26114 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

that this proposal would not have

sufficient federalism implications to

warrant the preparation of a Federalism

Assessment.

For the reasons discussed above, I

certify that this proposed regulation (1)

is not a ‘‘significant regulatory action’’

under Executive Order 12866; (2) is not

a ‘‘significant rule’’ under the DOT

Regulatory Policies and Procedures (44

FR 11034, February 26, 1979); and (3) if

promulgated, will not have a significant

economic impact, positive or negative,

on a substantial number of small entities

under the criteria of the Regulatory

Flexibility Act. A copy of the draft

regulatory evaluation prepared for this

action is contained in the Rules Docket.

A copy of it may be obtained by

contacting the Rules Docket at the

location provided under the caption

ADDRESSES.

List of Subjects in 14 CFR Part 39

Air transportation, Aircraft, Aviation

safety, Safety.

The Proposed Amendment

Accordingly, pursuant to the

authority delegated to me by the

Administrator, the Federal Aviation

Administration proposes to amend part

39 of the Federal Aviation Regulations

(14 CFR part 39) as follows:

PART 39—AIRWORTHINESS

DIRECTIVES

1. The authority citation for part 39

continues to read as follows:

Authority: 49 U.S.C. 106(g), 40113, 44701.

§ 39.13 [Amended]

2. Section 39.13 is amended by

adding the following new airworthiness

directive:

Dornier Luftfahrt GMBH: Docket 98–NM–

123–AD.

Applicability: Model 328–100 series

airplanes, equipped with nose landing gear

(NLG) having serial below IL113; certificated

in any category.

Note 1: This AD applies to each airplane

identified in the preceding applicability

provision, regardless of whether it has been

modified, altered, or repaired in the area

subject to the requirements of this AD. For

airplanes that have been modified, altered, or

repaired so that the performance of the

requirements of this AD is affected, the

owner/operator must request approval for an

alternative method of compliance in

accordance with paragraph (b) of this AD.

The request should include an assessment of

the effect of the modification, alteration, or

repair on the unsafe condition addressed by

this AD; and, if the unsafe condition has not

been eliminated, the request should include

specific proposed actions to address it.

Compliance: Required as indicated, unless

accomplished previously.

To correct cracking in the axle adapter of

the shock absorber of the NLG, which could

cause failure of the NLG and consequent

damage to the airplane structure, accomplish

the following:

(a) Within 300 flight hours after the

effective date of this AD, perform a one-time

visual inspection to detect cracking in the

axle adapter of the NLG shock absorber, in

accordance with Dornier Service Bulletin

SB–328–32–213, dated April 16, 1997.

(1) If no cracking is detected, no further

action is required by this AD.

(2) If any cracking is detected, prior to

further flight, remove the NLG shock

absorber and replace with a new or

serviceable part, in accordance with the

service bulletin.

Note 2: Dornier Service Bulletin SB–328–

32–213, dated April 16, 1997, references

Messier-Dowty Service Bulletin 800–32–027,

dated May 7, 1997, as an additional source

of service information to accomplish the

inspection, removal, and repair.

(b) An alternative method of compliance or

adjustment of the compliance time that

provides an acceptable level of safety may be

used if approved by the Manager,

International Branch, ANM–116, FAA,

Transport Airplane Directorate. Operators

shall submit their request through an

appropriate FAA Principal Maintenance

Inspector, who may add comments and then

send it to the Manager, International Branch,

ANM–116.

Note 3: Information concerning the

existence of approved alternative methods of

compliance with this AD, if any, may be

obtained from the International Branch,

ANM–116.

(c) Special flight permits may be issued in

accordance with sections 21.197 and 21.199

of the Federal Aviation Regulations (14 CFR

21.197 and 21.199) to operate the airplane to

a location where the requirements of this AD

can be accomplished.

Note 4: The subject of this AD is addressed

in German airworthiness directive 97–142,

dated May 22, 1997.

Issued in Renton, Washington, on May 5,

1998.

John J. Hickey,

Acting Manager, Transport Airplane

Directorate, Aircraft Certification Service.

[FR Doc. 98–12510 Filed 5–11–98; 8:45 am]

BILLING CODE 4910–13–U

COMMODITY FUTURES TRADING

COMMISSION

17 CFR Parts 34 and 35

Over-the-Counter Derivatives

AGENCY: Commodity Futures Trading

Commission.

ACTION: Concept Release.

SUMMARY: The Commodity Futures

Trading Commission (‘‘CFTC’’ or

‘‘Commission’’) has been engaged in a

comprehensive regulatory reform effort

designed to update the agency’s

oversight of both exchange and offexchange markets. As part of this reform

effort, the Commission is reexamining

its approach to the over-the-counter

(‘‘OTC’’) derivatives market.

OTC derivatives are contracts

executed outside of the regulated

exchange environment whose value

depends on (or derives from) the value

of an underlying asset, reference rate, or

index. They are used by market

participants to perform a wide variety of

important risk management functions.

The CFTC’s last major regulatory actions

involving OTC derivatives were

regulatory exemptions for certain swaps

and hybrid instruments adopted in

January 1993. Since that time, the OTC

derivatives market has grown

dramatically in both volume and variety

of products offered and has attracted

many new end-users of varying degrees

of sophistication. The market has also

changed, with new products being

developed, with some products

becoming more standardized, and with

systems for central execution or clearing

being studied or proposed.

The Commission hopes that the

public comments filed in response to

this release will constitute an important

source of relevant data and analysis that

will assist it in determining whether its

current regulatory approach continues

to be appropriate or requires

modification. The Commission wishes

to maintain adequate safeguards without

impairing the ability of the OTC

derivatives market to continue to grow

and the ability of U.S. entities to remain

competitive in the global financial

marketplace. The Commission has

identified a broad range of issues and

potential approaches in order to

generate detailed analysis from

commenters. The Commission urges

commenters to analyze the benefits and

burdens of any potential regulatory

modifications in light of current market

realities. The Commission has no

preconceived result in mind. The

Commission is open both to evidence in

support of easing current restrictions

and evidence indicating a need for

additional safeguards. The Commission

also welcomes comment on the extent to

which certain matters are being or can

be adequately addressed through selfregulation, either alone or in

conjunction with some level of

government oversight, or through the

regulatory efforts of other government

agencies.

New regulatory restrictions ultimately

adopted, if any, will be adopted only

after publication for additional public

comment and will be applied

prospectively only. This release in no
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26115

1See Group of Thirty, Derivatives: Practices and

Principles 2 (1993).

2 International Swaps and Derivatives

Association, Summary of Recent Market Survey

Results, ISDA Market Survey, available at (http://

www.isda.org).

3 Id.

4 Id.

5 General Accounting Office, GAO/GGD–98–5,

OTC Derivatives: Additional Oversight Could

Reduce Costly Sales Practice Disputes 3 n.6 (1997)

[hereinafter ‘‘1997 GAO Report’’]. The notional

amount represents the amount upon which

payments to the parties to a derivatives transaction

are based and is the most commonly used measure

of outstanding derivatives transactions. Notional

amounts generally overstate the amount at risk and

the market value of such transactions.

6See, e.g., Jerry A. Markham, Commodities

Regulation: Fraud, Manipulation & Other Claims,

Section 27.05 nn. 2–22.1 (1997) (listing 22 examples

of significant losses in financial derivatives

transactions); 1997 GAO Report at 4 (stating that the

GAO identified 360 substantial end-user losses).

Some of these transactions involved instruments

that are not subject to the CEA.

7Each of these exemptions is discussed in Part II,

below.

8See, e.g., Proposed Rulemaking Permitting

Future-Style Margining of Commodity Options, 62

FR 66569 (Dec. 19, 1997); Concept Release on the

Denomination of Customer Funds and the Location

of Depositories, 62 FR 67841 (Dec. 30, 1997);

Account Identification for Eligible Bunched Orders,

63 FR 695 (Jan. 7, 1998); Maintenance of Minimum

Financial Requirements by Futures Commission

Merchants and Introducing Brokers, 63 FR 2188

(Jan. 14, 1998); Requests for Exemptive, No-Action

and Interpretative Letters, 63 FR 3285 (Jan. 22,

1998); Regulation of Noncompetitive Transactions

Executed on or Subject to the Rules of a Contract

Market, 63 FR 3708 (Jan. 26, 1998); Distribution of

Risk Disclosure Statements by Futures Commission

Merchants and Introducing Brokers, 63 FR 8566

(Feb. 20, 1998); Amendments to Minimum

Financial Requirements for Futures Commission

Merchants, 63 FR 12713 (March 16, 1998); Two-Part

Documents for Commodity Pools, 63 FR 15112

(March 30, 1998); and Trade Options on the

Enumerated Agricultural Commodities, 63 FR

18821 (April 16, 1998). See also Application of

FutureCom, Ltd. as a Contract Market in Live Cattle

Futures and Options, 62 FR 62566 (Nov. 24, 1997)

(Internet-based trading system); Application of

Cantor Financial Futures Exchange as a Contract

Market in US Treasury Bond, Ten-Year Note, FiveYear Note and Two-Year Note Futures Contracts, 63

FR 5505 (Feb. 3, 1998) (electronic trading system).

way alters the current status of any

instrument or transaction under the

Commodity Exchange Act. All currently

applicable exemptions, interpretations,

and policy statements issued by the

Commission regarding OTC derivatives

products remain in effect, and market

participants may continue to rely upon

them.

DATES: Comments must be received on

or before July 13, 1998.

ADDRESSES: Comments should be

mailed to Jean A. Webb, Secretary,

Commodity Futures Trading

Commission, Three Lafayette Centre,

1155 21st Street, NW, Washington, D.C.

20581; transmitted by facsimile to (202)

418–5521; or transmitted electronically

to {secretary@cftc.gov}. Reference

should be made to ‘‘Over-the-Counter

Derivatives Concept Release.’’

FOR FURTHER INFORMATION CONTACT: I.

Michael Greenberger, Director, David M.

Battan, Special Counsel, or John C.

Lawton, Associate Director, Division of

Trading and Markets, Commodity

Futures Trading Commission, Three

Lafayette Centre, 1155 21st Street N.W.,

Washington, D.C. 20581 (202) 418–5430.

SUPPLEMENTARY INFORMATION:

I. Introduction

A. Description of Over-the-Counter

Products and Markets

B. Purpose of This Release

II. Current Exemptions

A. Swaps

1. Policy Statement

2. Part 35

B. Hybrid Instruments

1. Background

2. Part 34

III. Issues for Comment

A. Background

B. Potential Changes to Current

Exemptions

1. Eligible Transactions

2. Eligible Participants

3. Clearing

4. Transaction Execution Facilities

5. Registration

6. Capital

7. Internal Controls

8. Sales Practices

9. Recordkeeping

10. Reporting

C. Self-Regulation

IV. Summary of Request for Comment

I. Introduction

A. Description of Over-the-Counter

Products and Markets

Over-the-counter (OTC) derivatives

are contracts executed outside of the

regulated exchange environment whose

value depends on (or derives from) the

value of an underlying asset, reference

rate or index.1 The classes of underlying

assets from which a derivative

instrument may derive its value include

physical commodities (e.g., agricultural

products, metals, or petroleum),

financial instruments (e.g., debt and

interest rate instruments or equity

securities), indexes (e.g., based on

interest rates or securities prices),

foreign currencies, or spreads between

the value of such assets.

