[Federal Register Volume 77, Number 213 (Friday, November 2, 2012)]
[Rules and Regulations]
[Pages 66220-66286]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-26407]
[[Page 66219]]
Vol. 77
Friday,
No. 213
November 2, 2012
Part II
Securities and Exchange Commission
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17 CFR Part 240
Clearing Agency Standards; Final Rule
Federal Register / Vol. 77 , No. 213 / Friday, November 2, 2012 /
Rules and Regulations
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-68080; File No. S7-08-11]
RIN 3235 AL13
Clearing Agency Standards
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``SEC'' or
``Commission'') is adopting a new rule in accordance with the
Securities Exchange Act of 1934 (``Exchange Act''), and the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 (``Dodd-Frank
Act''). The new rule establishes minimum requirements regarding how
registered clearing agencies must maintain effective risk management
procedures and controls as well as meet the statutory requirements
under the Exchange Act on an ongoing basis.
DATES: Effective Date: January 2, 2013.
FOR FURTHER INFORMATION CONTACT: Jeffrey Mooney, Assistant Director;
Katherine Martin, Senior Special Counsel; Doyle Horn, Special Counsel;
Stephanie Park, Special Counsel; or Justin Byrne, Attorney-Advisor;
Office of Clearance and Settlement, Division of Trading and Markets,
Securities and Exchange Commission, 100 F Street NE., Washington, DC
20549-7010 at (202) 551-5710.
SUPPLEMENTARY INFORMATION: The Commission is adopting rules for the
operation of a registered clearing agency that identify minimum
standards designed to enhance the regulatory framework for clearing
agency supervision.
Table of Contents
I. Background
A. Statutory Framework for the Regulation of Clearing Agencies
1. Introduction
2. Section 17A of the Exchange Act
3. The Dodd-Frank Act
a. Title VII of the Dodd-Frank Act
b. Title VIII of the Dodd-Frank Act
B. International Considerations
II. Overview of Proposal and General Comments Received on the
Proposing Release and Commission Response
A. Summary of the Clearing Agency Standards Proposing Release
B. General Comments Received on the Proposing Release and the
Commission Response
1. Timing of Implementation
2. Special Attention to Risk Management Standards
3. Coordinated U.S. Domestic and International Standards
4. Appropriate Distinctions Between Clearing Agencies
III. Description of Rule 17Ad-22
A. Overview and Scope
B. Definitions--Rule 17Ad-22(a)
C. Risk Management Requirements for Central Counterparties:
Rules 17Ad-22(b)(1)-(4)
1. Rule 17Ad-22(b)(1): Measurement and Management of Credit
Exposures
2. Rule 17Ad-22(b)(2): Margin Requirements
3. Rule 17Ad-22(b)(3): Financial Resources
4. Rule 17Ad-22(b)(4): Model Validation
D. Participant Access Standards for Central Counterparties:
Rules 17Ad-22(b)(5)-(7)
1. Rule 17Ad-22(b)(5): Non-Dealer Member Access
2. Rule 17Ad-22(b)(6): Portfolio Size and Transaction Volume
Thresholds Restrictions
3. Rule 17Ad-22(b)(7): Net Capital Restrictions
E. Record of Financial Resources and Annual Audited Financial
Statements: Rules 17Ad-22(c)(1)-(2)
1. Rule 17Ad-22(c)(1): Record of Financial Resources for Central
Counterparties
2. Rule 17Ad-22(c)(2): Clearing Agency Annual Audited Financial
Statements
F. Minimum Standards for Clearing Agencies: Rules 17Ad-22(d)(1)-
(15)
1. Rule 17Ad-22(d)(1): Transparent and Enforceable Rules and
Procedures
2. Rule 17Ad-22(d)(2): Participation Requirements
3. Rule 17Ad-22(d)(3): Custody of Assets and Investment Risk
4. Rule 17Ad-22(d)(4): Identification and Mitigation of
Operational Risk
5. Rule 17Ad-22(d)(5): Money Settlement Risks
6. Rule 17Ad-22(d)(6): Cost-Effectiveness
7. Rule 17Ad-22(d)(7): Links
8. Rule 17Ad-22(d)(8): Governance
9. Rule 17Ad-22(d)(9): Information on Services
10. Rule 17Ad-22(d)(10): Immobilization and Dematerialization of
Securities Certificates
11. Rule 17Ad-22(d)(11): Default Procedures
12. Rule 17Ad-22(d)(12): Timing of Settlement Finality
13. Rule 17Ad-22(d)(13): Delivery Versus Payment
14. Rule 17Ad-22(d)(14): Risk Controls To Address Participants'
Failure To Settle
15. Rule 17Ad-22(d)(15): Physical Delivery Risks
IV. Paperwork Reduction Act
A. Overview and Burden Estimate Comparison To Proposing Release
B. Summary of Collection of Information, Use of Information and
Comments Received
C. Total Initial and Annual Reporting and Recordkeeping Burdens
D. Collection of Information Is Mandatory
E. Confidentiality
V. Economic Analysis
A. Overview
B. Baseline
C. Consideration of Costs, Benefits, and the Effect on
Efficiency, Competition and Capital Formation
VI. Regulatory Flexibility Act Certification
VII. Statutory Authority and Text of Rule 17Ad-22
I. Background
A. Statutory Framework for the Regulation of Clearing Agencies
1. Introduction
Congress directed the Commission to facilitate the establishment of
a national system for the prompt and accurate clearance and settlement
of securities transactions when it added Section 17A to the Exchange
Act as part of the Securities Acts Amendments of 1975.\1\ The
Commission's ability to achieve this goal and its supervision of
securities clearance and settlement systems is based upon the
regulation of registered clearing agencies. Over the years, clearing
agencies registered with the Commission have become an essential part
of the infrastructure of the U.S. securities markets. Clearing agencies
help reduce the costs of securities trading and are required to be
carefully structured to manage and reduce counterparty risk.
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\1\ See 15 U.S.C. 78q-1 and S. Rep. No. 94-75, at 4 (1975) (the
Senate Committee on Banking, Housing and Urban Affairs urging that
``[t]he Committee believes the banking and security industries must
move quickly toward the establishment of a fully integrated national
system for the prompt and accurate processing and settlement of
securities transactions'').
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The Commission used this experience with regulating clearing
agencies to help address developments recently in the over-the-counter
(``OTC'') derivatives markets. In December 2008, the Commission acted
to facilitate the central clearing of credit default swaps (hereinafter
referred to as ``credit default swaps'' or ``CDS''), the largest
category of OTC security-based swaps, by permitting certain entities
that performed central counterparty (``CCP'') services to clear and
settle credit default swaps on a temporary, conditional basis.\2\
Consequently, some credit
[[Page 66221]]
default swaps transactions were centrally cleared prior to the
enactment of the Dodd-Frank Act.
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\2\ The Commission authorized five entities to clear credit
default swaps. See Exchange Act Release Nos. 60372 (July 23, 2009),
74 FR 37748 (July 29, 2009), 61973 (Apr. 23, 2010), 75 FR 22656
(Apr. 29, 2010) and 63389 (Nov. 29, 2010), 75 FR 75520 (Dec. 3,
2010) (CDS clearing by ICE Clear Europe Limited); 60373 (July 23,
2009), 74 FR 37740 (July 29, 2009), 61975 (Apr. 23, 2010), 75 FR
22641 (Apr. 29, 2010) and 63390 (Nov. 29, 2010), 75 FR 75518 (Dec.
3, 2010) (CDS clearing by Eurex Clearing AG); 59578 (Mar. 13, 2009),
74 FR 11781 (Mar. 19, 2009), 61164 (Dec. 14, 2009), 74 FR 67258
(Dec. 18, 2009), 61803 (Mar. 30, 2010), 75 FR 17181 (Apr. 5, 2010)
and 63388 (Nov. 29, 2010), 75 FR 75522 (Dec. 3, 2010) (CDS clearing
by Chicago Mercantile Exchange, Inc.); 59527 (Mar. 6, 2009), 74 FR
10791 (Mar. 12, 2009), 61119 (Dec. 4, 2009), 74 FR 65554 (Dec. 10,
2009), 61662 (Mar. 5, 2010), 75 FR 11589 (Mar. 11, 2010) and 63387
(Nov. 29, 2010), 75 FR 75502 (Dec. 3, 2010) (CDS clearing by ICE
Trust US LLC); 59164 (Dec. 24, 2008), 74 FR 139 (Jan. 2, 2009)
(temporary CDS clearing by LIFFE A&M and LCH.Clearnet Ltd.)
(collectively, ``CDS Clearing Exemption Orders''). LIFFE A&M and
LCH.Clearnet Ltd. allowed their order to lapse without seeking
renewal.
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2. Section 17A of the Exchange Act
Section 17A of the Exchange Act \3\ and Rule 17Ab2-1 \4\ require
entities to register with the Commission prior to performing the
functions of a clearing agency. Under the statute, the Commission is
not permitted to grant registration unless it determines that the rules
and operations of the clearing agency meet the standards set forth in
Section 17A.\5\ If the Commission registers a clearing agency, the
Commission oversees the clearing agency to facilitate compliance with
the Exchange Act using various tools that include, among other things,
the rule filing process for self-regulatory organizations (``SROs'')
and on-site examinations by Commission staff. Section 17A(d) also gives
the Commission authority to adopt rules for clearing agencies as
necessary or appropriate in the public interest, for the protection of
investors, or otherwise in furtherance of the purposes of the Exchange
Act and prohibits a registered clearing agency from engaging in any
activity in contravention of these rules and regulations.\6\ Pursuant
to Section 21(a) of the Exchange Act, the Commission can invoke its
enforcement powers to initiate and conduct investigations to determine
violations of the federal securities laws, including those specifically
applicable to clearing agencies.\7\ In so doing, the Commission may
institute civil actions seeking injunctive and other equitable remedies
and/or administrative proceedings to, among other things, suspend or
revoke registration, impose limitations upon a clearing agency's
activities, functions, or operations, or impose other sanctions.\8\
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\3\ See 15 U.S.C. 78q-1(b). See also Public Law 111-203 Sec.
763(b) (adding subparagraph (g) to Section 17 of the Exchange Act).
\4\ See 17 CFR 240.17Ab2-1.
\5\ Specifically, Sections 17A(b)(3)(A)-(I) identify
determinations that the Commission must make about the rules and
structure of a clearing agency prior to granting registration. See
15 U.S.C. 78q-1(b)(3)(A)-(I). The staff of the Commission provided
guidance on meeting the requirements of Section 17A in its
Announcement of Standards for the Registration of Clearing Agencies.
See Exchange Act Release No. 16900 (June 17, 1980), 45 FR 41920
(June 23, 1980).
\6\ See 15 U.S.C. 78q-1(d).
\7\ See 15 U.S.C. 78u.
\8\ See id.; see also 15 U.S.C. 78s(h).
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3. The Dodd-Frank Act
On July 21, 2010, President Barack Obama signed the Dodd-Frank Act
into law.\9\ The Dodd-Frank Act was enacted to, among other things,
promote the financial stability of the United States by improving
accountability and transparency in the financial system.\10\
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\9\ The Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010).
\10\ See id.
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a. Title VII of the Dodd-Frank Act
Title VII of the Dodd-Frank Act (``Title VII'') provides the
Commission and the Commodity Futures Trading Commission (``CFTC'') with
enhanced authority to regulate certain OTC derivatives in response to
the recent financial crisis.\11\ The Dodd-Frank Act is intended to
bolster the existing regulatory structure and provide regulatory tools
to oversee the OTC derivatives market, which has grown exponentially in
recent years and is capable of affecting significant sectors of the
U.S. economy. Title VII provides that the CFTC will regulate ``swaps,''
the Commission will regulate ``security-based swaps,'' and the CFTC and
the Commission will jointly regulate ``mixed swaps.'' \12\
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\11\ See id. secs. 701-774.
\12\ Section 712(d) of the Dodd-Frank Act provides that the
Commission and the CFTC, in consultation with the Board of Governors
of the Federal Reserve System, shall further define the terms
``swap,'' ``security-based swap,'' ``swap dealer,'' ``security-based
swap dealer,'' ``major swap participant,'' ``major security-based
swap participant,'' ``eligible contract participant'' and
``security-based swap agreement.'' The Commission and the CFTC
jointly adopted rules to further define the terms ``swap dealer,''
``security-based swap dealer,'' ``major swap participant,'' ``major
security-based swap participant'' and eligible contract
participant.'' Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant'',
Securities Exchange Act Release No. 34-66868 (Apr. 27, 2012).
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Title VII was designed to provide greater certainty that, wherever
possible and appropriate, swap and security-based swap contracts
formerly traded exclusively in the OTC market are centrally
cleared.\13\ The swap and security-based swap markets traditionally
have been characterized by privately negotiated transactions entered
into by two counterparties, in which each assumes the credit risk of
the other counterparty.\14\ Clearing of swaps and security-based swaps
was at the heart of Congressional reform of the derivatives markets in
Title VII.\15\ Clearing agencies are broadly defined under the Exchange
Act and undertake a variety of functions.\16\ One such function is to
act as a CCP, which is an entity that interposes itself between the
counterparties to a trade.\17\ For example, when a security-based swap
contract between two counterparties that are members of a CCP is
executed and submitted for clearing, it is typically replaced by two
new contracts--separate contracts between the CCP and each of the two
original counterparties. At that point, the original parties to the
transaction are no longer counterparties to each other. Instead, each
acquires the CCP as its counterparty, and the CCP assumes the
counterparty credit risk of each of the original counterparties that
are members of the CCP.\18\ Structured and operated appropriately, CCPs
may improve the management of counterparty risk and may provide
additional benefits such as multilateral netting of trades.\19\ The
Dodd-Frank Act
[[Page 66222]]
amended the Exchange Act to require, among other things, that
transactions in security-based swaps must be cleared through a clearing
agency if they are of a type that the Commission determines must be
cleared, unless an exemption from mandatory clearing applies.\20\ Title
VII of the Dodd-Frank Act also added new provisions to the Exchange Act
that require entities that act as a clearing agency with respect to
security-based swaps (``security-based swap clearing agencies'') to
register with the Commission \21\ and require the Commission to adopt
rules with respect to security-based swap clearing agencies.\22\
Compliance with any such rules is a prerequisite to the registration of
a clearing agency with the Commission and is also a condition to the
maintenance of its continued registration.\23\ Finally, Title VII
provided that some of the entities that the Commission permitted to
clear and settle credit default swaps on a temporary, conditional basis
prior to the July 21, 2010, enactment of the Dodd-Frank Act were deemed
to be registered clearing agencies (the ``Deemed Registered
Provision'').\24\
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\13\ See, e.g., Report of the Senate Committee, supra note 11,
at 34 (stating that ``[s]ome parts of the OTC market may not be
suitable for clearing and exchange trading due to individual
business needs of certain users. Those users should retain the
ability to engage in customized, uncleared contracts while bringing
in as much of the OTC market under the centrally cleared and
exchange-traded framework as possible.'').
\14\ See, e.g., Financial Stability Board, Implementing OTC
Derivatives Market Reforms (Oct. 25, 2010), available at http://www.financialstabilityboard.org/publications/r_101025.pdf.
\15\ As previously noted, the Dodd-Frank Act seeks to ensure
that, wherever possible and appropriate, derivatives contracts
formerly traded exclusively in the OTC market be cleared. See supra
note 11.
\16\ Section 3(a)(23)(A) of the Exchange Act defines the term
``clearing agency'' to mean any person who acts as an intermediary
in making payments or deliveries or both in connection with
transactions in securities or who provides facilities for the
comparison of data regarding the terms of settlement of securities
transactions to reduce the number of settlements of securities
transactions or the allocation of securities settlement
responsibilities. Such term also means any person, such as a
securities depository, who (i) acts as a custodian of securities in
connection with a system for the central handling of securities
whereby all securities of a particular class or series of any issuer
deposited within the system are treated as fungible and may be
transferred, loaned or pledged by bookkeeping entry without physical
delivery of securities certificates, or (ii) otherwise permits or
facilitates the settlement of securities transactions or the
hypothecation or lending of securities without physical delivery of
securities certificates. 15 U.S.C. 78c(a)(23)(A).
\17\ See id. An entity that acts as a CCP for securities
transactions is a clearing agency as defined in the Exchange Act and
is required to register with the Commission.
\18\ See Cecchetti, Gyntelberg and Hollanders, Central
Counterparties for Over-the-Counter Derivatives, Bank for
International Settlement Quarterly Review (Sept. 2009), available at
http://www.bis.org/publ/qtrpdf/r_qt0909f.pdf.
\19\ See id. at 46; see also Bank for International Settlements'
Committee on Payment and Settlement Systems and Technical Committee
of the International Organization of Securities Commissions,
Guidance on the Application of the 2004 CPSS-IOSCO Recommendations
for Central Counterparties to OTC Derivatives CCPs: Consultative
Report (May 2010), available at http://www.bis.org/publ/cpss89.pdf.
\20\ See 15 U.S.C. 78c-3; Exchange Act Release No. 34-63557
(Dec. 15, 2010), 75 FR 82490 (Dec. 30, 2010); Exchange Act Release
No. 34-67286 (June 28, 2012); 34-63556 (Dec. 15, 2010), 75 FR 79992
(Dec. 21, 2010).
\21\ 15 U.S.C. 78q-1(g) (adding subparagraph (g) to Section 17A
of the Exchange Act). Pursuant to Section 774 of the Dodd-Frank Act,
the requirement in Section 17A(g) of the Exchange Act for security-
based swap clearing agencies to be registered with the Commission
took effect on July 16, 2011.
\22\ 15 U.S.C. 78q-1(i) and (j). Public Law 111-203 sec. 763(b)
(adding subparagraphs (i) and (j) to Section 17A of the Exchange
Act).
\23\ Under the Exchange Act, a clearing agency can be registered
with the Commission only if the Commission makes a determination
that the clearing agency satisfies the requirements set forth in
paragraphs (A) through (I) of Section 17A(b)(3) of the Exchange Act.
15 U.S.C. 78q-1(b)(3).
\24\ See 15 U.S.C. 78q-1(l). The Deemed Registered Provision
applies to certain depository institutions that cleared swaps as
multilateral clearing organizations and certain derivatives clearing
organizations (``DCOs'') that cleared swaps pursuant to an exemption
from registration as a clearing agency. As a result, ICE Clear
Credit LLC, ICE Clear Europe Limited and the Chicago Mercantile
Exchange, Inc. were deemed registered clearing agencies with the
Commission on July 16, 2011, solely for the purpose of clearing
security-based swaps. Under this Deemed Registered Provision, an
eligible clearing agency is deemed registered for the purpose of
clearing security-based swaps and is therefore required to comply
with all requirements of the Exchange Act, and the rules thereunder,
applicable to registered clearing agencies, including, for example,
the obligation to file proposed rule changes under Section 19(b) of
the Exchange Act.
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b. Title VIII of the Dodd-Frank Act
In addition to the provisions from Title VII that expand the
Commission's authority under the Exchange Act to include activities
related to security-based swaps, Title VIII of the Dodd-Frank Act,
entitled the Payment, Clearing, and Settlement Supervision Act of 2010
(``Clearing Supervision Act''), establishes an enhanced supervisory and
risk control system for systemically important clearing agencies and
other financial market utilities (``FMUs'').\25\ In part, the Clearing
Supervision Act provides that the Commission, considering relevant
international standards and existing prudential requirements, may
prescribe regulations that contain risk management standards for the
operations related to payment, clearing, and settlement activities
(``PCS Activities'') \26\ of a Designated Clearing Entity or the
conduct of designated activities by a Financial Institution.\27\ In
prescribing such standards, the Commission must consult the Board of
Governors of the Federal Reserve System (``Federal Reserve'' or ``the
Board'') and the Financial Stability Oversight Council (``Council'').
On July 11, 2011, the Council published a final rule concerning its
authority to designate FMUs as systemically important,\28\ and on July
18, 2012, the Council designated The Depository Trust Company
(``DTC''), Fixed Income Clearing Corporation (``FICC''), National
Securities Clearing Corporation (``NSCC'') and The Options Clearing
Corporation (``OCC'') as systemically important.\29\
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\25\ See infra note 29. Under Section 803 of the Clearing
Supervision Act, clearing agencies may be FMUs. Therefore, the
Commission may be the Supervisory Agency of a clearing agency that
is designated as systemically important (``Designated Clearing
Entity'') by the Financial Stability Oversight Council
(``Council''). See 12 U.S.C. 5463. The definition of ``FMU,'' which
is contained in Section 803(6) of the Clearing Supervision Act,
contains a number of exclusions including, but not limited to,
designated contract markets, registered futures associations, swap
data repositories, swap execution facilities, national securities
exchanges, national securities associations, alternative trading
systems, security-based swap data repositories, security-based swap
execution facilities, brokers, dealers, transfer agents, investment
companies and futures commission merchants. 12 U.S.C. 5462(6)(B).
The designation of systemic importance hinges on a determination by
the Council that the failure of, or a disruption to, the functioning
of the FMU could create, or increase, the risk of significant
liquidity or credit problems spreading among financial institutions
or markets and thereby threaten the stability of the financial
system of the United States. See 12 U.S.C. 5463(a)(2)(A)-(E). The
designation of an FMU is significant, in part, because it will
subject such designated entity to heightened oversight consistent
with the terms of the Clearing Supervision Act. For example, the
Clearing Supervision Act requires the Supervisory Agency to examine
at least once annually any FMU that the Council has designated as
systemically important. The Commission intends to conduct such
annual statutory cycle examinations on the Commission's fiscal year
basis. The Commission staff anticipates conducting the first annual
statutory cycle examination of any designated FMU for which it is
the Supervisory Agency in the annual cycle following such
designation.
\26\ Certain post-trade processing activities that are not
captured by the Clearing Supervision Act may nevertheless be subject
to regulation by the Commission under the Exchange Act. See infra
note 100 and accompanying text.
\27\ See Section 805(a)(2) of the Clearing Supervision Act.
Those regulations may govern ``(A) the operations related to
payment, clearing, and settlement activities of such designated
clearing entities; and (B) the conduct of designated activities by
such financial institutions.'' 12 U.S.C. 5464(a)(2). PCS Activities
are defined in Section 803(7) of the Clearing Supervision Act. 12
U.S.C 5462(7).
The definition of ``financial institution,'' which is contained
in Section 803(5) of the Clearing Supervision Act, outlines numerous
exclusions but defines financial institution as a branch or agency
of a foreign bank, an organization operating under Section 25 or 25A
of the Federal Reserve Act, a credit union, a broker or dealer, an
investment company, an insurance company, an investment adviser, a
futures commission merchant, commodity trading advisor or commodity
pool operator and any company engaged in activities that are
financial in nature or incidental to a financial activity. 12 U.S.C.
5462(5)(A).
\28\ See 76 FR 44763 (July 27, 2011) (the Council also expects
to address the designation of payment, clearing, or settlement
activities as systemically important in a separate rulemaking).
\29\ See 12 U.S.C. 5321 (establishing the Council and
designating its voting and nonvoting members); see also 12 U.S.C.
5463 (designation of systemic importance). In accordance with
Section 804 of the Clearing Supervision Act, the Council has the
authority, on a non-delegable basis and by a vote of not fewer than
two-thirds of the members then serving, including the affirmative
vote of its chairperson, to designate those FMUs that the Council
determines are, or are likely to become, systemically important. The
Council may, using the same procedures, rescind such designation if
it determines that the FMU no longer meets the standards for
systemic importance. Before making either determination, the Council
is required to consult with the Board and the relevant Supervisory
Agency as determined in accordance with Section 803(8) of the
Clearing Supervision Act. Section 804 also sets forth procedures
that give entities 30 days advance notice and an opportunity for a
hearing prior to being designated as systemically important.
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B. International Considerations
Section 17A(i) of the Exchange Act provides that the Commission, in
establishing clearing agency standards and in its oversight of clearing
agencies, may conform such standards and such oversight to reflect
evolving international standards.\30\ Section 805(a) of the Clearing
Supervision Act directs the Commission to take into consideration
relevant international standards and existing prudential requirements
for clearing agencies that are designated as FMUs.\31\ The current
international standards most relevant to risk management of clearing
agencies
[[Page 66223]]
are the standards developed by the International Organization of
Securities Commissions (``IOSCO'') and the Committee on Payment and
Settlement Systems (``CPSS'') that are contained in the report entitled
Principles for Financial Market Infrastructures (``FMI Report'').\32\
The final FMI Report was published on April 16, 2012, and replaces CPSS
and IOSCO's previous standards applicable to clearing agencies that
were contained in the following reports: Recommendations for Securities
Settlement Systems (2001) (``RSSS'') and Recommendations for Central
Counterparties (2004) (``RCCP'') (collectively, ``CPSS-IOSCO
Recommendations'').\33\ These international standards were formulated
by securities regulators and central banks to promote sound risk-
management practices and encourage the safe design and operation of
entities that provide clearance and settlement services. The FMI Report
harmonizes and, where appropriate, strengthens the previous
international standards; it also incorporates additional guidance for
OTC derivatives CCPs.\34\
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\30\ 15 U.S.C. 78q-1(i).
\31\ 12 U.S.C. 5464(a)(1).
\32\ CPSS-IOSCO, Principles for Financial Market Infrastructures
(Apr. 2012), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf.
\33\ The complete RSSS and RCCP Reports are available on the Web
site of the Bank for International Settlements at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD123.pdf and http://www.iosco.org/library/pubdocs/pdf/IOSCPD176.pdf respectively.
The Board applies these standards in its supervisory process
and expects systemically important systems, as determined by the
Board and subject to its authority, to complete a self-assessment
against the standards set forth in the policy. See Policy on Payment
System Risk, 72 FR 2518 (Jan. 12, 2007).
\34\ See FMI Report, supra note 32.
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II. Overview of Proposal and General Comments Received on the Proposing
Release and Commission Response
A. Summary of the Clearing Agency Standards Proposing Release
On March 3, 2011, the Commission proposed for comment a series of
rules related to standards for the operation and governance of clearing
agencies (``Proposing Release'').\35\ The Proposing Release contained
the following proposals:
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\35\ See Exchange Act Release No. 34-64017 (Mar. 3, 2011), 76 FR
14472 (Mar. 16, 2011) (``Proposing Release''), available at http://www.sec.gov/rules/proposed/2011/34-64017fr.pdf.
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(1) Proposed Rule 17Ad-22, which would require certain minimum
standards for all clearing agencies registered with the Commission;
(2) Proposed Rule 17Aj-1, which would require dissemination of
pricing and valuation information by security-based swap CCPs;
(3) Proposed Rule 17Ad-23, which would require all clearing
agencies to have adequate safeguards and procedures to protect the
confidentiality of trading information of clearing agency participants;
(4) Proposed Rule 17Ad-24, which would exempt certain security-
based swap dealers and security-based swap execution facilities from
the definition of clearing agency;
(5) Proposed Rule 17Ab2-1, which would amend an existing Commission
rule concerning registration of clearing agencies to account for
security-based swap clearing agencies and to make other technical
changes;
(6) Proposed Rule 17Ad-25, which would require all clearing
agencies to have procedures that identify and address conflicts of
interest;
(7) Proposed Rule 17Ad-26, which would require clearing agencies to
set standards for all members of their boards of directors or
committees; and
(8) Proposed Rule 3Cj-1, which is modeled on Section 3C(j) of the
Exchange Act and would require all clearing agencies to designate a
chief compliance officer.
The Commission also noted in the Proposing Release that the
definition of clearing agency under Section 3(a)(23)(A) of Exchange Act
includes any person who:
Acts as an intermediary in making payments or deliveries
or both in connection with transactions in securities;
Provides facilities for the comparison of data regarding
the terms of settlement of securities transactions, to reduce the
number of settlements of securities transactions, or for the allocation
of securities settlement responsibilities;
Acts as a custodian of securities in connection with a
system for the central handling of securities whereby all securities of
a particular class or series of any issuer deposited within the system
are treated as fungible and may be transferred, loaned, or pledged by
bookkeeping entry, without physical delivery of securities certificates
(such as a securities depository); or
Otherwise permits or facilitates the settlement of
securities transactions or the hypothecation or lending of securities
without physical delivery of securities certificates (such as a
securities depository).\36\
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\36\ 15 U.S.C. 78c(a)(23)(A).
Based on the Exchange Act definition, the Commission stated its
preliminary view that certain post-trade processing services may fall
within the clearing agency definition and asked for comments regarding
the Commission's preliminary interpretation.
Since the publication of the Proposing Release, the Commission has
received 25 comment letters on the Proposing Release from a broad range
of market participants, and the Commission and staff also had
discussions with representatives of clearing agencies, trade
associations, public interest groups and other interested parties.\37\
The Commission has taken into consideration international initiatives
and consulted with other U.S. financial regulators as appropriate,
including the
[[Page 66224]]
CFTC and the Federal Reserve, to inform the Commission's final actions.
Commenters generally supported the goals of the proposal. As further
discussed below, however, several commenters recommended that the
proposal be amended or clarified in certain respects.
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\37\ The comment file is published on the Commission's Web site,
available at http://www.sec.gov/comments/s7-08-11/s70811.shtml. See
Letter from American Benefits Council, dated May 6, 2011 (``ABC
Letter''); letter from Chris Barnard, dated March 21, 2011
(``Barnard Letter''); letter from Dennis M. Kelleher, President &
CEO and Steven W. Hall, Securities Specialist, Better Markets, Inc.,
dated April 29, 2011 (``Better Markets Letter''); letter from Joanne
Medero, Richard Prager and Supurna VedBrat, BlackRock, dated April
29, 2011 (``BlackRock Letter''); letter from Craig S. Donohue, CME
Group, dated April 29, 2011 (``CME Letter''); letter from Glenn
Davis, Senior Research Associate, Council of Institutional
Investors, dated April 14, 2011 (``CII Letter''); letter from Ernst
& Young, dated April 29, 2011 (``ENY Letter''); letter from Mark
Beeston, Chief Executive Officer of Portfolio Risk Services,
ICAP[supreg], dated July 7, 2011 (``ICAP Letter''); letter from R.
Trabue Bland, Intercontinental Exchange, Inc., dated April 29, 2011
(``ICE Letter''); letter from Robert Pickel, Executive Vice
Chairman, International Swaps and Derivatives Association, dated
April 29, 2011 (``ISDA Letter''); letter from Ian Axe, CEO,
LCH.Clearnet Group Limited, dated April 28, 2010 (``LCH Letter'');
letter from Stuart J. Kaswell and Carlotta King, Managed Funds
Association, dated March 24, 2011 (``MFA (Kaswell/King) Letter'');
letter from Stuart J. Kaswell, Executive Vice President & Managing
Director, General Counsel, Managed Funds Association, dated April
29, 2011 (``MFA (Kaswell) Letter''); letter from Kevin Gould,
President, MarkitTM, dated April 29, 2011
(``MarkitTM (April) Letter''); letter from Kevin Gould,
President, MarkitTM, dated July 26, 2011
(``MarkitTM (July) Letter''); letter from Jeff Gooch,
CEO, MarkitSERVTM, dated April 29, 2011
(``MarkitSERVTM (April) Letter''); letter from Jeff
Gooch, CEO, MarkitSERVTM, dated July 18, 2011
(``MarkitSERVTM (July) Letter''); letter from Norman
Reed, General Counsel, Omgeo, dated May 5, 2011 (``Omgeo Letter'');
letter from Larry E. Thompson, General Counsel, The Depository Trust
& Clearing Corporation, dated April 29, 2011 (``The DTCC (April)
Letter''); letter from Larry E. Thompson, General Counsel, The
Depository Trust & Clearing Corporation, dated July 21, 2011 (``The
DTCC (July) Letter''); letter from William H. Navin, Executive Vice
President, General Counsel and Secretary, The Options Clearing
Corporation, dated April 29, 2011 (``The OCC Letter''); letter from
James Cawley, Co-Founder, Swaps and Derivatives Market Association,
dated June 3, 2011 (``SDMA (June) Letter''); letter from Christoffer
Mohammar, General Counsel, TriOptima Group, dated April 29, 2011
(``TriOptima Letter''); letter from Richard H. Baker, President &
Chief Executive Officer, Managed Funds Association, dated March 24,
2011 (``MFA (Baker) Letter''); letter from James Cawley, Co-Founder,
Swaps and Derivatives Market Association, dated April 19, 2011
(``SDMA (April) Letter'').
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After careful review and consideration of the comments, the
Commission is today adopting Rule 17Ad-22, with certain modifications
discussed below, to address comments received. As adopted, Rule 17Ad-22
is meant to establish minimum requirements for registered clearing
agency risk management practices and operations with due consideration
given to equivalent standards of other regulators in the United States
\38\ and to international standards, as discussed above in Section I.B.
We expect to address separately the other proposed rules and matters
contained in the Proposing Release as explained in more detail in
Section II.B below.
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\38\ See Derivatives Clearing Organization General Provisions
and Core Principles 76 FR 69334 (Nov. 8, 2011) (CFTC adopting final
regulations to implement certain provisions of Title VII and Title
VIII of the Dodd-Frank Act governing DCO activities) (``DCO
Release''); Financial Market Utilities 76 FR 18445 (Apr. 4, 2011)
(notice of proposed rulemaking to promulgate risk-management
standards governing the operations related to the payment, clearance
and settlement activities of certain financial market utilities that
are designated systemically important by the Council).
---------------------------------------------------------------------------
B. General Comments Received on the Proposing Release and the
Commission Response
The Proposing Release was published in the Federal Register on
March 16, 2011, and the comment period closed on April 29, 2011.\39\
The Proposing Release contained proposed rules that cover various
aspects of a clearing agency's operations and risk management that are
listed in full in Section II.A. In addition to specific comments
regarding the substance of the rules in the Proposing Release, a number
of the comments the Commission received concern the larger framework
for our rulemaking efforts involving clearing agencies and the manner
in which the rules may be implemented. These comments focus on issues
such as ensuring that: (1) Sufficient time be given to clearing
agencies to implement all new standards appropriately; (2) the
Commission's regulations relating to risk management standards in
particular be given careful consideration and recognize the complexity
of the issues involved; (3) the Commission's regulations are consistent
with those of other U.S. regulatory agencies and CPSS and IOSCO
initiatives; and (4) appropriate distinctions between clearing agencies
that provide CCP and central securities depository (``CSD'') services
from those that provide post-trade processing services are recognized
in the Commission's regulations.
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\39\ See supra note 35.
---------------------------------------------------------------------------
Set forth below is a description of the comments received by the
Commission that express concerns about the general approach to clearing
agency reform reflected in the Proposing Release. The Commission has
carefully considered these general comments that were provided
concerning the larger framework for our rule making efforts involving
clearing agencies.\40\ To address the concerns they raise, we have
determined to take the actions described below.
---------------------------------------------------------------------------
\40\ See supra note 9, at Preamble.
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1. Timing of Implementation
a. Comments Received
Three commenters asked for the implementation of the proposed rules
to be subject to appropriate phase-in periods.\41\ One commenter
suggested that the appropriate phases should be determined by the
Commission in consultation with the affected clearing agencies.\42\
Another commenter requested that if the rules are adopted as proposed
then they should not become effective for at least two years.\43\ Two
commenters stated that they believe that implementing all of the
proposed rules in the Proposing Release at the same time would require
extensive new policies and procedures, drafting, proposing and approval
of rules and rule changes, raising additional financial resources,
hiring and training of personnel, operational changes and many other
tasks that would require clearing agencies to simultaneously respond to
separate requirements promulgated under the Dodd-Frank Act.\44\
Accordingly, these commenters requested that the Commission provide
adequate time to implement necessary changes and expressed that phase-
in periods would be appropriate.
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\41\ See The DTCC (April) Letter at 5; The OCC Letter at 17; MFA
(Kaswell/King) Letter at 2.
\42\ See The DTCC (April) Letter at 5.
\43\ See The OCC Letter at 17 (adding that if the Commission
adopts a financial resources standard in Rule 17Ad-22(b)(3) to
require a security-based swaps clearing agency that performs CCP
services to have enough financial resources to be able to withstand
the default of its two largest participants in extreme but plausible
market conditions then that requirement should be subject to delayed
implementation of at least two years).
\44\ See id.; The DTCC (April) Letter at 6.
---------------------------------------------------------------------------
One commenter asked the Commission to publish any modifications it
may make to the proposed rules for an additional comment period.\45\
Others stressed that if the Commission makes significant changes to its
proposed rules, then the rules should be republished for further
comment.\46\
---------------------------------------------------------------------------
\45\ See The DTCC (April) Letter at 2.
\46\ See The OCC Letter at 17.
---------------------------------------------------------------------------
One commenter stated that clearing agency rules such as those
related to governance, conflicts of interest, registration, and
financial resources should be adopted early in the implementation of
rules for the security-based swap market.\47\ The commenter also stated
that barriers to effective ``buy-side'' participation in CCPs must be
eliminated early in the phase-in process to enable ``buy-side''
participants to clear voluntarily at the same time as dealers.\48\
---------------------------------------------------------------------------
\47\ See MFA (Kaswell/King) Letter at Annex A.
\48\ See id.
---------------------------------------------------------------------------
b. Commission Response
In light of the request by commenters for a phased approach to
implementation of the clearing agency standards set forth in the
Proposing Release,\49\ the Commission has decided to address the
standards in stages.
---------------------------------------------------------------------------
\49\ See supra notes 41-44 and accompanying text.
---------------------------------------------------------------------------
In the first stage, the Commission is adopting only Rule
17Ad-22. The compliance date for Rule 17Ad-22 will be sixty days from
publication in the Federal Register.
The second planned stage in the implementation of
standards for clearing agencies is the consideration by the Commission
of rules that correspond to proposed Rules 17Aj-1; 17Ad-23; 17Ad-24;
17Ab2-1 and 3Cj-1 as well as the clearing agency governance and
conflict of interest concerns that its previous proposal addressed
through its proposal of Rule 17Ad-25, Rule 17Ad-26 and Regulation
MC.\50\
---------------------------------------------------------------------------
\50\ Ownership Limitations and Governance Requirements for
Security-Based Swap Clearing Agencies, Security-Based Swap Execution
Facilities, and National Securities Exchanges with Respect to
Security-Based Swaps under Regulation MC, Exchange Act Release No.
344-63107 (Oct. 14, 2010), 75 FR 65882 (Oct. 26, 2010) (``Regulation
MC'').
---------------------------------------------------------------------------
The third planned stage is for the Commission to consider
rules tailored to clearing agencies that perform certain post-trade
processing services. The Commission sought comment concerning these
types of clearing agencies in the Proposing Release and preliminarily
intends to propose rules addressed to them as described in more detail
in Sections II.B.4 and III.A below. As appropriate, the Commission may
[[Page 66225]]
also propose rules that will incorporate principles set forth in the
FMI Report.
The Commission believes the phased approach to implementation
provides clearing agencies with the benefit of additional time with
respect to some of the requirements contemplated in the Proposing
Release, while putting into place minimum standards for operational and
risk management practices of registered clearing agencies. This
approach will allow the Commission to consider further the comments
received on the Proposing Release and evolution of clearance and
settlement activity in light of the requirements of Title VII and Title
VIII of the Dodd-Frank Act, including the implementation of the
mandatory clearing requirements with respect to security-based swaps
mandated by the Dodd-Frank Act. Because the Commission is adopting
17Ad-22 largely as proposed, the Commission is not republishing Rule
17Ad-22 for additional comments.
We believe that the implementation of these standards is an
important first step in crafting regulatory changes contemplated by
Title VII and Title VIII of the Dodd-Frank Act as intended by Congress.
The adoption of Rule 17Ad-22 will also allow the Commission to
coordinate its activities as the supervisory agency for clearing
agencies designated as systemically important financial market
utilities under Title VIII of the Dodd-Frank Act with the complementary
responsibilities of the Federal Reserve.\51\ In addition, the
Commission believes that the adoption of standards for registered
clearing agencies at this time will help facilitate the development of
the security-based swap market. Rule 17Ad-22 establishes minimum
standards for a wide range of issues, including governance, financial
resources and membership. For example, Rules 17Ad-22(b)(5), (6) and (7)
are designed to prohibit membership practices that may limit
competition among market participants. In particular, Rule 17Ad-
22(b)(6) is designed to facilitate correspondent clearing, which will
allow buy-side participants to obtain access to CCP services without
having to become direct members of a clearing agency.
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\51\ Section 805 of the Clearing Supervision Act provides that
(i) the Commission may prescribe standards for designated clearing
entities in consultation with the Council and the Board and (ii) the
Board may determine that the Commission's existing prudential
requirements with respect to designated clearing entities are
insufficient to prevent or mitigate significant credit, liquidity,
operational or other risks to the financial markets or the financial
stability of the United States.
---------------------------------------------------------------------------
2. Special Attention to Risk Management Standards
a. Comments Received
Generally, commenters supported the requirements of proposed Rules
17Ad-22(b)(1)-(4) that would govern the risk management standards and
practices of registered clearing agencies that perform CCP services or
CCPs.\52\ However, in several respects, commenters asked the Commission
to pay special attention to the technical nature of CCP risk management
practices that are addressed by these rules. The comments received by
the Commission span a range of views on these matters. But
thematically, many of them coalesce around a question of whether the
Commission should prescribe detailed specifications within these rules
to define compliance standards more clearly or take a less prescriptive
approach that affords clearing agencies greater discretion to
establish, implement, maintain and enforce policies and procedures
based on the facts and circumstances of the individual clearing agency.
---------------------------------------------------------------------------
\52\ See discussion infra Section III.C.
---------------------------------------------------------------------------
For instance, proposed Rule 17Ad-22(b)(1) would require a CCP to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to measure credit exposures to
participants at least once a day and limit exposures to potential
losses from defaults by its participants in normal market conditions so
that the operations of the clearing agency would not be disrupted and
non-defaulting participants would not be exposed to losses that they
cannot anticipate or control. Of those commenters who asked the
Commission to consider modifications to the proposed rule, two
suggested that public disclosure requirements should accompany any
choice made by a CCP to reduce margin requirements on the basis of an
inverse or offsetting correlation between participants' positions.\53\
Several others focused on what role the Commission should take in
defining ``normal market conditions'' for purposes of the rule \54\ as
well as how frequently a CCP should be required to measure its credit
exposures \55\ and whether such measurements should be required to
include the customers of participants.\56\
---------------------------------------------------------------------------
\53\ See ISDA Letter at 7; Better Markets Letter at 3-4.
\54\ See The OCC Letter at 7; Better Markets Letter at 3-4.
\55\ See LCH Letter at 2; Better Markets Letter at 5.
\56\ See LCH Letter at 2.
---------------------------------------------------------------------------
Proposed Rule 17Ad-22(b)(2) would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to use margin requirements to limit its credit
exposures to participants under normal market conditions and use risk-
based models \57\ to set margin requirements and review them at least
monthly. One commenter argued that CCPs should be required to make
their margin-setting methodology available to customers to help them
understand the responsibilities that are commensurate with CCP
participation.\58\ Another commenter suggested clearing agencies should
have discretion when complying with the rule to decide which aspects of
a margin methodology are appropriate for monthly review.\59\ Still
other commenters concentrated on the extent to which the Commission
should prescribe the parameters of a CCP's margin model, such as the
confidence level, amount of data used to inform the standard of
``normal market conditions,'' and the use of factors such as liquidity
and concentration.\60\
---------------------------------------------------------------------------
\57\ The term ``risk-based models'' is meant to encompass any
models, systems and associated parameters used by clearing agencies
to mitigate risks.
\58\ See MFA (Kaswell) Letter at 2.
\59\ See The OCC Letter at 7.
\60\ See, e.g., ISDA Letter at 7; Better Markets Letter at 3-4;
The OCC Letter at 7.
---------------------------------------------------------------------------
With respect to proposed Rule 17Ad-22(b)(3), commenters asked the
Commission to give further consideration to whether it is appropriate
to create different financial resources standards for a security-based
swap CCP. As proposed, the rule would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to maintain sufficient financial resources to
withstand, at a minimum, a default by the participant to which it has
the largest exposure in extreme but plausible market conditions,
provided that a security-based swap clearing agency would be required
to maintain sufficient financial resources to withstand, at a minimum,
a default by the two participants to which it has the largest exposures
in extreme but plausible market conditions. One commenter argued that
characteristics of the instruments traded in the security-based swap
market support differentiating the requirements of the rule \61\ while
other commenters advanced reasons for why it may be appropriate for the
rule to employ only a single standard.\62\ Commenters also highlighted
that it is important for the Commission to account for the
[[Page 66226]]
international standards in this area \63\ and they expressed
contrasting views about how standardized and prescriptive the
Commission should be in specifying the meaning of ``extreme but
plausible market conditions.'' \64\
---------------------------------------------------------------------------
\61\ See Better Markets Letter at 5.
\62\ See LCH Letter at 2; The OCC Letter at 8; The DTCC (April)
Letter at 12.
\63\ See The OCC Letter at 9; LCH Letter at 2-3.
\64\ See Better Markets Letter at 5-6; The DTCC (April) Letter
at 10; The OCC Letter at 10.
---------------------------------------------------------------------------
Similarly, some commenters asked the Commission to reconsider how
prescriptive it should be in its approach to the requirements of Rule
17Ad-22(b)(4).\65\ The proposed rule would require a CCP to establish,
implement, maintain and enforce policies and procedures reasonably
designed to provide for an annual model validation consisting of the
evaluation of the performance of the clearing agency's margin models
and the related parameters and assumptions associated with such models
by a qualified person who does not perform functions associated with
the clearing agency's margin models (except as part of the annual model
validation) and does not report to a person who performs those
functions. In this area, commenters expressed contrasting views about
the appropriate level of detail that should be embedded within the rule
to guide clearing agency practices. The comments addressed matters
including how frequently a model validation should be performed \66\
and, when a model validation is performed, how a CCP should be required
to ensure that the process represents a candid, independent and
objective assessment.\67\
---------------------------------------------------------------------------
\65\ See, e.g., The DTCC (April) Letter at 13; The OCC Letter at
11; Better Markets Letter at 6.
\66\ See The DTCC (April) Letter at 13; Better Markets Letter at
6.
\67\ See The DTCC (April) Letter at 13-15; The OCC Letter at 11;
Better Markets Letter at 6.
---------------------------------------------------------------------------
A more complete discussion of these comments and others that
pertain to Rules 17Ad-22(b)(1)-(4) is contained in Section III.C below.
b. Commission Response
The Commission acknowledges the many thoughtful comments we
received regarding the risk management standards and practices
reflected in the Proposing Release and agrees that the topic deserves
particular care and attention.\68\ We also agree with the commenters
who pointed out that:
---------------------------------------------------------------------------
\68\ See discussion supra Section II.B.
---------------------------------------------------------------------------
Many of the risk management standards and practices
underlying proposed Rule 17Ad-22 require relatively significant
judgments to be made and at times there are no established or
definitive sources of guidance to aid decision-making. Therefore, for a
CCP's risk management practices to be most effective, the CCP must have
some degree of flexibility to tailor the practices appropriately to
meet the demands of the specific financial markets it serves, and the
Commission's interpretation of Rule 17Ad-22 should not be rigidly
applied as uniform standards without variation.\69\
---------------------------------------------------------------------------
\69\ See infra notes 82-84 and accompanying text.
---------------------------------------------------------------------------
The specific risk management practices most appropriate
for any individual CCP and for registered clearing agencies generally
are unlikely to remain static.\70\ Rather, risk management practices
can be expected to evolve to keep pace with changes in technology,
market practices and financial professionals' understanding of the
characteristics of the markets.\71\
---------------------------------------------------------------------------
\70\ See infra note 79 and accompanying text.
\71\ See The DTCC (April) Letter at 6 (``As markets continue to
globalize and standards continue to evolve, the Commission should
consider additional modifications to its rules, as necessary and
appropriate, to meet the important objective that the Commission's
rules remain in alignment with global standards.'').
---------------------------------------------------------------------------
For example, the Commission recognizes that a less prescriptive
approach can help promote efficient practices and encourage regulated
entities to consider how to manage their regulatory obligations and
risk management practices in a way that complies with Commission rules
while accounting for the particular characteristics of their business
and believes the approach reflected in proposed Rule 17Ad-22 is
consistent with this perspective.
The Commission believes that one outgrowth of this less
prescriptive approach is that there may be additional questions from
the clearing agencies regarding how various regulatory requirements
apply with regard to clearance and settlement services for particular
instruments or products having different market characteristics.
Commenters were particularly concerned with the application of Rules
17Ad-22(b)(1)-(4) and with particular risk management standards,
including, but not limited to, the proper amount of financial
resources, measurement and management of credit exposures, back
testing, model validation, use of concentration, liquidity and other
factors to determine margin requirements, and the appropriate meaning
of ``extreme but plausible market conditions.''
We note that the Commission or its staff may from time to time
issue additional guidance to the extent necessary to address questions
arising from the dynamic nature of clearing agency risk management
practices, changing market practices, and technological advances.
To date, the Exchange Act and the related regulations promulgated
by the Commission have not established particularized requirements
regarding clearing agencies' risk management practices.\72\
Nevertheless, CCPs registered as clearing agencies generally adopt
margin requirements designed to cover potential losses under normal
market conditions to help ensure the financial safety of the
enterprise, protect the interests of clearing members, and meet or
exceed standards of risk management best practices recognized in the
financial services industry generally.\73\ Additional charges,
including, but not limited to, those contained in separately
constituted default or guaranty funds are also used to cover losses
beyond that (i.e., tail events associated with extreme but plausible
market conditions).\74\
---------------------------------------------------------------------------
\72\ See generally Section 17A of the Exchange Act (15 U.S.C.
78q-1) and Standards for Clearing Agency Regulation (Exchange Act
Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980)).
\73\ See, e.g., NSCC's Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Nov. 14, 2011),
available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf.
\74\ See CME Group letter to CPSS-IOSCO regarding the
Consultation Report: Principles for Financial Market Infrastructures
(July 28, 2011), available at http://www.bis.org/publ/cpss94/cacomments/cmegroup.pdf.
---------------------------------------------------------------------------
To meet this standard, the current practice of registered CCPs is
to calculate daily margin requirements using risk-based models to
ensure coverage at a 99% confidence interval over a designated time
horizon.\75\ Given the history of usage of this standard in CCP
practices and international standards,\76\ the Commission believes it
is appropriate to codify this commonly accepted practice as the minimum
benchmark for measuring credit exposures and setting margin
requirements. However, the Commission also recognizes that this minimum
standard may not be sufficient for all CCPs and believes the rules
allow flexibility for CCPs to adopt more conservative approaches when
appropriate given the nature of the financial product being cleared,
the preferences of their members, or other factors consistent with the
general responsibilities of clearing agencies under the Exchange Act to
perfect the national clearance and settlement system.
---------------------------------------------------------------------------
\75\ See infra Section V.B.2 (discussion on current industry
baselines).
\76\ See infra note 571 and accompanying text.
---------------------------------------------------------------------------
Furthermore, the Commission notes that a CCP can develop rules and
[[Page 66227]]
procedures that are tailored to its practices and operations in order
to meet the demands of the specific financial markets it serves. When a
CCP proposes to make rule changes, rule changes are required to be
submitted to the Commission under Section 19(b) of the Exchange Act and
are subject to review, public comment and approval, as applicable. In
addition to the SRO rule filing process, the Commission works closely
with each clearing agency it oversees from the point of its application
for registration with the Commission and thereafter through
examinations and periodic monitoring of the clearing agency's risk
management framework and operations.\77\
---------------------------------------------------------------------------
\77\ See Risk Management Supervision of Designated Clearing
Entities (July 2011), Report by the Commission, Board and CFTC to
the Senate Committees on Banking, Housing, and Urban Affairs and
Agriculture in fulfillment of Section 813 of Title VIII of the Dodd-
Frank Act, at 25.
---------------------------------------------------------------------------
3. Coordinated U.S. Domestic and International Standards
a. Comments Received
Three commenters strongly encouraged the Commission and the CFTC to
coordinate and cooperate in the development of their parallel
regulation of clearing agencies and derivatives clearing organizations
(``DCOs'') to build a harmonized U.S. framework for OTC derivatives and
to bring appropriate consistency to the two agencies' regulation of
similar products, practices and markets.\78\
---------------------------------------------------------------------------
\78\ See ICE Letter at 2; MFA (Kaswell) Letter at 8-9; CME
Letter at 4.
---------------------------------------------------------------------------
One commenter stressed that rules applicable to clearance and
settlement of single name credit default swaps should be comparable to
the final requirements applicable to clearance and settlement of index-
based credit default swaps because clearinghouses will undoubtedly
service both and therefore different sets of compliance standards could
lead to unnecessary operational inefficiencies and may have the
unintended consequence of tilting the market in favor of one class of
instruments.\79\
---------------------------------------------------------------------------
\79\ See CME Letter at 4.
---------------------------------------------------------------------------
Three commenters urged the Commission to incorporate specific
requirements for processing, clearing and transfer of customer
positions.\80\ Two of the commenters urged the Commission to adopt
specific rules in these areas that are similar to what the CFTC has
proposed for DCOs--specifically with respect to proposed Rule
39.12(b)(7).\81\
---------------------------------------------------------------------------
\80\ See MFA (Kaswell) Letter at 8-9; SDMA (June) Letter at 19;
Barnard Letter at 2.
\81\ See MFA (Kaswell) Letter at 8-9; SDMA (June) Letter at 19
(citing proposed rule 39.12(b)(7) from the CFTC's Requirements for
Processing, Clearing and Transfer of Customer Positions, 76 FR 13101
(Mar. 10, 2011) which would require ``each derivatives clearing
organization to coordinate with each swap execution facility and
designated contract market that lists for trading a product that is
cleared by the derivatives clearing organization, in developing
rules and procedures to facilitate prompt and efficient processing
of all contracts, agreements, and transactions submitted to the
derivatives clearing organization for clearing.''). The CFTC
reserved this rule section in its DCO Release but has not yet
adopted the proposed rule as a final requirement.
---------------------------------------------------------------------------
Three commenters expressed a preference for principles-based rather
than prescriptive rules.\82\ One commenter expressed its belief that
the CFTC's proposals for DCOs are overly prescriptive and should be
eschewed in favor of case-by-case review of a clearing organizations'
proposed rule changes.\83\ The commenter added that less prescriptive
rules will be easier to reconcile between the two regulatory
agencies.\84\
---------------------------------------------------------------------------
\82\ See CME Letter at 3; The DTCC (April) Letter at 6; The OCC
Letter at 2.
