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CFTC Roundtable of Recovery of Derivatives Clearing Organizations

Commodity Futures Trading Commission

Staff Roundtable on Recovery of Derivatives Clearing Organizations

Thursday, March 19, 2015      

Key Topics & Takeaways

  • Strong Framework: Chairman Massad said that effective risk mitigation is dependent on a strong “overall framework” and noted that while no U.S. CCP has ever had to use resources beyond that of a defaulting member, the rules require the CFTC to plan for a possible CCP wind-down.
  • Variation Margin Gains Haircutting: CME’s Cutinho, said variation margin gains haircutting “as a limited purpose tool is attractive” because it provides certainty and expediency, saying it is “far better than insolvency” but added that it is “not a perfect tool.” The panel agreed that these haircuts should only be used as a last resort.
  • Money Good vs. Position Good: Black Rock’s Walters said that as a fiduciary her firm views variation and initial margin as “sacrosanct” and would prefer a CCP resolution to a recovery because her clients would “rather be money good than position good.”
  • Post Auction Front Running: JP Morgan’s Romanath said that the current structure of default auctions does a good job of incentivizing members to participate but worried that expanding the scope of who can participate would risk “front-running” activity by firms who see the portfolio but do not win the auction.
  • Sufficiency of Liquidity Arrangements: Wasserman stated that arrangements of clearing members that are already in place to meet variation margin requirements are robust relative to the liquidity needs under an assessment requirement.

Meeting Participants

Opening Statements

Tim Massad, Chairman of the Commodity Futures Trading Commission (CFTC), noted that the issue of centralized counterparty (CCP) recovery and resolution has been getting increased attention recently and that “this is a good thing.” He said that effective risk mitigation is dependent on a strong “overall framework” and that the goal is to never have to use the tools that the roundtable was convened to discuss.  He noted that while no U.S. CCP has ever had to use resources beyond that of a defaulting member, the rules require the CFTC to plan for a possible CCP wind-down. 

Commissioner Sharon Bowen said it is critically important that CCPs have a data driven approach to their risk management process. 

Commissioner Giancarlo commended the expertise and hard work of the CFTC’s Division of Clearing and Risk and stressed their important role as more products move to centralized clearing. 

Robert Wasserman, CFTC Chief Counsel of the Division of Clearing and Risk, explained that under the Principles for Financial Market Infrastructures (PFMI) CCPs need a plausible means of addressing unbalanced positions and transparent tools to incentivize stakeholders to control the risk they bring into the clearing system. 

Panel 1: Variation Margin Gains Haircutting

Wasserman began the first panel discussion by noting that using variation margin gains haircutting, where profits are haircut to help fund the financial needs of a failing CCP after the default waterfall has been depleted, can have advantages over other options such as cash calls. There is concern, however, that participants may refuse to pay these haircuts especially if they are used more than once, he added. 

Sunil Cutinho, CME, noted that this haircutting would only be used if the “financial safeguards package” develop to withstand a crisis has been exhausted. He said variation margin gains haircutting “as a limited purpose tool is attractive” because it provides certainty and expediency, saying it is “far better than insolvency” but added that it is “not a perfect tool.” 

Separating Products

Thomas Kadlec, President of ADM Investor Services on behalf of the Commodity Markets Council (CMC), said the CMC would support such haircuts “with certain limitations” and asked if they would apply to all commodity products. He stressed that the rule “would really need to be vetted out” and noted that agriculture products are not likely to cause a CCP failure.

Oliver Frankel, Goldman Sachs, said that if agricultural products were separated out, it would make clearing them more expensive but would prevent contagion from other products. He then said that if this haircutting was used more than once, the only other alternative would be to wind-down a CCP. Cutinho said that silo-ing products is impractical and “not the solution.” 

Rajalakshini Romanath, JP Morgan, said that end-users will have expectations of cash flows but that they will not be receiving them fully under this haircutting regime, which she said has the potential to exacerbate market stress. She added that to the extent silos for products are used, they should be designed up front, but stressed that products within these silos should not be separated out. She then said that market participants should be compensated for the losses they incur as a result of haircuts. 

Money Good vs. Position Good

Kristen Walters, Black Rock, said that as a fiduciary her firm views variation and initial margin as “sacrosanct” and would prefer a resolution to a recovery because her clients would “rather be money good than position good.” She said that any client margin beyond a defaulting member should not be touched. 

Cutinho said that the amount of capital contributed to the default waterfall should be based on a clearing member’s level of systemic risk and said these haircuts allow the incentives of the auction processes to work. 

Walters stressed that overall risk assessment of the default fund is important because CCPs are for-profit entities and that mandatory clearing should not be in place if products are only available at one clearing house. 

Tracy Jordal, Pacific Investment Management Company (PIMCO), said that end-users of non-defaulting clearing members should not be penalized and noted that the variation margin gains haircutting is lopsided because it penalizes the “winner.” She suggested that initial margin along with variation margin should be haircut to mutualize losses. Wasserman, however, said that the statute does not allow for haircutting of initial margin. 