Like exchange-traded futures and

option contracts, OTC derivatives are

used to perform a wide variety of

important risk management functions.

End-users employ OTC derivatives to

address risks from volatility in interest

rates, foreign exchange rates,

commodity prices, and equity prices,

among other things. OTC derivative

instruments also can be used to assume

price risk in order to increase

investment yields or to speculate on

price changes. Participants in the OTC

derivatives market include banks, other

financial service providers, commercial

corporations, insurance companies,

pension funds, colleges and

universities, and governmental entities.

Use of OTC derivatives has grown at

very substantial rates over the past few

years. According to the most recent

market survey by the International

Swaps and Derivatives Association

(‘‘ISDA’’), the notional value of new

transactions reported by ISDA members

in interest rate swaps, currency swaps,

and interest rate options during the first

half of 1997 increased 46% over the

previous six-month period.2 The

notional value of outstanding contracts

in these instruments was $28.733

trillion, up 12.9% from year-end 1996,

62.2% from year-end 1995, and 154.2%

from year-end 1994.3 ISDA’s 1996

market survey noted that there were

633,316 outstanding contracts in these

instruments as of year-end 1996, up

47% from year-end 1995, which in turn

represented a 40.7% increase over yearend 1994.4 An October 1997 report by

the General Accounting Office (‘‘GAO’’)

suggests that the market value of those

OTC derivatives represents ‘‘about 3

percent’’ of the notional amount.5

Applying the 3% figure to the most

recent ISDA number for contracts

outstanding for the first half of 1997

indicates that the world-end market

value of these OTC derivatives

transactions is over $860 billion.

While OTC derivatives serve

important economic functions, these

products, like any complex financial

instrument, can present significant risks

if misused or misunderstood by market

participants. A number of large, well

publicized, financial losses over the last

few years have focused the attention of

the financial services industry, its

regulators, derivatives end-users, and

the general public on potential problems

and abuses in the OTC derivatives

market.6 Many of these losses have

come to light since the last major

regulatory actions by the CFTC

involving OTC derivatives, the swaps

and hybrid instruments exemptions

issued in January 1993.7

B. Purpose of This Release

The Commission has been engaged in

a comprehensive regulatory reform

effort designed to update the agency’s

oversight of both exchange and offexchange markets.8 As part of this

process, the Commission believes that it

is appropriate to reexamine its

regulatory approach to the OTC

derivatives market taking into account

developments since 1993. The purpose
26116 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

9 In addition to the exemptions discussed in the

text, the CEA excludes certain transactions.

Forward contracts are excluded in section 1a(11) of

the CEA, 7 U.S.C. 1A(11). The Treasury

Amendment of the CEA excludes ‘‘transactions in

foreign currency, security warrants, security rights,

resales of installment loan contracts, repurchase

options, government securities, or mortgage and

mortgage purchase commitments, unless such

transactions involve the sale thereof for future

delivery conducted on a board or trade.’’ Section

2(a)(1)(A)(ii), 7 U.S.C. 2(ii). Furthermore, options on

securities or securities indexes are excluded from

the Act. Section 2(a)(1)(B)(i), 7 U.S.C. 2a(i). The

Commission by order has also exempted certain

transactions in energy products from the provisions

of the CEA. Exemption for Certain Contracts

Involving Energy Products, 58 FR 21286 (April 20,

1993). In addition, the Commission has exempted

certain trade options. 17 C.F.R. 32.4; Trade Options

on Enumerated Agricultural Commodities, 63 FR

18821 (April 16, 1998). The Commission has also

exempted certain transactions in which U.S.

customers establish or offset foreign currency

options on the Honk Kong Futures Exchange.

Petition of the Philadelphia Stock Exchange, Inc. for

Exemptive Relief To Permit United States

Customers To Establish or Offset Positions in

Certain Foreign Currency Options on the Hong

Kong Futures Exchange, Ltd. Through Registered

Broker-Dealers, 62 FR 15659 (April 2, 1997). 10 54 FR 30694 (July 21, 1989). 11 Id. at 30696.

12 Id. at 30697. 13 Id at 30696–97. 14See id. at 30696 n. 17. 15Pub. L. No. 102–546 (1992), 106 Stat 3590,

3629. 16 7 U.S.C. 6(c)(1). 17 7 U.S.C. 6(c)(2). 18 7 U.S.C. 6(c)(3). 19 7 U.S.C. 6(c)(1). Section 4(d), 7 U.S.C. 6(d),

provides that

[t]he granting of an exemption under this section

shall not affect the authority of the Commission

under any other provision of the Act to conduct

investigations in order to determine compliance

with the requirements or conditions of such

exemption or to take enforcement action for any

violation of any provision of this Act or any rule,

regulation or order thereunder caused by failure to

comply with or satisfy such conditions or

requirements.

of this release is to solicit comments on

whether the regulatory structure

applicable to OTC derivatives under the

Commission’s regulations should be

modified in any way in light of recent

developments in the marketplace and to

generate information and data to assist

the Commission in assessing this issue. The market has continued to grow

and to evolve in the past five years. As

indicated above, volume has increased

dramatically. New end-users of varying

levels of sophistication have begun to

participate in this market. Products have

proliferated, with some products

becoming increasingly standardized.

Systems for centralized execution and

clearing are being proposed. The Commission hopes that the

public comments filed in response to

this release will constitute an important

source of relevant data and analysis that

will assist it in determining how best to

maintain adequate regulatory safeguards

without impairing the ability of the OTC

derivatives market to continue to grow

and the ability of U.S. entities to remain

competitive in the global financial

marketplace. The Commission has no

preconceived result in mind. The

Commission wishes to draw on the

knowledge and expertise of a broad

spectrum of interested parties including

OTC derivatives dealers, end-users of

derivatives, other regulatory authorities,

and academicians. The Commission

urges commenters to provide detail on

current custom and practice in the OTC

derivatives marketplace in order to

assist the Commission in gauging the

practical effect of current exemptions

and potential modifications. The Commission is open both to

evidence in support or broadening its

exemptions and to evidence indicating

a need for additional safeguards. Serious

consideration will be given to the views

of all interested parties before regulatory

changes, if any, are proposed. In

evaluating the comments and ultimately

deciding on its course of action, the

Commission will, of course, also engage

in its own research and analysis. Any

proposed changes will be carefully

designed to avoid unduly burdensome

or duplicative regulation that might

adversely affect the continued vitality of

the market and will be published for

public comment. Moreover, any changes

which impose new regulatory

obligations or restrictions will be

applied prospectively only. As this process goes forward, the

Commission is mindful of the industry’s

need to retain flexibility in designing

new products as well as the need for

legal certainty concerning the

enforceability of agreements. Therefore,

the Commission wishes to emphasize

that, as was the case with other recent

concept releases, this release identifies

a broad range of issues in order to

stimulate public discussion and to elicit

informed analysis. This release does not

in any way alter the current status of

any instrument or transaction under the

CEA. All currently applicable

exemptions, interpretations, and policy

statements issued by the Commission

regarding OTC derivatives products

remain in effect, and market

participants may continue to rely upon

them.

II. Current Exemptions 9

A. Swaps

1. Policy Statement

The Policy Statement was adopted by

the Commission on July 21, 1989.10 It

provides a safe harbor from regulation

by the Commission under the CEA for

qualifying agreements. It addresses only

swaps settled in cash, with foreign

currencies considered to be cash.11

To qualify for a safe harbor from

regulation under the Policy Statement, a

swap agreement must have all of the

following characteristics: (1)

individually tailored terms; (2) an

absence of exchange-style offset; (3) an

absence of a clearing organization or

margin system; (4) undertaken in

conjunction with a line of business; and

(5) not marketed to the general public. These conditions limit the

applicability of the Policy Statement

primarily to agreements entered into by

institutional and commercial entities

such as corporations, commercial and

investment banks, thrift institutions,

insurance companies, governments and

government-sponsored or -chartered

entities. The Commission indicated

however, that the restrictions did not

‘‘preclude dealer transactions in swaps

undertaken in conjunction with a line of

business, including financial

intermediation services.’’ 12 Moreover,

the restrictions reflect the Commission’s

understanding that qualifying

transactions will be entered into with

the expectation of performance by the

counterparties, will be bilaterally

negotiated as to material economic

terms based upon individualized credit

determinations, and will be documented

by the parties in an agreement (or series

of agreements) that is not

standardized.13 The restrictions are not

intended to prevent the use of master

agreements between two counterparties,

provided that the material terms of the

master agreement and the transaction

specifications are individually tailored

by the parties.14

2. Part 35

The Futures Trading Practices Act of

1992 (‘‘1992 Act’’) 15 added subsections

(c) and (d) to section 4 of the Act.

Section 4(c)(1) 16 authorizes the

Commission, by rule, regulation or

order, to exempt any agreement,

contract or transaction, or class thereof

from the exchange-trading requirements

of Section 4(a) or any other requirement

of the Act other than Section 2(a)(1)(B).

Section 4(c)(2) 17 provides that the

Commission may not grant any

exemption unless the Commission

determines that the transaction will be

entered into solely between

‘‘appropriate persons.’’ 18 that the

exchange trading requirements of

Section 4(a) should not be applied, that

the agreement, contract or transaction in

question will not have a material

adverse effect on the ability of the

Commission or any contract market to

discharge its regulatory or selfregulatory duties under the Act, and

that the exemption would be consistent

with the public interest and the

purposes of the Act.

The Commission may grant

exemptions ‘‘either unconditionally or

on stated terms or conditions.’’ 19 Thus,
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26117

20 7 U.S.C. 2a. Section 2(a)(1)(B) of the Act

establishes the respective jurisdiction of the CFTC

and of the SEC over different instruments and

restricts or prohibits certain types of securities

futures.

21 7 U.S.C. 6b and 6o.

22Regulation 32.9, 17 CFR 32.9, prohibits fraud

in connection with commodity options

transactions.

23 7 U.S.C. 9 and 13(a)(2).

24Pub. L. No. 93–463 (1974), 88 Stat. 1389. See

Commission Regulation 35.1(a) and Exemption for

Certain Swap Agreements, 58 FR 5587 at 5588

(January 22, 1993) (adopting Part 35 Rules).

25 In issuing the swap exemption, the

Commission also acted pursuant to its authority to

regulate options under Section 4c(b) of the CEA, 7

U.S.C. 6c(b). See Exemption for Certain Swap

Agreements, 58 FR 5587 at 5589 (Jan. 22, 1993).

26 Id. at 5588. 27See id. at 5589.

28See id. at 5589–90.

29See id. at 5590.

Section 4(c) gives the Commission the

authority to tailor its regulatory program

to fit the realities of the marketplace and

the needs of market participants.