\83\ See The OCC Letter at 2.
\84\ See id.
---------------------------------------------------------------------------
One commenter strongly encouraged the Commission to avoid final
action on its proposed rules before it has clarity on what
clearinghouse regulations are ultimately adopted by European and United
Kingdom regulators and what approaches to regulation are embraced by
the final FMI Report.\85\ The commenter argued that this approach would
allow the Commission to adopt rules that would not unknowingly force
market activity into other jurisdictions by virtue of associated
regulatory costs.\86\
---------------------------------------------------------------------------
\85\ See The OCC Letter at 3.
\86\ See id.
---------------------------------------------------------------------------
b. Commission Response
We recognize that both domestic and foreign regulators may be
undertaking similar regulatory initiatives with respect to risk
management and operation of clearing agencies. We believe that adopting
Rule 17Ad-22 now, largely in the form proposed, and the phased
implementation schedule set forth above \87\ will ensure that the
Commission's rulemaking for clearing agencies will be coordinated with
equivalent processes being undertaken by the CFTC and the Federal
Reserve in the United States and foreign regulators. As discussed
above, the CPSS-IOSCO Recommendations served as the benchmark for the
operations of the CCPs and CSDs around the world since the publication
of the RSSS in 2001 and the RCCP in 2004, respectively. In addition,
the CFTC and Federal Reserve have also considered the CPSS-IOSCO
Recommendations in their rulemaking efforts with respect to the
clearance and settlement process. Consequently, the final rules that
the CFTC recently adopted to govern the activities of a DCO \88\ and
the rules proposed by the Federal Reserve for certain CCPs and CSDs
\89\ each borrow from the principles in the CPSS-IOSCO Recommendations
and reflect requirements that we believe are consistent with the
minimum requirements for registered clearing agencies that the
Commission is adopting in Rule 17Ad-22. Because Rule 17Ad-22 will
generally codify existing practices that similarly reflect the CPSS-
IOSCO Recommendations, the Commission does not believe it will conflict
with regulatory requirements that are being implemented by other
regulators or in other jurisdictions.
---------------------------------------------------------------------------
\87\ See supra Section II.B.
\88\ See Derivatives Clearing Organization General Provisions
and Core Principles, supra note 38.
\89\ See Financial Market Utilities, supra note 25.
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4. Appropriate Distinctions Between Clearing Agencies
a. Comments Received
In the Proposing Release, the Commission identified certain
services in the area of post-trade securities processing that may be
captured by the definition of a clearing agency in the Exchange Act.
Two commenters generally supported the distinctions the Commission
proposed for rules that should apply to all types of clearing agencies
versus those that should apply only to CCPs.\90\ Several commenters
argued that entities that perform certain post-trade processing
services (i.e., comparison of trade data, collateral management and
tear-up/compression) are not performing services that fall within the
definition of a clearing agency under the Exchange Act and consequently
entities that perform these services should not be required to register
as a clearing agency or comply with Rule 17Ad-22.\91\
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\90\ See TriOptima Letter at 5; ICE Letter at 2.
\91\ See generally TriOptima Letter; Markit (April) Letter;
Markit (July) Letter; MarkitSERV (April) Letter; MarkitSERV (July)
Letter; Omgeo Letter.
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b. Commission Response
We are not persuaded by commenters who suggested that post-trade
processing services should be automatically excluded from the
definition of a clearing agency in the Exchange Act.\92\ We believe
that view is inconsistent with the plain meaning of the clearing agency
definition because the definition of clearing agency in
[[Page 66228]]
Section 3(a)(23)(A) of the Exchange Act covers any person who acts as
an intermediary in making payments or deliveries or both in connection
with transactions in securities and provides facilities for the
comparison of data regarding the terms of settlement of securities
transactions, to reduce the number of settlements of securities
transactions, or for the allocation of securities settlement
responsibilities.\93\ That view also is inconsistent with prior
interpretive guidance from the Commission addressing the broader
spectrum of activities that are associated with that term.\94\ The
determination of whether particular activities meet the definition of a
clearing agency depends on the totality of the facts and circumstances
involved.\95\
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\92\ See supra note 91 and accompanying text.
\93\ See supra note 36.
\94\ See Confirmation and Affirmation of Securities Trades;
Matching, Exchange Act Release No. 34-39829 (Apr. 6, 1998), 63 FR
17943 (Apr. 13, 1998) (noting that ``[t]he Commission is of the view
that matching constitutes a clearing agency function within the
meaning of the clearing agency definition under Section 3(a)(23) of
the Exchange Act. Specifically, matching constitutes `comparison of
data respecting the terms of settlement of securities
transactions.''').
\95\ See, e.g., supra note 1, at 91 (the Senate Committee on
Banking, Housing and Urban affairs acknowledging that through the
intended breadth of the clearing agency definition the Commission
even retains authority ``to negate, by rule, exclusions in this
category in order to assure the prompt and accurate clearance and
settlement of securities transactions or to prevent evasions of the
Exchange Act'').
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On July 1, 2011, the Commission published a conditional, temporary
exemption from clearing agency registration for entities that perform
certain post-trade processing services for security-based swap
transactions.\96\ The order facilitated the Commission's identification
of entities that operate in that area and that accordingly may fall
within the clearing agency definition. Several entities complied with
the conditions of that order and remain exempt from clearing agency
registration under its terms.\97\ By allowing potential clearing agency
registrants to elect temporary, conditional exemption from
registration, the order has given the Commission more time to consider
whether these entities meet the clearing agency definition and, if
registration is required, to consider what form of regulation may be
most appropriate for those services.
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\96\ See, e.g., Exchange Act Release No. 34-64796 (July 1,
2011), 76 FR 39963 (July 7, 2011) (providing an exemption from
registration under Section 17A(b) of the Exchange Act, and stating
that ``[t]he Commission is using its authority under section 36 of
the Exchange Act to provide a conditional temporary exemption [from
clearing agency registration], until the compliance date for the
final rules relating to registration of clearing agencies that clear
security-based swaps pursuant to sections 71A(i) and (j) of the
Exchange Act, from the registration requirement in Section 17A(b)(1)
of the Exchange Act to any clearing agency that may be required to
register with the Commission solely as a result of providing
Collateral Management Services, Trade Matching Services, Tear Up and
Compression Services, and/or substantially similar services for
security-based swaps'').
\97\ The Commission notes further that its adoption of Rule
17Ad-22 does not have any effect on the Commission's order granting
a conditional temporary exemption from clearing agency registration
for entities that perform certain post-trade processing services for
security-based swap transactions. See supra note 96 and accompanying
text. The temporary exemption is conditioned on these entities
providing the Commission with identifying information and a detailed
description of the types of services they provide. Section 17A(g) of
the Exchange Act contains a registration requirement for security-
based swaps clearing agencies. Section 17A(j) of the Exchange Act
requires the Commission to adopt rules governing persons that are
registered as clearing agencies for security-based swaps under the
Exchange Act, and Section 17A(i) requires security-based swaps
clearing agencies to comply with such standards as the Commission
may establish by rule as a condition to being registered or
maintaining registration. As the Commission previously indicated
with respect to the effective date for Section 17A(g), if a Title
VII provision requires a rulemaking, such provision will not go into
effect ``not less than'' 60 days after publication of the final
related rule. 76 FR 36287, 36302 (June 22, 2011). The Commission has
not adopted any rules applicable to clearing agencies that perform
services; therefore, the registration requirement of Section 17A(g)
will not be applicable to such clearing agencies until the date when
rules with respect to such clearing agencies are adopted pursuant to
Section 17A(i).
---------------------------------------------------------------------------
The Commission preliminarily agrees with commenters that it is
appropriate to consider a tailored framework of regulation for clearing
agencies that perform certain post-trade processing services because
such activities do not involve the same credit, market and operational
risk concerns that are presented by clearing agencies that perform CCP
or CSD services.\98\ Accordingly, the Commission intends to separately
address clearing agencies that perform only post-trade processing
services. The Commission has previously distinguished entities that
provide certain post-trade services and fall within the definition of
clearing agency from those entities that provide services more commonly
associated with the functions of a clearing agency (e.g., CCP and CSD
services).\99\ As part of its future rulemaking regarding these types
of clearing agencies, the Commission may consider whether to apply the
future rules to clearing agencies engaged in activities that were
separately identified by Congress as PCS Activities in the Clearing
Supervision Act. In particular, the Clearing Supervision Act identifies
the following as PCS Activities:
---------------------------------------------------------------------------
\98\ See supra notes 90-91 and accompanying text.
\99\ See, e.g., Exchange Act Order No. 34-44188 (Apr. 17, 2001)
(providing an exemption from registration as a clearing agency to a
subsidiary of Omgeo conducting electronic trade confirmation and
matching services).
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(1) Calculation and communication of unsettled financial
transactions between counterparties;
(2) netting of transactions;
(3) provision and maintenance of trade, contract, or instrument
information;
(4) management of risks and activities associated with continuing
financial transactions;
(5) transmittal and storage of payment instructions;
(6) movement of funds;
(7) final settlement of financial transactions; and
(8) other similar functions that the Council may determine.\100\
---------------------------------------------------------------------------
\100\ 12 U.S.C. 5462(7).
---------------------------------------------------------------------------
Accordingly, at this time, the Commission does not intend for Rule
17Ad-22 to apply to clearing agencies that perform post-trade
processing services. The scope of Rule 17Ad-22 will be limited to
clearing agencies that are registered with the Commission and the rule
will not apply to any clearing agencies operating pursuant to an
exemption from registration as a clearing agency granted by the
Commission, unless the terms of future exemptions specifically
contemplate its application, in whole or in part. The Commission has
clarified this as part of the final Rule 17Ad-22 adopted today by
adding the word ``registered'' before the term ``clearing agency''
appearing in the first instance in paragraphs (b), (c)(1), (c)(2), and
(d). For this reason, references to the term ``clearing agency'' in
this release are generally intended to capture only registered clearing
agencies, unless the context suggests otherwise. The Commission may
consider at a later time whether rules tailored to clearing agencies
that provide post-trade processing services would be appropriate.
III. Description of Rule 17Ad-22
A. Overview and Scope
The Commission is adopting Rule 17Ad-22 with minor modifications
from the proposal to implement the statutory provisions for clearing
agencies under the Exchange Act. Rule 17Ad-22 requires registered
clearing agencies to establish, implement, maintain and enforce written
policies and procedures that are reasonably designed to meet certain
minimum requirements for their operations and risk management practices
on an ongoing basis. These minimum requirements will work in tandem
with the requirements in
[[Page 66229]]
Section 17A that the Commission must make certain determinations
regarding a clearing agency's rules.
The Commission anticipates that the clearing agency's rules and
procedures will likely continue to evolve so that the clearing agency
can adequately respond to changes in technology, legal requirements,
trading volume, trading practices, linkages between financial markets
and the financial instruments traded in the markets that a clearing
agency serves. Accordingly, registered clearing agencies must evaluate
continually and make appropriate updates and improvements to their
operations and risk management practices to facilitate the prompt and
accurate clearance and settlement of securities transactions and to
safeguard securities and funds in their custody or control.
Rule 17Ad-22 consists of the following parts: (1) Rule 17Ad-22(a)
provides definitions for certain terms; (2) Rule 17Ad-22(b) contains
risk management and participation requirements for registered CCPs; (3)
Rule 17Ad-22(c) establishes a reporting requirement for registered
clearing agencies with respect to certain matters including financial
resources and methodologies used to calculate financial requirements;
and (4) Rule 17Ad-22(d) requires registered clearing agencies, as
applicable, to meet certain minimum standards.
As noted above, at this time, the Commission intends for Rule 17Ad-
22 to apply only to registered clearing agencies. The Commission may
consider at a later time whether any additional rules tailored to
clearing agencies that perform post-trade processing services would be
appropriate. In addition, Rule 17Ad-22 will not apply to any clearing
agencies operating pursuant to an exemption from registration as a
clearing agency granted by the Commission unless the terms of future
exemptions specifically contemplate its application, in whole or in
part.
B. Definitions--Rule 17Ad-22(a)
1. Proposed Rule
Proposed Rule 17Ad-22(a) contains five definitions. Proposed Rule
17Ad-22(a)(1) would define ``central counterparty'' as a clearing
agency that interposes itself between counterparties to securities
transactions to act functionally as the buyer to every seller and as
the seller to every buyer. Proposed Rule 17Ad-22(a)(2) would define
``central securities depository services'' to mean services of a
clearing agency that is a securities depository as described in Section
3(a)(23) of the Exchange Act.\101\ Proposed Rule 17Ad-22(a)(3) would
define ``participant,'' for the limited purposes of Rules 17Ad-22(b)(3)
and 17Ad-22(d)(14), to mean that if a participant controls another
participant, or is under common control with another participant, then
the affiliated participants shall be collectively deemed to be a single
participant. Proposed Rule 17Ad-22(a)(4) would define ``normal market
conditions,'' for the limited purposes of Rules 17Ad-22(b)(1) and (2),
to mean conditions in which the expected movement of the price of
cleared securities would produce changes in a clearing agency's
exposures to its participants that would be expected to breach margin
requirements or other risk control mechanisms only one percent of the
time.\102\ Proposed Rule 17Ad-22(a)(5) would define ``net capital,''
for the limited purpose of Rule 17Ad-22(b)(7), to have the same meaning
as set forth in Rule 15c3-1 under the Exchange Act for broker-dealers
or any similar risk adjusted capital calculation for all other
prospective clearing members.\103\
---------------------------------------------------------------------------
\101\ See supra note 36 and accompanying text.
\102\ The definition of normal market conditions in Rule 17Ad-
22(a)(4) is consistent with the corresponding explanation
established in the CPSS-IOSCO Recommendations. See RCCP, supra note
33, at 21 (explanatory note number 1).
\103\ As appropriate, the clearing agency may develop risk-
adjusted capital calculations for prospective clearing members that
are not broker-dealers.
---------------------------------------------------------------------------
2. Comments Received
Commenters generally supported proposed Rule 17Ad-22(a)(3) because
it would require a clearing agency to take account of an entire group
of affiliated entities when complying with the financial resources
requirements of proposed Rule 17Ad-22(b)(3), as well as the
requirements in proposed Rule 17Ad-22(d)(14) for risk controls to
address participants' failures to settle.\104\ However, one commenter
recommended that the rule employ the phrase ``participant family''
because ``participant'' on its own may be easily confused with other
uses of that term in the Exchange Act and in the rules and regulations
thereunder.\105\ Accordingly, the commenter suggested that
``participant family'' should be defined to mean each participant that
controls, is controlled by or is under common control with another
participant.\106\ The commenter recommended that the standard of
control for this purpose should be defined as the disclosed ownership
of 50% or more of the voting securities or other interests in a
participant and that it should be based on information available to the
clearing agency.\107\
---------------------------------------------------------------------------
\104\ See The DTCC (April) Letter at 9-10.
\105\ See id.
\106\ See The DTCC (April) Letter at 10.
\107\ See id.
---------------------------------------------------------------------------
One commenter expressed concern about the definition of ``normal
market conditions'' as conditions in which the expected movement of the
price of cleared securities would produce changes in a clearing
agency's exposures to its participants that would be expected to breach
margin requirements or other risk control mechanisms only one percent
of the time.\108\ The commenter argued that it would be unusual to
define normal market conditions this way (i.e., using margin
requirements as a standard of measure) because margin models are
designed to adjust during periods of market turbulence.\109\
---------------------------------------------------------------------------
\108\ See The OCC Letter at 7.
\109\ See id.
---------------------------------------------------------------------------
The Commission received no comments on proposed Rules 17Ad-
22(a)(1), (2) and (5).
3. Final Rule
As described more fully below, the Commission is adopting Rules
17Ad-22(a)(1), (2), (4) and (5) as proposed. We are also adopting Rule
17Ad-22(a)(3) with certain modifications to address concerns of
commenters.
We agree with commenters who suggested that in the interest of
clarity and to avoid confusion with use of the term ``participant''
elsewhere in Exchange Act regulations, Rule 17Ad-22(a)(3) should be
modified so that the term defined by the rule is ``participant family''
instead of ``participant.'' We are also modifying Rule 17Ad-22(a)(3)
with respect to the language that describes the test for determining
when a sufficient relationship of control exists between participants
to qualify them as a ``participant family.'' The definition has been
expanded to include entities controlled by a participant and to cover
direct and indirect relationships. Accordingly, Rule 17Ad-22(a)(3) now
provides that participants will be deemed to be a ``participant
family'' for purposes of Rules 17Ad-22(b)(3) and 17Ad-22(d)(14) when
``a participant directly, or indirectly through one or more
intermediaries, controls, is controlled by, or is under common control
with, another participant.'' This modification is intended to respond
to the recommendation of commenters and more closely conform the text
of Rule 17Ad-22(a)(3) to the language in which this standard appears in
other contexts within the U.S. federal securities
[[Page 66230]]
laws.\110\ At the same time, we are not narrowing the definition of
control in this context to mean ownership of 50% or more of the voting
securities or other interests in a participant.\111\ We believe the
more appropriate evaluation of control is based on the relationship
between the entities and the power, directly or indirectly, to direct
the management or policies of a company, whether through ownership of
securities, by contract, or otherwise. In conducting this evaluation,
clearing agencies should also be guided by the definition of
``control'' set forth in Rule 405 under the Securities Act of 1933,
using the information available to them.
---------------------------------------------------------------------------
\110\ See, e.g., 17 CFR 230.405 (using ``controls or is
controlled by, or is under common control with'' in the definition
of affiliate found in Rule 405 under the Securities Act of 1933).
\111\ See supra note 107 and accompanying text.
---------------------------------------------------------------------------
The Commission agrees with the commenter that well-designed margin
models include factors that adjust to periods of market turbulence. The
Commission, however, is not persuaded by the argument that the
definition of normal market conditions in Rule 17Ad-22(a)(4) is at odds
with the concept of certain periods of market turbulence.\112\ The rule
defines ``normal market conditions'' as those that prevail 99 trading
days out of 100. Margin models and other risk control mechanisms
designed to adjust during periods of market turbulence are consistent
with the definitional standard to the extent they help to reduce the
number of trading days during which a clearing agency's exposure to
participants are not fully covered by such measures.
---------------------------------------------------------------------------
\112\ The Commission notes that the definition of normal market
conditions found in Rule 17Ad-22(a) is modeled on the current
international standard for determining normal market conditions in
the CPSS-IOSCO Recommendations.
---------------------------------------------------------------------------
The definition of ``normal market conditions'' in Rule 17Ad-
22(a)(4) is also modeled on relevant and analogous international
standards. The RCCP stipulates that a CCP should limit its exposures to
potential losses from defaults by its participants in normal market
conditions and defines ``normal market conditions'' as price movements
that produce changes in exposures that are expected to breach margin
requirements or other risk controls only 1% of the time.\113\ The
standard also comports with the international standard for bank capital
requirements established by the Bank for International Settlements,
which requires banks to measure market risks at a 99% confidence
interval when determining regulatory capital requirements.\114\
---------------------------------------------------------------------------
\113\ See Bank for International Settlements' Committee on
Payment and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions,
Recommendations for Central Counterparties (Nov. 2004), at 18-21,
available at http://www.bis.org/publ/cpss64.pdf.
\114\ See infra Section V.B.2 (discussion on current industry
practices).
---------------------------------------------------------------------------
C. Risk Management Requirements for Central Counterparties: Rules 17Ad-
22(b)(1)-(4)
Rules 17Ad-22(b)(1)-(4) contain several requirements that address
risk management practices by registered CCPs. Specifically, the
proposed rules would create standards with respect to: (1) Measurement
and management of credit exposures; (2) margin requirements; (3)
financial resources; and (4) annual evaluations of the performance of
the clearing agency's margin models.
During the comment period, commenters pointed out that to properly
frame these requirements requires a great deal of technical expertise
and that a failure to properly allow that expertise to influence final
rules adopted by the Commission could result in inefficient
requirements that lack the proper degree of flexibility to achieve
prudent risk management practices without being overly burdensome. In
some cases, commenters argued that personnel at the clearing agencies
possess the requisite levels of experience and expertise to help the
Commission shape CCP risk management standards.\115\
---------------------------------------------------------------------------
\115\ See The DTCC (April) Letter at 18-20; The OCC Letter at
12; LCH Letter at 3-4.
---------------------------------------------------------------------------
As an initial matter, the Commission believes that Rules 17Ad-
22(b)(1)-(4) are appropriate minimum standards for registered CCPs and
that they are consistent with existing international standards of
practice. However, we agree that the process of evaluating, testing and
refining CCP risk management standards will be ongoing and necessarily
include an open dialogue among the CCPs, investors, the Commission and
various other interested parties. In particular, the Commission will
carefully consider further input from interested parties obtained
through outreach to various constituencies and in response to any rules
or rule amendments that may be proposed by the Commission upon
considering the international standards developed by CPSS-IOSCO in the
FMI Report.
Further, Rules 17Ad-22(b)(1), (2), and (3) establish targets for
clearing agencies to meet without prescribing a particular method.
Accordingly, the rules provide clearing agencies with the flexibility
to establish risk management procedures (e.g., back testing, stress
testing, model validation procedures and the composition of financial
resources) that are appropriately tailored to current market conditions
and can be revised over time to address changes in market conditions.
Given the existing use and general understanding by U.S. CCPs and CCPs
and regulatory authorities around the world of the RCCP and the
principles that form the basis of Rules 17Ad-22(b)(1), (2) and (3), the
Commission is adopting these rules largely as proposed.
1. Rule 17Ad-22(b)(1): Measurement and Management of Credit Exposures
a. Proposed Rule
Proposed Rule 17Ad-22(b)(1), as proposed, would require a CCP to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to measure its credit exposures to its
participants at least once each day, and limit its exposures to
potential losses from defaults by its participants under normal market
conditions \116\ so that the operations of the CCP will not be
disrupted and non-defaulting participants will not be exposed to losses
that they cannot anticipate or control.
---------------------------------------------------------------------------
\116\ See supra note 102 and accompanying text.
---------------------------------------------------------------------------
b. Comments Received
Three commenters urged the Commission to consider adopting a more
prescriptive version of the rule.\117\ Of this group, one suggested
that the rule should permit a CCP to use correlated positions to reduce
initial margin requirements only if the CCP can demonstrate a robust
correlation between those positions under stressed market conditions
and the CCP publicly discloses its methodology periodically for
determining the correlation and the CCP's resulting margin
requirements.\118\ Another commenter suggested that a CCP should be
required to measure credit exposures several times each business day
and to recalculate initial and variation margin for each clearing
member and the clearing member's clients more than once each day.\119\
The third commenter stated that Rule 17Ad-22(b)(1) should also require
the CCP to perform intraday calculations of credit risk exposure when
circumstances warrant, including situations where the security-based
swap is illiquid, difficult to price, or highly volatile.\120\
---------------------------------------------------------------------------
\117\ See ISDA Letter at 7; LCH Letter at 2; Better Markets
Letter at 5.
\118\ See ISDA Letter at 7.
\119\ See LCH Letter at 2.
\120\ See Better Markets Letter at 5.
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[[Page 66231]]
c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(1) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. We
agree with commenters that the risks CCPs face are subject to change
over time due to the potential for significant changes in the risk
profiles of participants and if those risks are not appropriately
measured and managed by the CCP, they can result in the accrual of
significant liabilities.\121\ The Commission believes that measuring
credit exposures once each day is the minimum frequency of measurement
that will permit a clearing agency to consider effectively the credit
exposures it faces.
---------------------------------------------------------------------------
\121\ See supra notes 119-120 (citing the Better Markets Letter
and LCH Letter).
---------------------------------------------------------------------------
The Commission agrees with commenters that clearing agencies may
need to measure credit exposures more frequently than once each day in
order to ensure that the CCP can facilitate the prompt and accurate
clearance and settlement of securities transactions and ensure that
they operate safely and efficiently. That point of view is reflected in
the rule requirement that the measurement must be performed at least
once each day. However, the Commission believes that a less
prescriptive and more flexible rule sets a more appropriate baseline
standard. Each CCP is exposed to participants in different markets
characterized by different trading patterns, volumes, liquidity,
transparency and other unique market characteristics. Rather than
prescribing a specific frequency for risk exposure measurements (other
than the once daily minimum), the Commission believes that CCPs should
monitor exposure and margin coverage on an intraday basis depending on
the individual risk characteristics of their members and businesses,
and adjust their risk management processes as needed. This stance is
also consistent with our understanding that the practice at many CCPs
is to measure credit exposures more than once daily.\122\
---------------------------------------------------------------------------
\122\ See id.
---------------------------------------------------------------------------
While the Commission also agrees with commenters who expressed the
view that a CCP should provide reductions in initial margin
requirements based on offsetting or inversely correlated positions only
if the CCP can demonstrate a robust correlation between those
positions--including under stressed market conditions,\123\ the rule is
being adopted as proposed. The Commission believes that the
determination of whether positions are sufficiently correlated to
warrant offsets or whether reductions should be provided at all, is a
matter that should be determined by the CCP as it implements its risk
management procedures, and submitted to the Commission for review and
public comment, as part of the Section 19b-4 rule filing process. The
Commission believes that the rule should allow each CCP the flexibility
to set margin requirements based on the unique products and markets
that it serves. Margin requirements will vary based on a number of
factors, including, but not limited to, the type, volume, and
volatility of the instruments cleared. It is difficult to make
determinations at the rule level regarding the suitability of margin
reductions based on adequate position correlations; therefore, the
Commission believes it is more appropriate to conduct such
methodological evaluations during the supervisory process.
---------------------------------------------------------------------------
\123\ See supra note 118 and accompanying text.
---------------------------------------------------------------------------
As adopted, Rule 17Ad-22(b)(1) does not require that a registered
CCP publicly disclose its correlation methodology and related margin
requirements.\124\ Correlation methodology is generally considered
confidential by clearing agencies because it is a critical element in
determining their margin requirements. While CCPs generally provide
this type of information to their participants, it typically is not
made public. In this connection, we are adopting Rule 17Ad-22(d)(9),
discussed below, which requires each registered CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to provide market participants with sufficient
information to enable them to identify and evaluate the risks and costs
associated with using its services. Rule 17Ad-22(d)(9) is intended in
part to promote appropriate levels of transparency concerning a CCP's
margin practices while allowing registered clearing agencies to tailor
disclosure in a way that preserves incentives for business model
innovations and responsible competition among clearing agencies.
---------------------------------------------------------------------------
\124\ See The OCC Letter at 17; The DTCC (April) Letter at 7.
---------------------------------------------------------------------------
We are also adopting Rule 17Ad-22(b)(1), as it was proposed, to
require registered CCPs to establish, implement, maintain, and enforce
written policies and procedures reasonably designed to limit their
exposures to potential losses from participant defaults. By collecting
sufficient margin and having other liquid resources at its disposal,
the Commission expects that a clearing agency will be able to limit its
exposures to potential losses from defaults by clearing members in
normal market conditions.\125\
---------------------------------------------------------------------------
\125\ See supra note 102 and accompanying text.
---------------------------------------------------------------------------
2. Rule 17Ad-22(b)(2): Margin Requirements
a. Proposed Rule
Proposed Rule 17Ad-22(b)(2) would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to: (i) Use margin requirements to limit its credit
exposures to participants under normal market conditions; \126\ (ii)
use risk-based models to set margin requirements; and (iii) review the
models at least monthly.
---------------------------------------------------------------------------
\126\ See id.
---------------------------------------------------------------------------
b. Comments Received
One commenter recommended that the rule be amended to require that
the CCP's margin requirements must be sufficient to limit credit
exposures to both the CCP's participants and the clients of the CCP's
participants.\127\ Another commenter supported standardization of the
way CCPs set margin requirements and stated that the final rule should
require those clearing agencies to make their margin-setting
methodology available to customers.\128\ The commenter argued that this
disclosure would enable market participants to reasonably anticipate
when additional margin may be required and would consequently promote
stable liquidity in the marketplace.\129\
---------------------------------------------------------------------------
\127\ See LCH Letter at 2.
\128\ See MFA (Kaswell) Letter at 2.
\129\ See id. (noting that if the Commission requires the
creation of these transparent conditions with respect to margin in
its final rules, then the commenter would fully support the ability
of clearing agencies to have flexibility to modify margin
requirements as necessary, including by imposing special margin
requirements or requiring intraday posting of margin).
---------------------------------------------------------------------------
In response to a question asked by the Commission in the Proposing
Release, one commenter stated that adopting Rule 17Ad-22(b)(2) as
proposed is unlikely to create the risk that CCPs will lower margin
standards to compete for business.\130\ The commenter asserted that
integrity in risk management is the primary focus of CCPs, and that a
CCP would suffer severe reputational harm if it risked using guaranty
fund resources to cover margin deficiencies of clearing members.\131\
In addition, according to the commenter, CCPs do not alter margin
requirements based on the
[[Page 66232]]
identity of the individual counterparty.\132\
---------------------------------------------------------------------------
\130\ See id.
\131\ See id.
\132\ See MFA (Kaswell) Letter at 2-3.
---------------------------------------------------------------------------
One commenter contended that certain aspects of a CCP's margin
methodology, such as choice of confidence levels (used to estimate
expected shortfall), the number of days' data relied on, and the
various weights used to determine stress test charges do not need to be
reviewed on a monthly basis.\133\ If the final rule does require a
monthly review, the commenter suggested that the Commission should make
clear that CCPs have substantial discretion to determine which aspects
of the model are appropriate for the monthly review.\134\ In contrast,
another commenter asked the Commission to consider a more prescriptive
approach to the rule. It suggested that Rule 17Ad-22(b)(2) should be
modified to require a clearing agency to use two to three years of
historical price data when establishing normal market conditions,
consider liquidity and the amount of time necessary to replace a
position once a default occurs, and make a showing of significant and
reliable correlation of price risks before it is allowed to net initial
margin using long and short positions.\135\
---------------------------------------------------------------------------
\133\ See The OCC Letter at 7.
\134\ See id.
\135\ See Better Markets Letter at 3-4.
---------------------------------------------------------------------------
One commenter focused more narrowly on the appropriate confidence
level that should be applied to initial margin collected by a clearing
agency.\136\ The commenter argued that setting the appropriate
confidence level is directly tied to the degree of mutualization
performed by a clearing agency (i.e., the lesser the degree of
mutualization the higher the appropriate confidence level because the
amount of funds available to manage a default will be reduced).\137\
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\136\ See ISDA Letter at 7.
\137\ See id. (stating, for example, that if the clearing agency
performs mutualization in its default fund and for clients in
omnibus client accounts then a 99% confidence level is completely
appropriate. By contrast, if the clearing agency imposes a
requirement for individualized client accounts instead of an omnibus
account, then the commenter believes that a confidence level greater
than 99% is likely appropriate).
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c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(2) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. This
requirement recognizes that the collection of assets (e.g., cash or
securities) from participants provides the clearing agency with assets
to limit its exposure to a participant in the event of a participant
default. By limiting its credit exposure in this manner, a CCP is less
likely to be subject to disruptions in its operations as a result of a
participant default, thereby facilitating the prompt and accurate
clearance and settlement of securities transactions.
The Commission does not believe it is necessary to amend the rule
to state that a registered CCP's margin requirements must limit credit
exposures to customers of participants as well as participants.\138\
Margin requirements applicable to a customer's securities positions are
established in accordance with regulations specifically governing
customer margin practices \139\ and in some cases through additional
margin requirements imposed by the participant to address its credit
risk to the customer. As a result, even when a participant is
transacting on the behalf of a customer, the CCP enters into a
transaction only with the participant, and therefore it is the
participant's creditworthiness that the clearing agency's margin
requirements must adequately address.
---------------------------------------------------------------------------
\138\ See supra note 127 and accompanying text.
\139\ See, e.g., 17 CFR 240.15c3-3 (Customer protection--
reserves and custody of securities and Regulation T, 12 CFR 220).
---------------------------------------------------------------------------
The Commission is aware that some CCPs may already have the ability
to measure credit exposures to customers of participants as well as to
participants. To the extent that such margin practices are already in
place or develop over time to help ensure prompt and accurate clearance
and settlement in the market the clearing agency serves, we believe
those practices can be effective in limiting aggregate credit exposures
of clearing agencies. We agree that the ability to limit credit
exposures to customers of participants using margin may help inform and
shape appropriate credit risk management practices in certain cases--
for example, where (i) direct access to a clearing agency by some
participants may be relatively more constrained by the operational or
financial demands commensurate with participation; (ii) open interest
periods associated with the instruments cleared by the clearing agency
are relatively significant; or (iii) customer margin requirements are
established independently from the CCP (e.g., pursuant to regulation or
by agreement with a participant). However, we believe that, at this
time, individual CCPs should develop rules and procedures to address
these specific circumstances consistent with their general
responsibilities as clearing agencies under the Exchange Act and that
rules of this kind would be subject to the rule filing procedures of
Section 19b-4.
The Commission is not amending Rule 17Ad-22(b)(2) to specify which
aspects or components of the CCP's risk-based models must be reviewed
in the context of the CCP's monthly review.\140\ The Commission
recognizes that some assumptions that underlie model parameters may be
widely accepted by current convention, and those components therefore
may be less likely to become outdated from month to month. On the other
hand, the Commission notes that market conditions and risks are
constantly changing and CCPs will need to exercise discretion in how
they administer their review of those components.
---------------------------------------------------------------------------
\140\ See supra note 134 and accompanying text.
---------------------------------------------------------------------------
The Commission notes that, to the extent a CCP believes that an
assumption in a model or parameter does not lend itself to empirical
testing, a review of that assumption can in some cases be accomplished
by the CCP performing a theoretical assessment of that assumption
compared to alternative assumptions. For example, a CCP may evaluate
the appropriateness of the number of days of market data used in its
margin model or the expected amount of time needed to liquidate a
security in an event of default by comparing the performance of the
margin model when a range of representative values is input.
Also consistent with the intent of preserving appropriate
flexibility for clearing agencies to tailor their methods of achieving
compliance, the Commission is not prescribing a particular confidence
level for initial margin in Rule 17Ad-22(b)(2).\141\ Rather, subject to
Commission oversight, Rule 17Ad-22(b)(2) allows a confidence level
determination to be made by the clearing agency as part of the
development of its margin parameters and risk-based models. In arriving
at an appropriate confidence level, we agree with commenters that the
extent of mutualization of financial resources performed by a CCP in
its risk management practices and the particular use of individualized
client accounts or an omnibus account structure are appropriate factors
to consider.\142\ The Commission also chose not to stipulate specific
requirements pertaining to the scope of historical price data,
liquidity and replacement considerations, and the correlation of price
risks used in calculating margin requirements, again opting for a more
flexible standard. While a clearing
[[Page 66233]]
agency may take such factors into consideration when determining margin
requirements, each registered CCP should be free to develop the best
margin methodology to accommodate its unique products and markets.
Accordingly, the Commission believes that it should not attempt to
prescribe the appropriate margin methodologies for each CCP or
financial instrument.\143\
---------------------------------------------------------------------------
\141\ See supra note 136 and accompanying text.
\142\ See supra note 137 and accompanying text.
\143\ See Section 17A discussion supra Section I.A.2 and
accompanying text.
---------------------------------------------------------------------------
We agree with commenters who asserted that a CCP's disclosure of
its margin-setting methodology to customers facilitates prompt and
accurate clearance and settlement by enabling market participants to
better plan for margin costs associated with the use of the clearing
agency.\144\ As noted above, registered CCPs must submit their risk
management procedures, including margin methodology, to the Commission
for review and public comment as a proposed rule change under Rule 19b-
4. The Rule 19b-4 process provides for public disclosure, as well as an
opportunity for interested parties to comment on the proposed rule
change. In addition, the Commission believes that any reasonable
process for implementing risk management practices will involve
further, more detailed communication with clearing members and their
customers regarding the particular expected results of the practices in
identified circumstances. Such communication may involve both direct
contacts with members and their customers or indirect contacts through
general information published by the CCP on its Web site or in other
generally available resources.
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\144\ See supra note 59.
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3. Rule 17Ad-22(b)(3): Financial Resources
a. Proposed Rule
Proposed Rule 17Ad-22(b)(3) would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to maintain sufficient financial resources to
withstand, at a minimum, a default by the participant to which it has
the largest exposure in extreme but plausible market conditions,
provided that a security-based swap clearing agency would be required
to maintain sufficient financial resources to withstand, at a minimum,
a default by the two participants (also referred to as the ``cover
two'' standard) to which it has the largest exposures in extreme but
plausible market conditions.\145\
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\145\ See proposed Rule 17Ad-22(a)(3), supra Section III.B.1
(defining ``participant'' for purposes of proposed Rule 17Ad-
22(b)(3)).
---------------------------------------------------------------------------
b. Comments Received
Commenters expressed a wide range of views concerning proposed Rule
17Ad-22(b)(3). Some commenters generally supported the proposed
rule.\146\ Others expressed concern that the introduction of two
different financial resources standards may discourage CCPs from
extending their services to security-based swaps or may discourage
prospective participants from seeking membership in CCPs for security-
based swaps, which would disrupt the goal of the Dodd-Frank Act to
promote central clearing.\147\ One commenter stated its opinion that no
historical or empirical case has been made for changing the way that
CCPs currently measure the sufficiency of their financial resources and
that no cost-benefit analysis has been done on the impact of any such
change on the operations and economics of CCPs.\148\
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\146\ See Better Markets Letter at 5 (supporting the rule and
stating that it appropriately differentiates between security-based
swap and non security-based swap clearing agencies due to unique
features of the security-based swap markets, such as jump-to-default
risk); see also Barnard Letter at 1 (supporting generally the thrust
of the Commission's proposals in the Proposing Release, particularly
proposed Rule 17Ad-22 concerning standards for clearing agencies);
BlackRock Letter at 2 (supporting Rules 17Ad-22(b)(1)-(7) because
these rules will benefit the markets by reducing concentration risk,
increasing the diversity of market participants involved in
governance, enhancing competition and lowering costs for customers
of clearing members); MFA (Kaswell) Letter at 2 (generally
supporting the rules proposed under 17Ad-22(b) because they would
establish reasonable, objective, risk-based criteria for fair and
open access).
\147\ See LCH Letter at 2; The OCC Letter at 9.
\148\ See The DTCC (April) Letter at 12.
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A commenter also suggested that CCPs should consider the
simultaneous default of multiple clearing members when sizing their
financial resources but that a simultaneous default of the two largest
clearing members is an extremely implausible occurrence, and
accordingly it is not a scenario that should be embedded as a fixed
requirement in the Commission's rules.\149\ That commenter stated that
it is reasonable to assume a default by the two largest participants
would take place in conditions of heightened market volatility, which
would cause a CCP to collect more financial resources because of the
risk-based nature of margin requirements.\150\
---------------------------------------------------------------------------
\149\ See The OCC Letter at 8.
\150\ See The OCC Letter at 9.
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One commenter disagreed with assertions in the Proposing Release
that the performance of CCP services for security-based swaps entails
risks that are unique to those products and that those unique risks
support the proposed ``cover two'' requirement.\151\ The commenter also
stated that accounting for the jump-to-default risk of certain
security-based swap instruments (i.e., credit-default swaps) should be
addressed through calculation of financial resource requirements using
more extreme market scenarios instead of adjusting the number of
participant defaults.\152\ The commenter urged the Commission to
consider how changes taking place to the infrastructure and risk
management practices in the securities markets due to the Dodd-Frank
Act may render irrelevant certain risks that are associated with
security-based swaps today.\153\
---------------------------------------------------------------------------
\151\ See The OCC Letter at 8 (expressing by way of example that
a total return security-based swap on a single underlying security
of a company that has a large market capitalization is a lower risk
management challenge for a clearing agency that performs CCP
services than a put or a call option on the same underlying
security. It expressed a belief that the risk is much the same as a
security future on the same underlying).
\152\ See id.
\153\ See id.
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Commenters supported the position that the Commission's regulatory
standards for CCPs should be modified where appropriate to account for
the relevant work of international standard setters such as the CPSS
and IOSCO.\154\ However, commenters pointed out that a ``cover two''
standard would be inconsistent with the existing CPSS-IOSCO
Recommendations for financial resources.\155\ They also urged the
Commission not to require any CCP to increase its liquidity resources
or otherwise re-engineer its risk management controls unless and until
there is industry and regulatory consensus on the changes that should
be made.\156\ These commenters encouraged the Commission to ensure that
its final rulemakings are aligned with the existing CPSS-IOSCO
Recommendations to the closest extent possible.\157\
---------------------------------------------------------------------------
\154\ See The OCC Letter at 9 (citing CPSS-IOSCO Recommendation
for Central Counterparties, Recommendation 3).
\155\ See id.
\156\ See The DTCC (April) Letter at 12.
\157\ See LCH Letter at 2-3; The OCC Letter at 9.
---------------------------------------------------------------------------
Commenters disagreed over what role the Commission should play in
defining the term ``extreme but plausible market conditions'' as that
term appears in proposed Rule 17Ad-22(b)(3).\158\ One commenter favored
a significant role for
[[Page 66234]]
the Commission.\159\ Other commenters agreed that CCPs should be
primarily responsible for determining the parameters of the standard
because of their unique access to market data and understanding of the
range of applicable market conditions.\160\ Those commenters stated
that Rule 17Ad-22(b)(3) should clarify that a CCP is responsible for
determining what constitutes ``extreme but plausible market
conditions.''
---------------------------------------------------------------------------
\158\ See Better Markets Letter at 5-6; The DTCC (April) Letter
at 10.
\159\ See Better Markets Letter at 5-6 (stressing that the
Commission should provide concrete guidance on the meaning of
``extreme but plausible market conditions'' to prevent lax or self-
serving interpretation of that standard and to promote consistent
practices among clearing agencies that will prevent the adoption of
lower standards designed to reduce costs and attract business volume
at the expense of stability and risk mitigation. The commenter also
expressed that the Commission's definition of the standard should
focus on unprecedented periods of illiquidity, volatility and
interconnectedness that lead to multiple defaults).
\160\ See The DTCC (April) Letter at 10; The OCC Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(3) with certain
modifications to address concerns raised by commenters, including but
not limited to the clarification discussed in Sections II.B.4 and III.A
regarding the application of the rule only to registered clearing
agencies and clarifications relating to the term ``participant family''
as discussed above.\161\ The Commission believes that requiring a
registered CCP, other than a security-based swap CCP, to maintain
sufficient financial resources to withstand, at a minimum, a default by
the participant family to which it has the largest exposure in extreme
but plausible market conditions, reduces the likelihood that a default
would create losses that disrupt the operations of the CCP and
adversely affect the clearing agency's non-defaulting participants.
---------------------------------------------------------------------------
\161\ See supra note 146 (supporting the rule as proposed); see
also supra section III.B.3 (discussing the term ``participant
family'').
---------------------------------------------------------------------------
While the Commission is sensitive to the consequences of
establishing a different standard for CCPs that clear security-based
swaps, the Commission believes that the financial resources of the
entity must be robust enough to accommodate the risks that are
particular to each market served--irrespective of whether such analysis
results in different standards. The Commission believes that requiring
a security-based swap CCP to cover its two largest potential exposures
is the appropriate standard due to the nature of these products.
Security-based swaps pose unique risk management issues. In particular,
credit default swaps, a subset of security-based swaps, are non-linear
financial instruments subject to additional risk factors such as jump-
to-default risk \162\ and asymmetrical risk allocation between short
and long counterparties. Unlike other products that also exhibit these
characteristics (e.g., Long-Term Equity Anticipation Securities
(LEAPS)), credit default swaps are unique in their size relative to
their underlying markets. Recent research shows that notional
outstandings in credit default swaps are often close to or greater than
the outstanding value of the underlying instruments.\163\ The
traditional procedures for a clearing agency to handle a default may
not be effective and may entail significant risk to a CCP clearing
security-based swaps.\164\ To address this concern, CCPs have
implemented procedures that provide for the management and oversight of
the liquidation or transfer of the defaulting member's positions by a
default management committee comprising senior CCP staff and
representatives from member institutions.\165\
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\162\ Jump-to-default risk refers to the expected change in the
value of a CDS contract if a credit event were to occur with respect
to a reference entity under the terms of the CDS contract,
triggering an obligation for the seller of protection under the
contract to make a lump sum payment to the protection buyer. Jump-
to-default only refers to the incremental information in the
determination that a credit event has occurred because the market
already prices the probability of a credit event. In practice,
credit events are largely anticipated such that jump-to-default
results in small changes in value as opposed to a first order
pricing effect. Jump-to-default risk exists for all CDS, not merely
those on reference entities perceived as risk credits. While the
decline in contract value from a credit event is usually bigger for
creditworthy reference entities (because the initial contract value
is higher and thus has farther to fall), jump-to-default risk can
also be measured for distressed reference entities that are expected
to suffer a credit event in the near future. As a hypothetical
example, market participants might have measured the jump-to-default
risk in ``Hypothetical Risky Corporation'' five-year CDS when the
CDS was trading at 70% upfront (that is, a seller would need to
receive an up-front payment of 70% of notional value to write the
contract) and the expected value in default was 80% upfront
(implying a 20% recovery rate) as being equal to 10% of notional
value; equally, they might have measured the jump-to-default risk of
``Hypothetical Safe Corporation'' five-year CDS when it was trading
at 0.30% per annum and no up-front payment (roughly equivalent to an
up-front payment of 1.5%) with an expected value in default of 60%
upfront (implying a 40% recovery rate) as being equal to
approximately 58.5% of notional value. See generally Darrell Duffie
and Haoxiang Zhu, Does a Central Clearing Counterparty Reduce
Counterparty Risk? (Stanford Univ. 2010), available at http://
www.stanford.edu/~duffie/DuffieZhu.pdf.
\163\ See, e.g., Stavros Peristiani, Vanessa Savino, ``Are
Credit Default Swaps Associated with Higher Corporate Defaults?'',
Federal Reserve Bank of New York Staff Report No. 494 (May 2011);
Alessandro Fontana and Martin Scheicher, ``An analysis of euro area
sovereign CDS and their relation with government bonds,'' European
Central Bank Working Paper Series, No. 1271 (Dec. 2010).
\164\ For example, when a participant defaults, the CCP
terminates all of its contracts with the defaulting participant. The
traditional procedures for handling a default, which are used by
CCPs for most exchange-traded derivatives, call for the CCP to
promptly enter the market and replace the contracts, so as to hedge
against further losses on the open positions created by termination
of the defaulter's contracts. However, if the markets for the
contracts cleared by the CCP are illiquid, entering the market may
induce adverse price movements, especially if the defaulting
participant's positions are large relative to the overall market for
the contracts. See Bank for International Settlement's Committee on
Payment and Settlement Systems, New Developments in Clearing and
Settlement Arrangements for OTC Derivatives (Mar. 2007).
\165\ See id.
---------------------------------------------------------------------------
The Commission does not believe that changes in the security-based
swap market resulting from the Dodd-Frank Act (e.g., mandatory clearing
requirements, the establishment of the Council, etc.) have eliminated
or will eliminate the additional risk management challenges of
security-based swaps noted above. Therefore, the Commission believes
that it should codify the existing standard for maintenance of
financial resources established by CCPs currently clearing security-
based swaps.
The Commission notes that current industry participants recognize
the need for more stringent financial resource requirements for CCPs
that clear credit default swaps.\166\ This point is evidenced by the
fact that the ``cover two'' standard has been employed since before the
enactment of the Dodd-Frank Act and prior to the adoption of the
European Market Infrastructure Regulation (``EMIR'') \167\ by the major
CCPs clearing credit default swaps, both in the United States and
internationally. For example, both of the registered CCPs providing
clearing services for credit default swap transactions to customers in
the United States, ICE Clear Credit and ICE Clear Europe, already meet
a ``cover two'' standard as does CME Group (``CME'') with respect to
its clearing service for index credit default swaps, which is
registered with the Commission but does not yet provide CCP services
for security-based swaps.\168\ LCH.Clearnet, a leading CCP
[[Page 66235]]
for OTC derivatives in Europe, maintains a ``cover two'' standard for
its credit default swap CCP activities.\169\ These practices are
consistent with the ``cover two'' financial resources requirement for
European CCPs contained in EMIR.\170\
---------------------------------------------------------------------------
\166\ See, e.g., ISDA Letter at 1; see also Letter to William C.
Dudley from the OTC Derivatives Supervisors Group, dated March 31,
2011, available at http://www.newyorkfed.org/newsevents/news/markets/2011/SCL0331/pdf (generally supporting enhancing the
framework for OTC derivatives risk management).
\167\ Regulation No. 648/2012 of the European Parliament and of
the Council of 4 July 2012 on OTC derivatives, central
counterparties and trade repositories, 2012 O.J. (L 201).
\168\ See CFTC-SEC Staff Roundtable on Clearing of Credit
Default Swaps (Oct. 2010), at 123, available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission7_102210-transcrip.pdf (Stan Ivanov, ICE Clear Credit stating ``at ICE
we look at two simultaneous defaults of the two biggest losers upon
extreme conditions * * *.''). See also CDS Clearing Solution ICE
Clear Europe (June 2012), at 6, available at https://www.theice.com/publicdocs/clear_europe/ICE_Clear_Europe_CDS_Clearing_Overview.pdf (``Guaranty Fund covers simultaneous default of 2
largest Clearing Members''); CME Rulebook, Chapter 8H, Rule 8H07,
available at http://www.cmegroup.com/rulebook/CME/I/8H/07.html.
\169\ See LCH.Clearnet CDS Clearing Rulebook, Chapter 4, Article
4.4.1.2 (May 5, 2012), available at http://www.lchclearnet.com/Images/CDSClear%20Rulebook_tcm6-61343.pdf.
\170\ See supra note 167, at 43.
---------------------------------------------------------------------------
Given that both of the registered CCPs providing clearing services
for security-based swap transactions already meet the proposed
standard, and that CME, which proposes to provide such services, is
currently following a ``cover two'' standard in index credit default
swap clearing, the Commission believes that Rule 17Ad-22(b)(3) does not
represent a change in existing market practices and would not hinder
the growth of existing security-based swap CCPs.\171\ Furthermore, the
Commission does not believe the rule poses an overly burdensome barrier
to entry for future CCPs wishing to clear security-based swaps, as we
do not intend the rule to require a registered CCP clearing security-
based swaps to cover its two largest participant exposures in the event
of default for all of its products. A CCP can choose to maintain a
separate default fund for security-based swaps, limiting the overall
financial burden.\172\
---------------------------------------------------------------------------
\171\ See supra note 168.
\172\ See CME Rulebook, Chapter 8, Rule 802, available at http://www.cmegroup.com/rulebook/CME/I/8/02.html (``The Clearing House
shall establish a guaranty fund (the ``Base Guaranty Fund'') for
products other than CDS Products * * *''); see also CME Rulebook,
Chapter 8H, Rule 8H07, available at http://www.cmegroup.com/rulebook/CME/I/8H/07.html (``The Clearing House shall establish a
financial safeguards package to support CDS clearing, and each CDS
Clearing Member shall make a CDS Guaranty Fund deposit with the
Clearing House.''); see generally discussion infra Section
V.B.1.iii.c.
---------------------------------------------------------------------------
We are adopting Rule 17Ad-22(b)(3) with modifications intended to
recognize different types of structures currently employed by CCPs
clearing security-based swaps and similar structures that may be
developed in the future. The final rule allows that the policies and
procedures may provide that the additional financial resources required
to be held under the ``cover two'' standard may be maintained for the
entire CCP or in separately maintained funds. This modification from
the proposal recognizes that clearing agencies' practices may be
structured as (i) conducting security-based swap clearing activities in
a separate legal entity or (ii) maintaining within one legal entity
separate rules, membership requirements, risk management practices, and
financial resources specifically designed to cover the CCP's exposures
to a separate pool of instruments that includes security-based swaps.
The Commission also believes that as security-based swap CCPs introduce
new products for clearing on an incremental basis in the future, the
adopted rule will provide them with appropriate flexibility to organize
their operations to obtain additional financial resources to cover
exposures for each new security-based swap product in the manner most
appropriate for their organization.\173\
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\173\ The Commission is also aware that clearing agencies that
provide CCP services for security-based swap transactions generally
do not separate their operations and risk management practices
between swap and security-based swap instruments. For example, we
understand that some registered clearing agencies may wish to accept
customer assets used to margin customer positions consisting of
swaps and security-based swaps in commingled customer omnibus
accounts and are already offering clearing services for swaps and
security-based swaps in commingled proprietary accounts.
Accordingly, where a clearing agency's operations and risk
management practices are commingled, the clearing agency will be
subject to the ``cover two'' requirement applicable to security-
based swap CCPs under Rule 17Ad-22(b)(3). See Letter from Winston &
Strawn LLP, dated Nov. 7, 2011 (requesting exemptive relief for ICE
Clear Credit LLC in connection with a program to commingle customer
funds and implement portfolio CDS).
---------------------------------------------------------------------------
Some commenters argued that the Commission should not adopt a
standard for the level of financial resources that may be inconsistent
with the FMI Report and that there should be industry and regulatory
consensus on the level of financial resources that must be
maintained.\174\ The FMI Report states that CCPs should maintain
financial resources to cover the default of the largest two
participants when the CCP is involved in activities with a more-complex
risk profile.\175\ The FMI Report describes a more-complex risk profile
as ``clearing financial instruments that are characterized by discreet
jump-to-default price changes or that are highly correlated with
potential participant defaults.'' \176\ The vast majority of security-
based swaps by notional value and other measures are credit default
swaps products with such characteristics, and, accordingly, the
Commission believes that the standard being adopted today with regard
to security-based swaps is substantially similar to that in the FMI
Report.\177\ As security-based swap products with different
characteristics are proposed for clearing over time, the Commission
would evaluate risk profiles of such products to consider how they
would be treated under the ``cover two'' standard.
---------------------------------------------------------------------------
\174\ See supra note 156.
\175\ See FMI Report, supra note 32, at 36 (Principle 4: Credit
risk ``In addition, a CCP that is involved in activities with a
more-complex risk profile or that is systemically important in
multiple jurisdictions should maintain additional financial
resources sufficient to cover a wide range of potential stress
scenarios that should include, but not be limited to, the default of
the two participants and their affiliates that would potentially
cause the largest aggregate credit exposure to the CCP in extreme
but plausible market conditions. All other CCPs should maintain
additional financial resources sufficient to cover a wide range of
potential stress scenarios that should include, but not be limited
to, the default of the participant and its affiliates that would
potentially cause the largest aggregate credit exposure to the CCP
in extreme but plausible market conditions.'').
