[Federal Register Volume 75, Number 200 (Monday, October 18, 2010)]
[Proposed Rules]
[Pages 63732-63753]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-26220]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 37, 38, 39, and 40
RIN 3038-AD01
Requirements for Derivatives Clearing Organizations, Designated
Contract Markets, and Swap Execution Facilities Regarding the
Mitigation of Conflicts of Interest
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Commodity Futures Trading Commission (the ``Commission'')
hereby proposes rules to implement new statutory provisions enacted by
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the ``Dodd-Frank Act''). Specifically, the proposed rules
contained herein impose new requirements on derivatives clearing
organizations (``DCOs''), designated contract markets (``DCMs''), and
swap execution facilities (``SEFs'') with respect to mitigation of
conflicts of interest.
DATES: Submit comments on or before November 17, 2010.
ADDRESSES: You may submit comments, identified by RIN number, by any of
the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Agency Web Site: http://www.cftc.gov. Follow the
instructions for submitting comments on the Web site.
E-mail: [email protected].
Fax: 202-418-5521.
Mail: David A. Stawick, Secretary of the Commission,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, NW., Washington, DC 20581.
Hand Delivery/Courier: Same as mail above.
FOR FURTHER INFORMATION CONTACT: Nancy Liao Schnabel, Special Counsel,
Division of Clearing and Intermediary Oversight (DCIO), at 202-418-5344
or [email protected]; Lois Gregory, Assistant Deputy Director for
Market Review, the Division of Market Oversight (DMO), at 202-418-5569
or [email protected]; Andrea Musalem, Special Counsel, DCIO, at 202-
418-5167 or [email protected]; Jordan O'Regan, Attorney-Advisor, DCIO,
at 202-418-5984 or [email protected]; Cody Alvarez, Attorney-Advisor,
DMO, at 202-418-5404 or [email protected]; Dana Brown, Law Clerk, DMO,
at 202-418-5093 or [email protected]; Jolanta Sterbenz, Counsel, Office
of the General Counsel, at 202-418-6639 or [email protected]; David
Reiffen, Senior Economist, Office of the Chief Economist, at 202-418-
5602 or [email protected]; or Alicia Lewis, Attorney-Advisor, DCIO, at
202-418-5862 or [email protected]; in each case, also at the Commodity
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,
NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
I. Background
On July 21, 2010, President Obama signed the Dodd-Frank Act.\1\
Title VII of the Dodd-Frank Act \2\ amended the Commodity Exchange Act
(``CEA'') \3\ to establish a comprehensive new regulatory framework for
swaps and certain security-based swaps. The legislation was enacted to
reduce risk, increase transparency, and promote market integrity within
the financial system by, among other things: (i) Providing for the
registration and comprehensive regulation of swap dealers and major
swap participants; \4\ (ii) imposing mandatory clearing and trade
execution requirements on clearable swap contracts; (iii) creating
robust recordkeeping and real-time reporting regimes; and (iv)
enhancing the rulemaking and enforcement authorities of the Commission
with respect to, among others, all registered entities and
intermediaries subject to the oversight of the Commission.
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\1\ See Dodd-Frank Act, Pub. L. 111-203, 124 Stat. 1376 (2010).
The text of the Dodd-Frank Act may be accessed at http://www.cftc.gov./LawRegulation/OTCDERIVATIVES/index.htm.
\2\ Pursuant to Section 701 of the Dodd-Frank Act, Title VII may
be cited as the ``Wall Street Transparency and Accountability Act of
2010.''
\3\ 7 U.S.C. 1 et seq.
\4\ In this release, the terms ``swap dealer'' and ``major swap
participant'' shall have the meanings set forth in Section 721(a) of
the Dodd-Frank Act, which added Sections 1a(49) and (33) of the CEA.
However, Section 721(c) of the Dodd-Frank Act directs the Commission
to promulgate rules to further define, among other terms, ``swap
dealer'' and ``major swap participant.'' The Commission is in the
process of this rulemaking. See, e.g., http://www.cftc.gov/LawRegulation/OTCDerivatives/OTC_2_Definitions.html. The
Commission anticipates that such rulemaking will be completed by the
statutory deadline of July 15, 2011.
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In order to ensure the proper implementation of the comprehensive
new regulatory framework, especially with respect to (ii) above, the
Dodd-Frank Act requires \5\ the Commission to promulgate rules to
mitigate conflicts of interest in the operation of certain DCOs, DCMs,
and SEFs. First, Section 726(a) of the Dodd-Frank Act specifically
empowers the Commission to adopt ``numerical limits * * * on control''
or ``voting rights'' that enumerated entities \6\ may hold with respect
to such DCOs, DCMs, and SEFs. Second, Section 726(b) of the Dodd-Frank
Act directs the Commission to determine the manner in which its rules
may be deemed necessary or
[[Page 63733]]
appropriate to improve the governance of certain DCOs, DCMs, or SEFs or
to mitigate systemic risk, promote competition, or mitigate conflicts
of interest in connection with the interaction between swap dealers and
major swap participants, on the one hand, and such DCOs, DCMs, and
SEFs. Finally, Section 726(c) of the Dodd-Frank Act directs the
Commission to consider the manner in which its rules address conflicts
of interest in the abovementioned interaction arising from equity
ownership, voting structure, or other governance arrangements of the
relevant DCOs, DCMs, and SEFs. The Commission must complete a
rulemaking under Section 726 of the Dodd-Frank Act within 180 days
after enactment--i.e., by January 14, 2011.\7\
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\5\ See the following colloquy between Representative Stephen
Lynch and Representative Barney Frank on the language that became
Section 726 of the Dodd-Frank Act:
Madam Speaker, for the purpose of a colloquy, I would like to
engage with the chairman of the committee and the drafter of this
legislation. I congratulate him on the great work he has done on
this reform bill.
Mr. Chairman, I want to call your attention to sections 726 and
765 of the bill. These two provisions require the CFTC and the SEC
to conduct rulemakings to eliminate the conflicts of interest
arising from the control of clearing and trading facilities by
entities such as swap dealers and major swap participants.
This problem arises because, right now, 95 percent of all of the
clearinghouses in this country are owned by just five banks. So,
while we are relying on the clearinghouses to reduce systemic risk,
we have the banks now owning the clearinghouses.
The question I have is regarding the intent of the conferees in
retaining subsection B of these provisions. It could be loosely
construed to leave it up to the agencies whether or not to adopt
rules.
Mr. Chairman, do you agree that my reading of sections 726 and
765 affirmatively require these agencies to adopt strong conflict of
interest rules on control and governance of clearing and trading
facilities?
Mr. FRANK of Massachusetts. If the gentleman would yield to me,
he has been a leader in this important area, and he is a careful
lawyer and understands that just saving a principle isn't enough.
You've got to make sure it is carried out. Dealing with a conflict
of interest that he has been a leader in identifying is essential if
this is going to work. So I completely agree with him. Yes, we mean
both of those subsections, and it is a mandatory rulemaking.
I will say to my neighbor from Massachusetts that we will be
monitoring this carefully. They can expect oversight hearings
because, yes, this is definitely a mandate to them to adopt rules to
deal with what would be a blatant conflict of interest in the
efficacy rules, and we intend to follow that closely.
156 Cong. Rec. H5217 (2010).
\6\ The ``enumerated entities'' include: (i) Bank holding
companies with over $50,000,000,000 in total consolidated assets;
(ii) a nonbank financial company supervised by the Board of
Governors of the Federal Reserve System; (iii) an affiliate of (i)
or (ii); (iv) a swap dealer; (v) a major swap participant; or (vi)
an associated person of (iv) or (v).
\7\ In adopting rules to implement Section 726 of the Dodd-Frank
Act, the Commission is also implementing Section 725(d) of the Dodd-
Frank Act. The latter states: ``[t]he Commodity Futures Trading
Commission shall adopt rules mitigating conflicts of interest in
connection with the conduct of business by a swap dealer or a major
swap participant with a derivatives clearing organization, board of
trade, or a swap execution facility that clears or trades swaps in
which the swap dealer or major swap participant has a material debt
or material equity investment.''
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In carrying out Section 726 of the Dodd-Frank Act,\8\ the
Commission identifies in Section II below the following potential
conflicts of interest:
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\8\ Although the Commission is proposing the rules contained
herein to specifically carry out Section 726 of the Dodd-Frank Act
(as well as Section 725(d) of the Dodd-Frank Act), the Commission
notes that it has additional authority to propose such rules under
Sections 735(b), 735(c), and 733 of the Dodd-Frank Act. See infra
note 17 for a more extensive description of Sections 735(b), 735(c),
and 733 of the Dodd-Frank Act.
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Conflicts of interest that a DCO may confront when
determining (i) whether a swap contract is capable of being cleared,
(ii) the minimum criteria that an entity must meet in order to become a
swap clearing member, and (iii) whether a particular entity satisfies
such criteria; \9\ and
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\9\ The Commission requests comment as to whether DCOs, like
DCMs and SEFs, have (or potentially may have) other conflicts of
interest that implicate the balance between advancement of
commercial interests and fulfillment of self-regulatory
responsibilities.
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Conflicts of interest that a DCM or SEF may confront in
balancing advancement of commercial interests and fulfillment of self-
regulatory responsibilities.
The Commission proposes in Section III below (i) structural governance
requirements and (ii) limits on the ownership of voting equity and the
exercise of voting power, and describes, in each case, the manner in
which such proposals may mitigate conflicts of interest in the
operation of a DCO, DCM, or SEF.\10\
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\10\ Commission regulations (the ``Regulations'') referred to
herein are found at 17 CFR Ch. 1.
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In general, the proposed rules include strengthened versions of the
acceptable practices that the Commission previously adopted for the DCM
core principle on conflicts of interest.\11\ The proposed rules impose
structural governance requirements and limits on the ownership of
voting equity and the exercise of voting power. They impose specific
composition requirements on DCO, DCM, or SEF Boards of Directors and
require each DCO, DCM, or SEF to have a nominating committee and one or
more disciplinary panels. Each DCO must have a risk management
committee and each DCM or SEF must have a regulatory oversight
committee and a membership or participation committee, subject to
specific composition requirements.
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\11\ See, generally, ``Conflicts of Interest in Self-Regulation
and Self-Regulatory Organizations,'' 74 FR 18982 (April 27, 2009)
(which defined ``public director''); 72 FR 6936 (Feb. 14, 2007)
(which adopted final acceptable practices for the DCM core
principle) (the ``DCM Conflicts of Interest Release''); 71 FR 38740
(July 7, 2006) (which proposed acceptable practices for the DCM core
principle).
Currently, DCM core principle 15 addresses conflicts of
interest. See 7 U.S.C. 7(d)(15). The Dodd-Frank Act has redesignated
DCM core principle 15 as DCM core principle 16, but has left the
actual language of the principle substantively unchanged.
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The proposed rules limit DCM or SEF members (and related persons)
from beneficially owning more than twenty (20) percent of any class of
voting equity in the registered entity or from directly or indirectly
voting an interest exceeding twenty (20) percent of the voting power of
any class of equity interest in the registered entity. With respect to
a DCO only, the proposed rules require a DCO to choose one of two
alternative limits on the ownership of voting equity or the exercise of
voting power. Under the first alternative, no individual member may
beneficially own more than twenty (20) percent of any class of voting
equity in the DCO or directly or indirectly vote an interest exceeding
twenty (20) percent of the voting power of any class of equity interest
in the DCO. In addition, the enumerated entities, whether or not they
are DCO members, may not collectively own on a beneficial basis more
than forty (40) percent of any class of voting equity in a DCO, or
directly or indirectly vote an interest exceeding forty (40) percent of
the voting power of any class of equity interest in the DCO.
Under the second alternative, no DCO member or enumerated entity,
regardless of whether it is a DCO member, may own more than five (5)
percent of any class of voting equity in the DCO or directly or
indirectly vote an interest exceeding five (5) percent of the voting
power of any class of equity interest in the DCO.
Notwithstanding the foregoing, the proposed rules recognize that
circumstances may exist where neither alternative would be appropriate
for a DCO. Consequently, the proposed rules provide a procedure for the
DCO to apply for, and the Commission to grant, a waiver of the limits
specified in the first and second alternative.
The proposed rules reflect consultation with staff of the following
agencies: (i) The Securities and Exchange Commission (the ``SEC'');
\12\ (ii) the Board of Governors of the Federal Reserve, (iii) the
Office of the Comptroller of the Currency; (iv) the Federal Deposit
Insurance Corporation; and (v) the Treasury Department. Staff from each
of these agencies has provided verbal and/or written comments, and the
proposed rules incorporate elements of the comments provided. The
proposed rules have been further informed by (i) the joint roundtable
that Commission and SEC staff conducted on August 20, 2010 (the
``Roundtable'') \13\ and (ii) public comments posted to the Web site of
the Commission.\14\ Finally, mindful of the importance of international
harmonization,\15\ the proposed rules incorporate certain elements of:
(i) The Proposal for a Regulation of the European Parliament and of the
Council on OTC Derivatives, Central Counterparties, and Trade
Depositories (the ``European Commission Proposal''); \16\ and (ii) the
latest draft of the Principles for Financial Market Infrastructures,
which would ultimately be reviewed by the Committee on Payment and
Settlement Systems of the Bank for International Settlements and the
Technical Committee of the
[[Page 63734]]
International Organization of Securities Commissions.
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\12\ Section 765 of the Dodd-Frank Act requires the SEC to
promulgate rules to mitigate conflicts of interest in the operation
of (i) a clearing agency that clears security-based swaps, (ii) a
security-based swap execution facility, or (iii) a national
securities exchange that posts or makes available for trading
security-based swaps.
\13\ The transcript from the roundtable (the ``Roundtable Tr.'')
is available at: http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/derivative9sub082010.pdf.
\14\ Such comments are available at: http://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_9_DCOGovernance.html.
\15\ Currently, the Commission regulates certain entities based
outside of the United States (e.g., LCH.Clearnet Limited and ICE
Clear Europe Limited (``ICE Clear Europe''), each of which is based
in the United Kingdom).
\16\ COM(2010) 484/5.
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The Commission anticipates conducting at least one other rulemaking
that may impose requirements on DCOs, DCMs, and SEFs with respect to
governance and mitigation of conflicts of interest.\17\ The Commission
expects to finish such rulemaking by the statutory deadline of July 15,
2011.
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\17\ Such rulemaking would implement Sections 735(b) and 725(c)
of the Dodd-Frank Act, which amends Sections 5(d) and 5b(c) of the
CEA to add new core principles, or to supplement existing core
principles, regarding the governance of DCMs and DCOs, and the
mitigation of conflicts of interest in the operation of such
entities. Such core principles would apply to all DCMs and DCOs,
regardless of whether they clear or list swap contracts or only
commodity futures or options. Such rulemaking would also implement
Section 733 of the Dodd-Frank Act, which inserts new Section 5h of
the CEA to create a registration category for SEFs, and to impose
core principles that include the mitigation of conflicts of
interest. The Commission is considering the proposals set forth
below, among others, with respect to the second rulemaking: (1)
Requiring each DCO, DCM, or SEF to have a regulatory program to (i)
identify, on an ongoing basis, existing and potential conflicts of
interest, and (ii) to make decisions in the event of such conflict;
(2) mandating that each DCO, DCM, or SEF (i) prescribe limits on use
of non-public information, and (ii) afford transparency with respect
to governance arrangements; (3) requiring each DCO, DCM, or SEF to
report to the Commission whenever (i) the Board of Directors rejects
a recommendation or supersedes an action of the DCM or SEF
Regulatory Oversight Committee, DCM or SEF Membership or
Participation Committee, or DCO Risk Management Committee, as
applicable, or (ii) the DCO Risk Management Committee rejects or
supersedes an action of the DCO Risk Management Subcommittee, if
applicable; (4) mandating minimum governance fitness standards for
DCO and DCM members and participants; and (5) prescribing minimum
standards regarding (i) DCM consideration of market participant
views and (ii) the diversity of DCM Board of Directors, if the DCM
is publicly-listed.
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The Commission requests comment on all aspects of this release.
II. Conflicts of Interest
As mentioned above, Title VII of the Dodd-Frank Act amended the CEA
to establish a comprehensive new framework for swaps and security-based
swaps. This framework imposes mandatory clearing and trade execution
requirements with respect to clearable swap contracts. Some market
participants, investor advocates, and academics have expressed a
concern that the enumerated entities have economic incentives to
minimize the number of swap contracts subject to mandatory clearing and
trading. They contend that control of a DCO by the enumerated entities,
whether through ownership or otherwise, constitutes the primary means
for keeping swap contracts out of the mandatory clearing requirement,
and therefore also out of the trading requirement. The Commission
addresses these arguments below. The Commission also examines the
contention that sustained competition between DCMs or SEFs with respect
to the same swap contracts may exacerbate certain structural conflicts
of interest, as the DCM Conflicts of Interest Release defines such
term.\18\
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\18\ According to the DCM Conflicts of Interest Release, ``[t]he
presence of potentially conflicting demands within a single entity--
regulatory authority coupled with commercial incentives to misuse
such authority--constitutes the new structural conflict of interest
addressed by the acceptable practices adopted herein.'' 72 FR at
6937.
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a. DCOs
In general, in the commodity futures and options markets, the DCM
decides which contracts to list, whereas the DCO manages the risk of
guaranteeing such contracts. Clearing members exercise significant
control over the manner in which a DCO manages risk, whether the
members own the DCO or not.\19\ Based on Commission experience, such
control has generally permitted the DCO to serve the purposes of the
CEA, especially with respect to ``ensur[ing] the financial integrity of
all transactions subject to [the CEA] and the avoidance of systemic
risk.'' \20\ Clearing members contribute substantial financial
resources to the DCO default or guarantee fund. If a clearing member
defaults, and the DCO holds insufficient performance bond from such
member to cover its losses, then the DCO would access the default or
guarantee fund. Thus, the DCO spreads its losses across all clearing
members. This mechanism creates an incentive for each clearing member
to ensure that (i) other clearing members meet certain financial
requirements and (ii) the DCO adopt a conservative approach towards
risk management, especially in determining whether a particular
contract would be acceptable for clearing.
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\19\ The CME Group, Inc. (the ``CME Group''), a publicly-listed
corporation, wholly owns the Chicago Mercantile Exchange, Inc.
