CFTC’s DCO exemptive regime: why the market should care

Author: IFLR Correspondent | Published: 6 Nov 2015
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The Commodity Futures Trading Commission (CFTC) has acted on its long-stated intention to establish a regime to exempt comparably regulated foreign swaps clearinghouses from derivatives clearing organisation (DCO) registration.

In August, the CFTC provided the Australian Securities Exchange (ASX) with a conditional exemption from DCO registration, and last week the CFTC issued similar exemptions to Korea Exchange (KRX) and Japan Securities Clearing Corporation (JSCC).

The issuance of these exemptions is important; not only for these three clearinghouses and their respective participants, but more generally because of its broader impact on the clearing landscape.

Backdrop

The CFTC takes the position that any clearinghouse that clears a swap for a US person – directly for a US clearing member or indirectly for a US customer of any clearing member – must either register with the CFTC as a DCO, or obtain an exemption from DCO registration. The registration requirement applies regardless of whether the swap cleared for a US person is subject to a mandatory clearing requirement.

Due to the CFTC’s expansive 'US person’ definition, the DCO registration requirement is triggered even when a foreign clearinghouse clears for certain firms that operate outside of the US, such as foreign branches of US banks. 

The Dodd-Frank Act permits the CFTC to exempt a foreign swaps clearinghouse from DCO registration, but only if:

  • the CFTC determines that the clearinghouse is subject to 'comparable, comprehensive supervision and regulation’ by authorities in the clearinghouse’s home country or the Securities and Exchange Commission; and
  • the clearinghouse maintains certain rules. 

Until it exempted ASX in August, the CFTC had not exercised this exemptive authority.  That said, ASX, KRX and JSCC – as well as certain other unregistered foreign clearinghouses – have been legally clearing swaps for some US firms under temporary, limited CFTC staff (Staff) no-action relief.


The ASX, KRX and JSCC exemptions are similar in many respects


The exemptions

The ASX, KRX and JSCC exemptions are similar in many respects. The CFTC conditioned each exemption on the clearinghouse’s ongoing observance of the international standards for clearinghouses – the Principles for Financial Market Infrastructures (PFMIs) – and the CFTC’s receipt of annual representations from the clearinghouse’s home country authorities confirming the continued good standing of the clearinghouses in Australia, Korea and Japan, respectively. Each of these jurisdictions maintains clearinghouse regulatory standards deemed consistent with the PFMIs.

The CFTC also conditioned each exemption on, among other things: the clearinghouse’s consent to jurisdiction in the US; agreement to make its books and records open to CFTC inspection; maintenance of certain rules concerning open access; and ongoing satisfaction of swap data reporting requirements plus various other daily, quarterly, event-specific and ad hoc reporting requirements.  

In addition, the CFTC has limited the types of US firms for whom the exempt clearinghouses may clear. ASX and KRX may clear any type of swap, and JSCC may clear any type of interest rate swap (IRS), for any US clearing member and any US affiliate of any clearing member – but not for any US customer or any customer of any futures commission merchant. 

Implications

The CFTC’s issuance of the exemptions has important implications for the clearinghouses and their respective clearing participants. While the exemptions and the clearinghouses’ prior Staff no-action relief share certain similarities (including that both forms of relief prohibit clearing for US customers), exempt status offers important advantages. 

For example, the Staff’s no-action letters imposed broad limitations on the types of swaps that each clearinghouse could clear for US firms: ASX was permitted to clear only Australian and New Zealand dollar-denominated IRS for US firms; KRX was permitted to clear only Korean won-denominated IRS for US firms; and JSCC was permitted to clear for US firms only those IRS subject to Japanese clearing requirements, Japanese yen-denominated IRS referencing the Tokyo InterBank Offered Rate and overnight index swaps. The CFTC did not carry over these restrictive product limitations in the exemptions. Therefore, as an exempt DCO, ASX and KRX may now clear any type of swap for US firms (for example, IRS and non-deliverable forwards denominated in any currency and broad-based equity index credit default swaps), and JSCC may now clear any type of IRS for US firms. 

The exemptions also provide the three clearinghouses with a more settled CFTC regulatory status than Staff no-action relief, which has generally been issued for one-year terms, and therefore require renewal. Clearing participants of ASX, KRX and JSCC also benefit from the changes in the clearinghouses’ regulatory status. This is because the clearinghouses now represent, from a CFTC regulatory perspective, a more reliable clearing option for US firms, and the clearinghouses may now, if they choose, expand the types of swaps they will clear for US firms. 

More generally, the CFTC’s issuance of the exemptions also has relevance for other clearinghouses and market participants. For example, the CFTC exemptive orders provide a guidepost that other foreign swaps clearinghouses – both registered DCOs and unregistered clearinghouses – can use to evaluate the costs, benefits and limitations of exempt DCO status. This is important because the CFTC has not issued public guidance on the eligibility criteria and the conditions and limitations of exempt status, and had only provided private, individualised guidance to those clearinghouses that had approached the Staff about the possibility of an exemption.    


The compliance obligations that the CFTC has imposed on exempt DCOs are arguably more extensive than necessary


The package of ongoing compliance obligations that the CFTC has imposed on exempt DCOs is arguably more extensive than necessary for 'exempt’ status, and resembles a 'DCO light’ registration scheme. However, to be sure, exempt DCOs are subject to a much less burdensome set of CFTC regulatory requirements than registered DCOs. Accordingly, foreign clearinghouses currently registered with the CFTC might ultimately decide that the benefits of registration are not worth the significant costs of complying with the full panoply of DCO regulatory requirements, and therefore might seek to deregister and obtain an exemption. Notably, if any registered DCOs deregister in favour of exempt status, and the CFTC continues to prohibit exempt DCOs from clearing for US customers, then US firms that are neither clearing members nor affiliated with a clearing member (for example, US buyside firms) would have fewer available clearinghouses through which to clear.

Finally, the availability of exemptions for foreign clearinghouses also adds further competitive pressure to US clearinghouses. As previously noted, an exempt DCO can clear more types of swaps and also represents a more reliable long-term clearing option for US firms than a clearinghouse operating under temporary, product-limited Staff no-action relief. This increased competition may spur enhancements in clearinghouse technologies and services, and lead to better pricing.

Going forward

The CFTC’s emerging exempt DCO programme may evolve further in the coming months and years. Given the important implications of regulatory developments in this area, swap market participants plus foreign and US clearinghouses are well advised to continue to closely monitor these issues. 

By Davis Polk & Wardwell partner Annette L Nazareth and associate Jeffrey T Dinwoodie in Washington, DC