Proposal To Exempt the Trading and Clearing of Certain Credit Default Products Traded on the Chicago Board Options Exchange and Cleared Through the Options Clearing Corporation Pursuant to the Exemptive Authority in § 4(c) of the Commodity Exchange Act

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed order and request for comment.

SUMMARY:

The Commodity Futures Trading Commission (“CFTC” or the “Commission”) is proposing to exempt the trading and clearing of certain credit default products that are proposed to be traded on the Chicago Board Options Exchange (“CBOE”) and cleared through the Options Clearing Corporation (“OCC”) from any applicable provisions of the Commodity Exchange Act (“CEA”). Authority for this exemption is found in Section 4(c) of the CEA.

DATES:

Comments must be received on or before May 29, 2007.

ADDRESSES:

Comments may be submitted by any of the following methods:

• Federal eRulemaking Portal: http://www.regulations.gov/http://frwebgate.access.gpo/cgi-bin/leaving. Follow the instructions for submitting comments.
• E-mail: secretary@cftc.gov. Include “OCC Clearing Credit Default Options” in the subject line of the message.
• Fax: 202-418-5521.
• Mail: Send to Eileen A. Donovan, Acting Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
• Courier: Same as mail above.

All comments received will be posted without change to http://www.CFTC.gov/.

FOR FURTHER INFORMATION CONTACT:

John C. Lawton, Deputy Director and Chief Counsel, 202-418-5480, jlawton@cftc.gov, and Robert B. Wasserman, Associate Director, 202-418-5092, rwasserman@cftc.gov, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1151 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Introduction

The OCC is both a Derivatives Clearing Organization (“DCO”) registered pursuant to Section 5b of the CEA, 7 U.S.C. 7a-1, and a securities clearing agency registered pursuant to Section 17A of the Securities Exchange Act of 1934 (“1934 Act”). The CBOE is a national securities exchange registered as such under Section 6 of the 1934 Act.

CBOE has filed with the Securities and Exchange Commission (“SEC”) proposed rule changes to provide for the listing and trading on CBOE of cash-settled, binary call options based on credit events in one or more debt securities. These options are referred to as Credit Default Options (“CDOs”), and would pay the holder a specified amount upon the occurrence, as determined by CBOE, of a “Credit Event,” defined to mean an “Event of Default” on any debt security issued or guaranteed by a specified “Reference Entity.”

CBOE has also filed with the SEC proposed rule changes to provide for the listing and trading on CBOE of Credit Default Basket Options (“CDBOs”). These are similar in concept to CDOs, except that a CDBO covers more than one Reference Entity, and for each Basket Component (that is, a single Reference Entity) a notional value (a fraction of the aggregate Notional Face Value of the basket) and a recovery rate is specified. Upon the occurrence of a Credit Event involving a particular Reference Entity, the payout to the holder is equal to the product of (a) The Notional Face Value of that Basket Component multiplied by (b) one minus the recovery rate specified in advance for that Basket Component. CDBOs may be of the multiple-payout variety, or of the single-payout variety, where a payout occurs only the first time a Credit Event is confirmed with respect to a Reference Entity prior to expiration.

OCC has filed with the CFTC, pursuant to Section 5c(c) of the CEA and Commission Regulations 39.4(a) and 40.5 thereunder, requests for approval of rules and rule amendments that would enable OCC to clear and settle these CDOs and CDBOs in its capacity as a registered securities clearing agency (and not in its capacity as a DCO). Section 5c(c)(3) provides that the CFTC must approve any such rules and rule amendments submitted for approval unless it finds that the rules or rule amendments would violate the CEA.

The request for approval concerning the CDO product was filed effective March 8, 2007. On April 23, 2007, the review period was extended pursuant to Regulation 40.5(c) until June 6, 2007, on the ground that the CDOs “raise novel or complex issues, including the nature of the contract, that require additional time for review.” The request for approval concerning the CDBO product was filed effective April 23, 2007, and absent an extension the review period is scheduled to run until June 7, 2007.

II. Section 4(c) of the Commodity Exchange Act

Section 4(c)(1) of the CEA empowers the CFTC to “promote responsible economic or financial innovation and fair competition” by exempting any transaction or class of transactions from any of the provisions of the CEA (subject to exceptions not relevant here) where the Commission determines that the exemption would be consistent with the public interest. The Commission may grant such an exemption by rule, regulation or order, after notice and opportunity for hearing, and may do so on application of any person or on its own initiative.

In enacting Section 4(c), Congress noted that the goal of the provision “is to give the Commission a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner.” Permitting the CDOs and CDBOs to trade on CBOE and be cleared on OCC as discussed above may foster both financial innovation and competition. The CFTC believes that the venue or venues for trading and clearing of instruments such as CDOs and CDBOs should be determined by the competitive forces of the market, particularly where any potential venue would be subject to federal regulatory oversight. The CFTC is requesting comment on whether it should exempt CDOs and CDBOs, as described above, that are traded on CBOE and cleared through OCC, from any provision of the CEA that might be transgressed by trading and clearing those transactions as described above.

