Risk Management Supervision 

of Designated Clearing Entities

Board of Governors of the Federal Reserve System

Securities and Exchange Commission

Commodity Futures Trading Commission

W ashington , D.C. • J uly 2011

Risk Management Supervision 

of Designated Clearing Entities

Board of Governors of the Federal Reserve System

Securities and Exchange Commission

Commodity Futures Trading Commission

W ashington , D.C. • J uly 2011

Contents

Preface ......................................................................................................................................... 1

Organization of the Report .......................................................................................................... 1

Section I: Executive Summary ............................................................................................. 3

Section II: Introduction ......................................................................................................... 7

Description of DCE Operations .................................................................................................... 7

Section III: DCE Risks and Risk Management .......................................................... 11

Risk Management at DCEs ........................................................................................................ 12

Section IV: Common Elements of Risk-Based Supervision .................................... 13

Risk-Focused Supervisory Objectives ........................................................................................ 13

Risk Management Standards ..................................................................................................... 13

Supervisory Processes and Tools ............................................................................................... 14

Section V: Recommendations ............................................................................................ 15

Appendix: Overview of Current Supervisory Frameworks

for Clearing Entities and Systemically Important

Financial Market Utilities ................................................................................................... 19

SEC Supervisory Program for Clearing Agencies ........................................................................ 19

CFTC Supervisory Program for Derivatives Clearing Organizations .............................................. 22

Federal Reserve Supervisory Program for FMUs ......................................................................... 24

i
Preface

The Commodity Futures Trading Commission

(CFTC), the Securities and Exchange Commission

(SEC), and the Board of Governors of the Federal

Reserve System (the Board) are submitting this

report to the Senate Committees on Banking, Housing, and Urban Affairs and Agriculture, Nutrition,

and Forestry and the House Committees on Financial Services and Agriculture in fulfillment of Section

813 of Title VIII of the Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010 (the

Act). Section 813 of the Act requires that the CFTC

and the SEC coordinate with the Board to jointly

develop risk management supervision programs for

clearing entities that have been identified as systemically important by the Financial Stability Oversight

Council (the Council). A clearing entity (CE) is either

a derivatives clearing organization (DCO) registered

with the CFTC under Section 5b of the Commodity

Exchange Act (CEA) or a clearing agency (CA) registered with the SEC under Section 17A of the Securities Exchange Act of 1934 (the Exchange Act). Title

VIII does not apply to, and the recommendations in

this report do not address, DCOs and CAs that have

not been designated as systemically important by the

Council. Systemically important clearing entities are

defined as designated clearing entities (DCEs) by

the Act.

Section 813 also requires the CFTC, the SEC, and

the Board to make recommendations in four areas:

(1) improving consistency in the DCE oversight programs of the SEC and CFTC, (2) promoting robust

risk management by DCEs, (3) promoting robust risk

management oversight by regulators of DCEs, and

(4) improving regulators’ ability to monitor the

potential effects of DCE risk management on the stability of the financial system of the United States.

Organization of the Report

This report is organized in five sections. Section I

provides an executive summary of the main findings

and recommendations that the respective agencies

plan to implement to address the four areas identified

in Section 813. Section II is an introduction to the

role of systemically important financial market utilities generally and DCEs specifically in the financial

system. Section III of the report provides a high-level

overview of DCE risks and risk management. Section IV outlines the generally accepted elements of a

sound risk-based supervisory program. Section V

discusses the recommendations pursuant to Section

813. The Appendix contains an overview of the current supervisory programs at the CFTC, the SEC,

and the Board.

1

Section I: Executive Summary

DCEs provide multilateral clearing and settlement

services and risk management services to their participants covering a wide range of securities and

derivatives transactions. DCEs play a vital role in the

proper functioning of financial markets and are

increasingly important given the mandated central

clearing of certain swaps and security-based swaps

that is required by the Act. DCEs reduce risk and

improve efficiency for their participants and the

broader financial system. At the same time, DCEs

inherently concentrate and transform risks and, thus,

must be well-designed and operated in a manner that

supports the stability of the broader financial system.

Congress has provided the CFTC and the SEC with

expanded authority to regulate DCOs and CAs in

Title VII and Title VIII of the Act and, in the exercise of this authority, the CFTC and the SEC have

each recently proposed regulations for such clearing

entities that include enhanced risk management standards.1 Given the importance of risk management

standards in promoting robust risk management by

DCEs and robust risk management oversight by

regulators of DCEs, the CFTC and the SEC are

working diligently to review comments on the proposed regulations and to promptly promulgate final

regulations in consultation with the Board and other

agencies.

In addition, Congress has provided a new cooperative supervisory framework for DCEs in Title VIII of

the Act. This framework provides requirements for

enhanced risk management, a greater focus on systemic risk both within and across DCEs, an

enhanced role for the Board in the supervision of risk

management standards for systemically important

financial market utilities, and closer consultation

among the CFTC, the SEC, and the Board. Through

closer consultation, the CFTC, the SEC, and the

Board will enhance their ability to look across systemically important financial market utilities in a

consistent way to identify and address sources of systemic risk. Consultation will also provide opportunities to leverage the agencies’ unique perspectives in

order to gain a broader view and understanding of

the various risks and risk management techniques at

systemically important financial market utilities, as

well as common risk issues and interdependencies

across these utilities and between these utilities and

the broader financial system. The new Title VIII

supervisory framework does not replace the existing

supervisory programs at each agency. Rather, the new

framework builds on each agency’s existing supervisory program with an interagency consultative process that should, over time, enhance and reinforce

existing supervisory programs through the benefits of

shared expertise and information among the CFTC,

the SEC, and the Board.

The agencies recommend that they implement the

following five actions that are intended to achieve the

statutory goals of improving consistency in oversight,

promoting robust risk management, promoting

robust risk management oversight, and improving

regulators’ ability to monitor risks pursuant to Section 813 of the Act. The CFTC, the SEC, and the

Board believe that the consultation and cooperation

described in the recommendations are consistent with

the enhanced supervision established in Title VIII,

1 See Financial Resources Requirements for Derivatives Clearing

Organizations, 75 FR 63113 (Oct. 14, 2010); Provisions Common to Registered Entities, 75 FR 67282 (Nov. 2, 2010); General Regulations and Derivatives Clearing Organizations, 75 FR

77576 (Dec. 13, 2010); Information Management Requirements

for Derivatives Clearing Organizations, 75 FR 78185 (Dec. 15,

2010); Risk Management Requirements for Derivatives Clearing Organizations, 76 FR 3698 (Jan. 20, 2011), 76 FR 16587

(March 24, 2011), 76 FR 16588 (March 24, 2011); and Requirements for Processing, Clearing and Transfer of Customer Positions, 76 FR 13101 (March 10, 2011), all issued by the CFTC,

and Ownership Limitations and Governance Requirements for

Security-Based Swap Clearing Agencies, Security-Based Swap

Execution Facilities, and National Securities Exchanges with

Respect to Security-Based Swaps under Regulation MC, 75 FR

65882 (October 26, 2010) and 76 FR 12645 (March 8, 2011);

Process for Submissions for Review of Security-Based Swaps

for Mandatory Clearing and Notice Filing Requirements for

Clearing Agencies, 75 FR 82490 (December 30, 2010); and

Clearing Agency Standards for Operation and Governance, 76

FR 14472 (March 16, 2011), all issued by the SEC. The Board

also issued a proposed rulemaking on risk management standards. See “Financial Market Utilities” issued by the Board on

March 30, 2011 (76 FR 18445 (April 4, 2011)).

3
will enable the CFTC, the SEC, and the Board to

carry out their responsibilities under Title VIII, and

will further the purposes of Title VIII to mitigate systemic risk in the financial system and to promote

financial stability. These actions build on the preexisting working relationships and past joint efforts

among the agencies and are designed to help further

strengthen and enhance the government’s oversight

of DCEs.

1. The CFTC and the SEC should work toward finalizing rulemakings establishing enhanced risk management standards for DCOs and CAs, including

DCEs, in consultation with the Board and other

agencies. The CFTC and the SEC should continue

such consultation in connection with future agency

rulemakings related to changes in risk management

standards for DCEs. The CFTC and the SEC

have each recently proposed regulations, including critical risk management standards, governing

the clearing and settlement operations of DCOs

and CAs, including DCEs. The CFTC and the

SEC should work to promptly promulgate final

regulations, in consultation with the Board and

other agencies, and will consult with the Board

and other agencies in connection with future

agency rulemakings related to risk management

standards for DCEs.

2. The CFTC and the SEC should formalize a process

for consulting with the Board regarding proposed

material changes to a DCE’s rules, procedures, or

operations. Section 806(e) of the Act requires the

CFTC and the SEC to consult with the Board

before taking any action on, or completing their

review of, a DCE’s proposed changes to rules,

procedures, or operations that could materially

affect the nature or level of the DCE’s risks.

Meaningful consultation contributes to an effective assessment of proposed changes through the

timely, constructive exchange of comments and

views on the proposed changes among appropriate agency staff.

