Advanced Swaps & Other Derivatives 2016

CORPORATE LAW AND PRACTICE Course Handbook Series Number B-2278 Advanced Swaps & Other Derivatives 2016 Co-Chairs Gary Barnett Joshua D. Cohn To order this book, call (800) 260-4PLI or fax us at (800) 321-0093. Ask our Customer Service Department for PLI Order Number 148951, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

3 Derivatives Clearing (August 15, 2016) Kathryn M. Trkla Foley & Lardner LLP If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written. 87

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This outline provides an overview of regulation of derivatives clearing organizations ( DCOs ) under the Commodity Exchange Act ( CEA ) and rules of the Commodity Futures Trading Commission ( CFTC ). It also covers recent developments impacting global regulation of central counterparties ( CCPs ) for derivatives, notably, the CFTC s adoption in March of a substituted compliance framework for CCPs based in the European Union ( EU ) that are dually authorized under the European Market Infrastructure Regulation ( EMIR ) and regulated as DCOs. That development, along with an earlier agreement between the CFTC and European Commission on a common approach towards regulation of EU-based and U.S.-based CCPs operating in both jurisdictions, is significant for opening the way for the European Securities and Market Authority ( ESMA ) to recognize certain U.S.-based DCOs as third country CCPs. I. REGULATION OF CLEARING UNDER THE CEA FRAMEWORK The CEA framework establishes a comprehensive framework for regulating derivatives transactions and markets, including registration and regulation of CCPs as DCOs. A. Definition of Derivative Clearing Organization As defined in CEA defined 1a(15), a DCO is a person that engages in any of the following activities in respect of any agreement, contract or transaction: 1. It enables each party to the agreement, contract or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; or 2. It arranges or provides, on a multilateral basis, for settlement or netting of obligations resulting from such agreements, contracts or transactions by participants (i.e., members) in the DCO; or 3. It otherwise provides clearing services or arrangements that mutualize or transfer among the DCO s participants (i.e., members) the credit risk arising from such agreements, contracts or transactions. 3 89

B. Registration or Exemption 1. A CCP for agreements, contracts or transactions in futures or options on futures (collectively futures ) or swaps for which U.S. persons are counterparties is generally required to register with the CFTC as a DCO. See CEA 5b(a). 2. The CFTC, though, also has authority to exempt a CCP from DCO registration. See CEA 5b(h). See below for an explanation of how the CFTC has applied this authority to a CCP located outside the U.S. C. Regulation of DCOs 1. A DCO is subject to various core principles set out in CEA 5b (c)(2)(a) though (R), in areas ranging from clearing member eligibility standards, financial resources, risk management, settlement procedures, default procedures, treatment of funds, rule enforcement and legal risk. 2. A DCO is also subject to the CFTC s Part 39 Regulations. a. Subpart A sets out general provisions covering definitions, registration procedures, procedures for implementing rules and clearing new products, 1 CFTC review of swaps for a clearing determination, enforceability and anti-fraud. b. Subpart B sets out substantive requirements that apply to all DCOs. The rules impose detailed requirements that implement the DCO core principles set out in the CEA. See Table 1 (attached) for a summary of the Subpart B Rules. c. Subpart C sets out heightened standards that apply to any DCO that is designated systemically important by the U.S. Financial Stability Oversight Council ( FSOC ). 2 The rules 1. A DCO is also subject to more detailed filing and approval procedures set out in the CFTC Part 40 Regulations, which also apply to exchanges registered with the CFTC as designated contract markets and to trading facilities for swaps registered with the CFTC as swap execution facilities. 2. The CFTC adopted the Subpart C Rules pursuant to Section 805(a) of Title VIII of the Dodd-Frank Act. That provision authorized the CFTC to prescribe rules for DCOs designated systemically important by the FSOC for which the CFTC is the Supervisory Authority. It also required the CFTC to consider international standards in adopting such rules. The CFTC designed the Subpart C Regulations 4 90

