CFTC Global Markets Advisory Committee Meeting
Commodity Futures Trading Commission
Global Markets Advisory Committee Meeting
Thursday, May 14, 2015
Key Topics & Takeaways
- Inter-affiliate Transactions: Morgan Stanley’s Hill said that if margin requirements are imposed on inter-affiliate transactions, the CFTC would effectively eviscerate the clearing exemption and make these transactions more expensive than clearing. He also noted that the prudential regulators took a different approach due to other banking regulations that require banks to treat their affiliates in the same way they treat third parties
- De-Guaranteed Transactions: CFTC’s Kim said the CFTC staff is “very much concerned about and definitely mindful of” the de-guarantee issue in trying to develop a proposal for Commission’s consideration. She added that the CFTC is “rethinking this issue and looking at the safety and soundness concerns” and “it may be more appropriate to address it at an entity level.”
- Cross-Border Approaches: Panelist debated whether the CFTC should take a transactional approach or an entity-level approach to cross-border swaps regulation. Most panelists stressed the need for the CFTC and prudential regulators to harmonize their regimes.
- CCP Insurance: CFTC’s Wasserman noted that a CCP insurance program would be difficult to establish because CCPs need payments on a same-day basis and insurance funds might pose an availability problem.
- Skin in the Game: Bank of England’s Bailey said “it’s clear that skin in the game should act as an incentive” but that it should be calibrated appropriately. The Fed’s Marquardt said that “the debate continues” on whether “skin in the game” should be included in international frameworks and warned that if the CCP contribution is too large and high up in the waterfall it could “go broke” covering clearing member defaults.
Meeting Participants
- Tim Massad, CFTC Chairman
- Mark Wetjen, CFTC Commissioner
- Sharon Bowen, CFTC Commissioner
- Christopher Giancarlo, CFTC Commissioner
- Robert Wasserman, CFTC Division of Clearing and Risk
- Jeffrey C. Marquardt, Deputy Director, Federal Reserve System
- Fabrizio Planta, European Securities and Markets Authority
- David Bailey, Bank of England
- Shunsuke Shirakawa, Japanese Financial Services Agency
- Carlene Kim, CFTC Deputy General Counsel
- Sean Campbell, Deputy Associate Director, Federal Reserve System
- Members of the GMAC
Opening Statements
Commissioner Wetjen
Mark Wetjen, Commissioner of the Commodity Futures Trading Commission (CFTC), said in his opening remarks that regulators around the globe have significantly raised the standards of centralized counterparties (CCPs) since 2009 but noted that as clearing volumes have increased the CFTC must “be cognizant of the resulting increased concentration of risk and what that means for stakeholders.” He stressed that global coordination of further regulatory enhancements is critical.
Wetjen said that comments on the CFTC’s proposal regarding the cross-border application of margin rules appear to have a “consensus view” in favor of the prudential regulator’s approach, to ensure harmony between domestic regulators.
Chairman Massad
CFTC Chairman Massad noted that many of the issues around CCP risk focus on ensuring that the incentives of clearinghouses and its clearing members are aligned and that the capital requirements are thought of in the context of recovery planning and processes. Massad added that international dialogue on the rule for margin for uncleared swaps “is extremely important.”
Commissioner Bowen
Commissioner Sharon Bowen said she was interested in hearing about the appropriate amount of “skin in the game” that a clearinghouse should have as well as “the costs and benefits of requiring higher capital contributions from clearinghouses.”
Bowen said that the CFTC needs to ensure that stress tests “not only capture” historical crisis, but also be “truly reflective” of the changes and realities in today’s marketplace.
Commissioner Giancarlo
Commissioner Christopher Giancarlo highlighted that the Global Markets Advisory Committee (GMAC) is “an important element in the process of trying to coordinate global regulation in the reform of financial markets.”
Panel 1 – Assessing Clearinghouse Capital Contributions and Stress Testing
Robert Wasserman – CFTC
Robert Wasserman, Chief Counsel of the CFTC’s Division of Clearing and Risk, began the first panel discussion noting that the International Organization of Securities Commissions (IOSCO) has been working on issues of CCP risk management for years and had published Principles for Financial Market Infrastructures (PFMIs) in 2012. He explained that these groups along with the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB) have been working on a comprehensive analysis of CCP risk, including taking stock of over 30 CCPs to determine current practices.
