SEC Interim Final Temporary Rule

On January 14, 2009, the Securities and Exchange Commission (SEC) issued an interim final temporary rule to facilitate the clearing and settling of credit default swaps (CDS) by central counterparty clearinghouses.1 This rule exempts CDS from certain provisions of the Securities Act of 1933 (1933 Act), the Securities Exchange Act of 1934 (1934 Act), and the Trust Indenture Act of 1939 that would prevent such contracts from being traded through a central counterparty on an exchange or clearinghouse. The SEC’s exemption is a necessary step for the success of the various proposals to clear CDS through a central counterparty, including those sponsored by CME Group, Inc. (CME), NYSE Euronext, and Intercontinental Exchange (ICE), each of whose current status is summarized below. The development of central counterparty clearing for CDS is a fundamental component of the federal government’s efforts to effectively regulate derivatives transactions.2  

Each of the proposals mentioned above seeks to move CDS trading from the less regulated over-the-counter market onto a more regulated clearinghouse or exchange. In addition to more regulation, regulators view these proposals favorably to the extent they will require margining and will provide more consistent and transparent valuations in the CDS market. Without a change in SEC rules interpreting federal securities laws, this transition would be problematic to the extent the transition caused CDS trades through the clearinghouses and exchanges to be securities that would trigger broader application of the 1933 Act and the 1934 Act. In particular, as securities, CDS would have to comply with extensive registration and reporting requirements, which may discourage market participants from clearing their CDS trades through central counterparties.  

Traditional over-the-counter CDS do not have to comply with the registration and reporting requirements of the 1933 Act and the 1934 Act because they fall within the definition of “security-based swap agreements,” which are exempted from the extensive regulations placed on “securities” by Section 2A of the 1933 Act and Section 3A of the 1934 Act. The definition of “security-based swap agreements” for the 1933 Act and the 1934 Act comes from Sections 206B and 206C of the Gramm-Leach-Bliley Act of 1999 (GLBA). As defined in the GLBA, a “security-based swap agreement” is a transaction “the material terms of which (other than price and quantity) are subject to individual negotiation….” The individual negotiation component of the GLBA definition will no longer be possible once CDS contracts are standardized for purposes of central counterparty clearing. As a result, the viability of centrally cleared CDS would be put in jeopardy because of burdensome registration and reporting requirements under the 1933 Act and 1934 Act.  

Through its interim final temporary rule, the SEC has addressed the aforementioned problem by exempting eligible CDS from all applicable 1933 Act and 1934 Act regulations, except the anti-fraud provisions of Section 17(a) of the 1933 Act. While the SEC’s exemption is temporary and subject to certain conditions (including that sales and offers be limited to “eligible contract participants” as defined in the Commodity Futures Modernization Act of 20003), it paves the way for counterparties currently involved in the CDS market to transfer their clearing and trading activities onto one of the proposed clearinghouses or exchanges.  

Update on Central Counterparty CDS Proposals

As evidenced by the SEC’s interim final temporary rule, federal regulators are eager to bring a CDS central counterparty to market. Currently, proposals by CME, NYSE Euronext, and ICE are winding their way through the regulatory approval process, with the backers of each proposal seeking to become the dominant platform on which the $31 trillion CDS market will clear and trade. These three proposals represent the most viable options for central counterparty clearing and trading of CDS, and we have provided a summary of the status of each proposal below.  

CME Credit Market Derivatives Exchange. The CME, operator of the world’s largest futures exchange, is adapting its existing clearinghouse operated through the Chicago Mercantile Exchange Inc. to accommodate CDS and has joined up with Citadel Derivatives Group LLC to develop an electronic execution platform. The CME’s platform will be regulated by the Commodity Futures Trading Commission (CFTC) as a derivatives clearing organization. In addition to both initial and ongoing CFTC regulation, however, the CME’s proposal must receive an exemption from the SEC from certain securities law requirements.  