also apply to any DCO that is not designated by the FSOC, but that has elected to comply with those requirements. See Table 2 (attached) for a summary of the Subpart C Rules. II. REGULATION OF CROSS-BORDER CLEARING SERVICES A. U.S.-based DCOs Operating in Other Countries 1. Depending on the scope of the products and markets for which it clears and the location of market participants using its services, a U.S.-based DCO may have to obtain approval, equivalence recognition or exemption in other jurisdictions. 2. Notably, a U.S.-based DCO must be recognized by ESMA as a third-country CCP to offer its services in the EU. B. Non-U.S. CCPs Operating in the U.S. Registration or Exemption 1. The CFTC requires a non-u.s. CCP to register as a DCO if the CCP: a. Provides clearing services with respect to trades in futures executed on or subject to the rules of a regulated U.S. futures exchange, i.e., a designated contract market; or b. Provides clearing services with respect to swaps transactions of U.S. customers of the CCP s clearing members. For this purpose, a customer is a person whose account is not classified as a proprietary account of the clearing member as that term is defined in CFTC Rule 1.3(y). Under that definition, affiliates would generally be classified as non-customers. 2. A number of non-u.s. CCPs are registered as DCOs, and thus are subject to dual regulation under the laws of their home jurisdictions and the CEA framework. a. Six non-u.s. CCPs are registered as DCOs: Eurex Clearing AG; ICE Clear Europe Ltd; LCH.Clearnet Ltd; LCH.Clearnet SA; Natural Gas Exchange; and Singapore Exchange Derivatives Clearing Limited. (in conjunction with the other Part 39 Regulations) to meet the Principles for Financial Market Infrastructures jointly issued by CPSS-IOSCO in 2012. 5 91

b. One non-u.s. CCP has an application pending for DCO registration, CME Clearing Europe Ltd. (which is expected to receive approval in the very near term). 3. The CFTC has granted exemptions from DCO registration to four non-u.s. CCPs, in each case limited to clearing proprietary transactions in swaps for U.S. clearing members (including transactions of their affiliates): ASX Clear (Futures) Pty Limited; Japan Securities Clearing Corporation; Korea Exchange, Inc.; and OTC Clearing Hong Kong Limited. 4. A CCP for trades executed on or subject to the rules of a foreign board of trade ( FBOT ) may be covered by an implicit exemption from DCO registration. a. As reflected in the CFTC s Part 30 Rules, a CCP is not required to register as a DCO to clear trades for U.S. customers of the CCP s clearing members in transactions in futures executed on or subject to the rules of an FBOT. (The clearing member could be a foreign broker or (far less common) a firm that is registered with the CFTC as a futures commission merchant ( FCM ). 3 ) b. A CCP for an FBOT that registers in that capacity with the CFTC may operate pursuant to an implicit exemption from DCO registration, with respect to both futures and swaps executed on or subject to the rules of the FBOT. 4 Although the CCP could register as a DCO, 5 that is not required if the exchange demonstrates through the FBOT registration process that the CCP meets international standards for central 3. Under Part 30, a foreign broker may clear trades in FBOT-listed futures for U.S. customers indirectly, through a customer omnibus account it carries for an FCM. A foreign broker may also clear such trades directly for U.S. customers without registering as an FCM if it qualifies for exemption from such registration under CFTC Rule 30.10, on the basis that the CFTC has determined that it is subject to comparable regulation in its home jurisdiction. 4. An FBOT is required to register with the CFTC only if it provides direct access, i.e., an explicit grant of authority, to members or other participants located in the U.S. to enter trades directly on the FBOT s trade matching system. 5. In light of the decision embodied in Part 30 that DCO registration is not required for a CCP to clear trades of U.S. customers in an FBOT s listed futures, there is an open issue whether the CFTC would grant DCO registration, if sought, to the CPP with respect to such futures contracts. 6 92