3. The CFTC, the SEC, and the Board should develop

and implement an ongoing consultative mechanism

that promotes (a) a shared understanding of potential systemic risks, and (b) an exchange of insights

on effective supervisory risk management practices

and techniques. Although the risk management

supervision programs at the CFTC, the SEC, and

the Board have a common focus on certain core

risks, they necessarily differ in some respects

because of unique legal bases for supervision,

agency mandates, and types of entities and markets supervised by each agency. These differences

may give rise to distinct agency-specific emphases

in the supervisory process, approaches to risk

assessment, and supervisory tools and procedures. In light of these differences, the agencies

believe that the opportunity to share their unique

supervisory perspectives on risks and risk management and to learn from each other will be an

important mechanism for identifying systemic

risks, improving consistency over time in the

DCE oversight programs of the CFTC and the

SEC, and promoting more effective risk management supervision across DCEs.

The ongoing consultative mechanism among the

CFTC, the SEC, and the Board should consist of

an annual planning and coordination meeting

supplemented by ongoing dialogue and periodic

meetings as warranted. The purpose of the meeting and ongoing dialogue should be to identify

emerging risks, discuss key DCE risk issues that

may be examined by each agency, and help

inform effective supervisory responses to such

risks. Key DCE risk issues should generally be

framed in terms of relevant risk management

standards. These consultations should also serve

as an important mechanism for providing input

and context to bilateral consultations between

each agency and the Board regarding the scope

and methodology of planned examinations (see

number 4 below). The agencies believe that this

proposed mechanism for interagency coordination, informed by applicable statutory requirements, agency regulations, supervisory guidance,

and international standards, should provide

greater consistency of supervisory inquiry from

which the agencies can promote greater awareness

of systemic risk, and help identify areas for

enhancing risk management practices at DCEs.

4. The CFTC and the SEC should develop a process

for consulting with the Board at least once a year

regarding the scope and methodology of their

planned examinations of DCEs for which each is

the Supervisory Agency and providing the Board

with the opportunity to participate on such examinations. The CFTC and the SEC should review

and incorporate the risk issues described in Section 807(a) of the Act during their annual

examination-planning process. Before completing

this process, the CFTC and the SEC should each

separately consult, and work collaboratively with,

the Board regarding the scope and methodology

of DCE examinations that are scheduled for the

4 Risk Management Supervision of Designated Clearing Entities
upcoming examination cycle, consistent with Title

VIII, and additionally consult, as needed, during

the year. The CFTC and the SEC shall lead

examinations within their respective jurisdictions

as provided for by Section 807(d) of the Act.

Consultations with the Board on the scope and

methodology of DCE examinations and participation by the Board on relevant examinations are

important elements to enable the Board to carry

out its responsibilities under Title VIII. The

Board expects to participate on each relevant

DCE examination where practicable as allowed

under Section 807(d)(2) of the Act.

5. The CFTC, the SEC, and the Board should develop

a process for appropriate information sharing

related to DCEs. An important component of

effective interagency consultation and risk identification is appropriate information sharing

among the agencies. Title VIII provides the

authority for such information sharing in Section

809 pursuant to which the agencies plan to

develop an appropriate process for regular information exchange. The process should cover procedures for sharing, and preserving the confidentiality of, written and oral information such as

examination reports, information about material

concerns, and other appropriate confidential

supervisory information. One possible mechanism for implementing such information sharing

may be through a Memorandum of Understanding (MOU) among the CFTC, the SEC, and the

Board.

July 2011 5

Section II: Introduction

In Title VIII of the Act, Congress finds that the

proper functioning of the financial markets is dependent upon safe and efficient arrangements for the

clearing and settlement of payments, securities, and

other financial transactions.2 The entities providing

these arrangements are known as financial market

utilities (FMUs).3 For all types of financial transactions, FMUs contribute to financial market stability

by facilitating post-trade processing and the

exchange of funds or other assets from one party to

another, and in certain cases providing financial

guarantees. Title VIII applies to designated FMUs

(DFMUs), which are FMUs designated by the Council as “systemically important.” An FMU is considered “systemically important” if the Council determines that the failure or disruption to the functioning of the FMU “could create, or increase, the risk of

significant liquidity or credit problems spreading

among financial institutions or markets and thereby

threaten the stability of the financial system of the

United States.”4

DCEs are a subset of DFMUs.5 DCEs are commonly classified according to the functions they perform: a central counterparty is an entity that interposes itself between counterparties to contracts

traded in financial markets, becoming the buyer to

each seller and seller to each buyer to ensure the performance of open contracts; a central securities

depository is an entity that holds securities accounts

as bookkeeping entries rather than as physical certificates, and provides central safekeeping and other

asset services, and in many cases also operates a securities settlement system, which is a set of arrangements that enables transfers of securities, either for

payment or free of payment.6

In the United States,

DCOs supervised by the CFTC function as central

counterparties that clear financial and commodity

futures contracts, options on futures, and swaps,

including interest rate swaps, energy swaps, and

equity and credit default swaps based on broad-based

indexes. CAs supervised by the SEC function as securities depositories, securities settlement systems, and

central counterparties that variously clear and settle

trades of securities, including options and securitybased swaps.

Description of DCE Operations

DCEs are closed systems that provide services to participants, which are members of the DCE. Participants typically must meet pre-established eligibility

criteria in order to obtain clearing privileges at a

DCE. Business models for DCEs vary and include

entities that are part of publicly traded companies

and entities that function as participant-owned utilities. To operate, DCEs establish a common set of

rules and procedures governing their participants,

provide a technical infrastructure for clearance and

settlement, and establish a governing risk management framework. Each DCE is unique, but in general, a DCE clears transactions or trades submitted

by participants, calculates whether and how much

each participant owes on either a gross or net basis,

collects payments from participants that owe money,

and pays participants that are owed money. DCEs

and their participants collect and pay money through

2 See §802(a)(1) of the Act.

3 See §803(6)(A)of the Act, which defines “financial market utility” as any person that manages or operates a multilateral

system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.

Section 803(6)(B)(i) of the Act excludes designated contract

markets, registered futures associations, swap or security-based

swap data repositories, swap execution facilities, national securities exchanges, or alternative trading systems from the definition

of an FMU.

4 See §803(9) of the Act.

5 This report refers to DCEs even though no clearing entity or

other FMU has yet been designated by the Council as systemically important. The term DCEs is used for ease of reference to

the Act.

6 The definitions of central counterparty, central securities

depository, and securities settlement system are internationally

recognized definitions. See “Principles for financial market

infrastructures, consultative report,” Committee on Payment

and Settlement Systems Publications No. 94, Bank for International Settlements (March 2011).

7
settlement banks, which are typically commercial

banks. Settlement banks execute payments via payment systems, which are a type of FMU that facilitate funds transfers among participants. On an average day, the value of transactions cleared and settled

by DCEs ranges from billions of dollars to trillions

of dollars. On days of market volatility, the value can

be significantly higher than the average.

DCE members are active participants in financial

markets, such as banks, broker–dealers, and futures

commission merchants (FCMs). Banks, broker–

dealers, and FCMs use DCEs for proprietary activity

and as intermediaries for institutional investors, retail

investors, and proprietary trading firms.7 These

financial institutions become participants in a DCE

because clearing and settling a high volume of financial transactions multilaterally through a central

counterparty may in many cases allow for greater

efficiency and lower costs than settling bilaterally. In

addition, DCEs are often able to manage risks for

their participants related to the clearing and settling

of financial transactions more effectively, and, in

some cases, reduce certain risks, such as the risk that

a purchaser of a security will not receive the security

or that a seller of a security will not receive payment

for the security. Finally, certain participants may be

legally required to clear and settle through a DCE

based on the type of financial product for which they

trade or for which they facilitate trades.8

Figure 1

depicts where DCEs fit into the U.S. financial system.

Figure 1 shows that DCEs are critical central points

in the financial system. A large portion of financial

activity originated by retail investors, institutional

investors, broker–dealers, FCMs, and banks ultimately flows through one or more DCEs. DCEs have

direct links to participants and indirect links to the

customers of participants. DCEs are also linked to

each other through common participants and, in

some cases, by operational processes. These linkages

are what make DCEs both a beneficial source for

reducing risks and a potential conduit for risks.

DCEs play a vital role in fostering the proper functioning of financial markets, but if they are not effectively managed they have the potential to act as

transmission channels for financial shocks, particularly on days of market stress. For example, participants that owe money on a given day are required to

settle their obligations according to a precise timetable during the day. If a participant defaulted on a

payment obligation that it owed to a DCE and the

obligation was sufficiently large that the DCE did not

have enough liquid resources to cover the defaulting

participant’s obligations, the DCE would not be able

to pay what it owed to other participants. In turn,

those participants expecting payments at a certain

time might be unable to honor other financial obliga7

Some DCEs permit proprietary trading firms, including highfrequency traders (HFTs), that meet the DCE’s participation

requirements to clear trades without intermediation by a

broker-dealer or FCM.

8 Title VII of the Act requires mandatory clearing for swaps and

security-based swaps. See §§723 and 763 of the Act.

Figure 1. DCEs and the U.S. Financial System

1. A number of proprietary trading firms, such as corporations, hedge funds, and swap dealers have become direct participants of DCEs.

2. DCEs.

8 Risk Management Supervision of Designated Clearing Entities
tions, potentially setting off a systemic cascade of

funding shortfalls and possible credit losses.