\176\ See id.
\177\ The Commission has previously estimated that single-name
CDS will constitute roughly 95% of the market, as measured on a
notional basis, for instruments that fall within the definition of
security-based swap. See Securities Exchange Act Release No. 34-
66868 (Apr. 27, 2012), 77 FR 30596 (May 23, 2012), at 30636, n.476.
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The Commission also is not persuaded that the ``cover two''
standard reflects an implausible occurrence that therefore should not
be embedded into the Commission's rules. The financial crisis of 2008
demonstrated the plausibility of the default of two large participants
in a clearing agency over a brief period. One large investment bank was
saved from the brink of default in March 2008.\178\ In September 2008,
two large financial institutions failed and another large financial
institution was rescued from insolvency by the Federal Reserve.\179\
Throughout the course of these events, the U.S. and world financial
markets were affected by a systemic crisis of confidence that stifled
the ability of market participants to obtain financing and avoid
default.\180\ The Commission believes therefore that it is plausible to
[[Page 66236]]
assume that a systemic market disruption like that which was
experienced in 2008 could affect the two largest participants of a
security-based swap CCP.
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\178\ See Board of Governors of the Federal Reserve System, Bear
Stearns, JPMorgan Chase, and Maiden Lane LLC, http://www.federalreserve.gov/newsevents/reform_bearstearns.htm (last
visited June 25, 2012).
\179\ LaBonte and Norden Berg, Dodd-Frank Act, Congressional
Research Services, Title VIII: Supervision of Payment, Clearing and
Settlement Activities (Dec. 10, 2010), at 1, available at http://www.llsdc.org/attachments/files/279/CRS-R41529.pdf (noting the
failures of Lehman Brothers Holdings, Inc. and Washington Mutual,
Inc. in 2008 and the subsequent rescue of American International
Group, Inc.).
\180\ See, e.g., Trustee's Preliminary Investigation Report and
Recommendations of the Attorneys for James W. Giddens for the SIPA
Liquidation of Lehman Brothers, Inc. (Aug. 25, 2010), available at
http://dm.epiq11.com/LBI/Project/default.aspx.
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One clearing agency commented that since its modeling assumptions
for simultaneous default of two participants assume significant market
volatility but its modeling assumptions for the default of the largest
participant assume low volatility, it is possible that a requirement
for financial resources to cover the default of the largest two
participants may result in only a slightly higher or even a lower
requirement than one for financial resources to cover the default of
the largest participant.\181\ However, the Commission is not persuaded
by this comment and the assumption regarding low volatility. All
registered clearing agencies are expected to ensure that the
assumptions underlying their models are reasonably designed to meet the
requirements of the Exchange Act and related regulations at all times,
and the Commission staff reviews the practices of clearing agencies in
this area through its established supervisory process. To the extent
Commission staff identifies shortcomings in an individual registered
clearing agency's practices relevant to its maintenance of the ``cover
one'' or ``cover two'' requirements, further action may be taken to
address such concerns, as may be necessary or appropriate. For example,
in connection with an examination, the Commission can request
corrective action as part of its examination findings. Where there are
shortcomings that violate the clearing agency's rules or Rule 17Ad-
22(b)(3), the Commission may take enforcement action.\182\
---------------------------------------------------------------------------
\181\ See supra note 150.
\182\ See Section 17A discussion supra Section I.A.2 and
accompanying text.
---------------------------------------------------------------------------
Finally, the Commission does not believe that Rule 17Ad-22(b)(3)
will require major changes to the practices that have been developed to
measure the sufficiency of financial resources at registered CCPs. The
Commission understands that all CCPs currently registered with the
Commission maintain enough financial resources to withstand the default
of their largest participant under extreme but plausible market
conditions.\183\ All of the security-based swap transactions that are
centrally cleared in the United States are handled by a security-based
swap CCP that maintains enough financial resources to be able to
withstand the default of its two largest participants.\184\
---------------------------------------------------------------------------
\183\ See, e.g., International Monetary Fund, Publication of
Financial Sector Assessment Program Documentation--Detailed
Assessment of Observance of the National Securities Clearing
Corporation's Observance of the CPSS-IOSCO Recommendations for
Central Counterparties (2010), at 10, available at http://www.imf.org/external/pubs/ft/scr/2010/cr10129.pdf (assessing NSCC's
observance of Recommendation 5 from the RCCP that a CCP should
maintain sufficient financial resources to withstand, at a minimum,
the default of a participant to which it has the largest exposure in
extreme but plausible market conditions and noting that NSCC began
evaluating itself against this standard in 2009 and has back-testing
results to support that during the period from January through April
2009 there was sufficient liquidity to cover the needs of the
failure of the largest affiliated family 99.98% of the time);
International Monetary Fund, Publication of Financial Sector
Assessment Program Documentation--Detailed Assessment of Observance
of the Fixed Income Clearing Corporation--Government Securities
Division's Observance of the CPSS-IOSCO Recommendations for Central
Counterparties (2010), at 9-10, available at http://www.imf.org/external/pubs/ft/scr/2010/cr10130.pdf (finding that Fixed Income
Clearing Corporation's Government Securities Division ``observed''
the requirement to maintain enough financial resources to meet the
default of its largest participant in extreme but plausible market
conditions).
\184\ See supra note 168 (reflecting that ICE Clear Credit
``looks at two simultaneous defaults of the two biggest losers upon
extreme conditions * * *.''). Most centrally cleared CDS
transactions have cleared at ICE Clear Credit or ICE Clear Europe
Limited. As of April 19, 2012, ICE Clear Credit had cleared
approximately $15.6 trillion notional amount of CDS contracts based
on indices of securities and approximately $1.5 trillion notional
amount of CDS contracts based on individual reference entities or
securities. As of April 19, 2012, ICE Clear Europe had cleared
approximately [euro]7.2 trillion notional amount of CDS contracts
based on indices of securities and approximately [euro]1.2 trillion
notional amount of CDS contracts based on individual reference
entities or securities. See https://www.theice.com/marketdata/reports/ReportCenter.shtml. As of April 19, 2012, CME had cleared
approximately $522 billion notional amount of CDS contracts based on
indices of securities.
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The Commission agrees with the commenter who suggested that it is
important for the Commission to provide concrete guidance regarding the
meaning of ``extreme but plausible market conditions'' to assure
consistent treatment of that term across clearing CCPs. In general,
``extreme but plausible market conditions'' are tail event conditions
in which the price movement of a cleared security results in losses
exceeding expectations at a 99% confidence interval, causing a clearing
agency's exposures to its participants to breach margin requirements or
other risk controls (i.e., a one out of 100 days scenario). For
example, ``extreme but plausible market conditions'' may include or
exceed the worst historical price movement for a particular financial
instrument over a specified time horizon. However, the Commission also
agrees with commenters that argued that industry professionals,
including but not limited to personnel at the clearing agencies
themselves, are likely to be equipped with the relevant expertise that
can contribute to developing a well-informed standard of ``extreme but
plausible market conditions.'' To ensure that the standard is
consistently applied across CCPs and that it accurately captures the
market understanding of the terminology, the Commission expects to
review and publish for public comment rule proposals from clearing
agencies adopting a definition for ``extreme but plausible market
conditions'' that is appropriate for the market they serve.
4. Rule 17Ad-22(b)(4): Model Validation
a. Proposed Rule
Rule 17Ad-22(b)(4), as proposed, would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to provide for an annual model validation process
consisting of evaluating the performance of the CCP's margin models and
the related parameters and assumptions associated with such models by a
qualified person who does not perform functions associated with the
clearing agency's margin models (except as part of the annual model
validation) and does not report to a person who performs these
functions.\185\ The Commission is adopting Rule 17Ad-22(b)(4) to ensure
that a registered CCP's models are validated by qualified persons free
from influence from the persons responsible for development or
operation of the systems and models being validated, with sufficient
frequency to assure that the models perform in a manner that
facilitates prompt and accurate clearance and settlement of
transactions.
---------------------------------------------------------------------------
\185\ Any person responsible for supervising the operation of
the clearing agency's margin model would be viewed as performing the
functions associated with the clearing agency's margin model and
could not therefore have supervisory authority over the person
conducting the model validation.
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b. Comments Received
Commenters generally supported proposed Rule 17Ad-22(b)(4) \186\
but
[[Page 66237]]
they also provided several suggested modifications regarding the
required frequency of the model validation and how best to achieve the
proper level of scrutiny and testing of the model's adequacy. One
commenter stated that the rule should not require the model to be
validated on an annual basis. Instead, the commenter suggested that the
frequency should be left to the discretion of the clearing agency
because it is in the best position to determine the appropriate
timing,\187\ and in the absence of a material change (either to the
model itself or in the market environment that affects the model),
requiring an annual validation may be unnecessary and overly
burdensome.\188\
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\186\ See The DTCC (April) Letter at 13 (supporting Rule 17Ad-
22(b)(4) and recommending certain clarifications); see also Barnard
Letter at 1 (supporting generally the thrust of the Commission's
proposals in the Proposing Release, particularly proposed Rule 17Ad-
22 concerning standards for clearing agencies); BlackRock Letter at
2 (supporting Rules 17Ad-22(b)(1)-(7) because these rules will
benefit the markets by reducing concentration risk, increasing the
diversity of market participants involved in governance, enhancing
competition and lowering costs for customers of clearing members);
LCH Letter at 3 (generally supporting the Commission's proposed
rules under 17Ad-22(b)); MFA (Kaswell) Letter at 2 (generally
supporting the Commission's proposed rules under 17Ad-22(b)).
\187\ See The DTCC (April) Letter at 13.
\188\ See id.
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Commenters also argued that the CCP is in the best position to
determine how to conduct a candid assessment free from outside
influence concerning its margin models and that qualified internal
personnel at the CCP are capable of validating the models if reasonable
steps are taken to ensure objectivity (i.e., the reviewers are not the
same individuals who are or who were involved in designing the models
or who are otherwise biased due to their involvement in implementation
of the models).\189\ Commenters argued that Rule 17Ad-22(b)(4) should
not prescribe a particular method for a clearing agency to achieve that
outcome.\190\
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\189\ See The DTCC (April) Letter at 13; The OCC Letter at 11.
\190\ See The DTCC (April) Letter at 13.
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One commenter recommended that the Commission should replace the
text in proposed Rule 17Ad-22(b)(4) that addresses independence with
language from the Proposing Release that ``the person validating the
clearing agency's model should be sufficiently free from outside
influences so that he or she can be completely candid in their [sic]
assessment of the model.'' \191\ The commenter stated that this
construction is more consistent with RCCP 4: Financial Resources \192\
and with Principle 6: Margin from the Consultative version of the FMI
Report \193\ because it does not prescribe a model validation frequency
or a specific way to achieve integrity in the validation process.\194\
Another commenter stated that proposed Rule 17Ad-22(b)(4) should be
strengthened to require the model validation to be performed by an
outside, independent expert and that the CCP must adjust and revalidate
the model at any time it has reason to believe the model is no longer
adequate.\195\
---------------------------------------------------------------------------
\191\ See The DTCC (April) Letter at 14.
\192\ See RCCP, supra note 33, at 19.
\193\ See Principles for Financial Market Infrastructures
Consultative Report (Mar. 2011), at 40, http://www.iosco.org/library/pubdocs/pdf/IOSCOPD350.pdf; but see supra note 32, at 56
(stating in the finalized FMI Report that a CCP should have its
margin model validated at least annually).
\194\ See The DTCC (April) Letter at 15.
\195\ See Better Markets Letter at 6.
---------------------------------------------------------------------------
Another commenter stated that requiring a CCP to bring independence
to the model review process by detaching it from the model development
process would effectively require maintenance of two quantitative
teams.\196\ According to this commenter, that result would impose costs
on the CCP to staff both teams as well as create potential staffing
problems because talented personnel with the requisite quantitative
skills often view the review process as non-creative.\197\ That
structure, the commenter argued, may create adversarial relationships
within the CCP and could require senior management to resolve highly-
technical disputes between the model development team and model review
team.\198\
---------------------------------------------------------------------------
\196\ See The OCC Letter at 11.
\197\ See id.
\198\ See id.
---------------------------------------------------------------------------
The same commenter suggested that proposed Rule 17Ad-22(b)(4)
should be revised to require a CCP to do the following: (1) Maintain a
culture of commitment to quality where correcting and improving models
is career-enhancing; (2) adopt sound policies and procedures that
create a transparent and auditable model review process; and (3)
require that reporting lines must come together at a person who is
well-versed in technical quantitative matters.\199\ Commenters also
cited to the recently released Supervisory Guidance on Model Risk
Management, in which the Federal Reserve and the Office of the
Comptroller of the Currency stated that ``corporate culture plays a
role [in providing appropriate incentives for proper model review] if
it establishes support for objective thinking and encourages
questioning and challenging of decisions'' and that ``independence may
be supported by separation of reporting lines, [but] it should be
judged by actions and outcomes because there may be additional ways to
ensure objectivity and prevent bias.'' \200\
---------------------------------------------------------------------------
\199\ See id.
\200\ See id.; see also The DTCC (April) Letter at 14 (citing
Supervisory Guidance on Model Risk Management (Apr. 4, 2011)),
available at http://www.occ.treas.gov/news-issuances/bulletins/2011/bulletin-2011-12a.pdf.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(4) with certain
modifications to address concerns raised by commenters, including the
clarification discussed in Sections II.B.4 and III.A regarding the
application of the rule only to registered clearing agencies. In light
of comments asking the Commission to clarify the standard of
independence of the qualified person who performs the model validation,
the Commission is revising the text of Rule 17Ad-22(b)(4) so that the
annual model validation must be performed by a qualified person who is
free from influence from the persons responsible for development or
operation of the systems and models being validated. Generally, the
Commission would consider that a person was free from influence when
that person does not, including but not limited to, perform functions
associated with the clearing agency's margin models (except as part of
the annual model validation) and does not report to a person who
performs these functions. The Commission believes that the change from
the proposal addresses the concerns raised by commenters.\201\
Specifically, the Commission agrees that who will be the reviewer of
the model is best left to the discretion of the CCP, so long as the
goals of the model validation process are achieved.\202\
---------------------------------------------------------------------------
\201\ See, e.g., The OCC Letter at 11-12 (stating that ``[w]e
think that a clearing agency is capable of validating its own models
through the use of qualified internal personnel, provided that
appropriate steps are taken to ensure objectivity, such as ensuring
that the reviewers are not the same individuals as those who are or
were involved in designing such models or are otherwise biased due
to their involvement in implementation of the models. Many employees
who perform functions associated with margin models may have no
particular conflict or bias that would prevent them from conducting
objective model validations and, in fact, many such employees may
have a strong interest in ensuring that margin models are as well-
designed as possible.'').
\202\ See The DTCC (April) Letter at 14 (``The DTCC model risk
policy provides that all models must be certified as valid by a
qualified independent reviewer, defined as `a qualified reviewer
that did not develop and does not currently own the model.' The
reviewer may be an individual or unit within the organization or an
outside consultant.'').
---------------------------------------------------------------------------
As proposed, Rule 17Ad-22(b)(4) would not have permitted the model
validation to be performed by a person performing functions associated
with the CCP's margin models (except as part of the annual model
validation), or who reports to a person who performs those
functions.\203\ The Commission reasoned in the Proposing Release that a
person involved with the functions related to the model's operation, or
someone who reports to such a person, may be less
[[Page 66238]]
likely to evaluate critically the margin models.\204\ After considering
the comments, the Commission agrees that instead of requiring a
particular method or reporting structure, the less-prescriptive
language from the Proposing Release, namely, that a person may perform
the model validation as long as that person is free from influence from
the persons responsible for development or operation of the systems and
models being validated so that he or she can be candid in his or her
assessment of the model, would be appropriate to achieve the intended
purpose.
---------------------------------------------------------------------------
\203\ See supra note 185 and accompanying text.
\204\ See supra note 35.
---------------------------------------------------------------------------
The Commission also notes that the ``sufficiently free from
influence'' standard is consistent with the FMI Report, which does not
prescribe a specific method to assure the effectiveness of the
validation process,\205\ and is consistent with the recent guidance
from the Federal Reserve and the Office of the Comptroller of the
Currency in Supervisory Guidance on Model Risk Management.\206\ The
revised standard adopted by the Commission herein would not require the
clearing agency to detach model review from model development or to
maintain two separate quantitative teams and thus would not lead to
potential increased costs.
---------------------------------------------------------------------------
\205\ See FMI Report, supra note 32.
\206\ Board of Governors of the Federal Reserve System and the
Office of the Comptroller of the Currency, Supervisory Guidance on
Model Risk Management (Apr. 4, 2011), at 9, available at http://occ.gov/news-issuances/bulletins/2011/bulletin-2011-12a.pdf (stating
that independence for model review ``should be judged by actions and
outcomes, since there may be [many] ways to ensure objectivity and
prevent bias'').
---------------------------------------------------------------------------
The Commission is not persuaded that the model validation must be
performed by an outside independent expert.\207\ As noted above, the
Commission believes that objectivity can be preserved where the person
performing the model validation is an employee of the CCP as long as
the clearing agency strictly adheres to the standard the Commission is
adopting herein. Because the Commission has not previously required
CCPs to perform an annual model validation, we understand that the
implementation of this requirement may require the exercise of
substantial judgment by such clearing agencies in the adoption and
implementation of written policies and procedures. The Commission
intends to review the development of compliance practices and to issue
interpretive guidance as appropriate.
---------------------------------------------------------------------------
\207\ See supra note 195.
---------------------------------------------------------------------------
The Commission is not persuaded that the frequency of the model
validation should be left to the discretion of the CCP. Current model
validation practices vary among CCPs. Some CCPs conduct annual
validations, while other conduct them on an ad hoc basis. Because of
the role margin plays in a default, a CCP needs assurance of its value
in the event of liquidation, as well as the capacity to draw upon its
margin promptly. The Commission believes, especially considering its
statutory responsibilities and the importance of model validation in
limiting systemic risk, that it is important to create a consistent and
uniformly applied minimum standard across all clearing CCPs. The
Commission believes that requiring model validation at least annually
is appropriate because model performance is not ordinarily expected to
vary significantly over short periods but should be reevaluated as
market conditions change. Furthermore, the Commission does not think
the standard of an annual model validation is too burdensome,
particularly given the fact that the Commission is not prescribing any
specific qualifications or credentials of the person performing the
model validation and is not requiring the person performing the model
validation to be independent of the clearing agency and given how
important understanding of the margin methodology is to the risk
management framework.
The requirement for an annual model validation does not preclude
the CCP from adjusting its model any time it has reason to believe that
the model is no longer adequate. In fact, as noted above, Rule 17Ad-
22(b)(2) requires a CCP to review its risk-based models to set margin
requirements at least monthly.
The Commission continues to believe that clearing agencies that
provide CCP services must have a qualified person conduct a review of
models that are used to set margin levels, along with related
parameters and assumptions, to assure that the models perform in a
manner that facilitates prompt and accurate clearance and settlement of
transactions. In determining whether a person is qualified to conduct
the model validation, registered CCPs may consider several factors,
including the person's experience in validating margin models,
expertise in risk management generally, and understanding of the
clearing agency's particular operations and procedures.
While the Commission agrees with the commenter who suggested that
CCPs should strive to create a culture of commitment to quality where
improving models is career-enhancing and to adopt sound policies and
procedures to create a transparent and auditable model review
process,\208\ the Commission believes that this result can be achieved
by requiring that a model validation review occur annually and that the
reviewer be qualified and free from influence from the persons
responsible for development or operation of the systems and models
being validated.
---------------------------------------------------------------------------
\208\ See supra note 199 and accompanying text.
---------------------------------------------------------------------------
D. Participant Access Standards for Central Counterparties: Rules 17Ad-
22(b)(5)-(7)
Section 17A of the Exchange Act requires that a clearing agency
shall not be registered unless the Commission determines, among other
things, that the clearing agency's rules do not impose burdens on
competition that are unnecessary or inappropriate to promote the
purposes of the Exchange Act \209\ and that the rules are not designed
to permit unfair discrimination in the admission of participants or
among participants in the use of the CCP.\210\ Therefore, when
evaluating the participation standards at a CCP, the Commission must
strike an appropriate balance between affording CCPs the necessary
discretion to select clearing members that do not jeopardize the CCP's
ability to facilitate prompt and accurate clearance and settlement
while also not impeding access to central clearing among a range of
market participants.
---------------------------------------------------------------------------
\209\ 15 U.S.C. 78q-1(b)(3)(F).
\210\ 15 U.S.C. 78q-1(b)(3)(G).
---------------------------------------------------------------------------
Rules 17Ad-22(b)(5), (6) and (7) introduce certain requirements
regarding access to registered CCPs. Respectively, the rules would
require a registered CCP to do the following: (1) Provide the
opportunity for a person who does not perform any dealer or security-
based swap Dealer services to obtain membership; (2) refrain from using
minimum portfolio size and minimum volume transaction thresholds as
conditions to membership; and (3) provide the ability to obtain
membership to persons who maintain net capital equal to or greater than
$50 million.
Rules 17Ad-22(b)(5), (6) and (7) each address the common topic of
access to and participation in CCPs. Several commenters provided
general comments on that shared focus. Those comments represent a wide
range of views and are reflected immediately below.
Some commenters expressed their general support for the ways that
Rules 17Ad-22(b)(5), (6), and (7) would promote fair and open access to
CCP services through CCP participation
[[Page 66239]]
requirements that are risk appropriate without being unnecessarily
restrictive.\211\ One of these commenters expressed support for the
design of the rules but also made a request for the rules to offer more
flexibility and latitude for CCPs to establish participation
requirements that ensure integrity of operation and risk management.''
\212\
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\211\ See LCH Letter at 3 (upholding the Commission's intent of
``ensuring broad participation in and open access to clearing
agencies''); MFA (Kaswell) Letter at 2, 3 (generally supporting the
Commission's proposed rules under 17Ad-22(b)); CME Letter at 3
(generally supporting ``the regulatory objective of participation
requirements that are risk appropriate without being unnecessarily
restrictive, in order to promote fair and open access to clearing
services.'').
\212\ See LCH Letter at 3.
---------------------------------------------------------------------------
Two commenters urged the Commission not to adopt proposed Rules
17Ad-22(b)(5), (6) and (7).\213\ The first commenter concluded that the
proposed rules, while well-intentioned, ``are unnecessary and
counterproductive to the goal of fair and open access within a
framework of the safe and sound operation of clearing agencies.'' \214\
In particular, this commenter stated its belief that proposed Rules
17Ad-22(b)(5), (6) and (7) are overly prescriptive and that the
Commission already has ample and alternative authority under which to
monitor membership practices.\215\ Specifically, the commenter pointed
to the existing requirement in Section 17A(b)(3)(F) of the Exchange Act
that a clearing agency shall not be registered unless the Commission
determines that the clearing agency's rules are not designed to permit
unfair discrimination in the admission of participants or among
participants in the use of the clearing agency. The commenter also
stated that if proposed Rule 17Ad-22(d)(2) is adopted, that rule would
already require clearing agencies to establish, implement, maintain and
enforce written policies and procedures reasonably designed to have
participation requirements that are objective, publicly disclosed, and
that permit fair and open access.\216\ Finally, this commenter argued
that proposed Rules 17Ad-22(b)(5), (6) and (7) do not conform to
current or proposed global standards related to participation in CCPs.
In contrast, the commenter stated its belief that Section 17A(b)(3) of
the Exchange Act and proposed Rule 17Ad-22(d)(2) are consistent with
RCCP Recommendation 2: Participation requirements \217\ as well as FMI
Principle 18: Access and participation requirements.\218\
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\213\ See The DTCC (April) Letter at 9; The OCC Letter at 12.
\214\ See The DTCC (April) Letter at 18.
\215\ See id.
\216\ See id.
\217\ RCCP Recommendation 2 provides that ``[a] CCP's
participation requirements should be objective, publicly disclosed,
and permit fair and open access.''
\218\ Principle 18 from the FMI Report provides that ``[a]n FMI
should have objective, risk-based, and publicly disclosed criteria
for participation, which permit fair and open access.''
---------------------------------------------------------------------------
The second commenter, while not opposed to the substance of
proposed Rules 17Ad-22(b)(5), (6) and (7), generally questioned the
need to hard wire these requirements into the Commission's rules.\219\
Specifically, this commenter argued that the Commission already has
authority under Section 17A(b)(3)(F) of the Securities Exchange Act to
deny registration to a clearing agency if the clearing agency's rules
are designed to permit unfair discrimination in the admission of
participants or among participants in the use of the clearing
agency.\220\ In addition, this commenter stated that under proposed
Rule 17Ad-22(d)(2) the Commission would gain less prescriptive but
broader and coextensive rule-based authority without imposing ``one
size fits all'' access requirements.\221\
---------------------------------------------------------------------------
\219\ See The OCC Letter at 12.
\220\ See id.
\221\ See id.
---------------------------------------------------------------------------
In the ``Final Rule and Guidance'' sections for Rules 17Ad-
22(b)(5), (6) and (7) below, we address these more general comments in
the context of a discussion of the more specific comments the
Commission received on the proposed rules.
1. Rule 17Ad-22(b)(5): Non-Dealer Member Access
a. Proposed Rule
Rule 17Ad-22(b)(5), as proposed, would require a registered CCP to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide the opportunity for a person
that does not perform any dealer \222\ or security-based swap dealer
\223\ services to obtain membership on fair and reasonable terms at the
CCP in order to clear securities for itself or on behalf of other
persons.
---------------------------------------------------------------------------
\222\ The term ``dealer'' is defined in Section 3(a)(5) of the
Exchange Act and means any person engaged in the business of buying
and selling securities for such person's own account through a
broker or otherwise. The definition contains an exception for a
person that buys or sells securities for such person's own account,
either individually or in a fiduciary capacity, but not as a part of
a regular business. There is also an exception for banks engaging in
certain specified activities. See 15 U.S.C. 78c(a)(5) for the
complete definition.
\223\ Pursuant to Section 761 of the Dodd-Frank Act, the term
``security-based swap dealer'' is added as Section 3(a)(71) of the
Exchange Act, 15 U.S.C. 78c(a), and generally means any person who
(A) Holds itself out as a dealer in security-based swaps; (B) makes
a market in security-based swaps; (C) regularly enters into
security-based swaps with counterparties as an ordinary course of
business for its own account; or (D) engages in any activity causing
it to be commonly known in the trade as a dealer or market maker in
security-based swaps. The Commission and the CFTC jointly adopted
rules to further define the terms ``swap dealer,'' ``security-based
swap dealer,'' ``major swap participant,'' ``major security-based
swap participant,'' and eligible contract participant.'' See supra
note 12 (Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant'', Securities
Exchange Act Release No. 34-66868 (Apr. 27, 2012), 77 FR 30596 (May
23, 2012)).
---------------------------------------------------------------------------
b. Comments Received
Some commenters generally supported the goals of Rule 17Ad-
22(b)(5),\224\ while other commenters expressed several concerns.\225\
Specifically, one commenter stated that ``any regulatory mandate to
admit specific entities as members of a CCP could undermine the
impartial development and application of risk-based standards for
membership.'' \226\ This commenter acknowledged the discussion in the
Proposing Release explaining that proposed Rule 17Ad-22(b)(5) would not
prohibit a clearing agency from using factors aside from a potential
clearing member's dealer or security-based swap dealer status to make
an admissions decision, but nevertheless urged the Commission to forgo
adoption of the rule altogether because it believes clearing agencies
should be permitted, under Commission oversight, to determine how best
to promote correspondent clearing \227\ and to design membership
standards.\228\ The
[[Page 66240]]
commenter suggested that if the rule is adopted, it should be modified
to reflect the more permissive process for evaluation described in the
body of the Proposing Release, namely by clarifying that the clearing
agency may take other factors into account in making membership
decisions.\229\
---------------------------------------------------------------------------
\224\ See supra note 211 (citing LCH Letter, MFA (Kaswell)
Letter, and CME Letter); see also Barnard Letter at 1 (supporting
generally the thrust of the Commission's proposals in the Proposing
Release, particularly proposed Rule 17Ad-22 concerning standards for
clearing agencies); BlackRock Letter at 2 (supporting Rules 17Ad-
22(b)(1)-(7) because these rules will benefit the markets by
reducing concentration risk, increasing the diversity of market
participants involved in governance, enhancing competition and
lowering costs for customers of clearing members).
\225\ See The DTCC (April) Letter at 18-19; The OCC Letter at
12.
\226\ See The DTCC (April) Letter at 18.
\227\ Correspondent clearing is an arrangement between a current
participant of a clearing agency and a non-participant that desires
to use the clearing agency for clearance and settlement services.
\228\ See The DTCC (April) Letter at 18-19. The commenter also
stated its belief that ``financial resources'' and
``creditworthiness'' should be expressly added to the factors that
may be considered. Moreover, the commenter suggested that the term
``otherwise qualified'' be clarified as it was not precise enough
standard to meaningfully inform clearing agencies of what criteria
may be considered when evaluating potential members.
\229\ See The DTCC (April) Letter at 19.
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c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(5) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies.
While the Commission understands concerns raised by commenters, the
Commission ultimately believes that the benefits of Rule 17Ad-22(b)(5)
are critical to maintaining fairness and open access to central
clearing for all market participants, including security-based swaps
participants. The Commission believes that no registered CCP should
deny membership solely because a person does not perform any dealer or
security-based swap dealer services and that such a requirement
unfairly discriminates against certain market participants and should
be prohibited. The Commission does not believe that performing dealer
or security-based swap dealer services is, by itself, a sufficient
indicator of whether an applicant should be admitted to a clearing
agency.
Dealer and security-based swap dealer services generally involve
services designed to facilitate securities transactions by buying and
selling securities for a person's own account.\230\ The Commission
continues to believe that requiring registered CCPs to allow persons
who are not dealers or security-based swap dealers to become members of
the clearing agency will promote more competition by allowing more
firms to clear, thereby increasing competition among clearing members
on both price and service which should, in turn, reduce costs to market
participants. The enhanced access to central clearing should engender
more correspondent clearing in the security-based swap market. Because
of the relationship between security-based swaps and traditional
securities (e.g., market participants using security-based swaps to
hedge positions in traditional securities), the Commission believes
that applying these rules to all CCPs will help ensure that market
participants have access to central clearing in all instruments that
are centrally cleared.
---------------------------------------------------------------------------
\230\ See supra note 222.
---------------------------------------------------------------------------
In situations where direct access to clearing agencies is limited
by reasonable participation standards, firms that do not meet these
standards may still be able to access clearing agencies through
correspondent clearing arrangements with direct participants.\231\ Such
a process involves the non-participant entering a correspondent
clearing arrangement with a participant so that the transaction may be
submitted by the participant to the clearing agency. Thus, the success
of correspondent clearing arrangements depends on the willingness of
participants to enter such arrangements with non-participant firms that
may act as direct competitors to the participants in the participants'
capacity as dealers or security-based swap dealers in the market for
the relevant securities. Given that the existing CCP participants that
are dealers or security-based swap dealers may therefore have
incentives to restrict competitors in the securities execution markets
from accessing a CCP, correspondent clearing arrangements may be
inhibited unless participants that do not provide dealer or security-
based swap dealer services are provided with the ability to become
direct members of a clearing agency.
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\231\ See Exchange Act Release Nos. 63107 (Oct. 14, 2010), 75 FR
65882 (Oct. 26, 2010) and 64018 (Mar. 3, 2011), 76 FR 12645 (Mar. 8,
2011) (Ownership Limitations and Governance Requirements for
Security-Based Swap Clearing Agencies, Security-Based Swap Execution
Facilities, and National Securities Exchanges with Respect to
Security-Based Swaps under Regulation MC).
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Also, the Commission is not persuaded by the comment that Rule
17Ad-22(b)(5) is likely to undermine the impartial development and
application of risk-based standards for membership.\232\ Simply stated,
Rule 17Ad-22(b)(5) is designed to prohibit registered CCPs from denying
membership on fair and reasonable terms to otherwise qualified persons
solely by virtue of the fact that they do not perform any dealer or
security-based swap dealer services.\233\ The Commission fully
recognizes that persons who are not dealers or security-based swap
dealers may fail to meet other standards for membership at a clearing
agency, such as the operational capabilities required for direct
participation. While non-dealer status cannot serve as the sole reason
for denying membership, Rule 17Ad-22(b)(5) does not prohibit a
registered CCP from taking other standards of membership into account
when establishing membership criteria for non-dealers.
---------------------------------------------------------------------------
\232\ See supra note 228.
\233\ See Proposing Release, supra note 35, at Section II.A.
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Because the factors that each CCP considers when establishing
membership criteria differ based on the particular characteristics of
the relevant clearing agency and the markets it serves, the Commission
believes that it would be counterproductive to modify Rule 17Ad-
22(b)(5) to make it more specific and therefore more constraining. One
commenter, however, requested that the Commission provide additional
clarity in terms of what is required to be considered ``otherwise
qualified'' for membership at a CCP.\234\ In response to this comment,
the Commission notes that, for purposes of Rule 17Ad-22(b)(5), the term
``otherwise qualified'' means that the clearing agency's sole reason
for denying membership to a prospective participant would be the
prospective participant's status as a non-dealer or non security-based
swap dealer and that it otherwise maintains the financial resources,
creditworthiness, operational capacity, and any other additional
characteristics necessary to meet the obligations of participation. As
CCPs shape practices to come into compliance with Rule 17Ad-22(b)(3),
the Commission will consider whether further guidance is appropriate.
---------------------------------------------------------------------------
\234\ See supra note 229.
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The Commission believes that the incentives of persons who do not
perform dealer or security-based swap dealer services to promote access
at a CCP in general would tend to be consistent with increased
competition in the market for the relevant securities. These persons do
not execute securities trades for their own account. Instead, they
provide correspondent clearing services for market participants.\235\
As a result, their ability to provide correspondent clearing services
would tend to increase as competition and transaction volumes
increased. Accordingly, the Commission believes that Rule 17Ad-22(b)(5)
will foster the development of correspondent clearing arrangements that
will allow market participants who are not dealers or security-based
swap dealers to obtain access to a registered CCP and that such access
will have the beneficial result of greater competition in and access to
central clearing. Moreover, because entities must meet all of the
standards for membership, the Commission does not believe that it will
undermine the
[[Page 66241]]
development or application of risk management standards.
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\235\ For a description of correspondent clearing activity, see
generally The Role and Regulation of Clearing Brokers, 48 Bus. Law
841 (May 1993).
---------------------------------------------------------------------------
2. Rule 17Ad-22(b)(6): Portfolio Size and Transaction Volume Thresholds
Restrictions
a. Proposed Rule
Rule 17Ad-22(b)(6), as proposed, would prohibit a CCP from having
membership standards that require participants to maintain a portfolio
of any minimum size or to maintain a minimum transaction volume.
b. Comments Received
Some commenters expressed general support for the goals of proposed
Rule 17Ad-22(b)(6).\236\ At the same time, one commenter opposed
adoption of the rule because of concern that ``any regulatory mandate
on portfolio size and transaction volume thresholds could undermine the
impartial development and application of risk-based standards for
membership'' in a CCP.\237\ This commenter also questioned why certain
language in the discussion section of the Proposing Release (explaining
that the proposed rule ``would not prohibit a central counterparty from
considering portfolio size and transaction volume as one of several
factors when reviewing a potential participant's operations'') was not
included in the text of the proposed rule.\238\ In addition, the
commenter stated that even if a CCP has the discretion to consider
portfolio size and transaction volume when making a membership
decision, it is unclear how much weight the clearing agency actually
may give to this factor without running afoul of Rule 17Ad-
22(b)(6).\239\ Finally, this commenter noted that it ultimately would
prefer to see the Commission not adopt Rule 17Ad-22(b)(6) and instead
continue to oversee determinations made by clearing agencies concerning
membership standards and the weight, if any, to be given to portfolio
size and transaction volume.\240\
---------------------------------------------------------------------------
\236\ See supra note 211 (citing LCH Letter, MFA (Kaswell)
Letter, and CME Letter); see also Barnard Letter at 1 (supporting
generally the thrust of the Commission's proposals in the Proposing
Release, particularly proposed Rule 17Ad-22 concerning standards for
clearing agencies); BlackRock Letter at 2 (supporting Rules 17Ad-
22(b)(1)-(7) because these rules will benefit the markets by
reducing concentration risk, increasing the diversity of market
participants involved in governance, enhancing competition and
lowering costs for customers of clearing members).
\237\ See The DTCC (April) Letter at 19.
\238\ See id.
\239\ See The DTCC (April) Letter at 19-20.
\240\ See The DTCC (April) Letter at 20.
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c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(6) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies.
We believe that imposing minimum thresholds on the size or
transaction volume of a participant's portfolio would not function as a
good indicator of whether the participant is able to meet its
obligations to a CCP.\241\ The Commission believes that trading volume
and portfolio size alone are poor grounds for limiting participant
access to central clearing, and that sole use of these criteria could
indicate unfair discrimination against certain market participants and
thus should be prohibited as the sole basis for determining membership.
---------------------------------------------------------------------------
\241\ Rule 17Ad-22(b)(6) would not prohibit a clearing agency
from imposing maximum portfolio sizes or transaction volume amounts.
---------------------------------------------------------------------------
New participants to a CCP that do not, at least initially, intend
to transact in substantial size or volume may nevertheless have the
operational and financial capacity to perform the activities that other
participants are able to perform. Therefore, the Commission believes
that Rule 17Ad-22(b)(6) will help facilitate compliance with the
requirement in Section 17A of the Exchange Act that the rules of a CCP
must permit fair and open access.\242\
---------------------------------------------------------------------------
\242\ See supra note 210.
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For the same reasons discussed in connection with Rule 17Ad-
22(b)(5), the Commission is not persuaded by the comment that Rule
17Ad-22(b)(6) is likely to undermine the impartial development and
application of risk-based standards for membership.\243\ Specifically,
the rule does not prohibit a CCP from considering portfolio size and
transaction volume as one of several factors when reviewing a potential
participant's operations. Rather, the rule prohibits the establishment
of minimum portfolio sizes or transaction volumes that by themselves
would act as barriers to participation by new participants in clearing.
Rule 17Ad-22(b)(6) is an absolute bar to the sole use of these criteria
for determining membership. The Commission also does not believe that
it would be prudent to modify the rule text to make it more specific
and potentially more constraining because the factors that each CCP
considers when establishing appropriate membership criteria differ to
some degree based on the particular characteristics of the relevant
clearing agency and the markets it serves. As noted more generally in
Section II.B above, the Commission will consider whether to issue
further guidance to facilitate compliance as clearing agencies
establish, implement, maintain and enforce policies and procedures
responsive to Rule 17Ad-22(b)(6).
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\243\ See supra note 237.
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3. Rule 17Ad-22(b)(7): Net Capital Restrictions
a. Proposed Rule
Proposed Rule 17Ad-22(b)(7) would require a CCP to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to provide a person that maintains net capital
\244\ equal to or greater than $50 million with the opportunity to
obtain membership at the CCP, with any net capital requirements being
scalable so that they are proportional to the risks posed by the
participant's activities to the CCP.
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\244\ Proposed Rule 17Ad-22(a)(5) would define ``net capital''
for the limited purposes of proposed Rule 17Ad-22(b)(7) to have the
same meaning as set forth in Rule 15c3-1 under the Exchange Act for
broker-dealers or any similar risk adjusted capital calculation for
all other prospective clearing members.
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b. Comments Received
Some commenters supported proposed Rule 17Ad-22(b)(7).\245\ Several
commenters expressed support for the rule because it would require
access to a CCP to be scaled in a risk-based way.\246\ One of these
commenters expressed the hope that the CFTC would adopt a similar
requirement and urged the Commission to work together with the CFTC to
harmonize their respective rules in this area.\247\
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\245\ See MFA (Kaswell) Letter at 3; ISDA Letter at 4; BlackRock
Letter at 1.
\246\ See ISDA Letter at 4; MFA (Kaswell) Letter at 3; BlackRock
Letter at 1.
\247\ See ISDA Letter at 4. See also Derivatives Clearing
Organization General Provisions and Core Principles, supra note 38
(in which the CFTC adopted Rule 39.12(a)(2)(iii) to require that a
DCO shall not set a minimum capital requirement of more than $50
million for any person that seeks to become a clearing member in
order to clear swaps).
---------------------------------------------------------------------------
Another commenter supportive of Rule 17Ad-22(b)(7) urged the
Commission to modify the rule to eliminate the ability of a CCP to
raise its minimum net capital threshold above $50 million.\248\ This
commenter stressed that if the Commission declined to take such action
when adopting a final rule, then the Commission should (i) Require the
clearing agency's rationale to meet a higher burden of proof than
currently proposed; (ii) require the clearing agency to demonstrate not
only that it
[[Page 66242]]
could not effectively manage the risk using other measures but also
that raising the minimum capital requirement is the least restrictive
means by which to address the risk posed to the clearing agency; and
(iii) review the clearing agency's showing and make an express
determination that no other, less- competitively-restrictive measures
are available to the clearing agency to manage the risk
effectively.\249\
---------------------------------------------------------------------------
\248\ See MFA (Kaswell) Letter at 4-5 (noting that the CFTC in
the DCO Release adopted rule 39.12(a)(2)(iii) in a form that does
not permit adjustment of the $50 million net capital requirement for
membership).
\249\ See MFA (Kaswell) Letter at 4-5.
---------------------------------------------------------------------------
One commenter stated that net capital, without regard to other risk
factors, does not conclusively establish creditworthiness or any of the
other generally accepted qualifications for becoming a member of a
CCP.\250\ Another commenter agreed with this assertion, but cited it as
support for Rule 17Ad-22(b)(7) on the basis that clearing members with
net capital closer to $50 million may have other characteristics that
make their risk profile less risky than clearing members with greater
amounts of net capital.\251\
---------------------------------------------------------------------------
\250\ See The DTCC (April) Letter at 20.
\251\ See MFA (Kaswell) Letter at 3.
---------------------------------------------------------------------------
Several commenters expressed concern over proposed Rule 17Ad-
22(b)(7).\252\ One commenter stated that the proposed $50 million net
capital standard could create conditions where a clearing member at
that net capital level might use its $50 million of net capital to
access multiple clearing agencies.\253\ Commenters suggested that this
standard would increase the likelihood that the clearing member would
not be able to meet capital calls close in time from multiple clearing
agencies.\254\ To address this concern about margin call risk, the
commenter suggested that the rule should be modified to require: (i)
Daily reporting from each clearing member of its capital cover for the
potentially numerous assessments that it could be subject to from each
clearing agency where it is a member; (ii) the clearing member to
conduct regular stress tests at an ``extreme but plausible'' market
level in relation to the potentially numerous clearing agency
assessments that it could be subject to, and to provide the results to
each clearing agency where it is a member; and (iii) each clearing
agency to monitor and assess, on a daily basis, the ability of a
clearing member and its related affiliates to meet these potential
assessment exposures and share this daily analysis with other CCPs and
any relevant prudential regulator.\255\ The commenter stated that
unless regulators and clearing agencies are able and willing to commit
to these actions, then it believes that a far larger minimum net
capital requirement, such as $1 billion, is appropriate.\256\
---------------------------------------------------------------------------
\252\ See The OCC Letter at 12; The DTCC (April) Letter at 9.
\253\ See ISDA Letter at 3.
\254\ See id.
\255\ See id.
\256\ See id.
---------------------------------------------------------------------------
Another commenter expressed concern that because not all market
participants use a net capital computation, the proposed rule could
give unfair advantages to some market participants over others in terms
of gaining and retaining membership at a CCP.\257\ The commenter
concluded that proposed Rule 17Ad-22(b)(7) should not be adopted, and
instead CCPs should continue to determine membership standards subject
to Commission oversight (including capital requirements and other
measures of creditworthiness) as well as how best to ensure that access
to the clearing agency is fair and open.\258\
---------------------------------------------------------------------------
\257\ See The DTCC (April) Letter at 20.
\258\ See id.
---------------------------------------------------------------------------
One commenter noted the Commission's reference in the Proposing
Release to the tiered membership standards of the FICC as an example of
capital-related requirements that differentiate between types of
participants.\259\ The commenter stated its opposition to ``tiers'' in
the membership structure of CCPs on the basis that they can have
discriminatory or anti-competitive effects.\260\ Finally, another
commenter stated it generally does not see the need for the approach
proposed in Rule 17Ad-22(b)(7) because it believes the Commission has
other tools at its disposal to review membership standards on a case-
by-case basis that account for the nature of a particular clearing
agency's activities and the risks associated with those
activities.\261\
---------------------------------------------------------------------------
\259\ See MFA (Kaswell) Letter at 4.
\260\ See id.
\261\ See The OCC Letter at 12.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(b)(7) with certain
modifications, including the clarification discussed in Sections II.B.4
and III.A regarding the application of the rule only to registered
clearing agencies. As noted by the commenters expressing support for
the rule,\262\ we believe that persons that maintain a net capital
level of equal to or greater than $50 million, as well as an
appropriate level of financial expertise, should not be denied
participation in a CCP based solely on their net capital levels,
provided that such persons are able to comply with other reasonable
membership standards. In the Proposing Release, we cited recent broker-
dealer reporting data available to the Commission reflecting that the
$50 million threshold for net capital is a standard that provides the
potential for approximately 4% of the total number of broker-dealers or
approximately 201 firms could be eligible to gain clearing membership
at one of the registered clearing agencies.\263\ According to this
data, raising the net capital requirement to $100 million would have
reduced the community of eligible broker-dealers by 73 firms or 35% to
128 eligible firms, while reducing the net capital threshold to as low
as $25 million would increase the number of broker-dealer potentially
eligible for membership by 86 firms or 43% to 287 firms (approximately
6% of broker-dealers). The Commission believes that firms that maintain
a net capital level of equal to or greater than $50 million have
sufficient financial resources to participate at some level in a CCP
provided that they are able to comply with other reasonable membership
standards and is concerned that some firms with less than $50 million
of net capital may not have sufficient financial resources to fulfill
membership obligations. The rule also ensures that each clearing agency
will have the flexibility to develop scalable policies and procedures
to limit the activities of participants based on their level of net
capital.\264\ For example, a CCP can place limits on its potential
exposure to participants operating at certain net capital thresholds by
restricting the maximum size of the portfolio such participants are
permitted to maintain at the clearing agency. Accordingly, the
Commission believes the $50 million minimum standard strikes the proper
balance between promoting open access to central clearing among
participants that have the capacity to participate without posing undue
risk to CCPs. The Commission also believes that Rule 17Ad-22(b)(7)
would facilitate sound
[[Page 66243]]
risk management practices by the clearing agencies. The CCPs that seek
Commission permission to employ a higher net capital requirement as a
condition for membership at the clearing agency must demonstrate to the
Commission that such a requirement is necessary to mitigate risks that
could not otherwise be effectively managed by other measures. The CCPs
seeking to implement such requirements should examine and articulate
the benefits of higher net capital requirements and link the nature and
degree of participation with the potential risks posed by the
participant.
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\262\ See supra note 245.
\263\ Even if proposed Rule 17Ad-22(b)(7) is successful in
encouraging the broadening of membership in CCPs that clear CDS, the
Commission believes the number of broker-dealers newly eligible for
clearing membership that become clearing members as a result of this
change is likely to be substantially less than 201.
\264\ The Commission notes that some clearing agencies currently
utilize capital-related requirements that differentiate among types
of participants. For instance, the FICC has maintained a $50 million
net worth requirement and $10 million excess net capital requirement
for its Category 1 Dealer Netting Members and a $25 million net
worth requirement and $10 million excess net capital requirement for
its Category 2 Dealer Netting Members. This type of arrangement
would continue to be acceptable under Rule 17Ad-22(b)(7).
---------------------------------------------------------------------------
The Commission also does not believe that $50 million net capital
standard contained in Rule 17Ad-22(b)(7) would give an advantage to
some prospective members at a CCP over others. Further, the rule
explicitly is not intended in any way to create an ``entitlement'' to
membership for firms with more than $50 million in capital. Upon
adoption of Rule 17Ad-22, a registered CCP cannot restrict access
because a participant does not have a net capital level of $50 million
or more; however, the CCP's policies and procedures can prescribe other
reasonable membership standards and can be reasonably designed to limit
the activities of the participant in comparison to the activities of
other participants that maintain a higher net capital level. For
example, as a way to help make its requirements scalable, a registered
CCP may elect to place limits on its potential exposure to participants
operating at certain net capital thresholds by restricting the maximum
size of the portfolio such participants are permitted to maintain at
the CCP.
Rule 17Ad-22(b)(7) also permits a registered CCP to provide for a
higher net capital requirement (i.e., higher than $50 million) as a
condition for membership at the clearing agency if the clearing agency
demonstrates to the Commission that such a requirement is necessary to
mitigate risks that could not otherwise be effectively managed by other
measures, such as scalable limitations on the transactions that the
participants may clear through the CCP, and the Commission approves the
higher net capital requirement as part of a rule filing or clearing
agency registration application. While the Commission is sympathetic to
commenters who asked the Commission to eliminate the ability in Rule
17Ad-22(b)(7) of a clearing agency to impose a higher net capital
requirement and argued for a heightened burden of proof in such
cases,\265\ the Commission has decided not to modify this part of the
rule. Specifically, the Commission recognizes the benefit of
maintaining flexibility to allow a CCP to impose higher net capital
requirements in circumstances where that is necessary to mitigate risks
that could not otherwise be effectively managed by other measures. For
the same reason, the Commission is declining to modify the rule to
prohibit a CCP from having tiered membership standards. The Commission
is not persuaded by commenters who stated that use of tiered membership
standards by clearing agencies is by itself anti-competitive because
the Commission believes the approach taken by the rule permits well
capitalized mid-tier firms to compete directly with large dealers and
notes that Section 17A of the Exchange Act expressly requires that the
rules of a clearing agency not be designed in a way that the rules
discriminate among participants in their use of clearing agency
services.\266\ It is the Commission's view that tailoring participant
membership standards based on participant risk profile is neither
discriminatory nor anti-competitive. In addition, the use of scalable
limitations on the transactions that the participants may clear and
settle through the clearing agency is likely to be a key tool for
allowing a clearing agency to comply with Rule 17Ad-22(b)(7) without
encountering the delay and operational difficulties of having to
request Commission approval to impose a net capital requirement that
exceeds $50 million and without compromising the clearing agency's risk
management standards.\267\
---------------------------------------------------------------------------
\265\ See supra notes 248-249 and accompanying text.
\266\ See id.
\267\ Compare with note 258 and accompanying text (the
Commission is not persuaded by the position that Rule 17Ad-22(b)(7)
should not be adopted, but agrees with the commenters premise that
clearing agencies should retain some discretion to allow their
expertise to inform participation standards within the requirements
of the rule).
---------------------------------------------------------------------------
Finally, the Commission did not make any changes to Rule 17Ad-
22(b)(7) in response to suggestions that the rule could create margin
call risk because a participant with the minimum net capital level
might access multiple clearing agencies.\268\ The Commission does not
believe that the rule will increase margin call risk. While the
Commission understands the concerns raised by this commenter, the
Commission believes that the clearing agencies themselves are best
positioned to address this issue due to their expertise in this area,
as well as their other regulatory obligations related to their risk
management and financial well-being. Rule 17Ad-22(d)(2) requires
clearing agencies to establish, implement, maintain and enforce written
policies and procedures reasonably designed to require participants to
have sufficient financial resources and robust operational capacity to
meet obligations arising from participation in the CCP and have
procedures in place to monitor that participation requirements are met
on an ongoing basis. Accordingly, a small clearing member should not be
able to expose a clearing agency to significant risk even if it is able
to clear at multiple CCPs.\269\ The Commission also will be able to
monitor the financial strength of clearing members that are registrants
pursuant to other financial reporting requirements. Accordingly, we
believe that it is important to allow CCPs enough flexibility to
determine the most effective approach for mitigating any potential call
risk. In addition, the Commission will continue to monitor this issue
and will consider whether any regulatory changes are necessary based on
experience with the $50 million capital standard. The Commission will
also consider any further action responsive to this issue after
receiving input from interested parties through the outreach described
in Section II.B.
---------------------------------------------------------------------------
\268\ See supra notes 253-256 and accompanying text.
\269\ For example, CCPs that participate in the Shared Market
Information System (SHAMIS) will be able to see a clearing member's
risk and financial information across participating CCPs, and a CCP
also could on its own initiative require clearing members to
directly report their clearing activity at other clearing agencies.
Other similar systems may develop in the future.
---------------------------------------------------------------------------
E. Record of Financial Resources and Annual Audited Financial
Statements: Rules 17Ad-22(c)(1)-(2)
1. Rule 17Ad-22(c)(1): Record of Financial Resources for Central
Counterparties
a. Proposed Rule
Proposed Rule 17Ad-22(c)(1) would provide that each fiscal quarter
(based on calculations made as of the last business day of the clearing
agency's fiscal quarter), or at any time upon Commission request, a CCP
shall calculate and maintain a record \270\ of the financial resources
necessary to meet its requirement in proposed Rule 17Ad-22(b)(3) and
sufficient documentation to explain the methodology it uses to compute
such financial resource requirement.
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\270\ See Exchange Act Rule 17a-1 (17 CFR 240.17a-1). Clearing
agencies may destroy or otherwise dispose of records at the end of
five years consistent with Exchange Act Rule 17a-6 (17 CFR 240.17a-
6).
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[[Page 66244]]
b. Comments Received
Commenters generally supported proposed rule 17Ad-22(c)(1).\271\
---------------------------------------------------------------------------
\271\ See The DTCC (April) Letter at 7; see also Barnard Letter
at 1 (supporting generally the thrust of the Commission's proposals
in the Proposing Release, particularly proposed rule 17Ad-22
concerning standards for clearing agencies); LCH Letter at 1
(stating its general belief that the rules in the Proposing Release
``will help establish a comprehensive regulatory framework to reduce
risk, increase transparency and promote market integrity within the
financial system.'').
