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U.S. Exchanges Close Ranks on SwapClear

By Robert Hunter

When the London Clearing House announced in July 1997 its intention to introduce a facility to clear swaps between member firms—essentially dusting off a failed initiative of the Chicago Mercantile Exchange in 1992 called the CME Depository Trust Co.—the idea was met with little fanfare. But when the LCH decided to petition the Commodity Futures Trading Commission for regulatory exemption for SwapClear in July of this year, in the hopes of tapping directly into the massive U.S. over-the-counter market, it sparked a firestorm of controversy (see “Will the CFTC Pull The Plug On SwapClear?” September). The Chicago Board of Trade and the New York Mercantile Exchange quickly responded to the proposal with acerbic comments and forceful recommendations, nixing any chance of quick approval.

At first glance, the LCH appears to have enough legal wiggle-room to escape CFTC regulation. According to the CFTC’s 1993 swaps exemption, as long as a swap is not fungible, isn’t written in standardized economic terms, has creditworthy counterparties that satisfy an eligibility requirement, and isn’t traded on a multilateral system such as an exchange, a swap avoids CFTC regulatory scrutiny. And since the LCH is a foreign organization that falls under a regulatory regime comparable to the CFTC, exemption seems to be a no-brainer.

The CBOT, predictably, views the LCH as a competitive threat. In its September 8 comment letter, it argued that rather than granting “piecemeal” exemption only to the LCH, the CFTC should “develop a generic framework for allowing swaps clearing which would be available equally to all clearing organizations, including those affiliated with U.S. futures exchanges.”

The CBOT claims it had considered creating a similar facility some years ago, but was discouraged from devoting substantial resources because of indications that the CFTC opposed expansion of the swaps exemption to include futures exchanges seeking to serve as clearing agents. “To grant the LCH the exemptive [sic] relief it seeks in the absence of [a general regulatory] framework,” the CBOT asserts, “would give the LCH an unwarranted competitive advantage of being the first in the swaps-clearing market. Further, if the Commission grants the petition, it would enable a foreign entity, the LCH, to gain a nearly insurmountable lead toward a monopoly in the clearing of OTC swaps before the U.S.-based clearinghouses have an opportunity to compete, to the detriment of the U.S. derivatives industry.”

The CBOT also argues that the contracts cleared under SwapClear will become increasingly standardized. “The most likely scenario,” it writes, “is an ever-increasing standardization over time to facilitate secondary trading in the swaps contracts among the participants in the market, the SwapClear dealers and the SwapClear clearing members. Thus, the LCH could become an incubator for a new type of futures-like market.”

The NYMEX shares the CBOT’s concerns. In its September 23 comment letter, it calls not only for the CFTC to publish standards for all prospective entities that wish to petition for exemption, but to ensure that certain regulatory safeguards are in place. “In contrast to a privately negotiated, bilateral off-exchange swap transaction where the parties need only be concerned about the credit risk posed by their respective counterparties,” the NYMEX asserts, “the operation of a swaps clearing facility would entail the pooling or concentration of financial and credit risks from many transactions into one centralized facility…[T]he Commission has a statutory obligation to require that appropriate regulatory safeguards be in place to ensure that such systemic risks have been addressed.”

For its part, the LCH has come out swinging. Its October 9 response to the comments concludes with a nasty swipe at the CBOT and the NYMEX: “the real gravamen of CBOT’s and NYMEX’s complaint is not with LCH’s SwapClear facility, but rather stems from their perception of the Commission’s level of regulation of their exchange-traded markets. With all due respect to CBOT and NYMEX, other, more appropriate forums are available to CBOT and NYMEX for addressing their grievances with the Commission.” (In case you were wondering, Webster’s defines gravamen as “the material or significant part of a grievance or complaint.”)

Many view the LCH’s petition to the CFTC as an overly cautious, lawyerly defense mechanism, since its rejection will not deter SwapClear’s summer 1999 launch—U.S. firms wishing to use SwapClear would simply operate through offshore subsidiaries. But clearly that outcome isn’t in the best interest of the U.S. derivatives industry. CFTC chairwoman Brooksley Born has long expressed a desire to revisit the 1993 swaps exemption; now it looks as though she might get her wish.

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