[Federal Register Volume 82, Number 225 (Friday, November 24, 2017)]
[Notices]
[Pages 55905-55912]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2017-25354]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-82109; File Nos. SR-LCH SA-2017-006; SR-LCH SA-2017-
007]


Self-Regulatory Organizations; LCH SA; Order Approving Proposed 
Rule Changes To Add Rules Related to the Clearing of Options on Index 
Credit Default Swaps

November 17, 2017.

I. Introduction

    On August 1, 2017 and August 18, 2017, Banque Centrale de 
Compensation, which conducts business under the name LCH SA (``LCH 
SA''), filed with the Securities and Exchange Commission 
(``Commission''), pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4 thereunder,\2\ 
proposed rule changes (SR-LCH SA-2017-007 and SR-LCH SA-2017-006, 
respectively) to amend LCH SA's (1) CDS Clearing Rule Book (the ``Rule 
Book''); (2) CDS Clearing Supplement (the ``Clearing Supplement''); (3) 
CDS Clearing Procedures (the ``CDS Clearing Procedures''); (4) CDS 
Dispute Resolution Protocol (the ``Dispute Resolution Protocol); (5) 
Reference Guide: CDS Margin Framework

[[Page 55906]]

(``CDSClear Margin Framework''); and (6) CDSClear Default Fund 
Methodology (``Default Fund Methodology'' together ``LCH SA Rules'')) 
in order to permit LCH SA to clear options on index credit default 
swaps (``CDS Options'').\3\ The proposed rule changes were published in 
the Federal Register on August 21, 2017 and August 31, 2017.\4\ On 
October 4, 2017, the Commission extended the time period in which to 
approve, disapprove, or institute proceedings to determine whether to 
disapprove the proposed rule changes to November 19, 2017 for proposed 
rule change SR-LCH SA-2017-007,\5\ and to November 29, 2017 for 
proposed rule change SR-LCH SA-2017-006.\6\ The Commission received no 
comment letters regarding the proposed changes. For the reasons 
discussed below, the Commission is approving the proposed rule changes.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ All capitalized terms used but not defined in this Order 
have the same meaning as in the LCH SA Rules.
    \4\ Securities Exchange Act Release No. 34-81399 (Aug. 15, 
2017), 82 FR 39622 (Aug. 21, 2017) (SR-LCH SA-2017-007) (``Notice 
007''); and Securities Exchange Act Release No. 34-81487 (Aug. 25, 
2017), 82 FR 41438 (Aug. 31, 2017) (SR-LCH SA-2017-006) (``Notice 
006'' and jointly, the ``Notices'').
    \5\ Securities Exchange Act Release No. 34-81818 (October 4, 
2017), 82 FR 47277 (Oct. 11, 2017).
    \6\ Securities Exchange Act Release No. 34-81819 (October 4, 
2017) 82 FR 47257 (October 11, 2017).
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II. Description of the Proposed Rule Changes

    LCH SA proposed to offer clearing services for certain options on 
index credit default swaps. A CDS Option is a contract that provides 
the buyer of the option the right, but not the obligation, to either 
buy or sell protection on the underlying index CDS, with the seller of 
the CDS Option standing as the counterparty, at a predefined exercise 
price on a specified exercise date. LCH SA proposed to clear CDS 
Options for which the underlying is a European index CDS that is 
currently cleared by LCH SA through its CDSClear service. Specifically, 
LCH SA represented that it would offer clearing services only for CDS 
Options for those contracts whose underlying index CDS is either the 
on-the-run or on-the-run minus one Markit iTraxx Europe Index or the 
Markit iTraxx Europe Crossover Index with 5-year tenors, and which will 
have expiries of one, two, or three months.\7\
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    \7\ See generally, Notice 006, 82 FR at 41438. LCH SA 
represented that extension of the CDS Clearing Service to clear CDS 
Options that reference indices other than the Markit Itraxx Europe 
Index would require amendments to the CDS Clearing Supplement, and 
potentially to the Rule Book and certain risk methodology 
documentation, and would therefore likely be subject to regulatory 
review and approval. See Notice 006, 82 FR at 41438-39.
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    In order to effectuate this initiative, LCH SA has proposed rule 
changes to its Rule Book, Clearing Supplement, CDS Clearing Procedures, 
Dispute Resolution Protocol, CDSClear Margin Framework, and Default 
Fund Methodology.