---------------------------------------------------------------------------
c. Final Rule
We are adopting Rule 17Ad-22(c)(1) as proposed, except for the
clarification discussed in Sections II.B.4 and III.A regarding the
application of the rule only to registered clearing agencies. The
Commission believes that it is appropriate to require registered
clearing agencies to make these calculations quarterly or at any time
based on the request of the Commission because it provides a periodic
update of the financial resources that are needed by the clearing
agencies as market conditions change. The structure of Rule 17Ad-
22(c)(1) also provides flexibility for the Commission to request such
calculations on a real-time basis, which we believe to be useful during
periods of market stress or other circumstances where more timely
information is desired. The Commission believes that these calculations
and related documentation will also help our oversight of compliance by
clearing agencies with Rule 17Ad-22(b)(3) by providing a clear record
of the method used by the clearing agency to maintain sufficient
financial resources.
2. Rule 17Ad-22(c)(2): Clearing Agency Annual Audited Financial
Statements
a. Proposed Rule
Rule 17Ad-22(c)(2), as proposed, would require a clearing agency to
post on its Web site an annual audited financial report. Each financial
report would be required to: (i) Be a complete set of financial
statements of the clearing agency for the most recent two fiscal years
of the clearing agency and be prepared in accordance with U.S.
generally accepted accounting principles (``U.S. GAAP''), except that
for a clearing agency that is a corporation or other organization
incorporated or organized under the laws of any foreign country, the
financial statements may be prepared according to U.S. GAAP or
International Financial Reporting Standards as issued by the
International Accounting Standards Board (``IFRS''); (ii) be audited in
accordance with standards of the Public Company Accounting Oversight
Board by a registered public accounting firm that is qualified and
independent in accordance with Rule 2-01 of Regulation S-X (17 CFR
210.2-01); and (iii) include a report of the registered public
accounting firm that complies with paragraphs (a) through (d) of Rule
2-02 of Regulation S-X (17 CFR 210.2-02).
b. Comments Received
Commenters generally supported proposed Rule 17Ad-22(c)(2).\272\ In
response to a question asked by the Commission in the Proposing
Release, one commenter stated that it does not believe the Commission
should require a reconciliation to U.S. GAAP for reports prepared using
IFRS because it believes that IFRS is a high-quality set of accounting
standards that is widely recognized, understood and used by investors
when evaluating investment opportunities.\273\ The commenter also asked
the Commission to consider allowing non-U.S. based clearing agencies to
prepare their financial statements in accordance with accounting
standards generally accepted in the clearing agency's particular
jurisdiction so long as the financial statements are accompanied by a
reconciliation to U.S. GAAP.\274\ The commenter suggested that not
allowing this flexibility could force non-U.S. based clearing agencies
to post financial statements on their Web site that do not conform to
the clearing agency's local accounting and financial reporting
requirements.\275\
---------------------------------------------------------------------------
\272\ See The DTCC (April) Letter at 7; ENY Letter at 2.
\273\ See ENY Letter at 1.
\274\ See id. at 2.
\275\ See id.
---------------------------------------------------------------------------
c. Final Rule
We are adopting Rule 17Ad-22(c)(2) as proposed, except for the
clarification discussed in Sections II.B.4 and III.A regarding the
application of the rule only to registered clearing agencies. We have
also changed references to ``annual audited financial report'' to
``annual audited financial statements'' to be consistent with the term
used in Regulation S-X. Furthermore, we have clarified that a
registered clearing agency will be required to post its financial
statements of income, changes in stockholders' equity and other
comprehensive income and cash flows \276\ within 60 days after the end
of its fiscal year, which is consistent with the staff guidance on
meeting the requirements of Section 17A in its Announcement of
Standards for the Registration of Clearing Agencies.\277\ The
Commission believes that requiring the disclosure of the clearing
agency's annual audited financial statements to be an additional layer
of information about the activities and financial strength of the
clearing agency that market participants may find useful in assessing
their use of the clearing agency's services.\278\
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\276\ The added language, ``changes in stockholders' equity and
other comprehensive income,'' does not change the substance of the
rule as provided in the Proposing Release. This language has been
added in the final rule to clarify the scope of what is meant by a
complete set of financial statements consistent with customary
industry accounting practices.
\277\ See Exchange Act Release No. 16900 (June 17, 1980), 45 FR
41920 (June 23, 1980) (``Accordingly, a clearing agency should
undertake in its rules to furnish to participants, within 60 days
following the close of the clearing agency's fiscal year,
unconsolidated audited comparative financial statements which are
prepared in accordance with generally accepted accounting principles
and are covered by a report prepared by its independent public
accountant.'').
\278\ The requirements of proposed Rule 17Ad-22(c)(2) concerning
the audited annual financial statements would apply individually to
each respective clearing agency.
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Consistent with recommendations from commenters, we are adopting
Rule 17Ad-22(c)(2) in a form that does not require a reconciliation to
U.S. GAAP for clearing agency reports that are prepared using
IFRS.\279\ We appreciate the request made by commenters for the
Commission to consider allowing non-U.S. based clearing agencies to
prepare their financial statements in accordance with accounting
standards generally accepted in their home jurisdiction so long as the
financial statements are accompanied by a reconciliation to U.S.
GAAP.\280\ However, we also recognize the advantages of financial
statement disclosure that are limited to more widely applied bases of
accounting and may offer more utility to market participants,
regulators and other stakeholders of clearing agencies. Therefore, we
have limited the different bases of accounting upon which the annual
audited financial statements may be prepared to IFRS and U.S. GAAP.
---------------------------------------------------------------------------
\279\ See supra note 273.
\280\ See supra notes 274-275 and accompanying text.
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F. Minimum Standards for Registered Clearing Agencies: Rules 17Ad-
22(d)(1)-(15)
Rule 17Ad-22(d) sets forth certain minimum standards regarding the
operations of registered clearing agencies providing CCP or CSD
services. The standards established in Rule 17Ad-22 address areas
including: (1) Transparent and enforceable rules and procedures; (2)
participation requirements; (3) custody of assets and
[[Page 66245]]
investment risk; (4) operational risk; (5) money settlement risk; (6)
cost-effectiveness; (7) links; (8) governance; (9) information on
services; (10) immobilization and dematerialization of securities
certificates; (11) default procedures; (12) timing of settlement
finality; (13) delivery versus payment; (14) risk controls to address
participants' failures to settle; and (15) physical delivery risks.
Like Rules 17Ad-22(b) and (c), Rule 17Ad-22(d) is designed to work
in tandem with the Commission's existing mandate under Section 17A of
the Exchange Act by establishing minimum standards for clearing agency
operations. In particular, Congress directed the Commission to
facilitate the establishment of (1) a national system for the prompt
and accurate clearance and settlement of transactions in securities
(other than exempt securities) and (2) linked or coordinated facilities
for clearance and settlement of transactions in securities, securities
options, contracts of sale for future delivery and options thereon, and
commodity options. \281\ In using its authority, the Commission must
consider the public interest, the protection of investors, the
safeguarding of securities and funds, and the maintenance of fair
competition among brokers and dealers, clearing agencies, and transfer
agents.\282\ When Congress established this system for the regulation
of clearing agencies in 1975, Congress found that:
---------------------------------------------------------------------------
\281\ See 15 U.S.C. 78q-1(a)(2)(A).
\282\ See 15 U.S.C. 78q-1(b)(3)(A)-(I).
---------------------------------------------------------------------------
The prompt and accurate clearance and settlement of
securities transactions, including the transfer of record ownership and
the safeguarding of securities and funds related thereto, are necessary
for the protection of investors and persons facilitating transactions
by and acting on behalf of investors.
Inefficient procedures for clearance and settlement impose
unnecessary costs on investors and persons facilitating transactions by
and acting on behalf of investors.
New data processing and communications techniques create
the opportunity for more efficient, effective, and safe procedures for
clearance and settlement.
The linking of all clearance and settlement facilities and
the development of uniform standards and procedures for clearance and
settlement will reduce unnecessary costs and increase the protection of
investors and persons facilitating transactions by and acting on behalf
of investors. \283\
---------------------------------------------------------------------------
\283\ See 15 U.S.C. 78q-1(a)(1).
---------------------------------------------------------------------------
These findings serve as objectives in the Commission's ongoing
efforts to enhance efficiency and reduce risk in the operation of the
U.S. clearance and settlement system. Over the years, the Commission's
view of the actions by a clearing agency that are necessary to meet
these objectives as well as the other requirements in Section 17A has
changed with prevailing market conditions and as new technologies are
developed. For example, in the years after the October 1987 market
break, the Commission worked to implement a number of changes in the
securities markets, including the reduction of the standard settlement
time frame for a securities transaction to the third day after the
securities trade date (i.e., T+3) and the conversion to a same-day
funds settlement system.\284\ In 2004, in a concept release titled
Securities Transaction Settlement, the Commission noted at that time
that (1) size and growth of the securities markets; (2) tighter
linkages among markets and market participants; and (3) a possible
wide-scale regional disruption prompted the Commission to consider
shortening the standard T+3 securities settlement cycle even further to
mitigate the possibility of systemic disruptions and to facilitate a
more efficient clearance and settlement system.\285\
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\284\ See 17 CFR 240.15c6-1; Exchange Act Release No. 34-26051
(Aug. 31, 1988), 53 FR 34852 (Sept. 8, 1988).
\285\ See Concept Release: Securities Transaction Settlement,
Release No. 34-49405 (Mar. 11, 2004).
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Over time, changes to the U.S. legal framework have also led to
enhancements in the operation of the U.S. clearance and settlement
system. For example, the adoption of Revised Article 8 of the Uniform
Commercial Code in 1995 strengthened the laws governing the holding and
transfer of securities.\286\ In response, clearing agencies changed
their rules to provide greater legal certainty to their direct
investors and provide greater protection to investors.\287\ Amendments
to the U.S. bankruptcy code in 2005 similarly provided an opportunity
for enhanced legal protections for clearing agencies and clearing
agency participants.\288\
---------------------------------------------------------------------------
\286\ See generally James S. Rogers, Policy Perspectives on
Revised U.C.C. Article 8 (1996), Boston College Law School Faculty
Papers, Paper 343, available at http://lawdigitalcommons.bc.edu/cgi/viewcontent.cgi?article=1346&context=lsfp.
\287\ Securities and Exchange Act Release Nos. 39924 (Apr. 27,
1998), 63 FR 24584 (May 4, 1998) and 36781 (Jan. 26, 1996), 61 FR
3958 (Feb. 2, 1996).
\288\ Bankruptcy Abuse Prevention and Protection Act of 2005,
Public Law 109-8, 119 Stat. 23.
---------------------------------------------------------------------------
Consistent with these examples of how the Commission's approach to
administrative oversight and practices by clearing agencies have
changed over time to meet the objectives of Section 17A, the Commission
believes that Rule 17Ad-22(d) creates standards for various aspects of
the payment, clearance and settlement process and that to meet these
standards clearing agencies will likely need to update their rules and
procedures as market conditions evolve (e.g., through new products and
trading strategies), to keep pace with relevant changes in technology,
and appropriately respond to other conditions.\289\ The discussion
below provides greater detail regarding each respective standard
covered in Rules 17Ad-22(d)(1)-(15). As indicated in Section II.B the
Commission intends to observe clearing agency practices as they are
developed to establish, implement, maintain and enforce policies and
procedures that are intended to achieve compliance with Rules 17Ad-
22(d)(1)-(15). Monitoring those practices and through cognizance of
changes in other relevant areas that affect a clearing agency's
operation and governance, such as market conditions, technology, or
international standards, the Commission may modify Rules 17Ad-22(d)(1)-
(15) over time or adopt additional rules as appropriate. The Commission
may also choose to issue further guidance concerning its rules for
clearing agencies.
---------------------------------------------------------------------------
\289\ See supra note 71.
---------------------------------------------------------------------------
1. Rule 17Ad-22(d)(1): Transparent and Enforceable Rules and Procedures
a. Proposed Rule
Rule 17Ad-22(d)(1), as proposed, would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide for a well-founded,
transparent and enforceable structure for each aspect of their
activities in all relevant jurisdictions.\290\
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\290\ A relevant jurisdiction would include, among others,
activities (1) In the United States, (2) involving any means of
interstate commerce, or (3) in respect to providing clearing
services to any U.S. person. For clearing agencies that operate in
multiple jurisdictions, this also could include resolving possible
conflicts of laws issues that the clearing agency may encounter.
---------------------------------------------------------------------------
b. Comments Received
Commenters generally supported Rule 17Ad-22(d)(1).\291\
---------------------------------------------------------------------------
\291\ See The DTCC (April) Letter at 7 (noting its support for
proposed Rule 17Ad-22(d)(1) as drafted); see also Better Markets
Letter at 2 (stating generally that ``[i]n fashioning the rules, and
in accordance with the Dodd-Frank Act, the Commission has
appropriately taken into account international standards governing
clearance and settlement''); Barnard Letter at 1 (supporting
generally the thrust of the Commission's proposals in the Proposing
Release, particularly proposed Rule 17Ad-22 concerning standards for
clearing agencies); The OCC Letter at 7 (applauding the Commission
generally for choosing to incorporate many aspects of the current
CPSS-IOSCO Recommendations in the Proposing Release); LCH Letter at
1 (stating its general belief that the rules in the Proposing
Release ``will help establish a comprehensive regulatory framework
to reduce risk, increase transparency and promote market integrity
within the financial system'').
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[[Page 66246]]
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(1) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. We
believe that well-founded, transparent and enforceable policies and
procedures established to underpin a clearing agency's operational and
business activities are essential to reduce legal risks and enhance a
clearing agency's ability to facilitate the prompt and accurate
clearance and settlement of securities transactions and safeguard
securities and funds as required for the protection of investors by
Section 17A of the Exchange Act.\292\
---------------------------------------------------------------------------
\292\ 15 U.S.C. 78q-1(a)(1)(A).
---------------------------------------------------------------------------
To achieve compliance with Rule 17Ad-22(d)(1), a clearing agency
must have written policies and procedures \293\ in place that, at a
minimum, address the significant aspects of a clearing agency's
operations and risk management to provide a well-founded legal
framework and must be clear, internally consistent, and readily
accessible by the public in order to provide a transparent legal
framework. In addition, the clearing agency must be able to enforce its
policies and procedures that contemplate enforcement by the clearing
agency. Moreover, policies and procedures that govern or create
remedial measures that a party other than the clearing agency (such as
a clearing member) can undertake to seek redress or to promote
compliance with applicable rules must be enforceable.\294\ Examples of
legal risk in the operation of a clearing agency include, among other
things, the likelihood that the policies and procedures of a clearing
agency are incomplete, opaque, or not enforceable and will therefore
adversely affect the functioning of the clearing agency.\295\ The
Commission believes that it is helpful for a clearing agency to bear
these risk factors in mind and that it should also consider the extent
to which changes in the legal framework affecting the clearing agency
may require changes to its organization and practices to ensure that
the establishment, implementation, maintenance and enforcement of its
policies and procedures continues to provide for a well-founded,
transparent and enforceable structure that protects the interests of
the clearing agency and its participants.
---------------------------------------------------------------------------
\293\ Clearing agencies are SROs as defined in Section 3(a)(26)
of the Exchange Act. A stated policy, practice, or interpretation of
an SRO, such as a clearing agency's written policies and procedures,
would generally be deemed to be a proposed rule change, unless (1)
it is reasonably and fairly implied by an existing rule of the self-
regulatory organization or (2) it is concerned solely with the
administration of the self-regulatory organization and is not a
stated policy, practice, or interpretation with respect to the
meaning, administration, or enforcement of a SRO's existing rule.
See 17 CFR 240.19b-4.
\294\ The Commission believes that Rule 17Ad-22(d)(1) would
augment the Exchange Act requirement that the rules of the clearing
agency must provide that its participants shall be appropriately
disciplined for any violation of any provision of the rules of the
clearing agency. See 15 U.S.C. 78q-1(b)(3)(G).
\295\ See generally RSSS Recommendation 1, Legal Framework and
RCCP Recommendation 1, Legal Risk, supra note 33.
---------------------------------------------------------------------------
2. Rule 17Ad-22(d)(2): Participation Requirements
a. Proposed Rule
Rule 17Ad-2(d)(2), as proposed, would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to require participants to have
sufficient financial resources and robust operational capacity to meet
obligations arising from participation in the clearing agency; have
procedures in place to monitor that participation requirements are met
on an ongoing basis; and have participation requirements that are
objective, publicly disclosed, and permit fair and open access.
b. Comments Received
Some commenters supported proposed Rule 17Ad-22(d)(2).\296\
---------------------------------------------------------------------------
\296\ See The DTCC (April) Letter at 7; see also Better Markets
Letter at 2; Barnard Letter at 1; The OCC Letter at 7; LCH Letter at
1.
---------------------------------------------------------------------------
One commenter stated its specific preference for proposed Rule
17Ad-22(d)(2) to facilitate the Commission's regulation of access at
clearing agencies compared to Rules 17Ad-22(b)(5), (6) and (7) for
CCPs.\297\ The commenter suggested that adoption of Rule 17Ad-22(d)(2),
though not a prescriptive rule, would give the Commission a broad level
of plenary authority over participant access to clearing agencies.\298\
---------------------------------------------------------------------------
\297\ See The OCC Letter at 12.
\298\ See id.
---------------------------------------------------------------------------
One commenter recommended that the Commission should take an
expansive, prescriptive approach to its rule requirements for clearing
agency participation and participant monitoring.\299\ The commenter
asked that the Commission be more detailed in the requirements of its
proposed rules that address participation standards, like Rule 17Ad-
22(d)(2).\300\ The commenter suggested that the Commission should apply
this approach within several categories of clearing agency operation
that it believes comprise risk management.\301\
---------------------------------------------------------------------------
\299\ See Barnard Letter at 1; ISDA Letter at 3-4.
\300\ See ISDA Letter at 3-4.
\301\ See id. (citing the following areas as components of a
clearing agency's risk management framework: (1) Board and senior
management oversight; (2) an organizational structure that conforms
to the overall strategy and risk policy set by the board; (3) that
individuals permitted to take risk on behalf of the clearing member
have a strong understanding of the organization's risk profile, the
products it trades, and approved trading limits; (4) risk management
that is independent and reports directly to senior management or the
board; and (5) strong systems and procedures for controlling,
monitoring, and reporting risk (including for transactions with
affiliates)).
---------------------------------------------------------------------------
One commenter supported the requirement in Rule 17Ad-22(d)(2) for
clearing members to have written policies and procedures for risk
management but also emphasized the importance of placing emphasis on
practical experience in risk management.\302\ The commenter urged the
Commission to require that participants in a clearing agency must be
able to participate in its default management process, which includes
the ability to bid for the portfolios of other clearing members.\303\
The commenter also stated that if a clearing agency admitted a clearing
member that was unable to participate in default management, it would
reduce available resources and liquidity, place heightened burdens on
other clearing members, and reduce the likelihood that the clearing
agency's risk management process would operate effectively.\304\
---------------------------------------------------------------------------
\302\ See ISDA Letter at 4.
\303\ See ISDA Letter at 5.
\304\ See id.
---------------------------------------------------------------------------
One commenter encouraged the Commission to prohibit clearing
agencies from imposing rules or engaging in conduct that is prejudicial
to indirect clearing participants compared to direct clearing
participants (e.g., with respect to eligibility or the timing of
clearing or processing of trades), and stated that if a transaction
satisfies a clearing agency's rules then the clearing process for that
trade should be the same regardless of whether it involves direct or
indirect clearing participants.\305\
---------------------------------------------------------------------------
\305\ See MFA (Kaswell) Letter at 7 (further stating that this
includes ``barriers to competitive price provision by a liquidity
provider that is an indirect clearing participant versus a direct
clearing participant'' because ``when an indirect clearing
participant trades with another indirect clearing participant, the
clearing process should be identical and as prompt as when one of
the parties is a direct clearing participant so long as the
transaction satisfies the relevant clearing agency's rules,
requirements and standards otherwise applicable to such trades.'');
MFA (Baker) Letter Attachment 1, at 1.
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[[Page 66247]]
Some commenters expressed concern that clearing agency participants
may rely on the resources and services of a third party to meet the
requirements developed by clearing agencies pursuant to Rule 17Ad-
22(d)(2).\306\ One commenter expressed that it does not believe that a
clearing member should be able to use a credit facility funding
arrangement from an unaffiliated entity to satisfy financial resource
requirements developed by a clearing agency pursuant to Rule 17Ad-
22(d)(2).\307\ The commenter noted that in this case the clearing
member receives only a contractual right to funds, may need to attempt
to enforce that right at a time of stressed liquidity, and does not
have rights to monitor the financial resources of the liquidity
facility.\308\ The same commenter stated that participants should not
be permitted to outsource default management.\309\ It argued that
preventing the outsourcing of default management arrangements is
critical to mitigate risks associated with outsourcing.\310\
---------------------------------------------------------------------------
\306\ See ISDA Letter at 4-5.
\307\ See ISDA Letter at 4.
\308\ See id.
\309\ See ISDA Letter at 5.
\310\ See id. (noting (1) the fact that the third party does not
``have skin in the game'' and (2) the third party service provider
could inappropriately bind a clearing member to accept positions
from a defaulting clearing member that it is not equipped to handle.
The commenter also pointed out that conflicts of interest could
exacerbate these risks if the third party service provider is
operated by a competing clearing member).
---------------------------------------------------------------------------
Several commenters argued that Rule 17Ad-22(d)(2) is only
appropriate for CCPs.\311\ As noted below, Rule 17Ad-22(d)(2) only
applies to these entities.
---------------------------------------------------------------------------
\311\ See Omgeo Letter at 10; TriOptima Letter at 6-7.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(2) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies.
Rule 17Ad-22(d)(2) is intended to reduce the likelihood of defaults
by participants, while also providing flexibility for clearing agencies
to tailor standards that are linked to the obligations of the
participant. The Commission believes the rule fosters compliance with
the requirement under Section 17A of the Exchange Act that the rules of
a clearing agency must not be designed to permit unfair discrimination
in the admission of participants by requiring standards that are
designed to be measurable, open and fair.\312\
---------------------------------------------------------------------------
\312\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
We agree with those commenters who supported Rule 17Ad-22(d)(2) as
a mechanism to help ensure that clearing agencies meet the Exchange Act
requirements in their participation standard practices.\313\ However,
we are not persuaded by the position that Rule 17Ad-22(d)(2) is so
coextensive with the requirements of Rules 17Ad-22(b)(5), (6) and (7)
that it renders the adoption of those rules unnecessary.\314\ As
discussed above, Rules 17Ad-22(b)(5), (6) and (7) are responsive to
specific concerns about access to CCPs that have been brought to the
attention of the Commission in connection with efforts to promote
central clearing of security-based swaps by the financial services
industry, government regulators and legislators in response to the
recent financial crisis.\315\ We believe that Rule 17Ad-22 promotes the
compliance of all clearing agencies with the requirement in Section 17A
of the Exchange Act that a clearing agency's rules may not be designed
to permit unfair discrimination in the admission of participants or
among participants in the use of the clearing agency. We also believe
this complements the design of Rules 17Ad-22(b)(5), (6) and (7) to
specifically promote compliance with the fair access requirement by
CCPs.
---------------------------------------------------------------------------
\313\ See supra note 296.
\314\ See supra note 297.
\315\ See discussion supra Section II.B.
---------------------------------------------------------------------------
We agree with commenters that comprehensive and explicit
requirements are an appropriate part of a clearing agency's risk
management framework, including participation standards.\316\ We also
agree with commenters who stated that it is important for the
Commission to promote clearing agencies' use of practical experience in
establishing, implementing, maintaining and enforcing their policies
and procedures concerning participation standards and that the
inability of a clearing member to participate in the default management
process during a default would be problematic.\317\ Accordingly, we
believe that it is important to allow clearing agencies enough
flexibility to use their market experience to shape the rules, policies
and procedures addressing participation standards and for the
Commission to oversee the suitability of those standards through its
oversight, including the SRO rule filing process, periodic inspections
and examinations, and day-to-day monitoring of the activities of
clearing agencies. Because of the importance of clearing agency
flexibility and the existing oversight mechanisms, the Commission
declines to adopt more prescriptive requirements under Rule 17Ad-
22(d)(2) at this time.
---------------------------------------------------------------------------
\316\ See supra notes 299-300.
\317\ See supra note 302 and accompanying text.
---------------------------------------------------------------------------
We agree with commenters that credit facility arrangements
represent a contractual right to funds and that enforcement of that
contractual right may become more difficult during stressed market
conditions.\318\ However, we do not believe that the rule should
completely prohibit participants from using credit facility
arrangements with an unaffiliated entity to satisfy financial resource
requirements to a clearing agency because such credit facility
arrangements can be an important tool that allows clearing agencies to
access liquidity quickly in times of stress avoiding an immediate need
to liquidate assets. Instead, we expect clearing agencies to use their
expertise to establish rules, policies and procedures that properly
reflect the extent to which credit facility arrangements are
appropriate for participants at the particular clearing agency based on
the particular clearance and settlement services it provides.
---------------------------------------------------------------------------
\318\ See supra notes 306-308 and accompanying text.
---------------------------------------------------------------------------
We agree with commenters who stated that clearing agencies should
not process trades differently on the sole basis of whether the trade
is between direct clearing members or involves participants that access
the clearing agency through those clearing members, and so the
Commission does not find it necessary to create disparate standards for
the treatment of direct and indirect participants.\319\
---------------------------------------------------------------------------
\319\ See supra note 305 and accompanying text.
---------------------------------------------------------------------------
3. Rule 17Ad-22(d)(3): Custody of Assets and Investment Risk
a. Proposed Rule
Proposed Rule 17Ad-22(d)(3) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to hold assets in a manner whereby risk
of loss or of delay in access to them is minimized, and invest in
instruments with minimal credit, market and liquidity risks. Compliance
with the requirement is intended to improve the ability of the clearing
agency to meet its settlement
[[Page 66248]]
obligations by reducing the likelihood that assets securing participant
obligations to the clearing agency would be unavailable or insufficient
when the clearing agency needs to draw on them.
b. Comments Received
Some commenters expressed concerns about the application and scope
of proposed Rule 17Ad-22(d)(3). One commenter stated that proposed Rule
17Ad-22(d)(3) is not sufficiently clear in its scope.\320\ The
commenter urged the Commission to make clear that Rule 17Ad-22(d)(3)
applies only to the assets of the clearing agency that are available to
facilitate settlement in the event of a participant default and not
those assets that are held in custody by the clearing agency.\321\
---------------------------------------------------------------------------
\320\ See The DTCC (April) Letter at 21.
\321\ See The DTCC (April) Letter at 21-22 (remarking that it
believes this ambiguity is also contained in RCCP 7: Custody and
investment risks on which Rule 17Ad-22(d)(3) is modeled but noting
that proposed language for FMI Principle 16: Custody and investment
risk would resolve that ambiguity and asking the Commission to
revise Rule 17Ad-22(d)(3) as follows to make clear that the
requirements of the rule do not apply to assets of participants held
in custody: ``(d) Each clearing agency shall establish, implement,
maintain and enforce written policies and procedures reasonably
designed to, as applicable: (3) Hold its assets in a manner whereby
risk of loss or of delay in its access to them is minimized; and
invest such assets in instruments with minimal credit, market and
liquidity risks'').
---------------------------------------------------------------------------
However, another commenter asked the Commission to clarify that
proposed Rule 17Ad-22(d)(3) applies to customer assets only and not to
the assets of the clearing agency (or its sponsor).\322\ The commenter
noted that by defining the scope of Rule 17Ad-22(d)(3) that way the
rule would not apply to clearing agencies that perform post-trade
processing services (e.g., compression or collateral management) and do
not take in or retain any assets of their users.\323\ An additional
commenter agreed that Rule 17Ad-22(d)(3) should not apply to clearing
agencies that do not hold assets on behalf of participants.\324\
---------------------------------------------------------------------------
\322\ See TriOptima Letter at 7.
\323\ See id.
\324\ See Omgeo Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(3) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. The
Commission believes that Rule 17Ad-22(d)(3) strengthens the requirement
in Section 17A(b)(3)(F) of the Exchange Act that the rules of a
clearing agency must be designed to ensure the safeguarding of
securities and funds in the custody or control of the clearing agency
or for which the clearing agency is responsible.\325\ Because the
purpose of Rule 17Ad-22(d)(3) is to help ensure assets are available in
the event of a participant default, Rule 17Ad-22(d)(3) would apply to
all assets held by a clearing agency that may be used for that purpose.
However, the Commission notes that Rule 17Ad-22(d)(3) may not apply to
the assets of a participant's customer depending on how a clearing
agency's operations are structured. The Commission does not expect that
registered clearing agencies would need to rely on their physical
assets, such as computers, furniture and buildings, to cover a
participant default under the rule.
---------------------------------------------------------------------------
\325\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
We appreciate the concerns expressed by commenters who asked the
Commission to clarify how Rule 17Ad-22(d)(3) applies in the context of
the different services that a clearing agency may perform, and note
that Rule 17Ad-22 only applies to registered clearing agencies and does
not apply to entities that are exempt from registration as a clearing
agency.
4. Rule 17Ad-22(d)(4): Identification and Mitigation of Operational
Risk
a. Proposed Rule
Rule 17Ad-22(d)(4), as proposed, would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to identify sources of operational risk
and minimize these risks through the development of appropriate
systems, controls, and procedures; implement systems that are reliable,
resilient and secure and have adequate scalable capacity; and have
business continuity plans that allow for timely recovery of operations
and ensure the fulfillment of a clearing agency's obligations.
Rule 17Ad-22(d)(4) should help to ensure that clearing agencies are
able to operate with minimal disruptions, even during times of market
stress when there may be greater demands on their systems due to higher
volume. In addition, the rule would require that clearing agencies have
business continuity plans that allow for timely recovery of operations
and ensure the fulfillment of a clearing agency's obligations. This
requirement would be relevant in the event of, among other things,
deficiencies in information systems or internal controls, human errors,
management failures, unauthorized intrusions into corporate or
production systems, or disruptions from external events such as natural
disasters.
b. Comments Received
Several commenters recommended that the rule should not apply to
the activities of clearing agencies that perform post trade processing
services. For example, one commenter reasoned that the application of
proposed Rule 17Ad-22(d)(4) to a clearing agency that performs post-
trade comparison services is unnecessary if that clearing agency is
operating pursuant to a conditional exemptive order from the
Commission.\326\ The commenter stated that the conditions of an
exemptive order can be tailored to provide the Commission with
sufficient regulatory oversight of a clearing agency's operational
risks.\327\
---------------------------------------------------------------------------
\326\ See Omgeo Letter at 10.
\327\ See id. (identifying such measures as making the clearing
agency subject to: (1) The Commission's Automation Review Program,
(2) regular audits by Commission staff, (3) annual reports to the
Commission, (4) a duty to report systems outages to the Commission,
and (5) on-site inspections by Commission staff of the clearing
agency's facilities).
---------------------------------------------------------------------------
Another commenter expressed its view that operational risk
management and disaster recovery systems are critical to any well-
founded compression service or collateral management service.\328\
However, the commenter argued that a clearing agency that performs
those services should be free to implement and amend such procedures as
it considers necessary to operate its business without undue regulatory
delay or oversight.\329\
---------------------------------------------------------------------------
\328\ See TriOptima Letter at 7-8.
\329\ See id. (supporting its position through assertions that:
(1) The robustness of a compression service's systems will be a
competitive issue that will be determinant of the commercial
viability of the compression service; (2) compression services do
not represent a systemic risk to the viability of the market because
collateral management providers merely run a set of calculations for
collateral management purposes; (3) systems integrity is a central
feature of the provider's contractual framework and system design
and, ultimately, its ability to attract users; and (4) the risk of
data loss is, in practice, very small).
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(4) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. We
believe that Rule 17Ad-22(d)(4) complements the existing guidance
provided by the Commission in its Automation Review Policy Statements
\330\ and the Interagency
[[Page 66249]]
White Paper on Sound Practices to Strengthen the Resilience of the U.S.
Financial System.\331\ We also believe that Rule 17Ad-22(d)(4) helps to
address risks posed by potential operational deficiencies to a clearing
agency and its participants and therefore supports the requirement in
Section 17A of the Exchange Act that a clearing agency must be so
organized and have the capacity to be able to facilitate prompt and
accurate clearance and settlement. Finally, Rule 17Ad-22(d)(4) does not
require clearing agencies to eliminate all operational risks. Instead,
the rule provides registered clearing agencies with the ability to
consider the relevant trade-offs between cost and risk reduction. The
rule provides this ability by allowing registered clearing agencies,
subject to Commission oversight, to develop systems, controls, and
procedures that are ``appropriate'' in response to the identified
risks.\332\
---------------------------------------------------------------------------
\330\ See Automated Systems of Self-Regulatory Organizations,
Exchange Act Release No. 34-27445 (Nov. 16, 1989), 54 FR 48703 (Nov.
24, 1989); Automated Systems of Self-Regulatory Organizations (II),
Release No. 34-29815 (May 9, 1991), 56 FR 22489 (May 15, 1991)
(``Automation Review Policy Statements''). Generally, the guidance
in the Automation Review Policy Statements provides for the
following activities by clearing agencies: (1) Performing periodic
risk assessments of its automated data processing (``ADP'') systems
and facilities; (2) providing for the selection of the clearing
agency's independent auditors by non-management directors and
authorizing such non-management directors to review the nature,
scope, and results of all audit work performed; (3) having an
adequately staffed and competent internal audit department; (4)
furnishing annually to participants audited financial statements and
an opinion from an independent public accountant as to the clearing
agency's system of internal control--including unaudited quarterly
financial statements also should be provided to participants upon
request; and (5) developing and maintaining plans to assure the
safeguarding of securities and funds, the integrity of the ADP
system, and recovery of securities, funds, or data under a variety
of loss or destruction scenarios.
\331\ See Exchange Act Release No. 47638 (Apr. 7, 2003), 68 FR
17809 (Apr. 11, 2003), available at http://www.sec.gov/news/studies/34-47638.htm.
\332\ See discussion supra Section I.A.2.
---------------------------------------------------------------------------
As discussed above, Rule 17Ad-22 applies only to registered
clearing agencies. It does not apply to entities that perform post-
trade processing services or that are exempt from registration as a
clearing agency. As discussed above, entities that perform certain post
trade processing services, and that fall within the definition of
clearing agency, may be subject to different rulemaking by the
Commission at a later time.\333\
---------------------------------------------------------------------------
\333\ See discussion supra Section II.B.4 and Section III.A.
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5. Rule 17Ad-22(d)(5): Money Settlement Risks
a. Proposed Rule
Proposed Rule 17Ad-22(d)(5) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to employ money settlement arrangements
that eliminate or strictly limit the clearing agency's settlement bank
risks, that is, its credit and liquidity risks from the use of banks to
effect money settlements with its participants, and require funds
transfers to the clearing agency to be final when effected. Money
settlement arrangements, among other things, are meant to reduce the
risk that financial obligations related to the activities of the
clearing agency are not timely settled or discharged with finality.
Generally, money settlement by a clearing agency and its participants
involves the use of a settlement bank \334\ as an intermediary. Failure
by the settlement bank to effectuate timely and final settlement
adversely affects the clearing agency by exposing it to credit and
liquidity pressures that in turn can destabilize the clearing agency's
ability to facilitate prompt and accurate clearance and settlement.
---------------------------------------------------------------------------
\334\ A settlement bank is a bank that is used to effect money
settlements between a central counterparty and its participants.
---------------------------------------------------------------------------
The Commission is providing clearing agencies with flexibility to
implement arrangements in a manner fit for them to meet the requirement
of the rule. The Commission notes that there are a number of
arrangements that clearing agencies could establish to comply with the
rule, including criteria for use of settlement banks that address the
banks' creditworthiness, access to liquidity, and operational
reliability, and legal agreements with settlement banks to ensure that
funds transfers to the clearing agency are final when affected.
b. Comments Received
One commenter stressed that if the Commission adopts Rule 17Ad-
22(d)(5) as proposed then the Commission should clarify that a clearing
agency cannot eliminate all exposure to settlement bank risk.\335\ The
commenter pointed out that even if a clearing agency uses an account at
a U.S. Federal Reserve bank to make settlement with participants, the
clearing agency is still exposed to the settlement risk of the
commercial banks that are used by clearing agency participants.\336\
---------------------------------------------------------------------------
\335\ See The OCC Letter at 14.
\336\ See id.
---------------------------------------------------------------------------
The same commenter stressed that the Commission should not mandate
a minimum number of settlement banks and that the requirements of Rule
17Ad-22(d)(5) should focus on providing clearing agencies with
discretion to select settlement banks with care, diversifying risk
among those settlement banks to the extent practicable, and monitoring
their financial status.\337\
---------------------------------------------------------------------------
\337\ See id.
---------------------------------------------------------------------------
Two commenters argued that proposed Rule 17Ad-22(d)(5) should be
applicable only to clearing agencies that take in or process securities
or funds from users.\338\
---------------------------------------------------------------------------
\338\ See Omgeo Letter at 11; TriOptima Letter at 8 (stating
that the proposed rule should not apply to compression services and
collateral management providers that do not hold or process any of
their users' assets).
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(5) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. We
believe Rule 17Ad-22(d)(5) limits the potential that a clearing
agency's money settlement arrangements will cause the clearing agency
to face higher levels of credit and liquidity risks. In addition, the
Commission believes that the rule is consistent with the requirement of
Section 17A(b)(3)(F) of the Exchange Act, which requires the rules of a
clearing agency to be designed to assure the safeguarding of securities
and funds that are in the custody or control of the clearing agency or
for which it is responsible.\339\
---------------------------------------------------------------------------
\339\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
As noted, some commenters pointed out that a clearing agency may
not be positioned to eliminate all exposure to credit and liquidity
risks from the use of banks to effect money settlements.\340\ For
example, we agree that even if a clearing agency elects to use an
account at a U.S. Federal Reserve bank to make settlement with
participants, the clearing agency is still exposed to the settlement
risk of the banks chosen by clearing agency participants. The
Commission notes however that Rule 17Ad-22(d)(5) does not require a
clearing agency to completely eliminate settlement bank risks. Instead,
the clearing agency must establish, implement, maintain and enforce
written policies and procedures reasonably designed to employ money
settlement arrangements that eliminate or strictly limit the clearing
agency's settlement bank risks. We believe clearing agencies have the
authority
[[Page 66250]]
through their rules to shape the settlement bank practices in order to
achieve that outcome. We also agree with commenters that clearing
agencies should retain discretion, subject to Commission oversight, to
establish rules governing settlement bank practices with participants
that are tailored to the operations of the clearing agency.\341\
---------------------------------------------------------------------------
\340\ See supra notes 335-336 and accompanying text.
\341\ See supra note 337 and accompanying text.
---------------------------------------------------------------------------
As discussed above, Rule 17Ad-22 only applies to registered
clearing agencies and does not apply to entities that are exempt from
registration as a clearing agency except to the extent specifically
contemplated by the terms of a future exemption.
6. Rule 17Ad-22(d)(6): Cost-Effectiveness
a. Proposed Rule
Rule 17Ad-22(d)(6), as proposed, would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to be cost-effective in meeting the
requirements of participants while maintaining safe and secure
operations.
Having clearing agencies be mindful of the costs that are incurred
by their participants, while maintaining such compliance, should help
to reduce inefficiencies in the provision of clearing agency services.
This point is particularly important in circumstances where clearing
agencies may not be subject to strong competitive forces (such as when
there is only one clearing agency for an asset class) for the provision
of their services and therefore may have less of an incentive to be
cost-effective in meeting the requirements of participants.
Accordingly, the Commission believes the rule should potentially help
reduce the costs incurred for clearing agency services while also
maintaining appropriate standards for a clearing agency's operations.
b. Comments Received
Two commenters expressed reservations about the rule.\342\ One
commenter stated that it is unnecessary to apply proposed Rule 17Ad-
22(d)(6) to a clearing agency if the Commission already regulates the
cost-effectiveness of that clearing agency through conditions in an
exemptive order.\343\
---------------------------------------------------------------------------
\342\ See Omgeo Letter at 11; TriOptima Letter at 8.
\343\ See Omgeo Letter at 11 (``[P]ursuant to Omgeo's Exemptive
Order, Omgeo may not charge its customers more for use of its
central matching services than Omgeo charges its customers when all
counterparties are customers of Omgeo. Moreover, because DTCC, which
is industry-owned, is the majority owner of Omgeo's Class A
Interests, which controls the U.S. regulated aspects of Omgeo's
business, DTCC can influence the prices Omgeo charges for its U.S.
regulated services. This system has worked well, and therefore
application of Proposed Rule 17Ad-22(d)(6) to Omgeo is
unnecessary'').
---------------------------------------------------------------------------
Another commenter stressed that unless a provider of compression or
collateral management services is systemically important, or market
participants are obliged to purchase its services, then it should be
free to set fees in a fair and commercial manner that encourages broad
participation while permitting sufficient flexibility to offer
favorable rates to high-volume users, early adopters, magnet clients
and other key participants.\344\ The commenter added that portfolio
compression and collateral management are service areas in which cost
effectiveness is a dominant part of commercial viability and that those
services today do not represent a systemic risk to the viability of the
markets.\345\
---------------------------------------------------------------------------
\344\ See TriOptima Letter at 8.
\345\ See id.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(6) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. As
discussed above, the Commission believes Rule 17Ad-22(d)(6) is
appropriate and serves to advance the statutory goals of prompt and
accurate clearance and settlement.\346\ Specifically, the rule should
help reduce the costs incurred for clearing agency services by
requiring registered clearing agencies to be mindful of costs incurred
by their participants, which may include keeping fees lower for
participants, while also requiring that registered clearing agencies
maintain safe and secure operations.
---------------------------------------------------------------------------
\346\ See supra note 1.
---------------------------------------------------------------------------
With regard to suggestions that Rule 17Ad-22(d)(6) should not apply
to entities that perform certain post-trade services (i.e., comparison
of trade data, collateral management and compression/tear-up
services),\347\ or a clearing agency through the conditions of an
exemptive order rather than the requirements of Rule 17Ad-
22(d)(6),\348\ we note that Rule 17Ad-22 only applies to CCPs and CSDs
and does not apply to entities exempt from registration as clearing
agency except to the extent specifically contemplated by the terms of a
future exemption.
---------------------------------------------------------------------------
\347\ See supra notes 344-345 and accompanying text.
\348\ See supra note 343 and accompanying text.
---------------------------------------------------------------------------
7. Rule 17Ad-22(d)(7): Links
a. Proposed Rule
Rule 17Ad-22(d)(7), as proposed, would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to evaluate the potential sources of
risks that can arise when the clearing agency establishes links either
cross-border or domestically to clear or settle trades, and to ensure
that these risks are managed prudently on an ongoing basis. Tying the
operations of different clearing agencies together by link arrangements
potentially exposes a clearing agency and its members to the risk that
the other entity may experience a financial loss or is otherwise unable
to meet its settlement obligations that causes the clearing agency or
its members to fail to meet their obligations.\349\ Although the design
and operation of each link will present a unique risk profile, clearing
agencies potentially face legal, operational, credit and liquidity
risks from link arrangements. In addition, because links can create
interdependencies, clearing agencies may be affected by systemic risk
if there are deficiencies in these arrangements. The Commission
believes that requiring clearing agencies to evaluate and monitor any
link arrangements they maintain is essential to protect the
marketplaces that clearing agencies serve because the requirement would
reduce the likelihood that such arrangements perpetuate risks that
could create disruptions in the operations of clearing agencies.
---------------------------------------------------------------------------
\349\ A clearing agency may be required to enter into a
participant agreement with the other clearing organization as part
of the link arrangement, which includes sharing in the loss
allocations of that clearing organization. See RCCP 4.10.6, supra
note 33.
---------------------------------------------------------------------------
b. Comments Received
Three commenters expressed concerns about the rule.\350\ One
commenter expressed concern that proposed Rule 17Ad-22(d)(7) is not
sufficiently clear in scope.\351\ Specifically, the commenter stated
that it is not entirely clear whether the rule applies only to links
between clearing agencies or may also apply to other ``links'' and any
other entities that may be involved in the process of clearing and
settling trades.\352\ Accordingly, the
[[Page 66251]]
commenter asked the Commission to revise the proposed rule text for
17Ad-22(d)(7).\353\ An additional commenter suggested that proposed
Rule 17Ad-22(d)(7) should be modified to encourage prudent portfolio
compression and collateral management services globally.\354\ One
commenter argued that it should not be subject to Rule 17Ad-22(d)(7)
because it is already subject to the conditions of an exemptive order
from clearing agency registration by the Commission.\355\
---------------------------------------------------------------------------
\350\ See The DTCC (April) Letter at 22; TriOptima Letter at 9;
Omgeo Letter at 12.
\351\ See The DTCC (April) Letter at 22.
\352\ See id. (providing examples of these other types of links
such as those that a clearing agency may establish with a data
processor, pricing service, custodian bank, transfer agent or
liquidity provider).
\353\ See The DTCC (April) Letter at 23 (requesting that Rule
17Ad-22(d)(7) be revised as follows: ``Each clearing agency shall
establish, implement, maintain and enforce written policies and
procedures reasonably designed to, as applicable, evaluate the
potential sources of risks that can arise when the clearing agency
establishes links with other central counterparties or central
securities depositories either cross-border or domestically to clear
trades, and ensure that the risks are managed prudently on an
ongoing basis.'').
\354\ See TriOptima Letter at 9 (noting its belief that
regulations that restrict the global availability of compression
services and collateral management services will necessarily reduce
the effectiveness of the risk-management service, by reducing the
geographic scope of counterparties to which domestic users can
connect). The commenter expressed its views on modifying Rule 17Ad-
22(d)(7) in the larger context of its belief ``that the registration
requirement with respect to [portfolio compression services and] * *
* collateral management services is inappropriate and would place
unnecessary burdens on entities providing swap market participants
useful back-office tools that are intended to improve the efficiency
of collateral management systems in a manner that reduces systemic
risk.'' See TriOptima Letter at 1.
\355\ See Omgeo Letter at 12 (suggesting that its exemptive
order is the oversight mechanism that strikes the appropriate
balance to govern its link arrangements because its link
arrangements (1) do not involve the handling of securities or funds;
(2) provide for standardization and processing of information in a
uniform and efficient manner; and (3) disruptions to its link
arrangements are of a different type and are far less significant
than disruptions in the linkages of registered clearing agencies).
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(7) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. We
believe the rule is consistent with and furthers the purposes of the
Exchange Act. Section 17A(a)(1)(D) of the Exchange Act states that the
linking of all clearance and settlement facilities and the development
of uniform standards and procedures for clearance and settlement will
reduce unnecessary costs and increase the protection of investors and
persons facilitating transactions by and acting on behalf of
investors.\356\ Further, Section 17A(b)(3)(F) of the Exchange Act
requires that the rules of a clearing agency foster cooperation and
coordination with persons engaged in the clearance and settlement of
securities transactions.\357\
---------------------------------------------------------------------------
\356\ 15 U.S.C. 78q-1(a)(1)(D).
\357\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
The Commission agrees with the suggestion from some commenters that
the specific type of link arrangements contemplated by Rule 17Ad-
22(d)(7) is link arrangements between clearing agencies.\358\ The
Commission notes however that under Section 17A(b)(3)(F) of the
Exchange Act, a clearing agency is charged with responsibility to
coordinate with persons engaged in the clearance and settlement of
securities transactions, not just other clearing agencies.\359\
Accordingly, we have not amended the text of Rule 17Ad-22(d)(7) from
the proposal. Further, the Commission notes that during the clearance
and settlement process, a registered clearing agency is confronted with
a variety of risks that must be identified and understood if they are
to be effectively controlled.\360\ To the extent that these risks arise
as a result of a registered clearing agency's links with another entity
involved in the clearance and settlement process, Rule 17Ad-22(d)(7)
should help ensure that clearing agencies have policies and procedures
designed to identify those risks.
---------------------------------------------------------------------------
\358\ See supra note 352.
\359\ 15 U.S.C. 78q-1(b)(3)(F).
\360\ See RCCP, supra note 33, at 39.
---------------------------------------------------------------------------
Rule 17Ad-22 only applies to registered clearing agencies and does
not apply to entities that are exempt from registration as a clearing
agency, unless the terms of future exemptions specifically contemplate
its application, in whole or in part.
8. Rule 17Ad-22(d)(8): Governance
a. Proposed Rule
Proposed Rule 17Ad-22(d)(8) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to have governance arrangements that are
clear and transparent to fulfill the public interest requirements in
Section 17A of the Exchange Act applicable to clearing agencies,\361\
to support the objectives of owners and participants, and to promote
the effectiveness of the clearing agency's risk management
procedures.\362\
---------------------------------------------------------------------------
\361\ Section 17A(b)(3)(F) of the Exchange Act requires that the
rules of a clearing agency be designed to protect investors and the
public interest. 15 U.S.C. 78q-1(b)(3)(F).
\362\ Rule 17Ad-22(d)(8) would complement other applicable
requirements concerning governance at clearing agencies that may
also separately apply. These other requirements include the existing
regulatory framework of Section 17A of the Exchange Act and the
related requirements contemplated by proposed Rule 17Ad-25, as well
as Section 765 of the Dodd-Frank Act with respect to security-based
swap clearing agencies. See supra Section III.F (stating that
clearing agencies be required to establish, implement, maintain and
enforce written policies and procedures reasonably designed to
identify and address existing or potential conflicts of interest).
See also Exchange Act Release No. 63107 (Oct. 14, 2010), 75 FR 65882
(Oct. 26, 2010), supra note 231.
---------------------------------------------------------------------------
b. Comments Received
Two commenters registered their preference for what they regard as
the principles-based approach in proposed Rule 17Ad-22(d)(8) to
regulation of clearing agency governance rather than the prescriptive
rules set forth in the Commission's proposed Regulation MC applicable
to the security-based swap clearing agencies.\363\ One commenter urged
the Commission not to adopt hard and fast standards that will be costly
to implement and maintain and yield little or no apparent corresponding
regulatory benefits.\364\
---------------------------------------------------------------------------
\363\ See CME Letter at 3; The OCC Letter at 14 (referencing the
Commission's proposed requirements for clearing agencies in
Regulation MC).
\364\ See CME Letter at 4.
---------------------------------------------------------------------------
One commenter urged the Commission to ensure that Rule 17Ad-
22(d)(8) as well as any requirements adopted from the Commission's
proposed Regulation MC pertaining to the mitigation of conflicts of
interest are designed to ensure that buy-side market participants have
a meaningful voice in the operating committees of clearing agencies
because that representation is critical to promoting robust governance
arrangements at clearing agencies and serving the best interests of the
U.S. financial system.\365\ Another commenter stated that proposed
Rules 17Ad-22(d)(8), 17Ad-25, and 17Ad-26 reflect a better approach to
governance, conflicts of interest, and board and committee composition
than the Commission's proposed requirements for clearing agencies under
Regulation MC.\366\
---------------------------------------------------------------------------
\365\ See BlackRock Letter at 2.
\366\ See The DTCC (April) Letter at 8.
---------------------------------------------------------------------------
One commenter urged the Commission to consider complementing
proposed Rule 17Ad-22(d)(8) with a minimum board independence
requirement so that at least two-thirds of all board directors would be
required to be independent.\367\
---------------------------------------------------------------------------
\367\ See CII Letter at 1.
---------------------------------------------------------------------------
Several commenters made recommendations to the Commission
concerning the application of Rule 17Ad-22(d)(8) to clearing agencies
that perform post-trade processing services.\368\ One commenter stated
that if the Commission interprets proposed Rule 17Ad-22(d)(8) to be
applicable to
[[Page 66252]]
clearing agencies that perform post-trade processing services for
security-based swaps (e.g., comparison of data, portfolio compression
and collateral management) then the governance requirements should be
commensurate with the low risk presented by those service providers
because requirements that are unduly onerous would impose unnecessary
burdens and costs.\369\ Another commenter argued that application of
proposed Rule 17Ad-22(b)(8) to a clearing agency is unnecessary in
cases when an industry utility has such a significant influence over a
clearing agency's management and operation that the clearing agency's
governance is already appropriately transparent to fulfill the public
interest.\370\
---------------------------------------------------------------------------
\368\ See TriOptima Letter at 9; Omgeo Letter at 12.
\369\ See TriOptima Letter at 9.
\370\ See Omgeo Letter at 12.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(8) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. Rule
17Ad-22(d)(8) is designed to promote these types of arrangements and
the ability of a clearing agency to serve the interests of its various
constituents and the interests of the general public while maintaining
prudent risk management processes to promote prompt and accurate
clearance and settlement.
Governance arrangements have the potential to play an important
role in making sure that clearing agencies fulfill the Exchange Act
requirements that the rules of a clearing agency be designed to protect
investors and the public interest and to support the objectives of
owners and participants. Similarly, governance arrangements may promote
the effectiveness of a clearing agency's risk management procedures by
creating an oversight framework that fosters a focus on the critical
role that risk management plays in promoting prompt and accurate
clearance and settlement.\371\
---------------------------------------------------------------------------
\371\ The role of governance arrangements in promoting effective
risk management has also been a focus of rules recently proposed by
the Commission to mitigate conflicts of interest at security-based
swap clearing agencies. See Exchange Act Release No. 63107 (Oct. 14,
2010), 75 FR 65882 (Oct. 26, 2010).
---------------------------------------------------------------------------
We appreciate the perspective of commenters who prefer the more
general policies and procedures design of Rule 17Ad-22(d)(8) to any
more prescriptive rulemaking by the Commission in the area of clearing
agency governance.\372\ We agree that Rule 17Ad-22(d)(8) provides an
important element of discretion to a clearing agency to be able to use
its experience and expertise to hone policies and procedures for
governance arrangements that support the clearing agency's particular
operations. Even so, we are not persuaded by the assertions that more
prescriptive Commission rules to address clearing agency governance
practices would necessarily be disproportionately costly to implement
and maintain when compared to potential countervailing benefits.\373\
We continue to perform a careful review and evaluation of the comments
that the Commission received on proposed Rules 17Ad-25, 17Ad-26 and
Regulation MC, which commenters rightly observed represent separate,
and in some cases more prescriptive, proposed requirements related to
clearing agency governance and mitigation of conflicts of interest.
---------------------------------------------------------------------------
\372\ See supra note 364.
\373\ See id.
---------------------------------------------------------------------------
At this time, the Commission also is not acting on the
recommendation of some commenters to structure Rule 17Ad-22(d)(8) so
that it would require at least two-thirds of a clearing agency's board
of directors to be independent.\374\ Proposed Rule 17Ad-26 and
Regulation MC address whether and how to require some degree of
independent representation on the board of a clearing agency. We
believe it is more appropriate to consider those issues in connection
with the Commission's ongoing consideration of those rules.