counterparties issued jointly by the Committee on Payment and Settlement Systems and International Organization of Securities Commissions. See CFTC Rule 48.7(d)(1). III. EU - U.S. EQUIVALENCE A. Agreement to a Common Approach 1. Following extended discussions, on February 10, 2016, the CFTC and European Commission announced their agreement to a Common approach for transatlantic CCPs (Feb. 10, 2016) ( Common Approach ), regarding regulation of CCPs that are dually authorized and regulated under EMIR and regulated as DCOs under the CEA framework. 2. The Common Approach committed the CFTC to adopt an effective equivalent system for CCPs that are authorized under EMIR. 3. Notably, it also required the European Commission to propose a third-party equivalence decision regarding the CEA/CFTC regulatory framework for DCOs, as a predicate to ESMA granting recognition of U.S.-based DCOs operating in the EU as equivalent third country CCPs. a. Following recognition by ESMA, a U.S. DCO is permitted to offer its clearing services in the EU, in compliance with U.S. requirements under the CEA framework (in lieu of complying with requirements under the EMIR framework). b. Notably, a U.S. DCO that receives recognition is also then considered a qualifying CCP or QCCP for purposes of the EU Capital Requirements Regulation. That is important because EU banks and their subsidiaries are subject to lower risk weights for their exposures to a QCCP when computing the EU banks regulatory capital. B. CFTC Comparability Determination 1. In accordance with its next step obligation under the Common Approach, the CFTC in March issued its comparability 7 93

determination for EU-based CCPs in March 2016. 6 The determination took effect on March 22, 2016 (the date of publication in the Federal Register). See Comparability Determination for the European Union: Dually-Registered Derivatives Clearing Organizations and Central Counterparties, 81 FR 15260 (March 22, 2016) ( Comparability Determination ). 2. The Comparability Determination applies to a CCP that is based in the EU and authorized as a CCP under EMIR ( EU-CCP ), and which is currently registered as a DCO with the CFTC or that applies to register as a DCO. 3. The Comparability Determination provides that an EU-CCP may rely on substituted compliance with specified EU requirements in lieu of meeting certain CFTC requirements, in the areas of: a. Financial resources under DCO Core Principle B and CFTC Rule 39.11; b. Risk management under DCO Core Principle D and CFTC Rule 39.13; c. Settlement procedures under DCO Core Principle E and CFTC Rule 39.14; and d. Default rules and procedures under DCO Core Principle G and CFTC Rule 39.16. 4. The Comparability Determination also establishes a streamlined DCO registration process for an EU-based CCP that is authorized under EMIR. For the areas where substituted compliance is available, in lieu of submitting documents specified by the CFTC to demonstrate compliance with the corollary CEA/CFTC requirements, the applicant may use materials it submitted to its national competent authority ( NCA ) for its EMIR authorization, or documents that its NCA provides, to demonstrate the EU-CCP s compliance with the relevant substituted EMIR requirements. 6. The CFTC Division of Clearing and Risk issued a related no-action letter providing relief to EU-CCPs that are DCOs from certain CFTC requirements. See CFTC Letter No. 16-26 dated March 16, 2016. The letter covers areas where the CFTC had previously provided informal relief from compliance with certain CFTC rules, primarily in the context of the CCP s non-u.s. clearing services, including customer clearing services provided to non-fcm clearing members and their non- U.S. customers. 8 94

5. The CFTC reached its substituted compliance determination based on its evaluation of requirements under EMIR and under certain Regulatory Technical Standards ( RTSs ), including RTSs for capital requirements and for CCPs, which came into force in March 2013. The CFTC refers to the EMIR provisions and RTSs as the EMIR Framework. 6. The BREXIT referendum vote for the UK to withdraw as a member state of the EU should not have an immediate impact on the ability of a UK-based DCO there are currently two (ICE Clear Europe and LCH.Clearnet Ltd.), with a third pending (CME Clearing Europe) to operate under the relief provided in the Comparability Determination. For now, the relevant provisions under the EMIR framework for which substituted compliance is allowed continue to apply to a CCP authorized in the UK. If the UK makes any changes to those provisions in connection with the UK s separation from the EU, depending on the nature of those changes, the CFTC could decide to revoke or modify the availability of substituted compliance to UK-based CCPs. C. Status of EU Equivalence and Third-Country Recognition for U.S. DCOs 1. The European Commission adopted its equivalence decision on March 15, 2016. The decision is limited to a DCO that is subject to the CFTC s Part 39, Subpart C Rules, whether by virtue of being deemed systemically important by the FSOC or opt-in to such provisions. a. The decision is subject to the conditions that the DCO seeking recognition has rules and procedures to ensure that: The DCO uses a two-day liquidation period for derivatives executed on a regulated market for purposes of determining the initial margin to collect from clearing members for their proprietary positions in such derivatives; The DCO uses initial margin models that include measures to mitigate the risk of procyclicality for all derivatives; The DCO maintains sufficient pre-funded, available financial resources to be able to withstand the default of 9 95