A. Changes to CDS Clearing Rule Book

    As discussed in greater detail in the Notices, LCH SA proposed to 
amend its Rule Book to adopt several new terms defining, and related 
to, CDS Options. In addition, LCH SA proposed to modify the substance 
of certain existing defined terms to account for the clearing of CDS 
Options, and also proposed certain conforming and clarifying edits to 
terms and provisions throughout the Rule Book. Furthermore, LHC SA 
proposed additional edits to clarify the cross-border application of 
its operations, and to correct inconsistencies, or make clarifications, 
related to certain defined terms unrelated to the clearing of CDS 
Options.\8\ The most significant changes to the Rule Book concern end-
of-day pricing procedures for CDS Options, the default management of 
CDS positions, including CDS Options, and changes relating to the 
mechanics of clearing CDS Options. Each of these changes is further 
described below.
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    \8\ Notice 006, 82 FR at 41439-41440.
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    LCH SA proposed to add new processes for calculating end of day 
prices for CDS Options, which will be used for related risk 
calculations, valuing open positions, and calculating a Clearing 
Member's margin requirement in connection with CDS Options. LCH SA also 
proposed to amend its Rule Book to permit Clearing Members to make use 
of the LCH SA settlement prices with respect to CDS Options in the same 
way that Clearing Members are permitted to use the settlement prices 
for CDS.\9\
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    \9\ Notice 006, 82 FR at 41440-41.
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    LCH SA's proposed rule changes also set forth amendments to its 
Default Management Process, as set forth in Appendix 1 of its Rule 
Book. In addition to proposing various conforming edits and amendments 
to existing terms, as described in greater detail in the Notices, LCH 
SA proposed to amend its Default Management Process to provide that 
Clearing Members that are not registered for the CDS Option Clearing 
Service would not be required to participate in the bidding process for 
any Auction Package that contains cleared CDS Options. However, to the 
extent that a Clearing Member that is not registered to clear CDS 
Options submits winning bids for an Auction Package containing cleared 
CDS Options, LCH SA proposed to establish a process for automatic 
registration of that Clearing Member for the CDS Option clearing 
service and an update to such Clearing Member's Product Family 
Forms.\10\
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    \10\ Notice 006, 82 FR at 41441-42.
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    Finally, LCH SA proposed a number of operational changes with 
respect to clearing CDS Options. For example, with respect to 
membership, LCH SA proposed to add, among other things, a new article 
setting forth the procedures for registration for LCH SA's CDS Option 
clearing service. With respect to the clearing of CDS Options, LCH SA 
proposed rule changes regarding the novation of contracts that would 
provide that a cleared CDS Option would be replaced by two cleared 
transactions, and also proposed edits to clarify that LCH SA would 
calculate Clearing Member open positions by netting such cleared 
transactions. Moreover, LCH SA proposed amending its Rule Book to 
clarify that following a restructuring credit event or during other 
specified periods, LCH SA is permitted to compress cleared CDS Option 
transactions, and that premiums for such cleared transactions will be 
netted.\11\
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    \11\ Notice 006, 82 FR at 41440.
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B. Changes to Clearing Supplement

    LCH SA also proposed amendments to its Clearing Supplement. Under 
these proposed amendments, LCH SA would add a new Part C to the 
Clearing Supplement to establish the economic terms specific to cleared 
CDS Options transactions. Proposed Section 1 of Part C would generally 
set forth definitions for terms contained in Part C of the Clearing 
Supplement. Proposed Section 2 of Part C would set forth provisions for 
the creation of cleared CDS Options, as well as for the creation of 
cleared CDS Options transactions involving restructuring events, and 
transactions resulting from the exercise of the option. In particular, 
this section would provide the specific terms under which LCH SA and 
the Clearing Member enter into such transactions upon their creation 
and provides for the particulars of the confirmations of such 
transactions, as well as the procedures for compression exercises for 
cleared CDS Options transactions.\12\ Section 3 of proposed Part C 
would establish relevant payment obligations for LCH SA and Clearing 
Members in connection with CDS Options.
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    \12\ Notice 006, 82 FR at 41442.
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    Other provisions of proposed Part C of the Clearing Supplement 
would flesh out terms relating to restructuring,

[[Page 55907]]

exercise and assignment of CDS Options. For example, proposed Section 4 
of Part C would set forth the procedures used following certain credit, 
succession, or restructuring events. Section 5 of proposed Part C would 
establish requirements and procedures for the creation of paired 
transactions, triggering and partial triggering conditions for 
transactions following a determination of certain credit, succession or 
restructuring events, as well as notification requirements related 
thereto. Section 6 of Part C would establish procedures regarding 
creation of paired transactions for exercised CDS Options, the clearing 
of the transactions resulting from exercise, and delivery procedures 
for various related notices and reports. These proposed procedures 
would require LCH SA to notify the relevant matched buyers and sellers 
with the identity of the buyer or seller, as applicable, following the 
creation of each paired transaction by LCH SA resulting from an 
exercised CDS Option. The proposed changes also provide, among other 
things, that upon notification of exercise, the original CDS Option 
transaction will be deemed terminated and a new exercised transaction 
will be deemed to be created between the Clearing Members and LCH 
SA.\13\
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    \13\ Notice 006, 82 FR at 41442-43.
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    The remaining provisions in proposed Part C of the Clearing 
Supplement address settlement and other miscellaneous provisions. For 
example Section 7 of proposed Part C of the Clearing Supplement would 
provide that following exercise of a CDS Option, a new cleared index 
CDS transaction will be entered into between the relevant Clearing 
Members and LCH SA.\14\ Section 8 of Part C would set forth general 
rules related notices, including provisions regarding timing and 
delivery methods. Section 9 of proposed Part C would set forth 
procedures regarding the creation of paired transactions via an 
algorithm, address the registration of certain transactions resulting 
from restructuring events, address the resetting of trade dates, set 
forth mechanics for certain notices, and provide for the exercise of 
CDS Options by CDS Option buyers and sellers that are matched by LCH 
SA.\15\
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    \14\ Id.
    \15\ Id.
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C. Changes to CDS Clearing Procedures