In recognition of the risks posed by the concentration of clearance and settlement activity at DCEs,

Title VIII provides a framework for enhanced regulation and supervision of DCEs by the CFTC, the

SEC, and the Board.9

Specifically, Title VIII

• allows for the development of risk management

standards by the CFTC and the SEC governing the

operations of DCEs, as applicable, in consultation

with the Council and the Board10

• allows the Board to determine whether the existing

prudential requirements of the CFTC or the SEC

are insufficient to prevent or mitigate significant

liquidity, credit, operational, or other risks to the

financial markets or to the financial stability of the

United States11

• requires annual examinations of DCEs by the

CFTC or the SEC, including consultation with the

Board on the scope and methodology of the

examination12

• allows for Board participation on examinations of

DCEs, which shall be led by the CFTC or the SEC,

as applicable13

• provides for prior review and authority to the

CFTC or the SEC, in consultation with the Board,

to object to changes proposed by a DCE to its

rules, procedures, or operations that may materially

affect the nature or level of risks14

• allows the Board, after consulting the CFTC or the

SEC (as the applicable Supervisory Agency) and

the Council, to recommend enforcement action

against a DCE in certain cases15

• provides the Council and the Board authority to

obtain information to assess a DCE’s safety and

soundness and the systemic risk that the DCE’s

operations pose to the financial system16

• allows the CFTC, the SEC, and the Board to share

examination reports and other confidential information with each other, and17

• requires the CFTC and the SEC to coordinate with

the Board to jointly develop risk management

supervision programs for DCEs18

Overall, the emphasis on enhanced supervision under

Title VIII is on risk management, particularly with

regard to potential systemic risk, which in practice

means understanding the nature of the risks that

DCE activities pose to the broader financial system

and assessing the resources and capabilities of DCEs

to monitor and control such risks.

9 As defined in §803(A) of the Act, Supervisory Agency means

“the Federal agency that has primary jurisdiction over a designated financial market utility under Federal banking, securities,

or commodity futures laws.” The SEC and the CFTC are the

Supervisory Agencies for DCEs. Although the Board is not the

primary Supervisory Agency for DCEs, Title VIII grants the

Board a role in the framework for enhanced supervision of

DCEs.

10 See§805(a)(2)(A)(i) of the Act. These risk management standards shall take into consideration relevant international standards. In addition, these standards are not intended to usurp

existing regulatory and/or statutory principles or standards that

the CFTC or the SEC must follow in order to grant a DCE registration or a license to operate.

11 See § 805(a)(2)(B) of the Act.

12 See § 807(a) and (d) of the Act.

13 See § 806(d)(2) of the Act.

14 See § 806(e)(4) of the Act.

15 See § 807(e)(1) of the Act.

16 See § 809(b)(1) of the Act.

17 See § 809(e) of the Act.

18 See § 813 of the Act.

July 2011 9

Section III: DCE Risks and Risk

Management

As previously discussed, the centralization of clearance and settlement activities at DCEs allows market

participants to reduce costs, increase operational efficiency, and manage risks more effectively. While

DCEs can provide many risk management benefits to

participants, the concentration of clearance and

settlement activity at a DCE has the potential to disrupt the financial system if the DCE does not effectively manage the risks inherent in its clearance and

settlement activities. Key risks in the clearance and

settlement process include credit risk, market risk,

liquidity (funding) risk, operational risk, and legal

risk.

DCEs face counterparty (default) credit risk from

their participants and from service providers such as

banks and securities custodians. For DCEs that are

securities settlement systems or securities depositories, credit risk arises, for example, from the potential

that a participant will not pay what it owes for securities that it has purchased or will not deliver securities

that it has sold. For DCEs that clear and settle

derivatives contracts, credit risk arises from the

potential that a participant will not meet its margin

or settlement obligations or will not pay any other

amounts owed to the DCE.19 Credit risk also arises

for DCEs of any type from commercial banks or custodians that the DCE uses to effect money transfers

among participants, to hold overnight deposits, or to

safekeep collateral.

DCEs that are central counterparties take offsetting

positions as substituted counterparty and, therefore,

do not ordinarily face market risk except in the event

of a participant default. In such an event, this market

risk takes two forms. First, the DCE may need to liquidate collateral posted by the defaulting participant.

The DCE is therefore exposed to the risk that movement of market prices of the collateral of the defaulting participant could result in the DCE having insufficient financial resources to cover the losses in the

defaulting participant’s open positions. Second, a

DCE is subject to the risk of movement in the market prices of the defaulting participant’s open positions in the interval between when the DCE takes

control of those positions and when the DCE is able

to offset or liquidate those positions.

In addition to credit risk and the aforementioned

market risk, DCEs also face liquidity or funding risk.

Currently, to complete the settlement process, DCEs

rely on incoming payments from participants in net

debit positions in order to make payments to participants in net credit positions. If a participant does not

have sufficient funds to make an incoming payment

immediately when it is due (even though it may be

able to pay at some future time), or if a settlement

bank is unable to make an incoming payment on

behalf of a participant, the DCE faces a funding

shortfall. A DCE typically holds additional financial

resources to cover potential funding shortfalls such as

margin collateral or lines of credit. However, if collateral cannot be liquidated within a short time, or if

lines of credit are unavailable, liquidity risk is

exacerbated.

A DCE faces two types of non-financial risks –

operational and legal – that may disrupt the functioning of the DCE. Operational risk is a broad category

that relates to potential losses arising from deficiencies in internal processes, personnel, and information

technology. DCEs face operational risk from both

internal and external sources, including human error,

system failures, security breaches, and natural or

man-made disasters.

Legal risk is the risk that the DCE may suffer a loss

because the legal system underpinning a DCE’s

operations does not support its rules and procedures.

An example of legal risk is the risk that obligations

of the DCE’s participants to the DCE or the DCE’s

19 In this context, the DCE’s credit risk is closely related to the

participant’s market risk. A participant’s ability to meet its obligations to the DCE may be affected by the participant’s exposure to fluctuations in the market value of the participant’s

open positions. In addition, fluctuations in the market value of

the collateral posted by the participant may require the DCE to

obtain additional margin from the participant.

11
rights to collateral are not enforceable. Key aspects of

DCE operations in which legal risk is relevant include

laws and regulations governing contracts and insolvency, the rights of participants, the enforceability of

netting arrangements, and the discharge of obligations and settlement finality. The cross-border activities of a DCE may also present elements of legal risk.

Risk Management at DCEs

In order to manage this array of risks, DCEs employ

various risk management frameworks. These frameworks include rules, processes, procedures, and controls. For example, DCEs mitigate credit risk by,

among other things, establishing eligibility standards

for participants, collecting initial margin collateral

from participants to cover exposures, marking open

positions to market each day and collecting variation

margin, holding a pool of financial resources to

cover and mutualize losses from potential defaults,

and establishing minimum creditworthiness and capitalization criteria for commercial banks used as

settlement agents. DCEs mitigate market risk by

marking collateral to market, collecting additional

collateral where necessary, and taking appropriate

haircuts on the value of collateral. They manage

liquidity risk by collecting sufficient margin to cover

changes in portfolio values, calculating financial

resource needs based on stress testing (taking into

account both historical data and hypothetical scenarios), and holding and/or having access to sufficient financial resources to meet funding needs in the

event of a participant default.20 DCEs mitigate

operational risk by having effective policies, procedures, and internal controls; strong and well-tested

business continuity plans; and systematic monitoring

processes. Finally, DCEs mitigate legal risk by ensuring that their procedures and policies have a wellfounded legal basis in all the jurisdictions in which

each DCE operates.

DCEs have several incentives to implement comprehensive risk management programs. First, the ongoing viability of a DCE depends on its reputation and

the confidence that market participants have in its

clearance and settlement services. Thus, DCEs have

an incentive to minimize the likelihood that a participant failure or operational outage would disrupt

settlement. Second, many DCEs, including DCEs

that mutualize default risks, contribute a portion of

their own capital as part of their contingent

resources. Thus, DCEs have an economic interest in

sound risk management. Third, DCEs in the securities and derivatives markets are self-regulatory organizations (SROs) that enforce applicable rules and

requirements under SEC or CFTC oversight. Thus,

DCEs have a legal incentive to protect certain public

interests in the process of clearing securities or

derivatives.

DCEs’ incentives for sound risk management, however, may be tempered by cost-reduction or profitmaximizing pressures that are distinct from the public interest goals set forth in governing statutes. In

particular, DCEs and their participants may not

place the same weight on managing systemic risks

arising from the clearance and settlement process.

Moreover, DCEs that compete for clearing and

settlement business may have an incentive to lower

risk standards to obtain or maintain a competitive

advantage. In either case, DCE incentives may not be

aligned with public policy goals of financial stability.

As will be discussed in the next section, an effective

supervisory program serves as a necessary counterbalance to the DCE incentives described above to

ensure that a DCE’s risk management program comports with applicable statutes and regulations. Supervisory agencies use these programs to evaluate

whether DCE policies are adequate to protect against

applicable risks and foster financial stability in the

markets a DCE serves.

20 Financial resources are typically in the form of liquid assets

deposited by participants as margin, contributions to a guarantee fund, and pre-arranged third-party funding agreements.

12 Risk Management Supervision of Designated Clearing Entities
Section IV: Common Elements of Risk-Based

Supervision

Today, the CFTC’s and the SEC’s supervisory programs for clearing entities (CEs) and the Board’s

supervisory program for FMUs have three primary

elements in common: objectives that set forth the purpose of a CE or FMU evaluation, standards against

which the CE or FMU is evaluated, and processes

and tools for performing an evaluation. Additionally,

if, in the course of an evaluation, supervisors find

deficiencies, weaknesses, or significant unaddressed

risks at a CE or FMU, then supervisors have

recourse to a variety of corrective options, including

formal enforcement actions.