---------------------------------------------------------------------------
\374\ See supra note 367.
---------------------------------------------------------------------------
With regard to suggestions that Rule 17Ad-22(d)(8) should not apply
to entities that perform certain post-trade services (i.e., comparison
of trade data, collateral management and compression/tear-up
services),\375\ we note that Rule 17Ad-22 only applies to registered
clearing agencies and does not apply to entities exempt from
registration as a clearing agency, unless the terms of future
exemptions specifically contemplate its application, in whole or in
part.
---------------------------------------------------------------------------
\375\ See supra notes 368-370.
---------------------------------------------------------------------------
We are not persuaded by the argument that the operation of a
clearing agency through a utility model negates the need for Rule 17Ad-
22(d)(8) because regardless of the business model adopted, the board
should reflect the interests of the full range of stakeholders in order
to effective. \376\ In response to comments that the rule should apply
to a clearing agency in a way that is commensurate with the risk of its
services,\377\ the Commission expects that not all policies and
procedures established by clearing agencies to satisfy Rule 17Ad-
22(d)(8) will be the same. Instead, to be useful to a clearing agency
and its interested parties, the policies and procedures should
necessarily reflect the unique relationships at that clearing agency
between the scope of its operations and its governance and risk
management needs.
---------------------------------------------------------------------------
\376\ See supra note 370 and accompanying text.
\377\ See supra note 369 and accompanying text.
---------------------------------------------------------------------------
9. Rule 17Ad-22(d)(9): Information on Services
a. Proposed Rule
Proposed Rule 17Ad-22(d)(9) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to provide market participants with
sufficient information for them to identify and evaluate the risks and
costs associated with using the clearing agency's services.
The Commission believes that requiring a clearing agency to
disclose information sufficient for participants to identify risks and
costs associated with using the clearing agency will allow participants
to make informed decisions about the use of the clearing agency and
take appropriate actions to mitigate their risks and costs associated
with the use of the clearing agency.
b. Comments Received
One commenter stated that it does not believe that the proposed
rule is necessary because among other things a clearing agency's fees,
collateral deposits, and operational requirements are already included
in the clearing agency's rules and its published procedures and are
already required to be sufficiently available to market participants
and the public at large.\378\
---------------------------------------------------------------------------
\378\ See The OCC Letter at 15.
---------------------------------------------------------------------------
Two commenters expressed that application of proposed Rule 17Ad-
22(d)(9) to clearing agencies that do not handle securities or funds is
unnecessary.\379\
---------------------------------------------------------------------------
\379\ See Omgeo Letter at 12; see also TriOptima Letter at 9
(noting that compression services and collateral management services
operate on the basis of clear, standardized documentation and
present few risks to users. If a compression cycle or collateral
management service fails, the users' pre-existing transactions
remain in effect and the risks can be disclosed in user
documentation).
---------------------------------------------------------------------------
c. Final Rule
We are adopting Rule 17Ad-22(d)(9) as proposed, except for the
clarification discussed in Sections II.B.4 and III.A regarding the
application of the rule only to registered clearing agencies We believe
that requiring a clearing agency to have policies and procedures that
require a clearing agency to disclose
[[Page 66253]]
sufficient information so that participants can identify risks and
costs associated with using the clearing agency will allow participants
to make informed decisions about the use of the clearing agency and
take appropriate actions to mitigate their risks and costs associated
with the use of the clearing agency. While the rule provides clearing
agencies flexibility to determine how to adequately disclose
information so participants can identify and evaluate risks and costs
associated with participation, the Commission believes that disclosure
of the clearing agency rulebook, the costs of its services, a
description of netting and settlement activities it provides,
participants' rights and obligations, information regarding its margin
methodology, and information regarding the extreme but plausible
scenarios that the clearing agency uses to stress test its margin
requirements are among the categories of information that participants
could use to identify and evaluate risks and costs associated with use
of the clearing agency. The Commission also believes that it is
reasonable to expect that the type of information and level of detail
that market participants will consider to be sufficient will evolve
over time and therefore clearing agencies should seek to establish
regular channels of communication with market participants and
processes for continuously improving their disclosure practices as the
marketplace changes over time.
Because clearing agencies are SROs, their rules are published by
Commission and are generally available on each clearing agency's Web
site. Nevertheless, discrete rule proposals do not necessarily provide
a complete picture of a clearing agency's operations and the risk
mitigation procedures. Accordingly, the rule is intended to promote a
better understanding among market participants of a clearing agency's
operations. A better understanding should foster confidence in the
clearing agency's ability to manage those risks and costs, including,
but not limited to, any margin requirements, restrictions or
limitations of the clearing agency's obligations, and conditions used
by the clearing agency to test the adequacy of its financial resources.
We acknowledge that existing requirements address the need for
clearing agencies to incorporate matters such as the clearing agency's
fees, collateral deposits, and operational requirements in its rules
and procedures, which are already made available to market participants
and the public.\380\ The Commission is also aware that under Rule 17Ad-
22(d)(9), the nature of the information that clearing agencies must
provide, how frequently it must be provided, and who is entitled to
receive it are all aspects of compliance with Rule 17Ad-22(d)(9) that
implicate concerns by clearing agencies about protection of their
proprietary information.\381\ We believe that the nature and extent of
information that is required to be provided under Rule 17Ad-22(d)(9)
should be tailored to the needs of market participants based on the
risks and costs to which they are exposed. Clearing agencies are
expected to establish such tailored approaches in their policies and
procedures designed to achieve compliance with Rule 17Ad-22(d)(9).
---------------------------------------------------------------------------
\380\ See supra note 378.
\381\ See id.
---------------------------------------------------------------------------
We agree with commenters who recommended that Rule 17Ad-22(d)(9)
should only apply categorically to clearing agencies that take in or
process securities or funds. Rule 17Ad-22 only applies to registered
clearing agencies and does not apply to entities exempt from
registration as a clearing agency except to the extent specifically
contemplated by a future exemption.
10. Rule 17Ad-22(d)(10): Immobilization and Dematerialization of
Securities Certificates
a. Proposed Rule
Proposed Rule 17Ad-22(d)(10) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to immobilize \382\ or dematerialize
\383\ securities certificates and transfer them by book entry to the
greatest extent possible when the clearing agency provides CSD
services.\384\
---------------------------------------------------------------------------
\382\ Immobilization refers to any circumstance where an
investor does not receive a physical certificate upon the purchase
of securities or is required to physically deliver a certificate
upon the sale of securities.
\383\ Dematerialization is the process of eliminating physical
certificates as a record of security ownership.
\384\ See proposed Rule 17Ad-22(a)(2) for definition of
``central securities depository services.'' DTC is currently the
only registered clearing agency that provides central securities
depository services.
---------------------------------------------------------------------------
The Commission believes that the immobilization and
dematerialization of securities and their transfer by book entry
results in reduced costs and risks associated with securities
settlements and custody by removing the need to hold and transfer many,
if not most, physical certificates.\385\ The Commission also believes
that the proposed rule strengthens the requirement in Section
17A(b)(3)(F) of the Exchange Act for the rules of a clearing agency to
assure the safeguarding of securities and funds that are in the custody
or control of the clearing agency or for which it is responsible.\386\
---------------------------------------------------------------------------
\385\ By concentrating the location of physical securities in a
single central securities depository, clearing agencies are able to
centralize the operations associated with custody and transfer and
reduce costs through economies of scale. Virtually all mutual fund
securities, government securities, options, and municipal bonds in
the United States are dematerialized and most of the equity and
corporate bonds in the U.S. market are either immobilized or
dematerialized. While the U.S. markets have made great strides in
achieving immobilization and dematerialization for institutional and
broker-to-broker transactions, many industry representatives believe
that the small percentage of securities held in certificated form
impose unnecessary risk and expense to the industry and to
investors. See Exchange Act Release No. 8398 (Mar. 11, 2004), 69 FR
12921 (Mar. 18, 2004).
\386\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
b. Comments Received
One commenter expressed concern that proposed Rule 17Ad-22(d)(10)
places responsibilities on clearing agencies that perform CSD services
to immobilize or dematerialize securities that are beyond the clearing
agency's control. Therefore, the commenter requested that the rule be
revised to reflect the need for cooperation from market participants
and regulators.\387\
---------------------------------------------------------------------------
\387\ See The DTCC (April) Letter at 23-24 (asking the
Commission to reformulate Rule 17Ad-22(d)(10) as follows: ``Each
clearing agency shall establish, implement, maintain and enforce
written policies and procedures reasonably designed to, as
applicable, promote the immobilization or dematerialization of
securities certificates and transfer them by book entry to the
greatest extent possible when the clearing agency provides central
securities depository services.'').
---------------------------------------------------------------------------
Another commenter stated its belief that the proposed Rule 17Ad-
22(d)(10) should not apply to portfolio compression and collateral
management services for security-based swaps.\388\
---------------------------------------------------------------------------
\388\ See TriOptima Letter at 11.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(10) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. Rule
17Ad-22(d)(10) does not require a clearing agency to take any actions
that are beyond the scope of its rules, procedures and operations. We
agree that collaboration between regulators, market participants, and
clearing agencies is necessary to achieve total immobilization or
dematerialization of securities
[[Page 66254]]
certificates; but this result is not required by Rule 17Ad-22(d)(10).
The Commission also understands that some clearing agencies already
have taken steps in furtherance of full dematerialization in the U.S.
financial markets and that such efforts are ongoing.\389\
---------------------------------------------------------------------------
\389\ See DTCC White Paper, Strengthening the U.S. Financial
Markets: A Proposal to Fully Dematerialize Physical Securities,
Eliminating the Costs and Risks They Incur (July 2012).
---------------------------------------------------------------------------
In response to comments about the application of the rule to
portfolio compression and collateral management services, the
Commission notes that Rule 17Ad-22 only applies to registered clearing
agencies and does not apply to entities exempt from registration as a
clearing agency, unless the terms of future exemptions specifically
contemplate its application, in whole or in part.
11. Rule 17Ad-22(d)(11): Default Procedures
a. Proposed Rule
Proposed Rule 17Ad-22(d)(11) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to make key aspects of their default
procedures publicly available and establish default procedures that
ensure that the clearing agency can take timely action to contain
losses and liquidity pressures and to continue meeting its obligations
in the event of a participant default.
The Commission believes that the rule would provide certainty and
predictability to market participants about the measures a clearing
agency will take in the event of a participant default because default
procedures, among other things, are meant to reduce the likelihood that
a default by a participant, or multiple participants, will disrupt the
clearing agency's operations. By creating a framework of default
procedures that are designed to permit a clearing agency to take
actions to contain losses and liquidity pressures it faces while
continuing to meet its obligations, the clearing agency should be in a
better position to continue providing its services in a manner that
promotes accurate clearance and settlement during times of market
stress.
The Commission also believes that the requirements in Rule 17Ad-
22(d)(11) would increase the possibility that defaults by participants,
should they occur, would proceed in an orderly and transparent manner.
In particular, the rule would help to ensure that all participants are
aware of the default process and are able to plan accordingly and that
clearing agencies would have sufficient time to take corrective actions
to mitigate potential losses.
b. Comments Received
One commenter urged the Commission to place additional requirements
on clearing agencies to conduct and document a test of their default
management plans.\390\ The commenter stated its belief that default
management tests should be undertaken at least on a semi-annual
basis.\391\
---------------------------------------------------------------------------
\390\ See ISDA Letter at 5.
\391\ See id.
---------------------------------------------------------------------------
One commenter responded to a question asked by the Commission in
the Proposing Release about how much flexibility clearing agencies
should have in the amount of time they are permitted to manage a
default and perform a liquidation of positions. The commenter
recommended that in the context of security-based swaps the time
permitted should be the time necessary for the clearing agency to
actually liquidate a security-based swap portfolio rather than
establishing a predetermined period by rule.\392\ The commenter noted
that the time necessary depends on facts and circumstances and is
likely to be tied to the characteristics of the security-based swaps
involved and the particular markets it in which they trade--as well as
the liquidation times derived from the default management plan and
practice testing by the clearing agency.\393\ The commenter stated that
the Commission should have a view of and sign-off authority over the
clearing agency's default management plan.\394\ The commenter also
noted that clearing agencies should continually monitor the risk
associated with concentration in participants' positions, and if that
concentration could not be liquidated within the time required by the
default management plan, the clearing agency should have discretion to
include extra charges in initial margin to reflect that risk.\395\
---------------------------------------------------------------------------
\392\ See ISDA Letter at 6.
\393\ See id.
\394\ See id.
\395\ See id.
---------------------------------------------------------------------------
Two commenters argued that proposed Rule 17Ad-22(d)(11) should not
apply to entities that perform post-trade processing services such as
comparison of data,\396\ collateral management and portfolio
compression.\397\
---------------------------------------------------------------------------
\396\ See Omgeo Letter at 13.
\397\ See TriOptima Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(11) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. The
Commission believes that the requirements in Rule 17Ad-22(d)(11)
increase the possibility that defaults by participants, should they
occur, will proceed in an orderly and transparent manner because Rule
17Ad-22(d)(11) helps to ensure that all participants are able to plan
for the default process and that clearing agencies will have sufficient
time to take corrective action to mitigate potential losses.
As an initial matter, we believe that how frequently a clearing
agency conducts default management tests should be determined by each
individual clearing agency, in consultation with, and subject to
oversight by, the Commission.\398\ We agree that it is important for
clearing agencies to conduct default management tests, but clearing
agencies overseen by the Commission already largely perform these types
of exercises as part of their compliance with the requirements of
Section 17A of the Exchange Act. Unless additional circumstances
clarify that a prescriptive course of action by the Commission is
appropriate to bring more standardized scope and frequency to these
exercises, we believe that it is appropriate, subject to Commission
oversight, to continue to allow clearing agencies discretion to design
and perform default management tests that are suited to their
particular clearance and settlement activities.
---------------------------------------------------------------------------
\398\ See supra notes 390-391 and accompanying text.
---------------------------------------------------------------------------
With respect to the commenter who advised the Commission not to
establish a particular period in Rule 17Ad-22(d)(11) during which a
clearing agency would be required to manage and complete a default
liquidation process for security-based swaps, we are not adopting
specifically bounded timing requirements in Rule 17Ad-22(d)(11) for a
clearing agency to achieve compliance with the rule. Instead, our
current belief is that the more general approach we are adopting in
Rule 17Ad-22(d)(11) allows clearing agencies to establish, implement,
maintain and enforce policies and procedures that comply with Rule
17Ad-22(d)(11) and take into account the particular characteristics of
the financial instruments and market dynamics involved in a default at
a particular clearing agency. We believe this is the best approach to
allow clearing agencies to contain losses and the liquidity pressures
that they face while continuing to meet their obligations.
[[Page 66255]]
We also agree with commenters who suggested that it is appropriate
for clearing agencies to consider concentration risk in margin
practices and that if certain concentrations indicate that liquidation
of the concentrated positions could not be performed within the
parameters of the clearing agency's default management plan, then the
clearing agency should consider extra initial margin charges to account
for that occurrence.\399\ We believe that these issues are
appropriately addressed by individual clearing agencies through the
submission of proposed rule changes to the Commission for review and
public comment.
---------------------------------------------------------------------------
\399\ See supra note 395 and accompanying text.
---------------------------------------------------------------------------
With regard to suggestions that Rule 17Ad-22(d)(11) categorically
should not apply to entities that perform certain post-trade services
(i.e., comparison of trade data, collateral management and compression/
tear-up services),\400\ we note that Rule 17Ad-22 only applies to
registered clearing agencies and does not apply to entities exempt from
registration as a clearing agency, unless the terms of future
exemptions specifically contemplate its application, in whole or in
part.
---------------------------------------------------------------------------
\400\ See supra notes 396-397 and accompanying text.
---------------------------------------------------------------------------
12. Rule 17Ad-22(d)(12): Timing of Settlement Finality
a. Proposed Rule
Proposed Rule 17Ad-22(d)(12) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to ensure that final settlement occurs
no later than the end of the settlement day and that intraday or real-
time finality is provided where necessary to reduce risks. The
Commission believes that settlement finality should occur not later
than the end of the settlement day because it will help to limit the
volume of outstanding obligations that are subject to settlement at any
one time and thereby reduce the settlement risk exposure of
participants and the clearing agency.
b. Comments Received
One commenter that operates several clearing agencies expressed
concern that the second clause of proposed Rule 17Ad-22(d)(12), which
reads ``and require that intraday or real-time finality be provided
where necessary to reduce risks'' could be interpreted to require
intraday or real-time settlement finality beyond what its clearing
agencies currently provide and are capable of providing without
significant systems and process changes.\401\ The commenter asked the
Commission to clarify that the rule is not intended to impose an
obligation on the clearing agencies it operates to provide intraday or
real-time finality beyond their current practices or any obligation to
build additional capability unless and until there is industry and
regulatory consensus on whether and what additional capability to build
and how to allocate the cost.\402\
---------------------------------------------------------------------------
\401\ See The DTCC (April) Letter at 25.
\402\ See id.
---------------------------------------------------------------------------
One commenter expressed general support for proposed Rule 17Ad-
22(d)(12) but requested that the Commission provide clarification
regarding how the rule is compatible with correction of errors and also
clarify that ``title transfer'' of initial margin may not occur when it
is posted to a clearing agency.\403\ Another commenter stated that
although it generally supports the proposed requirement to ensure that
final settlement occurs no later than the end of the settlement day, it
also believes that this requirement must be interpreted
reasonably.\404\ The commenter asked the Commission to expressly state
in the adopting release that circumstances may arise that make same-
date settlement impossible, such as natural disasters, terrorist acts,
and major communications breakdowns.\405\ The commenter added that it
currently has the ability to make margin calls on an intraday basis as
necessary and its agreements with settlement banks expressly provide
when payments in satisfaction of such calls become irrevocable. \406\
The commenter asked the Commission to specifically state whether this
structure satisfies the requirements of proposed Rule 17Ad-
22(d)(12).\407\
---------------------------------------------------------------------------
\403\ See ISDA Letter at 7.
\404\ See The OCC Letter at 15.
\405\ See id.
\406\ See id.
\407\ See id.
---------------------------------------------------------------------------
One commenter expressed concern that proposed Rule 17Ad-22(d)(12)
fails to provide clear standards for real-time trade processing and
therefore does not provide a workable framework for trade processing
and clearing of security-based swaps.\408\ To address its concern, the
commenter requested that the Commission adopt rules equivalent to CFTC
Rules 37.6(b) and 39.12(B)(7) to require swaps to be immediately
confirmed and accepted for clearing upon execution.\409\
---------------------------------------------------------------------------
\408\ See SDMA Letter at 6.
\409\ See id.
---------------------------------------------------------------------------
Two commenters argued that proposed Rule 17Ad-22(d)(11) should not
apply to entities that perform post-trade processing services such as
comparison of data,\410\ collateral management and portfolio
compression,\411\ because those services do not involve settlement of
transactions.
---------------------------------------------------------------------------
\410\ See Omgeo Letter at 13.
\411\ See TriOptima Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(12) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. Rule
17Ad-22(d)(12) does not require a clearing agency that has policies and
procedures in place to facilitate final settlement by the end of the
settlement day to alter its rules and procedures. As stated in the
Proposing Release, ``intraday or real-time finality may be necessary to
reduce risk in circumstances where the lack of intraday or real-time
finality may impede the clearing agency's ability to facilitate prompt
and accurate clearance and settlement, cause the clearing agency's
participants to fail to meet their obligations, or cause significant
disruptions in the securities markets.'' \412\ The Commission agrees
with the commenter that a decision to revise the settlement process to
implement intraday settlement should involve consultation with all
stakeholders.\413\ The Commission is not proposing a rule at this time,
but plans to study the issue further. Furthermore, the need to correct
errors would not be a violation of Rule 17Ad-22(d)(12). We agree that
Rule 17Ad-22(d)(12) must be reasonably construed to provide that in
extreme circumstances same-date settlement may be impossible to achieve
(i.e., due to natural disasters, terrorist acts, and major
communications breakdowns).\414\ The Commission however notes that the
duty of a clearing agency to address these situations is governed by
Rule 17Ad-22(d)(4), which requires a clearing agency to establish,
implement, maintain and enforce written policies and procedures
reasonably designed to identify sources of operational risk and
minimize these risks through the development of appropriate systems,
controls, and procedures; implement systems that are reliable,
resilient and secure and have adequate scalable
[[Page 66256]]
capacity; and have business continuity plans that allow for timely
recovery of operations and ensure the fulfillment of a clearing
agency's obligations.
---------------------------------------------------------------------------
\412\ See Proposing Release, supra note 35, at 14490.
\413\ We note that one clearing agency has made efforts to
create a dialogue with the industry on the issue of shortening the
settlement cycle. See DTCC White Paper, Proposal to Launch a New
Cost-Benefit Analysis on Shortening the Settlement Cycle (Dec.
2011).
\414\ See supra note 404 and accompanying text.
---------------------------------------------------------------------------
We agree with commenters that the timing of the effective transfer
of initial margin is an important consideration related to achieving
settlement finality in an event of default.\415\ In general, the
validity of the clearing agency's liens and interest in collateral,
including initial margin posted by participants, likely could be
ascertained by referring to the clearing agency membership agreements,
its rules and procedures and Articles 8 and 9 of the Uniform Commercial
Code.
---------------------------------------------------------------------------
\415\ See supra note 403 and accompanying text.
---------------------------------------------------------------------------
With respect to the commenter who said that the rules in 17Ad-
22(d)(12): ``Fail to provide clear standards for real time trade
processing,'' the Commission does not intend for the rule to provide
standards for security-based swaps that are centrally cleared to be
confirmed, accepted for clearing and guaranteed by a clearing agency at
the point of trade execution.\416\ Instead, Rule 17Ad-22(d)(12) focuses
on achieving settlement on the particular settlement date associated
with the securities transaction or on an intraday or real-time basis
(i.e., delivery versus payment) where those additional steps are
necessary to reduce risks. The Commission continues to consider the
appropriateness of proposing more specific rules that would require
transactions to be immediately confirmed and accepted for clearing upon
execution.
---------------------------------------------------------------------------
\416\ See supra notes 408-409 and accompanying text.
---------------------------------------------------------------------------
We agree with commenters that Rule 17Ad-22(d)(12) should not apply
if a clearing agency's services do not involve the handling of
securities or funds to facilitate settlement of obligations. As
discussed above, Rule 17Ad-22 applies only to registered clearing
agencies and does not apply to entities exempt from registration as a
clearing agency, unless the terms of future exemptions specifically
contemplate its application, in whole or in part.
13. Rule 17Ad-22(d)(13): Delivery Versus Payment
a. Proposed Rule
Proposed Rule 17Ad-22(d)(13) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to eliminate principal risk by linking
securities transfers to funds transfers to achieve delivery versus
payment (``DVP'').
DVP eliminates the risk that a party would lose some or its entire
principal because payment is made only if securities are delivered. The
Commission believes that clearing agencies should be required to use
this payment method to reduce the potential that delivery of the
security is not appropriately matched with payment for a security,
thereby impeding the clearing agency's ability to facilitate prompt and
accurate clearance and settlement.
b. Comments Received
One commenter pointed out that the Commission previously approved
an SRO rule change which eliminated the commenter's right to reject
matched trades that are reported to it by an exchange even if the
purchasing clearing member eventually fails to pay the purchase price
of the option.\417\ This approach was adopted because of a preference
by the clearing agency and its participants to mutualize the risk of
such defaults rather than bear the risk that a completed trade would be
rejected on the following day because of the default of the
counterparty.\418\ The commenter asked the Commission to confirm that
it would not consider this policy to violate Rule 17Ad-22(d)(13).\419\
---------------------------------------------------------------------------
\417\ See The OCC Letter at 15.
\418\ See id.
\419\ See id.
---------------------------------------------------------------------------
Two commenters argued that proposed Rule 17Ad-22(d)(13) should not
apply to entities that perform post-trade processing services such as
comparison of data,\420\ collateral management and tear-up/
compression,\421\ because those services do not involve settlement of
transactions.
---------------------------------------------------------------------------
\420\ See Omgeo Letter at 13.
\421\ See TriOptima Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(13) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. As
described in the Proposing Release, DVP is achieved in the settlement
process when the mechanisms facilitating settlement ensure that
delivery occurs if and only if payment occurs.\422\ The Commission
believes that clearing agencies should be required to link securities
transfers to funds transfers in a way that achieves DVP to reduce the
potential that delivery of the security is not appropriately matched
with payment for a security, thereby impeding the clearing agency's
ability to facilitate prompt and accurate clearance and settlement.
---------------------------------------------------------------------------
\422\ See Bank for International Settlements, Delivery Versus
Payment in Securities Settlement Systems (1992), available at http://www.bis.org/publ/cpss06.pdf. Three different DVP models can be
differentiated according to whether the securities and/or funds
transfers are settled on a gross (trade-by-trade) basis or on a net
basis.
---------------------------------------------------------------------------
The elimination by a clearing agency of its right to reject matched
trades and subsequently relying on mutualization of resources to make
settlement if necessary does not violate Rule 17Ad-22(d)(13), as
mutualization of risk by participants is an acceptable means of
eliminating principal risk that would otherwise exist for a clearing
agency. The rule requires a clearing agency to establish policies and
procedures to link the transfer of securities and funds in a manner
that mitigates principal risk in the event of a participant default.
The rule does not govern when a clearing agency guarantees a
transaction or the clearing agency's loss allocation procedures in the
event of a default.
We agree with commenters who suggested that Rule 17Ad-22(d)(13) is
not applicable to clearing agencies that do not handle securities or
funds to perform settlement. As discussed above, Rule 17Ad-22 only
applies to registered clearing agencies and does not apply to entities
exempt from registration as a clearing agency, unless the terms of
future exemptions specifically contemplate its application, in whole or
in part.
14. Rule 17Ad-22(d)(14): Risk Controls To Address Participants' Failure
To Settle
a. Proposed Rule
Proposed Rule 17Ad-22(d)(14) requires clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to institute risk controls, including
collateral requirements and limits to cover the clearing agency's
credit exposure to each participant exposure fully, that ensure timely
settlement in the event that the participant with the largest payment
obligation is unable to settle when the clearing agency provides CSD
services \423\ and extends intraday credit to participants.
---------------------------------------------------------------------------
\423\ See proposed Rule 17Ad-22(a)(2) for definition of
``central securities depository services.''
---------------------------------------------------------------------------
The Commission believes it is important for clearing agencies that
provide CSD services to institute risk controls, including collateral
requirements and limits, to cover the clearing agency's credit exposure
to each participant exposure fully, that
[[Page 66257]]
ensure timely settlement in these circumstances to address the risk
that the participant may fail to settle after credit has been extended.
The Commission also believes that requiring the controls to be designed
to withstand the inability of the participant with the largest payment
obligation to settle, in such circumstances, would reduce the
likelihood of disruptions at the clearing agency by having controls in
place to account for the largest possible loss from any individual
participant and thereby help the clearing agency to provide prompt and
accurate clearance and settlement during times of market stress.
b. Comments Received
One commenter asked the Commission to revise Rule 17Ad-22(d)(14) to
expressly state that the rule applies to a clearing agency that
provides CSD services and extends intraday credit through the operation
of a net settlement system.\424\ The commenter emphasized that it is
important to acknowledge a distinction in the rule between central
securities depositories that operate gross settlement systems and those
that operate net settlement systems because gross settlement systems
amount to a direct intraday extension of credit while a net settlement
system places the clearing agency in the position of being a legal
agent that extends intraday credits on behalf of other participants
that are then settled only at one or more discrete, prescribed times
during the process day.\425\
---------------------------------------------------------------------------
\424\ See The DTCC (April) Letter at 25-26 (noting that the
standard in RSSS 9, on which Rule 17Ad-22(d)(14) is modeled,
specifically identifies central securities depositories that operate
net settlement systems).
\425\ See The DTCC (April) Letter at 26 (suggesting the
following language to revise the proposed rule: ``Each clearing
agency shall establish, implement, maintain and enforce written
policies and procedures reasonably designed to, as applicable,
institute risk controls, including collateral requirements and
limits to cover the clearing agency's credit exposure to each
participant family fully, that ensure timely settlement in the event
that the participant family with the largest payment obligation is
unable to settle when the clearing agency provides central
securities depository services and operates a net settlement system
or extends intraday credit to participants'').
---------------------------------------------------------------------------
Responding to a question posed by the Commission in the Proposing
Release, the same commenter stated its belief that clearing agencies
that provide CSD services should not be required to maintain enough
financial resources to be able to withstand a settlement failure by the
two participant families with the largest settlement obligations to the
clearing agency that performs central depository services.\426\ The
commenter argued that no empirical or historical case has been made to
support such a change in how clearing agencies that perform CSD
services currently operate their risk management controls.\427\
---------------------------------------------------------------------------
\426\ See The DTCC (April) Letter at 26-27.
\427\ See id.
---------------------------------------------------------------------------
One commenter stated that the requirements of proposed Rule 17Ad-
22(d)(14) should not apply to portfolio compression or collateral
management service providers for security-based swaps.\428\
---------------------------------------------------------------------------
\428\ See TriOptima Letter at 10.
---------------------------------------------------------------------------
c. Final Rule
We are adopting Rule 17Ad-22(d)(14) as proposed, except for the
clarification discussed in Sections II.B.4 and III.A regarding the
application of the rule only to registered clearing agencies. The
Commission believes it is important for clearing agencies that provide
CSD services to institute risk controls, including collateral
requirements and limits to cover the clearing agency's credit exposure
to each participant exposure fully, that ensure timely settlement in
these circumstances to address the risk that the participant may fail
to settle after credit has been extended. The Commission also believes
that requiring the controls that ensure timely settlement in the event
that the participant with the largest payment obligation is unable to
settle, in such circumstances, reduces the likelihood of disruptions at
the clearing agency.
The Commission considered the concerns of commenters who asked the
Commission to abstain from any action that would modify Rule 17Ad-
22(d)(14) to require a clearing agency that performs CSD services and
extends intraday credit to participants to maintain enough financial
resources to be able to withstand a settlement failure by the two
participant families with the largest settlement obligations to the
clearing agency.\429\ Rule 17Ad-22(d)(14) does not apply to clearing
agencies that provide CCP services.
---------------------------------------------------------------------------
\429\ See supra notes 426-427 and accompanying text.
---------------------------------------------------------------------------
We understand the request for clarification from some commenters
who asked the Commission to revise Rule 17Ad-22(d)(14) to apply solely
to a clearing agency that performs CSD services and extends intraday
credit to participants through a net settlement system.\430\ We agree
that the requirements of Rule 17Ad-22(d)(14) apply in full in the
context of the operation of a net settlement system. Nevertheless, a
clearing agency providing CSD services may choose to organize its
operations so that it settles transactions on a trade-for-trade or
gross basis and may extend credit in the form of intraday loans or
repurchase agreements to facilitate settlement. Accordingly, we are not
changing the text of Rule 17Ad-22(d)(14), as suggested, in order to
continue to address that situation if it occurs.
---------------------------------------------------------------------------
\430\ See supra notes 424-425 and accompanying text.
---------------------------------------------------------------------------
We agree with commenters who argued that Rule 17Ad-22(d)(14) does
not apply to clearing agencies that do not perform CSD services and do
not extend intraday credit to participants.\431\ As discussed above,
Rule 17Ad-22 only applies to entities that perform CCP or CSD services
and does not apply to entities exempt from registration as a clearing
agency, unless the terms of future exemptions specifically contemplate
its application, in whole or in part.
---------------------------------------------------------------------------
\431\ See supra note 428 and accompanying text.
---------------------------------------------------------------------------
15. Rule 17Ad-22(d)(15): Physical Delivery Risks
a. Proposed Rule
Proposed Rule 17Ad-22(d)(15) would require clearing agencies to
establish, implement, maintain and enforce written policies and
procedures reasonably designed to disclose to their participants the
clearing agency's obligations with respect to physical deliveries.\432\
---------------------------------------------------------------------------
\432\ The proposed rule would provide clearing agencies with the
flexibility to determine the method by which the clearing agency
will state this information to its participants. However, the
clearing agencies should take care to develop an approach that
provides sufficient notice to its participants regarding the
clearing agency's obligations.
---------------------------------------------------------------------------
The Commission believes that such policies and procedures will help
to ensure that participants have information that is likely to enhance
the participants' understanding of their rights and responsibilities
with respect to using the clearance and settlement services of the
clearing agency. The Commission also believes that providing such
information to participants would promote a shared understanding
regarding physical delivery practices between the clearing agency and
its participants that could help reduce the potential for fails and
thereby facilitate prompt and accurate clearance and settlement.
The rule also would require clearing agencies to reasonably design
their operations to identify and manage the risks that arise in
connection with their obligations for physical deliveries. The risks
associated with physical deliveries could stem from, among other
factors, operational limitations with respect to assuring receipt of
physical deliveries and processing of physical deliveries.
[[Page 66258]]
The Commission believes that requiring clearing agencies to identify
and manage these risks would reduce the potential that issues will
arise as a result of physical deliveries because the clearing agency
will have acted preemptively to deal with potential issues that may
disrupt the clearance and settlement process. Accordingly, the
Commission believes this requirement would help a clearing agency to
facilitate prompt and accurate clearance and settlement consistent with
Section 17A of the Exchange Act.\433\
---------------------------------------------------------------------------
\433\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
b. Comments Received
One commenter stated that the requirements of proposed Rule 17Ad-
22(d)(15) should not apply to portfolio compression or collateral
management service providers for security-based swaps.\434\
---------------------------------------------------------------------------
\434\ See TriOptima Letter at 11.
---------------------------------------------------------------------------
c. Final Rule
The Commission is adopting Rule 17Ad-22(d)(15) as proposed, except
for the clarification discussed in Sections II.B.4 and III.A regarding
the application of the rule only to registered clearing agencies. The
Commission believes that Rule 17Ad-22(d)(15) helps ensure that
participants will have information that enhances their understanding of
their rights and responsibilities with respect to using the physical
delivery services of a clearing agency which will help reduce the
potential for fails. Accordingly, the Commission believes this
requirement should help facilitate prompt and accurate clearance and
settlement consistent with Section 17A of the Exchange Act.\435\
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\435\ 15 U.S.C. 78q-1(b)(3)(F).
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As discussed above, Rule 17Ad-22 only applies to registered
clearing agencies and does not apply to entities exempt from
registration as a clearing agency, unless the terms of future
exemptions specifically contemplate its application, in whole or in
part.
IV. Paperwork Reduction Act
A. Overview and Burden Estimate Comparison to Proposing Release
Certain provisions of the final rules contain new ``collection of
information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\436\ In accordance with 44 U.S.C. 3507
and 5 CFR 1320.11, the Commission has submitted the information to the
Office of Management and Budget (``OMB'') for review. The title of the
new collection of information is ``Clearing Agency Standards.'' An
agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a currently
valid OMB control number. The control number for Rule 17Ad-22 is OMB
Control No. 3235-0695.
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\436\ 44 U.S.C. 3501 et seq.
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1. Changes in Estimates
As an initial matter, we note that the PRA burden estimates in this
adopting release are significantly lower than the PRA burden estimates
in the Proposing Release.\437\ Several reasons account for the change.
The Proposing Release contained five proposed rules with PRA collection
of information requirements in addition to Rule 17Ad-22--proposed Rules
17Aj-1, 17Ad-23, 17Ad-25, 17Ad-26 and 3Cj-1. As described above, these
other proposed rules are not being adopted at this time.
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\437\ See Proposing Release, supra note 35, at 14521 (``The
Commission preliminarily believes that for all respondent clearing
agencies the aggregate paperwork burdens contained in proposed Rules
17Ad-22(d)(1), (2), (3), (4), (5), (6), (7), (8), (9), (10), (11),
(12), (13), (14), (15), (b)(1), (2), (3), (4), (5), (6), (7), (c)(1)
and (2) would impose a one-time burden of 83,343 hours and an
ongoing annual burden of 39,658 hours.''). In the adopting release,
the Commission estimates the total initial burden for Rule 17Ad-22
to be 11,880 hours, with the total ongoing annual burden for Rule
17Ad-22 to be 4,888 hours. See infra Section IV.C.7.
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Additionally, the Proposing Release estimated that the proposed
rules would have applied to seventeen entities. A number of these
entities--in particular those providing post-trade processing services
for security-based swap transactions--would have been completely
unfamiliar with the Commission's registration process for clearing
agencies. Further, these entities typically do not have written rule
books to govern their relationship with their users. As a result, they
would have experienced significant initial burdens associated with the
proposed rules.
In contrast, the final rules being adopted today apply only to the
seven clearing agencies currently registered with the Commission that
provide CCP or CSD services, as discussed above in Section II.B.4.\438\
These registered clearing agencies already have written rules, policies
and procedures addressing significant aspects of Rule 17Ad-22. For
purposes of the PRA analysis, the Commission also estimates that three
entities may potentially register with the Commission as clearing
agencies acting as CCPs, bringing the total number of respondents to
ten--nine of which are CCPs and one of which is a CSD.\439\ The
Commission believes that some of the entities seeking to register with
the Commission as clearing agencies may already be providing similar
services in other jurisdictions and therefore may already have written
rules and procedures similar to those contemplated by Rule 17Ad-22.
Accordingly, the Commission believes that the potential PRA burden on
this smaller and more established group of respondents will be
significantly lower than the estimates provided in the Proposing
Release. Further, the Proposing Release treated each subsection of the
rule--and therefore each required policy and procedure--as a separate
PRA burden. However, the Commission believes that registered clearing
agencies are more likely to be able to address the changes required by
Rule 17Ad-22 in an integrated, not piecemeal, review and drafting
process. That is, respondents are likely to group aspects of Rule 17Ad-
22 together as they implement policies and procedures responsive to
Rule 17Ad-22. Therefore, the revised PRA burden estimates no longer
account for each requirement as a separate burden.
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\438\ The Commission also notes that the Boston Stock Exchange
Clearing Corporation (``BSECC'') and Stock Clearing Corporation of
Philadelphia (``SCCP'') are currently registered with the Commission
as clearing agencies but conduct no clearance or settlement
operations. See Securities Exchange Act Release Nos. 63629 (Jan. 3,
2011), 76 FR 1473 (Jan. 10, 2011), and 63268 (Nov. 8, 2010), 75 FR
69730 (Nov. 15, 2010), respectively.
\439\ The burden estimates include the possibility that either
BSECC or SCCP, or both, resume operations in the future.
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Finally, the Commission has revised the PRA burden estimates in
recognition that many parts of Rule 17Ad-22--specifically Rules 17Ad-
22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15)--reflect usual and customary
practices of registered clearing agencies. Since registered clearing
agencies already comply with significant aspects of Rule 17Ad-22 in the
normal course of their activities, many aspects of Rule 17Ad-22 impose
minimal PRA burdens on registered clearing agencies limited to the
review of the rule and their existing policies and procedures. As
discussed below, because certain rules would involve adjustments to a
registered clearing agency's rule book and its policies and procedures
rather than the creation of entirely separate policies and procedures
to support entirely new operations and practices, the Commission
recognizes that some aspects of Rule 17Ad-22 will impose incremental
new PRA burdens on registered clearing agencies.
Accordingly, the estimated PRA burdens discussed below reflect
these updated assessments of the likely PRA burdens.
[[Page 66259]]
2. Organization of PRA Review
The discussion of the PRA burdens and costs associated with Rule
17Ad-22 is organized in the following manner:
1. Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15)
2. Rule 17Ad-22(b)(4)
3. Rules 17Ad-22(b)(5)-(7)
4. Rule 17Ad-22(c)
5. Rule 17Ad-22(c)(1)
6. Rule 17Ad-22(c)(2)
Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15) are discussed
together because these rules represent usual and customary practices
already being implemented by registered clearing agencies. Because
Rules 17Ad-22(b)(4), (b)(5)-(7) and (c), respectively establish new
minimum practices for registered clearing agencies with regard to model
validation, membership practices and certain financial information, the
adopting release discusses these rules separately. The burden
discussion for Rules 17Ad-22(c)(1) and (2) has been split into sections
to account for the different information collection requirements for
varying numbers of respondents.
B. Summary of Collection of Information, Use of Information and
Comments Received
As noted earlier, the Commission received 25 comment letters
concerning the proposed rules.\440\ While the Commission received
general comments in support of its approach that is both consistent
with current global standards \441\ and principles-based,\442\ thereby
making compliance less burdensome for registered clearing agencies, a
few commenters discussed the paperwork and compliance burden concerns
for some of the rules associated with this adopting release. Some
commenters expressed general concerns about the burden of regulation,
but such comments focused on rules in the Proposing Release not being
adopted today and on areas that go beyond the scope of the adopting
release.\443\ Commenters expressed concerns about the burdens
associated with parts of Rule 17Ad-22(b), and those comments are
addressed below. Commenters did not specifically comment on the burdens
associated with Rule 17Ad-22(c)-(d).
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\440\ See supra note 37.
\441\ See The DTCC (April) Letter at 4 (stating that ``[t]he
application of global standards to clearing agencies will also
prevent clearing agencies and their participants from incurring
unnecessary expense associated with complying with different, and
potentially conflicting regulatory standards.''); see also The OCC
Letter at 3 (encouraging the Commission ``to avoid taking final
action on the Proposed Rules prior to receiving greater clarity on
what clearinghouse regulations are ultimately adopted by European
and U.K. legislators and regulators and what approaches to
regulation are ultimately embraced by CPSS/IOSCO. Many potential
market participants will be able to choose the jurisdiction in which
they conduct their clearing activity, and imposing more prescriptive
and costly regulatory burdens on U.S. clearing agencies will have a
predictably adverse competitive impact on those clearing
agencies.'').
\442\ See The DTCC (April) Letter at 6 (stating that ``[i]f the
Proposed Rules are overly prescriptive, organizations such as DTCC
may be subject to conflicting requirements and may be forced to
fragment certain enterprise-wide programs in order to comply with
such conflicting requirements, which could substantially increase
costs and compliance risks within such organizations.''); The OCC
Letter at 2 (stating that it ``support[s] the Commission's approach.
* * *''); CME Letter at 3 (stating that ``CME Group favors a
principles-based approach in these areas, and we urge the Commission
not to adopt hard and fast standards that will be costly to
implement and maintain and that yield little or no apparent
corresponding regulatory benefits.'').
\443\ See, e.g., ICE Letter at 1-2 (stating that ``[p]ost-trade
processing service providers would be unable to distribute end-of-
day settlement prices, as required by the Proposal, and the record
keeping requirements of the Proposal would prove so burdensome to
such providers that the efficiency and alacrity that they provide to
the CDS industry would be adversely affected.'').
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1. Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15)
The rules in the adopting release contain requirements subject to
the PRA. Rules 17Ad-22(b)(1)-(3) and (d)(1)-(15) contain ``collection
of information requirements'' within the meaning of the PRA. These
rules would require a registered clearing agency to have policies and
procedures to adequately document all material aspects of its liquidity
risk management processes and its compliance with their requirements.
The information collected by virtue of written policies and procedures
requirements contained in Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-
22(d)(1)-(15) generally codify usual and customary practices at CCPs
and registered clearing agencies, and thus the PRA burden would be
expected to be minimal. Rules 17Ad-22(b)(1)-(3) require written
policies and procedures that address risk management practices by CCPs.
Specifically, the rules would create standards with respect to: (1)
Measurement and management of credit exposures; (2) margin
requirements; and (3) financial resources. The Commission did not
receive comments on the burdens associated with Rules 17Ad-22(b)(1)-
(3).
Rule 17Ad-22(d) sets forth certain minimum standards regarding the
operations of registered clearing agencies. The standards established
in 17Ad-22(d) address areas including: (1) Transparent and enforceable
rules and procedures; (2) participation requirements; (3) custody of
assets and investment risk; (4) operational risk; (5) money settlement
risk; (6) cost-effectiveness; (7) links; (8) governance; (9)
information on services; (10) immobilization and dematerialization of
securities certificates; (11) default procedures; (12) timing of
settlement finality; (13) delivery versus payment; (14) risk controls
to address participants' failures to settle; and (15) physical delivery
risks. Commenters did not comment on the burdens associated with Rule
17Ad-22(d).
2. Rule 17Ad-22(b)(4)
Rule 17Ad-22(b)(4) contains ``collection of information
requirements'' within the meaning of the PRA. Rule 17Ad-22(b)(4) will
require a CCP to establish, implement, maintain and enforce written
policies and procedures reasonably designed to provide for an annual
model validation consisting of evaluating the performance of the
clearing agency's margin models and the related parameters and
assumptions associated with such models by a qualified person who is
free from influence so that he can be candid in his assessment of the
model.
One commenter stated that ``a regulatory requirement of model
validation on an annual basis is unnecessary (and may be overly
burdensome) * * *. [and] can be achieved in a less directive manner.''
\444\ The commenter did not provide an estimate of the proposed
burdens. The commenter suggested that model validation should be
conducted on a ``periodic'' basis by a qualified person who ``is
sufficiently free from outside influences to perform a candid
evaluation.'' \445\ The commenter did not explain how the suggested
alternative requirements would achieve the purposes of the rule with a
lesser burden.
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\444\ See The DTCC (April) Letter at 13.
\445\ See The DTCC (April) Letter at 15.
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The Commission is not persuaded by the position that the frequency
of the model validation should be left to the discretion of the
CCP.\446\ The rule requiring that CCPs have policies and procedures in
place for model validation at least annually is appropriate because
model performance is not ordinarily expected to vary significantly over
short periods but should be reevaluated as market conditions change.
Overall, the Commission believes the collection of information related
to Rule 17Ad-22(b)(4) is necessary to achieve its purpose, particularly
in light of the
[[Page 66260]]
Congressional mandate under the Dodd-Frank Act.
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\446\ See id.
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3. Rules 17Ad-22(b)(5)-(7)
Rules 17Ad-22(b)(5)-(7) contain ``collection of information
requirements'' within the meaning of the PRA. The information
collection under the written policies and procedures requirements
contained in Rules 17Ad-22(b)(5)-(7) would establish requirements
regarding access to CCPs.
One commenter expressed that proposed Rules 17Ad-22(b)(5)-(7)
providing for mandatory access to CCPs in certain circumstances goes
``beyond anything in current or proposed global standards * * *. [and
is, therefore,] unnecessary and counterproductive to the goal of fair
and open access within a framework of safe and sound operation.'' \447\
But the commenter did not provide an estimate of these burdens. Nor did
the commenter suggest alternative requirements that would achieve the
purposes of the rule with a lesser burden.
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\447\ See The DTCC (April) Letter at 5; see also The DTCC
(April) Letter at 4 (stating that ``[t]he application of global
standards to clearing agencies will also prevent clearing agencies
and their participants from incurring unnecessary expense associated
with complying with different, and potentially conflicting
regulatory standards.'').
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While the Commission understands the concerns raised, the
Commission ultimately believes that the benefits of Rules 17Ad-
22(b)(5)-(7) are critical to maintaining fairness and open access to
central clearing for all market participants, including security-based
swaps participants.\448\ In this regard, the Commission believes the
collection of information related to the rule is necessary to achieve
its purpose, particularly in light of the Congressional mandate under
the Dodd-Frank Act.
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\448\ See supra Section III.D.1.
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4. Rules 17Ad-22(c)(1)-(2)
Rule 17Ad-22(c)(1)-(2) contains ``collection of information
requirements'' within the meaning of the PRA. The information
collection under the written policies and procedures requirements
contained in Rule 17Ad-22(c) establishes a recordkeeping requirement
for CCPs regarding their responsibilities under Rule 17Ad-22(b)(3) and
for registered clearing agencies with respect to posting on their
respective Web sites annual audited financial statements.
Commenters did not specifically comment on the burdens associated
with Rule 17Ad-22(c)(1)-(2).
C. Total Initial and Annual Reporting and Recordkeeping Burdens
1. Standards in Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15)
That Impose a PRA Burden
The requirements to develop written policies and procedures in
Rules 17Ad-22(b)(1)-(3) and Rules 17Ad-22(d)(1)-(15) impose a PRA
burden. The requirements in Rules 17Ad-22(b)(1)-(3) will apply to CCPs
that are registered clearing agencies. The Commission estimates that a
total of nine CCPs \449\ will be subject to the burdens under Rules
17Ad-22(b)(1)-(3). Currently, six clearing agencies are registered to
provide CCP services, and the Commission estimates that three more
entities could register as clearing agencies to provide CCP services.
The requirements in Rules 17Ad-22(d)(1)-(15) (with the exception of
Rules 17Ad-22(d)(10) and (13)-(15), which are applicable only to CSDs),
on the other hand, apply to all registered clearing agencies, of which
there could potentially be a total of ten entities, including the one
registered clearing agency that is a CSD.
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\449\ The Commission believes that there is a potential for new
security-based swap clearing agencies to form but does not expect
there to be a large number based on the significant level of capital
and other financial resources needed for the formation of a clearing
agency.
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As noted above, registered clearing agencies already have written
policies and procedures that meet the standards set forth in Rules
17Ad-22(b)(1)-(3) and (d)(1)-(15) as part of their usual and customary
business practice. Accordingly, the Commission believes that the
registered clearing agencies would not need to build new infrastructure
or modify operations to continue to meet Rule 17Ad-22(b)(1)-(3) and
(d)(1)-(15). The Commission believes that registered clearing agencies
will incur the incremental burdens of reviewing existing policies and
procedures for compliance and updating existing policies and procedures
where appropriate. The requirements would impose an aggregate one-time
burden of approximately 1,750 hours for all registered clearing
agencies.\450\ The standards contained in Rule 17Ad-22(d) would also
impose ongoing burdens on registered clearing agencies. For example,
Rules 17Ad-22(b)(1)-(3) and (d)(1)-(15) would require registered
clearing agencies to perform certain ongoing monitoring and enforcement
activities with respect to the written policies and procedures the
registered clearing agency creates in response to the standard.
Accordingly, the Commission believes that those ongoing activities
would impose an aggregate annual burden of approximately 600 hours for
all respondent clearing agencies.\451\ Because recent assessments of
the registered U.S. clearing agencies support the conclusion that
clearing agencies and their rule books generally meet or exceed
analogous standards of operation and governance to those standards
within Rules 17Ad-22(b)(1)-(3) and (d)(1)-(15),\452\ the Commission
believes that the burden estimate for the aggregate one-time burden
should be revised down from the burden estimated in the Proposing
Release. The Commission estimates that because these initial compliance
efforts will largely comprise a review of existing policies and
procedures, the aggregate one-time burden on respondent clearing
agencies will be incremental to their current compliance processes. The
expected review of current policies and procedures will likely not
involve much involvement by the information technology staff at the
clearing agency or much involvement by the clearing agency's assistant
general counsel because the requirements of these rules have already
been written into and have been implemented as part of the policies and
procedures of registered clearing agencies. Accordingly, those burden
estimates have been reduced and the burden estimate for the compliance
attorney, who will most likely perform most of the review of current
policies and procedures, has been increased. In order to estimate the
one-time burden and annual burden for ongoing activities, we looked to
the burdens imposed by similar policies and procedures requirements in
Regulation NMS as a guide and adapted those figures for the purposes of
this release.\453\
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\450\ This figure was calculated as follows: ((Assistant General
Counsel at 60 hours) + (Compliance Attorney at 85 hours) + (Computer
Operations Manager at 15 hours) + (Senior Business Analyst at 15
hours)) = 175 hours x 10 respondent clearing agencies = 1,750 hours.
\451\ This figure was calculated as follows: Compliance Attorney
at 60 hours x 10 respondent clearing agencies = 600 hours.
For each respondent clearing agency, the estimated annualized
burden for Rules 17Ad-22(b)(1)--(3) and (d)(1)--(15) is 98 hours
(figure calculated as follows: 175 hours (Year 1 burden) + 60 hours
(Year 2 burden) + 60 hours (Year 3 burden) = 295 hours (estimated
total burden over 3 years) / 3 years = 98 hours).
\452\ See Proposing Release, supra note 35, at 14509.
\453\ See Exchange Act Release No. 51808 (June 9, 2005), 70 FR
37496 (June 29, 2005) (discussing in Section VIII.A.4 the time
needed from legal, compliance, information technology and business
operations personnel to create policies and procedures for
preventing and monitoring trade-throughs).
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[[Page 66261]]
2. Standards in Rule 17Ad-22(b)(4) That Impose a PRA Burden
The requirement to develop written policies and procedures in Rule
17Ad-22(b)(4) imposes a PRA burden. The requirement in Rule 17Ad-
22(b)(4) will apply to all CCPs. As discussed above, the Commission
estimates that nine CCPs will be subject to the burdens under Rule
17Ad-22(b)(4).
Based on the analogous policies and procedures requirements and the
corresponding burden estimates in Regulation NMS, the Commission has
preserved the burden estimates from the Proposing Release. The
Commission estimates that Rule 17Ad-22(b)(4) would impose a one-time
burden on each respondent CCP of 210 hours, corresponding to an
aggregate one-time burden on all respondent CCPs of 1,890 hours.\454\
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\454\ This figure was calculated as follows: ((Assistant General
Counsel at 87 hours) + (Compliance Attorney at 77 hours) + (Computer
Operations Manager at 23 hours) + (Senior Business Analyst at 23
hours)) = 210 hours x 9 respondent CCPs = 1,890 hours.
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Rule 17Ad-22(b)(4) would require one-time systems adjustments
related to the capability to perform an annual model validation. These
adjustments would amount to an aggregate one-time burden of
approximately 900 hours.\455\
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\455\ This figure was calculated as follows: ((Chief Compliance
Officer for 40 hours) + (Computer Department Operations Manager for
40 hours) + (Senior Programmer for 20 hours)) = 100 hours x 9
respondent CCPs = 900 hours.
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CCPs would be required to collect information relating to their
model validation standards required by Rule 17Ad-22(b)(4) on an ongoing
basis. The Commission expects that the exact burden of administering
the procedures for model validation standards would vary depending on
how frequently each CCP may need to update its procedures. Based on the
analogous policies and procedures requirements and the corresponding
burden estimates in Regulation NMS, the Commission estimates that the
ongoing requirements of this rule would impose an annual burden of 60
hours on each respondent CCP, corresponding to an aggregate annual
burden for all respondent CCPs of 540 hours.\456\
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\456\ This figure was calculated as follows: Compliance Attorney
at 60 hours x 9 respondent CCPs = 540 hours for all respondent CCPs.