Jean Phillipe Dion, RBC Capital Markets, stressed the importance of looking at the relative pros and cons of these haircuts, explaining that the alternative of “tear ups,” or closing out contracts, in the case of a CCP default has no obligation to make the market participant whole on their position. 

Phillip Priollo, Exelon, said that the use of these variation margin gain haircuts would only occur in a “dooms day scenario” and that he does not know what other tools would be available. 

Position in Waterfall

Phyllis Dietz, Acting Director of the CFTC’s Division of Clearing and Risk, asked if these haircuts could be employed further up in the default waterfall or if they should definitely be a last resort. The panel expressed agreement that they should be a last resort.

Lindsey Hopkins, Minneapolis Grain Exchange, said use of these haircuts would have long term negative reputational affects and stressed that rules should not be applied on a one-size fits all basis. 

Kevin McClear, InterContinental Exchange (ICE), said that these haircuts could possibly be used further up in the waterfall if the CCP wanted to save some resources for an auction or tear up process. 

Limited Use

Wasserman then asked how use of these haircuts would be limited and if these limits should come from governance structures or rules. 

Frankel said that governance and risk management functions should be involved in the determination on how to limit use of these haircuts, adding that continuing services regardless of losses “may not be the best strategy.” Cutinho said that the limit should be “hardwired.” Jordal said that the haircut process needs to be transparent as it may “scare” end-users. 

Kadlec said it is unrealistic to assume that the customer base will want to participate in the market when there are haircuts, saying they will “run for the hills.” He then suggested that regulators should have more direct oversight of CCPs risk committees to be a “fair arbiter” and align industry interests. 

Dietz said that the regulator would be “part of the decision making process” in a situation where a CCP was in danger of failing. 

Panel 2: Re-establishing a Matched Book

Wasserman highlighted that auctions at CCPs have been successful historically using default funds, but explained that the PFMIs require a viable plan to develop a matched book if the auction fails. He said some tools that CCPs could use if auctions fail may include: 1) forced allocation to non-defaulting participants at a determined price; 2) complete tear up, or termination of all positions marked to market; and 3) partial tear up, or terminating a portion of market positions. He then asked the panel how participation in auctions can be enhanced. 

EnhancingAuction Participation

McClear said he supports broad participation of clearing participants on behalf of their customers or direct participation of end-users themselves. 

Romanath said that the current structure of auctions, with senior and junior default contributions, does a good job of incentivizing members to participate but worried that expanding the scope of who can participate would risk “front-running” activity by firms who see the portfolio but do not win the auction. 

Biswarup Chatterjee, Citi on behalf of the International Swaps and Derivatives Association (ISDA),  suggested that in order to curb front-running, clearinghouses might consider requiring non-clearing members to put some minimum “skin in the game” before being able to view portfolios and participate in auctions.  

Joe Kamnik, Options Clearing Corporation (OCC), said that having complete tear up would create more incentive to participate in auctions than partial tear up, as participants may chose not to bid if there is a chance their position will remain intact.  

Participants went on to highlight the importance of “default drills” for all auction participants, and would suggest including non-clearing members in such scenarios, should participation be expanded.  In doing so, clearinghouses would have comfort in knowing that all auction participants – including buy side and end-user participants – would be prepared to partake in the auction and have the necessary infrastructures, compliance systems and experience. 

Failed Auctions

Wasserman then asked what should be done in the event of a failed auction and what risks are associated with tools such as forced allocations and tear-ups. 

Romanath said she believed that there will always be a market clearing price for positions if the CCP has the resources to meet this auction price. Frankel suggested, however, that a price may not be found if no market participant would find the positions being auctioned viable under their risk management. He then said that a problem with partial tear up is it would create un-hedged positions. Cutinho said that tear ups can provide certainty, cap losses, and return collateral back to participants. 

On forced allocations, most panelists expressed the view that this would be the least viable alternative in the event of a failed auction.  Panelists stated that there would likely be legitimate reasons why auction participants would choose not to take on the default position.  Thus, forcing allocation on a clearing member that already made the conscious decision not to take up a position in the auction would be a negative, risk-increasing outcome, since the participant may not be capable of taking on that position from a financial or risk perspective. 

Wasserman said he is concerned about creating directional positions for market participants if partial tear ups were used, where they would be un-hedged. 

As a way to limit these concerns, Cutinho said that transparent algorithms could be used to limit exposure of well functioning markets and thus only tear up non-functioning markets.  

Panel 3: Wind-down

Wasserman said the failure of a CCP is “especially pointed” for end-users because it would lead to an inability to hedge their positions. He noted that during a scenario where the CCP is in danger of failing, humans will need time to think and asked what the minimum amount of time needed would be and when a wind-down should begin. 

Romanath said it is important for a systemically important CCP to have a resolution strategy and be able to maintain operation of critical functions; otherwise there will be market destabilization. She then said that resolution plans need to be supported by prefunded capital. 