Part 35 of the Commission’s

regulations exempts swap agreements

meeting specified criteria from the

provisions of the CEA and the

Commission’s regulations promulgated

thereunder except for the following:

Section 2(a)(1)(B) of the CEA; 20 the

antifraud provisions set forth in

Sections 4b and 4o of the CEA 21 and

Commission Rule 32.9; 22 and the

antimanipulation provisions set forth in

Sections 6(c) and 9(a)(2) of the CEA.23

The Part 35 swap exemption is

retroactive and effective as of October

23, 1974, the date of enactment of the

Commodity Futures Trading

Commission at of 1974.24 Part 35 was

promulgated under authority granted to

the Commission by Section 4(c) of the

Act.25

To be eligible for exemptive treatment

under Part 35, an agreement: (1) must be

a swap agreement as defined in

Regulation 35.1(b)(1); (2) must be

entered into solely between eligible

swap participants; (3) must not be a part

of a fungible class of agreements that are

standardized as to their material

economic terms; (4) must include as a

material consideration the

creditworthiness of a party with an

obligation under the agreement; and (5)

must not be entered into and traded on

or through a multilateral transaction

execution facility. These criteria were

designed to assure that the exempted

swaps agreements met the requirements

set forth by Congress in Section 4(c) of

the CEA and ‘‘to promote domestic and

international market stability, reduce

market and liquidity risks in financial

markets, including those markets (such

as futures exchanges) linked to swap

markets and eliminate a potential source

of systemic risk.’’ 26

The definition of ‘‘swap agreement’’

provided in Regulation 35.1(b)(1) is as

follows:

Swap agreement means: (i) An agreement

(including terms and conditions incorporated

by reference therein) which is a rate swap

agreement, basis swap, forward rate

agreement, commodity swap, interest rate

option, forward foreign exchange agreement,

rate cap agreement, rate floor agreement, rate

collar agreement, currency swap agreement,

cross-currency rate swap agreement, currency

option, any other similar agreement

(including any option to enter into any of the

foregoing); (ii) Any combination of the

foregoing; or (iii) A master agreement for any

of the foregoing together with all

supplements thereto.

This definition is the same as the

definition of swap agreement set forth in

Section 4(c)(5)(B) of the CEA.27

Regulation 35.1(b)(2) defines ‘‘eligible

swap participant’’ as follows:

(i) A bank or trust company (acting on its

own behalf or on behalf of another eligible

swap participant);

(ii) A savings association or credit union;

(iii) An insurance company;

(iv) An investment company subject to

regulation under the Investment Company

Act of 1940 . . . or a foreign person

performing a similar role or function subject

as such to foreign regulation, provided that

such investment company or foreign person

is not formed solely for the specific purpose

of constituting an eligible swap participant;

(v) A commodity pool formed and operated

by a person subject to regulation under the

Act or a foreign person performing a similar

role or function subject as such to foreign

regulation, provided that such commodity

pool or foreign person is not formed solely

for the specific purpose of constituting an

eligible swap participant and has total assets

exceeding $5,000,000;

(vi) A corporation, partnership,

proprietorship, organization, trust, or other

entity not formed solely for the specific

purpose of constituting an eligible swap

participant (A) which has total assets

exceeding $10,000,000; or (B) the obligations

of which under the swap agreement are

guaranteed or otherwise supported by a letter

of credit * * * or other agreement by any

such entity referenced in this subsection

(vi)(A) * * * or * * * in paragraph (i), (ii),

(iii), (iv), (v), (vi) or (viii) of this section; or

(C) which has a net worth of $1,000,000 and

enters into the swap agreement in connection

with * * * its business; or which has a net

worth of $1,000,000 and enters into the swap

agreement to manage the risk of an asset or

liability owned or incurred in the conduct of

its business or reasonably likely to be owned

or incurred in * * * its business;

(vii) An employee benefit plan subject to

the Employee Retirement Income Security

Act of 1974 or a foreign person performing

a similar role or function subject as such to

foreign regulation with total assets exceeding

$5,000,000, or whose investment decisions

are made by a bank, trust company,

insurance company, investment adviser

subject to regulation under the Investment

Advisers Act of 1940 * * * or a commodity

trading advisor subject to regulation under

the Act;

(viii) Any governmental entity (including

the United States, any state, or any foreign

government) or political subdivision thereof,

or any multinational or supranational entity

or any instrumentality, agency, or

department of any of the foregoing;

(ix) A broker-dealer subject to regulation

under the Securities Exchange Act of 1934

* * * or a foreign person performing a

similar role or function subject as such to

foreign regulation, acting on its own behalf

or on the behalf of another eligible swap

participant: Provided, however, that if such

broker-dealer is a natural person or

proprietorship, the broker-dealer must also

meet the requirements of either subsection

(vi) or (xi) of this section;

(x) A futures commission merchant, floor

broker, or floor trader subject to regulation

under the Act or a foreign person performing

a similar role or function subject as such to

foreign regulation, acting on its own behalf

or on behalf of another eligible swap

participant: Provided, however, that if such

futures commission merchant, floor broker or

floor trader is a natural person or

proprietorship, the futures commission

merchant, floor broker or floor trader must

also meet the requirements of subsection (vi)

or (xi) of this section; or

(xi) Any natural person with total assets

exceeding at least $10,000,000.

The definition of ‘‘eligible swap

participant’’ in Regulation 35.1(b)(2) is

based on the list of appropriate persons

set forth in Section 4(c)(3)(A)–(J) of the

CEA. However, the Commission, relying

on authority provided in Section

4(c)(3)(K) of the CEA, adjusted those

definitions when it adopted Part 35.

These adjustments reflected the

international character of the swaps

market by assuring that both foreign and

United States entities could quality for

treatment as eligible swap participants.

In addition, the Commission raised the

threshold for the net worth or total asset

test that must be met by certain eligible

swap participants. It applied this test as

an indication of a swap participant’s

financial sophistication and

background.28 The Commission

indicated its belief that the definition of

‘‘eligible swap participant,’’ as adopted,

would not adversely affect the swap

market as it then existed.29

The remaining conditions that must

be satisfied by swap agreements in order
26118 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

30See id. at 5590–91.

31See id. at 5591.

32See id.

33See id.

34See id. at 5590.

35 Id. at 5590 n. 24.

36 54 FR 1139 (January 11, 1989).

37 Id.

38 54 FR 30684 (July 21, 1989).

39 Id.

40 55 FR 13582 (April 11, 1990).

41 17 CFR 34.2(a) (1997).

42 17 CFR 34.3(a) (1997).

43 17 CFR 34.3(a)(3)(i) (1997).

44 Id.

45 17 CFR 34.3(a)(3)(ii) (1997).

46 17 CFR 34.3(a)(3)(iii) (1997).

47 17 CFR 34.3(a)(4) (1997).

48 17 CFR 34.3(a)(2) (1997).

to qualify for the Part 35 exemption are

meant, among other goals, to assure that

the exemption does not permit the

establishment of an unregulated

exchange-like market in swaps.30 These

conditions require that the

creditworthiness of any party having an

obligation under the swap agreement

must be a material consideration in

entering into the agreement and prohibit

a swap that is part of a fungible class of

agreements, standardized as to their

material economic terms, or that is

entered into and traded on or through a

multilateral transaction execution

facility from qualifying for the Part 35

exemption. The Commission has made

clear that the Part 35 exemption does

not extend to transactions that are

subject to a clearing system where the

credit risk of individual counterparties

to each other is effectively eliminated.31

These conditions do not prevent

parties who wish to rely on the Part 35

exemption from undertaking bilateral

collateral or margining arrangements

nor from applying bilateral or

multiparty netting arrangements to their

transactions, provided however that, in

the case of multilateral netting

arrangements, the underlying gross

obligations among the parties are not

extinguished until all netted obligations

are fully performed.32 Nor is the Part 35

restriction on multilateral transaction

execution facilities meant to preclude

parties who engage in negotiated,

bilateral transactions from using

computer or other electronic facilities to

communicate simultaneously with other

participants, so long as they do not use

such facilities to enter orders or execute

transactions.33

Similarly, standardization of terms

that are not material economic terms

does not necessarily prevent an

agreement from qualifying for an

exemption under Part 35, provided that

the material economic terms of the swap

agreement remain subject to individual

negotiation by the parties.34 In this

respect, the Commission has explained

that:

[T]he phrase ‘‘material economic terms’’ is

intended to encompass terms that define the

rights and obligations of the parties under the

swap agreement, and that as a result, may

affect the value of the swap at origination or

thereafter. Examples of such terms may

include notional amount, amortization,

maturity, payment dates, fixed and floating

rates or prices (including method by which

such rates or prices may be determined),

payment computation methodologies, and

any rights to adjust any of the foregoing.35

B. Hybrid Instruments

1. Background

In 1989, the Commission recognized

that certain instruments combined

characteristics of securities or bank

deposits with characteristics of futures

or options and wished to exclude from

CEA regulation those hybrid

instruments whose commoditydependent value was less than their

commodity-independent value. The

Commission issued a Statutory

Interpretation Concerning Certain

Hybrid Instruments (‘‘Interpretation’’) 36

which excluded from regulation under

the CEA and CFTC regulations debt

securities within the meaning of Section

2(1) of the Securities Act of 1933 and

time deposits within the meaning of 12

CFR Section 204.2(c)(1) that had the

following characteristics: (1) indexation

to a commodity on no more than a oneto-one basis; (2) a limited maximum

loss; (3) inclusion of a significant

commodity component; (4) lack of a

severable commodity component; (5) no

required delivery of a commodity by

means of an instrument specified in the

rules of a designated contract market;

and (6) no marketing of the instruments

as futures contracts or commodity

options.37

Later in 1989, the Commission

adopted Part 34, which exempted

certain hybrid instruments with

commodity option components from the

CEA and from the Commission’s

regulations.38 While Part 34 expanded

the category of hybrid instruments that

were considered to be outside of the

CEA and the Commission’s regulations,

the Commission explicitly stated that it

intended not ‘‘to address the entire

universe of hybrid instruments in the

proposed rules, but rather to establish

an exemptive framework’’ that would

apply to certain instruments in which

issuers had expressed an interest to that

point.39 In 1990, the Commission issued

a revised Interpretation designed to

conform the Interpretation’s treatment

of hybrids with the treatment of hybrids

in Part 34.40 The revised Interpretation

expanded the class of securities and

depository accounts eligible as hybrid

instruments and expanded the class of

institutions eligible to transact in

hybrids.

Congress included a provision in the

1992 Act permitting the Commission to

exempt any transaction from all

provisions of the CEA except Section

2(a)(1)(B). Using this new authority

contained in Section 4(c) of the CEA,

the CFTC substantially modified the

Part 34 regulations to exempt certain

hybrids (including, for the first time,

hybrid instruments with futures-like

components) from most provisions of

the CEA and from the Commission’s

regulations.