    LCH SA also proposed changes to the CDS Clearing Procedures that 
would amend provisions regarding membership, margin and price alignment 
interest, collateral and cash payment, eligibility requirements, and 
CDS Option clearing operations. Regarding the membership provisions, 
LCH SA proposed amendments that would clarify that Applicants would be 
required to identify operational personnel that have knowledge of CDS 
Options as part of its registration, and would also describe procedures 
by which LCH SA will communicate approval of an application for 
registration for the CDS Option clearing service to an applicant, as 
well as procedures and conditions for withdrawal of registration from 
the service.\16\
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    \16\ Notice 006, 82 FR at 41444.
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    Regarding margin, LCH SA proposed to modify Section 2.7 of its 
Clearing Procedures to clarify that initial margin would cover the 
costs associated with a default of a Clearing Member, as well as a 
``double event of default,'' i.e., where the Clearing Member is the 
seller of protection on the underlying CDS index. Further modifications 
to Section 2.7 would include clarification that spread margin will be 
calculated using spread and volatility variations, and that short 
charge margin would be imposed in instances where a Clearing Member 
acts as a protection seller with respect to a CDS Option, a single name 
CDS transaction, or the CDS index underlying the CDS Option. Other 
proposed amendments affecting margin include clarifying that self-
referencing protection margin would be imposed where a Clearing Member 
acts as a protection seller with respect to the index CDS underlying a 
CDS Option for which such member is, or becomes, a reference entity. 
For Clearing Members acting as protection buyers with respect to the 
index CDS underlying a CDS Option, LCH SA proposed to require that such 
Clearing Members pay accrued fixed amount liquidation risk margin where 
the exercise of that CDS Option falls in the margin calculation time 
horizon. This margin add-on is designed to cover risks associated with 
an event of default when certain accrued fixed amount payments are due 
under the terms of the CDS Option during the period that the relevant 
transactions are liquidated under LCH SA's Default Management 
Process.\17\ LCH SA would also modify provisions relating to credit 
event margin to specify that where a credit event occurs regarding a 
reference entity that is the subject of a cleared transaction, each 
Clearing Member will be required to pay credit event margin to cover 
the risk of adverse changes in the estimated recovery rate arising in 
the event of non-payment of variation margin on the part of the CDS 
Option seller or CDS Option buyer with respect to a CDS Option 
transaction. LCH SA also proposed to clarify that variation margin will 
cover the change in market value of a CDS Option.\18\ Finally, LCH SA 
proposed to amend its CDS Clearing Procedures to state that Clearing 
Members are required to pay premiums to satisfy payment obligations 
with respect to a CDS option position.
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    \17\ Id.
    \18\ Id.
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    LCH SA also proposed various amendments related to member and 
product eligibility requirements. With respect to provisions regarding 
Clearing Member eligibility requirements, LCH SA proposed to amend 
Section 4.1 of the CDS Clearing Procedures to require that a Clearing 
Member be registered for the CDS Option clearing service in order to 
clear such products, and to set forth eligibility requirements related 
thereto. Regarding product eligibility requirements, LCH SA proposed to 
add new Section 4.4 to the CDS Clearing Procedures that would set forth 
criteria that LCH SA, in consultation with relevant internal 
committees, would consider with respect to which CDS Options will be 
eligible for clearing, as well as procedures for Clearing Members to 
submit a CDS Option for clearing in certain circumstances where the 
transaction is a risk reducing transaction, even if the relevant 
eligibility criteria are not satisfied. The proposed amendments would 
also require LCH SA to publish a list of clearing eligible CDS 
Options.\19\
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    \19\ Id.
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    LCH SA also proposed to amend Section 5 of the CDS Clearing 
Procedures, which addresses LCH SA's CDS clearing operations, to 
provide a description of the trade compression process with respect to 
CDS Options. Other proposed amendments to Section 5 include procedures 
to ensure that cleared transactions are stored and replicated on LCH 
SA's systems. Furthermore, the procedures describing the process for 
calculating end-of-day prices using data contributed by Clearing 
Members would be amended to account for CDS Options (as described more 
fully in the Notices), including amendments providing for procedures to 
effect cross trades where submitted prices from market participants do 
not reflect quoted daily prices for a particular CDS Option, and for 
calculating the variation margin requirement for CDS Options in the

[[Page 55908]]

event that necessary data is not received.\20\
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    \20\ Notice 006, 82 FR at 41444-45.
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    Additional changes relating to organization and numbering of 
various Rule Book and/or policy and procedure provisions, as well as 
certain conforming edits that were proposed are not discussed here, but 
are described in detail in the Notices.

D. Changes to Dispute Resolution Protocol

    LCH SA also proposed amendments to its Dispute Resolution Protocol 
that would specify that the Dispute Resolution Protocol would apply 
where the parties to the arbitration include a seller or buyer of a CDS 
Option, and where the dispute in question arises from cleared matched 
transactions resulting from exercise of the CDS Option or from 
restructuring events.\21\
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    \21\ Notice 006, 82 FR at 41445.
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E. Changes to CDSClear Margin Framework