He noted that some themes seen in these CCP reviews include 1) governance – focusing on risk appetite; defining extreme market conditions; stress tests design, execution, internal review; and disclosure of methodologies to regulators, clearing members, and the public; 2) identifying credit risk – focusing on liquidity risk in the event that one or more clearing members default; 3) stress test models – including design of stress scenarios and inclusion of forward-looking scenarios and discrete risk factors; and 4) concentration risk – looking at the size of clearing members’ portfolios.
Wasserman said that regulators may come out with additional guidance for public consultation before any final guidance was issued, noting this guidance could come out “as early as possible in 2016.”
Jeffrey Marquardt – Fed
Jeffrey C. Marquardt, Deputy Director of Bank Operations and Payment Systems for the Board of Governors of the Federal Reserve System (Fed), said he encourages in-depth work on liquidity stress testing as well as strong collaboration between regulators, CCPs, clearing members, and banking organizations.
Marquardt stated that stress testing standards should have more granularity and that long tail risk and waterfall default issues are important to consider. He added and that regulators should have objectives for what they are trying to accomplish with stress test work and suggested: 1) improving CCP’s own stress testing methodologies and reducing variation across CCPs; 2) enabling comparisons of risk across CCPs; 3) increasing transparency to regulators and the public; 4) increasing transparency across jurisdictions; and 5) helping clearing members understand their risks across multiple CCPs.
Marquardt said that regulators should be open to “some form of minimum international standards, not just voluntary guidance.”
Fabrizio Planta – ESMA
Fabrizio Planta, Team Leader Post-Trading at the European Securities and Markets Authority (ESMA), stated that there should be common standards for stress testing as well as more transparency and said he was encouraged that international regulators are moving to a more granular definition of common stress test requirements and standards. He noted that ESMA’s standards address liquidity, resources, and disclosures and said this European framework is a basis for work to develop a standardized EU-wide stress test.
David Bailey – BoE
David Bailey, Director of Financial Market Infrastructure at the Bank of England (BoE), said it is right for the regulators to “constantly challenge the CCP community” and their expectations of CCPs to ensure proper robustness of their risk management because of their systemic importance. He noted that stress testing is used by CCPs to size their default funds and said testing should “absolutely be tailored to the particular markets cleared by any one CCP.” Bailey said that regulators should assess the feasibility and use of stress testing that exists in the banking context and that CCP users should engage fully with the CCPs to address any concerns.
Shunsuke Shirakawa – FSA
Shunsuke Shirakawa, Deputy Commissioner for International Affairs at the Government of Japan’s Financial Services Agency (FSA), said it appears that risk is being concentrated at a small number of CCPs as central clearing mandates are being implemented.
Shirakawa noted that the PFMIs do not outline details of stress testing and, thus, it is an important step for international standard setters to be engaged on this topic to avoid unnecessary conflicts. While Shirakawa said that intentional standards are important for large global CCPs, he noted that one-size will not fit all, because there are many small CCPs operating in only in domestic markets. He said that a more flexible framework should be established for these smaller clearinghouses to limit impediments for new entrants and allow development of local CCPs.
Panel 1 – GMAC Discussion
Stress Test Methodology
David Weisbrod, CEO of LCH.Clearnet Group, said that there should be standardized stress scenarios for clearinghouses that include transparency, simplicity, and comparability. He said that regulators should give thought to segregation of assets because “lumping all assets into a single default fund has its risks” and added that stress tests should address auction procedures.
Wallace Turbeville, Fellow at Demos, said that there is a “strong sentiment” that whatever methodology regulators come up with for stress testing, is not actually what would happen in reality. He then stressed that “real comparability should be about the outcome” and whether CCPs are equally safe and sound.
Wasserman distinguished between standards for stress testing and standardized stress tests, explaining that it is “well possible to come to agreement on standards” but that coming to agreement on “evergreen standardized stress tests” that would operate across jurisdictions would be “very difficult indeed.” He expressed concern that having a standardized stress test could lead to CCPs “teaching to the test” where current market conditions are not reflected and good test results would give a “false sense of security.”
Governance
Commissioner Bowen asked why governance would not be part of standards, in terms of who conducts the stress tests.
Bailey said that governance is an “incredibly important part of stress testing” and that IOSCO should consider this as a part of its work.
Thomas Book, CEO of Eurex Clearing AG, noted that the role of stress testing is to define the guarantee fund and determine the mutualized component, which is a cost component for clearing members. He said that full transparency will promote competition among clearinghouses because the mutualized losses are a cost clearing member, and noted there is a conflict of interest that needs to be considered. He worried that regional differences in standards would cause risk to be allocated to areas where standards and costs are lower.
