On August 8, 2018 the Commodity Futures Trading Commission (CFTC) voted unanimously to propose rules (Proposed Rules) which would codify policies and procedures related to exempting derivatives clearing organizations (DCOs) located outside the US^[1] from the CFTC's registration requirement.^[2] The CFTC is currently seeking comments on a number of the aspects of the Proposed Rule. The comment period will run through October 12, 2018.^[3]

The Commodity Exchange Act (CEA) provides that a DCO may not clear swaps unless the DCO is registered with the CFTC.^[4] The CEA also permits the CFTC to exempt certain DCOs from registration if the CFTC determines that the DCO is subject to "comparable, comprehensive supervision and regulation" by relevant authorities in the DCO's home country.^[5] There are currently four DCOs that the CFTC has exempted from registration,^[6] but to date these exemptions have been granted on a case-by-case basis without codified policies or procedures for applicants to follow when applying for exemption or for the CFTC to follow when evaluating an application for exemption.

In the preamble to the Proposed Rules, the CFTC states that in has construed "comparable, comprehensive supervision and regulation" to mean "that the home country's supervision and regulatory framework should be consistent with, and achieve the same outcome as, the statutory and regulatory requirements applicable to registered DCOs."^[7] More specifically, the CFTC has determined that a supervisory and regulatory framework that conforms to the Principles for Financial Market Infrastructure^[8] (PFMIs) is comparable to, and as comprehensive as, the supervisory and regulatory framework applicable to registered DCOs.^[9]

The Proposed Rules largely codify the policies and procedures that have been followed by the CFTC, and are consistent with the terms and conditions that the CFTC has imposed, in granting exemptions to date. Specifically, the Proposed Rules can be summarized as follows:

• Eligibility Requirements (proposed 17 CFR 39.6(a)). In order to be eligible for an exemption from DCO registration:

o   the DCO must be organized in a jurisdiction in which a home country regulator applies to the DCO, on an ongoing basis, statutes, rules, regulations, policies, or a combination thereof that, taken together, are consistent with the PFMIs. The DCO must observe the PFMIs in all material respects and be in good regulatory standing in its home country; and

o   the DCO's home country regulatory must enter into a memorandum of understanding (MOU) with the CFTC pursuant to which, among other things, the home country regulator agrees to provide the CFTC with any information that the CFTC deems necessary to evaluate the DCOs initial and continued eligibility for exemption from registration or to review compliance with any conditions of such exemption.

• Conditions of Exemption (proposed 17 CFR 39.6(b)). A DCO which has been granted an exemption from registration would still be subject to the following conditions (amongst others):

o   Exempted DCOs would be prohibited from clearing futures commission merchants' (FCMs) customer positions (but would be permitted to clear their proprietary positions);

o   Exempted DCOs would be required to comply with the "open access" requirements of the CEA applicable to registered DCOs, which require that DCOs maintain rules providing that all such swaps with the same terms and conditions submitted to the DCO for clearing are economically equivalent and may be offset with each other (to the extent permitted by the DCO's rules);

o   Exempted DCOs would be required to submit to the CFTC's jurisdiction and designate a US agent;

o   Exempted DCOs would be required to be able to demonstrate to the CFTC compliance  with any of the conditions of its order of exemption, and to make all books and records open to the CFTC for inspection; and

o   Exempted DCOs would be required to provide an annual certification to the CFTC that they continue to observe the PFMIs in all respects.

• Reporting Requirements (proposed 17 CFR 39.6(c) & (d)). A DCO which has been granted an exemption from registration would be required to comply with certain daily and quarterly reporting requirements (consistent with those applicable to current registered DCOs),^[10] as well as requirements to report certain events, including:

o   daily reports, which would include reports on initial and variation margin on deposit for each US person;^[11]

o   quarterly reports, which would include reports on aggregate clearing volume of US persons and the average open interest of US persons. If the clearing member is a US person, this data would include the transactions and positions of the clearing member and all affiliates for which the clearing member clears; if the clearing member is not a US person, this data would only have to include the transactions and positions of US affiliates;

o   events which would require reporting include (i) changes in the DCO's home country regulatory regime, (ii) notification of enforcement actions taken by the DCO's home country regulatory, (iii) any change in the DCO's registration or licensing status with its home country regulator; (iv) notice of any event of default by a US person or FCM; and

o   that DCOs would need to report certain data to swap data repositories (SDRs) for swaps they clear that have been reported to an SDR. This data would cover the two swaps resulting from the novation of the original swap that had been submitted to the exempt DCO for clearing, as well as the termination of the original swap accepted for clearing.