The CFTC announced on December 23, 2008, that it will not object to the CME’s certification of plans to provide clearing services for certain CDS contracts through the current CME clearinghouse, which is already registered with the CFTC as a derivatives clearing organization.4 In the CFTC’s release, the agency noted that prior to certification of the proposal, its staff reviewed and approved the CME’s plans to clear CDS, including its planned risk management procedures.  

As part of its review of the CME proposal, the CFTC consulted with the staffs of the Federal Reserve Board(the Fed) and the SEC. Based on this consultation, the Fed’s staff expressed its support for the CFTC’s decision not to object to the CME’s certification. This type of cooperation between regulators is consistent with the policy objectives outlined in the memorandum of understanding entered into by the President’s Working Group on Financial Markets, which aimed in part at encouraging the creation of central counterparties for over-the-counter derivatives products by the end of 2008.  

The CME is currently waiting for final approval from the SEC in order to complete the regulatory process required to initiate its CDS proposal. The CME is also actively courting dealers in CDS to take equity stakes in its platform, and negotiating with Markit Group Limited to obtain licensing approval for the use of indexes and pricing methods so that it can begin clearing and trading CDS as soon as final SEC approval is obtained.  

NYSE Euronext Central Counterparty. On December 23, 2008, the SEC approved temporary exemptions allowing LCH.Clearnet Limited, in partnership with NYSE Euronext, to operate as a central counterparty for CDS.5 As did the CFTC with the CME certification, the SEC developed its temporary exemptions in close consultation with other regulators, including the Fed, the Federal Reserve Bank of New York, the CFTC, and the U.K. Financial Services Authority.  

In its press release announcing the temporary exemptions, the SEC stated that these exemptions will allow central counterparties such as LCH.Clearnet and certain of their participants to implement centralized clearing quickly, while providing the SEC time to review NYSE Euronext’s operations and evaluate whether registrations or permanent exemptions should be granted in the future. The conditions that apply to the exemptions are designed to ensure that key investor protections and important elements of SEC oversight remain in place, while taking into account the fact that applying all the particulars of the securities laws could have the unintended consequence of deterring the prompt establishment and use of a central counterparty. LCH.Clearnet’s primary regulator is the U.K. Financial Services Authority. The clearinghouse became the first central counterparty to clear CDS contracts on December 22, 2008, when its platform became operational in Europe. The exemption provided to LCH.Clearnet by the SEC paves the way for LCH.Clearnet to begin clearing CDS contracts in the United States.  

ICE Clearinghouse/Central Counterparty. This platform has received considerable attention since it has the support of most of the major dealers in the CDS market. On October 30, 2008, ICE announced that it would acquire The Clearing Corporation (CCorp), whose investors are nine major CDS dealers, in an effort to accelerate its CDS clearing initiative. CCorp, using its experience as a clearinghouse for futures and options contracts, has directed its efforts into developing a wholly owned, limited purpose, New York trust bank—ICE US Trust (the Bank)—to act as a clearinghouse for CDS contracts. The Bank’s application for a charter was approved by the New York State Banking Board on December 4, 2008, and the Bank’s primary regulators are the Fed and the New York State Banking Department.  

The Bank will work with the Depository Trust & Clearing Corporation (DTCC), utilizing the DTCC Deriv/SERV Trade Information Warehouse in conjunction with the Bank’s central counterparty services. The Bank will act as the central counterparty guarantor and use multi-lateral netting, margin collateral, and daily marking-to-market of positions to improve capital efficiency, increase regulatory transparency, lessen direct counterparty risk and reduce systemic risk.  

The Bank’s CDS platform is currently undergoing system testing and design validation. Formal launch of the CDS platform had been expected before year end; however, ICE is still awaiting regulatory approvals by the Fed and the SEC before the Bank can begin clearing and trading CDS contracts.  

We will continue to monitor regulatory developments with respect to central counterparty clearing and trading of CDS contracts and will keep you informed of progress made on the aforementioned proposals.