(``CME''). However, CME Clearing House, a division of CME, has a
Risk Committee that is composed of: (i) Two members of the CME Board
of Directors; (ii) five clearing member representatives; and (iii)
two additional individuals, one of whom cannot be a clearing member
representative. See CME Rule 403.A, available at: http://www.cmegroup.com/rulebook/CME/I/4/03.html.
\20\ See Section 3(b) of the CEA, 7 U.S.C. 5(b).
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This same mechanism also creates a disincentive for clearing
members to act collectively (i) to exclude other entities from becoming
clearing members or (ii) to bar a DCO from accepting new commodity
futures or options contracts. After all, each new clearing member must
contribute to the default or guarantee fund. Such contribution would
result in a pro rata decrease in the potential exposure of each other
clearing member to a default. Moreover, clearing members generally had
little incentive to prevent the DCO from accepting a particular
contract, absent a risk-based objection. In fact, the more different
types of contracts that a DCO accepts, the more the intermediation
services that such clearing member offers would likely be in demand.
The regulated market structure that the Dodd-Frank Act contemplates
for swap contracts is, in many ways, the mirror image of the market
structure for commodity futures and option contracts. Currently, most
swap contracts are privately negotiated between two parties, and are
generally not cleared.\21\ Section 723 of the Dodd-Frank Act requires:
(i) Swap contracts meeting certain criteria to be cleared with a DCO;
and (ii) such contracts to be executed on a DCM or SEF (unless no DCM
or SEF lists such contracts). Therefore, a DCO has unprecedented
influence over the manner in which a swap contract can be executed.
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\21\ See, e.g., Darrel Duffie, Ada Li, Theo Lubke, ``Policy
Perspectives on OTC Derivatives Market Infrastructure,'' Federal
Reserve Bank of New York Staff Report No. 424, dated January 2010,
as revised March 2010 (the ``FRBNY Staff Report''). According to
Section II of the FRBNY Staff Report, ``[a]n over-the-counter trade
is privately negotiated between the buyer and seller.'' According to
Section VII(A)(i) of the FRBNY Staff Report, ``[o]nly some types of
OTC derivatives are now cleared. These include, for example, certain
actively traded credit derivatives, some common forms of interest-
rate swaps, and some energy derivatives. Of these `eligible' types
of OTC derivatives, those for which clearing has been set up, not
all positions are actually cleared; the decision of which positions
to clear has to this point been left to the discretion of market
participants.''
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Certain market participants and academics believe that Section 723
of the Dodd-Frank Act does not introduce any new incentives for
clearing members to act collectively (i) to exclude other entities from
becoming clearing members or (ii) to bar a DCO from accepting new
contracts. First, they argue that clearing does not make a bilateral
swap contract less profitable.\22\ Second, they contend that, because
clearing does not impact the profitability of a bilateral swap
contract, swap clearing members that are
[[Page 63735]]
enumerated entities have specific, risk-based justifications for (i)
setting membership criteria that exclude certain entities \23\ and (ii)
determining that certain swap contracts cannot be cleared.\24\ Third,
they assert that such swap clearing members must have the right to
cause the DCO to act on such justifications, since ultimately, the
capital of such clearing members (i.e., their contributions to the
default or guarantee fund) may be accessed if a fellow clearing member
defaults.\25\
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\22\ See, e.g., Comments from James Hill, Managing Director and
Global Credit Derivatives Officer, Morgan Stanley, representing the
Securities Industry and Financial Markets Association (``Hill'')
(``I think there's a bit of a misconception that somehow clearing
makes trades less profitable. That's clearly not the case. In fact,
I think most of the large systemically important participants in
this market prefer clearing. And I think that's not just a
statement; there is significant anecdotal evidence to support that
perhaps the most important of which is LCH''), Roundtable Tr. at 21-
22.
\23\ See, e.g., Comments from Hill (``as a general rule, the
clearing member needs to be able to absorb losses, a default by
another clearing member, number one; and, number two, they need to
be able to absorb the economic transaction risk in the portfolio of
a defaulting member * * * And so the way these clearinghouses set up
their risk, you know, their admission or their membership criteria,
is both of those things. So, A, they have to have a capital base
sufficient to absorb losses and add in more capital to the
clearinghouse if a member defaults. And B, they have to be able to
in a situation where a clearing member has defaulted, which is
probably the time of most economic stress, you know, in the economy,
be able to take down the economic transaction risk of the swaps that
were otherwise, the defaulting member was otherwise a party to,
those trades need to be allocated among the surviving clearing
members * * * And so the way these clearinghouses developed their
criteria is they look at both of those prongs and they set
thresholds to make sure that the members who are admitted can do
those things. Because, remember, if you admit a member who can't do
both of those things, then what happens is the clearinghouse will
have insufficient capital in a situation where a member has
defaulted, which is the time of the highest economic stress''),
Roundtable Tr. at 28 to 29.
\24\ See, e.g., Comments from Hill (``In evaluating what trades
should be cleared, there's a balance that needs to be struck between
the goal of increasing clearing, obviously, but, B, you don't want
to put trades in the clearinghouse that can't be appropriately risk-
managed. So if you put trades in the clearinghouse that are illiquid
and can't be valued properly, what will happen is when a clearing
member defaults, there will be insufficient collateral with respect
to that trade because it wasn't properly valued in the
clearinghouse, and the surviving clearing members will be stressed
from an economic perspective in taking positions the value of which
cannot be readily ascertained. So it's critical that only trades
that can be appropriately risk-managed be put into the
clearinghouse. And I think what you'll see is that most of the
clearinghouses look to their clearing members to help them valuate
which trades are appropriate from a clearing perspective, and that
is completely consistent with the economic incentives because the
clearing members are the ones who have the overwhelming
preponderance of the capital in the clearinghouse. So it's their
capital that's at risk. They should certainly have a say in helping
the clearinghouse evaluate which trades are acceptable for clearing
and which trades are too risky or can't be valued, or are too
illiquid or not standardized and, therefore, shouldn't be
cleared''), Roundtable Tr. at 43 to 45.
\25\ Id. See, also, e.g., Comments from Lee Olesky, Chief
Executive Officer and Co-Founder, TradeWeb (``Olesky'') (``And I
second Mr. Hill's comments. I think that it's very important that
the people who bear the risk and supply the capital should have a
substantial voice in how that risk gets managed, and that includes
what contracts are accepted for clearing''), Roundtable Tr. at 46.
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Others do not agree. They maintain that certain enumerated entities
are active in the over-the-counter swap markets \26\ and that they earn
significant revenues from this line of business.\27\ Such entities may
experience substantial decreases in revenues if swap contracts were
required to be (i) cleared with a DCO and (ii) executed on a DCM or
SEF.\28\ Therefore, some contend that such entities may have an
incentive to represent that certain swap contracts do not meet the
mandatory clearing criteria under Section 723 of the Dodd-Frank
Act.\29\ Such swap contracts would also not be subject to the trading
requirement under Section 723 of the Dodd-Frank Act.
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\26\ For example, according to the Office of the Comptroller of
the Currency (``OCC''), as of the second quarter of 2009, U.S.
commercial banks held derivatives with $203.5 trillion in notional
value. Of that $203.5 trillion, the top five commercial banks held
approximately $197 trillion. The top five commercial banks were: (i)
JPMorgan Chase Bank N.A.; (ii) Goldman Sachs Bank USA; (iii) Bank of
America N.A.; (iv) Citibank N.A.; and (v) Wells Fargo Bank N.A. The
sixth commercial bank, holding approximately $3 trillion, was HSBC
Bank USA N.A. See OCC's Quarterly Report on Bank Trading and
Derivatives Activities, Second Quarter 2009.
\27\ Id. (stating that ``U.S. commercial banks reported revenues
of $5.2 billion trading cash and derivative instruments in the
second quarter of 2009, compared to a record $9.8 billion in the
first quarter'').
\28\ According to Section VI of the FRBNY Staff Report, ``[e]ven
after an OTC derivatives product has achieved relatively active
trading, and would be suitable for exchange trading, dealers have an
incentive to maintain the wider bid-ask spreads that they can obtain
in the OTC market relative to the spreads that might apply to the
same product on an exchange, where buyers and sellers can more
directly compete for the same trade. Further, exchanges are more
likely to match ultimate buyers to sellers, reducing the fraction of
trades intermediated by dealers. Thus, from the viewpoint of their
profits, dealers may prefer to reduce the migration of derivatives
trading from the OTC market to central exchanges.''
\29\ See, e.g., Comments of Heather Slavkin, Senior Legal and
Policy Advisor, Office of Investment, AFL-CIO (``Slavkin'') (``If
there's an interest among the people who own the clearinghouse, or a
conflict of interest that would create incentives for them to also
favor, you know, [not] allowing certain types of swaps to clear
because they may be more profitable for the institution generally if
they remain over the counter, then that can create perverse
incentives to maintain the OTC, nontransparent, systemically risky
markets when the goal needs to be to prevent those conflicts of
interest to ensure that anything that can be cleared does, in fact,
clear''), Roundtable Tr. at 21; Comments of Darrell Duffie, Dean
Witter Distinguished Professor of Finance at the Graduate School of
Business, Stanford University (``Duffie'') (``We talked earlier
about how the members of the clearinghouse should determine what
gets traded, and we also have conflicts of interest arising from the
incentives of the dealers to profit from bid versus ask on products
that are not traded on swap execution facilities. So the interaction
effect here is effectively if one gets cleared as one gets traded on
a swap execution facility, then we want to be very careful that the
members of a central clearing counterparty that determine what gets
cleared and, therefore, have control over what gets traded on swap
execution facilities are the members that have, you know, the right
social incentives to create competition''); Comments of Michael
Greenberger, Professor, University of Maryland School of Law
(``Greenberger'') (``If you have one clearinghouse dominated by the
major swaps dealers, they have several conflicting incentives. One
is, I reject the idea that somehow they do not want to keep a large
and vibrant over-the-counter market. We're told that clearing is
very profitable. If it was that profitable, where were these people
when we were aggressively arguing for mandatory clearing and
exchange trading? They were on the opposite side of that. The
transaction fees and the spreads still make an unregulated market
very, very profitable, probably more profitable than the profits
that would derive from clearing. So, if you have the swaps dealers
in control of a clearing facility, they have that incentive''),
Roundtable Tr. at 111.
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Although Section 723 of the Dodd-Frank Act grants the Commission
ultimate authority to determine whether a swap contract must be cleared
with a DCO, it also anticipates that the Commission would consider the
risk assessment of DCOs. Currently, DCOs that clear large volumes of
swap contracts tend to have swap clearing members that consist
exclusively of enumerated entities.\30\ Therefore, some argue that the
risk assessment of such DCOs may be compromised.\31\
[[Page 63736]]
Moreover, some contend that the swap clearing members of such DCOs may
exclude non-enumerated entities from becoming clearing members, because
non-enumerated entities may influence risk assessments of DCOs in favor
of clearing more swap contracts.\32\ Some market participants maintain
that such practices may have systemic implications.\33\
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\30\ For example, as of July 2, 2010, ICE Clear Europe cleared
approximately $3.3 trillion in European credit default swap
(``CDS'') indices and an additional $501 billion in European CDS
single-name instruments. See ``ICE Surpasses $10 Trillion Milestone
in Global CDS Clearing,'' available at:
http:[sol][sol]ir.theice.com/releasedetail.cfm?ReleaseID=485527.
As of September 20, 2010, all CDS clearing members of ICE Clear
Europe are banks, bank holding companies, or affiliates thereof.
Such members are: (i) Banc of America N.A.; (ii) Barclays Bank PLC;
(iii) BNP Paribas; (iv) Citigroup Global Markets Limited; (v) Credit
Suisse International; (vi) Deutsche Bank AG; (vii) Goldman Sachs
International; (viii) HSBC Bank PLC; (ix) JPMorgan Chase Bank, N.A.;
(x) Morgan Stanley Capital Services, Inc.; (xi) Nomura International
PLC; (xii) Soci[eacute]t[eacute] G[eacute]n[eacute]rale; (xiii) The
Royal Bank of Scotland PLC; (xiv) UBS AG, London Branch; and (xv)
UniCredit Bank AG. See ICE Clear Europe, Clearing Members, available
at: https:[sol][sol]www.theice.com/publicdocs/clear_europe/ICE_
Clear_Europe_Clearing_Member_List.pdf, and the release updating
such list, available at https:[sol][sol]www.theice.com/publicdocs/
clear_europe/circulars/C10080.pdf.
ICE Trust U.S. LLC (``ICE Trust''), an affiliate of ICE Clear
Europe, cleared approximately $6 billion in North American CDS
indices and $272 billion in North American single-name indices. The
CDS clearing members of ICE Clear Europe and ICE Trust generally
overlap (counting affiliated entities), except that Merrill Lynch
International is a clearing member of ICE Trust and
Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UniCredit Bank AG
are not. See ICE Trust, Participant List, available at:
https:[sol][sol]www.theice.com/publicdocs/ice_trust/ICE_Trust_
Participant_List.pdf. ICE Trust is currently not a DCO.
\31\ See note 29 above. See, also, Comments from Slavkin (``I
think that there's the risk that anything that could be made to
appear to be something that is a bilateral * * * contract, you could
have the spurious customization issues, if there's the opportunity
to get additional profits within the big dealer banks, and those
same dealer banks are running and controlling the clearinghouses,
then, you know, the potential for spurious customization becomes a
real issue and becomes a possibility''), Roundtable Tr. at 40.
In addition to noting that the enumerated entities may have
incentives to influence DCO risk assessments in favor of considering
fewer contracts to be suitable for mandatory clearing, certain
academics have observed that, for those contracts that nonetheless
are cleared, the enumerated entities may have incentives to lower
risk management standards. See, e.g., Comments from Greenberger (``*
* * yes, certain products will be cleared because they are
profitable and [the enumerated entities] may over calculate and be
over enthused about clearing things that are too risky''),
Roundtable Tr. at 112. For example, the enumerated entities may not
accurately calculate the amount of performance bond and/or guarantee
or default fund contributions necessary to clear a particular swap
contract.
\32\ See, e.g., Comments from Jason Kastner, Vice Chairman,
Swaps and Derivatives Markets (``Kastner'') (``Let me give you a
specific example. One of the members of this SDMA currently clears
13 percent of the business at a large exchange in Chicago. That
large, independent FCM is clearly qualified to become a swap
clearing member. But because of various conflicts of interest, the
risk committee of said exchange is precluding that firm, which is
clearly qualified and has the capital, from becoming a swap clearing
member * * * this goes back to the governance point and transparency
about who's making that decision and why, because a lot of times
what happens is people will swallow themselves in the cloak of risk
management or financial stability or whatever really to make an
anti-competitive stand. In other words, you can never say that you
don't want to let somebody in. But you could probably find an excuse
or a reason in the interest of systematic--you know, systemic
stability and the rest of it to put an asterisk on the application
or just delay it for awhile''), Roundtable Tr. at 90-91.
See, also, infra note 67 on the potential non-availability of
arrangements whereby a non-clearing futures commission merchant may
present a customer trade to a swap clearing member for clearing with
a DCO.
\33\ In Lessening Systemic Risk: Removing Final Hurdles to
Clearing OTC Derivatives, the Swaps and Derivatives Market
Association states: ``[r]estricted access leads to reduced clearing
which leads to systemic risk.''
---------------------------------------------------------------------------
The framers of the Dodd-Frank Act observe that the clearing of swap
contracts constitutes a key means for managing systemic risk, because
clearing removes the type of interconnectedness between financial
institutions that contributed to the financial crisis resulting from
the failure and bankruptcy of firms such as Bear Stearns, Lehman
Brothers, and AIG.\34\ Therefore, it is important to mitigate potential
conflicts of interest that may prevent clearable swap contracts from
becoming subject to mandatory clearing. At the same time, the
Commission recognizes that the safety and soundness of a DCO should not
be compromised. A DCO must not only have the ability to appropriately
manage the risk associated with each and every contract that it
guarantees, it must be able to decline accepting contracts for clearing
if they pose unacceptable risks. In addition, DCO members must have
input in setting membership criteria, because they bear the risk of
loss in the event of member default. Nevertheless, the Commission does
not believe that (i) subjecting more swap contracts to mandatory
clearing is incompatible with (ii) DCO safety and soundness.\35\
Rather, the Commission intends to ensure, through the proposed rules
below, that a DCO takes action to achieve both (i) and (ii), and that
the private, competitive interests of certain DCO members do not
capture DCO risk assessments.
---------------------------------------------------------------------------
\34\ See, e.g., the letter from Senators Christopher Dodd and
Blanche Lincoln, respective chairs of the Senate Banking and
Agriculture Committee, to Representatives Barney Frank and Collin
Peterson, respective chairs of the House Financial Services and
Agriculture Committees, dated June 30, 2010 (stating that ``Congress
determined that clearing is at the heart of reform--bringing
transactions and counterparties into a robust, conservative and
transparent risk management framework'').
\35\ Certain Roundtable participants agree. See Comments from
Duffie (``I don't think there's a conflict between the incentives
for competition, increasing competition in this market on the one
hand and the incentives for improving financial stability on the
other, or I don't think there's a problem between those two. You can
* * * have both. The incentives to watch for on competition are that
we've got enough access by multiple market * * * participants, and
that the oligopolistic nature of the market is, to some extent,
watched carefully by regulators''), Roundtable Tr. at 104.
---------------------------------------------------------------------------
b. DCMs and SEFs
The main function of a DCM, as well as a SEF, is to provide a
facility for: (i) The discovery of prices; and (ii) the execution of
transactions. However, in order to obtain and maintain a license to
perform such a function, each DCM and SEF must fulfill self-regulatory
obligations under the CEA and the Dodd-Frank Act.\36\ Therefore,
although each DCM or SEF \37\ is a commercial enterprise, the fact that
each entity has self-regulatory obligations means that each entity ``is
not simply a corporation, but a corporation charged with the public
trust.'' \38\ Section 3(b) of the CEA confers on the Commission the
responsibility for ensuring that each DCM or SEF appropriately
prioritizes its self-regulatory obligations. Such obligations include
appropriately implementing the comprehensive new framework that the
Dodd-Frank Act sets forth, as well as meeting existing requirements
under the CEA.