• Application Procedures (proposed 17 CFR 39.6(e)). DCOs applying for a registration exemption would need to follow the procedures outlined in the Proposed Rules, which include that:

o   applications be complete before the CFTC will consider them;

o   applications include identifying information about the DCO, as well information supporting the DCO's eligibility for exemption, including the DCO's most recent disclosures necessary to observe the PFMIs, which includes the financial market infrastructure (FMI) disclosure template set forth in Annex A to the Disclosure Framework and Assessment Methodology for the PFMIs. The CFTC notes that the FMI disclosure template is generally required by home country regulators that enforce PFMIs;

o   the CFTC reserves the right in the Proposed Rules to request additional supplemental information from applicants for DCO registration exemption;

o   applicants would be required to update the CFTC should they discover any material omissions or errors, or if there are any material changes in information provided; and

o   certain elements of the application (e.g. the cover page and documents that demonstrate an applicant's jurisdiction of organization) would be made public.

• Modifications (proposed 17 CFR 39.6(f) & (g)). Under the Proposed Rules, the CFTC would reserve the right to modify the terms and conditions of any exemption it grants, and it would be able to terminate an exemption upon request by the exempted DCO.

Finally, the CFTC has specifically requested comments on the following questions (in addition to requesting comments on the entirety of the Proposed Rules):

• Exempt DCOs are currently permitted to clear only proprietary positions of US persons and FCMs. The Proposed Rules would codify this approach. Should the CFTC consider permitting an exempt DCO to clear swaps for FCM customers?
• Should the CFTC impose any additional conditions on an exempt DCO or modify any of the existing conditions?
• Should any of the conditions imposed on an exempt DCO lead to an automatic termination of the exemption if the condition is not met?

The comment period runs through October 12, 2018.

^[1] We note that while the Proposed Rules do not specifically state that exemptions are reserved for DCOs located outside the US, the requirement that the DCO be subject to comparable supervision and regulation in its "home country" effectively renders this exemption available only to DCOs located outside the US.

^[2]  Exemption from Derivatives Clearing Organization Registration, 83 Fed. Reg. 39923 (Aug. 13, 2018), available at https://www.cftc.gov/sites/default/files/2018-08/2018-17335a.pdf.

^[3] We note that in its letter responding to Project KISS, a trade association commented that not permitting US clients that are not themselves members of central counterparties (CCPs) to clear with exempted DCOs ultimately prevents US banks from providing liquidity and hedging for clients in non-US markets, and argued that the CFTC should permit exempted DCOs to clear for US clients. The trade association also argued that central counterparties should not have to register as a DCO or obtain an order of exemption from registration solely due to the fact that they permit clearing members (or affiliates of clearing members) that are US persons to clear, for their proprietary accounts, swaps that are not subject to mandatory clearing under the CFTC’s rules (since such clearing is done on a strictly voluntary basis, US persons should therefore have more flexibility with regard to the CCP they select).

^[4] CEA § 5b(a).

^[5] CEA § 5b(h).

^[6] ASX Clear (Futures) Pty Limited, Korea Exchange, Inc., Japan Securities Clearing Corporation, and OTC Clearing Hong Kong Limited.

^[7] 83 Fed. Reg. at 39924.

^[8] See CPMI–IOSCO, Principles for financial market infrastructures (Apr. 2012), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377-PFMI.pdf  The PFMIs define a ‘‘financial market infrastructure’’ as a ‘‘multilateral system among participating institutions, including the operator of the system, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions.’’ See PFMIs, paragraph 1.8. Additionally, the PFMIs are ‘‘broadly designed to apply to all systemically important [financial market infrastructures].’’ See PFMIs, paragraph 1.20.

^[9] 83 Fed. Reg. at 39924.

^[10] See 17 CFR 39.19.

^[11] The term "US person" is not defined in the Proposed Rules, but in the Orders of Exemption for the four exempted DCOs (see FN 6), the CFTC used the term as defined in the Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45292 (July 26, 2013), available at https://www.cftc.gov/sites/default/files/idc/groups/public/@lrfederalregister/documents/file/2013-17958a.pdf (the Cross-Border Guidance). As such, we believe that references in the Proposed Rules to "US persons" are reasonably interpreted to be references to "US persons" as defined in the Cross-Border Guidance.  Unless otherwise noted, the term "US person" is used herein as defined in the Cross-Border Guidance.