This section briefly discusses key common elements

of the supervisory programs of the CFTC, the SEC,

and the Board.21 While each agency’s program is

unique, each uses these key elements. The CFTC and

the SEC will use their existing supervisory programs

to evaluate DCEs, incorporating information discussed in Section V of this report.

Risk-Focused Supervisory Objectives

A primary objective in supervision is to determine

whether a CE or FMU meets the risk management

requirements of the supervisor’s governing statutes

and regulations, both at a point in time and on an

ongoing basis. An effective supervisory program

enables a supervisor to gain a broader understanding

of the risk profile and risk management processes,

procedures, and controls of a DCE or FMU (i.e., its

risk management framework) in order to fulfill this

objective. In addition, the particular risks posed to

and by a CE or FMU guide the supervisor in determining the focus of its supervisory program for that

CE or FMU.

Risk Management Standards

Supervisory evaluation of a CE’s or FMU’s risk

management framework begins with an assessment

of that framework against standards that are established in statutory provisions, regulations, and policies. DCOs regulated by the CFTC must comply with

all the applicable provisions of the CEA, including

the DCO core principles established in Section 5b of

the CEA and relevant CFTC regulations, which

require the DCO to maintain adequate and appropriate risk management capabilities. Clearing agencies

regulated by the SEC must comply with all applicable

provisions of the Exchange Act, including Sections

17, 17A, and 19, and with the relevant rules and

regulations adopted by the SEC, which require CAs

to have the capacity to facilitate prompt and accurate

clearance and settlement. Systemically important

FMUs supervised by the Board are expected to meet

risk management expectations set forth in its Policy

on Payment System Risk, which incorporates recognized international risk management principles and

minimum standards.

In addition to existing statutory and regulatory standards, the CFTC, the SEC, and the Board are conducting rulemaking processes designed to promulgate

enhanced standards for DCEs and DFMUs consistent with Section 805 of Title VIII of the Act.22 In

doing so, the agencies are required to take into consideration relevant international standards and other

prudential requirements.23 International standards

established by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) provide a

basis for management of risks in systemically important systems. The international standards also pro21 Each agency’s program is discussed in detail in the appendix to

this report.

22 See supra note 2.

23 See §805(a)(2) of the Act.

13
vide a common risk management framework and a

set of minimum risk management principles across

national jurisdictions, which allow national authorities to more effectively cooperate and address global

systemic risk.24

Supervisory Processes and Tools

Supervisors use a variety of tools to assess a CE’s or

FMU’s condition, develop reasoned conclusions, and

induce corrective actions where needed. These may

include evaluation at the initial registration or application processes, examinations, ongoing monitoring,

cooperation with other domestic and foreign regulators, communication of findings, and agreements on

corrective actions.

Supervision generally begins with a CE’s or FMU’s

application for registration, authorization, or charter.

At this stage, the supervisor reviews the applicant’s

proposed risk management framework and determines the applicant’s ability to meet requirements of

governing statutes and regulations. Once an application is approved, the supervisor performs examinations of the CE’s or FMU’s operations. In general,

examinations consist of a review and evaluation of

internal CE and FMU reports and analysis related to

risk management and verification by examiners of

the information contained in the CE’s and FMU’s

reports and analysis.25 Examinations also typically

cover a review of policies, models, processes, procedures, and internal controls to evaluate the effectiveness and adequacy of DCE operations under relevant statutory and regulatory requirements. In addition to examinations, supervisors monitor CE and

FMU activities through a review of rules and procedures that are adopted or amended by the CE or

FMU. Examinations and rule filing review are

supplemented by ongoing monitoring, which could

include reviewing products that are accepted for

clearance and settlement; reviewing or conducting

periodic (such as daily or monthly) testing, including

back-testing and stress-testing, to verify the CE’s or

FMU’s measurements of credit, market, and liquidity risks; reviewing internal audit reports; regular discussions between supervisory and CE or FMU staff

and management; and information collection and

analysis.

At any stage during the supervisory process, supervisors may seek input from experts from functional

areas both within a particular Supervisory Agency as

well as from relevant domestic and foreign supervisors.

Supervisors communicate examination and monitoring results to the CE or FMU through orders, examination reports, or ad hoc communications. Supervisors typically provide a summary report or letter to

the CE or FMU containing recommendations that

the CE or FMU is expected to implement in order to

strengthen its risk management program. The CE or

FMU responds with a written description of the

actions that it has taken or plans to take in response

to the recommendations.

Finally, supervisors have statutory authority to

induce corrective actions or remediation when material weaknesses in risk management or violations of

relevant statutes or regulations have been identified.

This authority includes enforcement, such as the

institution of a civil or administrative action against

a CE or FMU leading to the imposition of sanctions

such as a civil monetary penalty, a cease and desist

order, or suspension or revocation of the CE’s or

FMU’s registration, authorization, or charter.

24 For example, these standards provide useful guidance to CEs,

FMUs, and supervisors regarding risk management in several

key areas including participation requirements, measuring and

managing credit risk, setting margin requirements, assessing

the sufficiency of financial resources, operational risk, and governance. See the CPSS Core Principles for Systemically Important Payment Systems (2001), the CPSS-IOSCO Recommendations for Securities Settlement Systems (2001), and the CPSSIOSCO Recommendations for Central Counterparties (2004).

The CFTC, the SEC, and the Board are working closely

together, along with other central banks and market regulators,

on revisions and enhancements to the existing standards. See

supra note 1.

25 Relevant statutory provisions and regulations generally require

CEs and FMUs to provide certain information about their

operations to their supervisors either routinely or upon

request, and permit supervisors to examine a CE’s or FMU’s

books and records at any time.

14 Risk Management Supervision of Designated Clearing Entities
Section V: Recommendations

The supervisory programs of the CFTC, the SEC,

and the Board are conducted in an autonomous

manner, with interagency cooperation where entities

are supervised by more than one agency.26 With Title

VIII, Congress has provided a new cooperative

supervisory framework for DCEs, a framework that

provides requirements for enhanced risk management, a greater focus on systemic risk both within

and across DCEs, an enhanced role for the Board in

the supervision of risk management standards for

systemically important financial market utilities

(DFMUs), and closer consultation among the

CFTC, the SEC, and the Board. The legal basis for

consultation is described in Section II of this report

and includes statutory authority for sharing examination reports and other confidential supervisory

information, Board participation on DCE examinations, and coordinated development of DCE risk

management supervision programs.

The primary purpose of closer consultation is to provide the CFTC, the SEC, and the Board an enhanced

ability to look across DFMUs in a consistent way to

identify and address sources of systemic risk. With

consultation, the agencies will have opportunities to

leverage their unique perspectives in order to gain a

broader view and understanding of the various risks

and risk management techniques at DFMUs, as well

as common risk issues and interdependencies across

DFMUs and between DFMUs and the broader

financial system. The new Title VIII supervisory

framework does not replace the existing supervisory

programs at each agency, and each agency continues

to have responsibility for enforcing its respective governing laws, regulations, and policies. Rather, the new

framework builds on each agency’s existing supervisory program with an interagency consultative process for managing systemic risk that should, over

time, enhance and reinforce existing supervisory

programs.

The agencies recommend that they take the following

five actions that are intended to achieve the statutory

goals of improving consistency in oversight, promoting robust risk management, promoting robust risk

management oversight, and improving regulators’

ability to monitor risks pursuant to Section 813 of

Title VIII. These actions build on the pre-existing

working relationships and past joint efforts among

the agencies, including policy work on the recent

CPSS-IOSCO consultative report on principles for

financial market infrastructures and recent supervisory collaboration in reviewing the clearing application of New York Portfolio Clearing, LLC, and are

designed to help further strengthen and enhance the

government’s oversight of DCEs.

The CFTC, the SEC, and the Board believe that the

consultation and cooperation described in the recommendations are consistent with the enhanced supervision established in Title VIII; will enable the CFTC,

the SEC, and the Board to carry out their responsibilities under Title VIII; and will further the purposes

of Title VIII to mitigate systemic risk in the financial

system and to promote financial stability. In particular, consultations with the Board on the scope and

methodology of DCE examinations and participation by the Board on relevant examinations are

important elements to enable the Board to carry out

its responsibilities under Title VIII, including (1)

promoting uniform risk management standards (Section 802(b)(1)) and assessing whether the existing

prudential requirements for DCEs are sufficient to

prevent or mitigate significant liquidity, credit, operational, or other risks to the financial markets or to

the financial stability of the United States (Section

805(a)(2)(B)); (2) assessing potential risks to a Federal Reserve Bank that might provide a DCE with

26 For example, the SEC and the Board have successfully collaborated in the past on supervisory issues and risk management

discussions related to the Depository Trust Company, which is

supervised by both the SEC and the Board, and the CFTC and

the SEC have successfully collaborated in the past with respect

to examining the Options Clearing Corporation, which is

supervised by both the CFTC and the SEC. All three agencies

have successfully collaborated in reviewing the recent clearing

application of New York Portfolio Clearing, LLC, a joint venture of the Depository Trust & Clearing Corporation and

NYSE Euronext.