Arthur Leiz, Managing Director, Goldman Sachs Asset Management, noted that in bi-lateral transactions a company can face many different counter-parties but that under clearing mandates, the number of ultimate counter-parties is limited to the CCPs. He said because of this, transparency on metrics of CCPs should be published to enable his firm to determine which CCP he would want to deal with.
Wasserman explained that CCP “skin in the game” could come in the form of an increase in resources, to increase the total default fund or replace the contributions of clearing members, or align interests by having the clearing members own the clearinghouse.
Planta said that “skin in the game” is a good incentive and that if shareholders never pay, the incentive will be to set up margin and collateral requirements in a way to attract the most business. He added that there is “no magic number” for where to set the contribution level but said an appropriate level would be one based on prudential considerations rather than competitive ones.
Bailey said “it’s clear that skin in the game should act as an incentive” but that it should be calibrated to provide the appropriate incentive. He added that it is important to consider where the CCP contribution is located in the default waterfall, saying there has been a strong argument that it should be before mutualization occurs. He noted, however, that there is merit in considering if whether this capital should be further down in the waterfall.
Shirakawa highlighted that CCP operators can be sources of operational and business risk and that they should have incentives to conduct proper risk management, but also noted that “skin in the game” can put expensive burdens on CCP operators in times of market stress.
Marquardt said that “the debate continues” on whether “skin in the game” should be included in international frameworks and that there should not be any decreases in required CCP resources. He stressed that if CCP capital is contributed earlier in the waterfall, then others should not be allowed to withdraw their resources and warned if the CCP contribution is too large and high up in the waterfall it could “go broke” covering clearing member defaults.
James J. Hill, Managing Director, Global Credit Derivatives Officer at Morgan Stanley, said that CCP capital contributions should be above non-defaulting members in the waterfall but said this does not need to be mandated by regulation. He also stated that the clearing members and a properly incentivized CCP owner should be allowed to assess risk and set proper “skin in the game” levels. He said that mandating a certain level could lead to costs that are ultimately born by clearing members and the buy-side.
Leiz said that an appropriate framework for determining “skin in the game” would ensure it is “sized according to the guarantee fund appropriately and also appropriately sized versus the revenue stream that [the CCP is] earning from that product”
Sunil Cutinho, President, CME Clearing, noted that as a CCPs contribution to the waterfall increases, it reduces the contributions of other participants in the waterfall. He agreed that CCP contributions should be the first after a defaulter’s funds but said regulators should be consider the “risk substitution effect” of CCP contributions.
Richard Berliand, Member, Supervisory Board, Deutsche Börse AG, said there has been debate about what form capital contributions can take, noting that some have suggested insurance as an alternative to equity.
Wasserman noted that CCPs need payments on a same-day basis and that insurance funds might pose an availability problem. Cutinho agreed with these concerns and added that if the insurance vehicles are not pre-funded or they have contingent funding they may not be able to pay out in the default of multiple members. He said pre-funded capital could address this but that pre-funding does not provide enough return for investors.
Panel 2 – Margin for Uncleared Swaps
Carlene Kim – CFTC
Carlene Kim, CFTC Deputy General Counsel, noted that the CFTC published proposed rules on margin for uncleared swaps as well as an advance notice of proposed rulemaking (ANPR) on three approaches to cross-border application of CFTC swaps rules. She explained that the first of these approaches is a transaction level approach consistent with the Commission’s cross-border guidance; the second is the approach proposed by the Prudential Regulators; and the third approach would apply margin rules at an entity-level.
Kim stated that it is important “to calibrate the cross-border application of the margin rules to mitigate potential for conflict or duplication with other jurisdictions.” She said the CFTC staff is “closely consulting and coordinating” with the prudential regulators and “has participated in numerous bilateral and multi-lateral discussions” with foreign regulatory authorities, including the EU and Japan.
Sean Campbell – Fed
Sean Campbell, Deputy Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System, stressed “the focus on safety and soundness is a key consideration throughout the entire rulemaking” and explained that the prudential regulators’ proposal would not apply to “foreign-foreign” transactions, where both the swap dealer and its counterparty are not organized under U.S. law and not guaranteed by a U.S. entity. Campbell added that allowing for substituted compliance with comparable foreign regulatory regimes would allow for a “good deal” of competition across global markets and would not “impair the safety and soundness requirements of the rule.”
