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Bloomberg L.P. v. Commodity Futures Trading Commission

United States District Court, District Circuit

June 7, 2013

BLOOMBERG L.P., Plaintiff,
v.
COMMODITY FUTURES TRADING COMMISSION, Defendant.

MEMORANDUM OPINION

BERYL A. HOWELL, District Judge.

This is a challenge to a regulation, 17 C.F.R. § 39.13(g)(2)(ii), promulgated by the United States Commodity Futures Trading Commission (the "CFTC" or the "Commission"), which sets minimum liquidation times for swaps and futures contracts. The plaintiff Bloomberg L.P. ("Bloomberg") claims, pursuant to the Administrative Procedure Act ("APA"), 5 U.S.C. §§ 500, et seq., that the Commission's regulation is both procedurally and substantively defective and must be set aside. Further, the plaintiff has applied for a preliminary injunction against the challenged regulation, claiming that a forthcoming phase of a related rule's implementation will cause the plaintiff imminent and irreparable harm if the minimum liquidation times are not enjoined. In this regard, Bloomberg alleges that, unless immediately enjoined, the Commission's regulation prescribing minimum liquidation times, when combined with other regulatory and market forces, will encourage the plaintiff's subscribers to migrate permanently to competitors' trading venues. The plaintiff, however, lacks standing to challenge the Commission's regulation and has not made a showing of imminent and irreparable harm sufficient to warrant the extraordinary relief of a preliminary injunction. Therefore, as discussed below, the Court denies the plaintiff's application for preliminary injunctive relief and dismisses this case for lack of standing.

I. BACKGROUND

Since this is an administrative law case, it is appropriate first to discuss generally the economic and regulatory framework of the challenged rule. Next, the Court will discuss the factual and procedural background of the particular rule being challenged.

A. Economic and Regulatory Framework

This case is about how the CFTC regulates the trading of derivatives. "Derivatives are financial contracts whose prices are determined by, or derived' from, the value of some underlying asset, rate, index, or event." Nat'l Comm'n on the Causes of the Fin. & Econ. Crisis: The Financial Crisis Inquiry Report: Final Report 45-46 (2011). These instruments are not used to form capital or invest; rather, they are used for "hedging business risk or for speculating on changes in prices, interest rates, and the like." Id. at 46. Although derivatives can come in many forms, there are two categories of derivatives implicated in this lawsuit: "swaps" and "futures."

1. How Swaps and Futures Contracts Are Traded

"A swap' is a contract that typically involves an exchange of one or more payments based on the underlying value of a notional amount of one or more commodities, or other financial or economic interest, " and it "transfers between the parties the risk of future change in that value without also transferring an ownership interest in the underlying asset or liability." Mem. in Supp. Pl.'s Appl. for Prelim. Inj. ("Pl.'s Mem.") at 3-4, ECF No. 13 (citing 7 U.S.C. § 1a(47)). In essence, the two parties to a swap agreement trade (or "swap") the cash flows stemming from the assets or liabilities underlying the agreement. For example, a fixed-to-floating interest rate swap is an agreement whereby one party agrees to pay the cash flows associated with a fixed interest rate, while the other party agrees to pay the cash flows associated with a referenced floating interest rate ( e.g., LIBOR). See, e.g., Financial Crisis Inquiry Report at 46. A "futures contract" or simply a "future, " by contrast, is "[a]n agreement to buy or sell a standardized asset (such as a commodity, stock, or foreign currency) at a fixed price at a future time." BLACK'S LAW DICTIONARY 746 (9th ed. 2009).

Futures contracts or their functional equivalents have been traded for millennia. See, e.g., Michael P. Jamroz, The Net Capital Rule, 47 BUS. LAW. 863, 890 n.186 (1992) ("The ultimate origins of the futures markets can be traced to 2000 B.C., where... merchants of what is now Bahrein Island took goods on consignment for barter in India.'" (quoting JERRY W. MARKHAM, THE HISTORY OF COMMODITY FUTURES TRADING AND ITS REGULATION 3 (1987)). In the United States, the first organized futures exchange was the Chicago Board of Trade, which officially began trading futures contracts in the 1860s. See MARKHAM, HISTORY OF COMMODITY FUTURES TRADING at 4. Indeed, "[b]y 1868, futures contracts had become standardized on the Chicago Board of Trade." Id. at 5. For several decades, futures exchanges operated without any federal regulatory oversight until 1922 when Congress enacted the Grain Futures Act, Pub. L. No. 67-331, 42 Stat. 998, which for the first time[1] required grain futures exchanges to be registered as "contract markets" and also required them to keep detailed records of trading information. See 42 Stat. at 1000 (providing for designation of "contract markets" by Secretary of Agriculture, and requiring contract markets to keep records of the terms of futures transactions).