15
access to an account and/or payment services (Section 806(a)); and (3) assessing potential risks to a

Federal Reserve Bank that might provide an advance

to a DCE in unusual or exigent circumstances (Section 806(b)). The agencies are cognizant that challenges to the effective implementation of the recommendations may arise; if they do, the agencies are

committed to working diligently to address the challenges together. Finally, the CFTC, the SEC, and the

Board also recognize that the processes for supervisory coordination outlined below will need to evolve

over time as risks, markets, and regulatory frameworks change.

1. The CFTC and the SEC should work towards

finalizing rulemakings establishing enhanced risk

management standards for DCOs and CAs, including DCEs, in consultation with the Board and other

agencies. The CFTC and the SEC should continue

such consultation in connection with future agency

rulemakings related to changes in risk management

standards for DCEs. The CFTC and the SEC

have each recently proposed regulations, including critical risk management standards, governing

the clearing and settlement operations of DCOs

and CAs, including DCEs. These sets of regulations are broadly consistent with each other, and

with both established and proposed international

standards. The process of developing these proposed regulations included both consultation

between the CFTC and the SEC, and consultations with the Board and other agencies represented on the Council. Adopting these regulations could promote both robust risk management by DCEs and robust risk management

oversight by their regulators. Accordingly, the

CFTC and the SEC should work diligently to

review public comments on the proposed regulations, and to work towards promulgating final

regulations, in consultation with the Board and

other agencies.

Enhancing risk management oversight under

Title VIII is promoted by improving the consistency of risk management standards among the

agencies. These goals are fostered by the process

of consultation between the agencies. Accordingly, the CFTC and the SEC will consult with

the Board and other agencies in connection with

their current risk management-related rulemakings as well as in connection with subsequent

changes to agency regulations related to risk

management standards for DCEs. Consultation

should take place sufficiently early in the review

process to allow adequate time to analyze the proposed regulatory change and engage in a meaningful exchange of views.

2. The CFTC and the SEC should formalize a process

for consulting with the Board regarding proposed

material changes to a DCE’s rules, procedures, or

operations. Section 806(e) of the Act requires the

CFTC and the SEC to consult with the Board

before taking any action on, or completing their

review of, a DCE’s proposed changes to its rules,

procedures, or operations that could, as defined

in the rules of the CFTC or the SEC, respectively,

materially affect the nature or level of the DCE’s

risks. Meaningful consultation contributes to an

effective assessment of proposed changes through

the constructive exchange of comments and views

among appropriate agency staff.27

3. The CFTC, the SEC, and the Board should develop

and implement an ongoing consultative mechanism

that promotes (a) a shared understanding of potential systemic risks, and (b) an exchange of insights

on effective supervisory risk management practices

and techniques. The core risks described in Section III of this report (credit, market, liquidity,

operational, and legal risk) are of interest to, and

monitored by, each supervisory agency. Furthermore, many DCEs have functionally similar clearing and settlement processes. For example, certain

DCOs and CAs that act as central counterparties

use similar risk management practices, such as

mutualization of central counterparty risk.

Despite these common supervisory interests and

common DCE practices, the risk management

supervision programs at the CFTC, the SEC, and

the Board necessarily differ in some respects

because of unique legal bases for supervision,

agency mandates, and types of entities supervised

by each agency. These differences may give rise to

distinct agency-specific emphases in the supervisory process, approaches to risk assessment, and

supervisory tools and procedures. In light of

these differences, the agencies believe that the

opportunity to share their unique supervisory

perspectives on risks and risk management with

the other agencies and to learn from the other

agencies will be an important mechanism for

identifying systemic risks, improving consistency

over time in the DCE oversight programs of the

CFTC and the SEC, and promoting more effec27 As with respect to agency rulemakings, consultation should

take place sufficiently early in the review process to facilitate a

meaningful exchange of views.

16 Risk Management Supervision of Designated Clearing Entities
tive risk management supervision across DCEs.

For example, the staffs of the CFTC, the SEC,

and the Board may identify, in their individual

risk assessments, the use of the same commercial

banks by multiple DCEs as settlement banks or

as providers of back-stop liquidity to the DCEs.

As a result of consultation, the three agencies

should be more readily able to identify such common DCE dependencies and understand the

potential systemic risk posed by reliance on the

same commercial banks. The agencies will also be

better able to determine if further assessments of

the DCEs’ risk management procedures to

address such dependencies, including the need to

test the adequacy of back-up lines on days of

market stress, would be critical to mitigating systemic risk. The agencies may also find it useful to

share perspectives on, and their various supervisory approaches to assessing, certain common

DCE risk management methods. Finally, consultation should help the agencies collectively to

identify and assess areas where DCE risk management practices may interact or be subject to a

stress event that would affect multiple DCEs.

Supervisory and analytical consultation on topics

such as these will enhance systemic oversight of

DCEs and improve the consistency of such oversight, as envisioned by Title VIII.

To promote effective consultation along these

lines, the agencies should hold an annual coordination and planning meetiecng supplemented by

ongoing dialogue and periodic meetings as warranted among the CFTC, the SEC, and the

Board. The purpose of the annual meeting and

ongoing dialogue should be to identify emerging

risks, discuss key DCE risk issues that may be

examined by each agency, and help inform effective supervisory responses to such risks.28 Key

risk issues should generally be framed in terms of

relevant risk management standards. These consultations should also be an important mechanism for providing input and context to bilateral

consultations between each agency and the Board

regarding the scope and methodology of planned

examinations (see number 4 below).

The agencies believe that this proposed mechanism for interagency coordination, informed by

applicable statutory requirements, agency regulations, supervisory guidance, and international

standards, should provide greater consistency of

supervisory inquiry from which the agencies can

promote greater awareness of systemic risk, and

help identify areas for enhancing risk management practices at DCEs. As risks and risk management practices evolve, consultation also

should facilitate shared learning and analysis

across the agencies so that supervisory programs

can adapt in response to changing DCE risks.

4. The CFTC and the SEC should develop a process

for consulting with the Board at least once a year

regarding the scope and methodology of their

planned examinations of DCEs for which each is

the Supervisory Agency and providing the Board

with the opportunity to participate on such examinations. The CFTC and the SEC should review

and incorporate the risk issues described in Section 807(a) of the Act during their annual examination planning process. Before completing this

process, the CFTC and the SEC should each

separately consult, and work collaboratively with,

the Board regarding the scope and methodology

of DCE examinations that are scheduled for the

upcoming examination cycle, consistent with Title

VIII, and additionally consult, as needed, during

the year. The CFTC and the SEC, as appropriate,

shall lead all examinations as provided for by Section 807(d) of the Act. The Board expects that it

will participate on every relevant DCE examination where practicable as allowed under Section

807(d)(2) of the Act.

5. The CFTC, the SEC, and the Board should develop

a process for appropriate information sharing. An

important component of effective interagency

consultation and risk identification is appropriate

information sharing among the agencies. Title

VIII provides the authority for such information

sharing in Section 809 pursuant to which the

agencies plan to develop an appropriate process

for regular information exchange. The process

should cover procedures for sharing, and preserving the confidentiality of, written and oral information such as examination reports, information

about material concerns, and other appropriate

confidential supervisory information. Therefore,

each of the agencies will need to determine which

reports and information may be appropriate to

share, the circumstances under which they might

be shared, and any appropriate conditions under

which they might be shared, including reasonable

assurances of confidentiality as required by Section 809 of the Act. Each agency will designate

28 Topics of potential systemic risk could include, for example,

analysis of the concentration of liquidity providers among

DCEs and DFMUs, or the effective risk management of crossmargining relationships between certain DCEs and DFMUs.

July 2011 17
staff who are authorized to request, receive,

notify, or be notified about such information.29

One possible mechanism for implementing such

information sharing may be through an MOU

among the CFTC, the SEC, and the Board.30

In addition to the sharing of supervisory information among the agencies, Section 809 of the

Act also authorizes the Board and the Council to

request reports or data from a DFMU in order to

permit the Board to assess the safety and soundness of the utility and the systemic risk that the

utility’s operations might pose to the financial

system. The Board must coordinate with the

Supervisory Agency first to determine if the

information is available from, or may be obtained

by, the Supervisory Agency. The Board will work

with the SEC and the CFTC to further define this

process. In general, the Board will request additional information when it is necessary to make

the assessment described in number 4 above.

29 A list of each agency’s staff designations will be provided to

relevant staff at the other agencies.

30 For example, an MOU has been successfully used for interagency sharing of information relating to ICE Trust’s clearing

of credit default swaps.

18 Risk Management Supervision of Designated Clearing Entities
Appendix: Overview of Current Supervisory

Frameworks for Clearing Entities and

Systemically Important Financial Market

Utilities

SEC Supervisory Program for

Clearing Agencies

Clearing agencies are overseen by the SEC and are

subject to registration and operational requirements

contained in the Exchange Act.31 In particular, Sections 17, 17A, and 19 of the Exchange Act and rules

and regulations thereunder set forth requirements

applicable to CAs.32 Clearing agencies must be registered with the SEC pursuant to Section 17A of the

Exchange Act, unless exempted by the SEC from

such registration.33 A registered CA is a selfregulatory organization (SRO). Pursuant to Section

19 of the Exchange Act, an SRO must file with the

SEC any proposed changes to its rules as well as

enforce compliance by its participants with its rules.