Angie Karna, Managing Director, Legal Department, Nomura Securities International, Inc., said that the “foreign-foreign” scenario under the proposal is very important to her firm and stressed that due to the “tremendous amount of international dialogue” round this rulemaking there should be “the maximum opportunity for findings of substituted compliance.” She later added that her firm likes the broader view of substituted compliance under the prudential approach, but that the transaction level approach “made the most sense” when looking at the possibilities of conflicts among the various other rules.
Eric Litvack, Chairman of the Board, ISDA, said that if “jurisdictional conflict” and “competitive disparities” are not eliminated “we are likely to find ourselves splitting the global markets” into “regional silos,” adding that partial substituted compliance under the entity level approach and prudential approach will not eliminate these conflicts. He said that a transaction level approach “has the most chance of achieving uniformity in margin requirements” and is “preferable from the standpoint of mitigating compliance costs and reducing opportunities for regulatory arbitrage.”
Turbeville responded that margining is an entity level activity and that “it doesn’t matter if a swap dealer is dealing with a non-U.S. person” because that activity can impair the integrity of the U.S. market in the same way as a transaction with a U.S. person.
Chris Allen, Managing Director and Global Head of Regulatory Strategy, Barclays, agreed that the prudential regulators’ approach “increases the instances in which effective substituted compliance” will be available and said that alignment of the approaches between the CFTC and the prudential regulators would “be appealing in terms of reducing conflicts and fragmentation.”
Adam Cooper, Chief Legal Officer, Citadel, said that the prudential regulators’ definition of foreign is not accurate and does not mirror that of the CFTC. He said that the “proper characterization of U.S. nexus” is that the “principle place of business” is in the U.S. He then said that using the transaction level approach “makes the most sense,” noting that the industry has invested in building an infrastructure transaction level compliance reporting and said entity level requirements would be costly and “potentially disruptive.”
George Harrington, Global Head, Fixed Income Trading, Bloomberg, said that the underlying liquidity of the products should be taken into consideration under the rulemaking to ensure the margin requirements are not too burdensome, which could create competitive disadvantages and drive business overseas.
Clive Christison, Regional Business Leader of Integrated Supply and Trading, BP, stressed that the uncleared swaps market is critical for commodities and market participant hedging. He said that there should be one set of rules for all market participants “regardless of whether counter party is domiciled” and added that the prudential approach is likely to be more aligned with other rules.
Massad noted the importance of getting the rules that the CFTC adopts “as much as possible the same” as the rules in other jurisdictions. He then asked CFTC staff about the situation where a U.S. firm previously guaranteed swaps transactions of its affiliate but then removed this or “de-guaranteed” these swaps. He mentioned that some participants said this action was done to avoid being subject to trading rules, but stated “this rule to me is fundamentally about risk.” He then asked about the difference between the approaches and if there are similar rules in other jurisdictions.
Kim responded that the CFTC staff is “very much concerned about and definitely mindful of” the de-guarantee issue in trying to develop a proposal for Commission’s consideration. She noted that margin is calculated on an individual transaction basis and is treated as a transaction level requirement in the guidance, but said that in “rethinking this issue and looking at the safety and soundness concerns” the CFTC staff thinks “it may be more appropriate to address it at an entity level.” Kim further explained staff is concerned that too many uncleared swaps of CFTC registered swap dealers may be excluded under the transaction approach and “therefore the risk will come back to the U.S. person and U.S. financial system.” She said the prudential approach limiting the exclusion “to truly pure foreign to foreign” transactions “may be worthwhile considering seriously.”
Wetjen then asked about the proper treatment of inter-affiliate trades “which tend to be international in nature given the way that global firms manage their risk.” He explained that the CFTC proposal imposed both initial and variation margin on these transactions and noted that the CFTC has an exception from the clearing requirement for inter-affiliate trades.
Hill replied that this topic is “one of the easier ones” because it “does have a right answer.” He said that with inter-affiliate trades, “flatten out the risk among the regulated entities” and that if these transactions were too expensive or not permitted, each of the two entities would actually be “off sides,” where one would be long and one short a position. He said that for this reason, the CFTC exempted these trades from the clearing mandate and made a decision that the transactions are an important risk management tool. Hill said “the exact same logic applies with respect to the margin requirement” and that if margin requirements are imposed the CFTC is “effectively eviscerating” the clearing exemption and “making it more expensive than clearing.”
Karna agreed, saying that inter-affiliate trades should not be dis-incentivized. She noted that neither Europe nor Japan imposes initial margin on these transactions and said he firm is concerned about making sure that U.S. clients have access to the “greatest amount of liquidity” and that adding inter-affiliate margin costs in only the United States, and not elsewhere, will result in a decrease of liquidity.