2. Part 34

A hybrid instrument is defined in Part

34 of the Commission’s regulations as

an equity security, a debt security, or a

depository instrument with at least one

commodity-dependent component that

has a payment feature similar to that of

a commodity futures contract, a

commodity option contract or a

combination thereof.41 Part 34 exempts

such hybrids, and those transacting in

and/or providing advice or other

services with respect to such hybrids,

from all provisions of the CEA except

Section 2(a)(1)(B) of the CEA, provided

that a number of conditions are met.42

The conditions include: (1) a

requirement that the issuer must receive

full payment of the hybrid’s purchase

price; 43 (2) a prohibition on requiring

additional out-of-pocket payments to

the issuer during the hybrid’s life or at

its maturity; 44 (3) a prohibition on

marketing the instrument as a futures

contract or commodity option; 45 (4) a

prohibition on settlement by delivery of

an instrument specified as a delivery

instrument in the rules of a designated

contract market; 46 (5) a requirement that

the hybrid be initially sold or issued

subject to federal or state securities or

banking laws to persons permitted

thereunder to purchase the

instrument; 47 and (6) a requirement that

the sum of the values of the commoditydependent components of a hybrid

instrument be less than the value of the

commodity-independent components.48

In imposing the first two conditions of

Part 34’s exemptions—the requirement

that the issuer of a hybrid instrument

receive full payment of the hybrid’s

purchase price and the ban on out-ofpocket payments from a hybrid

purchaser or holder to the instrument’s

issuer—the Commission sought to limit

the possible losses due to the
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26119

49Regulation of Hybrid Instruments, 58 FR 5580

at 5585 (January 22, 1993) (promulgating current

Part 34 Rules).

50Regulation of Hybrid Instruments, 54 FR 1128

at 1135 (January 11, 1989) (proposing original Part

34 Rules).

51 58 FR 5580 at 5582.

52 7 U.S.C. 6(c)(2)(B)(i).

53 58 FR 5580 at 5585.

54 17 CFR 34.3(a)(2) (1997).

55More specifically, the absolute net value of all

put option premiums with strike prices less than or

equal to the reference price would be added to the

absolute net value of all call option premiums with

strike prices greater than or equal to the reference

price. 58 FR 5580 at 5584. ‘‘Reference price’’ is

defined in Regulation 34.2(g), 17 CFR 34.2(g), ‘‘as

the nearest current spot or forward price at which

a commodity-dependent payment becomes nonzero, or in the case where two potential reference

prices exist, the price that results in the greatest

commodity-dependent value.’’

56 58 FR 5580 at 5584–85. 57See 1997 GAO Report at 71.

commodity-dependent components of a

hybrid instrument, reasoning that an

instrument permitting the accrual of

losses in excess of the face value of such

instrument is more akin to a position in

a commodity derivative than to a debt,

equity, or depository instrument.49 The

third condition outlined above, a

limitation on marketing the instrument

as a futures contract or a commodity

option, was intended to prevent

purveyors of hybrid instruments from

misleading investors as to the nature,

legal status and form of regulatory

supervision to which such instruments

are subject.50 The Commission did not

want potential buyers to believe that

hybrids were subject to the full

protections of the CEA.

The fourth condition noted above, a

prohibition on settlement by a contract

market delivery instrument, was

designed to guard against interference

with deliverable supplies for settlement

of exchange-traded futures or options

contracts.51 In adopting the fifth

condition, a limitation on persons

permitted to purchase an instrument,

the Commission was seeking both to

address customer protection concerns

and Congress’s concern, as embodied in

Section 4(c)(2)(B)(i) of the CEA,52 that

only transactions entered into between

appropriate persons may be exempted

from the CEA.53

This sixth requirement is referred to

as the ‘‘predominance test.’’ 54 It was

designed in response to authorization

granted by Congress in Section

4(c)(5)(A) of the CEA for the

Commission to exempt hybrids, which

were predominantly securities or

depository instruments. The

predominance test starts from the

premise that hybrid instruments can be

viewed as a combination of simpler

instruments, the payments on which

can be viewed as either commodityindependent or commodity-dependent.

The payments on a hybrid’s commodityindependent component are not

indexed or calculated by reference to

the price of an underlying commodity,

including any index, spread or basket of

commodities; the payments on a

hybrid’s commodity-dependent

component are so indexed or

referenced.

For a hybrid instrument to be

exempted by Part 34, the present value

of the returns associated with the

commodity-independent component of

an instrument (including any return of

principal) must be greater than the

‘‘commodity-dependent value’’ of the

instrument. In order to calculate the

commodity-dependent value of a

hybrid, Part 34 conceptually

decomposes a hybrid’s commoditydependent portion into options. The

absolute values of the premiums of all

implicit options that are at- or out-ofthe-money are summed to arrive at the

commodity-dependent value of the

hybrid instrument.55 These values are

calculated as of the time of issuance of

the hybrid instrument.56

III. Issues for Comment

A. Background

As the foregoing discussion indicates,

the Commission has recognized that

differences between exchange-traded

markets and the OTC derivatives market

warrant differences in regulatory

treatment. Pursuant to the exemptions,

activity in the OTC derivatives market

has generally been limited to

decentralized, principal-to-principal

transactions between large traders. This

has significant regulatory implications.

The OTC derivatives market does not

appear to perform the same price

discovery function as centralized

exchange markets. Accordingly, certain

regulatory requirements related to price

discovery have not been applied to the

OTC derivatives market. Thus, for

example, the Commission has not

suggested that it should preapprove

contract design in the OTC derivatives

market as it does for exchanges.

Similarly, the decentralization of

trading in the OTC market and the

relative sophistication of the

participants have meant that issues of

financial integrity and customer

protection differ from exchange markets.

Thus for example, while the

Commission has retained its fraud

authority for the swap market, it has not

required segregation of customer funds.

Developments in the market in the

last five years, however, indicate the

need to review the current exemptions.

As mentioned above, new end-users

have entered the market, new products

have been developed, some products

have become more standardized, and

systems for centralized execution and

clearing have been proposed. The terms

and conditions of the exemptions may

need adjustment to reflect changes in

the marketplace and to facilitate

continued growth and innovation.

In addition, the explosive growth in

the OTC market in recent years has been

accompanied by an increase in the

number and size of losses even among

large and sophisticated users which

purport to be trying to hedge price risk

in the underlying cash markets. Market

losses by end-users may lead to

allegations of fraud or misrepresentation

after they enter transactions they do not

fully understand. Moreover, as the use

of the market has increased, entities

such as pension funds and school

districts have been affected by

derivatives losses in addition to

corporate shareholders.57

Accordingly, the Commission believes

it is appropriate at this time to consider

whether any modifications to the scope

or the terms and conditions of the swap

and hybrid instrument exemptions are

needed to enhance the fairness,

financial integrity, and efficiency of this

market. The Commission reiterates that

the items listed below are intended

solely to encourage useful public

comment.

The Commission urges commenters to

analyze the benefits and burdens of any

potential modifications in light of

current market realities. In some areas,

regulatory relief or expanded access to

the market may be warranted while in

others additional safeguards may be

appropriate. The Commission is

especially interested in whether

modifications can be designed to

stimulate growth. This might be

accomplished, for example, by

increasing legal certainty and investor

confidence, thereby attracting new

market participants, or by facilitating

netting and other transactional

efficiencies, thereby reducing costs. As

discussed below, the Commission also

welcomes comment on the extent to

which certain matters can be adequately

addressed through self-regulation.

Finally, the Commission invites other

regulators to express their views on the

issues raised in this release and, in

particular, how best to achieve effective

coordination among regulators. The

Commission anticipates that, where

other regulators have adequate programs

or standards in place to address
26120 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

58 CFTC, OTC Derivatives Markets and Their

Regulation 78–79 (1993) (‘‘CFTC OTC Derivatives

Report’’) (discussing swaps exemption).

particular areas, the Commission would

defer to those regulators in those areas.

B. Potential Changes to Current

Exemptions

The exemptions provided by Part 34

and Part 35 reflect circumstances in the

relevant market at the time of their

adoption. As noted, the Commission

believes that it should review these

exemptions in light of current market

conditions. At the most general level,

three issues are presented with respect

to these exemptions: first, what criteria

should be applied in determining

whether a transaction or instrument is

eligible for exemption from the CEA;

second, what should be the scope of that

exemption; and third, what conditions

should be imposed, if any, to ensure

that the public interest and the policies

of the CEA are served.

1. Eligible Transactions

(a) Swaps. Part 35 sets forth certain

criteria that an instrument must meet in

order to qualify for the swap exemption.

These criteria impose restrictions upon

the design and execution of transactions

that distinguish the exempted swap

transactions from exchange-traded

products.58 Given the changes in the

swap market since Part 35 was adopted,

the Commission seeks comments as to

whether the criteria set forth in Part 35

continue to provide a meaningful,

objective basis for exempting

transactions from provisions of the CEA

and CFTC regulations.

In particular, some swap agreements

have become highly standardized. The

Part 35 exemption does not extend to

‘‘fungible agreements, standardized as to

their material economic terms.’’ The

Commission seeks comment on whether

this part of the Part 35 criteria provides

sufficient guidance for parties involved

in swaps. Parties may have difficulty in

readily assessing whether a particular

transaction qualifies for treatment under

the Part 35 exemption.

In order to provide greater clarity, the

Commission could adopt additional or

alternative requirements governing

exempted swap agreements. For

example, the Commission could provide

additional detail concerning the concept

of fungibility in this context. The

Commission could also clearly specify

which terms of an agreement would be

considered to be material economic

terms under Part 35.

Moreover, subject to consideration of

the requirements set forth in Sections

4(c)(1) and (c)(2) of the CEA, the

Commission could consider expanding

the scope of the swap exemption so that

it more clearly applies to certain classes

of transactions that exhibit some degree

of standardization. In this regard, while

Section 4(c)(5)(B) authorizes the

Commission to exempt non-fungible

swaps, the lack of fungibility is not a

necessary criterion under Sections

4(c)(1) or (c)(2) for exercising exemptive

authority.

Request for comment. The

Commission requests comment on

whether the swaps exemption should be

extended to fungible instruments and, if

so, under what circumstances. The

Commission is also seeking more

general comment as to whether the

swaps exemption continues to fulfill its

stated goals. In this regard, the

Commission is interested in

commenters’ views on what changes in

the current rules may be needed to

assure that Part 35 provides legal

certainty to the current market and

fulfills the statutory goals set forth in

Section 4(c) of the CEA.

In particular, the Commission

requests comment on the following

questions.

1. In what ways has the swap market

changed since the Commission adopted

Part 35. Please address:

(a) the nature of the products;

(b) the nature of the participants, both

dealers and end-users;

(c) the location of transactions;

(d) the business structure of

participants (e.g., the use of affiliates for

transacting OTC derivatives);

(e) the nature of counterparty

relationships;

(f) the mechanics of execution;

(g) the methods for securing

obligations; and

(h) the impact of the current

regulatory structure on any of the

foregoing.

2. What are the mechanisms for

disseminating the prices for swap

transactions?

3. Does the swap market serve as a

vehicle for price discovery in

underlying cash markets? If so, how?

Please describe.

4. To what extent is the swap market

used for hedging? To what extent is it

used for speculation? Please provide

details.

5. Is there a potential for transactions

in the swap market to be used to

manipulate commodity prices? Please

explain.

6. To what degree is the swap market

intermediated, i.e., to what extent do

entities

(a) act as brokers bringing end-users

together?

(b) act as dealers making markets in

products?

Please describe the intermediaries in

the market and the extent and nature of

their activities.

7. To what extent do swap market

participants act in more than one

capacity (e.g., as principal in some

transactions and broker in others)?

8. In light of current market

conditions, do the existing Part 35

requirements provide reasonable,

objective criteria for determining

whether particular swaps transactions

are exempted under the CEA? Should

the meaning of terms such as

‘‘fungible,’’ ‘‘material economic terms,’’

or ‘‘material consideration’’ be clarified

or modified in any way? If so, how?

