[Federal Register Volume 80, Number 93 (Thursday, May 14, 2015)]
[Notices]
[Pages 27798-27801]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-11595]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-74917; File No. SR-ICC-2015-004]
Self-Regulatory Organizations; ICE Clear Credit LLC; Order
Approving Proposed Rule Change Relating to Physical Settlement of CDS
Contracts
May 8, 2015.
I. Introduction
On March 11, 2015, ICE Clear Credit LLC (``ICC'') filed with the
Securities and Exchange Commission (``Commission'') the proposed rule
change SR-ICC-2015-004 pursuant to Section 19(b)(1) of the Securities
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder.\2\ The
proposed rule change was published for comment in the Federal Register
on March 27, 2015.\3\ The Commission received one comment.\4\ For the
reasons discussed below, the Commission is approving the proposed rule
change.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Securities Exchange Act Release No. 34-74563 (Mar. 23,
2015), 80 FR 16471 (Mar. 27, 2015) (File No. SR-ICC-2015-004).
\4\ See Comment from Kermit Kubitz, dated April 17, 2015,
available at https://www.sec.gov/comments/sr-icc-2015-004/icc2015004-1.htm.
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II. Description of the Proposed Rule Change
ICC proposes to amend its rules to modify the terms and conditions
for physical settlement of cleared CDS Contracts, and to adopt certain
new delivery procedures relating to physical settlement.
Under the current terms of the ICC Clearing Rules (``ICC Rules''),
upon the occurrence of a credit event under a cleared CDS Contract, the
contract is typically settled in cash in accordance with the terms of
the ICC Rules, which incorporate the applicable ISDA Credit Derivatives
Definitions (the ``ISDA Definitions'') and the market-standard credit
default swap auction methodology for determining the cash settlement
price. However, in certain circumstances, such as where the Credit
Derivatives Determinations Committee decides not to hold a cash
settlement auction for a particular credit event, or such an auction is
cancelled under the terms of the auction methodology (including because
of a failure to determine the auction settlement price), the CDS
Contracts provide for a fallback settlement method of physical
settlement. Under physical settlement of a CDS contract generally, the
protection buyer will be entitled to deliver one or more qualifying
deliverable obligations to the protection seller, in which case the
protection seller will be required to pay the protection buyer a
defined physical settlement amount. Under the current ICC Rules, if
physical settlement applies,\5\ ICC will match clearing participants
(``Participants'') that are protection buyers with Participants that
are protection sellers in the relevant contract, and the two
Participants will be responsible for effecting physical settlement
between them. ICC does not itself perform or guarantee performance of
physical settlement between the matched Participants. Once matching
occurs, the contract is purely a bilateral contract between the matched
Participants, and ICC has no further rights or obligations with respect
to the contract. ICC does, however, collect and hold physical
settlement margin as collateral agent on behalf of the protection buyer
to secure the protection seller's obligations to the protection buyer
under physical settlement.
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\5\ ICC notes that to date, physical settlement has not been
necessary for any of the CDS Contracts cleared by ICC.
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ICC proposes to amend the ICC Rules relating to physical settlement
such that ICC will be responsible for financial performance of physical
settlement. ICC notes that under the amended approach, it would still
require payments and deliveries in the ordinary course under physical
settlement to be made directly between the matched buying Participant
and selling Participant, with ICC only being obligated to make direct
payments in the case of certain defined settlement failure scenarios.
ICC believes that this proposed rule change will further the general
policy goals of central clearing for CDS transactions, and is
consistent with ICC's financial resources, risk management procedures
and operational capabilities.\6\
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\6\ ICC notes that a substantially similar approach to physical
settlement is used in the ICE Clear Europe Limited CDS clearing
service.
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ICC proposes to make certain amendments to Chapters 1, 4, 5, 21 and
22 of the ICC Rules. ICC also proposes
[[Page 27799]]
to adopt a related set of Delivery Procedures and Physical Settlement
and Notices Terms. Furthermore, ICC also proposes to make certain
related and conforming changes to its Risk Management Framework. All
capitalized terms not defined herein are defined in the ICC Rules.
In Chapter 1 of the ICC Rules, ICC proposes to amend the definition
of ``Client-Related Initial Margin'' so that it now includes Physical
Settlement Margin collected with respect to Client-Related Positions.
