The Commodity Futures Trading Commission (“CFTC”) has
proposed new governance
requirements (“Governance Proposal”) for derivatives
clearing organizations (“DCOs”). Under the Governance
Proposal, DCOs would need to create forums to consult with their
clearing members and the customers of clearing members on matters
that could materially affect the risk profile of the DCO and
respond to some feedback.

While the focus of the Governance Proposal is DCOs, clearing
members and customers of clearing members should consider the
ramifications of codifying this industry practice as a regulatory
requirement. Among other issues, clearing members and customers of
clearing members will need to consider carefully how they interact
with and manage the representatives who are selected to review DCO
risk matters and provide feedback.

Background

The Governance Proposal is based on recommendations from
the CFTC’s Market Risk Advisory Committee (“MRAC”).
MRAC is an advisory committee that is composed of DCOs, clearing
members, end-users, and other stakeholders. It assessed the
existing DCO governance requirements to identify opportunities to
enhance their effectiveness. Its recommendations were that the CFTC
should codify the existing risk governance practices of some DCOs
to enhance transparency and ensure the consideration of the views
of owners and participants in risk management matters.

Governance Proposal

There are two key elements to the Governance Proposal.

Risk Management Committees

First, each DCO would be required to establish and consult with
one or more risk management committees (“RMCs”) on
matters that could materially affect the risk profile of the
DCO.

The RMCs would be composed of representatives of clearing
members and customers of clearing members who are selected by the
DCO. The RMC would need to contain at least two representatives of
clearing members and two representatives of customers of clearing
members, although a DCO would have flexibility to set the maximum
size of the RMC based on its structure. The DCO would be required
to rotate the membership of the RMC on a regular basis, and the
CFTC is considering if it should add a minimum frequency for
rotations to the final rule.

As with other affiliated individuals, the DCO would need to
consider the fitness of individual members for RMC participation
and develop appropriate fitness standards. The individual members
of an RMC would be expected to serve as independent experts that
are “neither beholden to their employers’ particular
interests nor acting as fiduciaries of the DCO.”

The board of the DCO would be required to consult with, and
consider and respond to input from, an RMC on all matters that
could materially affect the risk profile of the DCO. This would
include any material change to the DCO’s margin model, default
procedures, participation requirements, and risk monitoring
practices, as well as the clearing of new products. While the board
would retain the ultimate responsibility to make major decisions
with respect to the DCO, it would be required to respond to the
substance of the input it receives from an RMC and could not merely
acknowledge that the input was received.

The CFTC requests comment on whether members of an RMC should be
permitted to share certain types of information they learn in their
capacity as an RMC member with fellow employees of their clearing
member or customer firm in order to obtain additional expert
opinion. It also asks if there should be criteria for the types of
information that may be shared and what measures should be taken to
ensure the confidentiality of DCO information.

The DCO would be required to maintain written policies and
procedures to make certain that the RMC consultation process is
described in detail and includes requirements for the DCO to
document the board’s consideration of and response to RMC
input. A DCO also would be required to maintain policies that are
designed to enable its RMC members to provide independent, expert
opinions in the form of risk-based input on all matters presented
to the RMC for consideration and perform their duties in a manner
that supports the safety and efficiency of the DCO and the
stability of the broader financial system.

Risk Advisory Working Groups

Second, each DCO would be required to establish one or more risk
advisory working groups (“RWGs”) from which the DCO may
seek risk-based input. The membership of RWGs generally would be
larger than an RMC, for example, including a diverse cross-section
of the DCO’s clearing members and customers of its clearing
members.

A DCO would be required to convene an RWG at least quarterly and
solicit input regarding all matters that could materially affect
the risk profile of the DCO. The CFTC is considering whether to
require DCOs to document RWG meetings.

Other Changes

The Governance Proposal also asks if a DCO should be required to
consult with a broad spectrum of market participants prior to
submitting any rule change to the CFTC. It also requests comment on
how DCOs should be expected to describe and respond to opposing
views.