9. What steps can the Commission

take to promote greater legal certainty in

the swap market?

10. What types of documentation are

relevant in determining whether a

particular transactions falls within the

swaps exemption and/or the Policy

Statement? Should the Commission set

standards in this regard?

11. If the current restrictions set forth

in the Part 35 requirements negatively

affect or potentially limit the OTC

market or its development in the United

States, what changes would alleviate the

negative effects? Should the exemption

in Part 35 be broadened in any manner?

12. What steps, if any, can the

Commission take to promote greater

efficiency in the swap market, such as

for example, by facilitating netting?

13. Are any changes in regulation

relating to the design or execution of

exempted swap transactions needed to

protect the interests of end-users in the

swap market? Are there changes in

regulation that would attract new endusers to the market or lead existing endusers to increase their participation?

14. Should distinctions be made

between swaps that are cash-settled and

swaps that provide for physical

delivery? Please explain.

15. Should transactions in fungible

instruments be permitted under the

swaps exemption?

16. To what extent should the

creditworthiness of a counterparty

continue to be required to be a material

consideration under the swaps

exemption? Please explain.

(b) Hybrid instruments. Part 34 was

designed to exempt from Commission

regulation instruments in which the

commodity futures or option

characteristics were subordinate to their

characteristics as securities and

deposits. Some experienced

practitioners have stated that the

definition of a hybrid instrument under

Part 34 is extremely complex and

difficult to understand and to apply.

Moreover, the Commission staff has
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26121

recently reviewed several hybrid

instruments that had very significant

commodity components yet were

apparently eligible for exemption under

Part 34’s technical definition.

For example, the Commission staff

recently reviewed an instrument

structured as a medium-term debt

instrument paying a small quarterly

coupon rate. At maturity, after

subtracting out a ‘‘factor’’ reflecting

certain costs borne by the issuer, the

purchaser would receive a payment that

was based on the performance of an

index of futures contract prices with no

upward limit on the commodity-based

return. Moreover, the holder could lose

its entire investment based on a

downward movement in the commodity

index. Commission staff believed that,

under Part 34 as currently written, the

instrument apparently would be exempt

from regulation under the CEA. A

regulatory definition that treats the

entire principal as ‘‘commodity

independent’’ despite the fact that all of

the principal on this instrument could

be lost as a direct result of movement in

the commodity index warrants

additional analysis.

Another conceptual concern with the

current definition is the manner in

which it assigns value to the

‘‘commodity dependent’’ component.

Futures-like elements are analyzed as a

combination of offsetting at-the-money

puts and calls. The sum of the absolute

values of these option premiums is the

assigned value of the futures-like

component. Some observers have

suggested that this test is not an

appropriate measure of the commodity

dependent value. As Part 34 is currently

structured, whether or not an

instrument qualifies for an exemption

depends critically on the total volatility

of the commodity-dependent portion.

This creates three potential problems.

First, the technical knowledge needed to

identify the commodity-dependent

volatility may be a challenge for some

market participants. Second, for two

instruments that are identical except for

their commodity-dependent volatility,

one might be classified as exempt while

the other might not. Indeed, if the

volatility of the underlying commodity

changes through time, the classification

of identical hybrid instruments issued

on different dates might be different.

Thus, Part 34 may create some

undesirable ambiguity regarding which

instruments qualify for an exemption.

Third, it appears to be paradoxical that

short-term instruments are more likely

to be classified as exempt than longterm instruments even though shortterm instruments generally are more

akin to exchange-traded futures in many

respects.

If the Commission were to modify or

to clarify the predominance test in a

way that resulted in more instruments

being found to have a predominant

commodity-dependent component, the

Commission could exercise its authority

under Section 4(c) to exempt some or all

of such instruments subject to specified

terms and conditions. As is the case

today, instruments in which the

commodity-independent component

was predominant would not be subject

to any such terms and conditions.

Request for comment. The

Commission requests comment on the

foregoing analysis. It welcomes

alternative suggestions for analyzing

hybrid instruments and for simplifying

the definition of exempt hybrid

instruments.

17. In what ways has the hybrid

instrument market changed since the

Commission adopted Part 34? Please

address:

(a) the nature of the products;

(b) the nature of the participants, both

dealers and end-users;

(c) the location of transactions;

(d) the nature of the counterparty

relationships;

(e) the mechanics of execution;

(f) the methods for securing

obligations; and

(g) the impact of the current

regulatory structure on any of the

foregoing.

18. What are the mechanisms for

disseminating prices for hybrid

instrument transactions?

19. Does the hybrid instrument

market serve as a vehicle for price

discovery in underlying commodities? If

so, how? Please describe.

20. To what extent is the hybrid

instrument market used for hedging? To

what extent is it used for speculation?

Please provide details.

21. Is there a potential for transactions

in the hybrid instrument market to be

used to manipulate commodity prices?

Please explain.

22. To what degree is the hybrid

instrument market intermediated, i.e., to

what extent do entities

(a) act as brokers bringing end-users

together?

(b) act as dealers making markets in

products?

Please describe the intermediaries in

the market and the extent and nature of

their activities and the extent to which

transactions in these instruments are

subject to other regulatory regimes.

23. To what extent do hybrid

instrument market participants act in

more than one capacity (e.g., as a

principal in some transactions and

broker in others)?

24. In light of current market

conditions, do the existing Part 34

requirements provide reasonable,

objective criteria for determining

whether a particular hybrid instrument

performs the functions of a futures or

option or those of a security or

depository instrument? Are the criteria

easily understood and applied by

participants in the market? Do they

properly distinguish types of

instruments? If not, should they be

changed? How?

25. What steps, if any, can the

Commission take to promote greater

legal certainty in the hybrid instrument

market? Please explain.

26. Should Part 34 be amended to

reflect more accurately or more simply

whether commodity-dependent

components predominate over

commodity-independent components?

27. Are changes in regulation relating

to the design or execution of

transactions in exempted hybrid

instruments needed to protect the

interests of end-users in the hybrid

instrument market? Are there changes in

regulation that would attract new endusers to the market or lead existing endusers to increase their participation?

28. Should the Commission exercise

its authority to exempt any hybrid

instruments with a predominant

commodity component subject to

specified terms and conditions? Please

explain.

2. Eligible Participants

Section 4(c)(2) states that ‘‘the

Commission shall not grant any

exemption under’’ authority granted

therein ‘‘unless the Commission

determines that . . . the agreement,

contract or transaction will be entered

into solely between appropriate

persons.’’ Section 4(c)(3) further states

that ‘‘the term ‘appropriate person’ shall

be limited’’ to the classes of persons

specifically listed therein including

‘‘[s]uch other persons that the

Commission determines to be

appropriate in light of their financial or

other qualifications or the applicability

of appropriate regulatory protections.’’

(a) Swaps. Part 35 currently contains

a requirement that an exempt swap

agreement be between eligible swap

participants, as defined in Regulation

35.1(b)(2). The list of eligible swap

participants in Part 35 is based

substantially on the list of ‘‘appropriate

person’’ defined in the CEA. The

Commission seeks comments as to

whether the current list of eligible swap

participants should be modified in any

way. The Commission requests

comment regarding whether the

definition is adversely affecting the
26122 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

59 54 FR 5587 at 5591.

60 Id. at 5591 n.30.

61Not all the proposed arrangements have

included the mutualization of risks among members

of a clearing organization. In some cases, a single

entity proposed to support the clearing

arrangements using its own assets.

62CFTC OTC Derivatives Report at 136–37. The

Lamfalussy standards are the following:

1. Netting schemes should have a well-founded

legal basis under all relevant jurisdictions;

2. Netting scheme participants should have a

clear understanding of the impact of the particular

scheme on each of the financial risks affected by the

netting process;

3. Multilateral netting systems should have

clearly-defined procedures for the management of

credit risks and liquidity risks which specify the

respective responsibilities of the netting provider

and the participants. These procedures should also

ensure that all parties have both the incentives and

the capabilities to manage and contain each of the

risks they bear and that limits are placed on the

maximum level of credit exposure that can be

produced by each participant.

4. Multilateral netting systems should, at a

minimum, be capable of ensuring the timely

completion of daily settlements in the event of an

inability to settle by the participant with the largest

single net-debit position;

5. Multilateral netting systems should have

objective and publicly-disclosed criteria for

admission which permit fair and open access; and

6. All netting schemes should ensure the

operational reliability of technical systems and the

availability of back-up facilities capable of

completing daily processing requirements.

swaps market by excluding persons who

should be included or, alternatively, by

including persons who are not, or

should not be, active in the current

market. The Commission also seeks

comment on whether additional persons

should be added and, if so, whether

additional protections would be

appropriate. In either case, commenters

are asked to describe such persons and

the protections they need, if any.

Any potential change must be

analyzed in light of the stated

Congressional intent that any exempted

transaction must be entered into solely

by appropriate persons as defined in

Section 4(c)(3)(A)–(K) of the Act. In

addition, any changes to the definition

of eligible swap participant would be

considered in light of any other relevant

changes that may result from

Commission follow-up to this concept

release.

(b) Hybrid instruments. As discussed

above, if the Commission were to

modify the predominance test under

Part 34, it might also decide to exempt

certain commodity-like hybrid

instruments subject to specified terms

and conditions. The Commission invites

analysis on the potential applicability of

an appropriate person standard in that

context.

Request for comment. 29. Should the

current list of eligible swap participants

be expanded in any way? Should it be

contracted in any way? If so, how and

why?

30. Are there currently eligible swap

participants who would benefit from

additional protections? Are there

potential swap participants who are not

currently eligible but would be

appropriate subject to additional

protections? In either case, please

describe the types of persons and the

types of protections.

31. Should the Commission establish

a class of eligible participants for the

trading of hybrid instruments with a

predominant commodity-dependent

component? If so, please describe.

32. Is it advisable to use a single

definition of sophisticated investor

whenever that concept arises under the

Commission’s regulations? If so, what

definition should apply?

3. Clearing

Clearing of swaps is not permitted

under Part 35. The Commission

expressly stated that:

The exemption does not extend to

transactions that are subject to a clearing

system where the credit risk of individual

members of the system to each other in a

transaction to which each is a counterparty

is effectively eliminated and replaced by a

system of mutualized risk of loss that binds

members generally whether or not they are

counterparties to the original transaction.59

Regulation 35.2 provides, however,

that ‘‘any person may apply to the

Commission for exemption from any of

the provisions of the Act (except

2(a)(1)(B)) for other arrangements or

facilities, on such terms and conditions

as the Commission deems appropriate.

* * *’’ The Commission included this

proviso in order to hold open the

possibility that swap agreements cleared

through an organized clearing facility

could be exempted from requirements of

the Act under appropriate terms and

conditions. The Commission

affirmatively stated that the proviso

‘‘reflects the Commission’s

determination to encourage innovation

in developing the most efficient and

effective types of systemic risk

reduction’’ and that ‘‘a clearing house

system for swap agreements could be

beneficial to participants and the public

generally.’’ 60

In the years since Part 35 was issued,

interest in developing clearing

mechanisms for swaps and other OTC

derivatives has increased. The

Commission has had extensive

discussions with several organizations

engaged in designing clearing

facilities.61 The Commission believes

that these efforts have reached a stage

where it is necessary to consider and to

formulate a program for appropriate

oversight and exemption of swaps

clearing.

