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The Commodity Futures Trading Commission (CFTC) has proposed a series of changes to its general regulations governing derivatives clearing organizations (DCOs).[1] The CFTC has stated that the proposed amendments are intended to enhance certain risk management and reporting obligations, clarify certain provisions, simplify registration and reporting processes and codify existing relief and guidance, consistent with the objectives of Project KISS,[2] the CFTC’s initiative to simplify its regulations and reduce costs for market participants. However, many of the proposed amendments would require significant changes to current practice and impose new obligations for DCOs (and their clearing members), and are not merely in the nature of clarifications, clean-up and codification of staff positions.
In 2011, the CFTC adopted Subparts A and B of Part 39 of its regulations to implement the DCO core principles set out under the Commodity Exchange Act (CEA), as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act. The CFTC in 2013 also adopted regulations in Subpart C of Part 39 to provide additional regulatory requirements for systemically important DCOs (SIDCOs) and other DCOs that elected to satisfy the higher standards (so-called “Subpart C DCOs”).
Key aspects of the proposal include the following:
Enterprise Risk Management (Rule 39.10(d))
The amendments would adopt new requirements for enterprise risk management, defined as an enterprise-wide strategic business process identifying potential events that may affect the enterprise and managing the probability or impact of those events on the enterprise as a whole such that the overall risk remains within the risk appetite. A DCO would be required to measure, monitor and manage identified sources of risk on an ongoing basis and to test the effectiveness of any mitigating controls to reduce risks. A DCO would also be required to establish and maintain an enterprise risk management framework, approved by its board or a board committee and reviewed annually and to appoint an enterprise risk officer. The proposal recognizes that enterprise risk management may be conducted on a group-wide basis.
Customer Account Level Reporting (Rule 39.13)
In a significant change, DCOs would be required to implement rules that require clearing members to provide daily reports to the DCO showing the end-of-day gross positions of each beneficial owner within each customer origin. DCOs in turn would be required to report this information to the Commission. Although some customer-by-customer reporting of this type has previously been required for swaps under the “LSOC” model in Part 22 of the CFTC rules, the CFTC regulations have not previously required this level of reporting for futures (for which the clearing member is only required to provide information as to the aggregate gross customer position). At a minimum, this change, if adopted, may result in significant additional operational and administrative obligations for DCOs and their members.
Other Risk Management and Margin Requirements (Rule 39.13)
The amendments would require a DCO, when conducting margin back testing, to compare portfolio losses only to those components of initial margin that capture changes in market risk factors. The rationale for this change is unclear, as is what exactly is meant by market risk factors for this purpose.
The CFTC has proposed to amend its requirement that a DCO align initial margin requirements with the risks of each product and portfolio to add that concentration risk must also be addressed.
The proposed amendments would also clarify that a DCO must collect customer initial margin on a gross basis only during its end-of-day settlement cycle, rather than intraday, though the CFTC would still strongly encourage DCOs to collect customer initial margin on a gross basis during any intraday settlement cycle as long as they are able to calculate the margin accurately.
The amendments would give DCOs greater flexibility to determine whether and by how much customer initial margin requirements must exceed the DCO’s minimum level.
The proposal would expand the DCO’s existing obligation to review clearing member risk management practices, by adding a requirement that the DCO “take appropriate action” based on the result of this review. It is not clear what type or level of responsibility the CFTC is intending to put on the DCO in this regard.
Financial Resources (Rule 39.11)
The amendments would make certain technical changes and clarifications to the required calculation of financial resources and liquidity resources and the stress loss calculation. Among other changes, the amendments would require that when calculating a DCO’s largest financial exposure (1) the DCO, in netting exposure against clearing member initial margin, must use only the required portions of the margin on deposit (and not any excess margin on deposit) and may only use customer initial margin to the extent permitted by law; and (2) the DCO must combine the customer and house stress test losses of each clearing member using the same stress test scenarios. The amendments would provide exceptions from certain requirements (including stress testing) for fully collateralized positions.
Commingling of Funds (Rule 39.15(b))
The proposed amendments would allow a DCO to commingle customer positions and margin in futures, options and swaps, or any combination thereof, and any related margin, pursuant to a DCO rule submitted for approval under Rule 40.5, without need for a formal “4d order” as under current practice. The amendment would also apply the same approach to commingling futures, swaps and positions in foreign futures and foreign options (and related margin).
Default Rules and Procedures (Rule 39.16)
The amendments would impose certain additional default management requirements. For default management auctions, mandatory bid requirements would expressly have to be proportional to the positions carried by the clearing member in the relevant product class (as reflected by initial margin requirements). Note that it is not clear how narrowly or broadly product class is to be defined for this purpose. Market participants may also question whether it is appropriate to only look at initial margin requirements (as opposed to guaranty fund or other factors) for this purpose.
There would also be a requirement to have a default management committee, which would have to include clearing members and which would need to be convened for a default involving substantial or complex positions. Although some DCOs currently use such committees, not all do so, or may not do so for all products.
The proposed amendments also would require that a DCO include its clearing members in default management plan testing on at least an annual basis, and encourage DCOs to ensure that a “sufficient portion” of its clearing membership participate in each test.
Reporting (Rule 39.19)
Event Reporting: The amendments would add a significant number of new reporting requirements for the following events or circumstances, including:
Several of these proposed requirements may be viewed as vague (particularly reporting as to “issues” with margin models, settlement banks, “major” board decisions, etc.). In several cases, the time frame for reporting would be quite limited as reporting would be required immediately or within one business day.
New Products: The amendments would require 30 days’ advance notice to the CFTC of any “new product.” This would be in addition to the existing self-certification or rule approval process for any related rule changes. Certain aspects of this proposal remain unclear, including: (i) how “new product” is to be interpreted (e.g., is this limited to new broad categories (like commencing clearing of interest rate swaps), or to narrower changes like a new CDS transaction type); and (ii) whether or how the requirement would apply to an exchange-traded product where the exchange is listing a new contract but no significant changes to the DCO operations are expected.
Recovery and Wind-Down Plans: The amendments would require formal submission to the CFTC of recovery and wind-down plans for SIDCOs and Subpart C DCOs. Other DCOs would have the option of submitting them.
Financial Reporting: The amendments would also make a number of technical changes to quarterly and annual financial reporting requirements. The CFTC would expressly permit use of IFRS as an alternative to U.S. GAAP for non-U.S. DCOs. Financial statements would be required to more clearly identify assets held to meet default and operating financial resources requirements.
Governance (Rule 39.24-26)
The amendments would provide that there must be representation of market participants (defined as clearing members or their customers) at the clearing house board level (i.e., having participation of market participants at a risk committee level is not sufficient). The amendments would also apply certain general standards for governance and conflicts of interest to all DCOs instead of only SIDCOs and Subpart C DCOs.
Other Amendments
In addition, the proposed amendments also include the following:
Comments on the proposal must be received by September 13, 2019.[3] The CFTC is seeking comments on all aspects of the proposal, and in an accompanying statement, Commissioner Dan Berkovitz also specifically requested feedback on the calculation of initial and excess margin, cross-margining programs and risk mitigation measures.[4]
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