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Commodity Futures Trading Commission Global Markets Advisory Committee Meeting

Commodity Futures Trading Commission

Global Markets Advisory Committee Meeting

Tuesday, September 24, 2019

Key Topics & Takeaways

Opening Statements & Introduction

Commissioner Dawn D. Stump

In her opening statement, Commodity Futures Trading Commission (CFTC) Commissioner and Global Markets Advisory Committee (GMAC) sponsor Stump thanked her fellow commissioners and welcomed Chairman Tarbert to his first GMAC meeting. Stump stated that this meeting would build upon the discussion of the April GMAC meeting and delve deeper into each of the panel topics, focusing specifically on the global process surrounding the implementation of initial margin for non-centrally cleared derivatives and how the phasing of such had progressed.

Chairman Heath Tarbert

In his opening statement, Tarbert emphasized the need to ensure that the implementation of CFTC’s uncleared margin rules is done in a manner with respect to their fellow regulators. He stated that the CFTC is amending the corresponding deadline for compliance in accordance with the proposed rulemaking issued by the Federal Deposit Insurance Corporation (FDIC) which stipulates the addition of another initial margin compliance period for smaller financial entities engaging in swaps. With respect to EMIR 2.2, Tarbert noted his concerns regarding implementation, specifically that it must be done correctly to avoid market fragmentation, contradictory regulatory rules and an increase in systemic risk.

Commissioner Brian D. Quintenz

Quintenz echoed the comments of Stump and Tarbert regarding the importance of continued public discussion on these items. He noted that issues arise when regulations are not properly calibrated to actual risk, citing the use of notional value in uncleared margin rules as an example. He commended the GMAC for addressing this issue and said he is pleased that action is being taken to alleviate unnecessary burden. On EMIR 2.2, Quintenz stated that he would like to receive clarity on the outcomes of the tiering process as soon as possible in order to avoid any negative consequences in implementation.

Commissioner Rostin Behnam

Behnam commended his fellow commissioners for taking on these important issues and agreed that further deliberation and recommendations are needed.

Panel 1 – Status Update on Implementation of Uncleared Margin Rules

Presenters:

  • Michael Gibson, Director, Division of Supervision and Regulation, Board of Governors of the Federal Reserve System
  • Rafael Martinez, Senior Financial Risk Analyst, Division of Swap Dealer and Intermediary Oversight, CFTC

Gibson outlined the original efforts of the G20 to improve the safety and security of derivatives markets via the shift of standardized derivatives into clearing and the implementation of margin requirements for uncleared derivatives. He cited two reasons for the introduction of margin requirements for uncleared derivatives: 1) to make sure that the incentives to encourage the movement of standardized derivatives into clearing functioned properly given the benefit of clearing for financial stability; and 2) recognizing that not all derivatives can be cleared and there needed to be a way to mitigate risk to the system. Gibson outlined what the uncleared margin requirements are, specifically that: 1) variation margin should be exchanged for uncleared derivatives; 2) entities above an international exposure threshold of 50 million (m), initial margin (IM) needs to be exchanged as well; and 3) this only applies to financial end users. He noted that the phase-in compliance period and implementation have been staggered based on notional amount of derivatives held by counterparties. Phases 1-4 maintained cut-offs based on this notional amount while Phase 5 would bring in 100s of smaller financial end-users.

In order to relieve the burden of Phase 5 implementation, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) issued a clarification that counterparties below the 50m exposure threshold would not have to have documentation in place until they crossed the scope threshold. The phase-in period was also extended by one year to 2021, essentially adding a ‘Phase 6’. Gibson noted that these changes have been supported by the U.S. prudential regulators in the recent proposed rulemaking from the FDIC. Gibson summarized this proposed rulemaking, specifically referring to the clarification on documentation for entities under the 50m threshold, the additional phase-in period and clarifications concerning the ability of legacy swaps to keep their status when replacing the London Interbank Offered Rate (LIBOR) and engaging in life-cycle events and the removal of inter-affiliate initial margin requirements.

Martinez stated that implementation should harmonize the international rules with U.S. prudential regulators. Martinez noted that the CFTC has responded to implementation challenges regarding the amending of legacy swaps, specifically referencing CFTC no-action relief stating that swaps transferred solely because of a no-deal Brexit would not cause these swaps to lose their status. Martinez stressed that the CFTC must continue to harmonize with prudential regulators and coordinate with other divisions regarding the transition away from LIBOR and addressing legacy swap status. He stated that they are actively preparing policy on this front.