Clearing organizations can provide

many benefits to participants, such as

the reduction of counterparty credit

risk, the reduction of transaction and

administrative costs, and an increase in

liquidity. They also can provide benefits

to the public at large by increasing

transparency. These benefits are

obtained at the cost of concentrating risk

in the clearing organization.

Accordingly, a greater need may exist

for oversight of the operations of a

clearing organization than for any single

participant in an uncleared market.

In the 1993 CFTC OTC Derivatives

Report, the Commission stated that the

regulatory issues presented by a facility

for clearing swaps ‘‘would depend

materially upon the facility’s design,

such as, for example, the extent to

which the construction of such a facility

is consistent with the minimum

standards for netting systems

recommended by the Report of the

Committee on Interbank Netting

Schemes of the Central Banks of the

Group of Ten Countries (Lamfalussy

Report).’’ 62 Comment is requested

concerning the usefulness of the

Lamfalussy standards in this context.

The Commission has identified the

following core elements that should be

addressed: the functions that an OTC

derivatives clearing facility would

perform; the products it would clear; the

standards it would impose on

participants; and the risk management

tools it would employ. As discussed

below, the Commission invites

comments on each of these topics.

(a) Functions. An OTC derivatives

clearing facility could perform a variety

of functions ranging from simple trade

comparison and recordation to netting

of obligations to the guarantee of

performance. For example, the

Commission notes that, in jurisdictions

other than the U.S., there may not be a

clearing guarantee, or the guarantee may

attach at a time other than the initiation

of the trade. The Commission requests

comment on which of these functions,

if any, should be permitted and under

what circumstances.

(b) Products cleared. The definition of

the term ‘‘swap agreement’’ in

Regulation 35.1(b)(1) is very broad.

Financial engineers are continually

designing new products that fall within

that definition but have novel

characteristics. As a practical matter, the

Commission believes that any OTC

derivatives clearing facility would be

most likely in the context of ‘‘plain

vanilla’’ products for which prices can

be readily established and for which

there is some standardization as to
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26123

63See Section 15 of the Act, 7 U.S.C. 19.

64Current Part 35 allows only certain eligible

swap participants to act on the behalf of another

eligible swap participant. See 17 CFR 35.1(b)(2)

(1997).

65 58 FR 5587 at 5591 n.30.

66 17 CFR 35.2(d) (1997).

6758 FR 5587 at 5591.

68 Id.

69 Id.

70 Id.

71 Id.

72 17 CFR 36.1–36.9 (1997).

73Section 4(c) Contract Market Transactions, 60

FR 51323 (Oct. 2, 1995).

terms. The Commission requests

comment on whether the range of

products that may be cleared through an

OTC derivative clearing facility, or their

terms of settlement, should be limited in

any way.

(c) Admission standards. The class of

eligible swap participants ias defined in

Regulation 35.1(b)(2). There is an

inherent tension between the desire to

promote open and competitive markets

by allowing access.63 and the desire to

maintain financial integrity by imposing

admission standards. The Commission

requests comment on what standards, if

any, it should establish, or permit an

OTC derivatives clearing facility to

establish, for admission as a clearing

participant. Comment is also requested

on whether clearing should be limited

to transactions undertaken on a

principal-to-principal basis or whether

agency transactions should be

included.64

(d) Risk management tools. An OTC

derivatives clearing facility could

choose from among many potential risk

management tools. These include

capital requirements for participants,

reporting requirements, position or

exposure limits, collateral requirements,

segregation requirements, mark-tomarket or other valuation procedures,

risk modeling programs, auditing

procedures, and information-sharing

arrangements. The clearing facility

could also draw upon its own capital,

its lines of credit, any guarantee funds

financed by clearing members, or other

arrangements for sharing losses among

participants. The relevance of these

various items would depend, of course,

on the functions the clearing facility

performed and the products its cleared.

The Commission requests comment on

how best to assure that a clearing

facility uses appropriate risk

management tools without preventing

flexibility in the design of such tools or

inhibiting the evolution of new risk

management technology.

(e) Other considerations. Permitting

OTC products to be cleared may make

them more like exchange-traded

products. The Commission welcomes

comment on how best to promote fair

competition and even-handed

regulation in the context of the

clearance of OTC derivative products.

In approving Part 35, the Commission

noted that it was ‘‘mindful of the costs

of duplicative regulation 65 and added

the proviso to Regulation 35.2 that the

Commission would consider ‘‘the

applicability of other regulatory

regimes’’ in addressing petitions for

further exemptive relief relating to

swaps facilities. The Commission

recognizes that existing clearing

facilities that are regulated by another

federal regulatory authority because the

clear products subject to that regulator’s

jurisdiction may wish to develop swap

clearing facilities. The Commission

requests comment on how to address

this situation.

Request for comment. 33. Are any

swaps currently subject to any type of

clearing function, either in the U.S. or

abroad? If so, please provide details.

34. Would permitting swap clearing

facilities promote market growth and

assist U.S. participants in remaining

competitive? If so, please describe the

appropriate elements of a program for

the oversight of swap clearing

organizations.

35. Should there be a limit on the

clearing functions permitted for swaps?

36. Should there be a limit on the

range of products that may be cleared

through a swap clearing facility?

37. Should there be standards for

admission as a clearing participant?

38. What types of risk management

tools should a clearing facility employ?

39. To what degree would cleared

swaps be similar to exchange traded

products? How best can the Commisison

promote fair competition and evenhanded regulation in this context?

40. How should the Commission

address OTC derivative clearing

facilities that are subject to another

regulatory authority by virtue of

conducting activities subject to that

regulator’s jurisdiction?

4. Transaction Execution Facilities

Regulation 35.2(d) provides that a

swap agreement may not be entered into

or traded on or through a multilateral

transaction execution facility

(‘‘MTEF’’).66 In the release issuing Part

35, the Commission described an MTEF

as:

[A] physical or electronic facility in which

all market makers and other participants that

are members simultaneously have the ability

to execute transactions and bind both parties

by accepting offers which are made by one

member and open to all members of the

facility.67

The Commission specified that the

MTEF limitation did not:

[P]reclude participants from engaging in

privately negotiated bilateral transactions,

even where these participants use computer

or other electronic facilities, such as ‘‘broker

screens,’’ to communicate simultaneously

with other participants so long as they do not

use such systems to enter orders to execute

transactions.68

The Commission noted that there

were no swap MTEFs in existence at

that time.69 Consistent with the proviso

in Regulation 35.2, the Commission

invited application for appropriate

exemptive relief for such facilities as

they were developed.70

The Commission is requesting

comment on whether the regulatory

approach to execution facilities should

be modified in any way. Specifically,

the Commission invites comment on

whether the description of MTEFs set

forth above is sufficiently clear, whether

it accurately delineates the relevant

features, and how the Commission

should address other types of entities

that facilitate execution, such as market

makers or bulletin board services. The

Commission recognized when it

promulgated Part 35 that MTEFs ‘‘could

provide important benefits in terms of

increased liquidity and price

transparency.’’ 71 The Commission seeks

comment on whether it should permit

swaps to be traded through an MTEF or

other similar facilities and, if so, what

terms and conditions should be applied.

It also seeks comment on the degree to

which such trading would be similar to

exchange trading and the degree to

which similar safeguards are needed. As

in the case of clearing facilities, the

Commission is mindful of the need to

promote fair competition between and

even-handed regulation of exchanges

and the swap market.

Part 36 of the Commission’s

regulations 72 was designed to allow

reduced regulation for exchange trading

limited to sophisticated traders. It was

intended to ‘‘permit * * * exchangetraded products greater flexibility in

competing with foreign exchange-traded

products and with both foreign and

domestic over-the-counter transactions

while maintaining basic customer

protection, financial integrity and other

protections associated with trading in

an exchange environment.’’ 73 No

contract market has applied for

exemption under Part 36. An analysis of

the perceived strengths and weaknesses

of Part 36 may be a useful starting point

in determining an appropriate

regulatory regime for execution

facilities. Accordingly, the Commission

requests comment on whether elements
26124 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

74Commodity Futures Trading Commission v.

British American Commodity Options Corp., 560

F.2d 135 at 139–40 (2d Cir. 1977) cert. denied, 438

U.S. 905 (1978).

75See, e.g., Sections 8a(2) and 8a(3) of the Act

(statutory disqualification) and Regulation 1.12

(requirement that registered futures commission

merchants (‘‘FCMs’’) and registered introducing

brokers (‘‘IBs’’), or any person who files an

application to be so registered, notify the

Commission if its capital falls below minimum

capital requirements); Regulation 1.15 (risk

assessment reporting for registered FCMs);

Regulation 1.17 (minimum capital requirements for

registered FCMs and registered IBs); Regulation 4.21

(requirement that commodity pool operators

(‘‘CPOs’’) who are registered or required to be

registered deliver a disclosure document to clients

or potential clients). Other regulations, however,

may be applicable to parties whether or not they are

registered or required to be registered. See, e.g., Part

189 (large trader reporting requirements).

76See, e.g., DPG Framework at 13–22; IOSCO,

The Implications for Securities Regulators of the

Increased use of Value at Risk Models by Securities

Firms, Section 2 (Jul. 1995); Basle Committee on

Banking Supervision, Framework for the Evaluation

of Internal Control Systems at 1 (Jan. 1998); Group

of Thirty, Derivatives: Practices and Principles at 2

(1993).

77See, e.g., Regulations 1.14(a)(1)(ii);

1.15(a)(1)(ii); 1.16(e)(2).

of Part 36 should be applicable to

execution facilities. Proposals for

modification of Part 36 are welcome.

Request for comment. 41. Should the

definition of MTEF be changed in any

way to provide more clarity?

42. Are MTEFs or other types of

execution facilities currently being used

for swap trading, either in the U.S. or

abroad? If so, please provide details.

43. What terms and conditions, if any,

should be applied to execution

facilities? Please address potential

competitive effects on current exchange

trading and the degree to which similar

requirements should be made

applicable. Please also address the

strengths and weaknesses of current Part

36 for this purpose.

5. Registration

Registration has been called ‘‘the

kingpin in [the CEA’s] statutory

machinery, giving the Commission the

information about participants in

commodity trading which it so vitally

requires to carry out its other statutory

functions of monitoring and enforcing

the Act.74 Registration identifies

participants in the markets and allows

for a ‘‘screening’’ process by requiring

applicants to meet fitness standards.

Registration may also facilitate

enforcement of fraud prohibitions. In

addition, the requirement to register

may trigger other standards and

obligations for registrants under the

CEA and Commission rules.75 Part 34

and Part 35 of the Commission’s

regulations currently exempt parties

from the registration requirements of the

Act with respect to qualifying

transactions.

The Commission seeks comment on

whether registration requirements for

dealers or intermediaries would be

useful or necessary for the Commission

in its oversight of the OTC derivatives

market. Registration would identify key

players in the OTC derivatives markets

but would not necessarily trigger the

full range of regulations applicable to

registered persons involved in

exchange-traded futures and options.

