
[Federal Register Volume 80, Number 93 (Thursday, May 14, 2015)]
[Notices]
[Pages 27798-27801]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-11595]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-74917; File No. SR-ICC-2015-004]


Self-Regulatory Organizations; ICE Clear Credit LLC; Order 
Approving Proposed Rule Change Relating to Physical Settlement of CDS 
Contracts

May 8, 2015.

I. Introduction

    On March 11, 2015, ICE Clear Credit LLC (``ICC'') filed with the 
Securities and Exchange Commission (``Commission'') the proposed rule 
change SR-ICC-2015-004 pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder.\2\ The 
proposed rule change was published for comment in the Federal Register 
on March 27, 2015.\3\ The Commission received one comment.\4\ For the 
reasons discussed below, the Commission is approving the proposed rule 
change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Securities Exchange Act Release No. 34-74563 (Mar. 23, 
2015), 80 FR 16471 (Mar. 27, 2015) (File No. SR-ICC-2015-004).
    \4\ See Comment from Kermit Kubitz, dated April 17, 2015, 
available at https://www.sec.gov/comments/sr-icc-2015-004/icc2015004-1.htm.
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II. Description of the Proposed Rule Change

    ICC proposes to amend its rules to modify the terms and conditions 
for physical settlement of cleared CDS Contracts, and to adopt certain 
new delivery procedures relating to physical settlement.
    Under the current terms of the ICC Clearing Rules (``ICC Rules''), 
upon the occurrence of a credit event under a cleared CDS Contract, the 
contract is typically settled in cash in accordance with the terms of 
the ICC Rules, which incorporate the applicable ISDA Credit Derivatives 
Definitions (the ``ISDA Definitions'') and the market-standard credit 
default swap auction methodology for determining the cash settlement 
price. However, in certain circumstances, such as where the Credit 
Derivatives Determinations Committee decides not to hold a cash 
settlement auction for a particular credit event, or such an auction is 
cancelled under the terms of the auction methodology (including because 
of a failure to determine the auction settlement price), the CDS 
Contracts provide for a fallback settlement method of physical 
settlement. Under physical settlement of a CDS contract generally, the 
protection buyer will be entitled to deliver one or more qualifying 
deliverable obligations to the protection seller, in which case the 
protection seller will be required to pay the protection buyer a 
defined physical settlement amount. Under the current ICC Rules, if 
physical settlement applies,\5\ ICC will match clearing participants 
(``Participants'') that are protection buyers with Participants that 
are protection sellers in the relevant contract, and the two 
Participants will be responsible for effecting physical settlement 
between them. ICC does not itself perform or guarantee performance of 
physical settlement between the matched Participants. Once matching 
occurs, the contract is purely a bilateral contract between the matched 
Participants, and ICC has no further rights or obligations with respect 
to the contract. ICC does, however, collect and hold physical 
settlement margin as collateral agent on behalf of the protection buyer 
to secure the protection seller's obligations to the protection buyer 
under physical settlement.
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    \5\ ICC notes that to date, physical settlement has not been 
necessary for any of the CDS Contracts cleared by ICC.
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    ICC proposes to amend the ICC Rules relating to physical settlement 
such that ICC will be responsible for financial performance of physical 
settlement. ICC notes that under the amended approach, it would still 
require payments and deliveries in the ordinary course under physical 
settlement to be made directly between the matched buying Participant 
and selling Participant, with ICC only being obligated to make direct 
payments in the case of certain defined settlement failure scenarios. 
ICC believes that this proposed rule change will further the general 
policy goals of central clearing for CDS transactions, and is 
consistent with ICC's financial resources, risk management procedures 
and operational capabilities.\6\
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    \6\ ICC notes that a substantially similar approach to physical 
settlement is used in the ICE Clear Europe Limited CDS clearing 
service.
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    ICC proposes to make certain amendments to Chapters 1, 4, 5, 21 and 
22 of the ICC Rules. ICC also proposes