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\36\ Section 3(a) of the CEA defines the ``national public
interest'' that transactions in commodity futures and options and
swaps serve. It states, ``[t]he transactions subject to this Act are
entered into regularly in interstate and international commerce and
are affected with a national public interest by providing a means
for managing and assuming price risks, discovering prices, or
disseminating pricing information through trading in liquid, fair
and financially secure trading facilities.'' 7 U.S.C. 5(a). The
importance of transactions in commodity futures and options, as well
as swaps, forms the basis for Commission regulation of DCMs and
SEFs.
Section 3(b) of the CEA describes the system of regulation that
Congress has directed the Commission to implement to achieve the
abovementioned purposes. It states: ``[i]t is the purpose of this
chapter to serve the public interests * * * through a system of
effective self-regulation of trading facilities, clearing systems,
market participants and market professionals under the oversight of
the Commission.'' 7 U.S.C. 5(a). The Commission has interpreted the
``self-regulation'' referenced in Section 3(b) of the CEA as
encompassing both (i) the registered entity ensuring that members
meet applicable statutory requirements, and (ii) the registered
entity having systems to ensure that it continues to meet applicable
statutory requirements. For example, as the Commission previously
stated in the DCM Conflicts of Interest Release, ``Core Principle 15
requires DCMs to maintain systems to minimize structural conflicts
of interest inherent in self-regulation, as well as individual
conflicts of interest faced by particular persons. The acceptable
practices are rationally related to the purposes of Core Principle
15.'' 72 FR at 6937, 6940.
\37\ As mentioned above, the SEF is a new registration category
that the Dodd-Frank Act created. Therefore, the Commission has never
opined as to whether a SEF is a ``self-regulatory organization''
within the meaning of Regulation 1.3(ee). However, a SEF has self-
regulatory obligations under the Dodd-Frank Act, as the Commission
has interpreted such obligations in the DCM Conflicts of Interest
Release. For example, to the extent that a SEF determines that it
must impose requirements on members in order to comport with a core
principle (e.g., with respect to position limits), a SEF must
monitor member compliance with such requirement, and must have the
authority and ability to enforce such requirement. See Section
5h(f)(2)(A) of the CEA, as added by Section 733 of the Dodd-Frank
Act.
\38\ Preamble to proposed acceptable practices on ``Conflicts of
Interest in Self-Regulation and Self-Regulatory Organizations,'' 71
FR 38740, 38741 (July 7, 2006).
---------------------------------------------------------------------------
As the DCM Conflicts of Interest Release notes, increased
competition may exacerbate conflicts of interest, causing a DCM to (i)
prioritize commercial interests over self-regulatory responsibilities;
\39\ and (ii) restrict access or impose burdens on access in a
discriminatory manner.\40\
[[Page 63737]]
The Dodd-Frank Act attempts to create conditions favorable to sustained
competition between DCMs and SEFs with respect to the same swap
contract. For example, the Dodd-Frank Act contemplates that either a
DCM or a SEF may list swap contracts.\41\ It also contemplates that
multiple DCMs or SEFs may list the same swap contract, and that such
swap contracts may be offset at the same DCO.\42\ Also, in requiring
certain swap contracts to be listed on a DCM or SEF,\43\ the Dodd-Frank
Act may encourage competition between standardized swap contracts and
commodity futures and options.\44\
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\39\ See, generally, the DCM Conflicts of Interest Release.
\40\ See, infra note 67 for a specific example of DCM or SEF
restrictions or burdens on access. Also, clauses (i) and (ii) are
not mutually exclusive. As the DCM Conflicts of Interest Release
notes, ``[s]elf-regulation's traditional conflict--that members will
fail to police their peers with sufficient zeal--has been joined by
the possibility that competing DCMs could abuse their regulatory
authority to gain competitive advantage or to satisfy commercial
imperatives.'' 72 FR at 6938. In its Concept Release Concerning
Self-Regulation, the SEC identified one method that national
securities exchanges have used to gain a competitive advantage:
``abus[ing] SRO status by overregulating members that operate
markets that compete with the SROs.'' Release No. 34-50700 (Nov. 18,
2004), 69 FR 71256 (Dec. 8, 2004).
Also, similar to the incentives that the enumerated entities may
have with respect to the mandatory clearing requirement, if the
enumerated entities control a DCM or SEF, they may cause such DCM or
SEF to not list a swap contract for trading, if it would be more
profitable to keep such contract bilaterally negotiated. However,
the Commission notes that nothing would prevent another DCM or SEF
from listing such contract, and that Section 723 of the Dodd-Frank
Act would require that a DCO clearing such contract provide non-
discriminatory access to such DCM or SEF.
\41\ See Section 2(h)(8) of the CEA, as added by Section 723 of
the Dodd-Frank Act.
\42\ See Section 2(h)(1)(B) of the CEA, as added by Section 733
of the Dodd-Frank Act. Whereas DCMs have competed in the past, and
are currently competing, to list commodity futures and options
contracts with the same economic terms and conditions, such
contracts have not been, and currently are not, fungible. In other
words, such contracts cannot be offset in the same DCO.
\43\ See Section 2(h)(8) of the CEA, as added by Section 723 of
the Dodd-Frank Act.
\44\ For example, two DCMs (i.e., the NASDAQ OMX Futures
Exchange and CME), as well as one exempt board of trade (i.e., Eris
Exchange), offer interest rate futures products. Currently, interest
rate swap contracts constitute a large percentage of the bilateral
swaps market. See, e.g., OCC's Quarterly Report on Bank Trading and
Derivatives Activities, First Quarter 2010, Executive Summary,
available at: http:[sol][sol]www.occ.treas.gov/ftp/release/2010-
71a.pdf. (stating that ``[d]erivative contracts remain concentrated
in interest rate products, which comprise 84% of total derivative
notional values'').
---------------------------------------------------------------------------
Such sustained competition, if it occurs,\45\ would constitute an
increase to the competition that most DCMs currently face with respect
to commodity futures and options. As described below, the Commission
intends to ensure through the proposed rules that each DCM or SEF
implements appropriate systems to manage such conflicts.
---------------------------------------------------------------------------
\45\ As discussed above, whether such competition occurs depends
in part on the manner in which Section 723 of the Dodd-Frank Act is
implemented.
---------------------------------------------------------------------------
c. Questions on Conflicts of Interest
The Commission seeks comment on the questions set forth below on
potential conflicts of interest.
Has the release correctly identified the conflicts of
interest that a DCO, DCM, or SEF may confront?
Has the release accurately specified the possible effects
of such conflicts of interest on DCO, DCM, or SEF operations? What are
other possible effects?
What other conflicts of interest may exist? What are the
effects of such conflicts?
III. Mitigation of Conflicts of Interest
To mitigate, on a prophylactic basis, the conflicts of interest
identified above, the Commission sets forth below proposed (i)
structural governance requirements and (ii) limits on the ownership of
voting equity and the exercise of voting power. As explained in greater
detail below, the Commission views (ii) as a method of enhancing (i),
in that (ii) limits the influence that certain shareholders may exert
over the DCO, DCM, or SEF Board of Directors. The Commission believes
that such influence may affect, among other things, the independent
perspective of public directors. The Commission does not believe that
stricter structural governance requirements (e.g., a higher percentage
of public directors) justify more lenient limits on the ownership of
voting equity and the exercise of voting power, or vice versa. However,
the Commission requests comment on the proper relationship between such
requirements and limits. The Commission also requests comment on
whether both (i) structural governance requirements and (ii) limits on
the ownership of voting equity and the exercise of voting power are
necessary or appropriate to mitigate the conflicts of interest
described in Section II, or whether one or the other (or neither) would
be effective.
In applying such requirements and limits, the Commission does not
propose to distinguish between DCMs and SEFs listing swap contracts. As
mentioned above, such DCMs and SEFs may experience sustained
competition with respect to the same swap contract, and therefore would
face the same pressures on self-regulation. Additionally, the
Commission does not propose to distinguish between (i) DCMs listing
swap contracts and (ii) DCMs listing only commodity futures and
options. As mentioned above, clearable swap contracts may share
sufficiently similar characteristics with certain commodity futures and
options as to compete with respect to execution. Therefore, a DCM
listing only commodity futures and options may face competition from a
SEF with fewer self-regulatory requirements, in the same manner as a
DCM listing swap contracts. Given that the same conflicts of interest
\46\ may concern both types of DCM, it would appear that the same (i)
structural governance requirements and (ii) limits on the ownership of
voting equity and the exercise of voting power should apply.
---------------------------------------------------------------------------
\46\ Namely, (i) prioritizing commercial interests over self-
regulatory responsibilities and (ii) restricting access or imposing
burdens on access in a discriminatory manner, in each case, because
of increased competition.
---------------------------------------------------------------------------
In addition, the Commission does not propose to distinguish between
(i) DCOs clearing swap contracts and (ii) DCOs clearing only commodity
futures and options. Certain standardized swap contracts have
sufficiently similar risk profiles to commodity futures and options
that the Commission has, on occasion, permitted such products to be
commingled and margined within the segregated customer account under
Section 4d of the CEA.\47\ If the Commission applied differential (i)
structural governance requirements and (ii) limits on the ownership of
voting equity and the exercise of voting power, the Commission risks
creating an incentive for regulatory arbitrage between the two types of
DCO.
---------------------------------------------------------------------------
\47\ 7 U.S.C. 6d.
---------------------------------------------------------------------------
The Commission requests comment on holding the two types of (i)
DCMs and (ii) DCOs to the same requirements regarding the mitigation of
conflicts of interest. The Commission also requests comment on holding
DCMs and SEFs listing swap contracts to the same requirements. The
Commission is specifically interested in the costs and benefits of its
approach.
a. Structural Governance Requirements
i. Independence
In general, the structural governance requirements mitigate
conflicts of interest at a DCO, DCM, or SEF by introducing a
perspective independent of competitive, commercial, or industry
considerations to the deliberations of governing bodies (i.e., the
Board of Directors and committees). Such independent perspective would
more likely encompass regulatory considerations, and to accord such
considerations proper weight. Such independent perspective also would
more likely contemplate the manner in which a decision might affect all
constituencies, as opposed to concentrating on the manner in which a
decision affects the interests of one constituency.\48\
---------------------------------------------------------------------------
\48\ See, e.g., the DCM Conflicts of Interest Release (stating
that ``the public interest will be furthered if the boards and
executive committees of all DCMs are at least 35% public. Such
boards and committees will gain an independent perspective that is
best provided by directors with no current industry ties or other
relationships which may pose a conflict of interest. These public
directors, representing over one-third of their boards, will
approach their responsibilities without the conflicting demands
faced by industry insiders. They will be free to consider both the
needs of the DCM and of its regulatory mission, and may best
appreciate the manner in which vigorous, impartial, and effective
self-regulation will serve the interests of the DCM and the public
at large. Furthermore, boards of directors that are at least 35%
public will help to promote widespread confidence in the integrity
of U.S. futures markets and self-regulation''). 72 FR 6946.
---------------------------------------------------------------------------
[[Page 63738]]
In the DCM Conflicts of Interest Release, the Commission emphasized
the importance of independent decision-makers in protecting DCM self-
regulatory functions from DCM commercial interests and that of its
constituencies. However, the Commission notes that participants in the
Roundtable raised the possibility that conflicts of interest may also
be mitigated by providing for fair representation of all constituencies
in the governance of a DCO, DCM, or SEF.\49\ Theoretically, all
constituencies would act in their own commercial, competitive, or
industry interests, but no one interest would dominate. The Commission
specifically requests comment regarding whether fair representation
would be preferable to, or would complement, director independence in
mitigating the DCO, DCM, and SEF conflicts of interest described in
Section II. The Commission would particularly welcome factual examples.
The Commission also requests comment on how the proposed structural
governance requirements should change if the Commission adopts a fair
representation standard as either an alternative to, or a complement
of, rules emphasizing an independent perspective.
---------------------------------------------------------------------------
\49\ See, e.g., Comment from Hal Scott, Nomura Professor of
International Financial Systems and Director of Program on
International Financial Systems, Harvard Law School (``Scott'')
(``When I spoke, I was saying I opposed ownership restrictions, I
was not talking about voting restrictions which I think is a
different issue, and the way I would put it is not a voting
restriction. I would turn it around to a duty of fair
representation, which the SEC is quite familiar with, and is applied
to their regulated entities which ensures that the users, more
broadly defined of the exchange. And maybe if you translated this
into the clearinghouse, the users, but not necessarily the members
of the clearinghouse, would have representation in terms of
governance * * * Independent directors, to me, are most needed with
public companies as under SOX when there was a broad duty to
shareholders. But I think what's needed in this context is more the
expert, and we heard before that it's very important that people
that know what they're doing have input into those, and clearly
major users of these clearinghouses, that is customers who clear
through a member. Major hedge funds, for instance, have a lot of
expertise, okay, in these areas, they're big traders * * *''),
Roundtable Tr. at 130-131; Richard Prager, Managing Director, Global
Head of Fixed Income Trading, Blackrock (``as the [sole] fiduciary
on this panel * * * we would be in support of a very inclusive
participation and governance with teeth''), Roundtable Tr. at 131-
132; Lynn Martin, Chief Operating Officer, NYSE Liffe U.S. (``You
may be aware that NYSE Euronext's U.S. Future Exchange--NYSE Life
U.S., is a semi-neutralized structure whereby we balance the views
of both the independence criteria as required by core principle 15
in the CFTC-DCM requirements, as well as the views of NYSE Euronext
and our external investor firms' views, such that no one board
action may be enacted based on the views of any one of those
constituents * * * So, it's our belief that a more balanced board
structure, a more balanced governance structure, is the proper way
to handle or potentially mitigate conflicts of interest''),
Roundtable Tr. at 121.
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ii. Board Requirements
1. Composition
As the DCM Conflicts of Interest Release states, ``the governing
board * * * is [the] ultimate decision maker and therefore the logical
place to begin to address conflicts.'' \50\ The Commission proposes (i)
maintaining the requirement that DCM Boards of Directors be composed of
at least 35 percent ``public directors'' \51\ and (ii) extending this
requirement to SEF and DCO Boards of Directors. In the DCM Conflicts of
Interest Release, the Commission stated that the 35 percent requirement
struck an appropriate balance between (i) the need to minimize
conflicts of interest in DCM decision-making processes with (ii) the
need for expertise and efficiency in such processes. Such rationale
would appear to apply to SEF and DCO Boards of Directors as well.\52\
---------------------------------------------------------------------------
\50\ 72 FR at 6940.
\51\ See Section III(a)(iv) of this release for more detail
regarding the definition of ``public director.''
The Commission notes that such percentage harmonizes with
Article 25(2) of the European Commission Proposal, which requires a
central counterparty (``CCP'') to have ``a board of which at least
one third, but no less than two, of its members are independent.''
\52\ 72 FR at 6946.
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In addition to the 35 percent composition requirement, the
Commission proposes specifying that DCO, DCM, and SEF Boards of
Directors may not have less than two public directors. Such a
requirement is also contained in the European Commission Proposal.\53\
As the Commission has observed that most DCO and DCM Boards of
Directors contain more than three members, the Commission does not
believe that such a requirement imposes additional burden. However, the
Commission welcomes comment on this proposal.
---------------------------------------------------------------------------
\53\ See Article 25(2) of the European Commission Proposal.
---------------------------------------------------------------------------
In order to prevent evasion of the abovementioned composition
requirements through corporate structuring or internal reorganization,
the Commission proposes extending the composition requirements to any
committee of the Board of Directors that may exercise delegated
authority with respect to the management of a DCO, DCM, or SEF.
Further, the Commission proposes prohibiting a DCO, DCM, or SEF from
permitting itself to be operated \54\ by another entity, unless such
entity agrees to comport with such requirements in the same manner as
the DCO, DCM, or SEF.
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\54\ The proposed rule defines ``operate'' as ``the direct
exercise of control (including through the exercise of veto power)
over the day-to-day business operations of'' a DCO, DCM, or SEF ``by
the sole or majority shareholder of such registered entity, either
through the ownership of voting equity, by contract, or otherwise.
The term `operate' shall not prohibit an entity, acting as the sole
or majority shareholder of such registered entity, from exercising
its rights as a shareholder under any contract, agreement, or other
legal obligation.''
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The Commission would like to clarify that it does not intend to
extend the abovementioned composition requirements to an entity that
does not exert active and recurrent control over the operations of a
DCO, DCM, or SEF. Consequently, the Commission proposes to deem an
entity to ``operate'' a DCO, DCM, or SEF only if it engages in ``the
direct exercise of control (including through the exercise of veto
power) over the day-to-day business operations'' of the registered
entity.
In addition to the abovementioned composition requirements, the
Commission proposes prohibiting a DCO, DCM, or SEF from permitting
itself to be operated by an entity unless such entity agrees to subject
(i) its officers, directors, employees, and agents to Commission
authority, and (ii) its books and records to Commission inspection and
copying. The Commission believes that such proposals are necessary to
ensure effective audits of DCO, DCM, or SEF operations, given the
corporate structure of the DCO, DCM, or SEF.
2. Questions on Composition
The Commission seeks comment on the questions set forth below on
DCO, DCM, and SEF Boards of Directors composition requirements:
Would such composition requirements be equally valid in
mitigating conflicts of interest concerning a privately-held DCO, DCM,
and SEF, as opposed to a publicly-held DCO, DCM, and SEF?
As mentioned above, would providing for fair
representation on DCO, DCM, or SEF Boards of Directors be preferable
to, or complementary to, mandating specific percentages of
[[Page 63739]]
public directors? Also, if the main purpose of the 35 percent
composition requirement is to introduce an independent perspective into
DCO, DCM, and SEF governance, would requiring one or two public
directors be sufficient, regardless of the size of the DCO, DCM, or SEF
Board of Directors?
As mentioned above, the Commission is seeking to mitigate
potential conflicts of interest that may influence a DCO regarding (i)
whether a swap contract is capable of being cleared, (ii) the minimum
criteria that an entity must meet in order to become a swap clearing
member, and (iii) whether a particular entity satisfies such criteria.
Because the DCO Board of Directors would make ultimate decisions
implicating (i), (ii), and (iii), is the 35 percent composition
requirement sufficient to ensure that the private, competitive
interests of certain DCO members do not capture DCO risk assessments
with respect to both products and membership? Or should the Commission
increase the required percentage of public directors to 51 percent? Or
is there a number less than 51 percent but greater than 35 percent that
would be more appropriate?