Instead it could be related to separate

and limited OTC derivatives market

regulations. Alternatively, the

Commission seeks comment on whether

it would be appropriate to adopt a

notice filing, requiring parties involved

in certain activities within the OTC

derivatives markets to identify

themselves to the Commission.

In addressing this issue, commenters

should consider, among other things,

whether a distinction should be made

between swaps and hybrid instruments.

Comment also would be useful on

whether it would be sufficient that a

person is registered or regulated by

another federal agency so that the

Commission should waive any

registration requirements for such

persons with respect to OTC derivatives

transactions.

Differences between the OTC

derivative market and exchange-traded

futures and option markets may affect

the need for registration in the context

of OTC derivatives trading. For

example, since swap transactions occur

among institutional participants who

bilaterally negotiate an agreement, there

may be reduced value added in

requiring dealers or advisors to undergo

fitness checks. Such institutional

participants would likely have the

resources to investigate the fitness of

potential counterparties and advisors.

Request for comment. 44. What

benefits might arise from requiring

registration of dealers, intermediaries,

advisors, or others involved in OTC

derivative transactions? Should any

requirement be in the form of a notice

filing or full registration?

45. What criteria should be used in

determining the types of transactions

and the types of market participants

subject to registration requirements?

46. Should regulation by other federal

agencies be a factor in permitting an

exemption from registration or notice

filing?

47. What role should membership in

a designated self-regulatory organization

play?

6. Capital

Capital requirements have long been

considered important for assuring a

firm’s ability to perform its obligations

to its customers and to its counterparties

and for controlling systemic risk. The

Commission currently imposes no

capital requirements on participants in

the OTC derivatives markets. Given the

sophistication of the participants, the

generally principal-to-principal nature

of their relationships with one another,

the fact that OTC derivatives dealers

typically do not hold customer’s funds

in an agency relationship (in contrast to

futures commission merchants or

broker-dealers), and the applicability of

other regulatory capital standards to

many market participants, capital

requirements may be unnecessary.

The Commission seeks to explore

whether regulatory capital might serve a

useful function in the context of the

OTC derivatives markets. For example,

regulatory capital might provide an OTC

derivatives dealer’s counterparties with

independent assurance of the

creditworthiness of the dealer or might

prevent the dealer from assuming

excessive leverage. Capital requirements

might also serve the function of

providing early warning of financial

difficulties.

Request for comment. 48. Are any

capital requirements for OTC

derivatives dealers needed? Why? What

benefits would they provide to the

market? What burdens would they

impose?

49. Should any reporting or disclosure

requirements be established for dealers

as an alternative to capital requirements

in order to permit counterparties to

evaluate their creditworthiness

adequately? Please explain.

50. Do ratings by nationally

recognized statistical rating

organizations fulfill the function of

assuring end-user counterparties of the

creditworthiness of OTC derivatives

dealers?

7. Internal Controls

The importance of internal controls

for financial services firms generally

and for derivatives dealers in particular

is widely recognized.76 The

Commission has long required

information concerning risk

management and internal control

systems from FCMs, as well as prompt

reporting of any material inadequacies

in such systems.77 Close attention to

risk management and internal control

systems may be especially important in

an environment where capital standards

(whether imposed by regulators or

internally) are reduced and are based on

the results of internal value-at-risk

models and calculations rather than on

more standardized ‘‘haircuts.’’ While a
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26125

78 1997 GAO Report at 71.

79By ‘‘end-users’’ the Commission is referring

generally to participants who use derivatives to

manage financial risks and opportunities that arise

in the course of their businesses. Dealers are

distinguished from end-users by their willingness to

make two-way markets in OTC derivatives, either

for end-users or for other dealers. See however,

Derivatives Policy Group, Framework for Voluntary

Oversight (Mar. 1995) (‘‘DPG Framework’’) (the

Framework was developed by a group of six major

investment firms). The DPG Framework refers to

dealers as ‘‘professional intermediaries’’ and to endusers as ‘‘nonprofessional counterparties.’’ This

difference in articulation is symptomatic of the

differing views that sometimes exist among the

participants in these markets concerning their

respective roles.

80 1997 GAO Report at 5.

81 Id. See DPG Framework at 9; and Federal

Reserve Bank of New York, Principles and Practices

for Wholesale Financial Market Transactions 1

(Aug. 17, 1995) (the Principles and Practices were

developed by a group of six financial industry trade

associations in coordination with the Federal

Reserve Bank of New York).

82See 17 CFR 35.2 (1997).

83See, e.g., OCC, Banking Circular 277: Risk

Management of Financial Derivatives, BC–277, 1993

WL 640326 (OCC) (Oct. 23, 1993); OCC Bulletin,

Questions and Answers Re: BCC 277, OCC 94–31,

1994 WL 194290 (OCC) (May 10, 1994); and

Division of Banking Supervision and Regulation,

Board of Governors of the Federal Reserve System,

Examining Risk Management and Internal Controls

for Trading Activities of Banking Organizations, [SR

93–69 (FIS)], (Dec. 20, 1993). These are not sales

practice standards in the usual sense but bank risk

management standards.

84 DPG Framework at 37. The 1997 GAO Report

recommends that the CFTC and SEC establish a

mechanism for determining that the DPG firms are,

in fact, following this and other sales practice

standards in the DPG Framework.

85 Id.

86The section of the DPG Framework on risk

management controls lists five basic risks of OTC

derivative transactions: market risk, credit risk,

liquidity risk, legal risk, and operational risk. Id. at

14–15. in addition to these firm-specific risks, the

CFTC OTC Derivatives Report lists a number of

potential risks arising from OTC derivatives

activities generally, including the complexity of the

derivatives marketplace, the fact that dealer activity

tends to be concentrated in a relatively small

number of large entities, the lack of transparency,

Continued

complete discussion of internal control

programs is beyond the scope of this

release, the following elements of such

a program are generally considered

particularly important: effective models

for measuring market and credit risk

exposure; careful procedures for

continuously validating those models,

including rigorous backtesting and

stress testing; netting arrangements that

are enforceable in the relevant

jurisdictions (and programs to review

their enforceability on a regular basis);

and a risk monitoring unit which

reports directly to senior management,

is independent of the business units

being monitored, and has the necessary

training and resources to accomplish its

control objectives.

Request for comment. 51. Would OTC

derivatives market participants benefit

from internal control guidelines? If so,

what market participants should be

covered?

52. What provisions should be

included in internal control

requirements, if any?

53. How should compliance with any

internal control requirements be

monitored (e.g., regular audits, periodic

spot checks, required reports)?

54. Who should be responsible for

monitoring compliance with any

internal control requirements (e.g.,

regulatory agencies, SROs, independent

auditors)?

55. Could and should internal control

standards serve as a substitute for

regulatory capital requirements?

8. Sales Practices

As noted in the Introduction, a

significant number of participants in the

OTC derivatives markets have

experienced large financial losses since

the Commission’s last regulatory

initiatives involving OTC derivatives.

The 1997 GAO Report notes that ‘‘[s]ales

practice concerns were raised in 209, or

58 percent, of [the] losses [reviewed in

the Report] and were associated with an

estimated $3.2 billion in losses.’’ 78 Size

and sophistication of a market

participant may not provide meaningful

protection against sales practice

concerns, such as fraud.

The parties to OTC derivatives

transactions are commonly referred to as

end-users and dealers.79 End-users and

OTC derivatives dealers may have

differing views concerning the

respective responsibilities of the parties

to an OTC derivatives transaction.

According to a survey undertaken in

conjunction with the GAO Report,

‘‘about one-half of all end-users of plain

vanilla or more complex OTC

derivatives believed that a fiduciary

relationship of some sort existed in

some or all transactions between them

and their dealer.’’ 80 By contrast, ‘‘two

dealer groups issued guidance asserting

that such transactions are conducted on

a principal-to-principal, or an ‘arm’slength,’ basis unless more specific

responsibilities are agreed to in writing

or otherwise provided by law.’’ 81 These

differences in view can create problems,

especially because of the extraordinary

complexity of some OTC derivatives

instruments and the information

disparity between a derivatives dealer

and many end-users. Therefore,

comments concerning whether there is

a need for sales practice rules applicable

to OTC derivatives dealers would be

useful.

In granting the Part 35 swaps

exemption, the Commission retained the

applicability of its basic antifraud and

antimanipulation authority.82 In

addition, some OTC derivatives

transactions are subject to sales practice

standards administered by other

financial regulatory agencies. For

example, both the Office of the

Comptroller of the Currency and the

Federal Reserve Board have issued

guidance addressing sales practice

issues in the context of a bank’s overall

responsibilities for managing the risks of

its financial activities, including OTC

derivatives.83

The Commission seeks comments

concerning potential sales practice

standards for principal-to-principal

transactions between dealers and endusers. The Commission would also

welcome information from commenters

concerning the volume of transactions,

if any, in which dealers act strictly as

agents, rather than principals, in

facilitating transactions between two

end-users and whether any specific

sales practice rules should apply to such

agency transactions. Likewise, the

Commission would welcome comments

on the volume of transactions in which

dealers trade directly with other dealers

for their own proprietary accounts and

whether any specific sales practice rules

should apply to those dealer-to-dealer

transactions.

(a) Disclosure. Traditionally, the most

fundamental regulatory protection in

the area of sales practices has been the

duty to disclose risks and other material

information concerning transactions to

potential customers. Disclosure

concerns have often been raised with

respect to OTC derivatives transactions.

For example, the DPG Framework, in its

section on counterparty relationships,

states that dealers should consider

providing new end-users with ‘‘[g]eneric

[r]isk [d]isclosure,’’ which it

characterizes as ‘‘disclosure statements

generally identifying the principal risks

associated with OTC derivatives

transactions and clarifying the nature of

the relationship between the [dealer]

and its counterparties.’’ 84 This section

of the DPG Framework goes on to

provide additional details on the nature

of the relationship to be clarified, stating

the DPG’s view that ‘‘OTC derivatives

transactions are predominantly arm’slength transactions in which each

counterparty has a responsibility to

review and evaluate the terms and

conditions, and the potential risks and

benefits, of prospective transactions

* * *.’’ 85 However, the DPG

Framework provides no further

guidance as the nature or content of the

generic risk disclosure.86 Comment is
26126 Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules

and systemic risk. See CFTC OTC Derivatives

Report at 112–122. It may also be appropriate to

consider whether to require dealers to disclose to

prospective end-users other material information

concerning OTC derivatives transactions, such as

the relationship of the parties, the material terms of

the contract, periodic reports of the status of the

end-user’s account, information on how the value

of the OTC derivatives instrument would be

affected by changes in the markets for the

underlying components, and other similar

information.

87 17 CFR 35.1(b)(2) (1997).

88The DPG has established voluntary reporting

requirements. See DPG Framework at 23–25. The

DPG has committed to regular periodic reporting

and to respond in good faith to ad hoc requests for

additional information by the CFTC. Id. at 1. The

DPG member firms currently provide to the

Commission on a quarterly basis a report detailing

for each member except Credit Suisse First Boston:

(1) a Credit-Concentration Report listing (on a ‘‘nonames’’ basis) the top 20 OTC derivatives exposures

and, for each exposure, the internal credit rating,

the industry segment, the current net exposure, the

next replacement value, the gross replacement

values (receivable and payable) and the potential

additional credit exposure (at a ten-day, 99-percent

confidence interval); (2) a Portfolio Summary

solicited on whether risk disclosure

should be required and, if so, the nature

and content of such disclosure.