For each respondent CCP, the estimated annualized burden for
Rule 17Ad-22(b)(4) is 143 hours (figure calculated as follows: 210
hours + 100 hours (Year 1 burden) + 60 hours (Year 2 burden) + 60
hours (Year 3 burden) = 430 hours (estimated total burden over 3
years) / 3 years = 143 hours).
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Based on its oversight of clearing agencies, the Commission
estimates that Rule 17Ad-22(b)(4) would impose an annual cost on all
respondent CCPs for work on model validation. The Commission believes
clearing agencies would hire a consulting firm that dedicates two
consultants to the project. Consistent with the Proposing Release,\457\
the Commission estimates that should respondent CCPs decide to hire
external consultants to develop and implement Rule 17Ad-22(b)(4)
through written policies and procedures, the ongoing cost associated
with hiring such consultants would be approximately $3.9 million per
year.\458\
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\457\ See Proposing Release, supra note 35, at 14529.
\458\ This figure was calculated as follows: 2 Consultants for
30 hours per week at $600 per hour = $36,000 per week x 12 weeks =
$432,000 per clearing agency x 9 respondent CCPs = $3,888,000. The
$600 per hour figure for a consultant was calculated using
www.payscale.com, modified by Commission staff to account for an
1800 hour work-year and multiplied by 5.35 to account for bonuses,
firm size, employee benefits and overhead.
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3. Standards in Rules 17Ad-22(b)(5)-(7) That Impose a PRA Burden
The requirements to develop written policies and procedures in
Rules 17Ad-22(b)(5)-(7) impose a PRA burden. These PRA burdens will
apply to all CCPs. As discussed above, the Commission estimates that
nine CCPs will be subject to the burdens under Rules 17Ad-22(b)(5)-(7).
The Commission believes that CCPs are more likely to be able to address
the changes required by Rules 17Ad-22(b)(5)-(7) in an integrated, not
piecemeal, review and drafting process to implement policies and
procedures responsive to these rules. Therefore, the revised PRA burden
estimates no longer account for each requirement as a separate burden.
Based on the analogous policies and procedures requirements and the
corresponding burden estimates in Regulation NMS, the Commission has
preserved the burden estimates from the Proposing Release. The
Commission estimates that Rules 17Ad-22(b)(5)-(7) would impose a one-
time burden on each respondent CCP of 210 hours, corresponding to an
aggregate one-time burden on all respondent CCPs of 1,890 hours.\459\
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\459\ This figure was calculated as follows: ((Assistant General
Counsel at 87 hours) + (Compliance Attorney at 77 hours) + (Computer
Operations Manager at 23 hours) + (Senior Business Analyst at 23
hours)) = 210 hours x 9 respondent CCPs = 1,890 hours.
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CCPs would be required to collect information relating to standards
of Rules 17Ad-22(b)(5)-(7) on an ongoing basis. Based on the analogous
policies and procedures requirements and the corresponding burden
estimates in Regulation NMS, the Commission estimates that the ongoing
requirements of this rule would impose an annual burden of 60 hours on
each respondent CCP, corresponding to an aggregate annual burden for
all respondent CCPs of 540 hours.\460\
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\460\ This figure was calculated as follows: Compliance Attorney
at 60 hours x 9 respondent CCPs = 540 hours for all respondent CCPs.
For each respondent CCP, the estimated annualized burden for
Rules 17Ad-22(b)(5)-(7) is 110 hours (figure calculated as follows:
210 hours (Year 1 burden) + 60 hours (Year 2 burden) + 60 hours
(Year 3 burden) = 330 hours (estimated total burden over 3 years) /
3 years = 110 hours).
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4. Standards in Rule 17Ad-22(c) That Impose a PRA Burden
The standards in Rule 17Ad-22(c) impose a PRA burden.\461\ The
requirements of Rule 17Ad-22(c) will apply to all registered clearing
agencies. Based on the analogous policies and procedures requirements
and the corresponding burden estimates in Regulation NMS, the
Commission has preserved the burden estimates from the Proposing
Release. In contrast to the Proposing Release's burden estimates for
proposed Rule 17Ad-22(c)(2), which accounted for 17 clearing agencies,
the burden estimate in the adopting release for Rule 17Ad-22(c)
reflects a smaller number of clearing agencies. The Commission
estimates that Rule 17Ad-22(c) would impose a one-time burden on each
respondent clearing agency of 191 hours, corresponding to an aggregate
one-time burden on all respondent clearing agencies of 1,910
hours.\462\
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\461\ The burden discussion for the different information
collection requirements of Rule 17Ad-22(c)(1)-(2) has been split
into sections to account for the different requirements for varying
numbers of respondents. Rule 17Ad-22(c) imposes an overall burden
relating to policies and procedures and system adjustments on all
registered clearing agencies, while Rule 17Ad-22(c)(1), as discussed
below, imposes on CCPs an ongoing burden to generate the required
reports concerning their financial resources and Rule 17Ad-22(c)(2),
as discussed below, imposes initial and ongoing burdens related to
annual audited financial statements to all registered clearing
agencies, some of which are already implementing this requirement as
part of their usual and customary practices.
\462\ This figure was calculated as follows: ((Assistant General
Counsel at 60 hours) + (Compliance Attorney at 85 hours) + (Computer
Operations Manager at 23 hours) + (Senior Business Analyst at 23
hours)) = 191 hours x 10 respondent clearing agencies = 1,910 hours.
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The Commission believes the one-time burden imposed would involve
adjustments needed to synthesize and format existing information in a
manner sufficient to explain the methodology the clearing agency uses
to meet the requirement of Rule 17Ad-22(c). The Commission believes
these adjustments would impose a one-time burden of 100 hours on each
clearing agency, corresponding to an aggregate one-time
[[Page 66262]]
burden imposed on all clearing agencies of 1,000 hours.\463\
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\463\ This figure was calculated as follows: ((Chief Compliance
Officer at 40 hours) + (Computer Operations Department Manager at 40
hours) + (Senior Programmer at 20 hours)) = 100 hours x 10
respondent clearing agencies = 1,000 hours.
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Clearing agencies would be required to collect information relating
to standards of Rule 17Ad-22(c) on an ongoing basis. Based on the
analogous policies and procedures requirements and the corresponding
burden estimates in Regulation NMS, the Commission estimates that the
ongoing requirements of this rule would impose an annual burden of 60
hours on each respondent clearing agency, corresponding to an aggregate
annual burden for all respondent clearing agencies of 600 hours.\464\
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\464\ This figure was calculated as follows: Compliance Attorney
at 60 hours x 10 respondent clearing agencies = 600 hours for all
respondent clearing agencies.
For each respondent clearing agency, the estimated annualized
burden for Rule 17Ad-22(c) is 137 hours (figure calculated as
follows: 191 hours + 100 hours (Year 1 burden) + 60 hours (Year 2
burden) + 60 hours (Year 3 burden) = 411 hours (estimated total
burden over 3 years) / 3 years = 137 hours).
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5. Standards in Rule 17Ad-22(c)(1) That Impose a PRA Burden
The standards in Rule 17Ad-22(c)(1) impose a PRA burden. In
contrast to the Proposing Release's burden estimates for proposed Rule
17Ad-22(c)(2), which accounted for 17 clearing agencies, the burden
estimate in the adopting release for Rule 17Ad-22(c)(1) reflects a
smaller number of clearing agencies. The requirements of Rule 17Ad-
22(c)(1) will apply to nine CCPs.
On an ongoing basis, the Commission estimates that for a CCP to
generate the required reports concerning its financial resources would
impose a burden of three hours per respondent CCP per quarter. This
amounts to an annual burden of 12 hours for each CCP and corresponds to
an aggregate annual burden of 108 hours for all respondent CCP. \465\
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\465\ This figure was calculated as follows: ((Compliance
Attorney at 1 hour) + (Computer Operations Department Manager at 2
hours)) = 3 hours per quarter x 4 quarters per year = 12 hours per
year x 9 respondent clearing CCPs = 108 hours.
For each respondent CCP, the estimated annualized burden for
Rule 17Ad-22(c)(1) is 8 hours (figure calculated as follows: 0 hours
(Year 1 burden) + 12 hours (Year 2 burden) + 12 hours (Year 3
burden) = 24 hours (estimated total burden over 3 years) / 3 years =
8 hours).
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6. Standards in Rule 17Ad-22(c)(2) That Impose a PRA Burden
The standards in Rule 17Ad-22(c)(2) impose a PRA burden. In
contrast to the Proposing Release's burden estimates for proposed Rule
17Ad-22(c)(2), which accounted for 17 clearing agencies, the burden
estimate in the adopting release for Rule 17Ad-22(c)(2) reflects a
smaller number of clearing agencies. The requirements of Rule 17Ad-
22(c)(2) will apply to all registered clearing agencies, a total of ten
respondents.
The Commission expects that the exact burden of collecting
information relating to the procedures for facilitating an annual
audited financial statement of the clearing agency and posting that
annual audited financial statement to the clearing agency's Web site
would vary depending on how frequently each clearing agency may need to
update its procedures. Also, the Commission estimates based on its
experience with entities of similar size to the respondents to this
collection, that the initial burden of generating annual audited
financial statements would generally require on average 500 hours per
respondent clearing agency.\466\ However, as most registered clearing
agencies are already implementing this requirement as part of their
usual and customary practices, the rule, as an initial burden, would
largely affect a total of four entities--three potential new entrants
and one clearing agency that currently does not have two years of
annual audited financial statements prepared in accordance with U.S.
GAAP or IFRS posted on its Web site and therefore, would be required to
incur the costs of paying for an independent audit for two years of
financial statements.\467\ The Commission estimates that Rule 17Ad-
22(c)(2) would impose a one-time burden on each of these four clearing
agencies of 500 hours to prepare and review internal financial
statements, corresponding to an aggregate one-time burden on the four
respondent clearing agencies of 2,000 hours.\468\ This requirement
would necessitate work hours of compliance personnel and finance
personnel at the clearing agency to compile relevant data, organize and
analyze that data, and then post it to the clearing agency's Web site
consistent with the rule.
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\466\ An example of the Commission's experience with entities of
a similar size to the respondents is that the Commission required
entities to post their annual financial statements on their
respective Web sites as conditions to the Commission's authorizing
them to provide CCP services for credit default swaps. See supra
note 2.
\467\ BSECC and SCCP currently do not post audited financial
statements on their Web sites and are considered new entrants.
\468\ This figure was calculated as follows: Senior Accountant
at 500 hours x 4 respondent clearing agencies = 2,000 hours.
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Clearing agencies also would be required to collect information
relating to any procedures used to support compliance with Rule 17Ad-
22(c)(2) on an ongoing basis. Based on the analogous policies and
procedures requirements and the corresponding burden estimates in
Regulation NMS, the Commission estimates that the ongoing requirements
of this rule would impose an annual burden of 250 hours on each
respondent clearing agency for collecting information relating to
administering policies and procedures for facilitating an annual
audited financial statement of the clearing agency and posting that
annual audited financial statement to the clearing agency's Web site
for an aggregate burden of 2,500 hours.\469\
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\469\ This figure was calculated as follows: Senior Accountant
at 250 hours x 10 respondent clearing agencies = 2,500 hours.
Annualized, the estimated burden for Rule 17Ad-22(c)(2) is 333
hours (figure calculated as follows: 500 hours (Year 1 burden) + 250
hours (Year 2 burden) + 250 hours (Year 3 burden) = 1,000 hours
(estimated total burden over 3 years) / 3 years = 333 hours). This
figure represents a weighted average for 10 respondent clearing
agencies. The burden will be higher for clearing agencies that have
not yet implemented Rule 17Ad-22(c)(2). The burden will be less for
clearing agencies that have already implemented the requirement as
part of their usual and customary practices.
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The requirement also would require the services of a registered
public accounting firm. The Commission estimates those services would
on average cost approximately $500,000 annually.\470\ Therefore, to
meet the ongoing requirements of Rule 17Ad-22(c)(2) the Commission
estimates a total annual cost of approximately $5,000,000 in the
aggregate for all respondent clearing agencies.\471\
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\470\ A precise estimate of audit costs for clearing agencies
cannot be made, and therefore, we examined a number of existing
surveys, (see, e.g., surveys by CFO.com studying large and small
public companies). While the costs may vary depending on the
circumstances, we are using an estimate of $500,000, which is on the
upper range for an average cost.
\471\ This figure was calculated as follows: $500,000 estimated
cost of registered public accounting firm x 10 respondent clearing
agencies = $5,000,000.
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7. Total Burden for Rule 17Ad-22
The total initial burden for Rule 17Ad-22 is 11,340 hours.\472\ The
total ongoing annual burden for Rule 17Ad-22 is 4,888 hours.\473\ The
ongoing
[[Page 66263]]
external cost for Rule 17Ad-22 is $8.9 million.\474\
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\472\ This figure was calculated as follows: 1,750 hours for
initial burdens associated with 17Ad-22(b)(1)-(3) and (d)(1)-(15) +
2,790 hours for initial burdens associated with 17Ad-22(b)(4) +
1,890 hours for initial burdens associated with 17Ad-22(b)(5)-(7) +
4,910 hours for initial burdens associated with 17Ad-22(c) = 11,340
hours.
\473\ This figure was calculated as follows: 600 hours for
annual burdens associated with 17Ad-22(b)(1)-(3) and (d)(1)-(15) +
540 hours for annual burdens associated with 17Ad-22(b)(4) + 540
hours for initial burdens associated with 17Ad-22(b)(5)-(7) + 3,208
hours for annual burdens associated with 17Ad-22(c) = 4,888 hours.
\474\ This figure was calculated as follows: $3,888,000 (for
Rule 17Ad-22(b)(4)) + $5,000,000 (for Rule 17Ad-22(c)(2)).
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D. Collection of Information Is Mandatory
The collection of information relating to Rule 17Ad-22(b) and Rule
17Ad-22(c)(1) will be mandatory for all CCPs. The collection of
information relating to Rule 17Ad-22(c)(2) and Rule 17Ad-22(d) will be
mandatory for all registered clearing agencies.
E. Confidentiality
The Commission expects that the written policies and procedures
that will be generated pursuant to Rules 17Ad-22(b)(1)-(7), Rule 17Ad-
22(c)(2), and Rules 17Ad-22(d)(1)-(15) will be communicated to the
members, subscribers, and employees (as applicable) of all entities
covered by the Rule. To the extent that this information is made
available to the Commission, it will not be kept confidential. Any
records generated in connection with the requirement of Rules 17Ad-
22(b)(1)-(3), Rules 17Ad-22(b)(5)-(7), Rule 17Ad-22(c)(2), and Rules
17Ad-22(d)(1)-(15) to establish written policies and procedures will be
required to be preserved in accordance with, and for the periods
specified in, Exchange Act Rules 17a-1 \475\ and 17a-4(e)(7).\476\
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\475\ 17 CFR 240.17a-1.
\476\ 17 CFR 240.17a-4(e)(7).
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The information collected pursuant to Rule 17Ad-22(c)(1) relating
to the calculation and maintenance of a record of the financial
resources necessary to meet the requirements of Rule 17Ad-22(b)(3) will
be retained by the registered clearing agencies that perform CCP
services and will be available to the Commission. To the extent that
the Commission receives confidential information pursuant to this
collection of information, such information would be kept confidential,
subject to the provisions of applicable law.\477\
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\477\ See, e.g., 5 U.S.C. 552 (Exemption 4 of the Freedom of
Information Act provides an exemption for ``trade secrets and
commercial or financial information obtained from a person and
privileged or confidential.'' 5 U.S.C. 552(b)(4). Exemption 8 of the
Freedom of Information Act provides an exemption for matters that
are ``contained in or related to examination, operating, or
condition reports prepared by, on behalf of, or for the use of an
agency responsible for the regulation or supervision of financial
institutions.'' 5 U.S.C. 552(b)(8)).
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V. Economic Analysis
A. Overview
The rules that we are adopting today are designed to enhance the
substantive regulation of securities clearing agencies. The Commission
is sensitive to the economic effects of the rules it is adopting today,
including their costs and benefits. Some of these costs and benefits
stem from statutory mandates, while others are affected by the
discretion we exercise in implementing the mandates. We requested
comment on all aspects of the costs and benefits of the proposal,
including any effect our proposed rules may have on efficiency,
competition, and capital formation.
As required by Title VII and Title VIII of the Dodd Frank Act, Rule
17Ad-22 will establish a regulatory framework for CCPs for security-
based swap transactions and clearing agencies that are designated as
systemically important by the Council. In so doing, Rule 17Ad-22 will
help ensure that clearing agencies maintain effective operational and
risk management procedures as well as meet the statutory requirements
under the Exchange Act on an ongoing basis. Rule 17Ad-22 is consistent
with the Dodd-Frank Act and the Congressional findings in the adoption
of Section 17A. Specifically, Congress found that:
(A) The prompt and accurate clearance and settlement of securities
transactions, including the transfer of record ownership and the
safeguarding of securities and funds related thereto, are necessary for
the protection of investors and persons facilitating transactions by
and acting on behalf of investors.
(B) Inefficient procedures for clearance and settlement impose
unnecessary costs on investors and persons facilitating transactions by
and acting on behalf of investors.
(C) New data processing and communications techniques create the
opportunity for more efficient, effective, and safe procedures for
clearance and settlement.
(D) The linking of all clearance and settlement facilities and the
development of uniform standards and procedures for clearance and
settlement will reduce unnecessary costs and increase the protection of
investors and persons facilitating transactions by and acting on behalf
of investors.\478\
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\478\ See 15 U.S.C. 78q-1(a)(1).
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Section 17A of the Exchange Act was adopted in direct response to
the paperwork crisis of the late 1960's that nearly brought the
securities industry to a standstill and directly or indirectly resulted
in the failure of large numbers of broker-dealers \479\ because the
industry's clearance and settlement procedures were inefficient and
lacked automation.
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\479\ This crisis resulted from sharply increased trading
volumes and historic industry inattention to securities processing,
as demonstrated by inefficient, duplicative and highly manual
clearance and settlement system, poor records, insufficient controls
over funds and securities, and use of untrained personnel to perform
processing functions. See, e.g., Securities and Exchange Commission,
Study of Unsafe and Unsound Practices of Brokers and Dealers, H.R.
Doc. No. 231, 92d Cong., 1st Sess. 13 (1971).
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Economic characteristics of FMIs,\480\ such as clearing agencies,
including economies of scale, barriers to entry, and the particulars of
their legal mandates may limit competition and confer market power on
FMIs, which could lead to lower levels of service, higher prices, or
under-investment in risk-management systems.\481\ In addition, the
institutional structure of entities that provide clearance and
settlement services may not provide strong incentives or mechanisms for
safe and efficient design and operation, fair and open access, or the
protection of participant and customer assets in some
circumstances.\482\ Moreover, the participants in a clearing agency may
not consider the full impact of their actions on other participants,
such as the potential costs of delaying payments or settlements.\483\
Overall, a clearing agency and its participants may generate
significant negative externalities for the entire securities market if
they do not adequately manage their risks.\484\
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\480\ A ``financial market infrastructure'' is a multilateral
system among participating institutions, including the operator of
the system, used for the purposes of clearing, settling, or
recording payments, securities, derivatives, or other financial
transactions. See id. at 7.
\481\ See FMI Report, supra note 32, at 11.
\482\ See id.
\483\ See id.
\484\ See id.
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While the Commission believes that the U.S. clearance and
settlement system currently works well, it is important that the
operations of clearing agencies evolve with the securities markets,
especially as clearing agencies affect a wider array of market
participants. A clearing agency's direct participants, such as broker-
dealers, banks and other types of financial intermediaries, use
clearing agencies to clear and settle proprietary trading activity.
They also use clearing agencies as intermediaries for institutional
investors, retail investors, and proprietary trading firms,\485\
because clearing and settling a high volume of financial transactions
multilaterally through a clearing agency may in many
[[Page 66264]]
cases allow for greater efficiency and lower costs than settling
bilaterally.\486\ In addition, clearing agencies are often able to
manage risks related to the clearing and settling of financial
transactions more effectively for their participants, and, in some
cases, reduce certain risks, such as the risk that a purchaser of a
security will not receive the security or the risk that a seller of a
security will not receive payment for the security.\487\
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\485\ Some clearing agencies permit proprietary trading firms,
including high-frequency traders, that meet the clearing agency's
participation requirements, to clear trades without intermediation
by a broker-dealer or futures commission merchant (``FCM'').
\486\ See Risk Management Supervision of Designated Clearing
Entities (July 2011), Report by the Commission, Board and CFTC to
the Senate Committees on Banking, Housing, and Urban Affairs and
Agriculture in fulfillment of Section 813 of Title VIII of the Dodd-
Frank Act.
\487\ See id.
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Because clearing agencies concentrate risk, a disruption in a
clearing agency's operations or the failure of a clearing agency to
meet its obligations could cause a systemic disruption that can be
costly for more than just the clearing agency and its members. For
example, a significant dollar value of financial transactions pending
for clearance or to be cleared in the future through the clearing
agency could fail to settle on time or at the original contract terms.
If the clearing agency acting as a CCP does not have the funds to cover
the fail, members of the clearing agency would suffer losses and
liquidity constraints due to their inability to access their clearing
fund contributions and the clearing agency's inability to honor its
obligations.\488\ In addition, the failure has the potential to harm
the market as a whole in all financial instruments cleared by that
clearing agency and its members, beyond the securities pending for
clearance at the time of the original settlement failure.
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\488\ See id. at 8. While no clearing agency has ever failed in
the United States, such failure is not impossible. See, e.g., Donald
MacKenzie, An Engine, Not A Camera: How Financial Models Shape
Markets (2009); Ian Hay Davison, Securities Review Committee Report
(1989) (discussing the events surrounding the failure of the Hong
Kong Futures Exchange Clearing Corporation in 1987).
---------------------------------------------------------------------------
The standards adopted today as part of Rule 17Ad-22 are intended to
help mitigate these risks by requiring measures that would reinforce
the safety of clearing agencies. Safe and reliable clearing agencies
are essential not only to the stability of the securities markets they
serve but often also to payment systems, which may be used by a
clearing agency or may themselves use a clearing agency to transfer
collateral. The safety of securities settlement arrangements and post-
trade custody arrangements is also critical to the goal of protecting
the assets of investors from claims by creditors of intermediaries and
other entities that perform various functions in the operation of the
clearing agency. Investors are more likely to participate in markets
when they have confidence in the safety and reliability of clearing
agencies; therefore the rule being adopted today should promote capital
formation.
In addition, the rule seeks to promote the efficiency of clearing
agencies. As described below, the structure of the clearing agency
market and the structure of the clearing agencies themselves may not
provide the competitive incentives necessary to promote transparency,
fair access, and efficient operations. Transparency helps to ensure
that clearing members can make more informed decisions and that market
participants in general have better information about the stability of
the system. In turn, transparency promotes competition by facilitating
comparisons across clearing agencies. Fair access ensures that a
variety of market participants can gain access to clearing and
settlement services and thus promotes competition by lowering barriers
to entry for clearing agency participants.\489\ Efficient operations
can result in higher quality services or lower fees (or both) to
clearing agency members and their customers.
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\489\ See infra discussion of Rules 17Ad-22(b)(5), (6) and (7)
in Section V.C.5.
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The analysis below examines the projected economic effects of the
adopted rules. The analysis starts with a baseline discussion of the
current regulatory landscape and existing industry practices of
clearing agencies relating to their operations and risk management
procedures and membership policies. This discussion provides a point of
comparison for the second half of the economic analysis, which is a
discussion of the benefits and costs of the rules, as well as
alternative approaches to the rules that were considered by the
Commission.\490\
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\490\ In discussing the current practices of the registered
clearing agencies below, we have omitted descriptions of the
variations in the practices, policies, and procedures among
registered clearing agencies that are, nevertheless, consistent with
the requirements of the final rules. However, while these variations
are not discussed, notable distinctions in practices, policies, and
procedures that significantly impact the economic analysis are
addressed, as applicable.
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B. Baseline
Rule 17Ad-22 impacts the market for clearing agency services in
securities, with an emphasis on CCP services. There are currently seven
clearing agencies registered with the Commission that provide CCP or
CSD services. Six of these clearing agencies offer CCP services, and
one is a CSD. Together, they processed over $1 quadrillion in financial
market transactions in 2011.\491\ Some of these clearing agencies also
are regulated by the CFTC, the Federal Reserve, and the New York State
Department of Banking.
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\491\ This figure was calculated from the following sources:
DTCC 2011 Annual Report, available at http://dtcc.com/about/annuals/2011/report.php; OCC 2011 Annual Report, available at http://www.optionsclearing.com/components/docs/about/annual-reports/occ_2011_annual_report.pdf; CME Group 2011 Annual Report, available at
http://cmegroup.com/investor-relations/annual-review/2011/downloads/CME_Group_2011_Annual_Report.pdf; InterContinental Exchange 2011
Annual Report, available at http://files.shareholder.com/downloads/ICE/1860307941x0x556734/44EA48C5-CBCB-4468-BF54-048BFEEC8264/ICE_2011AR.pdf.
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Central clearing facilitates the management of counterparty credit
risk among dealers and other institutions by shifting that risk from
individual counterparties to CCPs, thereby helping protect
counterparties from each other's potential failures and preventing the
buildup of risk in such entities, which could be systemically
important. Central clearing generally reduces the counterparty risk of
market participants, including market makers and dealers. If market
makers and dealers cannot diversify this counterparty risk, they
generally pass the costs on to their clients in the form of higher
transaction costs. In order for central clearing to reduce risk, mark-
to-market pricing and margin requirements need to be applied in a
consistent manner.\492\ CCPs generally use liquid margin collateral to
manage the risk of a CCP member's failure, and rely on the accuracy of
their margin calculations and their access to liquid collateral to
protect against sudden movements in market prices. A CCP can also
reduce systemic risk through netting, by reducing the amount of funds
or other assets that must be exchanged at settlement.\493\
Nevertheless, a CCP also concentrates risks and responsibility for risk
[[Page 66265]]
management in the CCP.\494\ Consequently the effectiveness of a CCP's
risk controls and the adequacy of its financial resources are critical
aspects of the infrastructure of the market it serves.\495\
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\492\ See Christopher Culp, OTC-Cleared Derivatives: Benefits,
Costs, and Implications of the ``Dodd-Frank Wall Street Reform and
Consumer Protection Act (Journal of Applied Finance, No. 2, 2010),
available at http://www.rmcsinc.com/articles/OTCCleared.pdf.
\493\ See, e.g., Darrell Duffie and Haoxiang Zhu, Does a Central
Clearing Counterparty Reduce Counterparty Risk?, (Stanford
University, Working Paper, 2010), available at http://
www.stanford.edu/~duffie/DuffieZhu.pdf; Nout Wellink, Mitigating
System Risk in OTC Derivatives Markets, (Banque de France, Financial
Stability Review, No. 14--Derivatives--Financial innovation and
stability, July 2010), available at http://www.banque-france.fr/fileadmin/user_upload/banque_de_france/publications/Revue_de_la_stabilite_financiere/etude15_rsf_1007.pdf; and Manmohan
Singh, Collateral, Netting and System Risk in the OTC Derivatives
Market,'' (International Monetary Fund, Working Paper, 2009),
available at http://www.imf.org/external/pubs/ft/wp/2010/wp1099.pdf.
\494\ See RCCP, supra note 33, at 1.
\495\ See id.
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The market for CCP services in the United States tends to be
segmented by financial instrument, with clearing agencies often
specializing in particular instruments. As such, some market segments
may have characteristics of natural monopolies capable of being
sustained despite the presence of competitors with the potential to
enter the market segment in question.\496\ For example, in the United
States, following a period of consolidation facilitated by the
introduction of Section 17A of the Exchange Act, only one CCP currently
processes transactions in U.S.-listed equities and only one CCP
processes transactions in exchange-traded options. However, three
clearing agencies currently serve as CCPs for swaps and security-based
swaps. Although two of the CCPs for security-based swaps are affiliated
entities, these affiliated CCPs do not compete with each other; one
primarily serves the U.S. market for security-based swaps, and the
other primarily serves the European market. Further, the affiliated CCP
serving the U.S. market has a dominant market share in the United
States, though the Commission believes this may be subject to change
over time as a result of competition from the other registered CCPs
offering security-based swap services, the entry of new competitors
into the U.S. market or other factors.
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\496\ A natural monopoly is one in which the economies of scale
make having a single provider more efficient (lower average cost)
than having multiple competitors.
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The following sections set the baseline for comparison in our
analysis of the economic effects. In particular, they describe the
legal framework under which registered clearing agencies operate and
the current practices of clearing agencies as they relate to the rules
being adopted today.
1. Legal Framework
a. Overview of Statutory Framework and the Dodd-Frank Act
In recognition of the risks posed by the concentration of clearance
and settlement activity at clearing agencies, the Exchange Act and
Titles VII and VIII of the Dodd-Frank Act provide a framework for
enhanced regulation and supervision of clearing agencies by the
Commission.
i. Exchange Act
Section 17A of the Exchange Act \497\ and Rule 17Ab2-1 \498\
require entities to register with the Commission prior to performing
the functions of a clearing agency. Under the statute, the Commission
is not permitted to grant registration unless it determines that the
rules and operations of the clearing agency meet the standards set
forth in Section 17A.\499\ If the Commission registers a clearing
agency, the Commission oversees the clearing agency to facilitate
compliance with the Exchange Act using various tools that include,
among other things, the rule filing process for SROs and on-site
examinations by Commission staff. Section 17A(d) also gives the
Commission authority to adopt rules for clearing agencies as necessary
or appropriate in the public interest, for the protection of investors,
or otherwise in furtherance of the purposes of the Exchange Act and
prohibits a registered clearing agency from engaging in any activity in
contravention of these rules and regulations.\500\ In 1980, the staff
of the Commission provided guidance on meeting the requirements of
Section 17A in its Standards for Clearing Agency Regulation.\501\
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\497\ See 15 U.S.C. 78q-1(b). See also Public Law 111-203 Sec.
763(b) (adding subparagraph (g) to Section 17 of the Exchange Act).
\498\ See 17 CFR 240.17Ab2-1.
\499\ See supra note 5.
\500\ See 15 U.S.C. 78q-1(d).
\501\ See supra note 5.
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ii. Title VII of the Dodd-Frank Act
As described in Section I above, the Dodd-Frank Act was enacted to,
among other things, mitigate systemic risk and promote the financial
stability of the United States by improving accountability and
transparency in the financial system and by providing for enhanced
regulation and oversight of institutions designated as systemically
important.\502\ Specifically, Title VII of the Dodd-Frank Act amended
the Exchange Act to require that security-based swap transactions must
be cleared through a clearing agency that is registered with the
Commission (or exempt from registration) if they are of a type that the
Commission determines be cleared, unless an exemption from mandatory
clearing applies.\503\ New Section 17A(i) of the Exchange Act also
gives the Commission authority to promulgate rules that establish
standards for security-based swap clearing agencies.\504\ Compliance
with any such rules is a prerequisite to the registration of a clearing
agency with the Commission \505\ and is also a condition to the
maintenance of its continued registration.\506\
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\502\ See supra note 20.
\503\ See 15 U.S.C. 78c-3(a)(1) (as added by Section 763(a) of
the Dodd-Frank Act).
\504\ 15 U.S.C. 78q-1(i).
\505\ Under the Exchange Act, a clearing agency can be
registered with the Commission only if the Commission makes a
determination that the clearing agency satisfies the requirements
set forth in paragraphs (A) through (I) of Section 17A(b)(3) of the
Exchange Act. 15 U.S.C. 78q-1(b)(3).
\506\ See supra Section I.A.3.
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iii. Title VIII of the Dodd-Frank Act
In addition to the provisions in Title VII that expand the
Commission's authority under the Exchange Act to include security-based
swap activities, Title VIII of the Dodd-Frank Act, entitled the
Clearing Supervision Act, establishes an enhanced supervisory and risk
control system for systemically important clearing agencies and other
FMUs.\507\ As previously noted, on July 18, 2012, the Council
designated DTC, FICC, NSCC and OCC as systemically important, and
Section 17A(i) of the Exchange Act provides that the Commission, in
establishing clearing agency standards and in its oversight of clearing
agencies, may conform such standards and such oversight to reflect
evolving international standards.\508\ Section 805(a) of the Clearing
Supervision Act supplements the Exchange Act requirements by mandating
the Commission to take into consideration relevant international
standards and existing prudential requirements for clearing agencies
that are designated as systemically important FMUs.\509\
---------------------------------------------------------------------------
\507\ See supra note 25.
\508\ 15 U.S.C. 78q-1(i).
\509\ 12 U.S.C. 5464(a)(1).
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In part, the Clearing Supervision Act provides that the Commission,
considering relevant international standards and existing prudential
requirements, may prescribe regulations that set risk management
standards for the operations related to PCS Activities \510\ of a
Designated Clearing Entity or the conduct of designated activities by a
Financial Institution.\511\ Creation of any such risk management
standards must be done in consultation with the Federal Reserve and the
Council.
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\510\ Certain post-trade processing activities that are not
captured by the Clearing Supervision Act may nevertheless be subject
to regulation by the Commission under the Exchange Act. See supra
note 100 and accompanying text.
\511\ See supra note 27.
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b. CPSS-IOSCO Standards
As noted above, the final FMI Report was published on April 16,
2012 to replace the earlier CPSS-IOSCO
[[Page 66266]]
Recommendations and therefore represents a new reference point of
international standards contemplated by the Exchange Act and the
Clearing Supervision Act relevant for actions taken by the
Commission.\512\ The FMI Report recognizes that FMIs can differ
significantly in design, organization and function and that certain
principles are not applicable to certain types of FMIs. The principles
are designed therefore to be applied holistically, and the Final Report
expressly provides flexibility in terms of how FMIs will apply the
principles. The clearing agencies registered with the Commission have
generally implemented the CPSS-IOSCO Recommendations. The FMI Report
states that financial market infrastructures (including CCPs and CSDs)
are expected to observe the principles contained in the FMI Report
through ``appropriate and swift action'' consistent with the national
laws of their home jurisdictions.\513\
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\512\ See supra note 32.
\513\ See RSSS and RCCP Reports, supra note 33.
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c. Complementary Regulation by Other Regulators
Rule 17Ad-22 and the rules for DCOs adopted by the CFTC \514\ are
generally consistent. The CFTC also incorporates some of the CPSS-IOSCO
Recommendations by rule to supplement the DCO core principles of the
Commodity Exchange Act (``CEA''). Nevertheless, there are some
differences between the rules the Commission is adopting today and
those of the CFTC.
---------------------------------------------------------------------------
\514\ See 76 FR 69334 (Nov. 8, 2011).
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First, Rule 17Ad-22(b)(1) requires a CCP to measure its credit
exposures to its participants at least once a day while the CFTC's DCO
rules require that DCOs perform that function periodically throughout
the day. Second, consistent with the current practice at registered
CCPs providing clearing of security-based swaps, Rule 17Ad-22(b)(3)
requires CCPs for security-based swaps to maintain enough financial
resources to withstand a default by the two largest participant
families.\515\ All other CCPs would be required to be able to withstand
a default by the single largest participant family, for the reasons
discussed in Section V.C below.
---------------------------------------------------------------------------
\515\ See supra Section III.C.3.
---------------------------------------------------------------------------
The CFTC applies the latter standard to all DCOs. In its October
2010 rule proposal, the CFTC proposed requiring that systemically
important DCOs maintain sufficient financial resources to meet their
financial obligations to their clearing members notwithstanding a
default by the two clearing members creating the largest combined
financial exposure for the systemically important DCO in extreme but
plausible market conditions.\516\ The CFTC did not adopt this proposal
as part of its final rules for DCOs. The CFTC stated that it was
premature to adopt this rule for the following reasons: (1) The Council
had not designated any DCOs as systemically important; (2) the final
FMI Report had not been published; and (3) EMIR was not final.\517\ The
CFTC stated that it would be closely monitoring developments and would
be prepared to revisit the issue if the European Union or other foreign
regulators move closer to implementation of their respective
reforms.\518\
---------------------------------------------------------------------------
\516\ See Financial Resources Requirements for Derivatives
Clearing Organizations, 75 FR 63113 (Oct. 14, 2010).
\517\ See id. at 69352.
\518\ We note that EMIR requires all CCPs to maintain sufficient
financial resources to withstand the default of the two participants
with the largest exposures. See supra note 167 at 43. EMIR was
adopted in July 2012. See supra note 167.
---------------------------------------------------------------------------
Third, Rule 17Ad-22(b)(4) requires model validations to be
performed ``annually'' by a person who is free from influence from the
persons responsible for development or operation of the systems and
models being validated so that he or she can be candid in his or her
assessment of the model. The CFTC rule requires an ``independent''
validation on a ``regular basis.''
Fourth, Rule 17Ad-22(b)(7) provides for scalability of net capital
requirements in proportion to the riskiness of the participants'
activities and permits CCPs to seek Commission approval to impose a net
capital requirement on participants that is higher than $50 million. In
contrast, the CFTC's DCO rules do not provide for scalability and do
not allow DCOs the option to seek approval for a higher net capital
requirement.
Finally, a DCO is required to publicly disclose its margin-setting
methodology and default procedures on its Web site. Rule 17Ad-22(d)(11)
requires a clearing agency to make key aspects of its default
procedures publicly available, but nothing in the rules the Commission
is adopting today would require publication of the clearing agency's
margin methodology.
2. Current Practices
An overview of the risk management practices, operations, policies
and procedures of registered clearing agencies is set forth below. The
discussions under the headings ``Risk Management--Measurement of credit
exposures,'' ``--Margin'' ``--Financial Resources'' and under the
heading ``Other Clearing Services'' are based upon public
representations \519\ made by registered clearing agencies regarding
their compliance with the CPSS-IOSCO Recommendations and upon the
Commission's observations with regard to registered clearing agencies
developed in carrying out its supervisory role. The discussion under
the heading ``Risk Management--Model Validation'' is based upon the
Commission's observations with regard to registered clearing agencies
in its supervisory role. The Commission notes that the practices
observed at registered clearing agencies generally are performed
pursuant to stated practices, policies and procedures as described
below.\520\
---------------------------------------------------------------------------
\519\ See, e.g., NSCC's Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Nov. 14, 2011),
available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf; DTC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Dec. 12, 2011),
available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf; FICC/GSD's Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Dec. 15, 2011),
available at http://www.dtcc.com/legal/compliance/FICC_Self-Assessment.pdf.
\520\ Registered clearing agencies are SROs as defined in
Section 3(a)(26) of the Exchange Act. A stated policy, practice, or
interpretation of an SRO, such as a clearing agency's written
policies and procedures, would generally be deemed to be a proposed
rule change. See 17 CFR 240.19b-4. See supra note 293.
---------------------------------------------------------------------------
a. Risk Management Practices
i. CCP Practices as They Relate to Rules 17Ad-22(b)(1)-(4)
CCPs have a range of tools that can be used to manage the financial
risks to which they are exposed, and the tools that an individual CCP
uses will depend upon the nature of its obligations. Nonetheless, there
is a common set of procedures that are implemented by many CCPs to
manage counterparty credit and liquidity risks. Broadly, these
procedures enable CCPs to manage their risks by limiting the likelihood
of defaults, by limiting the potential losses and liquidity pressures
if a default should occur, and by ensuring that there are adequate
resources to cover losses and meet payment obligations on schedule.
To manage its counterparty credit exposures to its participants
effectively, a clearing agency must be able to measure those exposures.
A clearing agency can ascertain its current credit exposure to each
participant by marking each participant's outstanding contracts to
current market prices and (to the extent permitted by a clearing
agency's rules and supported by law) netting any gains against any
losses. A clearing agency faces the risk that its exposure to
[[Page 66267]]
a participant can change as a result of a change in prices, in
positions, or both.
The current practice of each CCP registered with the Commission
includes these procedures: (1) Measuring credit exposures at least once
a day; (2) setting margin coverage at a 99% confidence level over some
set period; (3) using risk-based models; (4) establishing a fund that
mutualizes losses of defaults by one or more participants that exceed
margin coverage; and (5) maintaining sufficient financial resources to
withstand the default of at least the largest participant,\521\ and in
the case of security-based swap transactions, maintaining enough
financial resources to be able to withstand the default of their two
largest participants.\522\
---------------------------------------------------------------------------
\521\ See supra note 183.
\522\ See supra note 168.
---------------------------------------------------------------------------
1. Measurement of Credit Exposures
Currently, registered clearing agencies measure credit exposures at
least once per day. Clearing agencies that guarantee trades on the
trade date, such as the FICC/GSD and OCC, measure credit exposures
multiple times per day. NSCC does not guarantee trades until midnight
of T+1, and it only measures credit exposures daily, though it is
considering an accelerated trade guarantee proposal that would
potentially revise these practices.\523\
---------------------------------------------------------------------------
\523\ See NSCC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Nov. 14, 2011), at 24,
available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf.
---------------------------------------------------------------------------
2. Margin
Clearing agencies use risk-based models to set initial and
variation margin. Inputs to the margin calculation include, among other
things, portfolio size, asset price volatility, current asset values,
the likely liquidity of the asset should a particular market maker fail
(market-maker domination charges), the likely time it would take to
liquidate the assets, potential correlations between the value of
assets posted as collateral and the assets being cleared, and the
correlation of the prices in the portfolio of assets being cleared by
the participant.
The current practice of many CCPs registered as clearing agencies
is to calculate daily margin requirements using risk-based models to
ensure coverage at a 99% confidence interval over a designated time
horizon. Losses beyond this level are typically covered by the CCP's
guaranty fund. This standard is consistent with the RCCP, which has
been the internationally accepted minimum standard for CCPs.\524\ The
RCCP advises that CCPs use margin and other risk control mechanisms to
limit exposures to potential losses from defaults by participants in
normal market conditions. The generally recognized standard for normal
market conditions, as defined in the RCCP, is price movements that
produce changes in exposures that are expected to breach margin
requirements or other risk controls only 1% of the time (i.e., at a 99%
confidence interval).\525\
---------------------------------------------------------------------------
\524\ See supra note 74.
\525\ See Bank for International Settlements' Committee on
Payment and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions,
Recommendations for Central Counterparties, (Nov. 2004), at 21,
available at http://www.bis.org/publ/cpss64.pdf; see also infra
Section V.B.2 (discussion on current industry baselines and the use
of the 99% confidence level).
---------------------------------------------------------------------------
This standard comports with the international standard for bank
capital requirements established by the Bank for International
Settlements, which requires banks to measure market risks at a 99%
confidence interval when determining regulatory capital
requirements.\526\ At the time the Basel Committee on Banking
Supervision (the ``Committee'') contemplated this standard, banks
measured value-at-risk using a range of confidence intervals from 90-
99%.\527\ When determining the minimum quantitative standards for
calculating risk measurements, the Committee noted the importance of
specifying ``a common and relatively conservative confidence level,''
choosing the 99% confidence interval over the other, less conservative
measures.\528\ Since adopted by the Committee in 1998, it has become a
generally recognized practice of banks to quantify credit risk as the
worst expected loss that a portfolio might incur over an appropriate
time horizon at a 99% confidence interval.\529\
---------------------------------------------------------------------------
\526\ See Bank for International Settlements' Basel Committee on
Banking Supervision, International Convergence of Capital
Measurement and Capital Standards: A Revised Framework (June 2004),
available at http://www.bis.org/publ/bcbs107.pdf; see also Darryll
Hendricks and Beverly Hirtle, New Capital Rule Signals Supervisory
Shift (Sept. 1998), available at http://www.bis.org/bcbs/ca/alrequse98.pdf.
\527\ See Bank for International Settlements' Basel Committee on
Banking Supervision, An internal model-based approach to market risk
capital requirements (Apr. 1995), at 12, available at http://www.bis.org/publ/bcbs17.pdf.
\528\ See id.
\529\ See Kenji Nishiguchi, Hiroshi Kawai, and Takanori Sazaki,
Capital Allocation and Bank Management Based on the Quantification
of Credit Risk, FRBNY Economic Policy Review (Oct. 1998), at 83,
available at http://www.newyorkfed.org/research/epr/98v04n3/9810nish.pdf; see also Jeff Aziz and Narat Charupat, Calculating
Credit Exposure and Credit Loss: A Case Study (Sept. 1998), at 34,
available at http://www.bis.org/bcbs/ca/alrequse98.pdf.
---------------------------------------------------------------------------
3. Financial Resources
All clearing agencies that act as CCPs in the United States collect
contributions from their members to guaranty funds or clearing funds
for the mutualization of losses under extreme but plausible market
scenarios. The guaranty funds or clearing funds consist of liquid
assets, the sizes of which vary depending on the products that the CCP
clears. In particular, the guaranty funds for CCPs that clear security-
based swaps are relatively larger (as measured by the size of the fund
as a percentage of the total and largest exposures) than the guaranty
funds or clearing funds for other financial instruments. The guaranty
funds for security-based swaps are sized to achieve protection against
a default by two participant families to whom the clearing agency has
the largest exposures and are designed to protect the clearing agency
from the extreme jump-to-default risk associated with large protection
sellers. Security-based swap CCPs have organized their security-based
swap clearing operations either in a separate legal entity or by
establishing a separate fund and separate procedures (rules, membership
requirements and risk management practices) within a single legal
entity. The registered clearing agencies clearing products other than
security-based swaps maintain the financial resources to withstand the
default of the single largest participant family.\530\
---------------------------------------------------------------------------
\530\ See, e.g., DTC's Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Dec. 12, 2011),
available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf.
---------------------------------------------------------------------------
4. Model Validation
Clearing agencies registered with the Commission typically have a
model validation process in place that evaluates the adequacy of margin
models, parameters, and assumptions. Current model validation practices
vary among clearing agencies. Some registered clearing agencies conduct
annual validations, while others conduct them on an ad hoc basis or
perform validations on new models or changes to existing models before
implementing them. In addition to validating models, registered
clearing agencies typically review models used to calculate margin on a
regular basis and back-test them regularly to assess the reliability of
the methodology in achieving the desired coverage. Based on our
experience in supervising registered CCPs, we understand that
registered CCPs' approaches to model validation include model
validations
[[Page 66268]]
conducted by a qualified person who is either an outside third party or
is employed by the clearing agency but is free from influence from the
persons responsible for the development or operation of the models.
ii. Other Clearing Services (Practices as They Relate to Rule 17Ad-
22(d))
1. Legal Risk
Because registered clearing agencies are SROs, they have written
policies and procedures in place that, at a minimum, address the
significant aspects of their operations and risk management
practices.\531\ A large portion of these policies and procedures are
available to members and participants of clearing agencies, but it is
also ordinarily the practice of clearing agencies to limit members'
access to certain of their policies and procedures to ensure their
integrity, particularly those policies and procedures associated with
the oversight of clearing participants. Registered clearing agencies
also make their rule books and certain key procedures available to the
public to provide a transparent legal framework.\532\
---------------------------------------------------------------------------
\531\ See supra note 520.
\532\ Generally, the rules and procedures of registered clearing
agencies can be found on their respective Web sites.
---------------------------------------------------------------------------
Registered clearing agencies must be able to enforce those policies
and procedures and such enforcement powers are specifically
contemplated by operative provisions of the Exchange Act, subject to
oversight by the Commission.\533\ Clearing agency policies and
procedures that purport to create remedial measures that a party other
than the clearing agency (such as a clearing member) can use to seek
redress or to promote compliance with applicable rules must also be
enforceable in practice in order to be effective, and the Commission
believes that Rule 17Ad-22(d)(1) would augment the Exchange Act
requirement that the rules of the clearing agency must provide that its
participants shall be appropriately disciplined for any violation of
any provision of the rules of the clearing agency.\534\
---------------------------------------------------------------------------
\533\ See Sections 17A(b)(3)(A), (G), and (H) of the Exchange
Act.
\534\ See 15 U.S.C. 78q-1(b)(3)(G).
---------------------------------------------------------------------------
2. Participation Requirements
Applicants for membership must provide a registered clearing agency
with certain financial and operational information prior to being
admitted as a member and on an ongoing basis as a condition of
continuing membership. The registered clearing agency reviews this
information to ensure that the applicant has the operational capability
to meet the technical demands of interfacing with the clearing agency.
In particular, registered clearing agencies require that an applicant
demonstrate that it has adequate personnel capable of handling
transactions with the clearing agency and adequate physical facilities,
books and records and procedures to fulfill its anticipated commitments
to, and to meet the operational requirements of, the clearing agency
and other participants with necessary promptness and accuracy and to
conform to any condition or requirement that the clearing agency
reasonably deems necessary for its protection.
Registered clearing agencies use the ongoing monitoring process to
ensure they understand relevant changes in the financial condition of
their participants and to mitigate credit risk exposure of the clearing
agency to its participants. Financial statements filed with the
regulatory agencies, information obtained from other SROs and
information gathered from various financial publications are analyzed
by risk management staff so that the clearing agency may evaluate
whether the participant continues to be financially stable.
3. Custody of Assets and Investment Risk
Registered clearing agencies currently seek to minimize the risk of
loss or delay in access by holding assets that are highly-liquid (e.g.,
cash, U.S. Treasury securities or securities issued by a U.S.
government agency) and engaging banks to custody the assets and
facilitate settlement. Clearing agencies that are designated
systemically important by the Council may be provided account services
at the appropriate Federal Reserve Bank to the extent such services are
not already available as the result of other laws and regulations.\535\
The use of account services at the Federal Reserve Bank would reduce
custody risk in clearing agencies that are designated systemically
important by the Council.
---------------------------------------------------------------------------
\535\ See Section 806(a) of the Clearing Supervision Act. ``The
Board of Governors may authorize a Federal Reserve Bank to establish
and maintain an account for a designated financial market utility
and provide the services listed in section 11A(b) of the Federal
Reserve Act (12 U.S.C. 248a(b)) and deposit accounts under the first
undesignated paragraph of section 13 of the Federal Reserve Act (12
U.S.C. 342) to the designated financial market utility that the
Federal Reserve Bank is authorized under the Federal Reserve Act to
provide to a depository institution, subject to any applicable
rules, orders, standards, or guidelines prescribed by the Board of
Governors.'' 12 U.S.C. 5465(a).
---------------------------------------------------------------------------
4. Identification and Mitigation of Operational Risk
Registered clearing agencies develop and maintain plans to assure
the safeguarding of securities and funds, the integrity of the
Automated Data Processing systems, and recovery of securities, funds,
or data under a variety of loss or destruction scenarios.\536\ In
addition, clearing agencies generally maintain an internal audit
department to review the adequacy of the clearing agencies' internal
controls, procedures, and records with respect to operational risks.
Some clearing agencies also engage independent accountants to perform
an annual study and evaluation of the internal controls relating to its
operations.\537\
---------------------------------------------------------------------------
\536\ These practices, among others, have been developed
pursuant to Commission guidelines. See Automation Review Policy
Statements, supra note 330.
\537\ See NSCC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Nov. 14, 2011),
available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf.
---------------------------------------------------------------------------
5. Money Settlement Risks
Registered clearing agencies use settlement banks to facilitate the
cash portion of securities settlements. Because DTC is organized as a
limited purpose trust company and is a member of the Federal Reserve
System,\538\ it has an account at the Federal Reserve Bank of New York,
and uses that account to facilitate end-of-day settlement. NSCC, as an
affiliate of DTC, also uses that account.
---------------------------------------------------------------------------
\538\ See Section 806(a) of the Dodd-Frank Act (``The Board of
Governors may authorize a Federal Reserve Bank to establish and
maintain an account for a designated financial market utility and
provide the services listed in Section 11A(b) of the Federal Reserve
Act (12 U.S.C. 248a(b)) and deposit accounts under the first
undesignated paragraph of section 13 of the Federal Reserve Act (12
U.S.C. 342) to the designated financial market utility that the
Federal Reserve Bank is authorized under the Federal Reserve Act to
provide to a depository institution, subject to any applicable
rules, orders, standards, or guidelines prescribed by the Board of
Governors.'').
---------------------------------------------------------------------------
6. Cost-Effectiveness
Registered clearing agencies have procedures to control costs and
to regularly review pricing levels against operating costs. These
clearing agencies may use a formal budgeting process to control
expenditures, and may review pricing levels against their costs of
operation during the annual budget process. Clearing agencies also
analyze workflows in order to make recommendations to improve the
operating efficiency of the clearing agency.
[[Page 66269]]
7. Links
Each registered clearing agency is linked to other clearing
organizations, trading platforms, and service providers. An example of
such a link is DTC Canadian Link Service, which allows qualifying DTC
participants to clear and settle valued securities transactions with
participants of a Canadian securities depository. The link is designed
to facilitate cross-border transactions by allowing participants to use
a single depository interface for U.S. and Canadian dollar transactions
and eliminate the need for split inventories.\539\
---------------------------------------------------------------------------
\539\ See infra note 617.
---------------------------------------------------------------------------
8. Governance
Each registered clearing agency has a board that governs the
operations of the entity and supervises senior management. The key
components of a clearing agency's governance arrangements include the
clearing agency's ownership structure, the composition and role of its
board, the structure and role of board committees, reporting lines
between management and the board, and the processes that ensure
management is held accountable for the clearing agency's performance.
9. Information on Services
Because registered clearing agencies are SROs, their rules are
published by the Commission and are available on each clearing agency's
Web site. In addition, information regarding the operations and
services of each clearing agency can be found either on the clearing
agency's Web site or a Web site maintained by an affiliated entity of
the clearing agency.
10. Immobilization and Dematerialization of Securities Certificates
Virtually all mutual fund securities, government securities,
options, and municipal bonds in the United States are dematerialized,
and most of the equity and corporate bonds in the U.S. market are
either immobilized or dematerialized; some securities (e.g., mutual
fund shares, U.S. Treasury bills) are issued on a completely
dematerialized basis, while most securities issued to the public are
issued in the form of one or more physical certificates. Through the
end of 2010, over 99% of municipal and corporate debt by par value
distributed through DTC was in book-entry-only form.\540\ DTC estimates
that in excess of 90% of the corporate and municipal securities issued
to the public in the United States are distributed through DTC and are
represented by one or more physical certificates that are immobilized
at the depository.\541\
---------------------------------------------------------------------------
\540\ See DTCC White Paper, supra note 389.
\541\ See id.