[[Page 27799]]

to adopt a related set of Delivery Procedures and Physical Settlement 
and Notices Terms. Furthermore, ICC also proposes to make certain 
related and conforming changes to its Risk Management Framework. All 
capitalized terms not defined herein are defined in the ICC Rules.
    In Chapter 1 of the ICC Rules, ICC proposes to amend the definition 
of ``Client-Related Initial Margin'' so that it now includes Physical 
Settlement Margin collected with respect to Client-Related Positions. 
As discussed below, according to ICC, such Physical Settlement Margin 
is intended to secure the obligations of a Participant to ICC in 
connection with physical settlement. Similarly, in Rule 403, ICC 
proposes to amend the definition of ``Physical Settlement Margin'' to 
refer to such obligations to ICC (as opposed to the obligations to the 
matched Participant under the current ICC Rules). In Rule 502(b), a 
conforming reference to Physical Settlement Margin will be updated. A 
conforming change is also made in Rule 2101-02(a)(iv).
    ICC proposes changes to Chapter 22 (which covers physical 
settlement) by adding a new Rule 2200 with definitions relating to the 
revised physical settlement provisions, including ``Matched Delivery 
Buyer'' and ``Matched Delivery Seller,'' and the related terms 
``Matched Delivery Contract,'' ``Matched Delivery Buyer Contract,'' 
``Matched Delivery Seller Contract'' and ``MP Delivery Amount.'' As 
discussed below, these terms are used in connection with the matching 
of buying Participants and selling Participants in the revised 
settlement procedures. A new definition of ``Asset Package Delivery 
Notice'' has also been added to address notices in connection with 
Asset Package delivery under the 2014 ISDA Credit Derivatives 
Definitions (the ``2014 ISDA Definitions'').
    According to ICC, Rule 2201(a), which provides for matching of 
buying Participants and selling Participants into a Matched Delivery 
Pair in the case of physical settlement, will be revised to address 
scenarios where a Participant's CDS contracts must be split and matched 
with multiple other Participants for purposes of physical settlement. 
Conforming changes to use applicable defined terms (such as Relevant 
Restructuring Credit Event) will also be made. Rule 2201(b), which 
addresses delivery of certain notices between a Matched Delivery Pair, 
will be revised to include references to Asset Package Delivery 
Notices. Rule 2201(c) will be deleted at the request of Participants as 
being inconsistent with the terms of uncleared CDS and unnecessary in 
light of the provisions of the ISDA Definitions and Rule 2202.
    ICC also proposes changes to Rule 2202, which addresses resolution 
of disputes related to permissible deliverable obligations, in order to 
incorporate the concept of Asset Package Delivery under the 2014 ISDA 
Definitions, as well as related concepts of Prior Deliverable 
Obligations, Package Observable Bonds and Asset Package Delivery 
Notices. Rules 2202(b) and (c) will also be revised to address the 
consequences of a selling Participant's refusal to accept delivery of a 
particular obligation, including for the offsetting transaction between 
ICC and the buying Participant.
    Rule 2203 will be replaced with new provisions addressing ICC's 
role in physical settlement. When a Matched Delivery Pair is 
established, the CDS Contract between the Matched Delivery Buyer and 
ICC will be referred to as the Matched Delivery Buyer Contract, and the 
corresponding CDS Contract between ICC and the Matched Delivery Seller 
will be referred to as the Matched Delivery Seller Contract. Under the 
revised physical settlement approach, ICC intends to remain party to 
each such contract, but will require certain notices, payments and 
deliveries to take place directly between the Matched Delivery Buyer 