As discussed below, according to ICC, such Physical Settlement Margin
is intended to secure the obligations of a Participant to ICC in
connection with physical settlement. Similarly, in Rule 403, ICC
proposes to amend the definition of ``Physical Settlement Margin'' to
refer to such obligations to ICC (as opposed to the obligations to the
matched Participant under the current ICC Rules). In Rule 502(b), a
conforming reference to Physical Settlement Margin will be updated. A
conforming change is also made in Rule 2101-02(a)(iv).
ICC proposes changes to Chapter 22 (which covers physical
settlement) by adding a new Rule 2200 with definitions relating to the
revised physical settlement provisions, including ``Matched Delivery
Buyer'' and ``Matched Delivery Seller,'' and the related terms
``Matched Delivery Contract,'' ``Matched Delivery Buyer Contract,''
``Matched Delivery Seller Contract'' and ``MP Delivery Amount.'' As
discussed below, these terms are used in connection with the matching
of buying Participants and selling Participants in the revised
settlement procedures. A new definition of ``Asset Package Delivery
Notice'' has also been added to address notices in connection with
Asset Package delivery under the 2014 ISDA Credit Derivatives
Definitions (the ``2014 ISDA Definitions'').
According to ICC, Rule 2201(a), which provides for matching of
buying Participants and selling Participants into a Matched Delivery
Pair in the case of physical settlement, will be revised to address
scenarios where a Participant's CDS contracts must be split and matched
with multiple other Participants for purposes of physical settlement.
Conforming changes to use applicable defined terms (such as Relevant
Restructuring Credit Event) will also be made. Rule 2201(b), which
addresses delivery of certain notices between a Matched Delivery Pair,
will be revised to include references to Asset Package Delivery
Notices. Rule 2201(c) will be deleted at the request of Participants as
being inconsistent with the terms of uncleared CDS and unnecessary in
light of the provisions of the ISDA Definitions and Rule 2202.
ICC also proposes changes to Rule 2202, which addresses resolution
of disputes related to permissible deliverable obligations, in order to
incorporate the concept of Asset Package Delivery under the 2014 ISDA
Definitions, as well as related concepts of Prior Deliverable
Obligations, Package Observable Bonds and Asset Package Delivery
Notices. Rules 2202(b) and (c) will also be revised to address the
consequences of a selling Participant's refusal to accept delivery of a
particular obligation, including for the offsetting transaction between
ICC and the buying Participant.
Rule 2203 will be replaced with new provisions addressing ICC's
role in physical settlement. When a Matched Delivery Pair is
established, the CDS Contract between the Matched Delivery Buyer and
ICC will be referred to as the Matched Delivery Buyer Contract, and the
corresponding CDS Contract between ICC and the Matched Delivery Seller
will be referred to as the Matched Delivery Seller Contract. Under the
revised physical settlement approach, ICC intends to remain party to
each such contract, but will require certain notices, payments and
deliveries to take place directly between the Matched Delivery Buyer
and Matched Delivery Seller. Accordingly, under Rule 2203(a), for each
Matched Delivery Buyer Contract, ICC will designate the Matched
Delivery Seller to receive on ICC's behalf notices and deliveries from
the Matched Delivery Buyer and to make payments on ICC's behalf to the
Matched Delivery Buyer. Similarly, under Rule 2203(b), for each Matched
Delivery Seller Contract, ICC will designate the Matched Delivery Buyer
to deliver on ICC's behalf notices and deliveries to the Matched
Delivery Seller, and to receive on ICC's behalf payments from the
Matched Delivery Seller. The result is that notices, payments and
deliveries will be made directly between the Matched Delivery Buyer and
Matched Delivery Seller, in satisfaction of the parties and ICC's
respective obligations under both the Matched Delivery Buyer Contract
and Matched Delivery Seller Contract. Rule 2203(c) further clarifies
that the exercise of rights by Matched Delivery Buyer against ICC will
be deemed the exercise by ICC of the corresponding rights against
Matched Delivery Seller, and vice versa. Rules 2203(d) and (e) will
provide for copies of relevant notices to be provided to ICC, as well
as notice of the completion of settlement between the Matched Delivery
Buyer and Matched Delivery Seller. Rule 2203(f) will clarify the
obligations of the respective parties to a Matched Delivery Contract,
and address a scenario where an Asset Package being delivered is deemed
to have a value of zero under the 2014 ISDA Definitions. Rule 2203(g)
will allocate costs and expenses that may be incurred by ICC in
connection with physical settlement.