Martinez noted that the CFTC issued a July advisory codifying the BCBS and IOSCO guidance relating to 2020 phase-in. He stated that the CFTC is preparing a version of the proposed FDIC rule to extend the phase-in period by a year into 2021. He recognized that challenges exist for Phase 5 dealers when attempting to develop models and governance in order to meet phase-in requirements. Martinez concluded by stating that the CFTC views substituted compliance with other regulators, including the Securities and Exchange Commission (SEC), as a major tool to ease compliance.

Question & Answer

Joseph Cisewski asked generally about inter-affiliate initial margin (IA-IM) and margin period of risk (MPOR). He voiced his concern regarding the elimination of IA-IM and the practice of transferring risk back to the United States from affiliates.

Robert Klein and Jim Colby both stated that imposing IA-IM makes risk management more difficult and inefficient.

Panel 2 – Buy-Side Perspective on Implementation of Uncleared Margin Rules

Presenters:

  • Richard Grant, Global Head of Regulatory and Government Affairs, Associate General Counsel, AQR Capital Management, LLC
  • Wendy Yun, Managing Director & Associate General Counsel, Goldman Sachs Asset Management

Grant provided an overview on how AQR is complying with uncleared margin requirements (UMR) including: 1) forming an internal working group consisting of representatives from different offices covering all parts of the rule and; 2) establishing key internal milestones for implementing the rule. He outlined difficulties such as calculating initial margin, selecting external vendors, processing legal documentation as well as the necessary, and resource intensive, technological and system integration updates. He noted that these challenges apply to other parties in the system, such as Standard Initial Margin Model (SIMM) vendors, counterparties and custodians. Grant predicted that there would be an industry-wide rush near the final deadline, straining the industry. Due to this strain, some buy-side firms may have their compliance delayed despite their best efforts. Grant stated that any action regulators take to ease the overall burden on the industry, such as the addition of a new phase-in period and threshold adjustment, will allow resources to be focused on the most important aspects of the new regime. In particular, Grant argued that the regulatory treatment of physically settled FX swaps and forwards in the average aggregate notional amount (AANA) and IM should be amended. Grant stated that by forcing these swaps to be included in the AANA calculation puts an undue burden on firms without a regulatory goal being accomplished and by addressing this mismatch, regulators can further free up resources for entities that are the real focus of the rule. This recommendation was echoed later by Yun.

Yun encouraged global regulators to adopt both updated standards, BCBS/IOSCO guidance and the U.S. prudential regulators proposed rulemaking, to achieve consistency and clarity. She stated that while this change will provide time to prepare for the last two phase-in periods, that by itself will not solve the unique scoping and implementation challenges facing asset managers. Yun noted that asset managers do not maintain transparency or control in terms of the trading activity of their clients outside of their mandates. For this reason, asset managers face significant difficulty in implementing some key aspects of the UMR rules, specifically the AANA calculation and minimum transfer amounts (MTAs). Yun noted that these challenges exist because asset managers are not in control of their client’s information flow, notional amount calculation, client custodian selection and the time it takes to aggregate the information necessary to determine whether a given client is in scope.

Yun stated that all asset managers will be forced to proceed through the same ‘pipeline’ in trying to get the attention of the dealers and the custodians when preparing documentation. As a result, dealers may ‘choose’ based on the trading activity of the asset manager which ones they will prioritize for documentation, thereby disrupting client performance under their management. In this context, Yun recommended that the IM be calculated on an annualized basis using the same AANA periods that currently exist under the rules. Yun claimed that this would allow regulators and dealers to focus on those accounts that present systemic risk while mitigating and alleviating the dependency and latency faced by asset managers when awaiting necessary client information. Yun also called upon the CFTC and global regulators to not require consolidation of seeded funds, noting that in Europe, rules under the European Market Infrastructure Regulation (EMIR) do not require certain funds to be consolidated, resulting in a possible bifurcation of market liquidity and regulatory arbitrage as dealers seek to take advantage of this consolidation disparity.