Cutinho said that capital held outside of a waterfall is of “no use to recovery” and that if there is a “windfall,” in the form of a re-capitalization fund, at the end of a waterfall process there will be no incentive to participate in an auction. He added that targeted assessments could be made on the clearing members who bring the most risk into the system and said timing around making a wind-down decision must be flexible. 

Suspension of Clearing

McClear suggested that a CCP could be able to suspend trading for an “artificial weekend” in order to discuss next steps with its clearing members and regulators. He said there would not be much to lose by suspending clearing, if the CCP is still operationally solvent, before beginning a wind-down. 

Jordal said that the longer a CCP is suspended the less confidence the market will have. Walters said that the CCP should act decisively and quickly because the market may reach an “exhaustion point.” 

Cutinho and Frankel stressed that suspending market clearing is not a good idea because it would allow risks to accumulate and prevent markets from recovering and engaging in price discovery. 

Marcus Stanley, Americans for Financial Reform, said that the buy side “seems to want to get out as fast as possible” in order to manage risks on their own, in the event a CCP gets into trouble. He then said that CCP risk mutualization can spread rather than reduce risk in these types of events.  

Priollo said that end-users would seek to move their hedges to other exchanges if there are problems at one. Romanath, however, said it is unrealistic to assume that other venues will be functioning well enough to hedge positions for these end users, because in a scenario where one CCP is failing there will likely be more widespread problems across the financial system. She suggested that a bridge entity be created and that the clearing functionality of the failing CCP be transferred to it.  

Walters said that her clients do not want positions left outstanding and exposed to additional losses and stressed that regulators should be involved when decisions are made to wind-down a CCP. Wasserman said he was unsure if the CFTC has the ability to prevent a CCP from making a decision to wind itself down. 

Recapitalization Fund

Wasserman then asked if having a prefunded re-capitalization fund process that includes change of ownership would create an incentive for clearing members to “defect” from the auction process and let the CCP fail. He also asked if this kind of pre-funding would make the cost of clearing too expensive. 

Romanath said she did not think the clearing members are looking to get ownership of CCPs, but said they should be compensated in some way for their risk. Frankel said that prefunding assessment rights would be very expensive and that the probability of using them is remote. 

Walters said the purpose of pre-funding is to promote continuity of service and that a change in ownership would be the result of a failure in the CCP’s risk management. Cutinho disagreed, and said a CCP failure would be the result of a market failure. 

Panel 4: Liquidity Risk Management

Wasserman said that CCPs may need tools to manage their liquidity demands and asked what burdens these tools may place on participants. 

Liquidity Up-front

Romanath said front-end liquidity systems need to be strengthened and noted that there are costs to rules-based requirements because they are not market negotiated. She added that there are unfair burdens placed on members providing liquidity who have access to the Federal Reserve discount window. She said her firm would be better off if a higher minimum cash requirement was funded up-front, to avoid the risk of an unexpected demand for liquidity down the line. 

Suzanne Sprague, CME, said CME supports using commercially viable lines of credit, depending on what counts as a high quality liquid asset (HQLA). She noted that many clients do not always have access to cash and that collateral transformation takes place at the clearing member. She then explained that, due to Basel regulations, many clearing members are reluctant to hold cash from their clients because it is held on their balance sheet and counts toward capital requirement calculations.

Phillip Whitehurst, LCH, agreed that the burden and scale liquidity assessments should be done upfront. 

Cash Difficulties

McClear explained that CCPs often use overnight repurchase agreements to invest their cash, but said it has become more a burden to find reverse repos since new capital rules have been implemented. Sprague agreed and said there is a “circular problem” where clearing houses have to collect more cash but regulations seeking to minimize bank risk mean there are less places to invest this cash. 

Chatterjee said that having liquidity calls for only cash is a challenge and said that it could create a situation where participants are in technical default, as they have enough assets to cover their position but these assets are not in cash. 

Romanath expressed concern with a mismatch in the haircut level of the CCPs and that of the Federal Reserve and said it could cause liquidity problems. Sprague said that the CME’s haircut level is “pretty closely aligned” with that of the Fed for commercial credit facilities. 

Current Liquidity Arrangements

Wasserman stated that arrangements already in place to meet variation margin requirements are robust relative to the liquidity needs under an assessment requirement. Sprague agreed, saying that liquidity assessment payments made by clearing members are a fraction of the payments members have made historically for their margin requirements. 

Chatterjee responded that other end-users who have to meet variation margin requirements often rely on third parties to convert their cash. Romanath said that if CCPs could possibly have access to central banks on a routine basis, it would provide confidence.

McClear noted that ICE has applied to the Fed to gain access, as allowed under its systemically important financial institution (SIFI) designation, and said that all CCPs should be able to have access. 

Wasserman noted that the public comment period for the roundtable will be open until April 20, 2015.

For more information on this roundtable, please click here.