Consistent with Sections 17(a) and (b) and 17A of

the Exchange Act, the SEC has the authority to conduct examinations of, and obtain information from,

a CA.

Supervisory Objectives

In establishing a system for the regulation of CAs,

Congress found that

• the prompt and accurate clearance and settlement

of securities transactions, including the transfer of

record ownership and the safeguarding of securities and funds related thereto, are necessary for the

protection of investors and persons facilitating

transactions by, and acting on behalf of, investors

• inefficient procedures for clearance and settlement

impose unnecessary costs on investors and persons

facilitating transactions by, and acting on behalf of,

investors

• new data processing and communications techniques create the opportunity for more efficient,

effective, and safe procedures for clearance and

settlement

• the linking of all clearance and settlement facilities

and the development of uniform standards and

procedures for clearance and settlement will reduce

unnecessary costs and increase the protection of

investors and persons facilitating transactions by,

and acting on behalf of, investors34

As a result, Congress directed the SEC to facilitate

the establishment of (1) a national system for the

prompt and accurate clearance and settlement of

transactions in securities (other than exempt securities) and (2) linked or coordinated facilities for clearance and settlement of transactions in securities,

securities options, contracts of sale for future delivery

and options thereon, and commodity options.35 In

using its authority, the SEC must consider the public

interest, the protection of investors, the safeguarding

of securities and funds, and the maintenance of fair

competition among brokers and dealers, clearing

agencies, and transfer agents.36

31 See also Exchange Act Release No. 16900 (“Standards

Release”) (June 17, 1980), 20 FR 416 (July 1, 1980). The Standards Release provides SEC staff guidance pertaining to standards for the registration of clearing agencies based on the criteria set forth in the Exchange Act.

32 The Act amended Section 36 of the Exchange Act and altered

the SEC’s authority to provide exemptions from the registration requirements applicable to security-based swap clearing

agencies pursuant to Section 17A(g) of the Exchange Act. See

Section 772 of Pub. L. No. 111-203, 124 Stat. 1376 (2010)

amending Section 36 of the Exchange Act.

33 See 15 U.S.C. 78q-1(a)(1).

34 See 15 U.S.C. 78q-1(a)(2)(A).

35 See 15 U.S.C. 78q-1(b)(3)(A)-(I).

36 Sections 17A and 36 of the Exchange Act provide the SEC

with authority to conditionally or unconditionally exempt

clearing agencies from registration. Certain clearing agencies

that clear credit default swaps are operating under temporary

conditional exemptions that are set to expire on July 16, 2011,

when relevant provisions regarding their registration will

become effective under the Act. See Exchange Act Release

Nos. 60372 (July 23, 2009), 74 FR 37748 (July 29, 2009), 61973

(April 23, 2010), 75 FR 22656 (April 29, 2010) and 63389

(November 29, 2010), 75 FR 75520 (December 3, 2010) (CDS

clearing by ICE Clear Europe Limited); 60373 (July 23, 2009),

74 FR 37740 (July 29, 2009), 61975 (April 23, 2010), 75 FR

22641 (April 29, 2010) and 63390 (November 29, 2010), 75 FR

75518 (December 3, 2010), (CDS clearing by Eurex Clearing

AG); 59578 (March 13, 2009), 74 FR 11781 (March 19, 2009),

61164 (December 14, 2009), 74 FR 67258 (December 18,

19
Supervisory Processes and Tools

Application Review

The SEC’s oversight of CAs begins with a CA’s

application for registration, and continues following

registration through a review of rule filings submitted to the SEC, examinations by the SEC, and periodic monitoring of the CA’s risk management framework and operations.37 To register with the SEC, a

CA must submit a Form CA-1, which includes pertinent information regarding the operations of the

CA.38 When a Form CA-1 is filed, the SEC publishes

notice of the filing in the Federal Register and then

must either (1) grant the registration or (2) institute a

proceeding to determine whether such application

should be denied.39

Section 17A of the Exchange Act specifically sets

forth a list of standards, including those regarding a

CA’s organization and capacity, and rules that a CA

must comply with prior to having its application for

registration granted. All registered CAs must comply

with the standards in Section 17A, which include, but

are not limited to, maintaining rules for promoting

the prompt and accurate clearance and settlement of

securities transactions; assuring the safeguarding of

securities and funds which are in the custody or control of the CA or for which it is responsible; fostering

cooperation and coordination with persons engaged

in the clearance and settlement of securities transactions; removing impediments to, and perfecting the

mechanism of a national system for, the prompt and

accurate clearance and settlement of securities transactions; and, in general, protecting investors and the

public interest.40 A registered CA is also required to

provide fair access to clearing and to have the capacity to facilitate the prompt and accurate clearance

and settlement of securities transactions and derivative agreements, contracts, and transactions for which

it is responsible, as well as to safeguard securities and

funds in its custody or control or for which it is

responsible.41

When considering a request for registration, the SEC

typically reviews and evaluates the rules, policies, and

procedures of the CA for compliance with the

Exchange Act. This review includes, as appropriate,

an examination of proposed rules and supplementary

information on membership standards; representation of CA members in the management and operations of the CA; and a review of information related

to margin, financial resources, risk management,

default management, liquidity, safeguarding of

funds, and operational capacity.42

After registering with the SEC, CAs are required

under Section 19(b) of the Exchange Act to file with

the SEC copies of any proposed rule or any proposed

change in, addition to, or deletion from the CA’s

rules.43 The SEC reviews all proposed rule changes

and publishes them for comment.44 Many proposed

rule changes are required to be approved by the SEC

prior to going into effect;45 however, certain limited

types of proposed rule changes may be immediately

effective upon filing with the SEC.46 When reviewing

a proposed rule change, the SEC considers the submissions of the CA and any comments received on

2009), 61803 (March 30, 2010), 75 FR 17181 (April 5, 2010)

and 63388 (November 29, 2010), 75 FR 75522 (December 3,

2010) (CDS clearing by Chicago Mercantile Exchange Inc.);

59527 (March 6, 2009), 74 FR 10791 (March 12, 2009), 61119

(December 4, 2009), 74 FR 65554 (December 10, 2009), 61662

(March 5, 2010), 75 FR 11589 (March 11, 2010) and 63387

(November 29, 2010) 75 FR 75502 (December 3, 2010) (CDS

clearing by ICE Trust US LLC). Certain other clearing agencies are also currently operating under exemptions. See, e.g.,

Exchange Act Release No. 44188 (April 17, 2001), 66 FR

20494 (April 23, 2001) (order conditionally exempting Omgeo

Matching Services -US, LLC from CA registration with regard

to providing matching and confirmation/affirmation services).

37 Form CA-1 is used for initial registrations, requests for exemptions from registration, and amendments to existing registrations. 17 CFR §249b.200 Schedule A.

38 See 15 U.S.C. 78s(b).

39 See 15 U.S.C. 78q-1(b)(3)(F). Section 17A of the Exchange Act

also includes standards that help to mitigate conflicts of

interest.

40 See 15 U.S.C. 78q-1(b)(3)(A), (B), and (F).

41 See 15 U.S.C. 78q-1 and 17 CFR § 249b.200 Schedule A.

42 See 15 U.S.C. 78s(b)(1).

43 Title VIII of the Act contemplates an additional process

whereby changes to operating procedural rules related to

changes in material risks also need to be submitted to the

Supervisory Agency under a separate notice process.

44 See 15 U.S.C. 78s(b)(2) (establishing the statutory time frame

by which the SEC must either approve, disapprove or institute

proceedings with respect to a proposed rule change filing). See

also 12 U.S.C. 5465(e) (requiring all FMUs designated as systemically important by the Financial Stability Oversight Council to provide 60 days in advance notice to its Supervisory

Agency of “any proposed change to its rules, procedures, or

operations that could, as defined in rules of each Supervisory

Agency, materially affect the nature or level of risks presented

by the designated financial market utility.”)

45 See 15 U.S.C. 78s(b)(3)(A) (setting forth the types of proposed

rule changes that are permitted to take effect immediately upon

filing with the SEC and without the notice and approval procedures required by Section 19(b)(2) of the Exchange Act). The

SEC may temporarily suspend those rule changes within 60

days of filing and institute proceedings to determine whether

to approve or disapprove the rule changes. 15 U.S.C.

78s(b)(3)(C).

46 See 15 USC 78q-1(d). In addition, Title VII and Title VIII of

the Act also provide the SEC with certain rulemaking authority concerning CAs. See Pub, L. No. 111-203, 124 Stat. 1376

(2010).

20 Risk Management Supervision of Designated Clearing Entities
the proposed change in making a determination of

whether the proposed rule change is consistent with

the requirements of the Exchange Act. Section 17A

also gives the SEC authority to adopt rules for CAs

as necessary or appropriate in the public interest, for

the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act, and prohibits a registered CA from engaging in any activity

in contravention of these rules and regulations.47

This rulemaking authority may be used by the SEC

to provide appropriate standards concerning CA

activities.

Examinations

The SEC’s staff conducts examinations of CAs. As

an initial step of the examination, the SEC staff

assesses existing and emerging risks to identify areas

for review. The review areas may include an examination of corporate governance, internal controls, membership, ongoing member financial surveillance,

clearing fund sizing, margin models, risk management systems, capitalization and liquidity, and other

critical processes. SEC staff assesses the CA’s compliance with applicable statutory and regulatory

requirements and the CA’s oversight of participant

compliance with its rules.