---------------------------------------------------------------------------
11. Default Procedures
Each registered clearing agency makes publicly available rules,
policies or procedures that set forth the actions the clearing agency
may take in the event of a participant default, with the exception of
certain of their policies and procedures that are kept non-public to
ensure their integrity, such as those associated with the oversight of
clearing participants. For example, clearing agency rules typically
state what constitutes a default, identify whether the board or a
committee of the board may make that determination and describe what
steps the clearing agency may take to protect itself and its
participants. In this regard, clearing agencies typically attempt,
among other things, to close-out, to hedge or to liquidate a defaulting
participant's positions.
12. Timing of Settlement Finality
Each registered clearing agency has rules, policies or procedures
that provide for the settlement of their respective securities
transactions no later than the end of a pre-defined settlement day. For
example, DTC provides for final settlement of securities transfers no
later than the end of the day and the timing of finality is clearly
defined. Final cash settlement occurs at the end of the processing day
at DTC. Funds transfers through DTC's account at the Federal Reserve
Bank of New York that occur between DTC and a settling bank that is
acting on behalf of a DTC participant are final when made.
13. Delivery Versus Payment
Rule 17Ad-22(d)(13) would apply to registered clearing agencies
that provide CSD services. DTC currently is the only registered
clearing agency that is a CSD. DTC operates a Model 2 DVP system that
provides for gross settlements of securities transfers during the day
followed by an end of day net funds settlement.\542\ Under DTC's rules,
in a DVP transaction, the delivering party is assured that it will be
paid for the securities once they are credited to the receiving party's
securities account.\543\
---------------------------------------------------------------------------
\542\ See DTC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Dec. 12, 2011),
available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf.
\543\ See id.
---------------------------------------------------------------------------
14. Risk Controls To Address Participant's Failure To Settle
The sole registered clearing agency providing CSD services, DTC,
which also extends limited intraday credit to participants, has
policies and procedures in place to ensure that timely settlement can
be completed in the event of the default of the participant with the
largest settlement obligation. DTC has policies and procedures to
establish limits (called net debit caps) for each participant. The net
debit cap ensures that the amount of cash that a participant owes the
clearing agency at any one point in time does not exceed this pre-
defined limit or cap. The net debit cap is set in relation to a
participant's normal activity with the maximum net debit cap for an
individual participant currently set at $1.8 billion. DTC also has
implemented other risk management controls to help ensure settlement.
For example, DTC monitors the value of the collateral supporting each
participant's net debit in its settlement system based on the
security's prior business day's closing market price, less a haircut,
which is based primarily upon the availability of prices, ratings, and
the price volatility of the particular security.
15. Physical Delivery Risks
Each registered clearing agency has rules and procedures that
describe its obligations to its participants when it assumes deliveries
of physical instruments. For example, under NSCC's rules governing its
continuous net settlement (``CNS'') system, NSCC becomes the contra-
party for settlement purposes at the point NSCC's trade guarantee
attaches, thereby assuming the obligation of its members that are
receiving securities to receive and pay for those securities, and the
obligation of members that are delivering securities to make the
delivery. Unless NSCC has invoked its default rules, NSCC is not
obligated to make those deliveries until it receives from members with
delivery obligations deliveries of such securities; rather, deliveries
that come into CNS ordinarily are promptly redelivered to parties that
are entitled to receive them through an allocation algorithm. Members
are obligated to take and pay for securities allocated to them in the
CNS process. NSCC's rules also provide mechanisms allowing receiving
members a right to receive high priority in the allocation of
deliveries, and also permit a member to buy-in long positions that have
not been delivered to it by the close of business on the scheduled
settlement date.
[[Page 66270]]
b. Participant Access (Practices as They Relate to Rules 17Ad-22(b)(5)-
(7))
To address credit risk management, clearing agencies establish
requirements for participants' financial resources, creditworthiness,
and operational capability, and maintain procedures to ensure ongoing
compliance with their rules. In its regulatory capacity overseeing
clearing agencies, Commission staff has observed that applicants for
clearing agency membership must demonstrate standards of financial
responsibility, operational capability and character. Specific criteria
used by clearing agencies address the extent and nature of the business
the applicant intends to conduct through the clearing agency and the
applicant's capital resources and financial stability, including
factors bearing on its financial capability to meet its projected
clearing agency obligations.\544\
---------------------------------------------------------------------------
\544\ See, e.g., International Monetary Fund, Publication of
Financial Sector Assessment Program Documentation--Detailed
Assessment of Observance of the NSCC's Observance of the CPSS-IOSCO
Recommendations for Central Counterparties (2010), at 6-8, available
at http://www.imf.org/external/pubs/ft/scr/2010/cr10129.pdf; IMF's
Detailed Assessment of Observance of the Fixed Income Clearing
Corporation--Government Securities Division's Observance with the
CPSS-IOSCO Recommendations for Central Counterparties, performed in
connection with the Financial Sector Assessment Program of the
United States in 2010, at 6-8, available at www.imf.org/external/pubs/ft/scr/2010/cr10130.pdf.
---------------------------------------------------------------------------
As of December 31, 2011, registered CCPs (including those clearing
nontraditional securities such as credit default swaps) had the
following numbers of members:
FICC--302 members
NSCC--187 full members; 647 limited members
OCC--120 members
CME--64 members
ICE Clear Credit--27 members
ICE Clear Europe--60 members
CCPs for traditional securities already have rules regarding access and
membership. All CCPs for traditional securities allow non-dealer
members, and none of them have minimum portfolio size or trading volume
thresholds.\545\ In addition, the minimum capital requirements to
access these CCPs range from $500,000 to $10,000,000.
---------------------------------------------------------------------------
\545\ See infra discussion of Rules 17Ad-22(b)(5), (6) and (7)
in Section V.C.5 (benefits and costs of broad access requirements
and non-dealer membership).
---------------------------------------------------------------------------
Certain clearing agencies that provide CCP services for security-
based swap transactions, however, have required members to have
significant minimum portfolio sizes or trading volumes, meet
significantly higher minimum capital requirements, and require members
to operate a dealer business. Such requirements may present challenges
to new liquidity providers in the relevant market. The CCPs argue that
these requirements are necessary to mitigate the risk exposure of the
CCP in the event of default by a clearing member.\546\ For example,
because markets for credit default swaps are generally less liquid than
markets for exchange-traded derivatives, traditional procedures for a
CCP to handle a member default may not be effective. The traditional
procedures for handling a default, which are used by CCPs for most
exchange-traded derivatives, call for the CCP to terminate all of its
contracts with the defaulting participant and promptly enter the market
and replace the contracts, so as to hedge against further losses on the
open positions created by termination of the defaulter's contracts. But
if the markets for the contracts cleared by the CCP are illiquid,
prompt replacement of the contracts may induce adverse price movements,
especially if the defaulting participant's positions are large.
Consequently, the application of traditional default procedures to
illiquid credit default swaps contracts may entail significant risk to
the CCP.
---------------------------------------------------------------------------
\546\ See generally Bank for International Settlements, New
Developments in Clearing and Settlement Arrangements for OTC
Derivatives (Mar. 2007), at 27-29.
---------------------------------------------------------------------------
To address this potential risk, these CCPs developed a default
management process that requires traders from their clearing members to
be seconded to the CCP to manage the defaulter's portfolio. They would
be charged with neutralizing the market risk in the portfolio by
entering into new OTC derivative contracts with non-defaulting clearing
members. Once neutralized as much as possible, the portfolio would be
divided and auctioned to non-defaulting members. The CCP would
determine a reservation price for the auction, and if a non-defaulting
clearing member's bid exceeds that reservation price, the auction would
be deemed successful. If not, the auction would fail. In the event of a
failed auction, the portfolio would be divided among the non-defaulting
clearing members pro rata based on their volumes of business. Under
this process, a non-defaulting CCP participant would bear the risk of
entering the markets to hedge open positions created by a default only
if it is a successful bidder or if one or more auctions fail and it is
assigned positions because it has outstanding positions with the CCP.
This process creates a tension between the need for effective
default management procedures and the maintenance of fair and open
access to a CCP's services. Because of the stringent capital and other
requirements imposed by the CCP's membership standards, membership in a
CCP clearing security-based swaps generally has been limited to very
large dealers, those meeting the outstanding swap portfolio amount and
capital requirements. Current members may also have an incentive to
exclude new members, either to manage counterparty risk or to block
competitors. Being a member of a CCP may provide a competitive boost to
a new member that is a smaller dealer by allowing the CCP's
creditworthiness to be substituted for that of the new member.
Requirements that prevent smaller dealers from entering as new members
may, therefore, undermine competition and the entry of new liquidity
providers in the relevant market. Indeed, one committee argues that
access criteria in credit default swaps have had the effect of
excluding market participants such as mid-tier financial institutions
and buy-side firms from direct access to CCPs.\547\ While such
requirements have to date been adopted only by CCPs that engage in the
clearance and settlement of credit default swaps, the Commission
believes that preventing the introduction of such requirements also may
be an important consideration for other types of instruments.
---------------------------------------------------------------------------
\547\ See Committee on the Global Financial System, The
Macrofinancial Implications of Alternative Configurations for Access
to Central Counterparties in OTC Derivatives Markets (Nov. 2011), at
9.
---------------------------------------------------------------------------
c. Disclosure of Financial Information (Practices as They Relate to
Rule 17Ad-22(c))
Currently, there is no rule requirement under the Exchange Act or
Commission rule that mandates clearing agencies to record and maintain
information about their financial resources. Nevertheless, as part of
their ordinary risk management procedures developed in consultation
with their members, clearing agencies produce at least quarterly
internal reports regarding the ability of the CCP to withstand a
default by the participant (or two participants) to which the clearing
agency has the largest exposure in extreme but plausible market
conditions. In addition, as part of the Commission's supervision,
oversight and monitoring of clearing agencies, the Commission staff can
obtain such information on request. However, clearing agencies do not
all currently
[[Page 66271]]
record and maintain documentation that explains the methodology used to
compute their financial resource requirements as required by Rule 17Ad-
22(b)(3).
Commission staff guidance to clearing agencies provides that
clearing agencies should provide, within 60 days following the close of
the clearing agency's fiscal year, audited annual financial statements
to those participants who have made clearing fund contributions and/or
have money and/or securities in the clearing agency's systems.\548\
With one exception, the clearing agencies report their accounting
information in U.S. GAAP.\549\ At present, clearing agencies publish
annual audited financial statements on their respective Web sites and
provide unaudited quarterly and annual audited financial statements to
their members.\550\ All the clearing agencies currently have their
financial statements audited in accordance with the standards of the
PCAOB by a registered public accounting firm, and when the financial
statements are posted on their Web sites, the clearing agencies include
the report of the auditor.
---------------------------------------------------------------------------
\548\ See Exchange Act Release No. 16900 (June 17, 1980).
Because BSECC and SCCP do not conduct clearance and settlement
operations they do not post audited financial statements. See supra
note 438.
\549\ ICE Clear Europe posts financial statements in UK GAAP.
\550\ See DTC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Dec. 12, 2011),
available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf; NSCC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Nov. 14, 2011),
available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf; FICC/GSD's Assessment of Compliance with the CPSS/
IOSCO Recommendations for Central Counterparties (Dec. 15, 2011),
available at http://www.dtcc.com/legal/compliance/FICC_Self-Assessment.pdf.
---------------------------------------------------------------------------
d. Comparison of Current Practices and Rule to CPSS-IOSCO
Recommendations as Related to Rules 17Ad-22(b)(1)-(3) and (d)
In 2009, based upon an agreement reached with the U.S. Department
of Treasury, the operations of several U.S. clearing agencies were
assessed by independent assessors from the IMF against the CPSS-IOSCO
Recommendations.\551\ The IMF's assessments supported a finding of full
or broad observance of the CPSS-IOSCO Recommendations by each of the
clearing agencies registered with the Commission at that time. Further,
CME, ICE Clear Credit and ICE Clear Europe represented to the
Commission that they met the standards set forth in the RCCP when they
sought to obtain an exemption from the Commission to provide CCP
services for credit default swaps transactions.\552\ Only one CCP, OCC,
has not either been subject to an assessment using the RCCP or publicly
stated its view on whether it complies with the RCCP.\553\ Rules 17Ad-
22(b)(1), (2), (3) and (d) are largely modeled on the CPSS-IOSCO
Recommendations and therefore are largely consistent with observed
practices.
---------------------------------------------------------------------------
\551\ See supra note 183.
\552\ See generally Securities Exchange Act Release No. 60372
(July 23, 2009), 74 FR 37748 (July 29, 2009) (temporary exemptions
in connection with CDS clearing by ICE Clear Europe); Securities
Exchange Act Release No. 60373 (July 23, 2009), 74 FR 37740 (July
29, 2009) (temporary exemptions in connection with CDS clearing by
Eurex Clearing AG); Securities Exchange Act Release No. 59578 (Mar.
13, 2009), 74 FR 11781 (Mar. 19, 2009) (``March 2009 CME order'')
and Securities Exchange Act Release No. 61164 (Dec. 14, 2009), 74 FR
67258 (Dec. 18, 2009) (``December 2009 CME order'') (temporary
exemptions in connection with CDS clearing by CME); Securities
Exchange Act Release No. 59527 (Mar. 6, 2009), 74 FR 10791 (Mar. 12,
2009), Securities Exchange Act Release No. 61119 (Dec. 4, 2009), 74
FR 65554 (Dec. 10, 2009), and Securities Exchange Act Release No.
61662 (Mar. 5, 2010), 75 FR 11589 (Mar. 11, 2010) (temporary
exemptions in connection with CDS clearing by ICE Trust U.S. LLC).
\553\ Nevertheless, the Commission has approved a proposed rule
change by OCC that revised its clearing fund formula so that it
would be the larger of either of the following events: (1) The
default of the largest single clearing member group; or (2) an event
involving the near-simultaneous default of two randomly-selected
clearing member groups. For a more complete description of the
proposed rule change, see discussion of the costs of Rule 17Ad-
22(b)(3).
---------------------------------------------------------------------------
The table below maps the requirements of Rules 17Ad-22(b)(1)-(3)
and (d) to the corresponding CPSS-IOSCO Recommendations.
---------------------------------------------------------------------------
\554\ RCCP Recommendation 5: Financial Resources states that
``[a] CCP should maintain sufficient financial resources to
withstand, at a minimum, a default by the participant to which it
has the largest exposure in extreme but plausible market
conditions.'' The explanatory note states that this should be viewed
as a minimum standard and that planning by a CCP should consider the
potential for two or more participants to default in a short time
frame. Rule 17Ad-22(b)(3) requires that a clearing agency that
provides CCP services maintain sufficient financial resources to
withstand, at a minimum, a default by the participant family to
which it has the largest exposure in extreme but plausible market
conditions; provided that a security-based swap clearing agency
shall maintain sufficient financial resources to withstand, at a
minimum, a default by the two participant families to which it has
the largest exposures in extreme but plausible market conditions.
COMPARISON OF RULE 17Ad-22 TO CPSS-IOSCO RCCP AND RSSS STANDARDS
----------------------------------------------------------------------------------------------------------------
Rule 17Ad-22 CPSS-IOSCO RCCP and RSSS
----------------------------------------------------------------------------------------------------------------
17Ad-22 (b)(1): Measurement and RCCP Recommendation 3.
management of credit exposures.
17Ad-22 (b)(2):Margin requirements RCCP Recommendation 4.
17Ad-22 (b)(3): Financial RCCP Recommendation 5.\554\
resources.
17Ad-22 (d)(1): Transparent and RCCP Recommendation 1 and RSSS Recommendation 1.
enforceable rules.
17Ad-22 (d)(2): Participation RCCP Recommendation 2 and RSSS Recommendation 2.
requirements.
17Ad-22 (d)(3): Custody of assets RCCP Recommendation 7 and RSSS Recommendation 7.
and investment risk.
17Ad-22 (d)(4): Identification and RCCP Recommendation 8 and RSSS Recommendation 11.
mitigation of operational risk.
17Ad-22 (d)(5): Money settlement RCCP Recommendation 9 and RSSS Recommendation 10.
risks.
17Ad-22 (d)(6): Cost-effectiveness RCCP Recommendation 12 and RSSS Recommendation 15.
17Ad-22 (d)(7): Links............. RCCP Recommendation 10 and RSSS Recommendation 19.
17Ad-22 (d)(8): Governance........ RCCP Recommendation 13 and RSSS Recommendation 13.
17Ad-22 (d)(9): Information on RCCP Recommendation 14 and RSSS Recommendation 17.
services.
17Ad-22 (d)(10): Immobilization RSSS Recommendation 6.
and dematerialization of
securities certificates.
17Ad-22 (d)(11): Default RCCP Recommendation 6.
procedures.
17Ad-22 (d)(12): Timing of RSSS Recommendation 8.
settlement finality.
17Ad-22 (d)(13): Delivery versus RSSS Recommendation 7.
payment.
17Ad-22 (d)(14): Controls to RSSS Recommendation 9.
address participants' failure to
settle.
17Ad-22 (d)(15): Physical delivery RCCP Recommendation 10.
risks.
----------------------------------------------------------------------------------------------------------------
[[Page 66272]]
C. Consideration of Costs, Benefits, and the Effect on Efficiency,
Competition and Capital Formation
1. Overview
The purpose of each rule being adopted today is to enhance the
regulatory framework for registered clearing agencies. This regulatory
framework will facilitate ongoing compliance with the statutory
requirements that clearing agencies have rules that facilitate the
prompt and accurate clearance and settlement of securities transactions
and derivative agreements, contracts and transactions for which they
are responsible, and safeguard funds and securities. The rules do so by
requiring certain minimum standards. The Commission believes that these
requirements will help ensure resilient and cost-effective clearing
agency operations as well as promote transparency that would
consequently support confidence among market participants in clearing
agencies' ability to serve as efficient and financially stable
mechanisms for clearance and settlement and to facilitate capital
formation.
In addition, the rules relating to membership requirements will
help facilitate broad participation and open access to clearing
agencies. If the rules enhance market participation by investors, the
rules may thereby increase price competition, discovery, and price
efficiency in the securities cleared by the clearing agency.
Taken together, the rules are largely consistent with existing
industry practices. In particular, Rules 17Ad-22(b)(1)-(3) and (d) are
modeled on the CPSS-IOSCO Recommendations, which have been in place
since 2004 and are generally observed by all clearing agencies. Rule
17Ad-22(c)(2) would codify the existing practice of most registered
clearing agencies of maintaining certain financial information on their
Web sites. Registered CCPs already disclose their annual audited
financial statements on their Web sites, and all except for one
registered CCP prepare such financial statements using U.S. GAAP or
IFRS.\555\ By codifying existing practices, the rules ensure that these
benefits are being achieved with minimal need for change or for
disruption to the affected industry, while also providing new entrants
with legal certainty and transparency in meeting regulatory standards.
At the same time, the rules have been written to accommodate changes in
technology and market developments. Lastly, Rules 17Ad-22(b)(4) and
(b)(5)-(7) establish new minimum practices for clearing agencies with
regard to model validation and membership practices respectively.
---------------------------------------------------------------------------
\555\ ICE Clear Europe posts financial statements prepared in
accordance with UK GAAP.
---------------------------------------------------------------------------
In the Proposing Release, the Commission identified potential costs
and benefits resulting from Rule 17Ad-22, as proposed, and requested
comment on all aspects of the cost-benefit analysis, including the
identification and assessment of any costs and benefits that were
discussed in the analysis.
The Commission carefully considered all comments received on the
Proposing Release. The comments are discussed above in Section III in
relation to each part of Rule 17Ad-22. In particular, the Commission
carefully considered comments setting forth alternatives to the
requirements contained in Rule 17Ad-22. The discussion immediately
below takes into account the alternatives proposed by commenters.
Several commenters argued that Rule 17Ad-22(d) should not apply to
entities that perform certain post-trade processing services (i.e.,
comparison of trade data, collateral management and tear-up/
compression).\556\ In response to those comments, the Commission has
limited the scope of Rule 17Ad-22 to clearing agencies that are
registered with the Commission.
---------------------------------------------------------------------------
\556\ See generally TriOptima Letter; Markit (April) Letter;
Markit (July) Letter; MarkitSERV (April) Letter; MarkitSERV (July)
Letter; Omgeo Letter.
---------------------------------------------------------------------------
As discussed above, many of the provisions in Rule 17Ad-22 are
modeled on the CPSS-IOSCO Recommendations. As a general alternative to
prescribing its own requirements under Rule 17Ad-22, the Commission
considered requiring registered clearing agencies to perform self-
assessments using the CPSS-IOSCO Recommendations. This approach would
have been similar to the Board's amendment to its Payment System Risk
Policy Statement that directed certain systemically important entities
to conduct self-assessment using the CPSS-IOSCO Recommendations.\557\
The Commission decided against this alternative because the Commission
believes that it would be more appropriate for the Commission to
require registered clearing agencies to conduct assessments against
Commission rules because the Commission's regulatory approach relies on
examining and inspecting for compliance with, and, if necessary,
enforcing, a clear set of rules. Lastly, the Commission also considered
alternatives to each of the individual provisions of Rule 17Ad-22,
which are discussed in more detail below.
---------------------------------------------------------------------------
\557\ See supra note 33.
---------------------------------------------------------------------------
The Commission believes the resulting revised regulatory framework
should enhance confidence in the market and better serve market
participants. With the adoption of these rules, clearing agencies will
be well-positioned to withstand market volatility and evolve with
market developments and technological advancements. Establishing rules
that are consistent with current practice minimizes up-front costs and
provides a good starting point for promoting appropriate risk
management practices. As clearing agency practices evolve over time in
response changes in technology, legal requirements and other factors,
clearing agencies may need to make appropriate updates and improvements
to their operations and risk management practices, and as a result,
actual costs of ongoing compliance with Rule 17Ad-22 may differ from
the estimates discussed below.
The following addresses the entire rule and each rule provision
being adopted today, its purpose, benefits and costs, and the impact of
the rule on efficiency, competition and capital formation.\558\
---------------------------------------------------------------------------
\558\ Section 3(f) of the Exchange Act requires the SEC,
whenever it engages in rulemaking pursuant to the Exchange Act and
is required to consider or determine whether an action is necessary
or appropriate in the public interest, to consider, in addition to
the protection of investors, whether the action would promote
efficiency, competition, and capital formation. In addition, Section
23(a)(2) of the Exchange Act requires the SEC, when adopting rules
under the Exchange Act, to consider the impact such rules would have
on competition. Section 23(a)(2) of the Exchange Act also prohibits
the SEC from adopting any such rule that would impose a burden on
competition not necessary or appropriate in furtherance of the
purposes of the Exchange Act.
---------------------------------------------------------------------------
2. Purpose of Rule 17Ad-22
The adoption by the Commission of Rule 17Ad-22 should benefit the
U.S. financial markets in several ways. Because market participants and
regulatory authorities are familiar with the CPSS-IOSCO Recommendations
upon which Rule 17Ad-22 is based, the provisions being adopted today
will increase the consistency among regulatory frameworks worldwide and
thus diminish the opportunities for regulatory arbitrage. Since their
publication in 2001, and 2004, respectively, the RSSS and RCCP have
been used by the World Bank and IMF in numerous technical assistance
and FSAP missions.\559\ Regulators from
[[Page 66273]]
multiple jurisdictions also have assessed the operations of clearing
organizations using the RSSS and RCCP and incorporated them into their
regulatory frameworks.\560\ The CPSS-IOSCO Recommendations have been
used as a recognized standard for market participants and regulators to
compare the operations of CCPs and CSDs.
---------------------------------------------------------------------------
\559\ Between 2000 and 2009, 35 securities settlement systems
were assessed against the RSSS in 22 countries during FSAP and FSAP
update missions. See Presentation by Massimo Cirasino, World Bank,
and Christine Sampic, IMF, Financial Infrastructure Week, Rio de
Janeiro, Brazil (Mar. 15, 2011).
\560\ For example, the Board also has proposed a rule that is
modeled on the CPSS-IOSCO Recommendations and substantially similar
to Rule 17Ad-22. See 76 FR 18452 (Apr. 4, 2011).
---------------------------------------------------------------------------
The establishment of consistent standards for CCP and CSD
operations is an important goal that underpinned the enactment of
Section 17A of the Exchange Act. When Congress adopted Section 17A, as
part of the 1975 Amendments to the Securities Act (``1975
Amendments''), it determined that the implementation of linked systems
for clearance and settlement and uniform standards would reduce
unnecessary costs and increase the protection of investors and persons
facilitating transactions by and acting on behalf of investors. The
legislative history noted that when broker-dealers must deal with a
dozen or more different clearing and depository systems in their daily
securities operations, the result is excessive cost and poorer service
to investors.\561\ Rule 17Ad-22 establishes minimum standards for the
operations and risk management practices for clearing agencies that are
consistent with the standards for CCPs and CSDs operating domestically
and in other jurisdictions.
---------------------------------------------------------------------------
\561\ S. Rep. 94-75, 94th Cong., 1st Sess., at 184 (1975).
---------------------------------------------------------------------------
Furthermore, Rule 17Ad-22 will have the benefit of serving as a
minimum benchmark for the Commission in making its required
determinations regarding the rules of registered clearing agencies. For
example, for a clearing agency to be registered under Section 17A, the
Commission must find that it has the ability to facilitate the prompt
and accurate clearance and settlement of transactions, to safeguard
investor funds and securities, to remove impediments to and to perfect
the mechanism of a national clearance and settlement system, and in
general to protect investors and the public interest. Also, the
clearing agency's rules must provide adequate access to qualified
participants, fair representation of shareholders and participants,
equitable pricing, discipline of participants, and must not impose any
undue burden on competition.
Rule 17Ad-22 will also have the benefit of augmenting the
Commission's ability to regulate clearing agencies. Because clearing
agencies are SROs, after a clearing agency has been registered with the
Commission, the clearing agency must submit proposed rule changes to
the Commission for approval under Exchange Act Rule 19b-4. To approve a
clearing agency's proposed rule change, the Commission must find that
it complies with Section 17A. The minimum benchmark established by Rule
17Ad-22 will help ensure and demonstrate that the existing operations
of clearing agencies and their proposed rule changes meet or exceed
international standards while remaining appropriate for the individual
clearing agency. As a result, a clearing agency cannot use Rule 17Ad-22
to reduce the strength of its operational standards or adopt a new
policy or procedure that the Commission believes does not meet the
requirements of Section 17A.
Finally, the Commission believes Rule 17Ad-22 will help market
participants be in a position to better compare the operations of U.S.
clearing agencies with non-U.S. clearing organizations. In addition,
the Commission's adoption of Rule 17Ad-22 will lead to greater
confidence, both domestically and internationally, in the resiliency of
clearing agencies and their ability to support the U.S. financial
markets. The Commission's adoption of Rule 17Ad-22 may also reduce some
of the potential regulatory burden for CCPs and CSDs that may be
dually-regulated by the SEC and another domestic or foreign regulator
because it is modeled on standards already employed by other regulatory
authorities.
Below we discuss a number of costs and benefits that are related to
the rule being adopted today. Many of these costs and benefits are
difficult to quantify with any degree of certainty, especially as
practices at clearing agencies are anticipated to evolve and
appropriately adapt to changes in technology and market developments.
In addition, the extent to which the increased ability to enforce
standards that are incorporated in the rule will help limit future
risks is unknown. Moreover, this difficulty is aggravated by the fact
that limited public data exists that is related to a clearing agency's
risk management practices that could assist in quantifying certain
costs. Therefore, much of the discussion is qualitative in nature but
where possible, we quantify the costs.
Many, but not all, of the costs of the rule involve a collection of
information, and these costs and burdens were discussed in the
Paperwork Reduction Act section. When monetized \562\ those estimated
burdens and costs total $3.7 million \563\ in initial costs and $10.1
million \564\ in annual ongoing costs. A detailed discussion of other
economic
[[Page 66274]]
costs of the rulemaking is provided below.
---------------------------------------------------------------------------
\562\ To monetize the internal costs the Commission staff used
data from the SIFMA publications, Management and Professional
Earnings in the Security Industry--2010, and Office Salaries in the
Securities Industry--2010, modified by the Commission staff to
account for an 1800 hour work-year and multiplied by 5.35
(professionals) or 2.93 (office) to account for bonuses, firm size,
employee benefits and overhead.
\563\ The total initial cost was calculated as follows: [for
Rules 17Ad-22(b)(1)-(3) and (d)(1)-(15) (Assistant General Counsel
for 60 hours at $430 per hour) + (Compliance Attorney for 85 hours
at $320 per hour) + (Computer Operations Department Manager for 15
hours at $367 per hour) + (Senior Business Analyst for 15 hours at
$232 per hour) = $61,985 x 10 respondents = $619,850]; + [for Rule
17Ad-22(b)(4) ((Assistant General Counsel for 87 hours at $430 per
hour) + (Compliance Attorney for 77 hours at $320 per hour) +
(Computer Operations Department Manager for 23 hours at $367 per
hour) + (Senior Business Analyst for 23 hours at $232 per hour) =
$75,827 x 9 respondents = $682,443) + ((Chief Compliance Officer for
40 hours at $423 per hour) + (Computer Department Operations Manager
for 40 hours at $367 per hour) + (Senior Programmer for 20 hours at
$304 per hour) = $37,680 x 9 respondents = $339,120) = $1,021,563];
+ [for Rules 17Ad-22(b)(5)-(7) (Assistant General Counsel for 87
hours at $430 per hour) + (Compliance Attorney for 77 hours at $320
per hour) + (Computer Operations Department Manager for 23 hours at
$367 per hour) + (Senior Business Analyst for 23 hours at $232 per
hour)) = $75,827 x 9 respondents = $682,443]; + [for Rule 17Ad-22(c)
((Assistant General Counsel for 60 hours at $430 per hour) +
(Compliance Attorney for 85 hours at $320 per hour) + (Computer
Operations Department Manager for 23 hours at $367 per hour) +
(Senior Business Analyst for 23 hours at $232 per hour) = $66,777 x
10 respondents = $667,770) + ((Chief Compliance Officer for 40 hours
at $423 per hour) + (Computer Department Operations Manager for 40
hours at $367 per hour) + (Senior Programmer for 20 hours at $304
per hour) = $37,680 x 10 respondents = $376,800) = $1,044,570] +
[for Rule 17Ad-22(c)(2) (Senior Accountant for 500 hours at $198 per
hour) x 4 respondents = $396,000] = $3,764,426.
\564\ The total ongoing cost was calculated as follows: [for
Rules 17Ad-22(b)(1)-(3) and (d)(1)-(15) (Compliance Attorney for 60
hours at $320 per hour = $19,200 x 10 respondents = $192,000)]; +
[for Rule 17Ad-22(b)(4) ((Compliance Attorney for 60 hours at $320
per hour = $19,200 x 9 respondents = $172,800) + (2 Independent
Consultants for 30 hours per week at $600 per hour = $36,000 per
week x 12 weeks = $432,000 x 9 respondents = $3,888,000) =
$4,060,800]; + [for Rules 17Ad-22(b)(5)-(7) (Compliance Attorney for
60 hours at $320 per hour = $19,200 x 9 respondents = $172,800]; +
[for Rule 17Ad-22(c) (Compliance Attorney for 60 hours at $320 per
hour = $19,200 x 10 respondents = $192,000)]; [for Rule 17Ad-
22(c)(1) (Compliance Attorney for 1 hour at $320 per hour) +
(Computer Operations Department Manager for 2 hours at $367) =
$1,054 per quarter x 4 quarters per year = $4,216 per year x 9
respondents = $37,944]; [for Rule 17Ad-22(c)(2) (Senior Accountant
for 250 hours at $198 per hour) x 10 respondents = $495,000) +
(Independent Audit Fee = $500,000 per year x 10 respondents =
$5,000,000)] = $10,150,544.
---------------------------------------------------------------------------
Many parts of Rule 17Ad-22 are consistent with current practice and
therefore should not impose significant costs on registered clearing
agencies to comply with those provisions. As noted above, Rule 17Ad-22
also will have the benefit of augmenting the Commission's ability to
regulate clearing agencies. Rule 17Ad-22 should improve access to
security-based swap clearing agencies. The extent to which security-
based swap participants that will be eligible under new access
requirements choose to become members is unknown and we are unaware of
empirical data on the potential impact that this will have on
competition in the security-based swap market. Therefore, the
quantification of this benefit is not feasible.
3. Definitions (Rules 17Ad-22(a)(1)-(5))
a. Rule 17Ad-22(a)(1)
Rule 17Ad-22(a)(1) would define ``central counterparty'' as a
clearing agency that interposes itself between counterparties to
securities transactions to act functionally as the buyer to every
seller and as the seller to every buyer. The definition contained in
this rule is generally consistent with the common usage and
understanding of that term.\565\ The costs and benefits associated with
the impacts of the definition are incorporated in the discussion below
related to the costs and benefits of the provisions where the
definition is used.
---------------------------------------------------------------------------
\565\ See RCCP, supra note 33, Annex 5: Glossary.
---------------------------------------------------------------------------
b. Rules 17Ad-22(a)(2) and (5)
Rule 17Ad-22(a)(2) would define ``central securities depository
services'' to mean services of a clearing agency that is a securities
depository as described in Section 3(a)(23) of the Exchange Act.\566\
Rule 17Ad-22(a)(5) would define ``net capital,'' for the limited
purpose of Rule 17Ad-22(b)(7), to have the same meaning as set forth in
Rule 15c3-1 under the Exchange Act for broker-dealers or any similar
risk adjusted capital calculation for all other prospective clearing
members.\567\ The costs and benefits associated with the impacts of the
definition are incorporated in the discussion below related to the
costs and benefits of the provisions where the definition is used.
---------------------------------------------------------------------------
\566\ ``[Clearing agency] also means any person, such as a
securities depository, who (i) acts as a custodian of securities in
connection with a system for the central handling of securities
whereby all securities of a particular class or series of any issuer
deposited within the system are treated as fungible and may be
transferred, loaned, or pledged by bookkeeping entry without
physical delivery of securities certificates, or (ii) otherwise
permits or facilitates the settlement of securities transactions or
the hypothecation or lending of securities without physical delivery
of securities certificates.'' 15 U.S.C. 78c(a)(23).
\567\ As appropriate, the clearing agency may develop risk
adjusted capital calculations for prospective clearing members that
are not broker-dealers.
---------------------------------------------------------------------------
c. Rule 17Ad-22(a)(3)
Rule 17Ad-22(a)(3) would define ``participant family,'' for the
limited purposes of Rules 17Ad-22(b)(3) and 17Ad-22(d)(14), to mean
that if a participant controls another participant, or is under common
control with another participant, then the affiliated participants
shall be collectively deemed to be a single participant. The Commission
is not narrowing the definition of control in this context to mean
ownership of 50% or more of the voting securities or other interests in
a participant, as requested by one commenter.\568\ We believe the more
appropriate evaluation of control is based on the relation between the
entities and the power, directly or indirectly, to direct the
management or policies of a company, whether through ownership of
securities, by contract, or otherwise. In conducting this evaluation,
clearing agencies should also be guided by the definition of
``control'' set forth in Rule 405 under the Exchange Act, using the
information available to them. The costs and benefits associated with
the impacts of the definition are incorporated in the discussion below
related to the costs and benefits of the provisions where the
definition is used.
---------------------------------------------------------------------------
\568\ See supra note 107 and accompanying text.
---------------------------------------------------------------------------
d. Rule 17Ad-22(a)(4)
Rule 17Ad-22(a)(4) would define ``normal market conditions'' for
the limited purposes of Rules 17Ad-22(b)(1) and (2), to mean conditions
in which the expected movement of the price of cleared securities would
produce changes in a clearing agency's exposures to its participants
that would be expected to breach margin requirements or other risk
control mechanisms only one percent of the time.\569\
---------------------------------------------------------------------------
\569\ The definition of normal market conditions in Rule 17Ad-
22(a)(4) is consistent with the corresponding explanation
established in the CPSS-IOSCO Recommendations. See RCCP, supra note
33, at 21 (explanatory note number 1).
---------------------------------------------------------------------------
The rule conforms to the generally recognized standard of ``normal
market conditions'' as defined in the RCCP and is the benchmark for
most CCPs' margin methodologies, many of which use risk-based models to
ensure coverage at a 99% confidence interval, at minimum, over a
designated time horizon.\570\ The standard also comports with the
international standard for bank capital requirements established by the
Bank for International Settlements, which requires banks to measure
market risks at a 99% confidence interval when determining regulatory
capital requirements.\571\ The costs and benefits associated with the
impacts of the definition are incorporated in the discussion below
related to the costs and benefits of the provisions where the
definition is used.
---------------------------------------------------------------------------
\570\ See RCCP, supra note 33, Annex 5: Glossary. See also supra
discussion on 99% confidence interval as an accepted standard for
measuring market risk in Section II.B.2.b and discussion of current
industry baselines in Section V.B.
\571\ See Bank for International Settlements' Basel Committee on
Banking Supervision, International Convergence of Capital
Measurement and Capital Standards: A Revised Framework (June 2004),
available at http://www.bis.org/publ/bcbs107.pdf; see also Darryll
Hendricks and Beverly Hirtle, New Capital Rule Signals Supervisory
Shift, available at http://www.bis.org/bcbs/ca/alrequse98.pdf. See
also supra notes 526-529 and accompanying text.
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4. Risk Management Requirements for CCPs (Rules 17Ad-22(b)(1)-(4))
Rules 17Ad-22(b)(1)-(4) concern risk management requirements for
clearing agencies that perform CCP services. In particular, these rules
will require a clearing agency that provides CCP services to have
written policies and procedures reasonably designed to: measure its
credit exposures at least once a day, use margin requirements to limit
its exposures to potential losses from defaults by its participants,
use risk-based models and parameters to set margin requirements and to
review such requirements at least monthly, maintain sufficient
financial resources to withstand a default by the two participant
families, if clearing security-based swaps, or one participant family
otherwise, to which it has the largest exposure,\572\ and provide for
an annual model validation process.
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\572\ See Rule 17Ad-22(a)(3), supra Section III.B.3 (defining
``participant family'' for purposes of proposed Rule 17Ad-22(b)(3)).
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As described above, these rules are consistent with current
practice. Registered clearing agencies already have written policies
and procedures designed to meet these risk management requirements,
particularly Rules 17Ad-22(b)(1)-(3). While Rules 17Ad-22(b)(1)-(3)
reflect the CPSS-IOSCO Recommendations, which are observed by all
clearing agencies, Rule 17Ad-22(b)(4) would establish certain new
minimum practices for clearing agencies.
First, Rule 17Ad-22(b)(1) requires that each CCP measure
its credit exposures at least once per day. This rule codifies the
current minimum baseline adhered to by the two clearing
[[Page 66275]]
agencies presently registered with the Commission that provide CCP
services.
Second, Rule 17Ad-22(b)(2) requires that each CCP collect
margin from its participants to limit exposures resulting from changes
in prices or participant positions in current market conditions. This
margin can also be used to minimize the CCPs losses in the event of a
participant default. This rule is consistent with the current practice
of each CCP to calculate daily margin requirements using risk-based
models to ensure coverage at a 99% confidence interval (i.e., under
``normal market conditions''), at minimum, over a designated time-
horizon.
Third, and consistent with Rule 17Ad-22(b)(3), each CCP
currently maintains sufficient financial resources to withstand, at a
minimum, a default by the participant to which it has the largest
exposure in extreme but plausible market conditions.\573\ In addition,
both registered CCPs clearing security-based swap transactions maintain
additional financial resources sufficient to withstand the simultaneous
default by the two participant families to which the CCPs have the
largest exposures.
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\573\ See, e.g., supra notes 168 and 183.
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Fourth, Rule 17Ad-22(b)(4) would ensure that all CCPs have
annual model validations performed by a qualified person who is free
from influence from the persons responsible for development or
operation of the models being validated.
While not requiring major changes to existing operational practices
and policies and procedures currently in place at most registered
clearing agencies, Rules 17Ad-22(b)(1)-(4) provide enforceability to
minimum standards regarding how clearing agencies manage counterparty
credit and default risks. One of the primary roles of a CCP is to
mitigate counterparty credit and default risk. Because of the role
margin plays in a default, a CCP must have confidence that the
liquidation value of available margin will be sufficient to cover
amounts owed by a defaulting participant to the clearing agency, and
that the margin will be available for liquidation without delay. As
described in the baseline discussion,\574\ CCPs have mechanisms and
procedures in place to measure credit exposure. To effectively mitigate
counterparty credit risk, a CCP must have accurate and timely
measurements of its credit exposures to each of its counterparties, and
must impose adequate margin requirements determined by risk-based
models and parameters. CCPs may be faced with significant and rapid
changes in counterparty credit exposures.
---------------------------------------------------------------------------
\574\ See supra Section V.B.2.a.
---------------------------------------------------------------------------
Frequent measurement of counterparty credit exposures and the use
of validated risk-based modeling are essential to setting adequate
margin requirements. A good margin setting methodology will help avoid
both under- and over-collateralization. Under-collateralization exposes
a CCP to increased credit risk in the event of a participant default,
as the CCP may be unable to recover amounts owed to it from the
participant on an unsecured basis. Incurring losses on a counterparty
default could disrupt the operations of the clearing agency as well as
its non-defaulting participants by exposing them to unanticipated
liabilities. These disruptions could negatively impact price efficiency
and capital formation if distressed liquidations result in prices away
from fundamental values for significant periods of time. Over-
collateralization imposes unnecessary costs on trading by tying up
clearing member assets that could otherwise be used more efficiently,
harming allocative efficiency and capital formation. The Commission
believes that Rules 17Ad-22(b)(1)-(4) creates standards to mitigate a
CCP's risks associated with counterparty credit exposures and defaults.
Rules 17Ad-22(b)(1)-(4) acknowledge that appropriate risk
management will vary based on a number of factors relating to the
markets and products a CCP serves. Subject to minimum standards, the
rules permit each clearing agency the flexibility to develop the most
effective and economically efficient risk measurement and risk-based
modeling approaches for each of its unique markets and products to
achieve an optimal level of risk mitigation. By setting only a minimum
standard, the rules also allow each CCP to adapt its risk management
strategies as needed in response to dynamic market conditions rather
than locking the CCP into a fixed set of risk mitigation rules. The
minimum standards also prevent a CCP from establishing risk monitoring
procedures below a baseline in an effort to reduce costs and gain a
competitive advantage.
The Commission believes that credit exposures should be measured at
least once a day because a clearing agency that did not do so would not
be able to effectively manage its risk. However, the Commission
believes that it cannot reasonably determine the most appropriate
frequency for CCPs to monitor their risk exposures in all
circumstances. The minimum standards in Rules 17Ad-22(b)(1)-(4) are
intentionally written to comply with CPSS-IOSCO Recommendations and
limit systemic risk while not precluding entry to potential new entrant
CCPs. Each CCP is exposed to participants in different markets
characterized by different trading patterns, volumes, liquidity,
transparency and other unique market characteristics. Rules 17Ad-
22(b)(1)-(4) provide each CCP the flexibility to tailor its risk
management practices to each of its unique markets and products,
allowing it to develop the most economically efficient and effective
risk mitigation strategies possible.
The Commission considered the range of practices at registered
clearing agencies with respect to monitoring risk exposures and
recognizes that there is a risk that by setting the minimum standards
according to the highest level of current market practice, the
standards could be too high for some potential market conditions or
future security types. This could result in sub-optimal risk management
practices for a period in the future to the extent such factors are not
appropriately recognized by the Commission.
The Commission believes it is appropriate that CCPs clearing
security-based swaps are held to the higher minimum standard in Rule
17Ad-22(b)(3) than CCPs that do not clear security-based swaps. In
particular, the Commission believes that the requirement to maintain at
a minimum financial resources capable of withstanding the default of
its two largest participant families as opposed to only its largest
participant family is at this time appropriate for clearing security-
based swaps but not for other securities because of the unique and
heightened risks posed by credit default swaps relative to traditional
securities. Credit default swaps pose additional risk management
challenges in that their value can change by a large amount in an
extremely short time interval (i.e., they are subject to significant
jump-to-default risk).\575\ Unlike many equity and fixed income
securities, but similar to other derivative contracts, a CCP's
obligation when clearing credit default swaps does not end when the
transaction settles, but at its expiration. In addition, unlike other
products that also exhibit these characteristics, credit default swaps
are unique in their size relative to their underlying markets. Recent
research shows that notional outstanding in credit default swaps are
often close to or greater than the
[[Page 66276]]
outstanding value of the underlying instruments.\576\
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\575\ See supra note 162.
\576\ See supra note 163.
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Several other factors also complicate risk modeling for credit
default swaps. CCPs have only recently introduced clearing for
security-based swaps, so the risk models used by CCPs have not yet been
stressed by a substantial range of market conditions. In addition, many
security-based swaps are relatively illiquid, which complicates the
default management process. For example, more than 98% of single-name
credit default swap reference entities trade less than 10 times per
day.\577\ Low liquidity typically leads to wider bid-ask spreads,
greater price impact of trades, and potentially higher costs when
finding replacements for defaulted positions.
---------------------------------------------------------------------------
\577\ See Memorandum by the Commission's Division of Risk,
Strategy, and Financial Innovation, Security-Based Swap Block Trade
Definition Analysis (Jan. 13, 2011), available at http://www.sec.gov/comments/s7-34-10/s73410-12.pdf. See also Che Sidanius
and Anne Wetherilt, Thoughts on Determining Central Clearing
Eligibility of OTC Derivatives, (Bank of England, Financial
Stability Paper, No. 14, Mar. 2012), available at http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper14.pdf.
The authors report that in the six months ending February 2012, 90%
of their sample of 1,000 single name CDS contracts trade an average
of less than 50 times per week.
---------------------------------------------------------------------------
The Commission recognizes that requiring a different standard for
CCPs for security-based swaps could discourage new entrants from
entering into the market for these instruments because of higher
financial resource requirements relative to other types of instruments.
In particular, the higher the financial resource requirements, the
higher the costs to establish a new clearing agency, potentially
resulting in fewer clearing agencies.
While the Commission is sensitive to the consequences of
establishing a different standard for CCPs for security-based swaps,
the Commission believes that the financial resources of a CCP must be
robust enough to accommodate the risks that are particular to each
market served--irrespective of whether such analysis results in
different standards. As described above, the Commission believes that
Rule 17Ad-22(b)(3) does not represent a change in practice for any CCP
that currently clears credit default swaps, and to the extent that it
represents an increased financial resources requirement for potential
competitors, this increased burden is justified by the greater
difficulty of risk-management in credit default swaps as opposed to
traditional securities.\578\ Furthermore, the Commission believes that
the burdens associated with this provision are minimized as the rule
permits registered CCPs to comply with the ``cover two'' requirement by
establishing a separate fund and related procedures for their security-
based swap operations if they prefer this structure to the application
of the ``cover two'' requirement to the entire legal entity. As
security-based swap products with different characteristics are
proposed for clearing over time, the Commission would evaluate risk
profiles of such products to consider how they would be treated under
the ``cover two'' standard.
---------------------------------------------------------------------------
\578\ See CFTC-SEC Staff Roundtable on Clearing of Credit
Default Swaps (Oct. 2010), at 123, available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission7_102210-transcrip.pdf (Stan Ivanov, ICE Clear Credit stating ``at ICE
we look at two simultaneous defaults of the two biggest losers upon
extreme conditions * * *'').
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The Commission further recognizes the benefits associated with
establishing financial resource requirements that are consistent with
the international standards, such as the benefit of reduced incentives
for regulatory arbitrage. The Commission notes that the ``cover two''
requirement for security-based swaps CCPs is consistent with the
financial resource requirements for CCPs contained in the FMI Report
\579\ and in EMIR.
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\579\ See FMI Report, Principles 4 and 7, supra note 32.
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The Commission believes it is important to codify the practice of
obtaining an annual model validation to ensure that a CCP can evaluate
the continued appropriateness of its margin models. Rule 17Ad-22(b)(4)
also should help CCPs better evaluate their margin models, which should
promote greater confidence in clearing agencies' risk management
practices.
The Commission is also mindful of the costs associated with the
final rule. In particular, the Commission recognizes that though many
parts of Rule 17Ad-22 being adopted by the Commission today are a
codification of usual and customary practices at CCPs and clearing
agencies, they may still impose costs.
As noted above, the standards contained in Rule 17Ad-22(b)(1)-(4)
would impose certain burdens and related costs on respondent clearing
agencies. As discussed in Section IV.C, based on policies and
procedures requirements for Regulation NMS, and based on staff
conversations with industry representatives, the Commission has
estimated the burdens and related costs of these requirements for
clearing agencies.
The clearing agency standards in Rules 17Ad-22(b)(1)-(4) may
require respondent clearing agencies to review and amend their policies
and procedures. The standards contained in Rule 17Ad-22(b)(4) also
would impose one-time costs on clearing agencies to create policies and
procedures as well as require one-time systems adjustments related to
the capability to perform an annual model validation. The costs of
creating these policies are included in the $3.7 million startup cost
estimates discussed earlier.
The standards contained in Rules 17Ad-22(b)(1)-(3) also would
impose ongoing costs on clearing agencies such as monitoring and
enforcement activities with respect to the policies and procedures the
registered clearing agency creates in response to the standards. The
ongoing costs of these monitoring and enforcement activities are
included in the estimated $10.1 million annual costs discussed
earlier.\580\ These Rules may also impose additional incremental costs
related to, for example, employee training, systems testing, and other
operational considerations designed to ensure both initial and
continued compliance with such policies and procedures.
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\580\ This number also reflects the costs of Rules 17Ad-
22(d)(1)-(15).
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The standards contained in Rule 17Ad-22(b)(4) would also impose
ongoing costs on clearing agencies. For example, the clearing agency
standards in Rule 17Ad-22(b)(4) would collectively require respondent
CCPs to perform certain ongoing monitoring and enforcement activities
with respect to the policies and procedures the clearing agency creates
in response to the standard and to provide for an annual model
validation. The Commission believes clearing agencies would hire a
consulting firm \581\ that dedicates two consultants to the project.
The costs for the consultants are included in the $10.1 million annual
paperwork cost discussed earlier. Rule 17Ad-22(b)(4) may also impose
additional incremental costs associated with employee training, systems
testing, and other operational considerations designed to ensure
initial and continued compliance with the clearing agencies model
validation policies and procedures.
---------------------------------------------------------------------------
\581\ Currently, the majority of the clearing agencies
performing model validation employ a consulting firm; the remainder
of the clearing agencies have created an internal model validation
group that does not report to the person overseeing the development
or operation of the models.
---------------------------------------------------------------------------
Except as noted above, Rules 17Ad-22(b)(1)-(4) establish standards
that are already largely adhered to in practice by each CCP registered
with the Commission. Thus, while Rules 17Ad-22(b)(1)-(4) will require
each currently registered CCP to continue the
[[Page 66277]]
expenditures associated with maintaining current rules, policies, and
procedures, they should impose limited incremental costs.
In the Proposing Release, the Commission identified potential costs
and benefits resulting from Rules 17Ad-22(b)(1)-(4), as proposed, and
requested comment on all aspects of the cost-benefit analysis,
including the identification and assessment of any costs and benefits
that were not discussed in the analysis. Although the Commission did
not receive any comments on the specific cost-benefit analysis
contained in the Proposing Release, several commenters raised concerns,
which are discussed above in Section III.C.1.b, that have a bearing on
the costs and benefits associated with the rule. In response to these
comments, the Commission carefully considered alternatives to the
approach we are adopting in Rule 17Ad-22, including more prescriptive
alternatives (e.g., specifying how many times a day a clearing agency
should measure its credit exposures to its participants). However, as
noted above, clearing agencies match the frequency of credit exposure
calculations to the horizon of the guarantee they provide. The
requirement to measure credit exposure at least once per day does not
preclude more frequent measurement of credit exposure, allowing those
who guarantee intraday to measure exposures intraday. Therefore, the
Commission believes the flexibility provided by Rules 17Ad-22(b)(1) and
(2) appropriately reflects differences in clearing agency models.
The Commission also considered alternatives to Rule 17Ad-22(b)(3),
such as (1) requiring each clearing agency, regardless of the
securities cleared, to maintain sufficient financial resources to
withstand, at a minimum, a default by the participant family to which
it has the largest exposure in extreme but plausible market conditions,
and (2) requiring each clearing agency, regardless of the securities
cleared, to maintain sufficient financial resources to withstand, at a
minimum, a default by the two participant families to which it has the
largest exposure in extreme but plausible market conditions. The
Commission decided to create separate standards for the two different
kinds of CCPs because it believes that clearing security-based swaps is
inherently riskier than clearing other types of securities, as
discussed above.
Furthermore, the Commission considered a number of alternatives to
provisions in Rule 17Ad-22(b)(4). For example, one alternative was to
be more prescriptive in identifying who could perform the annual model
validations. The Commission recognizes there is a tradeoff between the
need for expertise in conducting model validations and the independence
of the validator. Therefore, Rule 17Ad-22(b)(4) sets a principle that
allows the clearing agencies to balance this trade-off in a way that
satisfies the purpose of the validation. The Commission also considered
alternatives, which would have required that model validations occur
more or less frequently than annually. The Commission believes that
requiring model validation at least annually is appropriate because it
complies with CPSS-IOSCO Recommendations and clearing agencies have
economic incentives to evaluate their models more frequently if market
conditions change, whether or not they are required to do so by
Commission rules.
5. Participant Access Standards for CCPs (Rules 17Ad(b)(5)-(7))
These rules establish requirements for policies and procedures
detailing membership practices. Although we believe that these rules
reflect current practices for some CCPs, they may require a change in
practice for others. Specifically, Rules 17Ad-22(b)(5), (6) and (7)
would introduce certain requirements regarding access to CCPs,
including that each CCP must: (1) Provide the opportunity for a person
who does not perform any dealer or security-based swap dealer services
to obtain membership; (2) preclude the use of minimum portfolio size
thresholds and minimum transaction volume thresholds as conditions to
membership; and (3) provide the ability to obtain membership to persons
who maintain net capital equal to or greater than $50 million.