Yun stated that from an asset manager perspective, the ability to continue to use cash as collateral and take advantage of services offered by custodians that sweep cash into money-market funds (MMFs) to be used as collateral is beneficial and should preserved. Yet, under current CFTC and prudential regulators rules, there are certain limitations on using MMFs that Yun characterized as overly burdensome and unwarranted. Yun encouraged global regulators to reexamine these limitations and allow their use as such usage would help asset managers meet the necessary transfer timing and avoid the issues that arise when using non-cash collateral. Yun, referencing Martinez’s comments on the modeling challenges faced by dealers, noted that in order for asset managers to comply with margin requirements, they need to know what type of model a dealer is using and whether it is necessary to build internal models or outsource to vendors. She concluded that for some end-user clients, the costs may be too high to support the use of derivatives, resulting in the closing of certain business lines.

Question & Answer

Alexandra Guest, saying she was not speaking from a buy-side perspective, agreed with Yun’s comments concerning information collection challenges and the difficulties that exist when conflicting models are in use. Guest encouraged the commission to examine this process and how best to mitigate this issue.

Darcy Bradbury asked generally concerning the AANA calculation and how asset managers are reliant on both clients and dealers to gather the necessary compliance information. She asked whether this burden of compliance would result in a degradation of trading activity. Grant and Yun responded that they anticipate engaging in individual client discussion to determine what makes the most sense and that it is not just their decision, as the dealers may be making their own decision about the effort needed to put these agreements into place. Bradbury concluded that she does want to see regulatory burden create a more inefficient uncleared swaps market.

Panel 3 – Custody Bank Perspective on Implementation of Uncleared Margin Rules

Presenters:

  • Judson Baker, Head of Product Development for Derivatives and Collateral Services, Northern Trust
  • Dominick Falco, Managing Director, Head of Segregation, BNY Mellon

Falco stated that the initial delays in terms of getting accounts set up during the first phase-in period of this process were a result of document negotiation. He noted that the industry has improved significantly in terms of negotiating the account control agreements (ACA) at the same time as the credit support annex (CSA), resulting in all 1,000 accounts set up in 2019 being completed on time. Falco predicted that they will probably set up 2,400 agreements in 2020, more than doubling the amount this year. Falco noted that these documentation challenges are a result of the interplay between the various required documents. For example, the International Swaps and Derivatives Association (ISDA) agreement often delays the finalization of the ACA, resulting in a ‘bottleneck’ occurring at the end of the negotiation period. He stated that BNY Mellon is undertaking a thorough review of their documentation process with the goal of reducing the amount of bespoke negotiation needed in the lead up to 2020 and 2021. Falco cited cross-jurisdictional challenges when completing the eligible collateral schedule as another source of significant delay in the documentation process.

Baker stated that he does not anticipate many operational throughout this process. He noted that Northern Trust can quantify how many, and at what point, clients are in scope in addition to knowing what dealers they are trading with. As such, Baker stated they are confident in gauging how much business they will be handling. He said that they are advising clients to negotiate the ACA first and that the account opening process will be triggered as soon as the client approached the 50m threshold. He indicated that many of their clients for segregation services will be existing clients but that they are also fielding interest from non-custody clients of their organization. He amplified the industry concern that this process is currently a heavy paper-based flow but noted that custodians are now adhering to industry standards on how to automate these messages. Baker concluded with his concern regarding eligibility rules and cash being viewed as a permissible asset, saying he would like to ensure that clients wishing to post initial margin as cash continue to be allowed to do so.

Panel 4 – Cross-Jurisdictional Issues in Implementation of Uncleared Margin Rules

Presenter:

  • Tara Kruse, Global Head of Infrastructure, Data and Non-Cleared Margin, ISDA

Kruse summarized the cross-jurisdictional differences that still exist and result in challenges for market participants. She cited AANA calculations as one area of concern and outlined the differences that currently exist in terms of methodology, timing of the calculation period and applicable compliance dates following the phase-in period. Kruse noted that variants in product scope make cross-border margining complex and results in an unlevel playing field across jurisdictions. She also referenced the fact that settlement deadlines vary significantly, with the U.S. being the most restrictive due to a T+1 settlement requirement. She said that this is particularly problematic for settlement between Asian and U.S. entities and that it prevents firms from using collateral types with longer settlement cycles. Kruse acknowledged that there is a direct conflict between U.S. and EU rules when it comes to the treatment of MMFs, meaning that MMFs cannot be used as collateral for U.S.-EU transactions. Kruse recommended that U.S. and global regulators prioritize equivalence in order to increase substituted compliance and simplify the complexity of the current cross-jurisdictional framework.