two clearing members with the largest exposures to the DCO, in extreme but plausible market conditions (socalled cover 2 ). b. The foregoing conditions do not apply with respect to certain agricultural-based derivatives. 2. On June 14, 2016, ESMA recognized the first U.S. DCO, the Chicago Mercantile Exchange, as a recognized third-country CCP. List of Central Counterparties authorised to offer services and activities in the Union (July 21, 2016). 7 TABLE 1: SUMMARY OF CFTC RULES IMPLEMENTING CEA DCO CORE PRINCIPLES The table provides a summary of requirements imposed under the Part 39 Subpart B Rules. Core Principle & CFTC Rule Description CEA CORE PRINCIPAL A: COMPLIANCE Rule 39.10 Requires a DCO to comply with core principles and related CFTC requirements; provides reasonable discretion to establish how to comply. (Restatement of the core principle.) Requires a DCO to have a chief compliance officer ( CCO ); prescribes the CCO s duties; and requires the CCO to prepare and submit to the CFTC an annual compliance report. Imposes recordkeeping requirements with respect to compliance policies and procedures, materials provided to the board or senior officer in connection with the review of the annual report, and the annual report and related work papers and documents. CEA CORE PRINCIPAL B: FINANCIAL RESOURCES Rule 39.11 Among other things, the rule: 7. Available at https://www.esma.europa.eu/sites/default/files/library/third-country_ ccps_recognised_under_emir.pdf. 10 96

Core Principle & CFTC Rule Description Requires a DCO to maintain sufficient liquid resources both to: Cover its financial obligations to clearing members notwithstanding the default of the clearing member creating the largest financial exposure in extreme but plausible market conditions, referred to as cover 1; and Enable it to cover operational costs for a minimum one year period, on a rolling basis. Prescribes types of financial resources a DCO may use to meet the requirements, e.g., the DCO s capital and guaranty fund deposits. Requires a DCO to compute financial resources monthly, including monthly stress testing to calculate (using reasonable discretion as to the methodology) amounts needed to meet the cover 1 requirement. Requires a DCO at least monthly to compute the current market value of its financial resources available to cover those obligations, with limitations on the value it may attribute to its assessment authority. Requires a DCO to effectively measure, monitor and manage liquidity risks, and to have sufficient liquidity resources to meet its cash obligations when they are due. Requires a DCO to hold assets is a manner that minimizes risk of loss or delay to access. Requires a DCO to submit reports on its financial resources each fiscal quarter and upon request. CEA CORE PRINCIPAL C: PARTICIPANT AND PRODUCT ELIGIBILITY Rule 39.12 Participant Eligibility. Sets out requirements with respect to admission and continuing eligibility requirements for clearing members. A DCO, among other things: Must provide for fair and open participation; May not limit clearing membership to swap dealers; and May not, with respect to swaps clearing, impose a minimum capital requirement of more than $50M. 11 97

Core Principle & CFTC Rule Description Product Eligibility. Requires a DCO to establish appropriate requirements for determining products it will clear, including the factors it should consider. Also requires a DCO, among other things, to have rules that set out the agency model for clearing of customer swaps transactions, i.e., to have rules that provide that when a swap is accepted for clearing, the original transaction is extinguished and replaced by an equivalent and opposite swap between the DCO and each clearing member, where the clearing member acts as agent for a customer trade. CEA CORE PRINCIPAL D: RISK MANAGEMENT Rule 39.13 Imposes various risk management requirements. Among others, a DCO must: Have a chief risk officer; Measure credit exposures and mark open positions to market for each clearing member at least daily; Use a risk-based model and parameters to set initial margin requirements at a confidence level of 99%; Collect initial margin on a gross basis from a clearing member with respect to its customer account(s), as if each customer were a clearing member; For cleared swaps, require a clearing member to collect initial margin from its customers at a level greater than the DCO s initial margin requirements that the clearing member must post with the DCO for the applicable product and swap portfolio; Require clearing members to maintain written risk management policies and procedures addressing the risks that they may pose to the DCO; and Have the authority to take additional actions, based on the application of objective and prudent risk management standards, such as to impose enhanced capital or margin requirements; impose position limits or prohibit an increase in positions or require reduction of positions; liquidate or transfer positions; or suspend or revoke clearing membership. 12 98

