On December 13, the CFTC published a final rule that establishes a timetable for mandatory clearing through a clearinghouse of interest rate and credit default swaps. “Clearing” is the process by which parties to a transaction reduce their exposure to each other by each transferring their portion of the transaction to a clearinghouse. The clearinghouse becomes the counterparty to each side of the transaction, thus reducing the counterparty risk of each of the transacting parties to the other. Compliance with the clearing requirements will be required as soon as March 2013 for some types of swap counterparties.
Only swaps that meet certain specifications are subject to the mandatory clearing requirement. If the swaps meet those specifications, they must be submitted for clearing to a derivatives clearing organization (DCO) that is registered with the CFTC. If no DCO clears a swap that is subject to mandatory clearing, the clearing requirement will not apply to the swap. Swaps are not required to be cleared unless clearing is generally available to all types of market participants. Counterparties will not need to submit a swap for clearing if they know that the DCO does not clear that particular swap. However, if a swap fails to clear because one or both counterparties have failed to meet the credit requirements of the DCO or clearing members, the swap must be cleared as soon as technologically practicable after the counterparties learn about the credit issue.
In the guidance accompanying the final rule, the CFTC stated that, subject to abuse and evasion rules, market participants are not required to structure their swaps in a particular manner or to disentangle swaps that serve legitimate business purposes in order to adhere to the clearing requirements.
The CFTC rule, which will be effective February 11, 2013, is available here.
What is “clearing”?
Clearing changes the traditional relationship between a counterparty and a dealer by placing a clearinghouse in the middle of each transaction. The dealer, which is likely to be a clearing member, acts as the clearing agent for its counterparty. The structure of cleared trades can take one of two forms, depending on whether the clearing member is acting as agent or as principal.
Under the first structure, when the clearing member acts as agent, the counterparty will face the clearinghouse directly. The clearing member generally is required to guarantee the performance of the counterparty’s obligations to the clearinghouse, but the clearing member does not guarantee the clearinghouse’s obligations. Under the second structure, when the clearing member acts as principal, the counterparty will face the clearing member and the clearing member will face the clearinghouse. The relationship between the counterparty and the clearing member in this second situation would be governed either by a new customer agreement covering, among other matters, margin requirements, events of default, position liquidation and payment obligations, or by a modified ISDA Master Agreement. Under both structures, the clearing member novates (or “gives up”) the transaction to the clearinghouse.
What market participants need to do now
Market participants that anticipate entering into swaps should check which clearing compliance date will apply to them and whether their swaps are likely to be eligible for either or both of the commercial end-user and interaffiliate exemptions from clearing (which are discussed below). Market participants also should determine whether any of their interest rate or credit default swaps fall into the classes and specifications that are subject to mandatory clearing. The CFTC is likely to issue clearing requirement determinations for other classes of swaps next year, and shorter compliance phase-in periods are possible in the future as counterparties and DCOs become accustomed to the mandatory clearing regime.
Interest rate swaps
For interest rate swaps, the requirements cover fixed-tofloating swaps, basis swaps and forward rate agreements that are specified in any one of four currencies – U.S. dollar, Euro, British pound and Japanese yen – and overnight index swaps based on U.S. dollar, Euro and British pound. To fall under the clearing requirement, the swaps must be based on specified floating rate indexes and must have termination dates that fall into prescribed ranges. The four classes selected for mandatory clearing account for more than 80% of the interest rate swap market.
The three affirmative specifications for interest rate swaps are the (1) currency in which the notional and payment amounts are specified, (2) rates referenced for both of the two payment streams in the swap and (3) stated termination date of the swap. To be subject to mandatory clearing, an interest rate swap also must not have any of three negative specifications, which are (1) swaps with optionality, (2) multiple currency swaps and (3) swaps with conditional notional amounts. With respect to conditional notional amounts, the CFTC clarified in the guidance accompanying the final rule that, to qualify for this exemption, first, the change in notional amount must be triggered by a defined event or condition, and second, the change must not be clearly predictable at the time the swap is executed. If the reduction in notional amount is voluntary, however, the negative specification for conditional notional amounts is not triggered and the swap is subject to clearing, assuming all other specifications apply.
The following tables show the four classes of interest rate swaps subject to mandatory clearing and the affirmative and negative specifications for each class. The swap classes and specifications are the same as those in the proposed clearing requirement determination published by the CFTC in August 2012.