The SEC staff also conducts regular inspections and

examinations of CAs’ compliance with the SEC’s

Automation Review Policy statements, which cover

the technological infrastructure of trading systems

and clearing agencies.48 These inspections focus on

market systems capacity, vulnerability assessments,

business continuity, and new software development,

and specifically assess information technology governance, application controls, systems development

methodology, information security, business continuity planning, systems capacity planning, computer

operations, outsourcing, and internal audit functions

of the CA.

After completing an examination, SEC staff compiles an examination report that contains a description of the review, analysis, conclusions, and recommendations. The SEC staffs’ examination conclusions are communicated to the CA through an exit

interview and through the issuance of a letter to the

CA that summarizes the conclusions and recommendations. The SEC staff expects the CAs to respond in

writing and address all issues, conclusions, and recommendations identified in the course of the examination. Through its examinations and, where applicable, ongoing monitoring procedures (described

below), the SEC staff works closely with the CA to

ensure all findings are addressed in a timely manner.

Ongoing Monitoring

The SEC staff participates in a variety of ongoing

monitoring reviews focused on governance and risk

frameworks and processes. As part of this process,

the SEC staff reviews a CA’s governance framework,

which may include compliance processes; internal

audit findings and resolution; board of directors

interaction; and risk management framework, including new products/initiative review and approvals,

margin methodology, back-testing and stress-testing

procedures, risk monitoring practices, model governance practices, and the sizing and allocation of total

financial resources.

Enforcement

Through the CA registration and rule filing process,

as well as the subsequent monitoring and surveillance

of the CA’s structure, functions, and operations, the

SEC is able to conduct thorough reviews, examinations, and monitoring of CAs to facilitate the establishment of a national system for the prompt and

accurate clearance and settlement of securities

transactions.

Finally, pursuant to Section 21(a) of the Exchange

Act, the SEC may initiate and conduct investigations

to determine if there have been violations of the fed47 See Exchange Act Release Nos. 27445 (November 16, 1989), 54

FR 48704, and 29815 (May 9, 1991), 56 FR 22489.

48 Section 1a(15) of the CEA, 7 U.S.C. 1a(15), defines a “derivatives clearing organization” as:

(A) IN GENERAL.- The term “derivatives clearing organization” means a clearinghouse, clearing association, clearing corporation, or similar entity, facility, system, or organization

that, with respect to an agreement, contract, or transaction-

(i) enables each party to the agreement, contract, or transaction to substitute, through novation or otherwise, the credit of

the derivatives clearing organization for the credit of the parties; (ii) arranges or provides, on a multilateral basis, for the

settlement or netting of obligations resulting from such agreements, contracts, or transactions executed by participants in

the derivatives clearing organization; or (iii) otherwise provides

clearing services or arrangements that mutualize or transfer

among participants in the derivatives clearing organization the

credit risk arising from such agreements, contracts, or transactions executed by the participants.

(B) EXCLUSIONS. – The term “derivatives clearing organization” does not include an entity, facility, system, or organization solely because it arranges or provides for – (i) settlement,

netting, or novation of obligations resulting from agreements,

contracts, or transactions, on a bilateral basis and without a

central counterparty; (ii) settlement or netting of cash payments through an interbank payment system; or (ii) settlement,

netting, or novation of obligations resulting from a sale of a

commodity in a transaction in the spot market for the

commodity.

July 2011 21
eral securities laws, including those specifically applicable to CAs. Following an investigation, the SEC

has the authority to institute civil actions seeking

injunctive and other equitable remedies and/or

administrative proceedings to, among other things,

suspend or revoke registration; impose limitations

upon a CA’s activities, functions, or operations; or

impose other sanctions, such as undertakings.

CFTC Supervisory Program for

Derivatives Clearing Organizations

Section 5b of the CEA, 7 U.S.C. 7a-1, requires a

DCO to register with the CFTC, and sets forth the

Core Principles with which the DCO must comply in

order to obtain and maintain its registration.49 There

are 18 Core Principles. The Core Principles address

compliance, financial resources, participant and

product eligibility, risk management, settlement procedures, treatment of funds, default rules and procedures, rule enforcement, system safeguards, reporting, recordkeeping, public information, information

sharing, antitrust considerations, governance fitness

standards, conflicts of interest, composition of governing boards, and legal risk.

Section 5c(c) of the CEA, 7 U.S.C. 7a-2(c), governs

the procedures for review and approval of new products, new rules, and rule amendments submitted to

the CFTC by a DCO.

Part 39 of the CFTC’s Regulations, 17 CFR Part 39,

implements Sections 5b and 5c(c) of the CEA by

establishing specific requirements for compliance

with the Core Principles as well as procedures for registration and for implementing DCO rules and clearing new products. Part 40 of the CFTC’s Regulations, 17 CFR Part 40, sets forth additional provisions applicable to a DCO’s submission of rule

amendments and new products to the CFTC.

Supervisory Objectives

The primary objective of the CFTC supervisory program is to ensure compliance with applicable provisions of the CEA and implementing regulations, and

in particular, the Core Principles applicable to DCOs.

The CFTC program takes a risk-based approach.

Supervisory Processes and Tools

Application Review

In order to register with the CFTC as a DCO, an

organization must submit an application in the form,

and containing the information, specified by the

CFTC demonstrating that it complies with the Core

Principles.50 Within 180 days of the submission, the

CFTC will approve or deny the application or register the applicant subject to conditions.51 During that

review period, the CFTC should conduct an on-site

review of the prospective DCO’s facilities, ask a

series of questions, and review all documentation

received.

Rule Changes

Under the CEA as amended by the Act, a DCO may

implement a new rule or rule amendment ten business days after providing to the CFTC a written certification that the new rule or rule amendment complies with the CEA and CFTC regulations.52 The

CFTC may stay the certification of a new rule or rule

amendment for up to 90 days after notifying the

DCO that (1) novel or complex issues require additional time to analyze; (2) the DCO has submitted an

inadequate explanation of the rule; or (3) the rule is

potentially inconsistent with the CEA or the CFTC’s

regulations. During the stay, the CFTC must provide

a public comment period for a minimum of 30 days.

If the CFTC has not previously withdrawn the stay,

the rule or rule amendment will become effective

after the expiration of 90 days, unless the CFTC has

determined that the rule or rule amendment is inconsistent with the CEA or CFTC regulations.

A DCO may also request CFTC approval of any new

rule or rule amendment either before or after it has

become effective.53 The rule or rule amendment will

be deemed approved 45 days after receipt of the

request by the CFTC, unless the DCO has been notified otherwise. The CFTC may extend the review

period for an additional 45 days if it finds that the

rule or rule amendment raises novel or complex

issues that require additional time for review or that

the rule or rule amendment is of major economic significance. The CFTC must approve a new rule or rule

49 See CEA §5b, 7 U.S.C. 7a-1.

50 If the application is materially incomplete, the CFTC may stay

the running of that 180-day period. See 17 CFR 39.3.

51 If the new rule or rule amendment involves a futures or

options on futures contract on a government security, the

DCO must also provide a copy of the certification to the Secretary of the Treasury. See CEA §5c(c), 7 U.S.C. 7a-2(c).

52 See CEA §5c(c), 7 U.S.C. 7a-2(c); 17 CFR 40.5.

53 See 17 CFR 40.6.

22 Risk Management Supervision of Designated Clearing Entities
amendment unless it finds that the new rule or rule

amendment is inconsistent with the CEA or the

CFTC’s regulations.

The CFTC retains the authority to stay the effectiveness of a rule that has already been implemented pursuant to self-certification procedures during the pendency of a CFTC proceeding for filing a false certification or a CFTC proceeding to itself alter or amend

the rule pursuant to Section 8a(7) of the CEA,

7 U.S.C. 12a(7).54

Ongoing Monitoring

CFTC risk surveillance staff monitors the risks

posed to and by DCOs, clearing members, and market participants, including market risk, liquidity risk,

credit risk, and concentration risk. This analysis

includes reviews of daily, large trader reporting data

obtained from market participants, clearing members, and DCOs, which is accessible at the trader,

clearing member, and DCO levels. Relevant margin

and financial resources are also included within the

analysis.

CFTC staff regularly conducts back-testing to review

margin coverage at the product level and follows up

with the relevant DCO regarding any exceptional

results. Independent stress testing of portfolios is

conducted on a daily, weekly, and ad hoc basis. The

independent stress tests may lead to individual trader

reviews and/or futures commission merchant (FCM)

risk reviews to gain a deeper understanding of a trading strategy, risk philosophy, risk controls and mitigants, and financial resources at the trader and/or

FCM level. The traders and FCMs that have a higher

risk profile are then reviewed during the CFTC’s

on-site review of a DCO’s risk management

procedures.

Examinations

The CFTC conducts examinations (under the Act,

for DCEs, this will be on an annual basis) and the

scheduling and scope-setting for these examinations

are risk-based in nature. During the planning phase

of an examination, staff considers results of analysis

by the CFTC’s risk surveillance functions, the previous examination report, the DCO’s financial statements, and changes in the DCO’s business. Should an

issue identified within the prior examination be

deemed as material or recurring, a follow-up review

on this topic will be included within the current

examination. Staff reviews financial statement data

received since the last examination for trends or

potential concerns. Information obtained either

through public news agencies or through private conversations with DCO staff is considered in order to

assess potential risk to the DCO. Typical Core Principles targeted on a regular basis within these examinations include those relating to financial resources,

risk management, settlement procedures, treatment

of funds, default rules and procedures, and system

safeguards.