Core Principle & CFTC Rule Description CEA CORE PRINCIPAL E: SETTLEMENT PROCEDURES Rule 39.14 Requires a DCO, among other things, to: Effect daily settlements and have authority and capacity to effect intra-day settlement; Have arrangements to eliminate or strictly limit its exposure to settlement banks; Provide for settlement finality; and For physical-delivery contracts, (i) have rules stating what obligations the DCO assumes and whether it indemnifies clearing members for losses they may incur in the delivery process and (ii) identify and manage risks of each obligation its assumes. CEA CORE PRINCIPAL F: TREATMENT OF FUNDS Rule 39.15 Requires a DCO, among other things, to: Comply with applicable CEA and CFTC segregation requirements; Hold customer funds in a manner that minimizes risk of loss or delay in the DCO s access to funds and assets belonging to clearing members and their customers; Have rules providing for prompt transfer of all or a portion of a customer s portfolio of positions, at the customer s instructions, from its carrying clearing member to another clearing member, without requiring positions to be closed out and re-booked, subject to certain conditions; and Comply requirements of CFTC Rule 1.25 with respect to the DCO s investment of customer segregated funds. Also sets out filing and approval requirements for a DCO to permit commingling of futures and swaps positions and funds within the same account class structure. CEA CORE PRINCIPAL G: DEFAULT RULES AND PROCEDURES Rule 39.16 Requires a DCO, among other things, to: Have a current default management plan; 13 99

Core Principle & CFTC Rule Description Have default procedures permitting it to take timely action in the event of a clearing member default to contain losses and liquidity pressures and to continue meeting its obligations; Have rules requiring a clearing member to provide prompt notice if it becomes the subject of a bankruptcy petition, receivership proceeding or equivalent; and Take appropriate action, in its discretion, with respect to a clearing member that has provided the foregoing notice or the house or customer positions of such clearing member, such as liquidation or transfer of positions or suspension or revocation of clearing membership. CEA CORE PRINCIPAL H: RULE ENFORCEMENT Rule 39.17 Requires a DCO to have adequate resources and arrangements to monitor and enforce compliance with its rules and to resolve disputes. Also permits a DCO to delegate such responsibility to a risk management committee, except responsibilities required of the CCO. CEA CORE PRINCIPAL I: SYSTEM SAFEGUARDS Rule 39.18 Imposes system safeguard requirements on a DCO, including among others, to have a program of risk analysis and oversight of operations and automated systems. CEA CORE PRINCIPAL J: REPORTING Rule 39.19 Requires a DCO to submit various reports and information to the CFTC, including among others: Daily reports, for each clearing member by house and customer origin (account), of initial margin requirements and deposits; daily variation margin and marketto-market amounts paid or collected; daily cash flows relating to options premiums and swaps-related payments such as coupon amounts; and end-of day positions; Audited year-end financial statements; and 14 100