    As described in greater detail in the Notices, LCH SA proposed 
several amendments to its CDSClear Margin Framework. These changes are 
as follows:
1. Changes Regarding CDS Option Pricing
    In addition to providing a revised organizational structure for the 
CDSClear Margin Framework, LCH SA proposed a new section describing the 
methodology to price CDS Options. The proposed pricing section would 
add a description of the methodology used to price CDS Options, 
including a proposal to adopt a modified version of a market standard 
model developed by Bloomberg that makes adjustments to the Black-
Scholes model (``Bloomberg Model''). LCH SA represented that this model 
is commonly used by dealers and buy-side participants.\22\
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    \22\ Notice 007, 82 FR at 39623.
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    In conjunction with use of the modified Bloomberg Model, LCH SA 
proposed to adopt provisions to account for implied volatility. In 
particular, LCH SA proposed to use a stochastic volatility inspired 
(``SVI'') model in constructing volatility surfaces, as well as to 
price (or reprice) CDS Options and interpolate implied volatilities 
derived from the modified Bloomberg Model.\23\ Regarding data required 
to calculate historical implied volatilities, LCH SA would adopt a 
section describing the database that would cover a 10-year look-back 
period, as well as the data that LCH SA would use to construct 
historical implied volatility in the case of missing at-the-money 
volatility and SVI data points in the historical time series data. As 
part of its end-of-day process for gathering price data from Clearing 
Members, LCH SA proposed to implement a new price submission mechanism 
for CDS Options that would, similar to the end-of-day price submission 
process for CDS, require Clearing Members to contribute prices for CDS 
Options where the members have at least one open position on one strike 
for a particular expiry. These contributed prices, in turn, would be 
used for marking the options book, if certain conditions are met. If 
such conditions are not met, LCH SA proposed to fall back to Markit's 
composite prices or use other pre-defined rules to fill in missing 
data.\24\
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    \23\ Id.
    \24\ Notice 007, 82 FR at 39623-24.
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    The purpose of these proposed changes is to provide for a 
methodology and model for pricing CDS Options, as well as to establish 
a process of obtaining pricing information from Clearing Members in 
order to allow LCH SA to accurately evaluate the value of the positions 
that Clearing Members take, and thereby allow LCH SA to measure its 
exposures to Clearing Members.
2. Changes to Total Initial Margin
    As described in greater detail in the Notices, LCH SA proposed to 
revise its CDSClear Margin Framework to mitigate the risks associated 
with clearing CDS Options. LCH SA's margin model is currently composed 
of six components: (1) Self-referencing margin, (2) spread margin, (3) 
short charge, (4) wrong-way risk margin, (5) interest rate risk margin, 
and (6) recovery rate margin. LCH SA proposes to add a new seventh 
margin component, vega margin, specifically to address volatility risk 
posed by CDS Options.
a. Self-Referencing Margin
    Under its current CDSClear Margin Framework, LCH SA uses self-
referencing margin to capture the profit and loss (``P&L'') impact 
resulting from a Clearing Member defaulting on a sold-protection 
position in CDS referencing its own name with zero recovery. Currently, 
LCH SA has established this self-referencing margin for CDS only. For 
CDS Options, LCH SA proposed to implement a methodology to measure 
spread margin that will calculate the P&L impact from a Clearing Member 
defaulting on a sold-protection position in CDS referencing the 
Clearing Member by taking the difference between the CDS Option's 
current value and the value after incorporating a loss amount in the 
underlying CDS index.\25\ The purpose of these proposed changes is to 
ensure that LCH SA can appropriately account for the impact of Clearing 
Members defaulting on sold-protection positions that underlie the CDS 
Options LCH SA proposed to clear in a fashion similar to that which LCH 
SA has in place for CDS.
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    \25\ Notice 007, 82 FR at 39624.
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b. Spread Margin
    Under the CDSClear Margin Framework, as currently constituted, LCH 
SA calculates a spread margin component using a value-at-risk (``VaR'') 
model to construct a distribution of potential losses based on 
simulated scenarios using joint credit spread and volatility variations 
taken from past observations and then calculates the expected shortfall 
based on a quantile of the worst losses that could arise in those 
scenarios. In order to adapt the spread margin component to account for 
the clearing of CDS Options, LCH SA proposed to apply to CDS Options 
the approach it currently uses for CDS with two adjustments. First, LCH 
SA proposed to calculate simulated volatilities by defining a shifted 
volatility curve for each option expiry date, in addition to the 
simulated credit spreads currently used for CDS. LCH SA would then use 
both simulated volatilities and simulated credit spreads to calculate 
estimated CDS Option values which would, in turn, be used as an input 
in the VaR model to establish an expected shortfall amount. Second, to 
account for CDS Options that expire within the 5-day margin period of 
risk, which is necessary to ensure that underlying indices can be 
automatically cleared by LCH SA upon exercise, LCH SA proposed to add 
spread margin provisions regarding whether a CDS Option would be 
exercised upon expiry based on a consideration of the CDS Option's 
present value on the date of expiry. Should LCH SA determine that a CDS 
Option would be exercised, it would take the resulting index CDS 
position into account as part of the expected shortfall 
calculation.\26\
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    \26\ Id.
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c. Changes to the Short Charge
    For the short charge component of its initial margin, which is 
designed to address jump-to-default risk, LCH SA currently uses the 
greater of its (i) ``global short charge,'' which is derived from a 
Clearing Member's largest net short exposure for CDS contracts and its 
top net short exposure among the three riskiest reference entities 
(with respect

[[Page 55909]]

