Clearing Hits Fork in Road

Terry Flanagan

Index and single-name CDS subject to different regulators.

The transition toward a new regime for clearing OTC swaps is proving to be bumpy for some derivatives clearing organizations, as they grapple with different sets of rules being formulated by the SEC and CFTC to implement the Dodd-Frank Act.

As a result of the bifurcation of regulatory authority over the swap market, cleared index credit default swaps (CDS) are subject to the Commodity Futures Trading Commission,
while security-based are subject to the Securities and Exchange Commission.

This split in regulatory authority results in different and in some ways inconsistent customer protection regimes for swaps and security-based swaps, according to a request for exemptive relief filed by ICE Clear Credit.

The request seeks to ameliorate the negative effects of disparate treatment by
subjecting all eligible Products cleared by ICE Clear Credit pursuant to a uniform and consistent customer protection regime under Section 4d of the Commodities Exchange Act and the commodity broker insolvency provisions of the U.S. Bankruptcy Code.

ICE Clear Credit proposes to permit the current customer account, which now holds
Index CDS, to also hold Security-Based CDS, subject to Section 4d(f) of the Act.

Additionally, ICE Clear Credit proposes to permit portfolio margining of the positions held in such commingled customer account, subject to the necessary portfolio margining approvals from the CFTC and the SEC.

The commingled 4d portfolio margining account will allow ICE Clear
Credit to offer the greatest benefit to the market and market participants by providing its
BD/FCM participants and their customers with greater operational efficiencies, capital
efficiency, and a more comprehensive offering of products that can be cleared.

Until July 16, 2011, ICE Clear Credit (formerly known as ICE Trust, was a New York-chartered limited purpose trust company and member of the Federal  Reserve System, acting as a central counterparty for the CDS market.  It was subject to direct
supervision and examination by the New York State Banking Department and the Federal
Reserve Bank of New York.

On July 16, 2011, ICE Trust converted from a regulated bank to a Delaware Limited Liability Company and changed its legal name to ICE Clear Credit LLC.  Also on that date, ICE Clear Credit became registered under the Dodd-Frank Act with the CFTC with respect to the clearing of index CDS, and with the SEC with respect to the clearing of security-based CDS.

ICE Clear Credit (as ICE Trust) began clearing CDS in March 2009,.At that time, its clearing business was limited to providing CDS clearing services for its participants’ proprietary accounts.  In December 2009, ICE Trust expanded its operations to provide Index CDS clearing services to customer accounts of participants.

ICE Clear Credit’s regulatory status is affected by Title VII of the Dodd-Frank Act,
which divides the universe of CDS currently cleared by ICE Clear Credit into two separate

Index CDS, such as broad-based CDS indices are defined as swaps, while
security-based CDS, such as single-name CDS and narrow-based CDS indices, are defined as security-based swaps.

As a result, primary regulatory authority over swaps and security-based swaps is split between the Commission and the SEC, respectively, and such instruments are subject to parallel regulatory regimes.

Absent relief from the CFTC and the SEC, BD/FCMs would be unable to use ICE
Clear Credit’s commingled customer account for clearing all categories of CDS transactions on behalf of customers, according to the request.

A 4d segregated account contains funds of customers trading futures and options on U.S. exchanges, and are held separate from the FCM’s own funds.

In 2009, prior to the passage of the Dodd-Frank Act, the CFTC issued proposed amending its bankruptcy regulations to create a separate “cleared OTC derivatives account class” that would apply in the event of the bankruptcy of an FCM.

As defined by the CFTC, a cleared OTC derivatives account class would include cleared OTC contracts that “are required to be held in a separate account for cleared OTC derivatives only, in accordance with the rules or bylaws of a clearing organization.”

The CFTC has proposed that each FCM and derivatives clearing organization be required to segregate the cleared swaps of each individual customer and relevant collateral, while permitting FCMs and DCOs to operationally commingle all relevant collateral in one account, known as the legally-separate and operationally-commingled (LSOC) model.

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