As described above, the Dodd-Frank Act envisions (i) a DCM
competing with a SEF to list the same swap contract, and (ii) a DCM
listing a commodity futures or options contract that competes with a
swap contract listed on a SEF. In both cases, a DCM would be competing
against an entity with lesser self-regulatory obligations. Such
competition may place increased stress on the manner in which the DCM
aims to satisfy its self-regulatory responsibilities. In light of such
stress, is the 35 percent composition requirement still sufficient to
protect the DCM self-regulatory function?
As referenced above, the Dodd-Frank Act anticipates that a
SEF would face a more competitive environment at inception than a DCM
currently listing commodity futures and options. As the DCM Conflicts
of Interest Release notes, increased competition may be detrimental to
self-regulation. Therefore, is the 35 percent composition requirement
appropriate to ensure that a SEF discharges its self-regulatory
functions in the first instance?
3. Substantive Requirements
In addition to the abovementioned composition requirements, the
Commission proposes the substantive requirements set forth below, which
aim to enhance the accountability of the DCO, DCM, or SEF Board of
Directors to the Commission regarding the manner in which such Board of
Directors causes the DCO, DCM, or SEF to discharge all statutory,
regulatory, or self-regulatory responsibilities under the Dodd-Frank
Act and the existing CEA.
The roles and responsibilities of a DCO, DCM, or SEF Board
of Directors must be clearly articulated, especially in respect of the
manner in which such Board of Directors ensures that the DCO, DCM, or
SEF complies with all statutory, regulatory, and self-regulatory
responsibilities under the Dodd-Frank Act and the existing CEA.
A DCO, DCM, or SEF Board of Directors shall review its
performance and that of its individual members annually. It should
consider periodically using external faciliators for such reviews.
A DCO, DCM, or SEF must have procedures to remove a member
from the Board of Directors, where the conduct of such member is likely
to be prejudicial to the sound and prudent management of the DCO, DCM,
or SEF.
Because of the highly specialized nature of DCO, DCM, or SEF
operation, the Commission proposes requiring that each member of a DCO,
DCM, or SEF Board of Directors have sufficient expertise, where
applicable, in financial services, risk management, and clearing
services. Roundtable participants generally agreed that a DCO, DCM, or
SEF Board of Directors must have sufficient expertise.\55\
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\55\ See, e.g., Comments from Slavkin (``I think having real
experts on the boards of directors is a very important issue. We all
saw situations in the last several years where there were boards
that were two-thirds independent and made really stupid decisions
about risk management. So, we need to make sure that there are
people on those boards of directors that really understand the risks
that exist within a clearinghouse and are prepared to perceive
potential risks that may arise in the system down the road and
address them. So they also need to have the personalities to stand
up to a board of directors that may be entrenched and have their own
interests that may differ from those that are in the best interests
of the systemic stability''), Roundtable Tr. at 77; Comments from
Johnathan Short, Senior Vice President, General Counsel and
Corporate Secretary, the IntercontinentalExchange, Inc. (``I mean,
she's right, but I just want to point out that there really is a
tension there, because some of the people who are best qualified to
assess risk in a given market are the people that some parts of
the--you know, of the market are complaining about is controlling
clearinghouses and controlling key infrastructure''), Roundtable Tr.
at 78; Comments from William H. Navin, Executive Vice President and
General Counsel, Options Clearing Corporation (``I would second
those remarks. Our experience has been that we've benefited greatly
from the expertise of industry directors, and I think it would be
throwing the baby out with the bathwater if substantial restrictions
on industry governance were to be enacted''), Roundtable Tr. at 78;
Comments from Greenberger (``I do agree with what has been said,
that you need experts on the board. What I disagree with is that all
expertise comes from five swaps dealers or it all comes from people
who work for banks. There are academics, former regulators, and, you
know, other participants in the market who have talked today about
their need for open and fair access. I think that kind of diversity
on the board is important''), Roundtable Tr. at 164.
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To ensure that members of a DCO, DCM, or SEF Board of Directors are
not incented to accord undue consideration to the commercial interests
of a DCO, DCM, or SEF in relation to regulatory interests, the
Commission proposes to prohibit linking the compensation of public
directors and other non-executive members of the Board of Directors to
the business performance of the DCO, DCM, or SEF.
The abovementioned substantive requirements are in accord with
certain provisions in the European Commission Proposal.\56\
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\56\ See Article 25 of the European Commission Proposal.
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4. Questions on Substantive Requirements
The Commission seeks comment on the questions set forth below on
the substantive requirements applicable to a DCO, DCM, or SEF Board of
Directors:
What substantive requirements, other than those identified
above, should the Commission consider imposing on a DCO, DCM, or SEF
Board of Directors to mitigate the potential conflicts of interest
described in Section II, as well as any potential conflicts of interest
not specified herein? For example, should the Commission consider any
additional requirements related to (i) the fiduciary duties that a DCO,
DCM, or SEF Board of Directors may owe or (ii) policies or charters
that the DCO, DCM, or SEF Board of Directors may adopt?
iii. Committees
1. Requirements for Each DCO, DCM, and SEF
a. Nominating Committee
As stated above, the structural governance requirements contained
herein focus on mitigating conflicts of interest through introducing a
perspective independent of competitive, commercial, or industry
considerations to the deliberations of DCO, DCM, and SEF governing
bodies. Public director composition requirements are not, in and of
themselves, sufficient to ensure the representation of such independent
perspective. The Commission also must protect the integrity of the
process by which the DCO, DCM, or SEF selects public directors.\57\
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\57\ See, e.g., Comments from Rick McVey, Chief Executive
Officer, MarketAxess (``McVey'') (``I personally think that one of
the most important areas to focus on is the governance and
nominating committee. How do people get on these boards? And if
there is a requirement that that process be independent I think you
would get both qualified people that are going to look after the
best interest of the company, and you would get better independence
on these boards''), Roundtable Tr. at 150.
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[[Page 63740]]
To this end, the Commission proposes requiring each DCO, DCM, or
SEF to have a Nominating Committee. The role of the Nominating
Committee would be to: (i) Identify individuals qualified to serve on
the Board of Directors, consistent with the criteria that the Board of
Directors require and any composition requirement that the Commission
promulgates; and (ii) administer a process for the nomination of
individuals to the Board of Directors. The Commission proposes that (i)
public directors comprise at least 51 percent of the Nominating
Committee, and (ii) a public director chair the Nominating Committee.
b. Disciplinary Panels
As stated above, each DCM and SEF must fulfill self-regulatory
obligations under the CEA and the Dodd-Frank Act. Also, each DCO has
certain self-regulatory obligations.\58\ The Commission proposes
requiring each DCO, DCM, or SEF to have one or more disciplinary
panels.\59\ The role of such disciplinary panels would be to conduct
hearings, render decisions, and impose sanctions with respect to
disciplinary matters.
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\58\ For example, to the extent that a DCO determines that it
must impose requirements on members in order to comport with a core
principle or other regulatory requirement (e.g., limits on ownership
and voting power), a DCO must monitor member compliance with such
requirement, and must have the authority and ability to enforce such
requirement. See Section 5b(c)(2)(H) of the CEA, as added by Section
725(c) of the Dodd-Frank Act.
\59\ The Commission understands that DCOs currently may not have
disciplinary panels, but that the Risk Management Committee of a DCO
may perform the functions of such panel. Therefore, consistent with
current practice, the Commission proposes to permit the DCO Board of
Directors to delegate to the Risk Management Committee the
performance of such functions. If the Board of Directors so
delegates, (i) the DCO would no longer need to maintain a
disciplinary panel, but (ii) the composition requirements applicable
to a disciplinary panel would be extended to any committee (or
similar body) to which a decision of the Risk Management Committee
may be appealed.
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The Commission believes that it is imperative for each DCO, DCM, or
SEF to exercise its disciplinary authority in an impartial manner. In
the DCM Conflicts of Interest Release, the Commission acknowledged the
value of fair representation in maintaining such impartiality.\60\ To
ensure that fair representation results in impartiality, the Commission
proposes (i) maintaining the requirement that each DCM adopt rules that
would preclude any group or class of participants from dominating or
exercising disproportionate influence on the disciplinary panel, and
(ii) extending such requirement to each DCO or SEF. The Commission also
proposes mandating that each DCO, DCM, or SEF adopt rules that would
prohibit any member of a disciplinary panel from participating in
deliberations or voting on any matter in which the member knowingly has
a financial interest.
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\60\ See 72 FR at 6952 (stating that ``fair disciplinary
procedures, with minimal conflicts of interest, require disciplinary
bodies that represent a diversity of perspectives and
experiences'').
---------------------------------------------------------------------------
In the DCM Conflicts of Interest Release, the Commission also
acknowledged the importance of an independent perspective.\61\ The
Commission proposes retaining and strengthening the role that such
perspective plays in DCO, DCM, or SEF disciplinary processes. First,
the Commission proposes (i) maintaining the requirement that each DCM
disciplinary panel include at least one ``public participant,'' \62\
and (ii) extending such requirement to each DCO or SEF disciplinary
panel. Second, the Commission proposes requiring that the chair of each
disciplinary panel be a public participant.
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\61\ Id. (stating that ``[t]he presence of at least one public
person on disciplinary bodies * * * provides an outside voice and
helps to ensure that the public's interests are represented and
protected. This approach is consistent with the Commission's overall
objective of ensuring an appropriate level of public representation
at every level of DCM decision making, while simultaneously
calibrating the required number of public persons to the nature and
responsibility of the decision-making body in question'').
\62\ Id. at 6957. In the proposed rules, a ``Public
Participant'' is defined as an entity that meets the bright-line
materiality tests in the definition of ``Public Director.''
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2. Requirements for Each DCO Only
a. Risk Management Committee (and Subcommittee)
The central purpose of a DCO is to guarantee the performance of
each derivatives contract that it clears. In order to fulfill such
guarantee, each DCO must appropriately manage the risks associated with
such contract. In general, a DCO convokes a committee to oversee risk
management. The Commission proposes to require each DCO to have a Risk
Management Committee.
Swap contracts, as well as commodity futures and options, are
complex instruments. Managing the risks of such instruments requires
expertise. In general, clearing members constitute the main source of
such expertise, as they (i) routinely execute trades in such
instruments and (ii) have experience in managing risks posed by
customer trades. Because of the lack of a centralized market for swap
contracts, swap clearing members also perform the function of (i)
pricing a swap contract and (ii) participating in an auction to
liquidate the swap contract in the event of member default.
However, as discussed above, swap clearing members at DCOs that
currently clear large volumes of swap contracts are exclusively
enumerated entities. Some have argued that the enumerated entities have
an incentive to influence DCO risk assessments regarding (i) whether a
swap contract is capable of being cleared, (ii) the appropriate
membership criteria for a swap clearing member, and (iii) whether a
particular entity meets such criteria. Therefore, the Commission must
carefully consider the composition of the Risk Management Committee, in
order to achieve (i) the increased clearing of swap contracts that the
Dodd-Frank Act contemplates without compromising (ii) DCO safety and
soundness.
The Commission proposes a three-pronged approach to mitigating the
potential conflict of interest identified above, while still ensuring
that the Risk Management Committee retains sufficient expertise. First,
the Commission proposes requiring that 35 percent of the Risk
Management Committee be composed of public directors, with sufficient
expertise in, among other things, clearing services.\63\ Second, the
Commission proposes requiring that 10 percent of the Risk Management
Committee be composed of customers of clearing members, who also
routinely execute swap contracts (as well as commodity futures and
options) and who have experience in using pricing models for such
contracts (if only to ensure that they receive a fair price from the
enumerated entities).\64\ Because customers benefit from a wider pool
of swap clearing members and greater competition between such members,
customers have an incentive to ensure that the membership criteria of a
DCO are risk-based, and do not reflect the private, competitive
interests of the enumerated entities. Third, the Commission proposes to
permit a DCO Risk Management Committee to delegate to a subcommittee
(the ``Risk
[[Page 63741]]
Management Subcommittee'') the responsibility to: (i) Determine the
standards and requirements for initial and continuing clearing
membership eligibility; (ii) approve or deny (or review approvals or
denials of) clearing membership applications; and (iii) determine
products eligible for clearing. If the Risk Management Committee
effects such a delegation, then it would free itself of the composition
requirements. The decisions of the Risk Management Subcommittee would
be subject to review by the Risk Management Committee. Therefore, if
the Risk Management Committee determines that a particular decision by
the Risk Management Subcommittee is overly risky, then the Risk
Management Committee may overrule that decision.\65\
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\63\ See Comments from Greenberger, supra note 55, regarding the
availability of such public directors.
\64\ See, generally, supra note 55.
Because customers do not contribute to the DCO default fund,
customers may have less capital at stake than clearing members if a
DCO improperly measures risk. Therefore, the Commission believes
that 10 percent representation would ensure that customers have
adequate voice on the DCO Risk Management Committee, without
adversely impacting the risk assessments of such committee.
\65\ The Commission is contemplating requiring the DCO to report
to the Commission whenever the Risk Management Committee overrules
the Risk Management Subcommittee, or whenever the Board of Directors
overrules the Risk Management Committee. If the Commission decides
to propose such requirement, it would be included in the second
rulemaking that the Commission contemplates finishing on governance
and mitigation of conflicts of interest. See supra note 17.
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In order to prevent evasion of the above-mentioned composition
requirements through internal reorganization, the Commission proposes
to prohibit:
A decision of the Risk Management Subcommittee from being
subject to the approval of, or otherwise restricted or limited by, a
body other than the DCO Board of Directors or the DCO Risk Management
Committee, including, without limitation, any advisory committee; and
Certain decisions of the Risk Management Committee \66\
from being subject to the approval of, or otherwise restricted or
limited by, a body other than the DCO Board of Directors, including,
without limitation, any advisory committee.
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\66\ I.e., any decision pertaining to (i) whether a swap
contract is capable of being cleared, (ii) the appropriate
membership criteria for a swap clearing member, and (iii) whether a
particular entity meets such criteria.
---------------------------------------------------------------------------
The Commission requests comment on its three-pronged approach,
including any alternatives to such approach. The Commission also
requests comment on (i) the specific percentages set forth above, and
(ii) the prohibitions on certain bodies approving of, or otherwise
restricting or limiting, the decisions of the Risk Management Committee
(or Risk Management Subcommittee, as applicable).
3. Requirements for Each DCM or SEF Only
a. Membership or Participation Committee
As mentioned above, increased competition may exacerbate conflicts
of interest, causing a DCM or SEF to (i) prioritize commercial
interests over self-regulatory responsibilities; and (ii) restrict
access or impose burdens on access in a discriminatory manner.
Roundtable participants identified a specific example of (ii), where
swap clearing members may seek to limit access to SEF execution and
pricing to customers executing through such members.\67\ The rationale
of such example would apply to a DCM as well. To protect decisions
regarding access from DCM or SEF commercial interests, or the interests
of the enumerated entities, the Commission proposes requiring a DCM or
SEF to have a Membership or Participation Committee, composed of
thirty-five percent public directors.\68\ Such committee would have the
responsibility to: (i) Determine the standards and requirements for
initial and continuing membership or participation eligibility; (ii)
review appeals of staff denials of membership or participation
applications; and (iii) approve rules that would result in different
categories or classes of members or participants receiving disparate
access. The Commission proposes prohibiting the Membership or
Participation Committee from upholding any staff denial if the relevant
application meets the standards and requirements that such committee
sets forth. Further, the Commission proposes prohibiting the Membership
or Participation Committee from restricting access or imposing burdens
on access in a discriminatory manner, within each category or class of
members or participants or between similarly situated categories or
classes of members or participants. Nothing in this preamble is meant
to prohibit the Commission from issuing substantive proposals regarding
access to a DCM or SEF in any subsequent proposed rulemaking.
---------------------------------------------------------------------------
\67\ See, e.g., Comments from Kastner (``I'll take the ball for
a second with the SEFs. The same principles that apply to DCOs in
terms of open access--also if you carefully apply to SEFs, anybody
who is able to get a clearing account at a qualified swap clearing
member or FCM to use the, you know, futures analog, anybody that
wants to trade on a SEF, the SEF should not have any barriers to
entry.''), Roundtable Tr. at 52, (``The point is if you have a firm
who is doing customer business and wants to engage in an interest
rate swap with an end user who is not a clearing member, that they
should be able to execute that trade with the end user and then give
up to a clearing member.''), Roundtable Tr. at 84; Comments from
William DeLeon, Executive Vice President, Global Head of Portfolio
Risk Management, PIMCO (``You know, that concept of using a SEF, I
think it should be free and open access * * *. The issue is that
there needs to be a guarantee that when you access a SEF, that when
you do a trade, that there is someone who is guarantee that that is
a good trade. So whether that means that there's a market maker * *
* or if that means that there's a DCM or an FCM or someone who's
going to guarantee that they're going to stand behind * * * unknown
clients * * * ''), Roundtable Tr. at 56.
\68\ The Commission acknowledges that a DCM may have already
assigned the functions of a Membership or Participation Committee to
other governing bodies. Therefore, the proposed rules permit the DCM
Board of Directors to delegate the performance of the functions of
the Membership or Participation Committee to one or more other
committees, provided that each such committee meets the applicable
composition requirements. If the Board of Directors chooses to so
delegate, the registered swap execution facility would no longer
need to maintain a Membership or Participation Committee.
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b. Regulatory Oversight Committee
In the DCM Conflicts of Interest Release, the Commission emphasized
the importance of a DCM Regulatory Oversight Committee (``ROC''):
Properly functioning ROCs should be robust oversight bodies
capable of firmly representing the interests of vigorous, impartial,
and effective self-regulation. ROCs should also represent the
interests and needs of regulatory officers and staff; the resource
needs of regulatory functions; and the independence of regulatory
decisions. In this manner, ROCs will insulate DCM self-regulatory
functions, decisions, and personnel from improper influence, both
internal and external.\69\
\69\ See 72 FR 6950, 6951.