After consideration of the factors described above,

an independent, comprehensive, and timely scope of

the examination is determined. Typically, a Scope

Memo is created along with a Supervisory Plan and

Examination Program. These documents ensure all

available information is considered, appropriate areas

are targeted, and specific review criteria are determined. An Engagement Letter is sent to the DCO

with an Initial Document Request List.

CFTC examination teams include risk analysts, DCO

analysts, and legal specialists. Teams range from three

to four individuals for the smallest DCO, to ten to

twelve individuals for the largest DCO. CFTC examinations are cross-functional and include staff from

the Division of Clearing and Intermediary Oversight’s Clearing Policy Group, Risk Surveillance

Group, and DCO Review Group. Joint examinations

may be conducted with the SEC when appropriate.

The examination team participates in a series of

meetings with the DCO at its facility. CFTC staff

communicates extensively with relevant DCO staff,

including senior management, and reviews documentation following the guidelines established within the

examination Scope Memo. Independent testing of

the data produced by the DCO is included within the

examination process. When relevant, walk-through

testing is conducted for key DCO processes.

Upon completion of the examination, staff drafts a

report to the CFTC. This report summarizes general

information regarding the DCO, the scope of the

current review, key elements of the examination, and

the results of the examination, including any issues of

concern. In addition, an Exam Report is created and

distributed to key individuals, including the DCO’s

senior management.

Enforcement

Deficiencies noted within the Exam Report are communicated to the DCO prior to the issuance of the

report. Various measures are used by the CFTC to 54 See CEA §6c, 7 U.S.C. 13a-1.

July 2011 23
assure that the DCO appropriately addresses such

issues, including escalating communications within

the DCO management and requiring the DCO to

demonstrate, in writing, timely correction of such

issues. The CFTC has additional means to enforce

compliance, including the CFTC’s ability to sue the

DCO in federal court for civil monetary penalties,55

issue a Cease and Desist order,56 or suspend or

revoke the registration of the DCO.57

Federal Reserve Supervisory Program

for FMUs

A financial market utility (FMU) that is a statelicensed bank (including trust companies) may apply

to the Board to become a member of the Federal

Reserve System. Under the Federal Reserve Act, as a

condition of membership, state member banks are

subject to examinations made at the direction of the

Board or the Federal Reserve Bank by examiners

selected or approved by the Board.58 In addition to

FMUs that are state-licensed member banks, the

Federal Reserve has supervisory authority over

FMUs that are Edge or agreement corporations;

uninsured, state-licensed branches and agencies of

foreign banks; bank holding companies and their

non-depository-institution subsidiaries; and, as of

July 21, 2011, savings and loan holding companies

and their non-depository-institution subsidiaries.

Under the Bank Service Company Act, the Board

participates with the other bank regulatory agencies

in supervising certain nonbank service companies

under the auspices of the Federal Financial Institutions Examination Council.59

In addition to its statutory supervisory authority, the

Board’s Policy on Payment System Risk outlines

principles and minimum standards regarding risk

management in payment and settlement systems,

including those operated by Federal Reserve Banks.

The Board is guided by this policy when exercising its

authority in supervising FMUs for which it is the primary regulator. Where the Board does not have

exclusive authority over systems covered by the

policy, it works with other domestic and foreign

financial system authorities to promote effective risk

management in these systems.

Supervisory Objectives

With regard to FMUs supervised by the Federal

Reserve, the primary objective of the supervisory

program is to evaluate the safety and soundness of

the entity. Safety and soundness is the overall stability, health, and condition of the FMU. An evaluation

of safety and soundness is risk-based, with the goal

of identifying the inherent risks of an FMU and

assessing the FMU’s ability to identify, measure,

monitor, and control those risks against relevant risk

management standards adopted by the Board in its

Payment System Risk Policy as well as other riskbased supervisory guidance. The evaluation also

includes an assessment of the FMU’s internal audit

and controls as well as compliance with applicable

banking laws and regulations.

Supervisory Processes and Tools

The evaluation of safety and soundness is implemented through an annual supervisory cycle that

begins with a formal risk assessment of the institution and includes thorough, risk-focused on-site

examinations, effective off-site surveillance, relevant

information collection and sharing with other supervisors, and cross-functional analysis with internal

experts. These tools and processes are discussed

below. The Federal Reserve places particular emphasis on on-site examinations and active dialogue with

FMU board and management and maintains a continual presence on-site at the FMU.

The purpose of gathering information using the various tools and processes is to evaluate whether the

FMU has a sound risk framework for comprehensively managing legal, credit, liquidity, operational,

and other risks. Specific aspects of these risks that

are measured include, but are not limited to, the

following:

Legal Risk

• a review of the laws and regulations that govern

property, contracts, insolvency, banking, secured

interests, insolvency, and investor protection in

relation to the FMU’s activity to ensure that the

FMU has a well-founded legal basis for its

operations

• an evaluation of whether the rights and interests of

participants are clearly articulated in the FMU’s

policies and the legal underpinnings of FMU

operations (e.g., settlement finality, netting, novation, procedures for participant default)

55 See CEA §6b, 7 U.S.C. 13a.

56 See CEA §5e, 7 U.S.C. 7b.

57 12 U.S.C.USC 325.

58 12 U.S.C. 325, 12 U.S.C.USC 1867.

59 12 U.S.C. 325, 12 U.S.C.USC 1867.

24 Risk Management Supervision of Designated Clearing Entities
Credit Risk

• an evaluation of FMU monitoring and managing

of credit risks from participants and from its settlement processes

• an evaluation of adequacy of financial resources to

cover potential losses by

—assessing the FMU’s framework for credit risk

management oversight, ensuring the adequacy of

participant membership requirements and collateral and margining arrangements

—assessing the procedures used by the FMU to

measure and test its current and potential exposures and ensuring sufficient liquid resources are

available to cover those exposures

—evaluating the governance process used by the

FMU to assess the models that it uses to set margin levels and to plan for default scenarios

Liquidity Risk

• an evaluation of whether the FMU is determining

total expected and plausible liquidity needs, available resources and arrangements to meet these

needs, and testing of the reliability of resources

and arrangements by ensuring that the FMU:

—produces periodic liquidity-needs reports that

measure its worst-case liquidity risk needs,

including (at least) the assumption of an affiliated family default, no incoming payments for

those defaulting members, and extreme price

moves

—describes its needs against its resources, its ability

to access cash and committed arrangements to

convert noncash assets into cash, and any

uncommitted arrangements the FMU relies on

for this purpose

—tests such arrangements and articulates contingency plans in the event one or more arrangements do not work

Operational Risk

• an evaluation of the procedures that the FMU has

for identifying operational risk from external and

internal sources and the policies, procedures, and

controls put in place to mitigate those risks,

including:

—reviewing the FMU’s internal controls and internal audit review

—ensuring that the FMU does periodic systems

testing

—assessing the quality of operations personnel

—ensuring there are formal change-management

procedures, benchmarks for operational reliability, and documentation for operational incidents

—ensuring sufficient systems-processing capacity

—assessing the FMU’s information security

program

—ensuring the FMU has a business continuity

plan that is periodically tested as well as crisis

management procedures

—assessing the continuity of technology links to

participants and service providers

—reviewing the FMU’s process for monitoring

outsourcing arrangements

Examinations and Control Testing

The scope of examination work and control testing, which are conducted on-site and off-site, are

determined by focusing on areas of higher risk.

This process identifies the risk areas to be reviewed,

as well as fully supporting key supervisory issues to

be examined or controls to be tested. The scope of

supervisory work to be conducted is vetted by the

Board and the Reserve Banks in order to ensure an

opportunity for relevant parties to provide insights

regarding the risks and controls being evaluated

and to ensure consistency in the supervisory

approach. The scoping process is formally documented through a scope memorandum and is

supplemented with an entry letter to the FMU that

serves as the examination document/meeting

request.

An examination includes transaction testing and

validation to assess risk control processes or validate management’s assertions around business

activities and related risk mitigation mechanisms.

Supervisory findings and/or concerns are communicated on a regular basis to the FMU. Outstanding issues and concerns, as well as any corrective

actions, are appropriately tracked and raised with

the FMU.

Ongoing Monitoring

Ongoing monitoring takes several forms. One piece

consists of validating the FMU’s processes for

identifying and managing risks related to new

product development and changes in business practices and services. Another piece consists of ensurJuly 2011 25
ing the FMU is continually identifying and measuring risk, including a mechanism for ensuring

regular, ongoing interaction and discussion with

the FMU’s board of directors, senior business

leaders, and risk control leadership. This discussion

focuses on both mitigating risks within the firm as

well as related financial market systemic risk. The

continuous monitoring process also includes regularly reviewing and assessing corporate governance

and committee records and documentation, transaction and risk management reports, compliance

reports, internal audit reports, and any other

reports deemed necessary to critically evaluate the

safety and soundness of the FMU and to ensure

strong and independent risk management functions

are in place.

Information Sharing

The supervisory program includes regular sharing,

and responding timely to requests for, supervisory

information between the relevant supervisory agencies, including relevant foreign authorities.

26 Risk Management Supervision of Designated Clearing Entities