Rule 2204, as revised, will address physical settlement of certain
deliverable obligations that do not settle in the ordinary course on a
delivery-versus-payment basis (``Non-DVP Obligations''). The rule
establishes a procedure under which the Matched Delivery Seller will
pay the physical settlement amount owed to ICC, which in turn will not
pay such amount to the Matched Delivery Buyer until ICC receives notice
that the obligation has been received by the Matched Delivery Seller
from the Matched Delivery Buyer. If the obligation is not delivered,
the physical settlement amount will be returned to the Matched Delivery
Seller.
ICC states that Rule 2205 will address settlement failures by the
Matched Delivery Seller or Matched Delivery Buyer. Under subsection
(a), if the Matched Delivery Seller fails to pay the physical
settlement amount when due, the Matched Delivery Buyer Contract will be
cash settled as between the Matched Delivery Buyer and ICC. ICC thus
will not be obligated to take delivery of the relevant deliverable
obligations (and dispose of them in a situation where the Matched
Delivery Seller has failed to perform), but will compensate the Matched
Delivery Buyer for the value of the Matched Delivery Buyer Contract
through the cash settlement process. Pursuant to subsection (b), ICC
may, in addition to its other default remedies, terminate the Matched
Delivery Seller Contract, in which case the Matched Delivery Seller
will owe ICC an amount equal to the cash settlement amount ICC paid the
Matched Delivery Buyer, together with other losses and expenses
incurred by ICC as a result of the failure. Rule 2205(c) provides that,
consistent with the terms of the ISDA Definitions applicable to a
protection buyer generally, any failure by ICC to deliver any
deliverable obligations to the Matched Delivery Seller (including as a
result of a failure by the Matched Delivery Buyer to make a delivery)
will not constitute a default by ICC, and the Matched Delivery Seller's
sole remedy will be as set forth in the Matched Delivery Seller
Contract (which may include, for example, buy-in remedies of the
Matched Delivery Seller). ICC will not have any obligation to purchase
or
[[Page 27800]]
acquire deliverable obligations (other than in settlement of the
Matched Delivery Buyer Contract) in order to settle the Matched
Delivery Seller Contract. In the event of a delivery failure by a
Matched Delivery Buyer, such party will be liable to ICC for any costs
incurred by ICC in settling the corresponding Matched Delivery Seller
Contract (in addition to ICC's other remedies for a default).
According to ICC, the changes to Rule 2206 are to cover certain
other, non-default scenarios in which physical settlement fails to
occur. Under Rules 2206(a) and (b), if physical settlement of the
Matched Buyer Delivery Contract does not occur because the deliverable
obligation is in less than the relevant minimum denomination or the
Matched Delivery Seller is not a permitted transferee of the
obligation, the failure will be treated as an illegality or
impossibility outside of the parties' control, which will result in
cash settlement \7\ under the ISDA Definitions. In this and other
scenarios where a cash settlement fallback applies, the same cash
settlement amount will apply to both the Matched Delivery Buyer
Contract and Matched Delivery Seller Contract under Rule 2206(c).
Similarly, in the case of a buy-in, the same buy-in price will apply to
both contracts. Rule 2206(d) will provide for cash settlement of both
the Matched Delivery Buyer Contract and Matched Delivery Seller
Contract in certain cases where delivery does not occur between the
Matched Delivery Buyer and the customer for which it is acting. Rule
2206(e) specifies the date of any cash settlement and provides for
notice of the relevant amount owed.
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\7\ Cash settlement in this context is different from the
auction cash settlement that normally applies to CDS contracts under
the ISDA Definitions, and is based on price quotations obtained by
the relevant party to the contract for the obligation or obligations
that cannot be delivered.
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According to ICC, Rule 2207(a) will provide for certain standard
representations and related provisions for physical settlement in the
ISDA Definitions to apply as between the Matched Delivery Buyer and
Matched Delivery Seller, and will clarify ICC's authority to designate
a Participant to make or receive physical settlement on its behalf as
provided in Rules 2203 and 2204 for purposes of Section 9.2(c)(iv) of
the 2003 ISDA Credit Derivatives Definitions or Section 11.2(c)(iv) of
the 2014 ISDA Definitions, even though the Participant is not its
Affiliate. Rule 2207(b) will clarify certain procedures for obtaining
price quotations for the relevant deliverable obligations in the event
that a cash settlement fallback applies.
Rule 2208 will allow the Matched Delivery Buyer and Matched
Delivery Seller to settle their rights and obligations as to physical
settlement through an alternative arrangement agreed between them
(referred to as a ``CADP''), in lieu of settlement pursuant to Chapter
22 of the ICC Rules. If they so agree, ICC will have no obligation in
respect of such alternative arrangement.