The Commission also underscored the importance of the DCM ROC being
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composed of 100 percent public directors:
The Commission strongly believes that new structural conflicts
of interest within self-regulation require an appropriate response
within DCMs. The Commission further believes that ROCs, consisting
exclusively of public directors, are a vital element of any such
response * * *. ROCs make no direct commercial decisions, and
therefore, have no need for industry directors as members. The
public directors serving on ROCs are a buffer between self-
regulation and those who could bring improper influence to bear upon
it.\70\
---------------------------------------------------------------------------
\70\ Id. at 6951.
The Commission proposes (i) maintaining the requirement that DCMs
have a ROC composed of only public directors, and (ii) extending such
requirement to SEFs, which also have self-regulatory obligations.
However, the Commission recognizes that SEFs--but not DCMs--must have a
chief compliance officer (i) to monitor SEF adherence to statutory,
regulatory, and
[[Page 63742]]
self-regulatory requirements and (ii) to resolve conflicts of interest
that may impede such adherence. The chief compliance officer must
report to the SEF Board of Directors (or similar governing body) or the
senior SEF officer.\71\ Since the Dodd-Frank Act charges the SEF Board
of Directors (or similar governing body) or the senior SEF officer with
the responsibility for overseeing the chief compliance officer
(including with respect to the resolution of conflicts of interest),
the Commission requests comment on whether requiring a SEF to also have
a ROC is necessary.
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\71\ See Section 5h(f)(15) of the CEA, as added by Section 733
of the Dodd-Frank Act.
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iv. Definition of Public Director
The proposed rules include a definition of ``public director'' that
makes several modifications to the definition of ``public director''
that the Commission adopted in 2009.\72\ Such modifications bring
several aspects of the definition in line with the definition of
``independent director'' that the SEC proposed in 2004.\73\ Since the
Commission is currently, or will in the future, be regulating some of
the same entities as the SEC,\74\ the modifications to the definition
of ``public director'' are intended to allow for greater harmonization
with the SEC and currently accepted practices.\75\
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\72\ See, generally, 74 FR 18982 (April 27, 2009).
\73\ See 69 FR 71127 (December 8, 2004) (the ``SEC 2004
Release'').
\74\ E.g., the Options Clearing Corporation, or a SEF that lists
both CDS indices and single-name CDS contracts.
\75\ See, e.g., the listing standards of NYSE Euronext or NASDAQ
OMX.
---------------------------------------------------------------------------
First, the proposed rules include a new bright-line test that
prohibits any director that is an officer of another entity, which
entity has a compensation committee, on which any officer of the
registered entity serves, from being a public director. This test is a
part of the independence tests of most listing standards and prevents a
public director from having a financial relationship that would likely
impair his independence. In light of the obvious conflicts that could
arise as a result of such a financial relationship, the Commission
proposes that this additional bright-line test be included in the
definition of ``public director.''
Second, the proposed rules would preclude directors that are
employees of members of DCOs, DCMs, and SEFs from being public
directors. The proposed rules would also preclude a director, or an
entity with which the director is an employee, from being a public
director if certain payments are made to such director. In 2009, the
Commission moved the evaluation of employment relationships from the
bright-line test to an analysis under the overarching materiality
standard. The Commission is re-evaluating such move in light of current
concerns regarding further protecting regulatory functions from
directors that are conflicted due to industry ties. The Commission
notes that CBOE Futures Exchange, LLC (``CFE'') submitted a comment
letter to this effect in 2009. In particular, CFE expressed concern
that, as a result of the removal of employment relationships from the
bright-line tests, all required public directors could be member
employees.\76\ At the time, the Commission felt that such a situation
would be incompatible with the overarching materiality test, even if
such prohibition against employment was not included in the bright-line
test. The Commission seeks comments regarding the re-insertion of
employment relationships in the bright-line tests.
---------------------------------------------------------------------------
\76\ CFE Comment Letter at 2.
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Third, the proposed ``public director'' definition includes an
expanded definition of ``immediate family'' that includes certain
family members, whether by blood, marriage or adoption, and also
includes any person residing in the home of the director or his
immediate family. Such change attempts to harmonize the ``public
director'' definition with the SEC 2004 Release and currently accepted
practices.
Finally, the Commission notes that the proposed rules retain the
one-year look-back period. The Commission seeks comment as to whether
such period should be increased, given (i) current concerns regarding
further protecting regulatory functions from directors that are
conflicted due to industry ties, and (ii) the goal of achieving harmony
with the SEC and currently accepted practices.
v. Questions on Committees and the Definition of Public Director
In addition to any questions that the Commission may have posed
above, the Commission seeks comment on the following questions
regarding DCO, DCM, or SEF committees, and the attendant composition
requirements, as well as the definition of public director:
Is each of the committees or panels specified above
necessary or appropriate for the mitigation of the conflicts of
interest described in Section II, or of any conflict of interest not
identified herein? If so, are the composition requirements applicable
to such committees necessary or appropriate to effect such mitigation?
What other ways should the Commission consider defining
``public director''? Are there other circumstances that the Commission
should include in the bright-line materiality tests? Are there
circumstances that the Commission should remove from such tests?
b. Ownership and Voting Limits
As mentioned above, the structural governance requirements mitigate
DCO, DCM, or SEF conflicts of interest by introducing a perspective
independent of competitive, commercial, or industry considerations to
the deliberations of governing bodies. The Commission believes that
limits on ownership of voting equity and the exercise of voting rights
would enhance the structural governance requirements.\77\ In general,
individuals are compensated for service on the Board of Directors (and
the committees thereof). Voting shareholders elect, directly or
indirectly, members of the Board of Directors. Such members serve as
fiduciaries to all shareholders under state law. Therefore, to ensure
that DCO, DCM, or SEF public directors maintain their independent
perspective (rather than solely representing the competitive,
commercial, or industry considerations of shareholders), the Commission
believes that limits on ownership of voting equity and the exercise of
voting rights are necessary.\78\
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\77\ The Commission proposes not to limit non-voting equity. In
general, a shareholder would have direct influence over a DCO, DCM,
or SEF Board of Directors only if the shareholder has the ability to
exercise voting rights with respect to, e.g., election,
compensation, or removal of directors. However, the Commission notes
that certain Roundtable participants disagree. See, e.g., Comments
from Slavkin (``I actually disagree with what the gentleman from JP
Morgan said when he said that he doesn't think that having an
economic stake without having a voting interest is a concern. I
think most of us can imagine a situation where someone owns 5
percent of our company and asks us to do something. I don't think it
matters if that person gets to vote for the board of directors, that
person has real influence regardless of whether it's formal
influence, there is going to be influence over the decision making,
there's going to be influence over the strategy and innovation and
the trajectory of the institution in general, so I do think we need
to look at ownership restrictions related to voting interests as
well as related to economic interests even when they're not tied to
actual voting shares''), Roundtable Tr. at 153. The Commission
requests comment on whether limits on non-voting equity would be
appropriate to the mitigation of conflicts of interest.
\78\ Certain Roundtable Participants agree. See, e.g., Comments
from Slavkin (``What I'm hearing from the people who support
governance as opposed to real caps on ownership is an argument in
favor of the status quo, and I think that when Congressman Brown--
I'm sorry, when Congressman Lynch proposed this amendment that was
passed in the House legislation, and when Senator Brown proposed,
you know, the Lynch Light version that was passed by the entire
Congress, their intention was to create real change in recognition
of the fact that the current system is broken. It doesn't work.
That's why we're all sitting around this table today. Governance is
a valuable tool, it's not the only tool, and I think it's our
responsibility to try to examine other options and I think that the
ownership cap is a real valuable tool that can be used to mitigate
the problems that exist in the current system''), Roundtable Tr. at
124 to 125.
The European Commission Proposal explicitly rejects ownership
limitations. See Section 4.3.4 of the European Commission Proposal
(stating that structural governance requirements ``are considered
more effective in addressing any potential conflicts of interest
that may limit the capacity of CCPs to clear, than any other form of
regulation which may have undesirable consequence on market
structures (e.g., limitation of ownership, which would need to
extend also to so-called vertical structures in which exchanges own
a CCP)'').
However, the European Commission Proposal explicitly preserves
the power of the regulator to refuse authorization of a CCP ``where,
it is not satisfied as to the suitability of the shareholders or
members that have qualifying holdings in the CCP, taking into
account the need to ensure the sound and prudent management of a
CCP.'' See Article 28(2) of the European Commission Proposal.
Further, the European Commission Proposal permits the regulator to
terminate authorization of a CCP where ``shareholders or members,
whether direct or indirect, * * * exercise an influence which is
likely to be prejudicial to the sound and prudent management of the
CCP.'' See Article 28(1) and (4) of the European Commission
Proposal.
The Commission requests comment as to whether a reservation of
power similar to that contained in the European Commission Proposal
would complement the limits on ownership of voting equity and the
exercise of voting power described above.
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[[Page 63743]]
i. DCOs
According to the DCM Conflicts of Interest Release, ``[t]oday's
DCMs * * * are vibrant commercial enterprises competing globally in an
industry whose ownership structures, business models, trading
practices, and products are evolving rapidly.'' \79\ The same
evolution, and the diversity in ownership structures that it engenders,
may be observed in DCOs. Therefore, in acknowledgement of the different
DCO ownership structures that currently or may in the future exist, the
Commission proposes that a DCO choose between one of two alternative
limitations on ownership of voting equity and the exercise of voting
rights. However, the Commission recognizes that circumstances may exist
where neither alternative may be appropriate. Consequently, the
Commission also proposes a waiver procedure.
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\79\ 72 FR at 6938.
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1. First Alternative
For the first alternative, the Commission proposes a combination of
a single-member limitation and an aggregate limitation (the ``First
Alternative'').
a. Single-Member Limitation
First, the Commission proposes requiring a 20 percent limitation on
the voting equity that any single member (and related persons) \80\ may
own.\81\ Economic research suggests that holding 20 percent voting
equity of an entity may be sufficient for exerting control over an
entity,\82\ especially if that entity has otherwise diffuse
ownership.\83\
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\80\ The Commission requests comment on whether the definitions
of ``related person'' in the proposed rules are under or over-
inclusive.
\81\ Ruben Lee, The Governance of Financial Infrastructure,
Oxford Finance Group, at 256 (January 2010) (stating that
``[m]andatory ownership constraints may prevent a single firm from
exercising undue influence over a market institution that is also an
SRO'').
\82\ See, generally, e.g., Bae, K-H., J-K and J-M Kang (2002).
``Tunneling or value added? Evidence from mergers by Korean business
groups'', Journal of Finance 57, pp. 2695-2740; Barclay, M. and C.
Holderness (1989) ``Private benefits from control of public
corporations'', Journal of Financial Economics 25, pp. 371-395;
Barclay, M. and C. Holderness (1991) ``Negotiated block trades and
corporate control'', Journal of Finance 46, pp. 861-878; Barclay, M.
and C. Holderness and D. Sheehan (2001) ``The block pricing
puzzle'', Working Paper; Cheung,Y-L, P.R. Rao and A. Stouraitis
(2006) ``Tunneling, propping, and expropriation: evidence from
connected party transactions in Hong Kong'', Journal of Financial
Economics 82, pp. 343-386; Claessens, S., S. Djankov, L.H.P. Lang
(2000) ``The separation of ownership and control in East Asian
corporations'', Journal of Financial Economics 58, pp. 81-112; Dyck,
A and L. Zingales (2004) ``Private benefits of control: An
international comparison'', Journal of Finance 59, pp. 537-600;
Faccio, M., L.H.P Lang, and L. Young (2001) ``Dividends and
expropriation'', American Economic Review 91, 54-78; and Morck, R.,
D. Wolfenzon, and B. Yeung (2005) ``Corporate governance, economic
entrenchment, and growth'', Journal of Economic Literature, 43, pp.
655-72.
The 20 percent limitation also accords with the proposals in the
SEC 2004 Release. See 69 FR at 71143-44.
\83\ As mentioned above, CME, for example, is wholly-owned by
CME Group. However, CME Group is a publicly-listed company with
diffuse ownership.
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As described above, based on Commission experience, control of a
DCO by members collectively has generally permitted the DCO to serve
the purposes of the CEA. However, such description does not necessarily
hold true if, for example, the DCO has demutualized but one member
retains sufficient voting ownership to dominate the DCO.\84\ Such
domination may result in the DCO relaxing risk management standards
with respect to that member, but imposing more stringent standards on
others.
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\84\ Comments from Greenberger (``if we want governance with
teeth, governance with teeth will have ownership limitations. You
can talk about fair representation, board governance, the fact of
the matter is, and I think this will bear its way out in the
comments to you, that does not protect fair and open access * *
*''), Roundtable Tr. 135.
---------------------------------------------------------------------------
Given the increased importance of the DCO in managing systemic
risk, the Commission believes that limiting the amount of voting equity
that any one member may own is appropriate to ensure impartiality in
risk assessment, especially in a DCO with otherwise diffuse ownership.
To prevent evasion of the 20 percent limitation, the Commission
proposes requiring an identical limit on voting rights; and if the DCO
is a subsidiary, extending the limitation to the shareholders of its
direct or indirect parent. If any parent is publicly-listed, then that
parent would have to comply with shareholder voting requirements
promulgated by the SEC or the exchange on which the parent is listed.
b. Aggregate Limitation
Further, the Commission proposes a 40 percent limitation on the
voting equity that the enumerated entities (and their related persons)
may own in the aggregate, regardless of whether such entities are DCO
members.\85\ As mentioned above, some market participants, investor
advocates, and academics have argued that the enumerated entities may
have commercial incentives to influence DCO risk assessments regarding
(i) whether a swap contract is capable of being cleared, (ii) the
appropriate membership criteria for a swap clearing member, and (iii)
whether a particular entity meets such criteria. The enumerated
entities may directly influence such assessments through participation
on the Risk Management Committee as clearing members, or indirectly
influence such assessments as voting shareholders. In general, the
Commission believes that the enumerated entities would attempt to
influence such assessments as voting shareholders only if the DCO has a
mutualized structure with concentrated ownership.\86\ In such a
structure, the percentage necessary for control would be higher than
the abovementioned 20 percent, which is sufficient for a diffuse
ownership structure.
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\85\ Cf. The Lynch Amendment, which prohibited certain
``restricted owners'' from collectively acquiring more than 20
percent of the voting equity in a DCO.
\86\ See, generally, Barclay, M. and C. Holderness (1989)
``Private benefits from control of public corporations'', Journal of
Financial Economics 25, pp. 371-395. The premise of this paper is
that (i) buyers of equity blocks in a publicly-traded corporation
appear, on average, to pay a premium above market price, and (ii)
such premium reflects the value to the buyer of being able to
influence the decisions of the corporation in a way that is
privately profitable, but not profitable to other shareholders. In
general, the Commission believes that, if a DCO has diffuse
ownership, the outlay that an enumerated entity would need to make
to influence DCO risk assessments as a voting shareholder would
likely exceed the outlay necessary to obtain the same amount of
influence through other means.
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In counterweight to the commercial incentives that the enumerated
entities may have to influence DCO risk assessments regarding (i),
(ii), and (iii)
[[Page 63744]]
above, the Commission acknowledges that the enumerated entities have
the capital and expertise necessary to manage the risks of clearing
swap contracts.\87\ Therefore, the Commission believes that a 40
percent aggregate limitation is appropriate, assuming that the DCO has
a mutualized structure with concentrated ownership, because it permits
the enumerated entities to influence, directly or indirectly, but not
control, DCO risk assessments.
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\87\ See, e.g., Comments from Jeremy Barnum, Managing Director,
J.P. Morgan (``Barnum'') (``So, on the question of--on the question
of ownership of clearinghouses and expertise and the Lynch
amendment, the--it is very appealing in principle to imagine that
these systemically important financial players into which we are
putting much more risk, could somehow be entirely free of the
nefarious influence of the evil dealers who contributed to the
crisis to quote Mr. Greenberger. But, unfortunately, they are, in
fact, the market participants who need to use the clearinghouses''),
Roundtable Tr. at 115; Comments from Olesky (``I think it's really
important to recognize--for all of us to recognize--that market
participants really engender many market facilities. And in my
experience in the investment of capital and the knowledge about a
particular space has led directly to innovations and advances both
with Tradeweb and another company I was with, BrokerTech; exchanges;
clearing corps. If you go back in history, those are the folks that
have the capital to support this innovation and the knowledge and
experience to move it forward. And while it's easy to sort of be
critical of that group, I think it's also important not to cut off
that flow of capital into innovative organizations that are really
groups of market participants that are investing in these types of
mechanisms * * * Tradeweb was started in 1997 with the internet with
a group of banks. We had four banks initially. Then we sold 100
percent of the company in 2004 and we weren't owned by any banks for
4 years. Then we had another investment back in, and we had a
minority stake by some banks. I think we really have to separate out
the ownership argument from the governance argument, because it's
critical to be able to access that capital for entrepreneurs and for
innovators when they're trying to build these mechanisms''),
Roundtable Tr. at 60 to 61.
---------------------------------------------------------------------------
In conjunction with the 40 percent aggregate limitation, the
Commission proposes requiring a majority vote for the passage of any
shareholder resolution; and if the DCO is a subsidiary, extending the
aggregate limitation and the requirement for a majority vote to the
shareholders of its direct or indirect parent. If any parent is
publicly-listed, then that parent would have to comply with shareholder
voting requirements promulgated by the SEC or the exchange on which the
parent is listed.
2. Second Alternative
For the second alternative, the Commission proposes a 5 percent
limitation on the voting equity that any DCO member or enumerated
entity (whether or not such entity is a DCO member), and the related
persons thereof in each case, may own (the ``Second Alternative'').
Such a limitation effectively ensures that neither a DCO member nor an
enumerated entity would have sufficient power, in a concentrated or
diffuse ownership structure, to exert undue influence, as a voting
shareholder, over DCO operations (including with respect to risk
assessments regarding (i), (ii), and (iii) above). Certain Roundtable
participants favor a similar approach.\88\
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\88\ See, e.g., Comments of Roger Liddell, Chief Executive
Officer, LCH.Clearnet Group (``Liddell'') (``To go back to the
question, I think with established organizations, then I think the
concept of some combination of ownership limits and voting caps
actually does make sense. For example, in the [LCH] clearinghouse,
we've got a 5 percent voting cap and have done for many years. And
the reason for that was to take away any incentive for anyone to
build up a stake greater than that so that we would be highly
unlikely to ever have less than 20 shareholders. That works well for
us''), Roundtable Tr. at 118 to 119.