and Matched Delivery Seller. Accordingly, under Rule 2203(a), for each 
Matched Delivery Buyer Contract, ICC will designate the Matched 
Delivery Seller to receive on ICC's behalf notices and deliveries from 
the Matched Delivery Buyer and to make payments on ICC's behalf to the 
Matched Delivery Buyer. Similarly, under Rule 2203(b), for each Matched 
Delivery Seller Contract, ICC will designate the Matched Delivery Buyer 
to deliver on ICC's behalf notices and deliveries to the Matched 
Delivery Seller, and to receive on ICC's behalf payments from the 
Matched Delivery Seller. The result is that notices, payments and 
deliveries will be made directly between the Matched Delivery Buyer and 
Matched Delivery Seller, in satisfaction of the parties and ICC's 
respective obligations under both the Matched Delivery Buyer Contract 
and Matched Delivery Seller Contract. Rule 2203(c) further clarifies 
that the exercise of rights by Matched Delivery Buyer against ICC will 
be deemed the exercise by ICC of the corresponding rights against 
Matched Delivery Seller, and vice versa. Rules 2203(d) and (e) will 
provide for copies of relevant notices to be provided to ICC, as well 
as notice of the completion of settlement between the Matched Delivery 
Buyer and Matched Delivery Seller. Rule 2203(f) will clarify the 
obligations of the respective parties to a Matched Delivery Contract, 
and address a scenario where an Asset Package being delivered is deemed 
to have a value of zero under the 2014 ISDA Definitions. Rule 2203(g) 
will allocate costs and expenses that may be incurred by ICC in 
connection with physical settlement.
    Rule 2204, as revised, will address physical settlement of certain 
deliverable obligations that do not settle in the ordinary course on a 
delivery-versus-payment basis (``Non-DVP Obligations''). The rule 
establishes a procedure under which the Matched Delivery Seller will 
pay the physical settlement amount owed to ICC, which in turn will not 
pay such amount to the Matched Delivery Buyer until ICC receives notice 
that the obligation has been received by the Matched Delivery Seller 
from the Matched Delivery Buyer. If the obligation is not delivered, 
the physical settlement amount will be returned to the Matched Delivery 
Seller.
    ICC states that Rule 2205 will address settlement failures by the 
Matched Delivery Seller or Matched Delivery Buyer. Under subsection 
(a), if the Matched Delivery Seller fails to pay the physical 
settlement amount when due, the Matched Delivery Buyer Contract will be 
cash settled as between the Matched Delivery Buyer and ICC. ICC thus 
will not be obligated to take delivery of the relevant deliverable 
obligations (and dispose of them in a situation where the Matched 
Delivery Seller has failed to perform), but will compensate the Matched 
Delivery Buyer for the value of the Matched Delivery Buyer Contract 
through the cash settlement process. Pursuant to subsection (b), ICC 
may, in addition to its other default remedies, terminate the Matched 
Delivery Seller Contract, in which case the Matched Delivery Seller 
will owe ICC an amount equal to the cash settlement amount ICC paid the 
Matched Delivery Buyer, together with other losses and expenses 
incurred by ICC as a result of the failure. Rule 2205(c) provides that, 
consistent with the terms of the ISDA Definitions applicable to a 
protection buyer generally, any failure by ICC to deliver any 
deliverable obligations to the Matched Delivery Seller (including as a 
result of a failure by the Matched Delivery Buyer to make a delivery) 
will not constitute a default by ICC, and the Matched Delivery Seller's 
sole remedy will be as set forth in the Matched Delivery Seller 
Contract (which may include, for example, buy-in remedies of the 
Matched Delivery Seller). ICC will not have any obligation to purchase 
or