In 1936, Congress replaced the Grain Futures Act with the Commodity Exchange Act ("CEA"), Pub. L. No. 74-675, 49 Stat. 1491, which broadened federal regulation of futures, established the Commodity Exchange Commission, [2] and granted that agency the power to regulate futures traders directly (as opposed to only regulating contract markets). See 49 Stat. at 1492. The CEA also, inter alia, (1) limited speculative positions that could be taken in futures markets, see id. § 5, and (2) established registration requirements for futures brokerage firms known as "futures commission merchants, " id. The Commodity Exchange Commission also "informally urged the exchanges to adopt minimum margin requirements, " even though the statute itself contained no authority to require the adoption of minimum margin rules. See MARKHAM, HISTORY OF COMMODITY FUTURES TRADING at 30. "Several exchanges agreed... and adopted minimum margin rules." Id.

In 1974, federal regulation of futures was expanded even further with the enactment of the Commodity Futures Trading Commission Act, Pub. L. No. 93-463, 88 Stat. 1389. That statute, which forms the basis of the current futures regulatory scheme, created the CFTC as an independent federal agency, authorized to seek injunctive relief, to alter the rules of a contract market, and to prescribe trading limits. See Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Curran, 456 U.S. 353, 365-66 (1982); see also CFTC Act § 101, 88 Stat. at 1389 (establishing the CFTC "as an independent agency of the United States Government").

Since the amendments to the CEA passed in the Futures Trading Act of 1982, the CEA has required futures to be traded on centralized exchanges known as "designated contract markets" ("DCMs"), see 7 U.S.C. § 6(a); see also Futures Trading Act of 1982, Pub. L. No. 97-444, § 204, 96 Stat. 2294, 2299, which are subject to a variety of regulatory requirements that ensure transparency and prudent risk management. For example, a DCM is required to "make public daily information on settlement prices, volume, open interest, and opening and closing ranges for actively traded contracts on the contract market." 7 U.S.C. § 7(d)(8). Specifically, DCMs are required to make information on prices, trading volume, and other trading information "readily available to the news media and the general public without charge, in a format that readily enables the consideration of such data, no later than the business day following the day to which the information pertains." 17 C.F.R. §§ 16.01(e), 38.451. Additionally, every transaction executed on a DCM must be "cleared" through an entity called a "derivatives clearing organization" ("DCO"). See 17 C.F.R. § 38.601(a); see also Part I.A.2 infra (discussing operation and regulation of DCOs).[3]

By contrast to the ancient roots of futures contracts, swaps are a much newer phenomenon. Although "there is some debate regarding the timing of the first modern swap agreement, scholars generally agree that the execution of a swap agreement between the World Bank and IBM [in 1981] was one of the earliest and most significant transactions in the development of the swap market." Kristin N. Johnson, Things Fall Apart: Regulating the Credit Default Swap Commons, 82 U. COLO. L. REV. 167, 193 n.141 (2011); see also Charles R.P. Pouncy, Contemporary Financial Innovation: Orthodoxy and Alternatives, 51 SMU L. REV. 505, 529-30 & n.153 (1998) (tracing roots of the swaps market and discussing the 1981 IBM/World Bank currency swap transaction). Unlike futures, swaps were (before 2010) traded almost entirely in unregulated "over the counter" ("OTC") markets, where large financial institutions acted as derivatives dealers.[4] See Financial Crisis Inquiry Report at 46. In OTC markets, transactions are not required to be cleared, dealers are not required to register with the government, and trading information is not required to be made public. See id.