Hill noted that one of the reasons the CFTC is considering this requirement is because the prudential regulators took a different approach due to other banking regulations that require banks to treat their affiliates in the same way they treat third parties. He said this is not applicable to the CFTC.
Campbell said that Hill’s point “is in part correct” that there are other banking regulations to place restrictions on dealings between banks and affiliates and that these are “a relevant consideration.” He added, however that “there are other considerations at play as well,” such as a situation where a bank has an insurance company under its holding company structure that engages in swaps, saying these counterparty risks should be margined.
Doug Hepworth, Independent Account Controller, Gresham Investment Management, said the unmediated application of the proposed rules produces problems of double counting.
Supurna VedBrat, Managing Director, BlackRock, said her firm takes into account the risk of the entity that they are facing for uncleared swaps and said the proposed rule would end up increasing pricing because of double margining or increase costs to end users. She also noted that her firm would need to “re-paper” its operations with European entities, which is not “an easy exercise.”
Turbeville suggested that the CFTC look at previous resolution authority proceedings since the primary strategy is to separate the subsidiaries of a systematically important bank, thus it “might be a good thing if subsidiaries, even though they’re inter-affiliates, were independently margined.” He added that “it is true” that the proposal makes the uncleared transactions more expensive than clearing, and that this policy was intended to discourage this practice.
Caitlin Kline, Derivatives Specialist, Better Markets, said it is not reasonable to assume that an increase in costs of inter-affiliate trades will impact hedging activity, because these transactions will need to done either way.
Litvack said that simulations have shown that the likely cost of having to double margin transactions would be effectively “hundred percent more margin,” that “inevitably would be passed on to the end user or simply discourage hedging.” He added that the proposal also increases risk facing the margin custodian.
Wetjen then asked to what degree the Fed is thinking about: 1) inter-affiliate trades becoming too expensive to the point that they are no longer done; 2) to what degree do these transactions increase the complexity of the firm as a whole; 3) how these transactions affect regulators as supervisors; and 4) if these transactions make revolving a firm more difficult.
Campbell replied that the Fed has received a wide array of comments that raised many of the points discussed at the meeting, including issues on resolution, risk management, and complexity. He said the Fed is “in the process of trying to sort through all those comments and think through those issues.” He added that “there are a lot of subtle issues that arise in the context of these inter-affiliate margin trades that the agencies are working through as we work towards the final rule.”
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Commodity Futures Trading Commission
Global Markets Advisory Committee Meeting
Thursday, May 14, 2015
Key Topics & Takeaways
- Inter-affiliate Transactions: Morgan Stanley’s Hill said that if margin requirements are imposed on inter-affiliate transactions, the CFTC would effectively eviscerate the clearing exemption and make these transactions more expensive than clearing. He also noted that the prudential regulators took a different approach due to other banking regulations that require banks to treat their affiliates in the same way they treat third parties
- De-Guaranteed Transactions: CFTC’s Kim said the CFTC staff is “very much concerned about and definitely mindful of” the de-guarantee issue in trying to develop a proposal for Commission’s consideration. She added that the CFTC is “rethinking this issue and looking at the safety and soundness concerns” and “it may be more appropriate to address it at an entity level.”
- Cross-Border Approaches: Panelist debated whether the CFTC should take a transactional approach or an entity-level approach to cross-border swaps regulation. Most panelists stressed the need for the CFTC and prudential regulators to harmonize their regimes.
- CCP Insurance: CFTC’s Wasserman noted that a CCP insurance program would be difficult to establish because CCPs need payments on a same-day basis and insurance funds might pose an availability problem.
- Skin in the Game: Bank of England’s Bailey said “it’s clear that skin in the game should act as an incentive” but that it should be calibrated appropriately. The Fed’s Marquardt said that “the debate continues” on whether “skin in the game” should be included in international frameworks and warned that if the CCP contribution is too large and high up in the waterfall it could “go broke” covering clearing member defaults.