[[Page 27800]]

acquire deliverable obligations (other than in settlement of the 
Matched Delivery Buyer Contract) in order to settle the Matched 
Delivery Seller Contract. In the event of a delivery failure by a 
Matched Delivery Buyer, such party will be liable to ICC for any costs 
incurred by ICC in settling the corresponding Matched Delivery Seller 
Contract (in addition to ICC's other remedies for a default).
    According to ICC, the changes to Rule 2206 are to cover certain 
other, non-default scenarios in which physical settlement fails to 
occur. Under Rules 2206(a) and (b), if physical settlement of the 
Matched Buyer Delivery Contract does not occur because the deliverable 
obligation is in less than the relevant minimum denomination or the 
Matched Delivery Seller is not a permitted transferee of the 
obligation, the failure will be treated as an illegality or 
impossibility outside of the parties' control, which will result in 
cash settlement \7\ under the ISDA Definitions. In this and other 
scenarios where a cash settlement fallback applies, the same cash 
settlement amount will apply to both the Matched Delivery Buyer 
Contract and Matched Delivery Seller Contract under Rule 2206(c). 
Similarly, in the case of a buy-in, the same buy-in price will apply to 
both contracts. Rule 2206(d) will provide for cash settlement of both 
the Matched Delivery Buyer Contract and Matched Delivery Seller 
Contract in certain cases where delivery does not occur between the 
Matched Delivery Buyer and the customer for which it is acting. Rule 
2206(e) specifies the date of any cash settlement and provides for 
notice of the relevant amount owed.
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    \7\ Cash settlement in this context is different from the 
auction cash settlement that normally applies to CDS contracts under 
the ISDA Definitions, and is based on price quotations obtained by 
the relevant party to the contract for the obligation or obligations 
that cannot be delivered.
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    According to ICC, Rule 2207(a) will provide for certain standard 
representations and related provisions for physical settlement in the 
ISDA Definitions to apply as between the Matched Delivery Buyer and 
Matched Delivery Seller, and will clarify ICC's authority to designate 
a Participant to make or receive physical settlement on its behalf as 
provided in Rules 2203 and 2204 for purposes of Section 9.2(c)(iv) of 
the 2003 ISDA Credit Derivatives Definitions or Section 11.2(c)(iv) of 
the 2014 ISDA Definitions, even though the Participant is not its 
Affiliate. Rule 2207(b) will clarify certain procedures for obtaining 
price quotations for the relevant deliverable obligations in the event 
that a cash settlement fallback applies.
    Rule 2208 will allow the Matched Delivery Buyer and Matched 
Delivery Seller to settle their rights and obligations as to physical 
settlement through an alternative arrangement agreed between them 
(referred to as a ``CADP''), in lieu of settlement pursuant to Chapter 
22 of the ICC Rules. If they so agree, ICC will have no obligation in 
respect of such alternative arrangement.
    Rules 2209(a) and (c) will provide that margin (including physical 
settlement margin) will continue to be called and held through 
settlement. Rule 2209(b) will provide that ICC will apply physical 
settlement margin to satisfy the Matched Delivery Seller's obligation 
to pay the physical settlement amount, and call such seller for any 
shortfall.
    ICC also proposes to adopt Delivery Procedures that will further 
specify certain operational and other details for the physical 
settlement process. According to ICC, Paragraph 1 will provide certain 
definitions used in the Delivery Procedures. Paragraph 3.2 will set out 
certain requirements for providing notices in connection with physical 
settlement. Paragraphs 3.3(a)-(e) will establish the procedures and 
timetable for ICC to allocate Matched Delivery Pairs and notify 
Participants accordingly. Paragraph 3.3(g) will address additional 
procedures concerning delivery of notices by Participants in connection 
with physical settlement, including as to relevant notice deadlines, 
requirements for providing copies of notices to ICC, treatment of late 
notices and procedures for disputes involving notices. Paragraph 4 of 
the Delivery Procedures will specify certain deadlines in connection 
with the physical settlement of Non-DVP Obligations under Rule 2204. 
Finally, Paragraph 5 will specify the deadline for notices that parties 
have elected a CADP.
    ICC also proposes to adopt a set of Physical Settlement and Notices 
Terms (``Notices Terms'') with respect to physical settlement. The 
Notices Terms are intended to set forth a uniform set of communications 
between a Participant and its customer in connection with physical 
settlement, including delivery of physical settlement notices and 
delivery and receipt of deliverable obligations as between the 
Participant and its customer. The Notices Terms will also address the 
operation of certain cash settlement and other fallbacks as between the 
Participant and its customer. The Notices Terms do not bind ICC and do 
not form part of the ICC Rules or ICC Procedures. The Notices Terms are 
published for the convenience and use of Participants and their 
customers, and are designed to be incorporated by reference in customer 
clearing documentation. However, a Participant and its customer may 
agree to vary the Notices Terms.
    ICC also proposes to make certain changes to its Risk Management 
Framework to accommodate the changes relating to physical settlement 
that are being made to the ICC Rules and procedures as set forth 
herein. As revised, the Risk Management Framework reflects ICC's 
obligations in respect of physical settlement as provided in the 
amended ICC Rules and procedures. It will set out the steps in the 
physical settlement process to be taken by ICC if physical settlement 
applies, including the matching of Participants into Matched Delivery 
Pairs, consistent with the ICC Rules and procedures. The revisions also 
address the calculation, collection and use of margin (including 
physical settlement margin) where physical settlement applies.