Without regulatory oversight, "OTC derivatives rapidly spiraled out of control and out of sight, growing to $673 trillion in notional amount." Id. at xxiv. OTC derivatives then "contributed significantly" to the global financial crisis in 2008, see id., and Congress responded by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank), Pub. L. No. 111-203, 124 Stat. 1376 (2010). Dodd-Frank, among other things, (1) placed swaps within the jurisdiction of the CFTC, see Dodd-Frank, § 722(a), 124 Stat. at 1672, (2) required the CFTC to determine which swaps must be cleared, see id. § 723(a)(3), 124 Stat. at 1676-77, and (3) mandated that all cleared swaps be traded like futures-on centralized, regulated exchanges, see id., 124 Stat. at 1681; see also S. Rep. No. 111-176, at 34 (2010) ("Trading more derivatives on regulated exchanges should be encouraged because it will result in more price transparency, efficiency in execution, and liquidity.").[5] In particular, Dodd-Frank generally requires that all cleared swaps be traded on either a DCM or a new entity called a "swap execution facility" ("SEF"). See 124 Stat. at 1681 (codified at 7 U.S.C. § 2(h)(8)). Since the CFTC's rules regarding mandatory clearing and SEFs are still being phased in, however, large swaths of swaps continue to be traded OTC.[6]

2. Derivatives Clearing Organizations

DCOs are "clearinghouses or similar entities that enable the parties to a derivatives transaction to substitute the credit of the DCO for the credit of the parties to the swap." Pl.'s Mem. at 7 (citing 7 U.S.C. § 2(h)(2)). A transaction is "cleared" when a member of a DCO uses a novation to interpose itself between the two original counterparties to the derivatives contract, thereby assuming the credit risk of both counterparties. See, e.g., Adam J. Levitin, Response: The Tenuous Case for Derivatives Clearinghouses, 101 GEO. L.J. 445, 451 (2013). "[E]ach DCM is connected to a single DCO..., which clears all futures contracts executed on that DCM." Decl. of Dr. Sharon Brown-Hruska ("Brown-Hruska Decl.") ¶ 17 (May 2, 2013), ECF No. 13-4.

DCO members are generally large financial institutions who "invest capital that the clearinghouse can use to cover default losses, " and in this way a DCO is "analogous to a mutual insurance company." Pirrong, The Clearinghouse Cure at 46. Unlike a mutual insurance company, however, which charges premiums to the customers it insures, DCOs require their members to post a "margin" or a "performance bond, " which acts as collateral against the possibility of default. See id.; see also Def.'s Mem. in Opp'n to Pl.' Appl. for Prelim. Inj. ("Def.'s Opp'n") at 3, ECF No. 21. When a trade is first cleared, the DCO collects an initial margin payment based on the amount of default risk assumed by the DCO, and then periodically (usually twice per day), the DCO will "mark positions to market" to ensure that "collateral reflects current market conditions." See Pirrong, The Clearinghouse Cure at 46. For example, if the price of a commodity goes down during the trading day, the buyer of a futures contract would be required to post additional margin "to offset the risk that a buyer might walk away from a futures contract in which the agreed-upon price now seems too high." Id.

DCOs reference a number of inputs to calculate how much margin they will require for a particular trade. In particular, "DCOs calculate the required margin according to a value-at-risk' formula." Def.'s Opp'n at 3. Value-at-risk ("VaR") is a formula that uses historical market data to predict what portion of a financial portfolio is statistically likely to be at risk of being lost in the market at any given point in time. See, e.g., The Risks of Financial Modeling: VaR and the Economic Meltdown: Hearing Before the Subcomm. on Investigations & Oversight of the H. Comm. on Sci. & Tech., 111th Cong. 87 (2009) (statement of Gregg E. Berman, Head of Risk Business, RiskMetrics Group) (explaining how VaR is calculated). In addition to market volatility and other considerations, see id., one "standard input" to the VaR formula "is the amount of time the DCO estimates it will take to liquidate the product or portfolio following a default, " Def.'s Opp'n at 3 & n.1. This is known as the "liquidation time" for a particular product or portfolio. See, e.g., Pl.'s Mem. at 8-9 ("Liquidation time is the estimated amount of time it would take a DCO to liquidate' a position held by a clearing member on behalf of its customer, in the case of default."). All else being equal, a higher liquidation time typically results in a higher initial margin requirement. See id. at 9; see also Def.'s Opp'n at 3 n.1 (providing typical VaR formula).

