CFTC Aligns Regulation of Certain DCOs with International Standards

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1 January 2, 2014 CFTC Aligns Regulation of Certain DCOs with International Standards Key Takeaways: > In November of 2013, the CFTC adopted regulations for systemically important DCOs, and other DCOs that voluntarily opt in, in accordance with international standards, that permit banks to hold significantly less capital against their exposure to such Covered DCOs (as defined below). > The regulations require Covered DCOs to maintain sufficient financial resources to withstand the default of their two largest clearing members and sufficient liquidity resources to continue clearing and settlement under a stress scenario. > The regulations also impose a number of new requirements with respect to corporate governance, disaster and recovery planning, disclosure, stress testing and efficiency. Introduction Contents Introduction... 1 The Final Rule and bank capital standards... 2 Financial resources requirements... 2 Governance standards... 3 Other requirements under the Final Rule... 3 Opt-in procedures for Subpart C DCOs... 4 Effective dates... 5 On November 15, 2013, the Commodity Futures Trading Commission (the CFTC ) adopted a final rule (the Final Rule ) intended to bring the agency s supervision of certain derivatives clearing organizations ( DCOs ) in line with international standards established by the Bank for International Settlements Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissioners ( CPSS-IOSCO ) known as the Principles for Financial Market Infrastructures (the PFMIs ). 1 The Final Rule was published in the Federal Register on December 2, The Final Rule applies to (1) DCOs that have been designated as systemically important ( SIDCOs ) by the Financial Stability Oversight Council ( FSOC ) and (2) DCOs which voluntarily opt in to be covered by the Final Rule ( Subpart C DCOs and, together with SIDCOs, Covered DCOs ). The Final Rule establishes a number of new standards for Covered DCOs, including with respect 1 Derivatives Clearing Organizations and International Standards, 78 Fed. Reg (Dec. 2, 2013), available at CFTC Aligns Regulation of Certain DCOs with International Standards 1

2 to financial resources, governance requirements, business continuity and disaster recovery planning, stress testing, and disclosure. The CFTC previously adopted a rule that imposed certain heightened requirements on SIDCOs (the Prior SIDCO Rule ). The Final Rule extends application of those requirements to Subpart C DCOs and establishes a number of new requirements inspired by the PFMIs for all Covered DCOs. The Final Rule and bank capital standards Under global bank capital standards promulgated by the Basel Committee on Banking Supervision in July 2012, a bank or banking organization may hold significantly less capital against an exposure to a central counterparty that is prudentially supervised in accordance with the PFMIs (such a central counterparty, a QCCP ) than it must with respect to other central counterparties. Because it implements the PFMIs, the Final Rule permits Covered DCOs to be treated as QCCPs, allowing banks to utilize them at significantly less cost. In granting non-systemically important DCOs the option to become Subpart C DCOs, the CFTC observed that being treated as a QCCP grants a DCO significant competitive advantages over non-qccp clearinghouses. Financial resources requirements The Final Rule s centerpiece is two requirements concerning Covered DCOs financial resources. First, a Covered DCO that is either systemically important in multiple jurisdictions or involved in activities with a complex risk profile must have financial resources sufficient to meet its obligations to its clearing members following the default of the two of its clearing members creating the largest combined loss under extreme but plausible market conditions (the Cover Two Requirement ). 2 In the Final Rule the CFTC identified clearing credit default swaps, credit default futures or any derivatives that reference either as having a complex risk profile, though it may determine that other clearing activities also have such a profile. The Final Rule also allows the CFTC to determine whether a Covered DCO is considered systemically important in multiple jurisdictions. In calculating the amount of financial resources that must be maintained under the Cover Two Requirement, a Covered DCO must treat affiliated clearing members as a single entity. When assessing its own available financial resources, a Covered DCO is forbidden from considering its ability to make default fund assessments in the future. This is significant because most DCOs default funds comprise funded and unfunded obligations with the ability to impose additional assessments on clearing members in the future. 2 The Cover Two Requirement was imposed on SIDCOs meeting the above criteria under the Prior SIDCO Rule, but the Final Rule extends its application to all Covered DCOs. CFTC Aligns Regulation of Certain DCOs with International Standards 2