Considerations

It appears from comments made by Commissioner Summer K.
Mersinger that 12 DCOs already have some form of an RMC and six
already have RWGs. This may indicate that RMCs and RWGs are widely
accepted best practices. However, imposing them as regulatory
requirements may create new concerns and crystalize existing
issues.

Independence

First, it is unclear how a DCO, clearing member, or customer of
a clearing member would be expected to ensure that members of an
RMC act as independent experts. The Governance Proposal notes that
there may be a tension between RMC members’ corporate law
duties to their employer and regulatory obligations to the DCO.
Moreover, members of an RMC presumably will be compensated by their
employer and, therefore, may have an implicit bias for their
employers’ particular interests. While the Governance Proposal
requests comment on whether a DCO should be required to have
policies for managing conflicts of interest involving RMC members,
it is not clear whether or how a DCO policy would be able to alter
RMC members’ duties to their employees.

Separately, the Governance Proposal does not address how
clearing members and customers of clearing members may interact
with and manage RMC members. For example, must a clearing member or
customer firm consider the ability of a prospective RMC member to
act independently of their commercial interests? May a clearing
member or customer firm ask an RMC member to consider or understand
commercial interests that affect a DCO risk matter, or must the RMC
member be walled off from all commercial information? It seems that
the CFTC may be seeking a level of independence in RMC members that
is more consistent with a public accountant or, at least, a second
or third line of defense. This may be difficult to achieve in
practice.

With respect to the RMC member’s status as a representative
and employee of the clearing member and customer firm, under what
circumstances may a clearing member or customer firm terminate all
or part of the relationship? For example, if an RMC member makes a
recommendation to a DCO that a clearing member disagrees with, may
the clearing member replace the RMC member or terminate their
employment?¹ Similarly, if an RMC member is investigated
or sued for their actions on the RMC (e.g., leaking information,
harassment), who is responsible/liable for their conduct and to
whom may they look for indemnification?²

Confidentiality

Second, it would seem preferable for the CFTC to define and
impose a duty of confidentiality on RMC and RWG members instead of
relying on DCO rules or contractual terms. This is particularly
true with respect to the contemplated information sharing
practices, which may vary among DCOs and among clearing members and
customer firms. A CFTC-imposed duty also may mitigate questions
regarding who is liable for an improper disclosure (e.g., the RMC
member as an individual, the RMC member as an employee, or the RMC
member’s employer).

More broadly, however, the CFTC’s recognition that highly
confidential material would be shared with the RMC members raises
questions with how that information should be stored and managed by
the RMC members. For example, may they retain confidential DCO
information in an employer-monitored email account? What if the
confidential DCO information discloses an impending peril for their
employer? Must the RMC member “sit” on this information
until the clearing member or customer firm becomes aware of it?
Could they disclose the risk to their employer without disclosing
the source of the information?

RWG Involvement

Third, the Governance Proposal’s discussion of RWGs is vague
and somewhat confusing. On one hand, it states that RWGs would need
to be convened at least once each quarter. On the other hand, it
implies that RWGs would have the opportunity to provide input on
all matters that could materially affect the risk profile of the
DCO. It is unclear how a DCO would be expected to seek input from
RWGs on time-sensitive matters that might not be able to wait until
the next quarterly meeting. It also is unclear if DCOs would be
required to provide RWGs with the same level of detail on
risk-related matters as is provided to RMCs.

Next Steps

Comments on the Governance Proposal are due to the CFTC by
October 11, 2022. If you have any questions or comments, we look
forward to hearing from you.

Footnotes

1. Presumably, an RMC member’s participation in an
RMC would end if the individual’s employment with the clearing
member or customer firm is terminated, but this is not stated in
the Governance Proposal.

2. Some DCOs indemnify RMC members, but this would not be
expressly required by the Governance Proposal.

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