One portion of Dodd-Frank put in place eighteen "core principles, " with which DCOs are required to comply. See Dodd Frank, § 725(c), 124 Stat. at 1687-92 (codified at 7 U.S.C. § 7a-1(c)(2)). One of those principles-Core Principle D-addresses risk management and states generally that each DCO "shall ensure that the [DCO] possesses the ability to manage the risks associated with discharging the responsibilities of the [DCO] through the use of appropriate tools and procedures." 7 U.S.C. § 7a-1(c)(2)(D)(i). Of particular relevance to this case, Core Principle D states that "[t]he margin required from each member and participant of a [DCO] shall be sufficient to cover potential exposures in normal market conditions." Id. § 7a-1(c)(2)(D)(iv). Further, Core Principle D requires that "[e]ach model and parameter used in setting margin requirements under clause (iv) shall be (I) risk-based; and (II) reviewed on a regular basis." Id. § 7a-1(c)(2)(D)(v).

B. Factual and Procedural Background

1. The Proposed Rule

Pursuant to Dodd-Frank's DCO Core Principles (including Core Principle D) and the rulemaking authority delegated by Congress in the CEA, see 7 U.S.C. § 12a(5), the Commission published a Notice of Proposed Rulemaking ("NPRM") on January 20, 2011. See Risk Management Requirements for Derivatives Clearing Organizations, 76 Fed Reg. 3698 (proposed Jan. 20, 2011). That NPRM proposed the promulgation of several rules implementing Core Principles C (Participant and Product Eligibility), D (Risk Management), E (Settlement Procedures), F (Treatment of Funds), G (Default Rules and Procedures), and I (System Safeguards). See id. at 3698. Of particular relevance to this case, the January 20, 2011 NPRM proposed a regulation that

would require a DCO to use margin models that generate initial margin requirements sufficient to cover the DCO's potential future exposures to clearing members based on price movements in the interval between the last collection of variation margin and the time within which the DCO estimates that it would be able to liquidate a defaulting clearing member's position (liquidation time).

Id. at 3704 (footnote omitted). The NPRM also proposed requiring DCOs to use liquidation times for this margin model that were: (1) "a minimum of five business days for cleared swaps that are not executed on a DCM, " and (2) "a minimum of one business day for all other products that it clears." Id. The NPRM also proposed that a DCO "would be required to use longer liquidation times, if appropriate, based on the unique characteristics of particular products or portfolios." Id.; see also id. at 3720-21 (proposing language of 17 C.F.R. § 39.13(g)(2)(ii)).

The Commission justified its proposed minimum liquidation times primarily by reference to current industry standards for DCOs. In this regard, the NPRM explained that "[a] minimum of one business day is the current standard that DCOs generally apply to futures and options on futures contracts." Id. at 3704. It further explained that "[s]everal clearing organizations currently use a five-day liquidation time in determining margin requirements for certain cleared swaps, " and thus "[t]he Commission believes that a minimum of five business days is appropriate for cleared swaps that are not executed on a DCM in that such a time period may be necessary to close out swap positions in a cost-effective manner." Id. Cognizant that it could benefit from public comment, however, the Commission also stated that it would "invite[] comment regarding whether the minimum liquidation times specified in proposed § 39.13(g)(2)(ii) are appropriate, or whether there are minimum liquidation times that are more appropriate." Id.

2. Public Comments on the Proposed Rule

At a broader level, the CFTC proposed rules implementing Dodd-Frank's DCO Core Principles through at least five separate NPRMs, including the January 20, 2011 NPRM discussed above. See 76 Fed. Reg. at 69, 335. The Commission had an initial comment period of sixty days for each NPRM, followed by a thirty-day reopened comment period, which was followed yet again by a late comment period lasting until August 25, 2011. See id. Therefore, public comment regarding the January 20, 2011 NPRM lasted for approximately eight months. During that time, the Commission received approximately 119 comment letters directed at the proposed rules regarding DCO Core Principles. See id. [7]

Numerous commenters remarked specifically on the Commission's proposed minimum liquidation times, though even the limited sample of comments submitted to the Court reveal a diversity of opinions on the appropriate policy for setting liquidation times.[8] Many of these comments took issue with the venue-based approach used in the NPRM. For example, LCH.Clearnet Group Limited-a large derivatives clearinghouse-suggested that "the rules should not prescribe differential margining treatment for Swaps with equivalent economic and risk profiles based on whether these are executed on a [DCM] or elsewhere." See Decl. of Mary T. Connelly ("Connelly Decl.") Ex. A ("LCH Comment Letter") at 11, ECF No. 21-2. Similarly, BlackRock, an asset management firm that represents several derivatives traders, "encourage[d] the CFTC not to treat swaps executed on [SEFs] differently from those executed on [DCMs], for purposes of a DCO's margin calculation." Connelly Decl. Ex. B ("BlackRock Comment Letter") at 2, ECF No. 21-2; see also Connelly Decl. Ex. H ("Nodal Exchange Comment Letter") at 2, ECF No. 21-2 ("Nodal Exchange is concerned that the Commission is prescribing initial margin methodology requirements based solely on the swap's execution venue rather than the swap's inherent risk characteristics.").