Fixed-to-floating swaps, basis swaps and forward rate agreements
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Overnight index swaps
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Credit default swaps
Credit default swaps subject to mandatory clearing are standardized contracts that provide credit protection on an untranched basis. Markit CDX indices are the standard North American credit default swap family of indices. The primary corporate indices are CDX North American Investment Grade (CDX.NA.IG) and CDX North American High Yield (CDX.NA.HY). The three primary indices for European-based corporate entities are iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High Volatility. Indices based on other types of entities (including indices from other regions and indices based on sovereign issuers) would be viewed by the CFTC as a separate class, and swaps based on those indices would not have to be cleared in the absence of another clearing requirement determination.
If any swap on a CDS index is of such a tenor that it is scheduled to terminate before July 1, 2013, the swap is not subject to mandatory clearing. Also, if a swap is based on a covered index but is rejected for clearing by any DCO because it uses non-standard terms or is denominated in a currency ineligible for clearing, that swap is not subject to the clearing requirement. The clearing determination covers each new series of indices that is created every six months. If a new series raises issues such as a DCO’s ability to risk-manage the contracts, the CFTC can stay the clearing requirement for such a series.
The following tables show the specifications that a swap must meet in any one of the two covered classes in order to be subject to mandatory clearing. The classes and specifications are the same as those in the proposed clearing requirement determination published by the CFTC in August 2012. Not all tenors are subject to the clearing requirement. For example, although CDX.NA.IG is also offered in 1- or 2-year tenors, the CFTC is not mandating clearing for swaps based on indices with those shorter tenors because no DCO currently clears such swaps.
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If a swap is subject to mandatory clearing but does not fall under any recognized exemption, persons executing the swap must submit it to a DCO for clearing as soon as technologically practicable after execution, but in any event by the end of the day of execution. If a swap is entered on a non-business day or after 4:00 pm at the location of the party, it is deemed to be entered the following business day. All DCOs are required to list all swaps that they clear on their websites and must identify which of those swaps are subject to mandatory clearing. The CFTC will maintain lists of swaps that are required to be cleared and of DCOs that are eligible to clear them on its website.
Under CFTC Rule 50.25, which was finalized in July 2012, the CFTC may implement a phased compliance schedule for the mandatory clearing of swaps involving “Category 1 Entities” and “Category 2 Entities.” This rule defines Category 1 Entities as swap dealers, security-based swap dealers, major swap participants, major security-based swap participants and active funds. Category 2 Entities are commodity pools, private funds as defined in Section 202(a) of the Investment Advisers Act of 1940 other than active funds, and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956, as long as such persons are not third-party subaccounts.
The CFTC has adopted this phased approach to the compliance schedule for interest rate and credit default swaps. Swaps between two Category 1 Entities have a compliance date of March 11, 2013, while swaps between a Category 2 Entity and a Category 1 Entity or another Category 2 Entity have a compliance date of June 10, 2013. All other swaps for which neither counterparty is eligible to claim an exception from the clearing requirement have a compliance date of September 9, 2013. For the European Untranched CDS Indices Class, a different compliance schedule will be in effect if no DCO begins offering clearing for iTraxx by February 11, 2013. In the guidance accompanying the final rule, the CFTC clarified that any swap entered into before its compliance date is not required to be cleared.
Exemptions from clearing
In July 2012, the CFTC finalized the commercial enduser exemption from the mandatory swap clearing requirement. Under this exemption, clearing requirements do not apply to swaps if one of the counterparties is a nonfinancial entity that is using the swap to hedge or mitigate commercial risk and that notifies the CFTC of how it generally meets its financial obligations associated with non-cleared swaps.
The other exemption from clearing is the inter-affiliate exemption, which is expected to be available for swaps between majority-owned affiliates. Unlike the commercial end-user exemption, the inter-affiliate exemption has not yet been released in final form, although a proposed rule was published in August 2012. However, in connection with the release of the final clearing requirement determination for interest rate and credit default swaps, the CFTC issued a no-action letter on November 28, 2012, in which the CFTC stated that it would not recommend enforcement action for failure to clear a swap subject to mandatory clearing if the following conditions are met:
- Either one counterparty to the swap is a majority owner of the other counterparty, or a third party is a majority owner of both counterparties to the swap;
- Financial statements of both counterparties and the third party majority owner, if any, are reported for accounting purposes on a consolidated basis; and
- Both counterparties agree not to clear the swap.
This no-action relief expires on April 1, 2013 or any earlier effective date of a final rule pertaining to the inter-affiliate exemption. In the guidance accompanying the final clearing requirement determination, the CFTC indicated that it anticipates finalizing the inter-affiliate exemption before the first clearing compliance date in March 2013.