Core Principle & CFTC Rule Description Reporting certain specified events, e.g., a decrease of 25% in the DCO s financial resources available to cover its financial obligations to clearing members in the event of the default of its clearing member creating the largest financial exposure in extreme but plausible market conditions. CEA CORE PRINCIPAL K: RECORDKEEPING Rule 39.20 Requires a DCO to maintain records of activities related to its business as a DCO. CEA CORE PRINCIPAL L: PUBLIC INFORMATION Rule 39.21 Requires a DCO to provide sufficient information to market participants to enable them to identify and evaluate risks and costs associated with using the services. Also requires a DCO to disclose various information publicly and to the CFTC, including its margin-setting methodology, and to post such information along with its rules and a current list of its clearing members on its website. CEA CORE PRINCIPAL M: INFORMATION SHARING Rule 39.22 Requires a DCO to enter into appropriate domestic and international information sharing agreements, and to use the information it obtains to carry out its risk management program. CEA CORE PRINCIPAL N: ANTITRUST CONSIDERATIONS Rule 39.23 Prohibits a DCO from adopting a rule or taking any action that results in an unreasonable restraint of trade or imposes a material anticompetitive burden, unless necessary or appropriate to achieve the purposes of the CEA. CEA CORE PRINCIPAL O: GOVERNANCE FITNESS STANDARDS Rule 39.24 RESERVED. The terms of the statutory core principle, though, apply. CEA 5b(c)(2)(O) requires a DCO to: Establish transparent governance arrangements to fulfill public interest requirements and consider views of owners and participants. 15 101

Core Principle & CFTC Rule Description Establish and enforce appropriate fitness standards for directors, disciplinary committee members, members of the DCO, any others with direct access to the DCO s settlement or clearing activities, and parties affiliated with the foregoing. CEA CORE PRINCIPAL P: CONFLICTS OF INTEREST Rule 39.25 RESERVED. The terms of the statutory core principle, though, apply. CEA 5b(c)(2)(P) requires a DCO to: Establish and enforce rules to minimize conflicts of interest in the DCO s decision-making process. Establish a process for resolving such conflicts of interest. CEA CORE PRINCIPAL Q: COMPOSITION OF GOVERNING BOARDS Rule 39.26 RESERVED. The terms of the statutory core principle, though, apply. CEA 5b(c)(2)(Q) requires a DCO to ensure that its governing board or committee includes market participants as members (interpreted to require at least 2 market participant representatives). CEA CORE PRINCIPAL R: LEGAL RISK Rule 39.27 Requires a DCO to operate pursuant to a well-founded, transparent, and enforceable legal framework that addresses each aspect of its activities. The framework must provide for: The DCO to act as a counterparty and novation; Netting arrangements; DCO s interest in collateral; Steps the DCO will take to address a clearing member default, including the unimpeded ability to liquidate collateral and close out or transfer positions in a timely manner; Finality of settlements and funds transfers, which must be irrevocable and unconditional when they are effected 16 102

Core Principle & CFTC Rule Description (no later than when DCO accounts are credited and debited); and Other significant aspects of the DCO s operations, risk management and related requirements. TABLE 2: SUMMARY OF CFTC RULES APPLICABLE TO SYSTEMICALLY IMPORTANT DCOS AND DCOS THAT ELECT TO BE SUBJECT TO SUCH RULE The table summarizes the rules set out in Subpart C of the CFTC Part 39 Rules. Rule Rule 39.31 Rule 39.11 Rule 39.32 Rule 39.33 Description Confirms that a DCO subject to Subpart C is subject to the full set of Part 39 Rules. Sets out the procedure for a DCO that has not been designated systemically important to apply for approval as a Subpart C DCO. Imposes governance standards. Imposes financial and liquidity resource requirements, which supplement the requirements of Rule 39.11. If the DCO is is systemically important in multiple jurisdictions or is involved in activities with a more complex risk profile, it must have financial resources to cover its financial obligations to clearing members in the event of a default by the two clearing members creating the largest combined loss to the derivatives clearing organization in extreme but plausible market conditions. May not include assessments for guaranty fund contributions in the calculation; guaranty fund deposits must be in hand to count. The DCO must maintain eligible liquidity resources to meet intraday, same-day and multiday settlement obligations with a high degree of confidence under a wide range of stress scenarios that should include... a default by the clearing member creating 17 103

