CFTC Final Rule – Clearing Requirement Determination (17 CFR Part 50)

in Commodity Futures Trading Commission, Derivatives, Payment, Clearing & Settlement

By Eric J. Peterman and Adia Goss

On July 24, 2012, the Commodity Futures Trading Commission (the “CFTC”) proposed new rules to require certain credit default swaps (“CDS”) and interest rate swaps (“IRS”) to be cleared by registered derivatives clearing organizations (“DCOs”).  On August 7, 2012 the CFTC issued proposed rules that specified the first determination of classes of swaps to be subject to mandatory clearing under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  A final rule was issued on December 13, 2012, and becomes effective on February 11. 2013.  Under the rules, market participants would be required to submit a swap that is identified in the rules as being subject to clearing by a DCO as soon as technologically practicable and no later than the end of the day of execution.  In a separate rule-making, the CFTC also finalized regulations on the timing of when market participants will need to comply with the new rules.

Background

 

One of the fundamental pillars of the new derivatives oversight system under the Dodd-Frank Act is mandatory clearing of standardized swaps, which the regulators hope will significantly lower the risks of the highly interconnected financial system.[1]  The new system requires most swaps to be traded on open platforms and then channeled through a clearinghouse, which collects margin from both sides and guarantees the deal.  The Dodd-Frank Act amended the Commodity Exchange Act (the “CEA”) to prevent market participants from engaging in a swap that is required to be cleared unless that person submits the swap for clearing to a DCO.   The Dodd-Frank Act also requires the CFTC to determine whether a swap is required to be cleared through either a CFTC-initiated review or a submission from a DCO for the review of a swap, or a group, category, type, or class of swaps.

 

Final Rule

 

The CFTC is proceeding with a clearing requirement based upon submissions from DCOs.  Instead of trying to define every single attribute for individual swap products, the CFTC listed specifications to classify swaps into groups that are subject to the clearing requirement.  The measure would require clearing of North American untranched CDS index contracts[2] and European untranched CDS index contracts,[3] as well as fixed-to-floating rate swaps, basis swaps, overnight index swaps and forward rate agreements on certain common indices.  The final rule sets out a table detailing the criteria for each class of swaps that must be cleared, which is attached as Appendix A hereto.  Clearing would not be required for tranches of credit indexes.

 

These CDS and IRS swaps described in Appendix A are not the only swaps that will be subject to mandatory clearing.  In fact, market participants may expect that a significant portion of the market will be subject to the mandatory clearing requirement since the CFTC has indicated that it might later decide to require clearing for energy, agricultural and equity indexes as well.  The final rule will not apply to non-financial entities hedging commercial risk that have been exempted from clearing.  If a CDS or an IRS falls into a category identified by the CFTC as being subject to clearing but such swap is, in fact, not offered for clearing by any DCO, then it would not be subject to mandatory clearing.  The CFTC and DCOs will maintain lists on their websites of swaps that are required to be cleared, and each DCO will also make publicly available a list of swaps that it accepts for clearing.  In its final rule, the CFTC delegates to the Director of the Division of Clearing and Risk (or any designees) the authority to determine whether swaps submitted by a DCO fall within a class of swaps that are subject to mandatory clearing.  Finally, the CFTC final rule includes a broad anti-evasion rule that makes it unlawful for any person to knowingly or recklessly evade, or abuse any exception to, the clearing requirements.

 

Appendix A

While describing clearing requirements the CFTC has referred to four interest rate swap classes and has developed the following class definitions based on information provided by the submitting DCOs and market convention.

 

  1. Fixed-to-floating swap”: A swap in which the payment or payments owed for one leg of the swap is calculated using a fixed rate and the payment or payments owed for the other leg are calculated using a floating rate.

 

  1. Floating-to-floating swap” or “basis swap”: A swap in which the payments for both legs are calculated using floating rates.

 

  1. Forward Rate Agreement” or “FRA”: A cash-settled forward contract on interest rates.

 

  1. Overnight indexed swap” or “OIS”: A swap for which one leg of the swap is calculated using a fixed rate and the other leg is calculated using a floating rate based on a daily overnight rate.