In proposing this exemption, the CFTC need not—and does not—find that the CDOs and CDBOs are (or are not) subject to the CEA. During the legislative process leading to the enactment of Section 4(c) of the CEA, the House-Senate Conference Committee noted that:

The Conferees do not intend that the exercise of exemptive authority by the Commission would require any determination beforehand that the agreement, instrument, or transaction for which an exemption is sought is subject to the Act. Rather, this provision provides flexibility for the Commission to provide legal certainty to novel instruments where the determination as to jurisdiction is not straightforward. Rather than making a finding as to whether a product is or is not a futures contract, the Commission in appropriate cases may proceed directly to issuing an exemption.

CDOs and CDBOs are “novel instruments” and the “determination as to [their] jurisdiction is not straightforward.” Given their potential usefulness to the significant market for credit derivatives products, however, the Commission believes that this may be an appropriate case for issuing an exemption without making a finding as to the nature of these particular instruments.

Section 4(c)(2) provides that the Commission may grant exemptions only when it determines that the requirements for which an exemption is being provided should not be applied to the agreements, contracts or transactions at issue, and the exemption is consistent with the public interest and the purposes of the CEA; that the agreements, contracts or transactions will be entered into solely between appropriate persons; and that the exemption will not have a material adverse effect on the ability of the Commission or any contract market or derivatives transaction execution facility to discharge its regulatory or self-regulatory responsibilities under the CEA.

The purposes of the CEA include “promot[ing] responsible innovation and fair competition among boards of trade, other markets and market participants.” It may be consistent with these and the other purposes of the CEA, and with the public interest, for the mode of trading of these transactions—whether it is to be through CFTC-regulated markets and clearing organizations or SEC-regulated markets and clearing organizations—to be determined by competitive market forces rather than by regulatory line-drawing. Accordingly, the CFTC is requesting comment as to whether an exemption from the requirements of the CEA should be granted in the context of these transactions.

Section 4(c)(3) includes within the term “appropriate persons” a number of specified categories of persons, and also in subparagraph (K) thereof “such other persons that the Commission determines to be appropriate in light of * * * the applicability of appropriate regulatory protections.” Both CBOE and OCC, as well as their members who will intermediate these transactions, are subject to extensive and detailed regulation by the SEC under the 1934 Act. The CFTC is requesting comment as to whether all persons trading CDOs and CDBOs traded on CBOE and cleared on OCC are appropriate persons.

In light of the above, the Commission also is requesting comment as to whether this exemption will interfere with its ability to discharge its regulatory responsibilities under the CEA, including its ability to determine whether the listing of similar or identical products on a designated contract market or derivatives transaction execution facility would or would not violate the CEA, or with the self-regulatory duties of any contract market or derivatives transaction execution facility.

III. Request for Comment

The Commission requests comment on all aspects of the issues presented by this proposed order.

IV. Related Matters

A. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (“PRA”) imposes certain requirements on federal agencies (including the Commission) in connection with their conducting or sponsoring any collection of information as defined by the PRA. The proposed exemptive order would not, if approved, require a new collection of information from any entities that would be subject to the proposed order.

B. Cost-Benefit Analysis

Section 15(a) of the CEA, as amended by Section 119 of the Commodity Futures Modernization Act of 2000 (“CFMA”), requires the Commission to consider the costs and benefits of its action before issuing an order under the CEA. By its terms, Section 15(a) as amended does not require the Commission to quantify the costs and benefits of an order or to determine whether the benefits of the order outweigh its costs. Rather, Section 15(a) simply requires the Commission to “consider the costs and benefits” of its action.

Section 15(a) of the CEA further specifies that costs and benefits shall be evaluated in light of five broad areas of market and public concern: Protection of market participants and the public; efficiency, competitiveness, and financial integrity of futures markets; price discovery; sound risk management practices; and other public interest considerations. Accordingly, the Commission could in its discretion give greater weight to any one of the five enumerated areas and could in its discretion determine that, notwithstanding its costs, a particular order was necessary or appropriate to protect the public interest or to effectuate any of the provisions or to accomplish any of the purposes of the CEA.

The proposed exemptive order may facilitate market competition. The Commission is considering the costs and benefits of this proposed order in light of the specific provisions of Section 15(a) of the CEA, as follows:

1. Protection of market participants and the public. CBOE, OCC and their members who would intermediate CDOs and CDBOs are subject to extensive SEC oversight.

2. Efficiency, competition, and financial integrity. The proposed exemption may enhance market efficiency and competition since it could encourage potential trading of CDOs and CDBOs on markets other than designated contract markets or derivative transaction execution facilities. Financial integrity will not be affected since the CDOs and CDBOs will be cleared by OCC, a DCO and SEC-registered clearing agency, and intermediated by SEC-registered broker-dealers.

3. Price discovery. Price discovery may be enhanced through market competition.

4. Sound risk management practices. OCC has described appropriate risk-management practices that it will follow to margin CDOs and CDBOs.

5. Other public interest considerations. The proposed exemption may encourage development of credit derivative products through market competition without unnecessary regulatory burden.

After considering these factors, the Commission has determined to seek comment on the proposed order as discussed above. The Commission invites public comment on its application of the cost-benefit provision.