to any entity type), and (ii) the ``high-yield short charge,'' which is 
derived from a Clearing Member's top net short exposure (with respect 
to high yield CDS) and its top two net short exposures among the three 
riskiest reference entities in the high yield category. In order to 
adapt the short charge margin for CDS Options, LCH SA proposed to 
consider the P&L impact of a credit event experienced by a constituent 
of an index CDS underlying the CDS Option to determine the short 
exposure for CDS Options. LCH SA also proposed to adopt an 
approximation approach to define changes in the CDS Option price 
relative to the total loss in the underlying index instead of repricing 
the CDS Option each day based on the spread level of the underlying and 
at-the-money volatility.\27\
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    \27\ Notice 007, 82 FR at 39624-25.
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    LCH SA proposed additional adjustments to the short charge margin 
component to accommodate the clearing of CDS Options. First, when 
calculating total short exposure for a reference entity, instead of 
using the current spread, which is LCH SA's approach for index CDS 
initial margin, total short exposure would be calculated for each day 
within the 5-day margin period of risk using simulated credit spread 
and at-the-money volatility data for CDS and CDS Options. Second, to 
address the non-linear nature of options, the total short exposure 
would not be the sum of P&L impacts of each individual entity's default 
where such entities are selected for calculating the global short 
charge, HY short charge, and financial short charge. Instead, LCH SA 
proposed to calculate each of these charges by considering the combined 
P&L impacts of simultaneous defaults of selected entities. Third, LCH 
SA proposed to compare three expected shortfall amounts to disaggregate 
the total short exposure in a manner that permits separate calculation 
of the short charge margin associated with the P&L impact of the jump-
to-default risk at the portfolio level and the spread margin that 
reflects the P&L impact that associated with changes in spreads and at-
the-money volatility. LCH SA represented that these calculations 
facilitate implementation of limits on portfolio margin required under 
the European Market Infrastructure Regulation and the financial short 
charge, among other things.\28\ Finally, LCH SA also proposed to 
consider the impact of option expiry on the P&L as part of the short 
charge calculation by considering cases in which the option exercise 
decision occurs before the occurrence of two credit events, and cases 
where the two credit events occur before option exercise. LCH SA 
proposed to use the worst case of these scenarios as part of the short 
charge calculation.\29\ LCH SA proposed these changes to ensure that it 
adequately addresses the jump-to-default risk associated with clearing 
CDS Options.
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    \28\ Notice 007, 82 FR at 39625.
    \29\ Notice 007, 82 FR at 39624-25.
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d. Changes to Interest Rate Risk Margin
    LCH SA also proposed modifications to interest rate risk margin. 
Under its current CDSClear Margin Framework, LCH SA calculates its 
interest rate risk margin by shifting interest rate curves and 
repricing the CDS portfolio. To accommodate clearing of CDS Options, 
LCH SA proposed to amend the methodology for calculating the interest 
rate risk margin component by providing for a repricing of CDS Option 
positions that uses the same ``bump'' parameters computed by taking the 
99.7 percent quantile of the interest rate return using the same sample 
of dates in the spread historical database.\30\ The changes proposed 
regarding interest rate risk margin are designed to ensure that LCH SA 
considers the risks to CDS Options associated with moves in interest 
rates.
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    \30\ Notice 007, 82 FR at 39625.
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e. Addition of Vega Margin
    As described in greater detail in the Notices, LCH SA proposed to 
add a new vega margin component to its initial margin framework. The 
new vega margin would consider option premium changes when skew is 
shifted by an extreme move, define shifts of the skew by multiplying a 
standard deviation of returns of historical skews by a percentile for a 
given probability threshold, and consider similar shocks on the 
volatility of volatility.\31\ The vega margin is intended to capture 
the risk of skew and volatility of volatility associated with the CDS 
Options.
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    \31\ Notice 007, 82 FR at 39625-26.
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f. Liquidity Risk Margin
    LCH SA proposed changes to the liquidity risk margin to accommodate 
portfolios that contain CDS Options. For CDS, under the current 
Framework, LCH SA calculates the liquidity risk margin by estimating 
the cost of liquidating a CDS portfolio. To calculate the liquidity 
charge for portfolios that include CDS Options, LCH SA proposed to 
consider the CDS Options separately from CDS, with the liquidity charge 
of the CDS Options based on the likely cost of any vega hedging that 
would be required in the event that a portfolio of CDS Options needs to 
be liquidated. LCH SA would then compute the portfolio liquidity charge 
as the sum of the liquidity charge for the CDS component of a portfolio 
and the liquidity charge for the CDS Options component.\32\ The 
proposed changes are intended to permit LCH SA to consider the cost of 
liquidating portfolios that contain CDS Options.
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    \32\ Notice 007, 82 FR at 39626.
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g. Changes to Accrued Coupon Liquidation Risk Margin
    LCH SA proposed changes to its accrued coupon liquidation risk 
margin to accommodate the clearing of CDS Options. Specifically, LCH SA 
stated that with respect to CDS Options, it would be exposed to coupon 
payment risk only if the option expiry falls within the 5-day 
liquidation period and the option is exercised. Consequently, LCH SA 
proposed to set the accrued coupon for CDS Options with an expiry of 
more than five days at zero, and the accrued coupon for options 
contracts with expiry falling within the 5-day liquidation period would 
be the accrued coupon for five days, if the options are exercised.\33\ 
The proposed changes are intended to allow LCH SA to cover the risk of 
additional coupon costs associated with CDS Options during the 5-day 
liquidation period.
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    \33\ Id.
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h. Credit Event Margin
    LCH SA also proposed to adjust its method for calculating credit 
event margin to accommodate CDS Options. Currently, LCH SA addresses 
risks associated with hard credit events due to uncertain recovery 
rates prior to an auction by imposing a margin that would cover an 
adverse 25 percent absolute recovery rate move from the credit event 
determination date up to--and including--the auction date. As discussed 
in greater detail in the Notices, to better capture the risk stemming 
from clearing CDS Options, in cases where several credit events occur, 
LCH SA proposed to calculate credit event margin for each affected CDS 
and CDS Option contract by considering adverse recovery moves that 
could be a combination of upward, downward, or flat for the various 
entities in the portfolio instead of summing the credit event margin 
covering 25 percent adverse recovery rate moves for each reference 
entity. Under this proposed approach, the aggregate P&L at the level of 
the CDS and CDS Options contract would be the credit event margin for 
the portfolio. Additionally, for restructuring