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To prevent evasion of the 5 percent limitation, the Commission
proposes requiring an identical limit on voting rights; and if the DCO
is a subsidiary, extending the limitation to the shareholders of its
direct or indirect parent. If any parent is publicly-listed, then that
parent would have to comply with shareholder voting requirements
promulgated by the SEC or the exchange on which the parent is listed.
3. Waiver
As mentioned above, the Commission believes that there may be
circumstances where the imposition of rigid limitations on ownership or
voting rights may not be appropriate for certain DCO ownership
structures. To provide flexibility, a DCO may request that the
Commission waive individual and/or aggregate ownership or voting rights
limitations by any entity for a reasonable period of time.
The Commission may grant the requested waiver if it determines that
ownership or voting rights limitations are not necessary or appropriate
to:
Improve the governance of the DCO;
Mitigate systemic risk;
Promote competition;
Mitigate conflicts of interest in connection with a swap
dealer's or major swap participant's conduct of business with the DCO
with respect to fair and open access and participation and product
eligibility; and
Otherwise accomplish the purposes of the Act.
The Commission may, at any time, revoke the waiver. Upon such
revocation, or at the expiration of the waiver period, any such DCO
shall require divestiture of any relevant entity's ownership or voting
rights percentages to an individual and/or aggregate level that is
consistent with the First or Second Alternative, or such other level
that the Commission deems appropriate based on the foregoing factors as
set forth in Section 726(b) of the Dodd-Frank Act.
4. Questions on the First and Second Alternatives and the Waiver
The Commission seeks comment on the questions set forth below on
the First and Second Alternatives, as well as the Waiver:
a. First and Second Alternatives
Are the First and Second Alternatives effective for
mitigating, on a prophylactic basis, conflicts of interest arising from
the control that (i) one member may exert as a dominant voting
shareholder of a DCO and (ii) the enumerated entities may collectively
exert as voting shareholders of a DCO (specifically with respect to the
DCO risk assessments referenced above)? What methods, other than the
First and Second Alternatives, should the Commission consider to
mitigate such conflicts of interest? What are the advantages and
disadvantages of such methods?
Under what circumstances would the First and Second
Alternatives not be appropriate for a DCO? For example, should the
First and Second Alternatives apply equally to established DCOs and
start-up DCOs? \89\
---------------------------------------------------------------------------
\89\ See, e.g., Comments from Olesky, supra note 87; Comments
from Liddell (``However, to pick upon the point that Lee Olesky made
before, I think you have to be a little bit careful in how you treat
entrepreneurials or starter ventures because most of the successful
starter ventures have started with a relatively small number of
banks sharing an interest in creating something which then becomes a
lot bigger''), Roundtable Tr. at 119.
---------------------------------------------------------------------------
Are the percentages that the Commission specifies in the
First and Second Alternatives effective for mitigating conflicts of
interest arising from the control that (i) one member may exert as a
dominant voting shareholder of a DCO and (ii) the enumerated entities
may collectively exert as voting shareholders of a DCO? If not, what
alternative percentages should the Commission consider to achieve such
mitigation?
Would the First and Second Alternatives be effective to
mitigate any potential conflicts of interest not discussed herein? If
not, then what other equity ownership and voting limits should the
Commission consider?
Should the limits in the First and Second Alternatives
only apply to clearing members, and not enumerated entities that are
not clearing members? Should the limits in the First and Second
Alternatives apply only to
[[Page 63745]]
DCOs, and not to their parent companies?
b. Waiver
The Commission seeks comment on (i) the circumstances
which may require an alternative ownership structure for a DCO, (ii)
the types of alternative ownership structures of DCOs that may require
flexibility in setting ownership or voting rights levels consistent
with achieving the goal of Section 726 of the Dodd-Frank Act to
mitigate conflicts of interest, and (iii) the appropriate means to
provide such flexibility to the Commission during the DCO application
process if such an organization were to adopt an alternative structure.
ii. DCMs or SEFs
The Commission proposes a 20 percent limitation on the voting
equity that any single member (and related persons) may own in a DCM or
SEF. As mentioned above, economic research suggests that holding 20
percent voting equity of an entity would be sufficient for control,
especially if such entity has otherwise diffuse ownership. Such a
limitation would prevent any one member of a DCM or SEF from dominating
the decision-making process. The Commission also proposes an identical
limitation on voting rights; and if the DCM or SEF is a subsidiary,
extending the limitation to the shareholders of its direct or indirect
parent. If any parent is publicly-listed, then that parent would have
to comply with shareholder voting requirements promulgated by the SEC
or the exchange on which the parent is listed.
The Commission, however, does not propose imposing a limitation on
the voting equity that the enumerated entities may own in the
aggregate. As mentioned above, the Dodd-Frank Act specifically attempts
to encourage sustained competition between multiple DCMs and SEFs over
listing the same swap contract. Based on comments from Roundtable
participants, the enumerated entities would be the most likely source
of funding for a new DCM or SEF.\90\ In this instance, the Commission
believes that the benefits of sustained competition between new DCMs
and SEFs outweigh the incremental benefit of better governance through
limitations on the aggregate influence of the enumerated entities.\91\
---------------------------------------------------------------------------
\90\ See, e.g., Comments of McVey (``I think when it comes to
ownership we have to realize that we are embarking on a major
transformation of OTC markets and all of these entities are going to
need capital to provide the market efficiencies that we're all
seeking to achieve. And rightly or wrongly, historically a
tremendous amount of the capital for clearing, e-trading, data and
affirmation hubs, has come from the dealer community, and I think it
would be very dangerous to cut off an important source of capital
that can lead to some of the market improvements that we're all
seeking to achieve''), Roundtable Tr. at 121 to 122.
\91\ See, generally, Comments of Barnum (``The traditional
vertically integrated exchange model for futures works beautifully
in a whole range of respects for those products from the perspective
of liquidity and systemic risk, but it has a couple problems. It
is--it does seem to create some natural monopoly properties. You can
debate whether they're severe enough to warrant action or not and
that's one of the kinds of tensions that needs to be balanced. In
addition, they work very well for the types of products that
naturally attract liquidity on exchanges. The whole premise of this
is that we're pushing a whole new set of products with different
liquidity characteristics into central counterparties. That means
that you cannot apply exactly the same framework. There are new
challenges that are being introduced. They create tensions. And
those tensions need to be looked at rationally in a continuum
framework that balances different social goods against each
other''), Roundtable Tr. at 116 to 117.
---------------------------------------------------------------------------
1. Questions on DCM or SEF Limits on Ownership and Voting Power
The Commission seeks comment on the questions set forth below on
the DCM or SEF limits on ownership and voting power:
Are the single-member limits on ownership and voting power
effective for mitigating, on a prophylactic basis, the conflicts of
interest that Section II identifies? What methods, other than such
limits, should the Commission consider to mitigate such conflicts of
interest? What are the advantages and disadvantages of such methods?
Should the Commission also consider instituting a waiver
procedure for DCMs and SEFs with respect to the single-member
limitation?
Should the single-member limitation be extended to the
parent company of a DCM or SEF?
IV. Effectiveness and Transition Period
As noted above, the Commission is contemplating rulemakings on
further defining certain entities implicated by the proposed rules
(e.g., swap dealers, major swap participants, and swap execution
facilities). The Commission anticipates that such rulemakings would be
completed by the statutory deadline of July 15, 2011. Therefore, the
Commission is proposing a staggered effective date for the final rules
on mitigation of conflicts of interest. Any portion of the final rules
implicating entities subject to further definition would not become
effective until sixty (60) days after July 15, 2011. Portions of the
final rules not involving such entities would become effective sixty
(60) days after the Federal Register publication of the final rules.
Although the Commission proposes that the final rules become
effective within the time periods specified above, consistent with the
DCM Conflicts of Interest Release, the Commission will permit each
existing DCO, DCM, and SEF to phase-in implementation of the final
rules over two (2) years or two regularly-scheduled Board of Directors
elections. The Commission expects, however, all new DCO, DCM, and SEF
applicants to fully comply with the final rules.
The Commission requests comment on the (i) timing of effectiveness
for the final rules, and (ii) the length of the phase-in implementation
period. The Commission further requests comment on whether new DCO,
DCM, and SEF applicants should have to demonstrate compliance with the
final rules to receive registration.
V. Numbering
As the proposed rules constitute amendments or additions to
Regulation Parts 1, 37, 38, 39, and 40, the Commission anticipates that
the numbering of such proposed rules will change upon completion of
other rulemakings concerning such parts.
VI. Related Matters
a. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') requires that agencies, in
proposing rules, consider the impact of those rules on ``small
entities.'' \92\ The term ``small entity'' has the same meaning as the
term ``small business'' under the RFA \93\ and the term ``small
business'' generally has the same meaning as the term ``small business
concern'' under section 3 of the Small Business Act.\94\
---------------------------------------------------------------------------
\92\ 5 U.S.C. 601 et seq.
\93\ 5 U.S.C. 601(6).
\94\ A ``small business concern'' is generally defined as one
which is independently owned and operated and which is not dominant
in its field of operation. 15 U.S.C. 632.
---------------------------------------------------------------------------
The proposed rules detailed in this release would only affect DCOs,
DCMs, and SEFs. The Commission has previously determined that DCOs \95\
and DCMs \96\ are not ``small entities'' for purposes of the RFA. In
contrast, SEFs constitute a new category of registrant that the Dodd-
Frank Act created. Accordingly, the Commission has not addressed the
question of whether SEFs are, in fact, ``small entities'' for purposes
of the RFA.
---------------------------------------------------------------------------
\95\ 66 FR 45604, 45609 (August 29, 2001).
\96\ 47 FR 18618, 18619 (April 30, 1982).
---------------------------------------------------------------------------
The Dodd-Frank Act defines a SEF to mean a trading system or
platform in which multiple participants have the
[[Page 63746]]
ability to execute or trade swaps by accepting bids and offers made by
multiple participants in the facility or system, through any means of
interstate commerce, including any trading facility that facilitates
the execution of swaps between persons and is not a designated contract
market.\97\ The Commission is hereby proposing that SEFs not be
considered to be ``small entities'' for essentially the same reasons
that DCMs and DCOs have previously been determined not to be small
entities. These reasons include the fact that the Commission designates
a contract market or registers a derivatives clearing organization only
when it meets specific criteria including expenditure of sufficient
resources to establish and maintain adequate self-regulatory programs.
Likewise, the Commission will register an entity as a SEF only after it
has met specific criteria including the expenditure of sufficient
resources to establish and maintain an adequate self-regulatory
program.\98\ Accordingly, the Commission does not expect the rules, as
proposed herein, to have a significant impact on a substantial number
of small entities. Therefore, the Chairman, on behalf of the
Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the
proposed amendments will not have a significant economic impact on a
substantial number of small entities. The Commission invites the public
to comment on whether SEFs covered by these rules should be considered
small entities for purposes of the RFA.
---------------------------------------------------------------------------
\97\ See Section 721 of the Dodd-Frank Act. The Commission
anticipates proposing regulations that would further specify those
entities that must register as a SEF. The Commission does not
believe that such proposals would alter its determination that a SEF
is not a ``small entity'' for purposes of the RFA.
\98\ See Core Principle 2 applicable to SEFs under Section 733
of the Dodd-Frank Act.
---------------------------------------------------------------------------
b. Paperwork Reduction Act
The Paperwork Reduction Act (``PRA'') \99\ imposes certain
requirements on Federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA. The
proposed rules do not require a new collection of information on the
part of any entities that would be subject to the proposed rules.
Accordingly, for purposes of the PRA, the Commission certifies that the
proposed rules, if promulgated in final form, would not impose any new
reporting or recordkeeping requirements.
---------------------------------------------------------------------------
\99\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
c. Cost-Benefit Analysis
Section 15(a) of the CEA \100\ requires that the Commission, before
promulgating a regulation or issuing an order, to consider the costs
and benefits of its action. By its terms, Section 15(a) of the CEA does
not require the Commission to quantify the costs and benefits of a new
regulation or to determine whether the benefits of the regulation
outweigh its costs. Rather, Section 15(a) of the CEA simply requires
the Commission to ``consider the costs and benefits'' of its action.
---------------------------------------------------------------------------
\100\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------
Section 15(a) of the CEA further specifies that costs and benefits
shall be evaluated in light of the following considerations: (1)
Protection of market participants and the public; (2) efficiency and
competition; (3) financial integrity of the futures markets and price
discovery; (4) sound risk management practices; and (5) other public
interest considerations. Accordingly, the Commission could, in its
discretion, give greater weight to any one of the five considerations
and could determine that, notwithstanding its costs, a particular
regulation was necessary or appropriate to protect the public interest
or to effectuate any of the provisions or to accomplish any of the
purposes of the Act.
The Commission has evaluated the costs and benefits of the proposed
rules, in light of the specific provisions of Section 15(a) of the CEA,
as follows:
1. Protection of market participants and the public. The proposed
rules concern governance and conflicts of interest and seek to improve
governance arrangements to prevent conflicts of interest that if not
addressed, would serve the interests of one group of constituents over
other groups, including other market participants and the public. The
proposed rules require governance arrangements that allow the
registered entities to better serve the public interest.
2. Efficiency and competition. The proposed rules provide for the
identification and mitigation of conflicts of interest, which improves
efficiency in decision-making and increases fair access to clearing and
markets which improves competition.
3. Financial integrity of futures markets and price discovery. The
proposed rules facilitate transparency in governance which, in turn,
facilitates transparency in matters governed including increased fair
access to clearing and trading which, in turn, facilitates price
discovery. This decreases risk which, in turn, increases financial
integrity.
4. Sound risk management practices. The proposed rules provide for
participation in decision-making by those who share in the risk
presented by the operation of the registered entity. The governance
arrangements provided by the proposed rules provide for a balance among
different interests (including the public interest) so that risks
presented by one group's interests will not dominate decision-making in
the organization. This balance should prevent excess risk associated
with any one group's interests from affecting operations.
5. Other public interest considerations. The proposed rules provide
for governance arrangements for DCOs, DCMs, and SEFs, as well as
methods of mitigating the presence of conflicts of interest, that
should, for the reasons, cited above, operate in the best interests of
the public.
Accordingly, after considering the five factors enumerated above,
the Commission has determined to propose the regulations set forth
below. The Commission invites public comment on its evaluation of the
costs and benefits of the proposed rules. Specifically, commenters are
invited to submit data quantifying the costs and benefits of the
proposed rules with their comment letters.
VII. Text of Proposed Rules
List of Subjects
17 CFR Part 1
Definitions, Directors, Committees.
17 CFR Part 37
Swap execution facility, Conflict of Interest, Membership, Access,
Voting, Ownership.
17 CFR Part 38
Designated contract markets, Conflict of interest, Membership,
Access, Voting, Ownership.
17 CFR Part 39
Registered clearing organization, Conflict of interest, Membership,
Access, Voting, Ownership.
17 CFR Part 40
Governance, Directors, Committees, Conflict of interest.
For the reasons stated in this release, the Commission hereby
amends 17 CFR parts 1, 37, 38, 39, and 40 as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
1. Revise the authority citation for part 1 to read as follows:
[[Page 63747]]
Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,
6h, 6i, 6j, 6k, 6l, 6m, 6n, 60, 6p, 7, 7a, 7b, 8, 9, 12, 12c, 13a,
13a-1, 16, 16a, 19, 21, 23, and 24 and Sec. 726, Pub. L. 111-203,
124 Stat. 1376.
2. Section 1.3 is amended by adding paragraphs (zz) through (aaa)
to read as follows:
Sec. 1.3 Definitions
(zz) Board of Directors. This term means the Board of Directors or
Board of Governors of a company or organization, or equivalent
governing body.
(aaa) Disciplinary Panel. This term shall be as defined in Sec.
40.9(c)(3)(i).
(bbb) Executive Committee. This term shall mean a committee of the
Board of Directors that may exercise the authority delegated to it by
the Board of Directors with respect to the management of the company or
organization.
(ccc) Public Director. This term means a member of the Board of
Directors (each, a ``director'') of a registered derivatives clearing
organization (as defined in Section 1a(15) of the Act), a board of
trade designated as a contract market pursuant to Section 5 of the Act,
or a registered swap execution facility (as defined in Section 1a(50)
of the Act), as applicable, who has been found, by the Board of
Directors of the registered entity, on the record, to have no material
relationship with such registered entity. The Board of Directors must
make such finding upon the nomination or appointment of the director
and as often as necessary in light of all circumstances relevant to
such director, but in no case less than annually.
(1) For purposes of this definition, a ``material relationship'' is
one that reasonably could affect the independent judgment or decision-
making of the director. In making the finding specified in paragraph
(ccc) of this section, the Board of Directors need not consider
previous service as a director of the registered entity to constitute a
``material relationship.'' Circumstances in which a director shall be
considered to have a ``material relationship'' with the registered
entity include, but are not limited to, the following:
(i) Such director is an officer or an employee of the registered
entity, or an officer or an employee of its affiliate. In this context,
``affiliate'' includes parents or subsidiaries of the registered entity
or entities that share a common parent with the registered entity;
(ii) Such director is a member of the registered entity, or a
director, an officer, or an employee of a member. In this context,
``member'' is defined according to Section 1a(34) of the Act and any
regulation promulgated thereunder, including, without limitation,
Sec. Sec. 1.3(c) and (q) of this chapter and any successor provisions;
(iii) Such director is an officer of another entity, which entity
has a compensation committee (or similar body) on which any officer of
the registered entity serves;
(iv) Such director, or an entity with which the director is a
partner, an officer, an employee, or a director, receives more than
$100,000 in combined annual payments for legal, accounting, or
consulting services from the registered entity, any affiliate thereof
(as defined in paragraph (ccc)(1)(i) of this section), any member of
the registered entity (as defined in paragraph (ccc)(1)(ii) of this
section), or any affiliate of such member. Compensation for services as
a director of the registered entity or as a director of an affiliate
thereof does not count toward the $100,000 payment limit, nor does
deferred compensation for services rendered prior to becoming a
director of the registered entity, so long as such compensation is in
no way contingent, conditioned, or revocable; or
(v) Notwithstanding paragraph (ccc)(1)(iv) of this section, in the
case of a public director that is a member of the Regulatory Oversight
Committee, the Risk Management Committee (or any subcommittee thereof),
or the Membership or Participation Committee (or any committee serving
a similar function), such director (other than in the capacity of a
member of such committee, any other committee, or the Board of
Directors, in each case, of the registered entity), accepts, directly
or indirectly, any consulting, advisory, or other compensatory fee from
the registered entity, any affiliate thereof (as defined in paragraph
(ccc)(1)(i) of this section), any member of the registered entity (as
defined in paragraph (ccc)(1)(ii) of this section), or any affiliate of
such member, other than deferred compensation for service rendered
prior to becoming a member of the Regulatory Oversight Committee, the
Risk Management Committee (or any subcommittee thereof), or the
Membership or Participation Committee (or any committee serving a
similar function), provided that such compensation is in no way
contingent, conditioned, or revocable.