(b) Customer information. Comment is

also solicited on whether it would be

appropriate to require the dealer to

obtain certain information from the enduser. Such information might include,

for example:

• net worth information;

• information confirming that the

end-user is within the class of eligible

participants set out in Section 35.1 of

the Commission’s regulations; 87 or

• information demonstrating that the

end-user is authorized to enter into the

transaction.

(c) Other possible sales practice rules.

Potential sales practice rules might also

include provisions requiring dealers to

supervise sales personnel and other

employees responsible for handling the

accounts of end-user customers. One

element of such supervision might be to

ensure that sales personnel are properly

trained.

The Commission also wishes to

consider what regime, if any, would be

appropriate for overseeing the

implementation and enforcement of any

sales practice rules for OTC derivatives,

including the costs and benefits of

alternative oversight mechanisms. In

that context, the Commission is seeking

comments on: (1) the appropriate direct

regulatory role of the CFTC with respect

to potential sales practice rules; (2) the

appropriate regulatory role of other

financial regulatory agencies, including

the applicability of any sales practice

rules administered by other agencies

and the degree of deference that should

be accorded to such rules; and (3) the

appropriate sales practice role of

industry self-regulatory bodies,

including the degree of CFTC oversight

necessary to assure that any industry

self-regulatory standards are properly

implemented and enforced.

Request for comment. 56. Since Part

35 was adopted, has the swap market

experienced significant problems

concerning fraud or sales practice

abuses? Since Part 34 was adopted, has

the hybrid instrument market

experienced significant problems

concerning fraud or sales practice

abuses? If so, please describe.

57. Is there a need for any sales

practice rules in the OTC derivatives

market? If so, what should the rules

provide, and to whom and under what

circumstances should they be

applicable?

58. Is there a need for risk disclosures

by OTC derivatives dealers to endusers? If so, what risks should be

disclosed?

59. Should OTC derivatives dealers be

required to supplement any required

generic risk disclosure statement with

additional firm- or transaction-specific

disclosures? If so, what should such

disclosures cover?

60. What kind of disclosures, if any,

should dealers make to end-users

clarifying the nature of the relationship

between the parties? Should there be

rules establishing duties of the OTC

derivatives dealer to its customers, and

if so, what should they require?

61. What kind of disclosures, if any,

should dealers make concerning the

material terms of OTC derivatives

contracts, including methods for

calculating price, value, profit and loss,

as well as the amount of commissions,

fees and other costs involved?

62. What other kinds of disclosures, if

any, might be appropriate concerning,

for example, potential conflicts of

interest, the dealer’s policies on helping

end-users to unwind transactions and

matters such as the dealer’s financial

soundness, experience, or track record?

63. Should dealers be required to

make periodic status reports to endusers concerning the status of their OTC

derivatives positions (e.g., value, profits

and losses)? If so, what kind of reports

should be required, and how often

should such reports be made?

64. Should dealers be required to

collect information concerning their

end-user customers? If so, what kind of

information? Should dealers be required

to retain documentation in their files

concerning such information, and if so,

what kind of documentation (e.g.,

confirming that particular information

has been collected and reviewed by

management to assure transactions are

in conformity with the end-user’s

investment goals and policies)?

65. What sales practice rules, if any,

should apply to transactions where a

dealer is acting as an agent or broker to

facilitate a principal-to-principal

transaction between two end-users?

Similarly, what sales practice rules, if

any, should apply to dealer-to-dealer

transactions where both dealers are

trading for their own proprietary

accounts?

66. Should dealers have to comply

with different sales practice standards

in dealing with end-users having

different levels of sophistication, based,

for example, or portfolio size,

investment experience, or some other

measure? If so, please elaborate.

67. Should dealers be required to

follow any supervision requirements in

connection with the activities of sales

personnel and other employees

responsible for handling the accounts of

end-user customers? Should complex or

highly leveraged transactions require

prior approval by senior management of

the dealer?

68. What is the appropriate regime for

formulating and overseeing the

implementation and enforcement of

possible sales practices rules, including

the appropriate roles of the

Commission, other financial regulators

and industry self-regulatory bodies?

9. Recordkeeping

The Commission has not required any

recordkeeping requirements for OTC

derivatives dealers or other OTC market

participants. Having retained authority

over fraudulent and manipulative

behavior in the OTC derivative market,

the Commission wishes comment on

whether some recordkeeping

requirements would facilitate its

exercise of that authority. Provisions

requiring the retention of written

records of transactions with

counterparties, for example, might be

considered. The Commission requests

comment on whether there should be

specific recordkeeping requirements for

transactions in the OTC derivatives

markets and, if so, what types of records

should be kept and by whom.

Request for comment. 69. Are

recordkeeping requirements for

participants in the OTC derivatives

markets needed? If so, what records

should be required? Who should be

required to keep them?

10. Reporting

The Commission currently does not

impose reporting requirements on OTC

derivatives market participants.88 The
Federal Register / Vol. 63, No. 91 /Tuesday, May 12, 1998 / Proposed Rules 26127

listing, by credit rating category and industry

segment, the current net exposure, net replacement

value, and gross replacement values; (3) a

Geographic Distribution listing, by country, the

current net exposure, the net replacement value,

and the gross replacement values; (4) a Net

Revenues Report listing, by product category and

month, the net revenue; and (5) a Consolidated

Activity Report listing, by product category, the

aggregate notional amount.

89See, e.g.: Framework for Voluntary Oversight,

supra; Principles and Practices for Wholesale

Financial Market Transactions, supra; and Global

Derivatives Study Group, Group of Thirty,

Derivatives: Practices and Principles, supra.

Commission requests comment on

whether specific reporting requirements

for participants in the OTC derivatives

markets are needed and, if so, what

reports should be made and by whom.

If the Commission were to establish

reporting requirements, it would

coordinate with other regulatory

agencies and, to the extent possible,

accept reports provided to other

regulatory agencies in satisfaction of the

Commission’s requirements. The

Commission solicits comment

concerning how these goals might best

be accomplished.

Request for comment. 70. Should the

Commission establish reporting

requirements for participants in the

OTC derivatives markets? If so, what

information should be reported? By

whom?

C. Self-Regulation

Having identified areas in which

current exemptions might be modified,

the Commission is also interested in the

views of commenters concerning

whether, and to what extent, any

needed changes concerning the

oversight of the OTC derivatives market

could be accomplished through

initiatives of industry bodies either

voluntarily or through a self-regulatory

organization empowered to establish

rules and subject to Commission

oversight. The Commission notes that

several industry organizations already

exist with an interest in maintaining

and improving the integrity of the OTC

derivatives marketplace. These

organizations include, among others, the

Derivatives Policy Group, the

International Swaps and Derivatives

Association, the Group of Thirty, and

the End-Users of Derivatives

Association. Industry groups have

already issued a number of voluntary

initiatives aimed at reducing risks and

promoting stability and integrity in the

OTC derivatives marketplace.89 The

Commission is interested in exploring

the extent to which concerns described

in this release might be addressed, and

adequate oversight of the OTC

derivatives marketplace might be

attained, through industry bodies or

through self-regulatory organizations.

Request for comment. 71. How

effective are current self-regulatory

efforts? What are their strengths and

weaknesses?

72. Are there particular areas among

those discussed above where selfregulation could obviate the need for

government regulation?

73. Please discuss the costs and

benefits of existing voluntary versus

potential mandatory self-regulatory

regimes.

74. If a self-regulatory regime were

adopted, what mechanism would best

assure effective oversight by the

Commission?

75. How best can the Commission

achieve effective coordination with

other regulators in connection with the

oversight of the OTC derivatives

market?

IV. Summary of Request for Comment

Commenters are invited to discuss the

broad range of concepts and approaches

described in this release. The

Commission specifically requests

commenters to compare the advantages

and disadvantages of the possible

changes discussed above with those of

the existing regulatory framework. In

addition to responding to the specific

questions presented, the Commission

encourages commenters to submit any

other relevant information or views.

Issued in Washington, D.C. this 6th day of

May, 1998, by the Commodity Futures

Trading Commission.

By the Commission (Chairperson BORN,

Commissioners TULL and SPEARS;

Commissioner HOLUM dissenting).

Jean A. Webb,

Secretary of the Commission.

Dissenting Remarks of Commissioner

Barbara Pedersen Holum, Concept

Release, Over-the-Counter Derivatives

In Section 4(c)(1) of the Commodity

Exchange Act, Congress authorized the

Commission to exempt certain

transactions ‘‘[i]n order to promote

responsible economic or financial

innovation and fair competition.’’

Indeed, it appears that the dramatic

growth in volume and the products

offered in the OTC derivatives market

may be attributed in part to the

Commission’s past exemptive action. In

the spirit of the Commission’s ongoing

regulatory review program, it is

appropriate to examine the continuing

applicability of the existing exemptions,

focusing on the expanding economic

significance of the OTC market.

However, in my judgement,the release

goes beyond the scope of regulatory

review by exploring regulatory areas

that may be inapplicable to an OTC

market. Accordingly, I am dissenting

from the majority’s decision to issue the

Concept Release on OTC Derivatives in

its current form.

Dated: May 6, 1998.

Barbara Pedersen Holum,

Commissioner.

[FR Doc. 98–12539 Filed 5–11–98; 8:45 am]

BILLING CODE 6351–01–M

DEPARTMENT OF HEALTH AND

HUMAN SERVICES

Food and Drug Administration

21 CFR Parts 430, 431, 432, 433, 436,

440, 441, 442, 443, 444, 446, 448, 449,

450, 452, 453, 455, and 460

[Docket No. 98N–0211]

Removal of Regulations Regarding

Certification of Antibiotic Drugs;

Companion Document to Direct Final

Rule

AGENCY: Food and Drug Administration,

HHS.

ACTION: Proposed rule.

SUMMARY: The Food and Drug

Administration (FDA) is publishing this

companion proposed rule to the direct

final rule, published elsewhere in this

issue of the Federal Register, which is

intended to repeal FDA’s regulations

governing certification of antibiotic

drugs. The agency is taking this action

in accordance with provisions of the

Food and Drug Administration

Modernization Act of 1997 (FDAMA).

FDAMA repealed the statutory

provision in the Federal Food, Drug,

and Cosmetic Act (the act) under which

the agency certified antibiotic drugs.

FDAMA also made conforming

amendments to the act.

DATES: Comments must be received on

or before July 27, 1998.

ADDRESSES: Submit written comments

to the Dockets Management Branch

(HFA–305), Food and Drug

Administration, 12420 Parklawn Dr.,

rm. 1–23, Rockville, MD 20857.

FOR FURTHER INFORMATION CONTACT:

Wayne H. Mitchell or Christine F.

Rogers, Center for Drug Evaluation and

Research (HFD–7), Food and Drug

Administration, 5600 Fishers Lane,

Rockville, MD 20857, 301–594–2041.

SUPPLEMENTARY INFORMATION:

I. Background

As described more fully in the related

direct final rule, section 125(b) of

FDAMA (Pub. L. 105–115) repealed

section 507 of the act (21 U.S.C. 357)