III. Comments

    The Commission received one comment concerning the proposed rule 
change. In this comment, the commenter expresses concern that ICC's 
proposed rule change to guarantee the financial performance of physical 
settlement, in addition to its existing guarantee of cash settlement, 
would add additional complexity to ICC's clearing business, 
particularly during times of financial stress. The commenter addresses 
three issues with the proposal. First, the commenter suggests that the 
``process, financial assets and liabilities, and legal obligations of 
all parties must be well understood,'' \8\ both by ICC and the 
Commission. Second, ``the SEC should have some periodic report on 
[ICC's] financial assets, potential obligations or value at risk, and 
ability to perform under normal or adverse circumstances.'' \9\ 
Finally, the commenter seeks assurance that the SEC would assess the 
impact ICC's guarantee of ``physical clearing on market participants'' 
in reducing those participants' ``financial commitment'' or 
leverage.\10\ The commenter did not opine on any particular aspects of 
the proposed rule change beyond these general statements.
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    \8\ Comment from Kermit Kubitz, dated April 17, 2015, available 
at https://www.sec.gov/comments/sr-icc-2015-004/icc2015004-1.htm.
    \9\ Id.
    \10\ Id.

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[[Page 27801]]

IV. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act \11\ directs the Commission to 
approve a proposed rule change of a self-regulatory organization if the 
Commission finds that such proposed rule change is consistent with the 
requirements of the Act and the rules and regulations thereunder 
applicable to such self-regulatory organization. Section 17A(b)(3)(F) 
of the Act \12\ requires, among other things, that the rules of a 
clearing agency are designed to promote the prompt and accurate 
clearance and settlement of securities transactions and, to the extent 
applicable, derivative agreements, contracts, and transactions, to 
assure the safeguarding of securities and funds which are in the 
custody or control of the clearing agency or for which it is 
responsible and, in general, to protect investors and the public 
interest.
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    \11\ 15 U.S.C. 78s(b)(2)(C).
    \12\ 15 U.S.C. 78q-1(b)(3)(F).
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    Rules 17Ad-22(b)(2-3) \13\ require each registered clearing agency 
that performs central counterparty services to establish, implement, 
maintain and enforce written policies and procedures reasonably 
designed to use margin requirements to limit its credit exposures to 
participants under normal market conditions and use risk-based models 
and parameters to set margin requirements and review such margin 
requirements and the related risk-based models and parameters at least 
monthly, and maintain sufficient financial resources to withstand, at a 
minimum, a default by the two participant families to which it has the 
largest exposures in extreme but plausible market conditions, in its 
capacity as a central counterparty for security based swaps.
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    \13\ 17 CFR 240.17Ad-22(b)(2-3).
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    Rule 17Ad-22(d)(15) \14\ requires each registered clearing agency 
to establish, implement, maintain and enforce written policies and 
procedures reasonably designed to state to its participants the 
clearing agency's obligations with respect to physical deliveries and 
identify and manage the risks from these obligations.
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    \14\ 17 CFR 240.17Ad-22(d)(15).
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    The Commission finds that the modification of the terms and 
conditions for physical settlement of cleared CDS Contracts and the 
adoption of certain new delivery procedures relating to physical 
settlement is consistent with the requirements of Section 17A of the 
Act \15\ and the regulations thereunder applicable to ICC.