[[Page 55910]]

events, LCH SA proposed to address each maturity separately instead of 
netting positions with the same reference entity due to the fact that 
different auctions may be held depending on the maturity of the 
contracts. Finally, LCH SA proposed some revisions regarding 
terminology for credit event margin, which is also described in greater 
detail in the Notices. For restructuring events, because different 
auctions may be held depending on the maturity of the contracts, 
recovery rates could differ across all contracts with differing 
maturity dates. Consequently, LCH SA proposed to consider each maturity 
separately instead of netting all positions with the same reference 
entity.\34\ The proposed changes are designed to allow LCH SA to cover 
the risks associated with the occurrence of several credit events, and 
to account for the effect of differing maturities.
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    \34\ Id.
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i. Changes To Streamline Descriptions and Improve Readability
    Finally, LCH SA proposed non-substantive changes that include 
moving sections discussing cash flow exchanges, contingency variation 
margin, and extraordinary margin to eliminate redundancy and improve 
readability.\35\
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    \35\ Notice 007, 82 FR at 39627.
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F. Changes to the Default Fund Methodology

    LCH SA proposed several changes to its Default Fund Methodology to 
accommodate the clearing of CDS Options. Under its current approach, 
the primary component of LCH SA's Default Fund Methodology is the 
identification of stress scenarios designed to impose market moves that 
are considered extreme but plausible above those that are used in the 
margin calculation in order to determine P&L impacts on Clearing Member 
portfolios. The two largest stress testing losses over initial margin 
(``STLOIM'') across all Clearing Member portfolios are then used by LCH 
SA, plus a 10 percent buffer, to size LCH SA's default fund.\36\
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    \36\ Id.
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    To accommodate the clearing of CDS Options, LCH SA proposed to 
amend the its Default Fund Methodology to take into account the new 
vega margin by adding a stressed vega margin calculation to LCH SA's 
stress test scenarios. In addition, LCH SA would add a new set of 
scenarios (referred to as ``Volatility Scenarios'') that would consider 
movements in the implied at-the-money volatilities of index families 
for historical and theoretical stress scenarios. Further amendments 
would result in a new method for calculating the stressed spread margin 
component of the STLOIM. Under the proposed modifications, the new 
calculation for stressed spread margin would take into account at-the-
money implied volatility moves for CDS Options and calculate the 
stressed spread margin in two scenarios: (1) Historical scenarios 
covering credit spread moves and at-the-money implied movements in 
combination; and (2) theoretical scenarios covering credit spread 
movements and at-the-money implied volatility moves independently. 
Changes to the stressed short charge component of STLOIM would be made 
to incorporate terms relevant to CDS Options, and the new stressed 
short charge calculation would largely follow the approach used for the 
short charge calculation as part of the initial margin framework to 
consider the non-linear nature of CDS Options, except that the number 
of entities assumed to be in default would be higher for the stressed 
short charge.
    As noted above, LCH SA proposed to implement a new stressed vega 
margin component to the STLOIM calculation. This new stressed vega 
margin component would be calculated in the same manner as the vega 
margin component, except that it would use a higher quantile. 
Additionally, a new section entitled ``Exercise Management'' would be 
added to the Default Fund Methodology that would take into account the 
impact of CDS Options that expire within the 5-day liquidation period, 
and another new section would be added that would set forth the P&L 
scenarios that are considered part of the Default Fund Methodology, 
including providing for a stressed spread margin calculation for 
specific products.\37\ These proposed changes are designed to ensure 
that LCH SA properly sizes the default fund to cover the two largest 
STLOIMs across all Clearing Member portfolios while taking into account 
that such portfolios may now include CDS Options.
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    \37\ Id.
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III. Discussion and Commission Findings

    Section 19(b)(2)(C) of the Act \38\ directs the Commission to 
approve a proposed rule change of a self-regulatory organization if the 
Commission finds that the 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 \39\ requires, among other things, that the rules of a 
registered clearing agency be designed to promote the prompt and 
accurate clearance and settlement of securities transactions and, to 
the extent applicable, derivative agreements, contracts, and 
transactions, as well as 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 to protect investors and the public 
interest. Rule 17Ad-22(e)(1) \40\ requires a covered clearing agency to 
establish, implement, maintain and enforce policies and procedures that 
are reasonably designed to provide for a well-founded, clear, 
transparent and enforceable legal basis for each aspect of its 
activities in all relevant jurisdictions.
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    \38\ 15 U.S.C. 78s(b)(2).
    \39\ 15 U.S.C. 78q-1(b)(3)(F).
    \40\ 17 CFR 240.17Ad-22(e)(1).
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    Rule 17Ad-22(b)(2) \41\ requires, in relevant part, a 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. Rules 
17Ad-22(e)(6)(i), (iv), and (v) \42\ require a covered clearing agency 
that provides central counterparty services to establish, implement, 
maintain and enforce written policies and procedures reasonably 
designed to cover its credit exposures to its participants by 
establishing a risk-based margin system that, at a minimum considers, 
and produces margin levels commensurate with, the risks and particular 
attributes of each relevant product, portfolio, and market, uses 
reliable sources of timely price data, and uses procedures and sound 
valuation models for addressing circumstances in which pricing data are 
not readily available or reliable, and that uses an appropriate method 
for measuring credit exposures that accounts for relevant product risk 
factors and portfolio effects across products.
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    \41\ 17 CFR 240.17Ad-22(b)(2).
    \42\ 17 CFR 240.17Ad-22(e)(6)(i), (iv), and (v).
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    Rule 17Ad-22(b)(3) \43\ requires, in relevant part, a registered 
clearing agency that performs central counterparty services to 
establish, implement, maintain and enforce written policies and 
procedures reasonably designed to maintain

