). The primary purpose of these rules is to harmonize the CFTC’s core principles and rules governing DCOs with international standards. Specifically, the regulations were developed for consistency with the Principles for Financial Market Infrastructures (“PFMIs”) published by the Committee on Payment and Settlement Systems and the Board of the International Organization of Securities Commissions.
The PFMIs apply to all financial market infrastructures, including DCOs (also referred to as “central counterparties” or “CCPs”), which have been determined by a national authority to be systemically important. In addition to applying these new regulations to DCOs that the Financial Stability Oversight Counsel has designated as systemically important (“SIDCOs”), the CFTC will also allow DCOs that have not been designated as systemically important to elect to become subject to the CFTC regulations implementing the PFMIs. (DCOs that opt in to these regulations are called “Subpart C DCOs”, referring to the subpart of the regulations where the relevant provisions reside.)
Why would DCOs voluntarily subject themselves to additional regulation? The answer lies in the Capital Requirements for Bank Exposures to Central Counterparties published by the Basel Committee on Banking Supervision in 2012, which govern capital charges arising from bank exposures to CCPs related to derivatives. Banks’ capital charges will be significantly reduced for exposures arising from derivatives cleared through CCPs that are prudentially supervised in a jurisdiction that has adopted regulations consistent with the PFMIs (“qualifying CCPs”). Banks will face substantially higher capital charges for exposures arising from derivatives cleared through non-qualifying CCPs. Because of the incentives for banks to clear their derivatives through qualifying CCPs, non-qualifying CCPs may be at a competitive disadvantage. By electing to become Subpart C DCOs, otherwise non-qualifying CCPs are expected to be qualifying CCPs, similar to SIDCOs.
There will be costs associated with opting in, where applicable, and achieving and maintaining compliance with the CFTC’s additional standards. The Chicago Mercantile Exchange, Inc. (“CME”) and ICE Clear Credit LLC (“ICE”) have been designated as SIDCOs and therefore are automatically subject to these new rules. LCH.Clearnet LLC and LCH.Clearnet Ltd. are CFTC-registered DCOs that have not been designated as SIDCOs and therefore will have a choice as to whether to become Subpart C DCOs. Based on comments submitted on the proposed rule by LCH.Clearnet Group Limited (“LCH”), it appears that they intend to opt in to the regulations. LCH stated that it “strongly supported” the CFTC’s proposal to allow non-SIDCOs to become qualifying CCPs by complying with stricter standards. In fact, LCH proposed that the heightened standards should automatically apply to all currently registered DCOs instead of making compliance optional for non-SIDCOs.
The new and revised standards introduced by the CFTC for consistency with the PFMIs address: governance arrangements, financial resources, system safeguards, default rules and procedures for uncovered losses or shortfalls, risk management, additional disclosure requirements, efficiency, and recovery and wind-down procedures.
The enhanced financial resources requirements are likely to have the most direct and immediate impact on users of DCOs. Under previously adopted CFTC regulations, all DCOs are required to maintain, at minimum, financial resources in excess of the amount required to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions (“Cover One”). SIDCOs and Subpart C DCOs will be required to maintain financial resources sufficient to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the two clearing members creating the largest combined financial exposure for the DCO in extreme but plausible market conditions (“Cover Two”) if the SIDCO or Subpart C DCO is either systemically important in more than one jurisdiction or involved in activities with a more complex risk profile. The CFTC has defined “activity with a more complex risk profile” to include the clearing of credit default swaps, credit default futures, or derivatives referencing either of the foregoing, as well as any other activity designated by the CFTC as having a more complex risk profile. Both of the existing SIDCOs, CME and ICE, will be subject to a Cover Two requirement. The new regulations clarify that DCOs are prohibited from including assessments as a financial resource in meeting either the Cover One or Cover Two requirement. Therefore, guaranty fund contributions must be pre-funded in order to be included in the calculation of the DCO’s available financial resources.
All SIDCOs and Subpart C DCOs are required to maintain eligible liquidity resources sufficient to enable them to perform their settlement obligations under a wide range of stress scenarios, including the default of the clearing member creating the largest liquidity requirements under extreme but plausible circumstances. Such liquidity resources must be maintained in all relevant currencies in which the SIDCO or Subpart C DCO has settlement obligations to its members. Only a short list of defined “qualifying liquidity resources” will satisfy the minimum liquidity requirements (generally, cash and certain committed funding arrangements). Several commenters raised practical concerns about the eligibility requirements, particularly the requirement to maintain resources in all settlement currencies, the requirement that sovereign obligations, such as U.S. Treasuries, be subject to prearranged funding arrangements, and the disqualification of funding arrangements including material adverse change conditions. It was argued that the restriction on eligibility of U.S. Treasuries as resources would require clearing members to deposit more cash with the DCO and that bank-affiliated clearing members could be subject to higher capital charges as a result. Despite these comments, the CFTC adopted the regulations largely as proposed with only minor modifications to the language.
Most of the new regulations will become effective on December 31, 2013; some will be effective earlier. The CFTC determined to waive the effective date requirements prescribed by statute to facilitate attainment of qualifying CCP status by year end. In order for non-SIDCOs to obtain qualifying CCP status by December 31, 2013, their election forms must be received by the CFTC by December 13, 2013. The CFTC declined to phase in the implementation of these new standards, as recommended by several commenters, but will consider individual requests for extensions of up to one year to comply with certain of the regulations.