(vi) Any of the relationships set forth in paragraphs (ccc)(1)(i)
through (ccc)(1)(v) of this section apply to the ``immediate family''
of such director, i.e., spouse, parents, children, and siblings, in
each case, whether by blood, marriage, or adoption, or any person
residing in the home of the director or that of his or her ``immediate
family.''
(2) All of the disqualifying circumstances described in paragraph
(ccc)(1)(i) through (ccc)(1)(v) of this section shall be subject to a
one-year look back.
(3) A public director of any registered entity specified in
paragraph (ccc) of this section may also serve as a public director of
an affiliate of the registered entity (as defined in paragraph
(ccc)(1)(i) of this section) if he or she otherwise meets the
requirements in paragraph (ccc)(1)(i) through (ccc)(1)(v) of this
section.
(ddd) Membership or Participation Committee. This term shall be as
defined in Sec. 37.19(c)(1)(i), with respect to a registered swap
execution facility, and Sec. 38.851(c)(1)(i), with respect to a
designated contract market.
(eee) Nominating Committee. This term shall be as defined in Sec.
40.9(c)(1)(i).
(fff) Regulatory Oversight Committee. This term shall be as defined
in Sec. 37.19(b)(1), with respect to a registered swap execution
facility, and Sec. 38.851(b)(1), with respect to a designated contract
market.
(ggg) Risk Management Committee. This term shall be as defined in
Sec. 39.13(g)(1).
PART 37--SWAP EXECUTION FACILITIES
3. Revise the authority citation for part 37 to read as follows:
Authority: Sec. 726, Pub. L. 111-203, 124 Stat. 1376.
4. Revise the heading to Part 37 to read as set forth above.
5. Add Sec. 37.19 to read as follows:
Sec. 37.19 Conflicts of Interest.
(a) General. The swap execution facility shall:
(1) Establish and enforce rules to minimize conflicts of interest
in its decision-making process; and
(2) Establish a process for resolving the conflicts of interest.
Nothing in this section shall supersede any requirement applicable to
the registered swap execution facility under Sec. 40.9 of this
chapter.
(b) Regulatory Oversight Committee.
(1) General. A registered swap execution facility shall have a
regulatory oversight committee (the ``Regulatory Oversight
Committee''), which shall:
(i) Monitor the regulatory program of the registered entity for
sufficiency, effectiveness, and independence;
(ii) Oversee all facets of the regulatory program, including:
(A) Trade practice and market surveillance; audits, examinations,
and
[[Page 63748]]
other regulatory responsibilities with respect to members (including
ensuring compliance with, if applicable, financial integrity, financial
reporting, sales practice, recordkeeping, and other requirements); and
the conduct of investigations;
(B) Reviewing the size and allocation of the regulatory budget and
resources, and the number, hiring, termination, and compensation of
regulatory personnel;
(C) Reviewing the performance of the Chief Compliance Officer (as
referenced in Section 5h(f)(15) of the Act) and making recommendations
with respect to such performance to the Board of Directors;
(D) Recommending changes that would ensure fair, vigorous, and
effective regulation; and
(E) Reviewing all regulatory proposals prior to implementation and
advising the Board of Directors as to whether and how such changes may
impact regulation.
(2) Reporting. The Regulatory Oversight Committee shall report to
the Board of Directors of the registered swap execution facility.
(3) Composition. The Regulatory Oversight Committee shall be
composed entirely of Public Directors.
(4) Delegation. The Regulatory Oversight Committee shall oversee
the regulatory program of the registered swap execution facility on
behalf of the Board of Directors. The Board of Directors shall delegate
sufficient authority, dedicate sufficient resources, and allow
sufficient time for the Regulatory Oversight Committee to fulfill its
mandate.
(c) Membership or Participation.
(1) Committee.
(i) General. A registered swap execution facility shall have a
membership or participation committee (the ``Membership or
Participation Committee''), which shall, at a minimum, perform the
following functions:
(A) Determine the standards and requirements for initial and
continuing membership or participation eligibility;
(B) Review appeals of staff denials of membership or participation
applications; and
(C) Approve rules that would result in different categories or
classes of members or participants receiving disparate access to the
registered swap execution facility.
(ii) Reporting. The Membership or Participation Committee shall
report to the Board of Directors of the registered swap execution
facility.
(iii) Composition. The Membership or Participation Committee shall
be composed of thirty-five percent Public Directors.
(iv) Delegation. The Board of Directors may choose to delegate the
performance of the functions of the Membership or Participation
Committee to one or more other committees, provided that each such
committee meets the composition requirements set forth in paragraph
(c)(1)(iii) of this section. If the Board of Directors chooses to so
delegate, the registered swap execution facility would no longer need
to maintain a Membership or Participation Committee.
(2) Access.
(i) In reviewing appeals of staff denials of membership or
participation applications, the Membership or Participation Committee
(or entity performing the functions of such committee) shall not uphold
any staff denial if the relevant application meets the standards and
requirements that such committee sets forth.
(ii) The Membership or Participation Committee (or entity
performing the functions of such committee) shall not, and shall not
permit the registered swap execution facility to, restrict access or
impose burdens on access in a discriminatory manner, within each
category or class of members or participants or between similarly-
situated categories or classes of members or participants.
(d) Limits on Voting Equity Ownership and the Exercise of Voting
Power.
(1) Definitions. For purposes of this Sec. 37.19(d):
(i) Related Persons means, with respect to any member of a
registered swap execution facility:
(A) Any person that, directly or indirectly, is a parent or
subsidiary of, or shares a common parent with, such member;
(B) Any partner, director, officer, or other employee of such
member;
(C) Any immediate family member of such member, or any immediate
family member of such member's spouse, in each case, who has the same
home as such member; or
(D) Any immediate family member of the persons enumerated in
paragraph (d)(1)(i)(B) of this section, or any immediate family member
of such person's spouse, in each case, who has the same home as such
person.
(2) Limits. A registered swap execution facility shall not permit
any member, together with any Related Persons of such member, to:
(i) Beneficially own, directly or indirectly, more than twenty
percent of any class of equity interest of the registered swap
execution facility entitled to vote; or
(ii) Directly or indirectly vote, cause the vote of, give any
consent or proxy with respect to the voting of, or enter into any
shareholder agreement regarding the voting of, any interest in the
registered swap execution facility that exceeds twenty percent of the
voting power of any class of equity interest of the registered swap
execution facility.
(3) Parent Companies. If the registered swap execution facility is
a subsidiary, paragraph (d)(2) of this section shall apply to its
parent, whether direct or indirect, in the same manner as it applies to
the registered swap execution facility. If any parent is publicly-
listed on a domestic exchange, then such parent must follow the voting
requirements promulgated by the Securities and Exchange Commission or
the entity on which such parent is listed.
(4) Remediation. A registered swap execution facility must have
rules addressing the manner in which it would remediate any breach of
the limits set forth in paragraph (d)(2) of this section. Such rules
must specify, at a minimum:
(i) The manner in which the registered swap execution facility
would redeem any equity interest that a member or a Related Person
purchased in excess of the limits set forth in paragraph (d)(2) of this
section;
(ii) The manner in which the registered swap execution facility
would disregard any votes cast in excess of such limits; and
(iii) The manner in which the registered swap execution facility
would cause any breach of such limits to be reported to the Chief
Compliance Officer (as referenced in Section 5h(f)(15) of the Act).
PART 38--DESIGNATED CONTRACT MARKETS
6. Revise the authority citation for part 38 to read as follows:
Authority: 7 U.S.C. 2, 5, 6, 6c, 7, 7a-2 and 12a and Sec. 726,
Pub. L. 111-203, 124 Stat. 1376.
7. Section 38.1 is amended by adding a new sentence to the end of
the section to read as follows:
Sec. 38.1 Scope.
* * * Nothing in this Part 38 shall apply to a board of trade
designated as a contract market pursuant to Section 5f of the Act.
8. Add Sec. 38.851 to read as follows:
Sec. 38.851 Conflicts of interest.
(a) General. A designated contract market shall establish and
enforce rules
[[Page 63749]]
to minimize conflicts of interest in its decision-making process and
establish a process for resolving any conflicts of interest. Nothing in
this section shall supersede any requirement applicable to the
designated contract market under Sec. 40.9 of this chapter.
(b) Regulatory Oversight Committee.
(1) General. A designated contract market shall have a regulatory
oversight committee (``Regulatory Oversight Committee''), which shall:
(i) Monitor the regulatory program of the registered entity for
sufficiency, effectiveness, and independence;
(ii) Oversee all facets of the regulatory program, including:
(A) Trade practice and market surveillance; audits, examinations,
and other regulatory responsibilities with respect to members
(including ensuring compliance with, if applicable, financial
integrity, financial reporting, sales practice, recordkeeping, and
other requirements); and the conduct of investigations;
(B) Reviewing the size and allocation of the regulatory budget and
resources, and the number, hiring, termination, and compensation of
regulatory personnel;
(C) Supervising the chief regulatory officer of the designated
contract market, who will report directly to the Regulatory Oversight
Committee;
(D) Recommending changes that would ensure fair, vigorous, and
effective regulation; and
(E) Reviewing all regulatory proposals prior to implementation and
advising the Board of Directors as to whether and how such changes may
impact regulation.
(2) Reporting. The Regulatory Oversight Committee shall report to
the Board of Directors of the designated contract market.
(3) Composition. The Regulatory Oversight Committee shall be
composed entirely of Public Directors.
(4) Delegation. The Regulatory Oversight Committee shall oversee
the regulatory program of the designated contract market on behalf of
the Board of Directors. The Board of Directors shall delegate
sufficient authority, dedicate sufficient resources, and allow
sufficient time for the Regulatory Oversight Committee to fulfill its
mandate.
(c) Membership or Participation.
(1) Committee.
(i) General. A designated contract market shall have a membership
or participation committee (``Membership or Participation Committee''),
which shall, at a minimum, perform the following functions:
(A) Determine the standards and requirements for initial and
continuing membership or participation eligibility;
(B) Review appeals of staff denials of membership or participation
applications; and
(C) Approve rules that would result in different categories or
classes of members or participants receiving disparate access to the
designated contract market.
(ii) Reporting. The Membership or Participation Committee shall
report to the Board of Directors of the designated contract market.
(iii) Composition. The Membership or Participation Committee shall
be composed of thirty-five percent Public Directors.
(iv) Delegation. The Board of Directors may choose to delegate the
performance of the functions of the Membership or Participation
Committee to one or more other committees, provided that each such
committee meets the composition requirements set forth in paragraph
(c)(1)(iii) of this section. If the Board of Directors chooses to so
delegate, the registered swap execution facility would no longer need
to maintain a Membership or Participation Committee.
(2) Access.
(i) In reviewing appeals of staff denials of membership or
participation applications, the Membership or Participation Committee
(or entity performing the functions of such committee) shall not uphold
any staff denial if the relevant application meets the standards and
requirements that such committee sets forth.
(ii) The Membership or Participation Committee (or entity
performing the functions of such committee) shall not, and shall not
permit the registered swap execution facility to, restrict access or
impose burdens on access in a discriminatory manner, within each
category or class of members or participants or between similarly-
situated categories or classes of members or participants.
(d) Limits on Voting Equity Ownership and the Exercise of Voting
Power.
(1) Definitions. For purposes of this Sec. 38.851(d):
(i) Related Persons means, with respect to any member of a
designated contract market:
(A) Any person that, directly or indirectly, is a parent or
subsidiary of, or shares a common parent with, such member;
(B) Any partner, director, officer, or other employee of such
member;
(C) Any immediate family member of such member, or any immediate
family member of such member's spouse, in each case, who has the same
home as such member; or
(D) Any immediate family member of the persons enumerated in
paragraph (d)(1)(i)(B) of this section, or any immediate family member
of such person's spouse, in each case, who has the same home as such
person.
(2) Limits. A designated contract market shall not permit any
member, together with any Related Persons of such member, to:
(i) Beneficially own, directly or indirectly, more than twenty
percent of any class of equity interest of the designated contract
market entitled to vote; or
(ii) Directly or indirectly vote, cause the vote of, give any
consent or proxy with respect to the voting of, or enter into any
shareholder agreement regarding the voting of, any interest in the
designated contract market that exceeds twenty percent of the voting
power of any class of equity interest of the designated contract
market.
(3) Parent Companies. If the designated contract market is a
subsidiary, paragraph (d)(2) of this section shall apply to its parent,
whether direct or indirect, in the same manner as it applies to the
designated contract market. If any parent is publicly-listed on a
domestic exchange, then such parent must follow the voting requirements
promulgated by the Securities and Exchange Commission or the entity on
which such parent is listed.
(4) Remediation. A designated contract market must have rules
addressing the manner in which it would remediate any breach of the
limits set forth in paragraph (d)(2) of this section. Such rules must
specify, at a minimum:
(i) The manner in which the designated contract market would redeem
any equity interest that a member or a Related Person purchased in
excess of the limits set forth in paragraph (d)(2) of this section;
(ii) The manner in which the designated contract market would
disregard any votes cast in excess of such limits; and
(iii) The manner in which the designated contract market would
cause any breach of such limits to be reported to the chief regulatory
officer.
PART 39--DERIVATIVES CLEARING ORGANIZATIONS
9. Revise the authority citation for part 39 read as follows:
Authority: 7 U.S.C. 7b and Sec. 726, Pub. L. 111-203, 124 Stat.
1376.
10. Add Sec. 39.13 to read as follows:
[[Page 63750]]
Sec. 39.13 Risk Management.
(a) through (g) [Reserved]
(g) Risk Management Committee.
(1) General. A derivatives clearing organization shall have a risk
management committee (the ``Risk Management Committee''), which shall,
at a minimum, perform the following functions:
(i) Advise the Board of Directors on significant changes to the
derivatives clearing organization's risk model and default procedures;
(ii) Determine the standards and requirements for initial and
continuing clearing membership eligibility;
(iii) Approve or deny (or review approvals or denials of) clearing
membership applications;
(iv) Determine products eligible for clearing; and
(v) Review the performance of the Chief Compliance Officer (as
referenced in Section 5b(i) of the Act) and make recommendations with
respect to such performance to the Board of Directors.
(2) Reporting. The Risk Management Committee shall report to the
Board of Directors of the derivatives clearing organization.
(3) Composition.
(i) The Risk Management Committee shall be composed of at least
thirty-five percent Public Directors of a derivatives clearing
organization and at least ten percent representatives of customers. In
this context, a ``customer'' means any customer of a clearing member,
including, without limitation:
(A) Any ``customer'' or ``commodity customer'' within the meaning
of Sec. 1.3(k) of this chapter;
(B) Any ``foreign futures or foreign options customer'' within the
meaning of Sec. 30.1(c) of this chapter; and
(C) Any customer entering into a cleared swap (as defined in
Section 1a(7) of the Act).
(ii) The remaining members of such Risk Management Committee (or
subcommittee thereof as described in paragraph (g)(5) of this section)
may be, in the discretion of the derivatives clearing organization,
representatives of clearing members. No such member shall be an
employee of the derivatives clearing organization.
(iii) The Chairman of the Risk Management Committee (or
subcommittee thereof as described in paragraph (g)(5) of this section)
shall be a Public Director.
(4) Meetings. The Risk Management Committee shall hold regular
meetings. The Committee may invite employees of the derivatives
clearing organization to attend its meetings in a non-voting capacity.
(5) Delegation. The Risk Management Committee may delegate, in
writing, the performance of the functions enumerated in paragraph
(g)(1)(ii) to (iv) of this section to a subcommittee, provided that
such subcommittee meets the composition requirements set forth in
paragraph (g)(3) of this section. If the Risk Management Committee
chooses to so delegate, then it would no longer be subject to such
composition requirements.
(6) Discretion.
(i) No decision of a subcommittee with delegated authority under
paragraph (g)(5) of this section, pertaining to the functions
enumerated in paragraph (g)(1)(ii) to (iv) of this section, may be
subject to the approval of, or otherwise restricted or limited by, a
body other than the Board of Directors or the Risk Management Committee
of the derivatives clearing organization, including, without
limitation, any advisory committee.
(ii) No decision of the Risk Management Committee pertaining to the
functions enumerated in paragraph (g)(1)(ii) to (iv) of this section,
may be subject to the approval of, or otherwise restricted or limited
by, a body other than the Board of Directors of the derivatives
clearing organization, including, without limitation, any advisory
committee.
11. Add Sec. 39.25 to read as follows:
Sec. 39.25 Conflicts of interest.
(a) General. (1) A derivatives clearing organization shall
establish and enforce rules to minimize conflicts of interest in its
decision-making process and establish a process for resolving any
conflicts of interest.
(2) Governance arrangements for derivatives clearing organizations
should be clear and transparent and be designed to promote the safety
and efficiency of the derivatives clearing organization, to support the
stability of the broader financial system and other relevant public
interest considerations, and to support the objectives of relevant
stakeholders.
(3) Nothing in this section shall supersede any requirement
applicable to the derivatives clearing organization under Sec. 40.9 of
this chapter.
(b) Limits on Voting Equity Ownership and the Exercise of Voting
Power.
(1) Definitions. For purposes of this Sec. 39.25(b):
(i) Affiliate means any person that, directly or indirectly,
controls, is controlled by, or is under common control with, another
person.