3 Second, the Final Rule requires a Covered DCO to maintain liquidity resources that will enable it to meet its intraday, same-day and multiday obligations to perform settlements, including the posting of margin and the making of settlement and coupon payments, under a wide range of stress scenarios, including the default of the clearing member creating the largest liquidity obligation in extreme but plausible market conditions. 3 Such liquidity resources must be maintained in all currencies for which a Covered DCO performs settlements, and can only include cash, committed 4 repurchase agreements, foreign exchange swaps or lines of credit, and highly marketable collateral that is convertible into cash pursuant to a pre-arranged funding arrangement. Governance standards The Final Rule also establishes new standards for the corporate governance of Covered DCOs, including, among other things, requiring that governance arrangements: > are in writing and describe the Covered DCO s management structure; > are disclosed to the CFTC, other regulators, clearing members, clearing members customers, and owners of the Covered DCO; > [p]lace a high priority on the safety and efficiency of the Covered DCO; > require the disclosure of major board decisions to clearing members and the CFTC in a manner consistent with confidentiality and disclosure requirements; > require the disclosure of board decisions that have a broad market impact to the public; and > describe procedures for identifying and managing conflicts of interest among board members. The Final Rule also creates standards for board members of a Covered DCO. Among other things, a Covered DCO s board must (1) have members with appropriate skills, (2) include non-executive directors, and (3) have its performance (and that of individual members) reviewed on a regular basis. Other requirements under the Final Rule In implementing the PFMIs, the Final Rule also imposes the following requirements: 3 4 The Final Rule further suggests that a Covered DCO that is systemically important in multiple jurisdictions or engages in activities with a complex risk profile should consider maintaining liquidity resources sufficient to meet the default of the two clearing members creating the largest aggregate liquidity obligation. An instrument is considered committed if it is legally binding and cannot be withdrawn at the election of the liquidity provider in times of stress. CFTC Aligns Regulation of Certain DCOs with International Standards 3

4 > Business continuity and disaster recovery: A Covered DCO must establish a business continuity and disaster recovery plan designed to enable it to recover its operations and resume processing, clearing and settlement no more than two hours after a wide-scale disruption. 5 > Recovery and wind-down planning: Covered DCOs must establish and maintain separate plans for recovery and wind-down resulting from (1) uncovered credit losses or liquidity shortfalls and (2) general business, operational or other risks. > Default rules: Under the Final Rule, a Covered DCO must have in place rules permitting it to allocate uncovered credit losses and liquidity shortfalls to its clearing members. > Stress tests: A Covered DCO must stress test its financial and liquidity resources on a daily basis, and must assess its stress testing scenarios on at least a monthly basis. Stress tests must take into account market stress, idiosyncratic stress, and combinations thereof. > Sensitivity analyses of margin models: Covered DCOs must conduct monthly sensitivity analyses of their margin models performance over both actual and hypothetical positions utilizing parameters reflecting a wide range of historical and hypothetical market conditions. > Disclosure requirements: A Covered DCO must publicly disclose its responses to the Disclosure Framework for Financial Market Infrastructures published by the CPSS-IOSCO and update that disclosure at least every two years. > Efficiency: Under the Final Rule, a Covered DCO s clearing and settlement arrangements, operating structure, products cleared and use of technology must be efficiently and effectively designed, and the Covered DCO must regularly review the efficiency of these systems. Opt-in procedures for Subpart C DCOs The Final Rule establishes procedures by which a DCO which has not been designated as systemically important by FSOC may elect to be a Subpart C DCO, and thus become subject to the Final Rule s requirements. 6 Unless the CFTC stays such an election, it will become effective either on the date specified by the DCO or 10 business days after the election is filed. A clearinghouse not registered with the CFTC as a DCO may also elect to be a Subpart C DCO in connection with a DCO registration application. 5 6 This requirement was previously imposed on SIDCOs under the Prior SIDCO Rule. Some commenters had argued that all DCOs should be subject to the Final Rule s requiremetns, though the CFTC rejected this request in favor of an opt-in regime. CFTC Aligns Regulation of Certain DCOs with International Standards 4

5 Effective dates Most of the Final Rule s requirements became effective on December 31, 2013, though non-systemically important DCOs were able to elect to become Subpart C DCOs beginning on December 13, A new Subpart C DCO must comply with the requirements of the Final Rule as of the effective date of its election (assuming that date is after December 31, 2013). All Covered DCOs, however, may request a one-year extension of the compliance date for the business continuity and disaster recovery planning, recovery and wind-down planning, and default rule requirements. CFTC Aligns Regulation of Certain DCOs with International Standards 5

6 Contacts If you have any questions, please contact the people on the right or your usual Linklaters contacts. For further information please contact: Caird Forbes-Cockell Jeffrey Cohen Mark Middleton Robin Maxwell Noah Melnick Counsel Authors: Include some of the individuals listed as Contacts. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2013 Linklaters in the U.S. provides leading global financial organizations and corporations with legal advice on a wide range of domestic and cross-border deals and cases. Our offices are located at 1345 Avenue of the Americas, New York, New York Linklaters LLP is a multinational limited liability partnership registered in England and Wales with registered number OC It is a law firm authorized and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at Alissa Clare Senior Associate Jacques Schillaci Associate Edward Ivey Associate CFTC Aligns Regulation of Certain DCOs with International Standards 6 //

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