Financial Industry Regulatory Authority, Inc. (FINRA) has established an Interim Pilot Program with respect to margin requirements for certain transactions in credit default swaps (CDSs). FINRA’s new Rule 4240 was approved by the Securities and Exchange Commission (SEC) went into effect on June 3, 2009. As set forth in FINRA Regulatory Notice 09-30, FINRA Rule 4240 applies to margin requirements for any transactions in CDS executed by a member, “including those in which the offsetting matching hedging transactions are effected by the member in contracts that are cleared through the central clearing counterparty clearing services” of the Chicago Mercantile Exchange (CME), which received conditional temporary exemptive relief from the SEC this past March to operate a central clearing entity for CDS. The Interim Pilot Program expires September 25, 2009, the same date on which the SEC’s interim final temporary rules expire.

Rule 4240 provides that margin for CDS offset by trades cleared through CME’s central clearing services must be at least equal to the minimum margin requirements established by CME for the offsetting trades. However, a member may require additional margin if it concludes that the CME margin requirements are inadequate with respect to a particular customer or broker-dealer. Additionally, for any CDS transaction settled over-the-counter or cleared through a central counterparty other than the CME, Rule 4240 establishes criteria by which members must determine minimum margin requirements.

Rule 4240 also requires that members provide written notice and submit all documentation relating the member’s risk controls and procedures to FINRA prior to entering into any clearing arrangement with respect to CDS transactions that use central clearing counterparty clearing services provided by a clearing agency. Under the rule, all members are required to monitor the risk of their customer or broker-dealer accounts with exposure to CDS and maintain a comprehensive written risk analysis methodology for assessing the risk posed by CDS to their capital. Procedures and guidelines for monitoring the risk and reviewing credit extension activities are set out under the rule. The rule also prohibits excessive concentration of risk with respect to any single reference entity under CDS transactions.