Rules 2209(a) and (c) will provide that margin (including physical
settlement margin) will continue to be called and held through
settlement. Rule 2209(b) will provide that ICC will apply physical
settlement margin to satisfy the Matched Delivery Seller's obligation
to pay the physical settlement amount, and call such seller for any
shortfall.
ICC also proposes to adopt Delivery Procedures that will further
specify certain operational and other details for the physical
settlement process. According to ICC, Paragraph 1 will provide certain
definitions used in the Delivery Procedures. Paragraph 3.2 will set out
certain requirements for providing notices in connection with physical
settlement. Paragraphs 3.3(a)-(e) will establish the procedures and
timetable for ICC to allocate Matched Delivery Pairs and notify
Participants accordingly. Paragraph 3.3(g) will address additional
procedures concerning delivery of notices by Participants in connection
with physical settlement, including as to relevant notice deadlines,
requirements for providing copies of notices to ICC, treatment of late
notices and procedures for disputes involving notices. Paragraph 4 of
the Delivery Procedures will specify certain deadlines in connection
with the physical settlement of Non-DVP Obligations under Rule 2204.
Finally, Paragraph 5 will specify the deadline for notices that parties
have elected a CADP.
ICC also proposes to adopt a set of Physical Settlement and Notices
Terms (``Notices Terms'') with respect to physical settlement. The
Notices Terms are intended to set forth a uniform set of communications
between a Participant and its customer in connection with physical
settlement, including delivery of physical settlement notices and
delivery and receipt of deliverable obligations as between the
Participant and its customer. The Notices Terms will also address the
operation of certain cash settlement and other fallbacks as between the
Participant and its customer. The Notices Terms do not bind ICC and do
not form part of the ICC Rules or ICC Procedures. The Notices Terms are
published for the convenience and use of Participants and their
customers, and are designed to be incorporated by reference in customer
clearing documentation. However, a Participant and its customer may
agree to vary the Notices Terms.
ICC also proposes to make certain changes to its Risk Management
Framework to accommodate the changes relating to physical settlement
that are being made to the ICC Rules and procedures as set forth
herein. As revised, the Risk Management Framework reflects ICC's
obligations in respect of physical settlement as provided in the
amended ICC Rules and procedures. It will set out the steps in the
physical settlement process to be taken by ICC if physical settlement
applies, including the matching of Participants into Matched Delivery
Pairs, consistent with the ICC Rules and procedures. The revisions also
address the calculation, collection and use of margin (including
physical settlement margin) where physical settlement applies.
III. Comments
The Commission received one comment concerning the proposed rule
change. In this comment, the commenter expresses concern that ICC's
proposed rule change to guarantee the financial performance of physical
settlement, in addition to its existing guarantee of cash settlement,
would add additional complexity to ICC's clearing business,
particularly during times of financial stress. The commenter addresses
three issues with the proposal. First, the commenter suggests that the
``process, financial assets and liabilities, and legal obligations of
all parties must be well understood,'' \8\ both by ICC and the
Commission. Second, ``the SEC should have some periodic report on
[ICC's] financial assets, potential obligations or value at risk, and
ability to perform under normal or adverse circumstances.'' \9\
Finally, the commenter seeks assurance that the SEC would assess the
impact ICC's guarantee of ``physical clearing on market participants''
in reducing those participants' ``financial commitment'' or
leverage.\10\ The commenter did not opine on any particular aspects of
the proposed rule change beyond these general statements.
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\8\ Comment from Kermit Kubitz, dated April 17, 2015, available
at https://www.sec.gov/comments/sr-icc-2015-004/icc2015004-1.htm.
\9\ Id.
\10\ Id.
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[[Page 27801]]
IV. Discussion and Commission Findings
Section 19(b)(2)(C) of the Act \11\ directs the Commission to
approve a proposed rule change of a self-regulatory organization if the
Commission finds that such proposed rule change is consistent with the
requirements of the Act and the rules and regulations thereunder
applicable to such self-regulatory organization. Section 17A(b)(3)(F)
of the Act \12\ requires, among other things, that the rules of a
clearing agency are designed to promote the prompt and accurate
clearance and settlement of securities transactions and, to the extent
applicable, derivative agreements, contracts, and transactions, to
assure the safeguarding of securities and funds which are in the
custody or control of the clearing agency or for which it is
responsible and, in general, to protect investors and the public
interest.
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\11\ 15 U.S.C. 78s(b)(2)(C).