Question & Answer

Alexandra Guest voiced her support for the commission examining the disparity in settlement times across jurisdictions. Masahiro Yamada expanded on this point and stated that generally, the committee and commission must continue to focus on implementation and harmonization across jurisdiction.

Panel 5 – EMIR 2.2 and ESMA Consultation

Presenters:

  • Sean Downey, Executive Director, Global Clearing & Risk Policy, CME Group
  • Jacqueline Mesa, Chief Operating Office & Senior Vice President of Global Policy, FIA
  • Carolyn Van den Daelen, Head of Regulation & Compliance, ICE Clear Europe

Downey provided a background on the initial proposal to amend the supervisory framework for non-EU central counterparty clearing (CCP) and noted that EMIR 2.2 is expected to be published in the Official Journal before the end of 2019. Mesa outlined that once this is published, ESMA will issue technical advice to the European Commission before the European Commission issues a delegated act that will govern EMIR 2.2. Mesa stated that she believes it may be as long as 18 months until EMIR 2.2 requirements are applied to non-EU CCPs. Downey outlined the next step involving the adoption of regulatory requirements covering three areas: 1) tiering; 2) comparable compliance; and 3) fees. He explained that EMIR 2.2 would sort CCPs into two tiers, Tier 1 indicating that the non-EU CCP is not systemically important and Tier 2 indicating that the non-EU CCP is systemically important. If categorized as Tier 2, direct application of European regulations would be applied to the non-EU CCP. EMIR 2.2 created five criteria to determine non-EU CPP’s systemic important in Europe. Downey noted that ESMA expanded upon these five criteria in their consultation to create a more expansive list of 14 indicators.

Van den Daelen noted that this tiering system has legal implications, specifically, that you are only allowed to provide clearing services to European clearing members and end-clients once you are deemed tier 1 or tier 2. Van den Daelen criticized ESMA’s 14 indicators for their lack of a nexus as to how these indicators determine a CCPs systemic impact.

Mesa added that these indicators are too broad and grants too much latitude to ESMA judgement, creating assessment uncertainty amongst CCPs. Mesa recommended that these indicators be ranked in terms of their importance when determining systemic risk. Downey agreed that nearly every indicator has language that does not apply to the EU nexus and that the ESMA consultation fails to fulfill the primary goal of EMIR 2.2, to evaluate non-EU CCPs and their systemic impact on EU markets.

All three panelists stated that ESMA’s comparable compliance proposal is unclear and includes certain conflicts. Downey noted that as drafted, it requires corresponding compliance to be as equal or as conservative as the corresponding EMIR requirements and if it is not, EMIR is applied as a floor. Downey continued to state that this effectively eliminates the whole concept of comparable compliance as it is impossible to always as strict or as conservative if you have two different requirements in two different regimes. Building on Downey’s comments, Van den Daelen stated that they believe that a regime of this nature will cause contradictory and duplicative requirements causing market fragmentation and real economic harm.

Question & Answer

Quintenz asked that given all the steps that need to occur, both legislative and regulatory, whether a temporary recognition extension in this process is likely. Van den Daelen responded that she believes an extension is likely and that clarity concerning an extension would be beneficial to both the clearing house and members. John Horkan echoed the sentiment that clarity is essential in this process to avoid market fragmentation and other negative outcomes.

Mark Wetjen expressed his concern with the role of European central banks within this non-EU CCP construct, specifically that they would serve as both supervisors and providers of emergency tools, creating uncertainty and potential conflict as to the role of the central banks. This concern was echoed by Masahiro Yamada and how in times of financial stress, the conflict requirements levied upon regulators and central banks could create more risk. Mesa commented that this lack of clarity could induce clearing houses to relocate their services out of a given jurisdiction, as the potential for relocation is still permitted under EMIR

Stump asked the panel to explain how a U.S. based CFTC registered derivatives clearing organization (DCO) offering commodities futures would be impacted if a U.S CCP is labeled as Tier 2. Downey stated that it might impact their ability to use letters of credit as collateral in addition to increasing costs and access.

Closing Remarks & Adjournment

GMAC members unanimously approved a recommendation to the CFTC that calls for the establishment of a GMAC subcommittee to further examine Phase 5 implementation of margin requirements for uncleared swaps. Stump voiced her approval for this measure.

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