[[Page 55911]]

additional financial resources sufficient 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 where such 
registered clearing agency acts as a central counterparty for security-
based swaps. Rules 17Ad-22(e)(4)(i) and (ii) \44\ require a covered 
clearing agency to establish, implement, maintain and enforce written 
policies and procedures reasonably designed to effectively identify, 
measure, monitor, and manage its credit exposures to participants and 
those arising from its payment, clearing, and settlement processes, 
including by maintaining sufficient financial resources to cover its 
credit exposure to each participant fully with a high degree of 
confidence and, for a covered clearing agency involved in activities 
with a more complex risk profile,\45\ maintaining additional financial 
resources at a minimum to enable it to cover a wide range of 
foreseeable stress scenarios that include, but are not limited to, the 
default of the two participant families that would potentially cause 
the largest aggregate credit exposure for the covered clearing agency 
in extreme but plausible market conditions.
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    \43\ 17 CFR 240.17Ad-22(b)(3).
    \44\ 17 CFR 240.17Ad-22(e)(4)(i) and (ii).
    \45\ Rule 17Ad-22(a)(4)(i) defines a covered clearing agency 
involved in activities with a more complex risk profile as a 
clearing agency registered with the Commission under Section 17A of 
the Act that provides central counterparty services for security-
based swaps. See 17 CFR 240.17Ad-22(a)(4)(i).
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    For the reasons discussed below, after reviewing the proposed rule 
changes as a whole, including the representation that LCH SA is 
limiting its clearing services for CDS Options to the specific 
underlying CDS indices, tenors and option expiries specified 
herein,\46\ the Commission finds that the proposed rule changes, which 
seek to amend LCH SA's Rule Book, Clearing Supplement, CDSClear 
Procedures, Dispute Resolution Protocol, CDSClear Margin Framework, and 
Default Fund Methodology to permit LCH SA to clear options on index 
credit default swaps (``CDS Options''), are consistent with Section 17A 
of the Act and the applicable provisions of Rule 17Ad-22 thereunder.
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    \46\ See supra note 7 and accompanying text.
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A. Changes to LCH SA's Rule Book, and Policies and Procedures

    The Commission finds that the proposed changes to LCH SA's Rule 
Book and Policies and Procedures are consistent with the requirements 
of Section 17A(b)(3)(F) regarding prompt and accurate clearance and 
settlement, and Exchange Act Rule 17Ad-22(e)(1). LCH SA proposed to 
modify its Rule Book, Clearing Supplement, CDSClear Procedures, and 
Dispute Resolution Protocol to extend its established legal framework 
to govern the clearing of CDS Options, to provide for managing defaults 
associated with CDS Options, and to apply membership obligations to 
Clearing Members seeking to register for the CDS Option clearing 
service. Among other things, the proposed amendments provided for 
definitions for various terms relevant to CDS Options, and amended 
existing terms to accommodate clearing CDS Options. Further, the 
proposed amendments would establish a process for applying for 
membership in the CDS Option clearing service, thereby requiring 
members to satisfy LCH SA's financial and operational requirements, as 
well as contractual obligations regarding performance. These 
obligations include those arising under LCH SA's default management 
process, which would also be amended to accommodate the clearing of CDS 
Options. Consequently, the Commission believes that by creating 
registration and membership obligations for entities seeking to 
participate in the CDS Option Clearing Service, and by adapting its 
CDSClear Procedures and Clearing Supplement to address operational 
aspects associated with clearing CDS Options, LCH SA has rules that are 
designed to ensure that Clearing Members participating in the CDS 
Option clearing service have the requisite ability to meet financial 
and operational obligations associated with clearing CDS Options, 
thereby ensuring the prompt and accurate clearance and settlement of 
such transactions. Therefore, the Commission finds that the proposed 
rule changes are consistent with Section 17A(b)(3)(F) of the Act.
    Additionally, based on these proposed changes, the Commission 
believes that LCH SA will be able to provide for a well-founded and 
enforceable legal basis for clearing CDS Options in jurisdictions in 
which LCH SA operates, similar to that established for the clearing of 
CDS. Moreover, because the documents that are the subject of the 
proposed amendments are available on LCH SA's public internet site, or 
provided to Clearing Members, the Commission believes that the policies 
and procedures applicable to members of the CDS Option clearing service 
are sufficiently clear and transparent. As a result, the Commission 
finds that the proposed changes affecting LCH SA's Rule Book, and other 
policies and procedures are consistent with the requirements of Rule 
17Ad-22(e)(1).

B. Changes to CDSClear Margin Framework and Default Fund Methodology

    The Commission finds that the proposed rule changes regarding LCH 
SA's CDSClear Margin Framework and Default Fund Methodology are 
consistent with the requirements of Section 17A(b)(3)(F) and Rules 
17Ad-22(b)(2), (b)(3), (e)(4)(i) and (ii), and (e)(6)(i), (iv) and (v).
1. CDSClear Margin Framework
    LCH SA proposed to amend its CDSClear Margin Framework to add a 
pricing methodology for CDS Options, based on a modified Bloomberg 
Model, and to add a process for obtaining pricing inputs from Clearing 
Members. By implementing a pricing methodology and process for 
obtaining pricing information from Clearing Members, the Commission 
believes that LCH SA will be able to adequately and consistently 
determine the value of the CDS Options it clears, and will also be able 
to appropriately mark the positions on a daily basis. As a result, the 
Commission finds that the proposed rule changes regarding LCH SA's 
pricing model and mechanism promote the prompt and accurate clearance 
and settlement of CDS Options and are consistent with the requirements 
of Section 17A(b)(3)(F) of the Act. Furthermore, because LCH SA 
proposed changes that would result in LCH SA relying on the Markit 
Composite or using other pre-defined rules to fill in missing data and 
complete the marking process, the Commission believes that the proposed 
rule changes provide that LCH SA has policies and procedures that are 
reasonably designed to ensure that LCH SA uses reliable sources of 
timely price data and uses procedures and sound valuation models for 
addressing circumstances in which pricing data are not readily 
available or reliable. Therefore, the Commission finds that the 
proposed rule changes are consistent with the requirements of Rule 
17Ad-22(e)(6)(iv).
    In addition, LCH SA proposed to amend its CDSClear Margin Framework 
to account for clearing CDS Options. Among other things, LCH SA 
proposed amending its self-referencing margin to calculate the P&L 
impact on a CDS Option based on losses in the underlying index CDS. In 
addition, LCH SA proposed to amend its spread margin to incorporate 
simulated volatilities that complement simulated credit spreads in the 
value-at-risk model LCH SA uses. Moreover, LCH SA