(ii) Enumerated Entities means:
(A) A bank holding company (as defined in Section 2 of the Bank
Holding Company Act of 1956 (12 U.S.C. 1841)) with total consolidated
assets of $50,000,000,000 or more,
(B) A nonbank financial company (as defined in Section 102 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act) supervised
by the Board of Governors of the Federal Reserve System,
(C) An Affiliate of such bank holding company or nonbank financial
company,
(D) A swap dealer (as defined in Section 1a(49) of the Act and any
regulations promulgated thereunder),
(E) A major swap participant (as defined in Section 1a(33) of the
Act and any regulations promulgated thereunder), and
(F) An associated person of a swap dealer or major swap participant
(as defined in Section 1a(3) of the Act and any regulations promulgated
thereunder).
(iii) Related Persons means, with respect to any person:
(A) An Affiliate of such person;
(B) Any partner, director, officer, or other employee of such
person;
(C) Any immediate family member of such person, or any immediate
family member of such person's spouse, in each case, who has the same
home as such person; or
(D) Any immediate family member of the persons enumerated in
paragraph (b)(1)(iii)(B) of this section, or any immediate family
member of such person's spouse, in each case, who has the same home as
such person.
(2) Limits. A derivatives clearing organization shall choose to
comport with either paragraph (b)(2)(i) or (b)(2)(ii) of this section:
(i)(A) The derivatives clearing organization shall not permit any
member, together with any Related Persons of such member, to:
(1) Beneficially own, directly or indirectly, more than twenty
percent of any class of equity interest of the derivatives clearing
organization entitled to vote; or
(2) Directly or indirectly vote, cause the vote of, give any
consent or proxy with respect to the voting of, or enter into any
shareholder agreement regarding the voting of, any interest in the
derivatives clearing organization that exceeds twenty percent of the
voting power of any class of equity interest of the derivatives
clearing organization.
(B) Additionally, a derivatives clearing organization shall not
permit the Enumerated Entities (whether or not they are clearing
members), together with any Related Persons of such Enumerated
Entities, to collectively:
(1) Own, on a beneficial basis, directly or indirectly, more than
forty percent of
[[Page 63751]]
any class of equity interest of the derivatives clearing organization
entitled to vote; or
(2) Directly or indirectly vote, cause the vote of, give any
consent or proxy with respect to the voting of, or enter into any
shareholder agreement regarding the voting of, any interest in the
derivatives clearing organization that exceeds forty percent of the
voting power of any class of equity interest of the derivatives
clearing organization.
(C) The derivatives clearing organization shall ensure that no
resolution or similar measure on which the Enumerated Entities are
entitled to vote shall be passed by less than a majority of all
outstanding equity interests similarly entitled to vote.
(ii) The derivatives clearing organization shall not permit any
member or any Enumerated Entity (whether or not such entity is a
member), together with any Related Persons in each case thereof, to:
(A) Beneficially own, directly or indirectly, more than five
percent of any class of equity interest of the derivatives clearing
organization entitled to vote; or
(B) Directly or indirectly vote, cause the vote of, give any
consent or proxy with respect to the voting of, or enter into any
shareholder agreement regarding the voting of, any interest in the
derivatives clearing organization that exceeds five percent of the
voting power of any class of equity interest of the derivatives
clearing organization.
(3) Waiver.
(i) A derivatives clearing organization may request that the
Commission waive the requirements set forth in paragraph (b)(2) of this
section.
(ii)(A) The Commission may grant a waiver for a period of time that
it deems reasonable if, upon a showing by a derivatives clearing
organization, the Commission determines that, with respect to the
derivatives clearing organization, the requirements set forth in
paragraph (b)(2) of this section are not necessary or appropriate to:
(1) Improve the governance of the derivatives clearing
organization;
(2) Mitigate systemic risk;
(3) Promote competition;
(4) Mitigate conflicts of interest in connection with a swap dealer
or major swap participant's conduct of business with the derivatives
clearing organization, including with respect to Section 2(h)(1)(B) and
Section 5b(c)(2)(c) of the Act; and
(5) Otherwise accomplish the purposes of the Act.
(B) The Commission may, at any time, revoke the waiver upon its own
motion. Upon such revocation, or at the expiration of the waiver
period, the derivatives clearing organization shall require all equity
holders to comport, through divestiture or other means, with the
requirements set forth in paragraph (b)(2) of this section.
(4) Parent Companies. If the derivatives clearing organization is a
subsidiary, paragraph (b)(2) of this section shall apply to its parent,
whether direct or indirect, in the same manner as it applies to the
derivatives clearing organization. If any parent is publicly listed on
a domestic exchange, then such parent must follow the voting
requirements promulgated by the Securities and Exchange Commission or
the entity on which such parent is listed.
(5) Remediation. A derivatives clearing organization must have
rules addressing the manner in which it would remediate any breach of
the limits set forth in paragraph (b)(2) of this section. Such rules
must specify, at a minimum:
(i) The manner in which the derivatives clearing organization would
redeem any equity interest that a member, the Enumerated Entities, or a
Related Person in each case thereof, purchased in excess of the limits
set forth in paragraph (b)(2) of this section;
(ii) The manner in which the derivatives clearing organization
would disregard any votes cast in excess of such limits; and
(iii) The manner in which the derivatives clearing organization
would cause any breach of such limits to be reported to the Chief
Compliance Officer (as referenced in Section 5b(i) of the Act).
PART 40--PROVISIONS COMMON TO REGISTERED ENTITIES
1. Revise the authority citation for part 40 to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 7, 7a, 8, and 12a, and Sec.
726, Pub. L. 111-203, 124 Stat. 1376.
2. Add Sec. 40.9 to read as follows:
Sec. 40.9 Governance.
(a) General. (1) Nothing in this section shall apply to a board of
trade designated as a contract market pursuant to Section 5f of the
Act.
(2) Capitalized terms not defined herein shall have the meanings
assigned to them in Sec. 1.3 of this chapter.
(3) Nothing in this section shall supersede any requirement
applicable to the registered entity under Parts 37, 38, or 39 of this
chapter.
(b) The Board of Directors.
(1) General.
(i) The Board of Directors of a registered derivatives clearing
organization, a designated contract market, or a registered swap
execution facility shall be composed of at least thirty-five percent,
but no less than two, Public Directors.
(ii) The roles and responsibilities of such Board of Directors must
be clearly articulated, especially in respect of the manner in which
the Board of Directors ensures that a registered entity referenced in
paragraph (b)(1)(i) of this section complies with all statutory,
regulatory, and self-regulatory responsibilities under the Act and the
regulations promulgated thereunder.
(2) Parent Companies.
(i) For purposes of paragraph (b)(2) of this section, ``operate''
shall mean the direct exercise of control (including through the
exercise of veto power) over the day-to-day business operations of a
registered entity specified in paragraph (b)(1)(i) of this section by
the sole or majority shareholder of such registered entity, whether
through the ownership of voting equity, by contract, or otherwise. The
term ``operate'' shall not prohibit an entity, acting as the sole or
majority shareholder of such registered entity, from exercising its
rights as a shareholder under any contract, agreement, or other legal
obligation.
(ii) A registered entity specified in paragraph (b)(1)(i) of this
section shall not permit itself to be operated by any entity unless
such entity agrees that:
(A) Paragraph (b)(1) of this section shall apply to such entity in
the same manner as it applies to the registered entity;
(B) The officers, directors, employees, and agents of such entity
shall be deemed to be the officers, directors, employees, and agents of
the registered entity, and shall thereby be subject to the authority of
the Commission pursuant to the Act and the regulations promulgated
thereunder; and
(C) Any books and records of such entity relating to such operation
shall be deemed to be the books and records of the registered entity
for purposes of the Act and the regulations promulgated thereunder.
Such books and records shall be subject at all times to inspection and
copying by the Commission, regardless of whether such books and records
contain confidential information, as long as such entity operates the
registered entity.
(3) Expertise. The members of the Board of Directors, including
Public Directors, of each registered entity specified in paragraph
(b)(1)(i) of this section, shall be of sufficiently good repute and,
where applicable, have sufficient expertise in financial services, risk
management, and clearing services.
[[Page 63752]]
(4) Compensation. The compensation of the Public Directors and
other non-executive members of the Board of Directors of a registered
entity specified in paragraph (b)(1)(i) of this section shall not be
linked to the business performance of such registered entity.
(5) Annual Self-Review. The Board of Directors of a registered
entity specified in paragraph (b)(1)(i) of this section shall review
its performance and that of its individual members annually. It should
consider periodically using external facilitators for such reviews.
(6) Board Member Removal. A registered entity specified in
paragraph (b)(1)(i) of this section shall have procedures to remove a
member from the Board of Directors, where the conduct of such member is
likely to be prejudicial to the sound and prudent management of the
registered entity.
(c) Committees and Panels.
(1) Nominating Committee.
(i) General. Each registered derivatives clearing organization,
designated contract market, or registered swap execution facility must
have a nominating committee (``Nominating Committee''), which shall, at
a minimum:
(A) identify individuals qualified to serve on the Board of
Directors, consistent with criteria approved by the Board of Directors,
and with the composition requirements set forth in this section; and
(B) Administer a process for the nomination of individuals to the
Board of Directors.
(ii) Reporting. The Nominating Committee shall report to the Board
of Directors of the registered entity.
(iii) Composition. The Nominating Committee shall be composed of at
least fifty-one percent Public Directors. The chair of the Nominating
Committee shall be a Public Director.
(2) Executive Committee. Any Executive Committee of a registered
derivatives clearing organization, designated contract market, or
registered swap execution facility shall be composed of at least
thirty-five percent, but no less than two, Public Directors.
(3) Disciplinary Panels.
(i) General. Each registered derivatives clearing organization,
designated contract market, or registered swap execution facility must
have one or more disciplinary panels (each, a ``Disciplinary Panel''),
each of which shall be responsible for conducting hearings, rendering
decisions, and imposing sanctions with respect to disciplinary matters.
(ii) Composition. Each Disciplinary Panel shall include at least
one person who would not be disqualified from serving as a Public
Director by Sec. 1.3(ccc)(1)(i)-(vi) and (2) of this chapter (a
``Public Participant''). Such Public Participant shall chair each
Disciplinary Panel. In addition, any registered entity specified in
paragraph (c)(3)(i) of this section shall adopt rules that would, at a
minimum:
(A) Further preclude any group or class of participants from
dominating or exercising disproportionate influence on a Disciplinary
Panel and
(B) Prohibit any member of a Disciplinary Panel from participating
in deliberations or voting on any matter in which the member has a
financial interest.
(iii) Appeals. If the rules of the registered entity provide that
the decision of a Disciplinary Panel may be appealed to another
committee of the Board of Directors (or similar body), then such
committee must also include at least one Public Participant, and such
Public Participant must chair the committee.
(iv) Exception. Notwithstanding the foregoing, paragraphs
(c)(3)(ii) through (c)(3)(iii) of this section do not apply to a
Disciplinary Panel convened for cases solely involving decorum or
attire.
(v) Delegation. With respect to a registered derivatives clearing
organization, the Board of Directors may delegate to the Risk
Management Committee the performance of the functions of the
Disciplinary Panel. If the Board of Directors so delegates:
(A) The registered derivatives clearing organization need no longer
maintain a Disciplinary Panel, but
(B) Paragraph (c)(3)(iii) of this section would still apply to any
committee (or similar body) to which a decision of the Risk Management
Committee may be appealed.
Issued in Washington, DC, on October 1, 2010, by the Commission.
David A. Stawick,
Secretary of the Commission.
Concurring Statement of Commissioner Scott D. O'Malia
October 1, 2010 Public Meeting
I concur in the Commission's proposal of rules pursuant to
Section 726 of the Dodd-Frank Act (the ``Act''). However, I have a
number of concerns associated with the prescriptiveness of the
proposed conflict of interest rules. I believe, given the goals of
the Act, it is appropriate to consider more flexible ownership
structures and voting rights levels as well as the availability of
waivers for derivatives clearing organizations (``DCOs'').
Ownership and Voting Limits on DCOs
A main goal of the Act is to mitigate systemic risk in the U.S.
financial system by imposing a mandatory clearing requirement on
swaps. Additionally, the business of clearing is serious and
financially complex. I am concerned that the proposed rules may not
properly consider the effect on mitigation of systemic risk,
competition, and capital formation in the DCO space, or afford the
Commission with the necessary flexibility to achieve those outcomes.
Given that the Commission has yet to consider any new DCO
applications under the Act, it is extremely unwise to conduct an
experiment with the ownership structure of DCOs.
Second, a stated goal of the Act was to provide all market
participants with fair, open, and non-discriminatory access to DCOs.
To achieve that end, Congress included Open Access and Participant
and Product Eligibility provisions in the Act.\101\ Each provision
addresses and attempts to eliminate the potential for clearing
entities to use ownership control to obstruct market participants
from gaining access to a DCO. Rather than utilizing the limited and
inflexible ownership caps in the proposed rules, I believe that the
open access and eligibility provisions will be more effective in
achieving the Act's goals of fair, open, and non-discriminatory
access to DCOs.
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\101\ Section 2(h)(1)(B) and Section 5b(c)(2)(c) of the Act.
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Third, an overarching goal of the Act is the international
harmonization of financial regulation. I believe that it's
especially important for the Commission to harmonize its rules with
those of foreign regulators in order to prevent regulatory
arbitrage. With that said, the European Commission released
(September 15, 2010) a proposal on financial reform which does not
place individual or aggregate ownership limits on DCOs under
European Union jurisdiction.
For the aforementioned reasons, I am in favor of a more flexible
approach to limitations on DCO ownership and voting rights,
including the availability of a full waiver for individual and
aggregate ownership or voting limits on swap dealers or major swap
participants that hold or desire to hold debt or equity positions in
DCOs.
Public Directors
I fully support the Commission's decision to require a
registered entity to have its board of directors and certain other
committees composed of thirty-five percent (35%) public directors.
This standard is consistent with the Commission's previous core
principle 15 for designated contract markets (``DCMs''). The
Commission thoroughly vetted this percentage with the public in a
recent rulemaking and it concluded that having a board of directors
for DCMs composed of thirty-five percent (35%) public directors was
neither overly burdensome nor cost prohibitive. Today's proposed
rulemaking also raises the question as to whether it is desirable to
expand the existing rule from thirty-five percent (35%) up to fifty-
one percent (51%) for DCMs, DCOs, and swap execution facilities. I
am interested to know how this proposal would enhance the governance
of the existing board structures of certain registered entities, and
more specifically, how it would expand the clearing and risk
management expertise of a DCO.
[[Page 63753]]
I strongly encourage the public to closely analyze the language
of each proposed rule and to provide the Commission with
constructive and detailed comments on each of them. In particular, I
am interested to know (i) what effect the Commission's proposed
rules on voting and ownership limitations will have on competition,
raising capital, and managing risk, and (ii) whether or not the open
access and eligibility provisions in Sections 2(h)(1)(B) and
5b(c)(2)(c) of the Act would be a more effective method for the
Commission to expand access to clearing, rather than placing limits
on the voting and ownership of DCOs.
Proposed Requirements for Derivatives Clearing Organizations,
Designated Contract Markets, and Swap Execution Facilities Regarding
the Mitigation of Conflicts of Interest
Commissioner Jill E. Sommers, Dissenting
The Commission is voting today on a proposal to implement two
sections of the Dodd-Frank Act regarding the governance of CFTC
regulated trading venues and clearinghouses that trade or clear
swaps and how to mitigate conflicts of interest that may arise in
connection with ownership interests that certain entities may have
in these registrants. Specifically, Section 725(d) of the Act
directs the Commission to:
Adopt rules mitigating conflicts of interest in connection with
the conduct of business by a swap dealer or a major swap participant
with at [DCO], [DCM], or a [SEF] that clears or trades swaps in
which the swap dealer or major swap participant has a material debt
or material equity investment.
Section 726 of the Act provides that the Commission shall adopt
rules which ``may'' include numerical limits on the degree of
control or voting rights that certain enumerated entities may
possess with respect to DCOs, DCMs and SEFs if the Commission
determines, after a review:
That such rules are necessary or appropriate to improve the
governance of, or to mitigate systemic risk, promote competition, or
mitigate conflicts of interest in connection with a swap dealer or
major swap participant's conduct of business with, a [DCO], [DCM],
or [SEF] that clears or posts swaps or makes swaps available for
trading and in which such swap dealer or major swap participant has
a material debt or equity investment.
I recognize that these provisions direct the Commission to adopt
strong governance rules to mitigate conflicts of interest in
connection with the interaction between swap dealers and major swap
participants and DCOs, DCMs and SEFs in which they have a material
debt or equity investment. In my opinion, however, the voting equity
restrictions being proposed are not necessary or appropriate to
mitigate the perceived conflicts and in fact, may do more harm than
good to the emerging marketplace for trading and clearing swaps.
In 2009, after more than two years of study, the Commission
finalized acceptable practices to provide a safe harbor for
complying with Core Principle 15 for DCMs dealing with conflicts of
interest. I support making those acceptable practices mandatory for
DCMs, DCOs and SEFs, as augmented by some of the additional
provisions being proposed today, such as the Risk Management
Committee for DCOs. I believe that strong governance rules, coupled
with the Commission's ultimate authority to determine which swaps
must be cleared, under Section 723 of Dodd-Frank, is sufficient to
ensure that swaps that should be listed for trading and cleared will
be listed for trading and cleared.
I have grave concerns that the proposed limitations on voting
equity, especially those proposed for enumerated entities in the
aggregate with respect to DCOs, may stifle competition by preventing
new DCMs, DCOs and SEFs that trade or clear swaps from being formed.
The Commission recognizes in the preamble to the proposal that the
enumerated entities will be the most likely source of funding for
new DCMs and SEFs and thus chose not to propose the aggregate limits
for trading venues. I believe the same logic applies with even
greater force for DCOs. I am equally concerned that a number of
recent entrants into the swaps trading and clearing space will
potentially be required to disband their operations if they are
unable to attract the required amount of non-voting equity within
the two-year/two board election cycles proposed. I also note that
the European Commission explicitly rejected ownership limitations in
its proposal for regulating OTC derivatives announced September 15th
because such limitations may have negative consequences for market
structures. I agree. And I hope that we will be mindful of global
consistency as we move forward. The marketplace for trading and
clearing swaps is in its infancy. I strongly believe that the
limitations the Commission is proposing will have the effect of
inhibiting emerging competition rather than promoting it. I
therefore cannot support today's proposal.
[FR Doc. 2010-26220 Filed 10-15-10; 8:45 am]
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