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An Overview of the CFTC and the Regulation of Derivatives Clearing Organizations

An Overview of the CFTC and the Regulation of Derivatives Clearing Organizations. James L. Carley Director Division of Clearing and Intermediary Oversight. Who is the Commodity Futures Trading Commission (“CFTC”)?.

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An Overview of the CFTC and the Regulation of Derivatives Clearing Organizations

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  1. An Overview ofthe CFTC and the Regulation of Derivatives Clearing Organizations James L. Carley Director Division of Clearing and Intermediary Oversight

  2. Who is the Commodity Futures Trading Commission (“CFTC”)? • The CFTC is an independent agency of the U.S. government which was created by Congress in 1974. • The CFTC’s mandate is to regulate commodity futures and option markets in the United States. • The CFTC also has the authority to regulate the activities of persons acting as intermediaries for U.S. customers trading on non-U.S. markets.

  3. What is the mission of the CFTC? • The mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the offer and sale of commodity futures and options and to foster open, competitive, and financially sound commodity futures and option markets. • The CFTC’s primary goals are customer protection, the integrity of the nation’s commodity markets and the financial integrity of the intermediaries in those markets. • The CFTC fulfills its mandate through the enforcement of the provisions of the Commodity Exchange Act and rules promulgated there under.

  4. What does the CFTC regulate? • Markets which list and trade futures and options on futures • Clearing houses which clear transactions that take place on regulated futures markets or on over-the-counter (OTC) markets. • Market participants such as intermediaries, traders, trading advisors and commodity pool operators.

  5. CFTC Regulation of OTC Clearing • President’s Working Group on Financial Markets (Treasury, Fed, SEC, CFTC) released a report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act in November 1999: • “Clearing of OTC derivatives has the potential to reduce counterparty risks associated with such transactions through risk management techniques that may include mutualizing risks, facilitating offset, and netting.”

  6. CFTC Regulation of OTC Clearing • PWG: • Because clearing tends to concentrate risks, Congress should enact legislation to provide for a comprehensive regulatory framework. • Legislation would encourage the development of clearing systems by: • clarifying their legal status; • subjecting them to appropriate supervision; and • ensuring that U.S. firms and markets are not competitively disadvantaged relative to their foreign counterparties.

  7. What is clearing? • Clearing is the process by which trades in futures and options are processed, guaranteed and settled by an entity known as a clearing house. • A clearing house acts as the central counter party to and guarantor of all trades that it has accepted for clearing from its clearing members. The clearing house “becomes the buyer to every seller and the seller to every buyer”, through a process known as “novation.”

  8. Who is involved in clearing? • Clearing houses have a legal relationship only with entities that they have admitted as clearing members. • Clearing houses have no legal relationship with the customers of their clearing members. • Clearing members are generally institutions such as futures commission merchants and broker/dealers that have the financial, risk management, and operational capabilities to function as clearing members. • Clearing members are also subject to minimum capital requirements by both the clearing house of which they are members and the CFTC.

  9. The Clearing Process - Clearing houses undertake some or all of the following activities: • Match, guarantee and settle all trades and register positions resulting from such trades. • Perform mark-to-market calculations of all open positions at least once a day and oversee the resulting cash flows between clearing member firms. • Manage the risk exposure that clearing firms present to the clearing house. • Perform the exercise and assignment of options contracts. • Facilitate, but not guarantee, the delivery of physical commodities.

  10. What clearing houses can do: • Clearing houses permit multilateral netting of positions and settlement payments. • Assuming contracts are fungible (interchangeable), clearing houses offset positions. • Clearing houses enable clearing members to substitute the credit and risk exposure of the clearing house for the credit and risk exposure of each other.

  11. What clearing houses can do: • Clearing houses maintain a package of financial safeguards that are designed to mitigate losses in the event a clearing member defaults on its obligations to the clearing house. • In the event of such a default, the clearing house will meet the obligations of the defaulter by first utilizing the collateral pledged to it by the defaulter. • If such collateral is insufficient to cure the entire amount of the defaulted amount, then the clearing house will utilize the components of its financial safeguards package to take care of the remaining defaulted amount.

