CFTC Staff Grants Relief from Clearing for Multilateral Compression Exercises and Partial Novation and Termination of Certain Swaps

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1 March 22, 2012 CFTC Staff Grants Relief from Clearing for Multilateral Compression Exercises and Partial Novation and Termination of Certain Swaps Key Takeaways: > CFTC staff grants no-action relief permitting swap counterparties to participate in multilateral compression exercises with respect to uncleared swaps without clearing amended or replacement swaps. > CFTC staff also allows market participants to partially terminate or novate uncleared swaps without clearing the resulting stub swap (though the novated (new) swap would have to be cleared unless it is otherwise exempt). Contents The Compression Exercises Letter... 2 The Partial Novation and Termination Letter... 3 Conclusion... 4 The Commodity Futures Trading Commission s (the CFTC ) Division of Clearing and Risk (the DCR ) issued no-action letters on March 18 and 20, 2013 granting relief from the clearing mandate of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act 1 (the Dodd-Frank Act ) to (1) certain amended and replacement swaps entered into in connection with multilateral portfolio compression exercises (the Compression Exercises Letter ), 2 and (2) partial novations and terminations of certain swaps (the Partial Novation and Termination Letter ). 3 Both letters subject the relief to numerous conditions, including that a transaction being modified (an Original Swap ) pre-date the effectiveness of mandatory clearing for its respective class of swap. The letters address significant and previously unresolved issues arising from Dodd-Frank s mandatory swap clearing requirements, which many market participants previously raised with the CFTC. Without this relief, market participants existing risk-reduction techniques could have run afoul of mandatory clearing, leading to distorted risk and investment management incentives and detracting from the CFTC s efforts to reduce market risks Pub. L , 124 Stat (2010). CFTC Letter No (Mar. 18, 2013), available at CFTC Letter No (Mar. 20, 2013), available at Termination

2 The Compression Exercises Letter The Compression Exercises Letter replied to a request from TriOptima, a provider of multilateral portfolio compression services. 4 The DCR indicated that such compression exercises either result in an amendment to an Original Swap (an Amended Swap ) between the parties or the termination of an Original Swap and its replacement with a new swap (a Replacement Swap ). The DCR stated that, for purposes of its letter, it would assume that an Amended Swap or Replacement Swap would have to be cleared pursuant to the Dodd-Frank Act if executed after the relevant compliance date of clearing, even if the Original Swap itself was executed before that date. 5 The DCR stated, however, that it would not recommend an enforcement action against market participants for failing to clear such an Amended Swap or Replacement Swap. To qualify for the relief, the following conditions must be met: > The multilateral portfolio compression exercise that generated the Amended Swap or Replacement Swap must satisfy the definition of Commission Rule (h) 6 and must involve more than two market participants; > The Original Swap submitted must not have been cleared by a derivatives clearing organization (a DCO ), and it must have been executed prior to the relevant clearing compliance date; 7 > The Amended Swap or Replacement Swap must (1) be generated in accordance with the multilateral portfolio compression service provider s established rules and parameters, (2) be entered into by the same counterparties as the Original Swap, (3) with the exception of notional amount, have the same material terms as the Original Swap, 8 and (4) be entered into solely for reducing operational or counterparty credit risk; and 4 The DCR explained that multilateral compression allows swap market participants to net down the size and/or number of outstanding swaps between them, lower the aggregate gross notional value of outstanding swaps, and decrease the number of outstanding swaps or the aggregate notional value of such swaps, thereby reducing operational risk and, in some instances, reducing counterparty credit risk. Compression Exercises Letter, at 2-4. Rule (h) defines a multilateral portfolio compression exercise as an exercise in which multiple swap counterparties wholly terminate or change the notional value of some or all of the swaps submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated swaps with other swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated swaps in the compression exercise. If the Original Swap was exempt from Title VII s clearing mandate for other reasons (e.g., it is a swap between a swap dealer and an end user), the Amended or Replacement Swap could presumably avoid the clearing requirement on the same grounds as the Original Swap. The DCR indicated that, among other things, the reference asset, the maximum maturity, and the average weighted maturity of the Amended or Replacement Swap must be the same as the Original Swap Termination 2

3 > The multilateral portfolio compression services methodology cannot permit market participants to specify which swaps will be amended or replaced. The Partial Novation and Termination Letter The DCR s Partial Novation and Termination Letter responds to a request submitted by ISDA. The DCR explained that counterparties to an Original Swap often terminate part of their obligations under the swap or novate to another counterparty a part of their obligations, leaving only a portion of the Original Swap between the original counterparties (that portion, a Stub Swap ). Under either a partial novation or a partial termination the notional amount of the Stub Swap would be less than the notional amount of the Original Swap. In its request, ISDA argued that requiring clearing of a Stub Swap would inhibit parties efforts to modify existing uncleared swaps in order to reduce their risk exposure. 9 The DCR assumed that a Stub Swap would be subject to mandatory clearing if executed after the relevant clearing compliance date. It nonetheless granted noaction relief to market participants in respect of that requirement, allowing them not to clear a Stub Swap, subject to the following conditions: 10 > The Original Swap being partially novated or partially terminated must not have been cleared by a DCO, and must have been executed prior to the clearing compliance date applicable to such swap; > The counterparties records concerning the Original Swap must be amended solely to reflect its reduced notional amount; > All of the other terms of the Stub Swap must remain the same as those of the Original Swap; > With respect to partial terminations, the portion of the Original Swap that is terminated is fully terminated (i.e., all rights with respect to that portion of the swap must be extinguished, with the exception of a promptly due termination payment); and > With respect to partial novations, the novated swap with the new counterparty must be submitted for clearing unless it is otherwise exempt from clearing (e.g., one of the counterparties can invoke the end user exception to clearing). 9 Partial Novation and Termination Letter, at In addition to the relief with respect to partial terminations and partial novations, the DCR also clarified that the full termination or novation of an Original Swap need not be cleared under Title VII because it has ceased to exist or because it no longer exists as between the original counterparties, provided that the counterparties amended their records to reflect the termination or novation. Partial Novation and Termination Letter, at 4-5. The DCR also made clear, however, that separately executed swaps that partially offset the risk of an Original Swap must be cleared provided they are executed after the relevant clearing compliance date. Indeed, ISDA had not requested relief with respect to such offsetting swaps. Id. at 2, 4. Termination 3

4 Conclusion With the commencement of mandatory clearing on March 11, 2013 for swap transactions referencing certain rates and credit indexes between swap dealers, major swap participants and certain active funds, the DCR s letters are an important development that is consistent with the goals of the Dodd-Frank Act. The letters will allow market participants to continue to conduct their own riskmitigating practices without having to consider the disincentives that mandatory clearing would impose on such efforts to otherwise minimize risk. The letters also reflect the CFTC s willingness to be flexible and accommodating to address unintended and potentially disruptive outcomes. Termination 4

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