\12\ 15 U.S.C. 78q-1(b)(3)(F).
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Rules 17Ad-22(b)(2-3) \13\ require each registered clearing agency
that performs central counterparty services 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
and parameters to set margin requirements and review such margin
requirements and the related risk-based models and parameters at least
monthly, and 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, in its
capacity as a central counterparty for security based swaps.
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\13\ 17 CFR 240.17Ad-22(b)(2-3).
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Rule 17Ad-22(d)(15) \14\ requires each registered clearing agency
to establish, implement, maintain and enforce written policies and
procedures reasonably designed to state to its participants the
clearing agency's obligations with respect to physical deliveries and
identify and manage the risks from these obligations.
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\14\ 17 CFR 240.17Ad-22(d)(15).
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The Commission finds that the modification of the terms and
conditions for physical settlement of cleared CDS Contracts and the
adoption of certain new delivery procedures relating to physical
settlement is consistent with the requirements of Section 17A of the
Act \15\ and the regulations thereunder applicable to ICC.
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\15\ 15 U.S.C. 78q-1.
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The proposed rule change will provide greater certainty and
timeliness with respect to the clearance and settlement of CDS
transactions in circumstances where physical settlement applies.
Although physical settlement applies only rarely, and as a fallback to
the normal procedure for cash settlement, the proposed rule change will
prevent Participants from being exposed to the credit risk of other
Participants with respect to the financial performance of physical
settlement by guaranteeing timely payment of settlement amounts that
are due to a non-defaulting party. As a result, the Commission believes
the proposed rule change will promote the prompt and accurate clearing
and settlement of CDS contracts, and, in general, protect investors and
the public interest consistent with the requirements of Section
17A(b)(3)(F) of the Act.\16\
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\16\ 15 U.S.C. 78q-1(b)(3)(F).
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Moreover, the proposed rule change will require ICC to collect
Physical Settlement Margin \17\ (in addition to initial and variation
margin) to cover the specific obligations of each Matched Delivery
Seller to the clearinghouse with respect to physical settlement.
Therefore, the Commission believes ICC will be able to maintain
financial resources sufficient to support its clearing operations,
including operations under the amended physical settlement procedures,
in a manner consistent with the requirements of Rule 17Ad-22(b)(2-
3).\18\ Furthermore, ICC proposes to amend text of ICC Rules 2203(a)--
(g), to address the legal obligations that arise between Participants
when settling a CDS Contract that is to be physically settled, with
corresponding changes to its Delivery Procedures. The Commission
believes that ICC's Rules, as amended, establish ICC's and
Participants' obligations for performance (including financial
performance) of physically settled contracts, the procedures for
settlement and the mechanism for ICC to effect settlement in cash
without having to acquire or dispose of the underlying deliverable
obligations, consistent with the requirements of Rule 17Ad-
22(d)(15).\19\
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\17\ The Physical Settlement Margin is calculated as the
notional value minus the estimated value of the deliverable
obligation and collected from the Matched Delivery Seller and held
by ICC until such time the Matched Delivery Buyer and the Matched
Delivery Seller as a pair confirm that settlement has been occurred.
Physical Settlement Margin is not collected from the Matched
Delivery Buyer. The estimated value of the deliverable obligation
will be determined by ICC using a ``haircut'' approach. ICC will use
the price of the cheapest-to-deliver bond as the basis for the
``haircut'' estimation. However, if reliable pricing is not
available, ICC reserves the right to determine a price of zero and
therefore charge the full notional amount as the Physical Settlement
Margin to the seller.
\18\ 17 CFR 240.17Ad-22(b)(2-3).
\19\ 17 CFR 240.17Ad-22(d)(15).
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V. Conclusion
On the basis of the foregoing, the Commission finds that the
proposal is consistent with the requirements of the Act and in
particular with the requirements of Section 17A of the Act \20\ and the
rules and regulations thereunder.
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\20\ 15 U.S.C. 78q-1.
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It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\21\ that the proposed rule change (SR-ICC-2015-004) be, and hereby
is, approved.\22\
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\21\ 15 U.S.C. 78s(b)(2).
\22\ In approving the proposed rule change, the Commission
considered the proposal's impact on efficiency, competition and
capital formation. 15 U.S.C. 78c(f).
\23\ 17 CFR 200.30-3(a)(12).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\23\
Robert W. Errett,
Deputy Secretary.
[FR Doc. 2015-11595 Filed 5-13-15; 8:45 am]
BILLING CODE 8011-01-P