[[Page 55912]]

proposed to amend its short charge to account for the P&L impact of a 
credit event on the reference obligations of a constituent of the 
underlying index CDS has on a CDS Option. Furthermore, LCH SA also 
proposed other amendments, described in greater detail in section 
II.e.2, above and in the Notices, to incorporate at-the-money 
volatility data, account for the non-linearity of CDS Options by 
considering the combined P&L impacts of simultaneous defaults, and to 
consider the impact of option expiry. LCH SA also proposed to amend its 
interest rate margin to calculate the P&L impact on CDS Options due to 
changes in interest rates, and proposed to introduce a new margin 
component, vega margin, to capture the risks associated with skew and 
volatility of volatility that specifically affect CDS Options. 
Similarly, LCH SA proposed amendments to its liquidity risk margin to 
account for the costs associated with vega hedging a portfolio of CDS 
Options, proposed changes to the accrued coupon liquidation risk margin 
to account for exposures to CDS Options during the 5-day liquidation 
period, and proposed changes to its credit event margin to account for 
different maturities separately and to consider combinations of upward, 
downward or flat recovery rate moves.
    Based on these proposed changes, the Commission believes that LCH 
SA will have rules that are designed to collect and maintain financial 
resources intended to cover the risks to which LCH SA is exposed in 
connection with offering clearing services for CDS Options. As a 
result, the Commission believes that LCH SA will be able to minimize 
the risk that the losses associated with the default of a participant 
(or participants) in the clearing service for CDS Options will extend 
to other participants in the service or negatively affect the U.S. 
financial system as a whole. Consequently, the Commission believes that 
the proposed rule changes will provide for rules that permit LCH SA to 
be able to safeguard the securities and funds which are in its custody 
or control or for which it is responsible, and to be able to protect 
investors and the public interest. Accordingly, the Commission finds 
that the proposed rule changes are consistent with the requirements of 
Section 17A(b)(3)(F).
    Moreover, considering these proposed changes as a whole, the 
Commission believes that the proposed rule changes will ensure that LCH 
SA uses margin requirements to limit its credit exposures to Clearing 
Members participating in the CDS Option clearing service. The 
Commission also believes that by changing its margin framework to add 
the new vega margin and revise existing individual margin components as 
described above, LCH SA reasonably considers the risks specific to CDS 
Options (including consideration of risks associated with skew and 
volatility of volatility, among others), and establishes an appropriate 
method for measuring its credit exposures to Clearing Members 
participating in the CDS Option clearing service. As a result, the 
Commission finds that the proposed rule changes are consistent with the 
requirements of Rules 17Ad-22(b)(2) and (e)(6)(i) and (v).
2. Default Fund Methodology
    LCH SA also proposed to amend its existing Default Fund Methodology 
to address the additional risks associated with clearing CDS Options. 
As described above, the Default Fund Methodology is designed to 
identify stress scenarios that impose extreme but plausible market 
moves in order to calculate stress losses in excess of margin. These 
losses are then used to size LCH SA's Default Fund. Among other things, 
LCH SA proposed to amend its Default Fund Methodology to take into 
account the new vega margin by adding a stressed vega margin, new 
Volatility Scenarios, and adopt a new method for calculating the 
stressed spread margin that would take into account at-the-money 
implied volatility moves for CDS Options in the stress scenarios used 
to size the CDSClear default fund. Based on these amendments, the 
Commission believes that LCH SA appropriately extends its existing 
Default Fund Methodology to address the clearing of CDS Options, and as 
a result will be able to maintain financial resources adequate to cover 
the risks associated with clearing CDS Options, including sufficient 
resources to enable LCH SA cover its credit exposure to each 
participant fully with a high degree of confidence and to cover the 
default of the two participant families to which LCH SA has exposures 
in extreme but plausible market conditions. Accordingly, the Commission 
finds that the proposed rule changes amending LCH SA's Default Fund 
Methodology are consistent with the requirements of Rule 17Ad-22(b)(3) 
and (e)(4)(i) and (ii).

IV. Conclusion

    It is therefore ordered pursuant to Section 19(b)(2) of the Act 
that the proposed rule changes (SR-LCH SA-2017-006 and SR-LCH SA-2017-
007) be, and hereby are, approved.\47\
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    \47\ In approving the proposed rule changes, the Commission 
considered the proposals' impact on efficiency, competition, and 
capital formation. 15 U.S.C. 78c(f).

    For the Commission by the Division of Trading and Markets, 
pursuant to delegated authority.\48\
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    \48\ 17 CFR 200.30-3(a)(12).
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Eduardo A. Aleman,
Assistant Secretary.
[FR Doc. 2017-25354 Filed 11-22-17; 8:45 am]
BILLING CODE 8011-01-P