 

The CFTC is proposing to classify interest rates swaps using the following affirmative specifications for each class: (i) currency in which the notional and payment amounts are specified; (ii) rates referenced for each leg of the swap; and (iii) stated termination date of the swap.  The CFTC also is proposing three “negative” specifications for each class: (i) no optionality (as specified by the DCOs); (ii) no dual currencies; and (iii) no conditional notional amounts.

 

The following tables set forth the specific specifications of each class subject to the clearing requirement:

 

Specification Fixed-to-Floating Swap Class
1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 28 days to 50 years 28 days to 50 years 28 days to 50 years 28 days to 30 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

 

Specification Basis Swap Class
1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 28 days to 50 years 28 days to 50 years 28 days to 50 years 28 days to 30 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

 

Specification Forward Rate Agreement Class
1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP) Yen (JPY)
2. Floating Rate Indexes LIBOR EURIBOR LIBOR LIBOR
3. Stated Termination Date Range 3 days to 3 years 3 days to 3 years 3 days to 3 years 3 days to 3 years
4. Optionality No No No No
5. Dual Currencies No No No No
6. Conditional Notional Amounts No No No No

 

Specification

Overnight Index Swap Class

1. Currency U.S. Dollar (USD) Euro (EUR) Sterling (GBP)
2. Floating Rate Indexes FedFunds EONIA SONIA
3. Stated Termination Date Range 7 days to 2 years 7 days to 2 years 7 days to 2 years
4. Optionality No No No
5. Dual Currencies No No No
6. Conditional Notional Amounts No No No

 

The CFTC requires two classes of CDS contracts to be subject to the clearing requirement.  The first class is untranched CDS contracts referencing North American corporate entities in Markit’s CDX.NA.IG and CDX.NA.HY indices.  The second class includes untranched CDS referencing European corporate entities in Markit’s iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High Volatility.

 

The following tables set forth the specific specifications of each class subject to the clearing requirement:

 

 

 

Specification 

North American Untranched CDS Indices Class1. Reference EntitiesCorporate2. RegionNorth America3. IndicesCDX.NA.IG

CDX.NA.HY4. TenorCDX.NA.IG: 3Y, 5Y, 7Y, 10Y

CDX.NA.HY: 5Y5. Applicable SeriesCDX.NA.IG 3Y: Series 15 and all subsequent Series, up to and including the current Series

CDX.NA.IG 5Y: Series 11 and all subsequent Series, up to and including the current Series

CDX.NA.IG 7Y: Series 8 and all subsequent Series, up to and including the current Series

CDX.NA.IG 10Y: Series 8 and all subsequent Series, up to and including the current Series

CDX.NA.HY 5Y: Series 11 and all subsequent Series, up to and including the current Series6. TranchedNo

 

Specification

European Untranched CDS Indices Class1. Reference EntitiesCorporate2. RegionEurope

3. IndicesiTraxx Europe

iTraxx Europe Crossover iTraxx Europe HiVol

4. TenoriTraxx Europe: 5Y, 10Y

iTraxx Europe Crossover: 5Y

iTraxx Europe HiVol: 5Y

5. Applicable SeriesiTraxx Europe 5Y: Series 10 and all subsequent Series, up to and including the current Series

iTraxx Europe 10Y: Series 7 and all subsequent Series, up to and including the current Series

iTraxx Europe Crossover 5Y: Series 10 and all subsequent Series, up to and including the current Series

iTraxx Europe HiVol 5Y: Series 10 and all subsequent Series, up to and including the current Series6. TranchedNo

 

 


[1] The CFTC Chairman Gary Gensler said in a statement that “one of the primary benefits of swaps-market reform is that standard swaps between financial firms will move into central clearing, which will significantly lower the risks of the highly interconnected financial system.”

[2] These are US dollar-denominated CDS covering North American corporate credits.

[3] These are Euro-denominated CDS referencing European corporate credits.

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