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

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 CFTCs 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 CFTCs primary goals are customer protection,
  the integrity of the nations 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

• Presidents 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
  members 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 firms 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