Rule 39.34 Rule 39.35 the largest aggregate liquidity obligation in extreme but plausible market conditions. It must also consider maintaining eligible liquidity resources to cover such settlement obligations under a stress scenario that includes a default by the two clearing members creating the largest aggregate liquidity obligation... in extreme but plausible market conditions. Prescribes the liquidity resources that are considered eligible, and standards for additional liquidity resources, liquidity providers and documentation of financial and liquidity resources. The DCO must treat affiliated clearing members as a single clearing member in its calculations of its financial resources and liquidity resources. Imposes heightened system safeguard standards that supplement the requirements of Rule 39.18. The DCO s business continuity and disaster recovery plans, physical, technological and personnel resources must have the objective to enable it to recover operations and resume daily processing, clearing and settlement within 2 hours of a widescale disruption. The DCO must maintain geographic dispersal of physical, technological and personnel resources consistent with prescribed standards to facilitate meeting the recovery time objective. The DCO must conduct regular tests of its business continuity and disaster recovery plans, including whether it is able to meet the 2 hour recovery time objective in the event of a wide-scale disruption. Imposes requirements on the DCO to have default rules and procedures covering uncovered credit losses or liquidity shortfalls. The DCO must adopt rules and procedures that fully address losses arising from a single or combined default relating to clearing member obligations. Rules and procedures must address (i) allocation of losses that exceed its available financial resources; (ii) repayment of borrowed funds; and (iii) replenishing financial resources used during a stress event. 18 104

Rule 39.36 Rule 39.37 Rule 39.38 The DCO must adopt rules and procedures for promptly meeting settlement obligations on a sameday basis and, as appropriate, on an intraday and multiday basis, in the scenario of a single or combined default involving one or more clearing members or a liquidity shortfall exceeding its financial resources. Imposes heightened risk management standards, which supplement the standards imposed under Rule 39.13. The DCO must conduct (i) daily stress testing of financial resources using defined parameters, and comprehensive analyses of its stress testing scenarios and parameters at least monthly and under prescribed circumstances; (ii) sensitivity analyses at least monthly of its margin models to analyze and monitor their performance and overall margin coverage; (iii) daily stress testing of its liquidity resources using defined parameters, and comprehensive analyses of its stress testing scenarios and parameters at least monthly and under prescribed circumstances; and (iv) an annual full validation of its financial risk management and liquidity risk management models. The DCO must monitor, manage and limit the credit and liquidity risks posed by its settlement banks and monitor and manage its credit and liquidity exposures to its settlement banks. In addition, it must establish strict criteria for its settlement banks, taking into account the regulation, supervision, creditworthiness, capitalization, access to liquidity and operational reliability of the settlement bank. Imposes requirements on the DCO to provide certain disclosures, including public disclosure of its responses to the Disclosure Framework for Financial Market Infrastructures published by the CPSS and IOSCO. Imposes efficiency standards under which the DCO must: Efficiently and effectively design its clearing and settlement arrangements; operating structure and procedures; scope of products cleared; and use of technology; Review its compliance with such arrangements on a regular basis; 19 105

Rule 39.39 Rule 39.40 Rule 39.41 Rule 39.42 Have clearly defined, measurable and achievable goals and objectives in the areas of minimum service levels, risk management expectations and business priorities; and Facilitate efficient payment, clearing and settlement by accommodating internationally accepted procedures and standards for communications. Requires the DCO to maintain a viable recovery and wind-down plan. Specifically, the plan must provide for recovery i.e., actions to maintain its viability as a going concern or orderly wind-down i.e., the permanent cessation or sale or transfer of one or more of its services necessitated by uncovered credit losses or liquidity shortfalls or general business, operational or other risks that threaten its viability as a going concern. The plan must also cover raising of additional financial resources if the DCO is unable, or virtually unable, to comply with its financial resource requirements. NOTE: On July 21, 2016, the CFTC Division of Clearing and Risk issued staff guidance to DCOs subject to Subpart C with respect to their further development of recovery and wind-down plans. See CFTC Letter No. 16-61. Provides that the Subpart C Rules, in conjunction with the other Part 39 Rules, are intended to be consistent with international standards and should be interpreted in that context. Implements special enforcement authority that the CFTC is given over a DCO that is designated as systemically important under Section 807(c) of the Dodd-Frank Act. Imposes special self-certification procedures on a DCO that is designated as systemically important for submitting changes to its rules, procedures or operations that could have a material effect on the nature or level of the risks that it presents. 20 106

NOTES 107

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