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    \15\ 15 U.S.C. 78q-1.
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    The proposed rule change will provide greater certainty and 
timeliness with respect to the clearance and settlement of CDS 
transactions in circumstances where physical settlement applies. 
Although physical settlement applies only rarely, and as a fallback to 
the normal procedure for cash settlement, the proposed rule change will 
prevent Participants from being exposed to the credit risk of other 
Participants with respect to the financial performance of physical 
settlement by guaranteeing timely payment of settlement amounts that 
are due to a non-defaulting party. As a result, the Commission believes 
the proposed rule change will promote the prompt and accurate clearing 
and settlement of CDS contracts, and, in general, protect investors and 
the public interest consistent with the requirements of Section 
17A(b)(3)(F) of the Act.\16\
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    \16\ 15 U.S.C. 78q-1(b)(3)(F).
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    Moreover, the proposed rule change will require ICC to collect 
Physical Settlement Margin \17\ (in addition to initial and variation 
margin) to cover the specific obligations of each Matched Delivery 
Seller to the clearinghouse with respect to physical settlement. 
Therefore, the Commission believes ICC will be able to maintain 
financial resources sufficient to support its clearing operations, 
including operations under the amended physical settlement procedures, 
in a manner consistent with the requirements of Rule 17Ad-22(b)(2-
3).\18\ Furthermore, ICC proposes to amend text of ICC Rules 2203(a)--
(g), to address the legal obligations that arise between Participants 
when settling a CDS Contract that is to be physically settled, with 
corresponding changes to its Delivery Procedures. The Commission 
believes that ICC's Rules, as amended, establish ICC's and 
Participants' obligations for performance (including financial 
performance) of physically settled contracts, the procedures for 
settlement and the mechanism for ICC to effect settlement in cash 
without having to acquire or dispose of the underlying deliverable 
obligations, consistent with the requirements of Rule 17Ad-
22(d)(15).\19\
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    \17\ The Physical Settlement Margin is calculated as the 
notional value minus the estimated value of the deliverable 
obligation and collected from the Matched Delivery Seller and held 
by ICC until such time the Matched Delivery Buyer and the Matched 
Delivery Seller as a pair confirm that settlement has been occurred. 
Physical Settlement Margin is not collected from the Matched 
Delivery Buyer. The estimated value of the deliverable obligation 
will be determined by ICC using a ``haircut'' approach. ICC will use 
the price of the cheapest-to-deliver bond as the basis for the 
``haircut'' estimation. However, if reliable pricing is not 
available, ICC reserves the right to determine a price of zero and 
therefore charge the full notional amount as the Physical Settlement 
Margin to the seller.
    \18\ 17 CFR 240.17Ad-22(b)(2-3).
    \19\ 17 CFR 240.17Ad-22(d)(15).
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V. Conclusion

    On the basis of the foregoing, the Commission finds that the 
proposal is consistent with the requirements of the Act and in 
particular with the requirements of Section 17A of the Act \20\ and the 
rules and regulations thereunder.
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    \20\ 15 U.S.C. 78q-1.
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\21\ that the proposed rule change (SR-ICC-2015-004) be, and hereby 
is, approved.\22\
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    \21\ 15 U.S.C. 78s(b)(2).
    \22\ In approving the proposed rule change, the Commission 
considered the proposal's impact on efficiency, competition and 
capital formation. 15 U.S.C. 78c(f).
    \23\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\23\
Robert W. Errett,
Deputy Secretary.
[FR Doc. 2015-11595 Filed 5-13-15; 8:45 am]
BILLING CODE 8011-01-P