The Commission is adopting Rules 17Ad-22(b)(5), (6) and (7) to
establish a regulatory framework for registered CCPs regarding
membership practices. These rules also address concerns about access to
central clearing in light of the proposed implementation of mandatory
clearing requirements around the world.\582\ The Commission believes
that Rules 17Ad-22(b)(5), (6) and (7) will complement Section 17A of
the Exchange Act, which requires that a clearing agency shall not be
registered unless the Commission determines, among other things, that
the clearing agency's rules do not impose burdens on competition that
are unnecessary or inappropriate to promote the purposes of the
Exchange Act \583\ and that the rules are not designed to permit unfair
discrimination in the admission of participants or among participants
in the use of the clearing agency.\584\
---------------------------------------------------------------------------
\582\ See, e.g., CFTC-SEC Staff Roundtable on Clearing of Credit
Default Swaps (Oct. 2010), available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission7_102210-transcrip.pdf.
\583\ 15 U.S.C. 78q-1(b)(3)(F).
\584\ 15 U.S.C. 78q-1(b)(3)(G).
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As described above, CCPs for securities other than security-based
swaps generally do not engage in the practices that Rules 17Ad-
22(b)(5), (6), and (7) are designed to prevent. However, CCPs for
security-based swaps have required members to have a minimum portfolio
size (e.g., $1 trillion outstanding) or minimum trading volume, meet
very high minimum capital requirements (e.g., $5 billion), and require
members to operate a dealer business. Rule 17Ad-22 is designed to
prohibit these types of practices by all CCPs, irrespective of the
types of products cleared, by establishing a minimum standard that
would have the benefit of uniformity for currently registered CCPs and
any future market entrants.
CCPs have membership requirements so that the CCPs and their
members can limit their exposures to less creditworthy market
participants. However, as noted above, members may have the incentive
to promote membership requirements that limit access to the CCP for
competitive reasons. While such requirements have to date been adopted
only by CCPs that engage in the clearance and settlement of credit
default swaps, the Commission believes that preventing the introduction
of such requirements also may be an important consideration for CCPs
that clear other instruments.\585\ If a clearing agency clears both
security-based swaps and other securities, Rule 17Ad-22(b)(6) will
prohibit the clearing agency from denying membership solely because the
applicant did not maintain a minimum portfolio size or minimum volume
in security-based swap transactions. The rule is being applied to all
clearing agencies, regardless of the type of instrument cleared, so
that an existing or future clearing agency could not use its market
power to exclude potential applicants for the benefit of its existing
members or unnecessarily restrict access to central clearing. Indeed,
the concerns noted above about the incentives to control access to CCPs
could apply to the clearing of any security. Accordingly, all CCPs,
regardless of the type of security, will be subject to Rules 17Ad-
22(b)(5), (6), and (7).
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\585\ See supra Section V.B.2.b and note 547.
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The Commission believes that no registered CCP should deny
[[Page 66278]]
membership solely because a person does not perform any dealer or
security-based swap dealer services or based on a minimum portfolio
size or minimum transaction volume thresholds. The Commission does not
believe that these factors are, by themselves, appropriate indicators
of whether an applicant should be admitted to membership in a clearing
agency. The Commission is adopting Rule 17Ad-22(b)(5) to help to foster
the development of correspondent clearing arrangements that will allow
market participants that are not dealers or security-based swap dealers
to obtain access to a CCP, which should have the beneficial result of
greater competition in and access to central clearing because these
persons do not execute securities trades for their own account.
Instead, they provide correspondent clearing services for market
participants.\586\ As a result, their ability to provide correspondent
clearing services would tend to increase as competition and transaction
volumes increased. The Commission further believes that imposing
minimum thresholds on the size or transaction volume of a participant's
portfolio would not function as a good indicator of whether the
participant is able to meet its obligations to a clearing agency.\587\
New participants in a CCP that do not initially intend to or have the
capacity to transact in substantial size or volume may nevertheless
have the operational and financial capacity to perform the activities
that other participants are able to perform but at lower size or volume
levels. Accordingly, the Commission believes that Rule 17Ad-22(b)(6)
will help facilitate the requirement in Section 17A of the Exchange Act
that the rules of a clearing agency must permit fair and open access to
qualified participants.
---------------------------------------------------------------------------
\586\ See supra note 235.
\587\ Proposed Rule 17Ad-22(b)(6) would not prohibit a clearing
agency from imposing maximum portfolio sizes or transaction volume
amounts.
---------------------------------------------------------------------------
Rule 17Ad-22(b)(7) will significantly increase access to clearing
membership in CCPs that clear credit default swaps while still allowing
CCPs to maintain what the Commission believes will be sufficient net
capital standards for members. For example, the rule establishes a
minimum net capital requirement of $50 million that only approximately
201 broker-dealers, or four percent of the total number of registered
broker-dealers, can satisfy today according to broker-dealer data
available to the Commission. A net capital threshold of $100 million
would reduce the number of broker-dealers that could meet the standard
by 73 (36%) to 128 eligible firms, while a further reduction of the net
capital requirement to $25 million would increase the number of
eligible broker-dealer firms by 86 (42%) to 287 (6% of all registered
broker-dealers).\588\ The Commission believes that firms that maintain
a net capital level of at least $50 million have sufficient financial
resources to participate at some level in a CCP, provided that they are
able to comply with other reasonable membership standards, and that the
increase in the potential pool of clearing members is consistent with
the Commission's intention of expanding access to clearing.
---------------------------------------------------------------------------
\588\ As stated above, the $50 million net capital requirement
affects access to CCPs that clear CDS. The Commission recognizes
that the number of dealers that clear CDS is significantly smaller
than the total number of broker-dealers, and that even if Proposed
Rule 17Ad-22(b)(7) is successful in encouraging the broadening of
membership in CCPs that clear CDS, the Commission believes the
number of broker-dealers newly eligible for clearing membership that
become clearing members as a result of this change is likely to be
substantially less than 201.
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The Commission carefully considered the tradeoffs of selecting a
lower or higher net capital threshold. A higher net capital requirement
may permit CCPs to exercise market power for the benefit of members by
limiting membership to an unduly small group of firms.\589\ This could
limit competition in the market for supplying dealer services as
dealers who are CCP members would have an advantage over other dealers.
It could also increase overall systemic risk by concentrating the
counterparty risk in relatively few participants. A less restrictive
capital requirement may also result in incentives for firms that are
not capable of participating in the default management process of a CPP
to effectively ``free ride'' on the default services provided by the
rest of the membership.\590\ The Commission believes that the $50
million capital requirement appropriately balances these concerns and
bridges the differences in current membership standards across
registered clearing agencies. At the same time, the Commission notes
that having a $50 million capital level does not create a right to
membership.
---------------------------------------------------------------------------
\589\ See Craig Pirrong, The Economics of Central Clearing:
Theory and Practice (ISDA Discussion Papers Series, No. 1, May
2011), at 28.
\590\ See id. at 28.
---------------------------------------------------------------------------
In addition, we note that the $50 million requirement is the same
as the CFTC's capital requirement for DCO membership.\591\ Establishing
a different requirement than that adopted by the CFTC could create
opportunities for regulatory arbitrage and would in effect make one
regulator's standard irrelevant for dually registered clearing agencies
like CME, ICE Clear Credit and OCC. Furthermore, some of these
competing concerns are addressed by the flexibility contemplated by
Rule 17Ad-22(b)(7), as it permits each clearing agency to develop
scalable policies and procedures to limit the activities of
participants based on their level of net capital.\592\ For example, a
clearing agency can place limits on its potential exposure to
participants operating at certain net capital thresholds by restricting
the maximum size of the portfolio such participants are permitted to
maintain at the clearing agency. The Commission also believes that Rule
17Ad-22(b)(7) would facilitate sound risk management practices by
encouraging clearing agencies to examine and articulate the benefits of
higher net capital requirements as a result of having clearing agencies
develop scalable membership standards that link the nature and degree
of participation with the potential risks posed by the
participant.\593\
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\591\ See supra note 38.
\592\ The Commission notes that some clearing agencies currently
utilize capital-related requirements that differentiate among types
of participants. For instance, FICC has maintained a $50 million net
worth requirement and $10 million excess net capital requirement for
its Category 1 Dealer Netting Members and a $25 million net worth
requirement and $10 million excess net capital requirement for its
Category 2 Dealer Netting Members.
\593\ See supra note 264.
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The Commission believes that Rules 17Ad-22(b)(5), (6) and (7) will
create the potential for greater access to clearing services for, and
opportunities for competition among market participants, particularly
for credit default swaps. The Commission believes that greater access
to clearing should benefit market participants by allowing them to
provide equivalent access to CCP clearing services for security-based
swaps to their customers. Doing so should increase opportunities for
competition among clearing firms on both price and service which
should, in turn, reduce costs to the ultimate customers for the
financial services being offered.
Rules 17Ad-22(b)(5), (6) and (7) may impose some costs on clearing
agencies due to the increased complexity of the policies and procedures
regulating access to the clearing agency. The Commission acknowledges
that lowering membership standards to increase the number of
participants may increase the likelihood of a participant default.
Nevertheless, broadening direct access will tend to reduce the
concentration of risk in any individual
[[Page 66279]]
direct clearing member. Further, while Rules 17Ad-22(b)(5), (6) and (7)
prohibit certain barriers to entry, these provisions nevertheless still
provide clearing agencies with the flexibility to develop membership
standards that maintain a robust risk management framework.
Typically, dealers innovate and customize in new financial
contracts to address specific risk-management problems of their
clients. It is not uncommon for these contracts to become exchange-
traded, as the market for the product matures. Dealers, however, may
have an incentive to maintain wider bid-ask spreads associated with a
customized contract relative to the spreads that might apply if it were
a standardized product. Greater access to a CCP could promote greater
standardization because all CCP members could submit transactions to
the CCP based on the CCP's pre-established rules. Accordingly, the
Commission believes that expanded membership will promote the natural
evolution of customized contracts to standardized contracts with deeper
liquidity and reduced bid-asked spreads.
In terms of comments received, one commenter believed that the
proposed rules are unnecessary and pointed to the existing requirement
in Section 17A(b)(3)(F) of the Exchange Act that a clearing agency
shall not be registered unless the Commission determines that the
clearing agency's rules are not designed to permit unfair
discrimination in the admission of participants or among participants
in the use of the clearing agency. The Commission believes Rules 17Ad-
22(b)(5)-(7) will guide registered CCPs to practices that support the
requirement to provide fair and open access.
The Commission is mindful of the costs associated with the final
rules. In particular, the Commission recognizes that creating new
policies and procedures can impose costs even if those policies and
procedures largely codify current practice.
As noted above, the standards contained in Rules 17Ad-22(b)(5)-(7)
would impose certain burdens and related costs on respondent clearing
agencies. As discussed in Section IV.C.3, based on policies and
procedures requirements for Regulation NMS, and based on staff
conversations with industry representatives, the Commission has
estimated the burdens and related costs of these requirements for
clearing agencies.
The clearing agency standards in Rules 17Ad-22(b)(5)-(7) would
require respondent clearing agencies to create policies and procedures.
The standards contained in Rules 17Ad-22(b)(5)-(7) would also impose
ongoing costs on clearing agencies. For example, the clearing agency
standards in Rules 17Ad-22(b)(5)-(7) would collectively require
respondent clearing agencies to perform certain ongoing monitoring and
enforcement activities with respect to the policies and procedures the
clearing agency creates in response to the standard. The costs of
creating these policies and procedures, and performing ongoing
monitoring and enforcement activities were included, respectively, in
the $3.7 million startup costs and $10.1 million annual ongoing costs
discussed earlier. These provisions may also impose incremental costs
related to, for example, employee training, systems testing, and other
operational considerations designed to ensure both initial and
continued compliance with the clearing agency's participant access
policies and procedures.
6. Record of Financial Resources and Annual Audited Financial
Statements (Rules 17Ad-22(c)(1)-(2))
Rule 17Ad-22(c)(1) provides that each fiscal quarter (based on
calculations made as of the last business day of the clearing agency's
fiscal quarter), or at any time upon Commission request, a CCP shall
calculate and maintain a record \594\ of the financial resources
necessary to meet its requirement in proposed Rule 17Ad-22(b)(3) and
sufficient documentation to explain the methodology it uses to compute
such financial resource requirement.
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\594\ See Exchange Act Rule 17a-1 (17 CFR 240.17a-1). Clearing
agencies may destroy or otherwise dispose of records at the end of
five years consistent with Exchange Act Rule 17a-6 (17 CFR 240.17a-
6).
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Rule 17Ad-22(c)(2) requires a clearing agency, within 60 days after
the end of its fiscal year, to post on its Web site annual audited
financial statements. Such financial statements shall: (i) Include, for
the clearing agency and its subsidiaries, consolidated balance sheets
as of the end of the two most recent fiscal years and statements of
income, changes in stockholders' equity and other comprehensive income
\595\ and cash flows for each of the two most recent fiscal years; (ii)
be prepared in accordance with U.S. GAAP, except that for a clearing
agency that is a corporation or other organization incorporated or
organized under the laws of any foreign country the consolidated \596\
financial statements may be prepared in accordance with U.S. GAAP or
IFRS; (iii) be audited in accordance with standards of the Public
Company Accounting Oversight Board by a registered public accounting
firm that is qualified and independent in accordance with Rule 2-01 of
Regulation S-X (17 CFR 210.2-01); and (iv) include a report of the
registered public accounting firm that complies with paragraphs (a)
through (d) of Rule 2-02 of Regulation S-X (17 CFR 210.2-02).
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\595\ The added language, ``changes in stockholders' equity and
other comprehensive income,'' does not change the substance of the
rule as provided in the Proposing Release. This language has been
added in the final rule to clarify the scope of what is meant by
complete set of financial statements consistent with customary
industry accounting practices.
\596\ The ``consolidation'' language does not change the
substance of the rule as provided in the Proposing Release, but has
been added to clarify that the financial statements requirement
pertains to that of the clearing agencies and its subsidiaries on a
consolidated basis.
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Rule 17Ad-22(c)(1) is, for the most part, identical to what is
described in the baseline section above, and thus, this rule will, for
the most part, codify an existing practice of clearing agencies. The
difference is that CCPs will now have to format and synthesize existing
information in a manner sufficient to explain the methodology the
clearing agency uses to meet the requirement of Rule 17Ad-22(b)(3).
In addition, Rule 17Ad-22(c)(2) is substantially similar to what is
described in the baseline section above. Most clearing agencies report
financial statements in accordance with Rule 17Ad-22(c)(2) with one
exception.\597\ Accordingly, Rule 17Ad-22(c)(2) is largely consistent
with current practice and will impose minimal costs on registered
clearing agencies.\598\
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\597\ See supra note 549.
\598\ Because BSECC and SCCP conduct no operations, we also
expect their respective costs to be minimal.
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As described above, these two rules, except where noted above,
codify current practice. To the extent that current practice is not
currently required by rule, the rules being adopted today allow for
greater enforceability of these disclosure practices, and as a result
ensure that CCPs continue to maintain an environment of transparency.
Rule 17Ad-22(c)(1) ensures that the Commission continues to be able
to monitor whether CCPs maintain the financial resources necessary to
meet its requirement in proposed Rule 17Ad-22(b)(3). The requirement
that CCPs will have to format and synthesize existing information in a
manner sufficient to explain the methodology the clearing agency uses
to meet the requirement of Rule 17Ad-22(c)(1), facilitates the
[[Page 66280]]
Commission's access to this information in a format that is clear and
understandable, and ensures that the Commission can obtain sufficient
documentation to understand and evaluate the methodology used by the
CCP to compute such financial resource requirement.
Rule 17Ad-22(c)(2) ensures that CCPs continue to provide
transparency to regulators and market participants. Transparency helps
to ensure that market participants in general have better information
about the stability of the system, and facilitates monitoring by the
Commission and other regulators, clearing members, investors, academics
and the public in general. Further, to the extent that CCPs are
systemically important institutions, regulators may also be monitoring
systemic risk when monitoring CCPs.
Transparency is particularly important to clearing members, whose
capital is at risk if a clearing member fails. Clearing members can use
the information codified in this rule to assess risks related to their
participation in the CCP and manage those risks. The information
codified in this rule can also be used by clearing members in a way
that promotes competition. In situations where multiple CCPs clear the
same product, clearing members may base their decision on which CCP to
use on the financial information codified in Rule 17Ad-22(c)(2), which
requires that CCPs make their financial information available to the
public, even during times of market stress. It is possible that if the
financial position of the CCP deteriorates, clearing members and
investors may discontinue membership in or otherwise limit their use of
that CCP, therefore driving CCPs with substandard risk management
practices out of business.
The Commission carefully considered alternatives to these
provisions. For example, an alternative to the requirements of Rule
17Ad-22(c)(2) would be to permit registered clearing agencies to post
audited financial statements prepared in accordance with the laws of
their country of origin, reconciled to U.S. GAAP. Indeed, one
registered clearing agency, ICE Clear Europe, currently posts on its
Web site audited financial statements prepared according to UK GAAP.
Having foreign CCPs prepare financial statements using more widely
applied bases of accounting such as U.S. GAAP or IFRS may offer greater
utility to market participants, regulators and other stakeholders of
clearing agencies. Therefore, we have limited the different bases of
accounting upon which the annual audited consolidated financial
statements may be prepared to IFRS and U.S. GAAP. The Commission
recognizes that there are costs associated with requiring that a
registered CCP comply with these reporting standards. However, to the
extent that the parent company of ICE Clear Europe already prepares
financial statements according to U.S. GAAP, we expect the costs of
this requirement to be less burdensome. The Commission also believes
that allowing CCPs to prepare financial statements in accordance with
the laws of their countries of origin and then reconcile the
differences to U.S. GAAP would add complexity associated with the
reconciliation that may offer less utility to market participants,
regulators and other stakeholders of clearing agencies because of the
burden of understanding and interpreting additional bases of accounting
would create for users.
The Commission is mindful of the costs associated with the final
rule. The exact nature of the procedures a clearing agency will
establish to support this requirement is likely to vary between
clearing agencies. Nevertheless, clearing agencies already make this
type of information available to the Commission and/or on their Web
sites. Therefore, the incremental cost of this Rule is unlikely to be
significant.
As noted above, the standards contained in Rules 17Ad-22 (c)(1) and
(2), would impose certain burdens and related costs on respondent
clearing agencies. As discussed in Section IV.C.4, based on policies
and procedures requirements for Regulation NMS, and based on staff
conversations with industry representatives, the Commission has
estimated the burdens and related costs of these requirements for
clearing agencies.
The clearing agency standards in Rules 17Ad-22(c)(1) and (2) would
require respondent clearing agencies to create policies and procedures.
The requirements would impose one-time costs related to the adjustment
of systems. These costs are included in the $3.7 million in startup
costs discussed earlier.
The standards contained in Rule 17Ad-22(c) would also impose
ongoing costs on clearing agencies. For example, the clearing agency
standards in Rules 17Ad-22 (c)(1) and (2) would collectively require
respondent clearing agencies to perform certain ongoing monitoring and
enforcement activities with respect to the policies and procedures the
clearing agency creates in response to the standard. These costs are
included in the $10.1 million in annual costs discussed earlier. These
rules may impose additional incremental costs related to, for example,
employee training, systems testing, and other operational
considerations designed to ensure both initial and continued compliance
with such policies and procedures.
Rule 17Ad-22(c)(2) would require each clearing agency to post on
its Web site its annual audited financial statements. The audited
financial statements would have to (i) be a complete set of
consolidated financial statements of the clearing agency and its
subsidiaries for the most recent two fiscal years and be prepared in
accordance with U.S. GAAP, except that for a clearing agency that is a
corporation or other organization incorporated or organized under the
laws of any foreign country the consolidated financial statements may
be prepared according to U.S. GAAP or IFRS; (ii) be audited in
accordance with standards of the Public Company Accounting Oversight
Board by a registered public accounting firm that is qualified and
independent in accordance with Rule 2-01 of Regulation S-X (17 CFR
210.2-01); and (iii) include a report of the registered public
accounting firm that complies with paragraphs (a) through (d) of Rule
2-02 of Regulation S-X (17 CFR 210.2-02). This requirement would
necessitate work hours of compliance personnel and finance personnel at
the clearing agency to compile relevant data, organize and analyze that
data, and then post it to the clearing agency's Web site consistent
with the rule. The requirement would also require the services of a
registered public accounting firm. These costs are included in the
$10.1 million in annual costs discussed earlier.
7. Minimum Standards for All Clearing Agencies
Rules 17Ad-22(d)(1)-(15) require certain minimum standards for
rules and procedures to be met by all clearing agencies. Rule 17Ad-
22(d)(1) requires that clearing agencies have rules and procedures that
are well-founded, transparent and enforceable for each aspect of their
activities in all relevant jurisdictions.\599\ Rules 17Ad-22(d)(2)-(15)
require that clearing agencies reasonably establish, implement,
maintain and enforce written policies and procedures reasonably
designed to:
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\599\ A relevant jurisdiction would include, among others,
activities (i) In the United States, (ii) involving any means of
interstate commerce, or (iii) in respect to providing clearing
services to any U.S. person. Clearing agencies that operate in
multiple jurisdictions may need to resolve possible conflicts of
laws issues that they may encounter.
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[[Page 66281]]
Require participants to have sufficient financial
resources and robust operational capacity to meet obligations arising
from participation in the clearing agency,
Hold assets in a manner whereby risk of loss or of delay
in access to them is minimized,
Identify sources of operational risk and minimize these
risks through the development of appropriate systems, controls, and
procedures,
Employ money settlement arrangements that eliminate or
strictly limit the clearing agency's settlement bank risks,
Provide that their operations are cost-effective in
meeting the requirements of participants while maintaining the safety
and security of operations,
Evaluate the potential sources of risks that can arise
when the clearing agency establishes links either cross-border or
domestically to clear or settle trades, and to ensure that these risks
are managed prudently on an ongoing basis,
Have governance arrangements that are clear and
transparent to fulfil the public interest requirements in Section 17A
of Exchange Act applicable to clearing agencies,\600\ to support the
objectives of owners and participants, and to promote the effectiveness
of the clearing agency's risk management procedures,
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\600\ Section 17A(b)(3)(F) of the Exchange Act requires that the
rules of a clearing agency be designed to protect investors and the
public interest. 15 U.S.C. 78q-1(b)(3)(F).
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Provide market participants with sufficient information
for them to identify and evaluate the risks and costs associated with
using clearing agencies' services,
Immobilize or dematerialize securities certificates and
transfer them by book entry to the greatest extent possible when the
clearing agency provides CSD services,
Make key aspects of their default procedures publicly
available and establish default procedures that ensure that the
clearing agency can take timely action to contain losses and liquidity
pressures and to continue meeting its obligations in the event of a
participant default,
Ensure that final settlement occurs no later than the end
of the settlement day and that intraday or real-time finality is
provided where necessary to reduce risks,
Eliminate principal risk by linking securities transfers
to funds transfers to achieve delivery versus payment (DVP),\601\
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\601\ See supra note 422.
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Institute risk controls, including collateral requirements
and limits to cover the clearing agency's credit exposure to each
participant family exposure fully, that ensure timely settlement in the
event that the participant with the largest payment obligation is
unable to settle when the clearing agency provides CSD services \602\
and extends intraday credit to participants,
---------------------------------------------------------------------------
\602\ See proposed Rule 17Ad-22(a)(2) for definition of
``central securities depository services.''
---------------------------------------------------------------------------
Disclose to their participants the clearing agency's
obligations with respect to physical deliveries.\603\
---------------------------------------------------------------------------
\603\ The proposed rule would provide clearing agencies with the
flexibility to determine the method by which the clearing agency
will state this information to its participants. However, the
clearing agencies should take care to develop an approach that
provides sufficient notice to its participants regarding the
clearing agency's obligations.
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In the Proposing Release, the Commission identified potential costs
and benefits resulting from Rules 17Ad-22(d)(1)-(15), as proposed, and
requested comment on all aspects of the cost-benefit analysis,
including the identification and assessment of any costs and benefits
that were not discussed in the analysis. The Commission did not receive
any comments on the specific cost-benefit analysis contained in the
Proposing Release.
Rules 17Ad-22(d)(1)-(15) are consistent with CPSS-IOSCO
Recommendations.\604\ As discussed below, Rules 17Ad-22(d)(1)-(15) for
the most part codify existing practices of clearing agencies registered
with the Commission. Adopting rules that reflect current practices has
the benefit of ensuring that future business practices are both
consistent with current practice and conform to international standards
without subjecting clearing agencies to significant costs. Accordingly,
the Commission believes that registered clearing agencies would not
need to build new infrastructure or modify operations to meet the
requirements of Rule 17Ad-22(d).\605\ The primary costs of implementing
such rules will be the incremental costs of enhancing and reviewing
existing policies and procedures for compliance and updating existing
policies and procedures where appropriate as discussed above in Section
IV.
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\604\ See table in Section V.B.2.d.
\605\ See generally International Monetary Fund, Publication of
Financial Sector Assessment Program Documentation--Detailed
Assessment of Observance of the NSCC's Observance of the CPSS-IOSCO
Recommendations for Central Counterparties (2010), at 4-29,
available at http://www.imf.org/external/pubs/ft/scr/2010/cr10129.pdf; International Monetary Fund, Publication of Financial
Sector Assessment Program Documentation--Detailed Assessment of
Observance of the DTC's Observance of the CPSS-IOSCO Recommendations
for Securities Settlement Systems (2010), at 4-40, available at
http://www.imf.org/external/pubs/ft/scr/2010/cr10128.pdf.
---------------------------------------------------------------------------
The requirements would impose one-time costs and ongoing costs to
perform certain ongoing monitoring and enforcement activities with
respect to the policies and procedures that are included in the $3.7
million in startup costs and $10.1 million in ongoing cost discussed
earlier.\606\ The Rules also may impose incremental costs related to,
for example, employee training, systems testing, and other operational
considerations designed to ensure both initial and continued compliance
with such policies and procedures.
---------------------------------------------------------------------------
\606\ This number also reflects the costs of Rules 17Ad-
22(b)(1)-(3).
---------------------------------------------------------------------------
As stated above, there are currently seven clearing agencies
registered with the Commission that provide CCP or CSD services. These
clearing agencies are SROs so the rules and procedures governing each
aspect of the clearance and settlement process are filed with the
Commission for notice and approval. Rule 17Ad-22(d)(1) will codify the
existing practices of registered clearing agencies of establishing a
rule book and developing policies and procedures to address each aspect
of their operations. Therefore, the SRO rule filing process should help
to ensure that such rules are well-founded, transparent, and provide an
enforceable legal framework for its activities.
As described above, each registered clearing agency has established
membership criteria and has procedures in place to monitor the
sufficiency of its participants' financial resources. Rule 17Ad-
22(d)(2) will codify these existing practices. The operational and
financial stability of participants is subject to market forces and can
therefore change over time. Because participants collectively
contribute to the operational and financial stability of a registered
clearing agency, the Commission believes that the proposed requirement
to continue to monitor compliance with the registered clearing agency's
participation requirements supports the Exchange Act requirement that
clearing agencies are able to facilitate prompt and accurate clearance
and settlement.\607\
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\607\ 15 U.S.C 78q-1(b)(3)(A).
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In addition, clearing agencies would be required to have
participation requirements that are objective,\608\
[[Page 66282]]
publicly disclosed, and facilitate fair and open access.\609\ The
Commission believes this requirement would foster compliance with the
requirement under Section 17A of the Exchange Act that the rules of a
registered clearing agency must not be designed to permit unfair
discrimination in the admission of participants by requiring standards
that are designed to be measurable, open and fair.\610\
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\608\ Objective criteria would generally include, but not be
limited to, criteria that are based on measureable facts such as
capital requirements.
\609\ Having open access, in part, involves having a process for
admission of participants that does not unfairly discriminate. See
15 U.S.C. 78q-1(b)(3)(F) (``The rules of a registered clearing
agency * * * are not designed to permit unfair discrimination in the
admission of participants or among participants in the use of the
registered clearing agency''). In addition, the Dodd-Frank Act added
Section 3C to the Exchange Act which provides in relevant part that
the rules of a registered clearing agency described in paragraph (1)
shall prescribe that all security-based swaps submitted to the
registered clearing agency with the same terms and conditions are
economically equivalent within the registered clearing agency and
may be offset with each other within the registered clearing agency;
and provide for non-discriminatory clearing of a security-based swap
executed bilaterally or on or through the rules of an unaffiliated
national securities exchange or security-based swap execution
facility. Public Law 111-203 sec. 763(a) (adding Section 3C to the
Exchange Act).
\610\ 15 U.S.C. 78q-1(b)(3)(F).
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During the clearance and settlement process, registered clearing
agencies are responsible for safeguarding assets that secure
participants' obligations. Registered clearing agencies currently seek
to minimize the risk of loss or delay in access by holding assets that
are highly-liquid (e.g., cash, U.S. Treasury securities or securities
issued by a U.S. government agency) and engaging banks to custody the
assets and facilitate settlement. The requirements of Rule 17Ad-
22(d)(3) are intended to codify existing practices and help ensure the
ability of the registered clearing agency to meet its settlement
obligations by reducing the likelihood that assets securing participant
obligations to the registered clearing agency would be unavailable or
insufficient when the registered clearing agency needs to draw on them.
Pursuant to guidance provided by the Division's Automated Review
Policy Statement,\611\ and Interagency White Paper on Disaster
Recovery,\612\ all registered clearing agencies, among other things,
develop and maintain plans to assure the safeguarding of securities and
funds, the integrity of the automated data processing systems, and
recovery of securities, funds, or data under a variety of loss or
destruction scenarios. In addition, the rule requires that clearing
agencies have business continuity plans that allow for timely recovery
of operations and ensure the fulfillment of a registered clearing
agency's obligations. Rule 17Ad-22(d)(4) would codify existing practice
and strengthen the requirement in Section 17A(b)(3)(F) of the Exchange
Act, which requires that the rules of a registered clearing agency must
be designed to ensure the safeguarding of securities and funds in the
custody or control of the registered clearing agency or for which the
registered clearing agency is responsible.\613\ In this way, the
Commission believes the rule also would promote protection of the
financial market served by the registered clearing agency.
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\611\ See Automation Review Policy Statements, supra note 330.
The Automation Review Policy Statements are not rules, but rather
general statements of policy based on cooperation between the SROs
and the Commission.
\612\ Sound Practices to Strengthen the Resilience of the U.S.
Financial System (Interagency Paper), Release No. 34-47638; File No.
S7-32-02 (Apr. 7, 2003).
\613\ 15 U.S.C. 78q-1(b)(3)(F).
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Registered clearing agencies use settlement banks to facilitate the
cash portion of the securities transaction. Failure by that bank to
effectuate timely and final settlement adversely affects the registered
clearing agency by exposing it to credit and liquidity pressures that
can adversely affect the registered clearing agency's ability to
facilitate prompt and accurate clearance and settlement. Rule 17Ad-
22(d)(5) is designed to reduce the risk that financial obligations
related to the activities of a registered clearing agency are not
settled in a timely manner or not discharged with finality. The
Commission also believes that the rule would assist a registered
clearing agency in meeting the requirement of Section 17A(b)(3)(F) of
the Exchange Act, which requires the rules of a registered clearing
agency to be designed to assure the safeguarding of securities and
funds which are in the custody or control of the registered clearing
agency or for which it is responsible.\614\
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\614\ 15 U.S.C. 78q-1(b)(3)(F).
---------------------------------------------------------------------------
Registered clearing agencies have procedures to control costs and
to regularly review pricing levels against operating costs. The
Commission believes that Rule 17Ad-22(d)(6) codifies this practice and
may help to reduce the fees a participant in a registered clearing
agency incurs for clearance and settlement services while also helping
to ensure that registered clearing agency maintains appropriate
operational standards. Having clearing agencies be mindful of the costs
that are incurred by their participants, while maintaining such
compliance, should help to reduce inefficiencies in the provision of
clearance and settlement services. Because there is often only a single
registered clearing agency per asset class per market, competitive
forces may not be sufficient by themselves in creating incentives to be
cost-effective in meeting the requirements of participants.
Section 17A(a)(1)(D) of the Exchange Act states that the linking of
all clearance and settlement facilities and the development of uniform
standards and procedures for clearance and settlement will reduce
unnecessary costs and increase the protection of investors and persons
facilitating transactions by and acting on behalf of investors.\615\
Further, Section 17A(b)(3)(F) of the Exchange Act requires that the
rules of a registered clearing agency foster cooperation and
coordination with persons engaged in the clearance and settlement of
securities transactions.\616\ Each registered clearing agency is linked
to other clearing organizations, trading platforms, and service
providers. The Commission believes that in the clearance and settlement
process, links should help improve market liquidity and make it easier
for participants to trade in other markets.\617\ Rule 17Ad-22(d)(7)
promotes these statutory requirements under the Exchange Act and
establishes a requirement that links created between clearing agencies
are managed in a safe and prudent manner.
---------------------------------------------------------------------------
\615\ 15 U.S.C. 78q-1(a)(1)(D).
\616\ 15 U.S.C. 78q-1(b)(3)(F).
\617\ For example, DTC Canadian Link Service allows qualifying
DTC participants to clear and settle valued securities transactions
with participants of a Canadian securities depository. The link is
designed to facilitate cross-border transactions by allowing
participants to use a single depository interface for U.S. and
Canadian dollar transactions and eliminate the need for split
inventories. See Exchange Act Release Nos. 52784 (Nov. 16, 2005), 71
FR 70902 (Nov. 23, 2005) and 55239 (Feb. 5, 2007), 72 FR 6797 (Feb.
13, 2007) (File No. SR-DTC 2006-15).
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Each registered clearing agency has a board that governs the
operations of the entity and supervises its senior management. Rule
17Ad-22(d)(8) is designed enhance the board's governance of the
registered clearing agency and the ability of the registered clearing
agency to serve the interests of its various constituencies while
maintaining prudent risk management processes. Clear and transparent
governance arrangements promote accountability and reliability in the
decisions, rules and procedures of the registered clearing agency
because they provide interested parties (such as owners, participants,
and the general public) with information about how such decisions are
made and what the
[[Page 66283]]
rules and procedures are designed to accomplish.\618\
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\618\ The Exchange Act currently requires that certain aspects
of a registered clearing agency's governance arrangements be made
clear and transparent. Section 19(b) of the Exchange Act requires
that clearing agencies, as SROs, file with the Commission any
proposed rule or any proposed change in, addition to, or deletion
from the rules of the registered clearing agency, accompanied by a
concise general statement of the basis and purpose of the proposed
rule change. 15 U.S.C. 78s(b).
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Governance arrangements have the potential to play an important
role in making sure that clearing agencies fulfill the Exchange Act
requirements that the rules of a registered clearing agency be designed
to protect investors and the public interest and to support the
objectives of owners and participants. Similarly, governance
arrangements may promote the effectiveness of a registered clearing
agency's risk management procedures by creating an oversight framework
that fosters a focus on the critical role that risk management plays in
promoting prompt and accurate clearance and settlement.\619\
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\619\ The role of governance arrangements in promoting effective
risk management has also been a focus of rules recently proposed by
the Commission to mitigate conflicts of interest at security-based
swap clearing agencies. See Exchange Act Release No. 63107, 75 FR
65882, supra note 231.
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Because clearing agencies are SROs, their rules are published by
the Commission and are available on each registered clearing agency's
Web site. In addition information regarding the operations and services
of each clearing agency can be found either on the clearing agency's
Web site or a Web site maintained by an affiliated entity of the
clearing agency. Rule 17Ad-22(d)(9) will maintain and enhance this
existing practice by requiring a registered clearing agency to disclose
information sufficient for participants to identify risks and costs
associated with using the registered clearing agency, thereby allowing
participants to make informed decisions about the use of the registered
clearing agency and to take appropriate actions to mitigate their risks
and costs associated with the use of the registered clearing agency.
While U.S. markets have made great strides in achieving
immobilization and/or dematerialization for institutional and broker-
to-broker transactions, many industry representatives believe that the
small percentage of securities held in certificated form impose
unnecessary risk and expense to the industry and to investors. Rule
17Ad-22(d)(10) will codify the existing practice, and promote further
immobilization and dematerialization of securities and their transfer
by book entry. This would result in reduced costs and risks associated
with securities settlements and custody for both clearing agencies and
participants by removing the need to hold and transfer many, if not
most, physical certificates.\620\
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\620\ See Exchange Act Release No. 8398 (Mar. 11, 2004), 69 FR
12921 (Mar. 18, 2004).
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Each registered clearing agency makes public rules, policies or
procedures that set forth the actions the clearing agency may take in
the event of a participant default and each makes key aspects of their
default procedures publicly available, with the exception of certain of
their policies and procedures that are kept non-public to ensure their
integrity, such as those associated with the oversight of clearing
participants. Rule 17Ad-22(d)(11) codifies this existing practice. The
Commission believes that default procedures reduce the likelihood that
a default by a participant, or multiple participants, will disrupt the
operations of the clearing agency and have a cascading effect on the
viability of the other participants of the clearing agency. Default
procedures also allow a clearing agency to wind down positions in an
orderly way and continue to perform its obligations in the event of a
participant default, assuring continued functioning of the securities
market in times of stress and reducing systemic risk.
The Commission believes that Rule 17Ad-22(d)(11) would increase the
probability that defaults by participants, should they occur, would
proceed in an orderly and transparent manner. This is the case because
the rule would help to ensure that all participants are aware of the
default process and are able to plan accordingly and that clearing
agencies would have sufficient time to take corrective actions to
mitigate potential losses. In addition, the transparency of default
procedures will increase the confidence of market participants as well
as members of the general public, that should a default occur, the
proper procedures would be followed, decreasing uncertainty and
lessening the likelihood of further market stress.
Each registered clearing agency has rules, policies or procedures
that provide for the settlement of its respective securities
transactions no later than the end of a pre-defined settlement day.
Rule 17Ad-22(d)(12) codifies this existing practice. The Commission
believes that settlement finality should occur no later than the end of
the settlement day to limit the volume of outstanding obligations that
are subject to settlement at any one time and thereby reduce the
settlement risk exposure of participants and the registered clearing
agency. Intraday or real-time finality may be necessary to reduce risk
in circumstances where the lack of intraday or real-time finality may
impede the registered clearing agency's ability to facilitate prompt
and accurate clearance and settlement, cause the registered clearing
agency's participants to fail to meet their obligations, or cause
significant disruptions in the securities markets.\621\
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\621\ See FMI Report, Principle 8, supra note 32.
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Generally, Rules 17Ad-22(d)(13)-(15) would apply to registered
clearing agencies that provide CSD services. DTC currently is the only
registered clearing agency that is a CSD. DTC operates a Model 2 DVP
system which provides for gross settlements of securities transfers
during the day followed by an end of day net funds settlement.\622\
Rule 17Ad-22(d)(13) codifies this existing practice. Delivery versus
payment eliminates the risk that a buyer would lose the purchase price
of a security purchased from a defaulting seller (or that a seller
would lose the sold security without receiving payment for a security
acquired by a defaulting buyer), because payment is made only if
securities are delivered. While the use of this payment method
eliminates principal risk, DVP procedures do not eliminate the risk
that the failure of the defaulting participant could result in systemic
disruptions, because the failure of a participant could produce
substantial liquidity pressures and replacement costs.
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\622\ See DTC's Assessment of Compliance with the CPSS/IOSCO
Recommendations for Central Counterparties (Dec. 12, 2011),
available at http://www.dtcc.com/legal/compliance/DTC_Self-Assessment.pdf.
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As discussed above, DTC has policies and procedures in place to
ensure that timely settlement can be completed in the event of the
default participant with the largest settlement obligation. DTC
establishes setting limits (called net debit caps) for each
participant. The net debit cap ensures that the amount of cash that a
participant owes the clearing agency does not exceed this pre-defined
limit or cap. Rule 17Ad-22(d)(14) codifies this existing practice. The
Commission believes it is important for clearing agencies that provide
CSD services to institute risk controls, including collateral
requirements and limits to cover the registered clearing agency's
credit exposure to each participant exposure fully, that ensure timely
settlement in these circumstances to address the risk that the
participant may fail to settle after credit has been extended. The
Commission also believes that requiring the controls to be designed to
withstand
[[Page 66284]]
the inability of the participant with the largest payment obligation to
settle, in such circumstances, would reduce the likelihood of
disruptions at the registered clearing agency by having controls in
place to account for the largest possible loss from any individual
participant and thereby help the registered clearing agency to provide
prompt and accurate clearance and settlement during times of market
stress.
A registered clearing agency faces both credit and liquidity risks
from the delivery process. At delivery, the entire principal value of a
transaction may be at risk, and this form of credit risk is often
termed principal risk. Liquidity risk arises because the registered
clearing agency, faced with a defaulting participant, must still make
payment to the non-defaulting party. The Commission believes that a
registered clearing agency should therefore ensure that its rules and
procedures provide clear risk management controls so that it can
identify and mitigate the credit and liquidity risks to which it is
exposed in the delivery process. These procedures should ensure that
the registered clearing agency will be able to adapt its risk
management framework as appropriate, as the steps necessary to mitigate
risks will depend on the obligations the registered clearing agency has
assumed, the mechanisms available for settlement, and the importance of
the risks from physical settlement to its overall operations.
The Commission also believes that providing such information to
participants would promote a shared understanding regarding physical
delivery practices between the registered clearing agency and its
participants that could help reduce the potential for fails and thereby
facilitate prompt and accurate clearance and settlement.
Registered clearing agencies have rules and procedures that
describe their obligations to its participants when they assume
deliveries of physical instruments. The Commission believes that Rule
17Ad-22(d)(15), by requiring a statement by the registered clearing
agency to its participants about the cleaning agency's obligations with
respect to physical deliveries, among other things, would ensure that
participants have information that is likely to enhance the
participants' understanding of their rights and responsibilities with
respect to using the clearance and settlement services of the
registered clearing agency. The Commission believes that ensuring
delivery of this information to participants about the clearing
agency's physical delivery obligations would promote a shared
understanding about physical delivery practices between the clearing
agency and its participants that would help mitigate misunderstandings
in the clearing agency's physical delivery operations and would
therefore facilitate prompt and accurate clearance and settlement.
The Commission carefully considered alternatives to Rule 17Ad-
22(d), including a more prescriptive approach suggested by some of the
commenters, and has decided to adopt the rule, modeled after recognized
international standards, in the form proposed. The Commission believes
the final rule will have the effect of harmonizing the Commission's
regulatory requirements with such standards as are now contemplated by
the Exchange Act and the Clearing Supervision Act, as well as
international standards. In particular, the Commission believes Rule
17Ad-22(d) will help market participants compare the operations of U.S.
clearing agencies with non-U.S. clearing organizations. The
Commission's adoption of Rule 17Ad-22(d) may also reduce some of the
potential regulatory burden for CCPs and CSDs that may be dually-
regulated by the SEC and another domestic or foreign regulator because
it is modeled on standards already employed by other regulatory
authorities.
VI. Regulatory Flexibility Act Certification
The Regulatory Flexibility Act (``RFA'') \623\ requires the
Commission, in promulgating rules, to consider the impact of those
rules on small entities. The Commission certified in the Proposing
Release, pursuant to Section 605(b) of the Regulatory Flexibility Act
of 1980 (``RFA''),\624\ that the proposed rule would not, if adopted,
have a significant impact on a substantial number of small entities. We
received no comments on this certification.
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\623\ 5 U.S.C. 601 et seq.
\624\ See 5 U.S.C. 605(b).
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A. Registered Clearing Agencies
Rule 17Ad-22 applies to all registered clearing agencies and sets
standards for such clearing agencies. For the purposes of Commission
rulemaking and as applicable to Rule 17Ad-22, a small entity includes,
when used with reference to a clearing agency, a clearing agency that
(i) Compared, cleared and settled less than $500 million in securities
transactions during the preceding fiscal year, (ii) had less than $200
million of funds and securities in its custody or control at all times
during the preceding fiscal year (or at any time that it has been in
business, if shorter) and (iii) is not affiliated with any person
(other than a natural person) that is not a small business or small
organization.\625\ Under the standards adopted by the Small Business
Administration, small entities in the finance industry include the
following: (i) For entities engaged in investment banking, securities
dealing and securities brokerage activities, entities with $6.5 million
or less in annual receipts; (ii) for entities engaged in trust,
fiduciary and custody activities, entities with $6.5 million or less in
annual receipts; and (iii) funds, trusts and other financial vehicles
with $6.5 million or less in annual receipts.\626\
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\625\ 17 CFR 240.0-10(d).
\626\ 13 CFR 121.201, Sector 52.
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Based on the Commission's existing information about the clearing
agencies currently registered with the Commission, the Commission
believes that such entities exceed the thresholds defining ``small
entities'' set out above. While other clearing agencies may emerge and
become eligible to operate as registered clearing agencies and while
other security-based swap lifecycle event service providers may be
required to register as clearing agencies, the Commission does not
believe that any such entities would be ``small entities'' as defined
in Exchange Act Rule 0-10.\627\ Furthermore, we believe it is unlikely
that any registered clearing agencies, security-based swap clearing
agencies or security-based swap lifecycle event services providers
would have annual receipts of less than $6.5 million. Accordingly, the
Commission believes that any registered clearing agencies will exceed
the thresholds for ``small entities'' set forth in Exchange Act Rule 0-
10.
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\627\ See 17 CFR 240.0-10(d). The Commission based this
determination on its review of public sources of financial
information about existing CCPs serving the OTC derivatives market
and lifecycle event service providers.
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B. Certification
For the reasons described above, the Commission again certifies
that Rule 17Ad-22 will not have a significant economic impact on a
substantial number of small entities.
VII. Statutory Authority and Text of Rule 17Ad-22
Pursuant to the Exchange Act, particularly, Sections 17A(d)
thereof, 15 U.S.C. 78q-1(d), Sections 17A(i), 17A(j) and 3C(j) thereof,
15 U.S.C. 78q-1(i), 78q-1(j) and 78c-3(j), respectively, Pub. L. 111-
203, Sec. 763, 124 Stat. 1841 (2010), and Sections 30(b) and 30(c)
thereof, 15 U.S.C. 78dd(b)and (c), and Section
[[Page 66285]]
805(a)(2) of the Clearing Supervision Act, 12 U.S.C. 5464(a)(2), the
Commission adopts new Rule 17Ad-22 to govern clearing agencies.
List of Subjects in 17 CFR Part 240
Reporting and recordkeeping requirements, Securities.
In accordance with the foregoing, Title 17, Chapter II of the Code
of Federal Regulations is amended as follows:
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE
0
1. The authority citation for Part 240 is amended by revising the
general authority and adding an authority for Sec. 240.17Ad-22 in
numerical order to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20,
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201 et seq.; 12
U.S.C. 5221(e)(3), 15 U.S.C. 8302, and 18 U.S.C. 1350, unless
otherwise noted.
* * * * *
Section 240.17Ad-22 is also issued under 12 U.S.C. 5464(a)(2).
* * * * *
0
2. Section 240.17Ad-22 is added to read as follows:
Sec. 240.17Ad-22 Standards for clearing agencies.
(a) Definitions. For purposes of this section:
(1) Central counterparty means a clearing agency that interposes
itself between the counterparties to securities transactions, acting
functionally as the buyer to every seller and the seller to every
buyer.
(2) Central securities depository services means services of a
clearing agency that is a securities depository as described in Section
3(a)(23) of the Act (15 U.S.C. 78c(a)(23)(A)).
(3) Participant family means that if a participant directly, or
indirectly through one or more intermediaries, controls, is controlled
by, or is under common control with, another participant then the
affiliated participants shall be collectively deemed to be a single
participant family for purposes of paragraphs (b)(3) and (d)(14) of
this section.
(4) Normal market conditions as used in paragraphs (b)(1) and (2)
of this section means conditions in which the expected movement of the
price of cleared securities would produce changes in a clearing
agency's exposures to its participants that would be expected to breach
margin requirements or other risk control mechanisms only one percent
of the time.
(5) Net capital as used in paragraph (b)(7) of this section means
net capital as defined in Sec. 240.15c3-1 for broker-dealers or any
similar risk adjusted capital calculation for all other prospective
clearing members.
(b) A registered clearing agency that performs central counterparty
services shall establish, implement, maintain and enforce written
policies and procedures reasonably designed to:
(1) Measure its credit exposures to its participants at least once
a day and limit its exposures to potential losses from defaults by its
participants under normal market conditions so that the operations of
the clearing agency would not be disrupted and non-defaulting
participants would not be exposed to losses that they cannot anticipate
or control.
(2) Use margin requirements to limit its credit exposures to
participants under normal market conditions and use risk-based models
and parameters to set margin requirements and review such margin
requirements and the related risk-based models and parameters at least
monthly.
(3) Maintain sufficient financial resources to withstand, at a
minimum, a default by the participant family to which it has the
largest exposure in extreme but plausible market conditions; provided
that a registered clearing agency acting as a central counterparty for
security-based swaps shall maintain additional financial resources
sufficient to withstand, at a minimum, a default by the two participant
families to which it has the largest exposures in extreme but plausible
market conditions, in its capacity as a central counterparty for
security-based swaps. Such policies and procedures may provide that the
additional financial resources may be maintained by the security-based
swap clearing agency generally or in separately maintained funds.
(4) Provide for an annual model validation consisting of evaluating
the performance of the clearing agency's margin models and the related
parameters and assumptions associated with such models by a qualified
person who is free from influence from the persons responsible for the
development or operation of the models being validated.
(5) Provide the opportunity for a person that does not perform any
dealer or security-based swap dealer services to obtain membership on
fair and reasonable terms at the clearing agency to clear securities
for itself or on behalf of other persons.
(6) Have membership standards that do not require that participants
maintain a portfolio of any minimum size or that participants maintain
a minimum transaction volume.
(7) Provide a person that maintains net capital equal to or greater
than $50 million with the ability to obtain membership at the clearing
agency, provided that such persons are able to comply with other
reasonable membership standards, with any net capital requirements
being scalable so that they are proportional to the risks posed by the
participant's activities to the clearing agency; provided, however,
that the clearing agency may provide for a higher net capital
requirement as a condition for membership at the clearing agency if the
clearing agency demonstrates to the Commission that such a requirement
is necessary to mitigate risks that could not otherwise be effectively
managed by other measures and the Commission approves the higher net
capital requirement as part of a rule filing or clearing agency
registration application.
(c) Record of financial resources and annual audited financial
statements. (1) Each fiscal quarter (based on calculations made as of
the last business day of the clearing agency's fiscal quarter), or at
any time upon Commission request, a registered clearing agency that
performs central counterparty services shall calculate and maintain a
record, in accordance with Sec. 240.17a-1 of this chapter, of the
financial resources necessary to meet the requirements of paragraph
(b)(3) of this section, and sufficient documentation to explain the
methodology it uses to compute such financial resource requirement.
(2) Within 60 days after the end of its fiscal year, each
registered clearing agency shall post on its Web site its annual
audited financial statements. Such financial statements shall:
(i) Include, for the clearing agency and its subsidiaries,
consolidated balance sheets as of the end of the two most recent fiscal
years and statements of income, changes in stockholders' equity and
other comprehensive income and cash flows for each of the two most
recent fiscal years;
(ii) Be prepared in accordance with U.S. generally accepted
accounting principles, except that for a clearing agency that is a
corporation or other organization incorporated or organized under the
laws of any foreign country the consolidated financial statements may
be prepared in accordance with
[[Page 66286]]
U.S. generally accepted accounting principles or International
Financial Reporting Standards as issued by the International Accounting
Standards Board;
(iii) Be audited in accordance with standards of the Public Company
Accounting Oversight Board by a registered public accounting firm that
is qualified and independent in accordance with 17 CFR 210.2-01; and
(iv) Include a report of the registered public accounting firm that
complies with paragraphs (a) through (d) of 17 CFR 210.2-02.
(d) Each registered clearing agency shall establish, implement,
maintain and enforce written policies and procedures reasonably
designed to, as applicable:
(1) Provide for a well-founded, transparent, and enforceable legal
framework for each aspect of its activities in all relevant
jurisdictions.
(2) Require participants to have sufficient financial resources and
robust operational capacity to meet obligations arising from
participation in the clearing agency; have procedures in place to
monitor that participation requirements are met on an ongoing basis;
and have participation requirements that are objective and publicly
disclosed, and permit fair and open access.
(3) Hold assets in a manner that minimizes risk of loss or of delay
in its access to them; and invest assets in instruments with minimal
credit, market and liquidity risks.
(4) Identify sources of operational risk and minimize them through
the development of appropriate systems, controls, and procedures;
implement systems that are reliable, resilient and secure, and have
adequate, scalable capacity; and have business continuity plans that
allow for timely recovery of operations and fulfillment of a clearing
agency's obligations.
(5) Employ money settlement arrangements that eliminate or strictly
limit the clearing agency's settlement bank risks, that is, its credit
and liquidity risks from the use of banks to effect money settlements
with its participants; and require funds transfers to the clearing
agency to be final when effected.
(6) Be cost-effective in meeting the requirements of participants
while maintaining safe and secure operations.
(7) Evaluate the potential sources of risks that can arise when the
clearing agency establishes links either cross-border or domestically
to clear or settle trades, and ensure that the risks are managed
prudently on an ongoing basis.
(8) Have governance arrangements that are clear and transparent to
fulfill the public interest requirements in Section 17A of the Act (15
U.S.C. 78q-1) applicable to clearing agencies, to support the
objectives of owners and participants, and to promote the effectiveness
of the clearing agency's risk management procedures.
(9) Provide market participants with sufficient information for
them to identify and evaluate the risks and costs associated with using
its services.
(10) Immobilize or dematerialize securities certificates and
transfer them by book entry to the greatest extent possible when the
clearing agency provides central securities depository services.
(11) Make key aspects of the clearing agency's default procedures
publicly available and establish default procedures that ensure that
the clearing agency can take timely action to contain losses and
liquidity pressures and to continue meeting its obligations in the
event of a participant default.
(12) Ensure that final settlement occurs no later than the end of
the settlement day; and require that intraday or real-time finality be
provided where necessary to reduce risks.
(13) Eliminate principal risk by linking securities transfers to
funds transfers in a way that achieves delivery versus payment.
(14) Institute risk controls, including collateral requirements and
limits to cover the clearing agency's credit exposure to each
participant family exposure fully, that ensure timely settlement in the
event that the participant with the largest payment obligation is
unable to settle when the clearing agency provides central securities
depository services and extends intraday credit to participants.
(15) State to its participants the clearing agency's obligations
with respect to physical deliveries and identify and manage the risks
from these obligations.
By the Commission.
Dated: October 22, 2012.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2012-26407 Filed 11-1-12; 8:45 am]
BILLING CODE 8011-01-P