ASX gets first DCO exemption from CFTC

ASX becomes first exempt DCO, and four Asian CCPs have also applied for an exemption

This is a 'world-first' CFTC decision

The Commodity Futures Trading Commission (CFTC) has granted Australian Securities Exchange (ASX) the first exemption from registering as a derivatives clearing organisation (DCO), allowing it the permanent right to clear derivatives for US clearing members but not US clients.

Under US rules, central counterparties (CCPs) must apply to the CFTC to become a DCO – effectively a fully recognised clearing house that has permission to clear derivatives for US banks and clients such as pension funds or hedge funds. The alternative is to go for an exemption that would limit clearing to US clearing members – effectively a substituted compliance regime for CCPs.

“This is the first order of its kind issued by the CFTC – it is a world-first,” says Amanda Harkness, group general counsel at ASX in Sydney. “The US authorities have provided a regulatory mechanism for exemption from DCO registration for the clearing of swaps where there is material equivalence of regulation by a home country regulator. The CFTC has recognised that its regulatory objectives and policy outcomes can be achieved through this process.”

A legal source close to the DCO exemption process says the move could provide a business boost for ASX, as it gives more certainty to market participants, given that the exemption is permanent and the Australian exchange has been relying on short-lived CFTC no-action letters while it awaited a decision.

Harkness says the decision is important in markets such as Australia, where US banks are major players in interest rate derivatives.

The exemption means that the opportunity to both participate in the market and clear with us is bigger

“It allows ASX to clear their proprietary swaps, and also supports the business franchise of US banks in our market. To date, US banks have participated through local subsidiaries. The exemption means that the opportunity to both participate in the market and clear with us is bigger,” she says.

The US regulator outlined the process to obtain a DCO exemption in a series of private letters to CCPs in 2014. The US regulator has not created a formal rule-making to set out the process, something that market participants had been expecting when the power to create an exemption pathway under section 5b(h) of the US Commodity Exchange Act was first touted more than 18 months ago.

A source at KRX tells Risk.net that the South Korean clearing house submitted its petition for exemption on August 13 while Hong Kong’s HKEx has also lodged an application with the US regulator. India’s over-the-counter clearing house, CCIL, is understood to have applied at the end of June.

All four Asian CCPs expressed an interest in the exemptive pathway last year because they primarily clear local currency products for market participants regionally, including US banks but not US clients. As a result, they were granted no-action relief to accept US clearing members until end-December 2015.

As an exempt DCO can’t clear trades for US clients, ASX hasn't ruled out the possibility of applying for DCO status in the future.

“We understand the CFTC’s regulatory concern requiring clearing houses that clear for US clients to register as a DCO. We also understand that major US clients want this. We are not expecting that there will be demand from US clients for us to provide this service. If there was sufficient interest, we would then consider if DCO registration made sense for us,” says Harkness.

But according to the legal source, allowing an exempt DCO to clear client trades would be a better outcome for the cleared derivatives market. If a US client can only clear through the handful of DCOs that currently exist where they have a relationship with a clearing member, it limits choice.

“The CFTC has said that for the time being they won’t allow an exempt DCO to clear client trades, but it wouldn’t surprise me if in the future regulators loosen that up. Allowing exempt DCOs to clear for US customers would increase competition and potentially encourage more clearing,” says the legal source.

JSCC still waiting

To date in Asia, SGX remains the only CCP to have gained DCO status – the Japan Securities Clearing Corporation still hasn’t received DCO status, despite first applying more than two years ago. Such a designation would be helpful for JSCC, given that it plans to start clearing US dollar, Australian dollar and euro interest rate swaps in September – and achieving DCO status would make it easier to attract business from US customers such as hedge funds.

The realisation of an exempt DCO pathway where exempt CCPs can’t clear for US customers also raises once more the question of equivalency with Europe’s rules – a matter that has been outstanding for more than a year and where the US has watched while jurisdictions in Asia received equivalency determinations ahead of it.

The legal source says that the establishment of the first DCO-exempt CCP at least supports the CFTC’s case that it is doing everything that it can in its negotiations with regulators, including those in the EU.

“The fact that the CFTC issued this exemption bolsters its argument that it’s willing to work with non-US regulators and CCPs to create a regulatory structure that makes sense and is willing to be flexible to avoid overlapping regulatory requirements where a clearing house is adequately regulated at home,” says the source.