In December 2009, CME began clearing Credit Default Swaps (“CDS”). Clearing members must meet certain additional requirements to be eligible to clear these cleared-only OTC derivative transactions. These requirements include that the clearing member maintain capital of at least $500 million and have appropriate risk management capabilities, operational infrastructure and experience in CDS clearing activity. In addition, the clearing member must be registered as a FCM if it will clear CDS transactions for customers.
At this time, the accounts of customers whose CDS transactions are submitted to CME for clearing (“CDS customer”) must be held in a CFTC Regulation 30.7 (“Reg. 30.7”) account in the firm’s bookkeeping system. In addition, the clearing member must use the Net Liquidating Value Method when calculating the Secured Amount Required for all accounts of the CDS customer. The Alternative Method may not be used to compute the Secured Amount Required for accounts containing CDS positions.
CME Clearing has established a Reg. 30.7 origin for the clearing of these CDS products. Mark-to-market variation to/from and collateral held in the Reg. 30.7 origin at CME Clearing must be reflected as a Reg. 30.7 asset in the Secured Amount Calculation. In addition, clearing members must obtain a satisfactory Reg. 30.7 acknowledgement letter from CME Clearing so that these assets may be properly included as Reg. 30.7 assets.
For further information on the CFTC Secured Calculation, please refer to the CFTC 1-FR Instruction Manual and the Joint Audit Committee’s (“JAC”) Foreign Futures and Options Guide on the JAC’s Web Site at www.wjammer.jac.
Proprietary positions of the clearing member and its noncustomer affiliates should continue to be reflected in the house origin of the firm’s bookkeeping system and cleared through the house origin at CME Clearing. Proprietary positions of noncustomer affiliates may be required to be included in the SEC Rule 15c3-3 Customer Reserve Formula.
If the CFTC issues an Order allowing CDS customer positions and the funds used to margin, guarantee or secure CDS transactions to be included as customer segregated assets (“CFTC 4(d) order”), the accounts of CDS customers must then be included in the customer segregated origin in the firm’s bookkeeping system. In addition, all cash and collateral received from CDS customers to margin, guarantee or secure the CDS positions must then be deposited in customer segregated bank or safekeeping accounts. Mark-to-market variation to/from and collateral held in the customer segregated origin at CME Clearing must also be reflected as a segregated asset on the Segregation Statement. At this time, such an Order has not been issued by the CFTC.
The CFTC has proposed a rule which would create a new Part 190/bankruptcy account class for cleared-only OTC derivative customers in the event of an FCM’s bankruptcy. The rule proposal is at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/e9-18853a.pdf. This rule has not been adopted. This new account class would be in addition to the existing account classes (i.e. futures, foreign futures and options, leverage and delivery).
Disclosures to Customers
CDS Customers must be Eligible Contract Participants as defined by CFTC rules in order to hold CME-cleared CDS products. However, natural persons which are Eligible Contract Participants may not hold CDS positions with a clearing member which is registered only as an FCM.
Clearing members which are registered as broker-dealers and/or FCMs must provide disclosure to their CDS customers that U.S. broker-dealer segregation requirements and SIPA protection laws do not apply to funds or securities held by the clearing member to collateralize CDS positions. The disclosure must also indicate that the applicable insolvency law may affect the customer’s ability to recover such funds or securities and the speed of any such recovery in an insolvency proceeding.
While the CDS positions are held in Reg 30.7 accounts, clearing members must also provide disclosure to their customers that uncertainty exists as to whether the customer would receive priority in bankruptcy (vis-à-vis other customers) with respect to any funds or securities held by the clearing member to collateralize CDS positions.
Clearing members which are registered only as FCMs must also disclose to their CDS customers that the clearing member is not regulated by the SEC.
Clearing members should adopt procedures to ensure that all eligibility requirements are met by and the appropriate disclosures are provided to their CDS customers.
Regulatory Capital Treatment
FINRA Rule 4240 requires that clearing member collect margin collateral from its customers and noncustomer affiliates which hold CME-cleared CDS products. The FINRA rule also requires that the clearing member take a CDS concentration charge where the maximum current and potential exposure to the largest single name CDS across all accounts exceed the clearing member’s tentative net capital. The capital charge is the aggregate margin requirement for such accounts on the positions in such single name CDS.
In addition, the SEC has also provided clarification as to the capital treatment of CDS positions cleared by a broker-dealer. The SEC has indicated:
· The broker-dealer need not take a proprietary capital charge for customer and noncustomer affiliate CDS positions which are properly margined per FINRA Rule 4240.
· The broker-dealer need not take proprietary capital charge if it issues a margin call to a customer or noncustomer affiliate and the margin call is met within one business day. If the margin call is not met within one business day, the broker-dealer must calculate a proprietary capital charge on the positions (not a commodity undermargined capital charge).
· If the customer or noncustomer affiliate defaults to the broker-dealer, the broker-dealer must treat the positions as proprietary and calculate a proprietary capital charge.
· The broker-dealer is required to take a capital charge on trade date if a CDS account is undermargined by more than 2% of the broker-dealer’s tentative net capital. The charge is calculated as the excess margin deficiency over 2% of the broker-dealer’s tentative net capital.
At this time, the risk margin requirement of customer and noncustomer affiliate CDS positions need not be included in the calculation of the CFTC risk-based capital requirement. However, the CFTC has recently adopted a rule requiring the risk margin requirement for all cleared-only OTC derivative products carried by an FCM, including CDS positions, be included in the CFTC’s risk-based capital calculation. This rule will be effective on March 31, 2010.
The CFTC has also adopted a rule which increases the percentage of noncustomer risk margin requirement included in the CFTC risk-based capital requirement from 4% to 8%. This rule will also be effective on March 31, 2010.
If the CFTC issues a CFTC 4(d) order prior to March 31, 2010, CME Group anticipates that the order will require the risk margin requirement of customer and noncustomer affiliates’ CDS positions be included in the CFTC’s risk-based capital calculation at that time.
Please contact CME Group’s Audit Department at 312.930.3230 if you have any questions.