This past week, regulatory action surrounding the credit default swaps (CDS) market heightened as the Securities and Exchange Commission (SEC), the Federal Reserve Board (the Fed) and the U.S. Treasury Department separately took actions to permit ICE US Trust LLC (“ICE Trust”), a New York limited liability trust company established jointly by IntercontinentalExchange, Inc. (ICE) and The Clearing Corporation (TCC) and approved by the New York State Banking Department last December to provide clearing services for CDS. Against the backdrop of the financial crisis, lawmakers and regulators alike have been pressing for the creation of one or more central counterparties (CCP) to clear CDS, as evidenced by the Memorandum of Understanding signed last November by the SEC, the Fed and Commodity and Futures Trading Commission (CFTC).

On Friday, the Fed announced its approval last Wednesday of ICE Trust’s application to become a member bank, based on ICE’s proposal submitted last October, and to serve as a CCP to clear CDS. In its order, the Fed, as the primary regulator of ICE Trust, stated that “as a member of the Federal Reserve System, ICE Trust would be eligible to open an account with, and receive payment services from, the Federal Reserve Bank of New York,” which indicated last November that its top priority was to see instituted a CCP for CDS contracts. In approving ICE’s proposal, the Fed, as required by the Federal Reserve Act and Regulation H, reviewed the financial history and condition of ICE Trust, the adequacy of its capital in relation to its assets, its prospective deposit liabilities and other corporate responsibilities, its future earning prospects, the general character of its management, whether its corporate powers are consistent with the purposes of the Federal Reserve Act and the convenience and needs of the serviced community.

The SEC also announced its approval of ICE Trust’s request for exemptive relief, as it granted temporary conditional exemptions allowing ICE Trust to operate as a CCP for CDS, similar to the temporary exemptive relief granted to LCH.Clearnet Ltd. last December. In granting the temporary exemptions, effective until December 7, 2009, the SEC attempted to balance the goal of quickly establishing a CCP for CDS transactions against the need for adequate time to review the operations of CCPs and carefully consider the implications of the exemptions. Pending complete review, the SEC is relying upon existing regulatory safeguards, ICE’s representations regarding internal compliance standards and procedures and additional conditions imposed by the SEC (requirements related to recordkeeping, access to information, regulatory reporting and making specific pricing information publicly available). The SEC is currently soliciting public comment on “all aspects of these exemptions” in order to assist in its determination of what further regulatory actions may be necessary with respect to operation of CCPs. In addition to these exemptions, the exemptions under various securities law requirements for CDS granted under interim final temporary rules adopted by the SEC in January also will apply.

The SEC order grants several exemptions:

  • ICE Trust is exempt from registering as a clearing agency under Section 17A of the Exchange Act with respect to its clearance of CDS between eligible contract participants meeting the SEC’s criteria under the order (Cleared CDS).
  • CDS which are not included in the Exchange Act’s definition of “swap agreements” (non-excluded CDS) from the securities laws are exempt to the same extent that “security-based swap agreements” are exempt. Like security-based swap agreements, however, non-excluded CDS are subject to SEC rules prohibiting fraud, manipulation and insider trading. This exemption is available to ICE Trust and parties to non-excluded CDS transactions, other than self-regulatory organizations, registered broker-dealers, and any entities that hold funds of third parties in connection with CDS transactions. Registered broker-dealers have the benefit of separate temporary exemptions granted by the SEC, as discussed below.
  • Temporary exemptive relief is granted from Exchange Act Sections 5 and 6 for broker-dealers and exchanges effecting transactions in non-excluded CDS. Subject to conditions, the exemption provides that an exchange effecting transactions in non-excluded CDS does not have to register with the SEC as a national securities exchange. In addition, broker-dealers may effect transactions in non-excluded CDS on an exchange which is not registered as a national securities exchange.
  • An exemption is provided for registered broker-dealers only, narrowly tailored so that it applies solely to their activities in connection with Cleared CDS. Broker-dealers engaging in Cleared CDS are exempt from the Exchange Act requirements and rules to the same extent they are exempt with respect to security-based swap agreements. However, the antifraud, anti-manipulation and insider trading prohibitions under the Exchange Act are explicitly applicable to broker-dealers engaged in Cleared CDS.

Treasury issued an order last week granting temporary exemptions from certain provisions of the Government Securities Act of 1986 (GSA) and related GSA regulations related to ICE Trust’s clearing of CDS that reference government securities. Under the first exemption, ICE Trust, certain ICE Trust participants (that are not government securities broker-dealers), and certain eligible participants clearing CDS meeting eligible criteria in the Treasury order are exempt from registration requirements under Section 15C (and related regulations) of the GSA. Under the second exemption, registered government securities broker-dealers that are not financial institutions are exempt from Treasury regulations to the extent that the SEC’s order exempts registered broker-dealers in connection with their activities related to Cleared CDS. The Treasury exemptive orders remain in effect for nine months, and Treasury is soliciting comment on “all aspects of these exemptions.”

Also last week, the Office of the Comptroller of the Currency (OCC) released an interpretive letter in which it authorized a national bank to become a clearing member of ICE Trust, provided that the bank established an appropriate risk management framework and receives a written supervisory no-objection letter from its examiner-in-charge prior to becoming a clearing member.

In furtherance of their jointly developed plan to clear CDS contracts, ICE completed its acquisition on Friday of TCC, which had developed the “CDS risk management framework, operational processes and infrastructure for ICE Trust’s clearing operations.” Such TCC methodologies will be used by the clearinghouse to “determine initial and variation margin requirements, guaranty fund requirements and official daily settlement prices.” Under the terms of the acquisition, announced last October, TCC shareholders received as consideration $39 million in cash paid by ICE and participation in a 50% profit-sharing arrangement in ICE Trust, though a separate pricing structure will apply to those shareholders who are also founding members of ICE Trust. ICE announced that the antitrust division of the Department of Justice approved the transaction last week, as it provided early termination of the Hart-Scott-Rodino waiting period to ICE and TCC.

Furthermore, ICE announced in February that its wholly-owned subsidiary, ICE Clear Europe, plans to develop ICE Trust Europe, a specialized CDS clearinghouse for European-based product. This past week, ICE Clear Europe, regulated by the U.K. Financial Services Authority, confirmed its commitment to working closely with European regulators and industry participants in establishing a European-regulated CCP for CDS. ICE Trust Europe anticipates launching its services in the first half of 2009.