  12. What clearing houses can do: Hypothetical scenario of clearing house default management • A clearing member defaults on an obligation to a clearing house in the amount of $100 million. The default is in respect of the proprietary positions of the clearing member. • The clearing house first utilizes the clearing member’s collateral that is pledged to it by the clearing member. This amounts to $50 million. • The clearing house satisfies the remaining default amount of $50 million by resorting to its clearing fund. At the time of the default, the value of the clearing fund is $500 million and is made up of clearing fund deposits of all clearing members.

  13. How clearing can help in the current credit situation in the U.S. energy markets • By functioning as the central counter party to transactions, the regulated clearing house will substitute its credit for that of the parties to the trade. • This will allow counter parties to “free up” bilateral credit lines, thus allowing them to trade more frequently.

  14. What clearing houses cannot do: • Clearing houses do not completely eliminate counter party credit risk. Clearing members are always subject to the risk of default or failure by the clearing house itself. • Clearing house protections do not generally flow to the customers of clearing member firms. • Customers of clearing firms are always subject to the risk of that firm’s inability to meet its obligations to the customer. This inability may arise based upon a default of another customer, so a clearing firm customer is always subject to the risk of fellow customers.

  15. Regulation of clearing houses –Registration requirement of certain Derivatives Clearing Organizations (“DCOs”) • All clearing houses that seek to provide clearing services with respect to futures contracts and options on such futures contracts must register with the CFTC as derivatives clearing organizations(“DCOs”) before they can begin providing such services. • The registration requirement is imposed by Section 5b(a) of the Commodity Exchange Act. • DCOs that are not required to register may nevertheless voluntarily register with the CFTC.

  16. Regulation of clearing houses –Exceptions to requirements to register as a DCO • The clearing house was “grandfathered” in to DCO status at the time of the enactment of the Commodity Futures Modernization Act in December 2000; or • The futures contract or option on such futures contract that the clearing house seeks to clear is either excluded from the Commodity Exchange Act or exempted by the Act; or • The futures contract or option on such futures contract that the clearing house seeks to clear is a security futures product and the clearing house is a clearing agency registered under the Securities Exchange Act of 1934.

  17. Regulation of clearing houses –Compliance with DCO Core Principles • To obtain and maintain registration, a DCO must comply with the thirteen (13) DCO Core Principles . • These Core Principles are imposed by Section 5b(c)(2) of the Commodity Exchange Act. • The CFTC has the responsibility to oversee DCOs to ensure continued compliance with DCO Core Principles.

  18. Regulation of clearing houses –The thirteen (13) DCO Core Principles 1. Adequate financial, operational and managerial resources. 2. Appropriate standards for participant and product eligibility. 3. Adequate and appropriate risk management capabilities. 4. Ability to complete settlements on a timely basis.

  19. Regulation of clearing houses –Thirteen (13) DCO Core Principles (cont.) 5. Standards and procedures to protect member and participant funds. 6. Efficient and fair default rules and procedures. 7. Adequate rule enforcement and dispute resolution procedures. 8. Adequate and appropriate systems safeguards, emergency procedures and plan for disaster recovery. 9. Obligation to provide necessary reports to allow CFTC to oversee activities.

  20. Regulation of clearing houses –Thirteen (13) DCO Core Principles (cont.) 10. Maintenance of all business records for five (5) years in a form that is acceptable to CFTC. 11. Publicize rules and operating procedures. 12. Participation in appropriate and applicable domestic and international information-sharing agreements. 13. Avoidance of actions that are unreasonable restraints of trade or that impose anti competitive burdens on trading.

  21. Forms of clearing house organization • An operating division of an exchange, • A subsidiary of the exchange, or • An independent entity that provides clearing services for a market.

  22. Who clears now? - DCOs currently registered with the CFTC • The Clearing Corporation • NYMEX Clearing House • CME Clearing House • New York Clearing Corporation • Kansas City Board of Trade Clearing Corporation • MGE Clearing House

  23. Who clears now? - DCOs currently registered with the CFTC • London Clearing House • The Options Clearing Corporation (OCC) • Guaranty Clearing Corporation • EnergyClear Corporation • Intermarket Clearing Corporation • OnExchange Clearing Corporation

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