In this same vein, numerous commenters raised concerns that the proposed venue-based rule would have anticompetitive effects in the swap trading platform marketplace. For example, BlackRock stated that the rule "would raise the cost of executing swaps on SEFs, undermine the competitiveness of SEFs, and restrict artificially the ability of market participants, including asset managers, to select the best means of execution for their swap transactions." BlackRock Comment Letter at 3. GFI Group Inc., which is a derivatives broker, was concerned that the venue-based approach "would inadvertently place [SEFs] that list cleared swaps for trading at a disadvantage relative to [DCMs] that list the same swaps, " which GFI believed was "inconsistent with" the CEA's open-access provisions that "require a DCO to adopt rules providing that all swaps with the same terms and conditions submitted to the DCO for clearing are economically equivalent within the DCO." Connelly Decl. Ex. D ("GFI Comment Letter") at 1-2, ECF No. 21-2; see also id. at 3 ("[T]he Proposed Rule would effectively place a tax' on market participants that desire to trade swaps on a SEF and would thus put SEFs at a competitive disadvantage that is neither necessary nor appropriate under the [CEA]."). MarketAxess Corporation, another dealer-broker, raised similar concerns. See Connelly Decl. Ex. E ("MarketAxess Comment Letter") at 2, ECF No. 21-2 (noting that venue-based approach "would place SEFs at a significant competitive disadvantage relative to DCMs and would frustrate congressional intent").

By contrast, at least one commenter cautioned that competition between DCOs with regard to margin requirements could prove ruinous. Alice Corporation Pty Ltd, an Australian financial markets research and development company, commented that the Commission should "[a]void a race to the bottom' between DCOs." See Connelly Decl. Ex. I ("Alice Comment Letter") at 8, ECF No. 21-2. In particular Alice noted that "[c]ompetition between DCOs has systemic risk consequences and careful oversight will be required to ensure competition on margin and clearing fees does not increase risk." Id. Alice went on to remark that "[t]here is great pressure from market participants for offset across different products, " and therefore "[o]ffsets across products with different maturities and risk profiles should be avoided where possible." Id.

As an alternative to a venue-based approach, several commenters advocated for a principles-based approach that would permit each DCO to set liquidation times in its discretion. See, e.g., LCH Comment Letter at 11 (suggesting that liquidation times should "be an objective function of the DCO's measurement of observed market volumes in given products and set at a period that would be sufficient to enable the DCO to adequately hedge or close-out a defaulting member's risk"). In this regard, some commenters suggested adopting the clearing standards set forth by the Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions ("CPSS-IOSCO"). See Connelly Decl. Ex. C ("Citadel Comment Letter") at 4, ECF No. 21-2; Connelly Decl. Ex. F ("MFA Comment Letter") at 5, ECF No. 21-2. Others suggested simply setting a one-day minimum liquidation time for all swaps and futures contracts regardless of trading venue. See GFI Comment Letter at 2; Nodal Exchange Comment Letter at 3.

By contrast, other comments noted that setting higher liquidation times for certain swaps than for other swaps and all futures would be appropriate. For example, LCH commented that "the current disparity between Swaps and futures contracts requires different risk management techniques and clearing processes." See LCH Comment Letter at 1. Although LCH "expect[ed] contract convergence as Swaps become more futures-like, " it commented that "it would be inappropriate at this stage to impose futures clearing criteria on long-dated, idiosyncratic and less liquid instruments." Id. Indeed, LCH explicitly stated that "the proposed time interval of one business day in [§ 39.13(g)(2)(ii)] is too short" for several reasons, including because "it can, and often will, be impossible for the DCO to close out the defaulting member's position within a one-day liquidation period, " which "is particularly important for DCOs clearing less liquid Swaps." Id. at 11. Nodal Exchange similarly remarked that, although the Commission's apparent ...


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