Meeting Participants
- Tim Massad, CFTC Chairman
- Mark Wetjen, CFTC Commissioner
- Sharon Bowen, CFTC Commissioner
- Christopher Giancarlo, CFTC Commissioner
- Robert Wasserman, CFTC Division of Clearing and Risk
- Jeffrey C. Marquardt, Deputy Director, Federal Reserve System
- Fabrizio Planta, European Securities and Markets Authority
- David Bailey, Bank of England
- Shunsuke Shirakawa, Japanese Financial Services Agency
- Carlene Kim, CFTC Deputy General Counsel
- Sean Campbell, Deputy Associate Director, Federal Reserve System
- Members of the GMAC
Opening Statements
Commissioner Wetjen
Mark Wetjen, Commissioner of the Commodity Futures Trading Commission (CFTC), said in his opening remarks that regulators around the globe have significantly raised the standards of centralized counterparties (CCPs) since 2009 but noted that as clearing volumes have increased the CFTC must “be cognizant of the resulting increased concentration of risk and what that means for stakeholders.” He stressed that global coordination of further regulatory enhancements is critical.
Wetjen said that comments on the CFTC’s proposal regarding the cross-border application of margin rules appear to have a “consensus view” in favor of the prudential regulator’s approach, to ensure harmony between domestic regulators.
Chairman Massad
CFTC Chairman Massad noted that many of the issues around CCP risk focus on ensuring that the incentives of clearinghouses and its clearing members are aligned and that the capital requirements are thought of in the context of recovery planning and processes. Massad added that international dialogue on the rule for margin for uncleared swaps “is extremely important.”
Commissioner Bowen
Commissioner Sharon Bowen said she was interested in hearing about the appropriate amount of “skin in the game” that a clearinghouse should have as well as “the costs and benefits of requiring higher capital contributions from clearinghouses.”
Bowen said that the CFTC needs to ensure that stress tests “not only capture” historical crisis, but also be “truly reflective” of the changes and realities in today’s marketplace.
Commissioner Giancarlo
Commissioner Christopher Giancarlo highlighted that the Global Markets Advisory Committee (GMAC) is “an important element in the process of trying to coordinate global regulation in the reform of financial markets.”
Panel 1 – Assessing Clearinghouse Capital Contributions and Stress Testing
Robert Wasserman – CFTC
Robert Wasserman, Chief Counsel of the CFTC’s Division of Clearing and Risk, began the first panel discussion noting that the International Organization of Securities Commissions (IOSCO) has been working on issues of CCP risk management for years and had published Principles for Financial Market Infrastructures (PFMIs) in 2012. He explained that these groups along with the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB) have been working on a comprehensive analysis of CCP risk, including taking stock of over 30 CCPs to determine current practices.
He noted that some themes seen in these CCP reviews include 1) governance – focusing on risk appetite; defining extreme market conditions; stress tests design, execution, internal review; and disclosure of methodologies to regulators, clearing members, and the public; 2) identifying credit risk – focusing on liquidity risk in the event that one or more clearing members default; 3) stress test models – including design of stress scenarios and inclusion of forward-looking scenarios and discrete risk factors; and 4) concentration risk – looking at the size of clearing members’ portfolios.
Wasserman said that regulators may come out with additional guidance for public consultation before any final guidance was issued, noting this guidance could come out “as early as possible in 2016.”
Jeffrey Marquardt – Fed
Jeffrey C. Marquardt, Deputy Director of Bank Operations and Payment Systems for the Board of Governors of the Federal Reserve System (Fed), said he encourages in-depth work on liquidity stress testing as well as strong collaboration between regulators, CCPs, clearing members, and banking organizations.
Marquardt stated that stress testing standards should have more granularity and that long tail risk and waterfall default issues are important to consider. He added and that regulators should have objectives for what they are trying to accomplish with stress test work and suggested: 1) improving CCP’s own stress testing methodologies and reducing variation across CCPs; 2) enabling comparisons of risk across CCPs; 3) increasing transparency to regulators and the public; 4) increasing transparency across jurisdictions; and 5) helping clearing members understand their risks across multiple CCPs.
Marquardt said that regulators should be open to “some form of minimum international standards, not just voluntary guidance.”
Fabrizio Planta – ESMA
Fabrizio Planta, Team Leader Post-Trading at the European Securities and Markets Authority (ESMA), stated that there should be common standards for stress testing as well as more transparency and said he was encouraged that international regulators are moving to a more granular definition of common stress test requirements and standards. He noted that ESMA’s standards address liquidity, resources, and disclosures and said this European framework is a basis for work to develop a standardized EU-wide stress test.
David Bailey – BoE
David Bailey, Director of Financial Market Infrastructure at the Bank of England (BoE), said it is right for the regulators to “constantly challenge the CCP community” and their expectations of CCPs to ensure proper robustness of their risk management because of their systemic importance. He noted that stress testing is used by CCPs to size their default funds and said testing should “absolutely be tailored to the particular markets cleared by any one CCP.” Bailey said that regulators should assess the feasibility and use of stress testing that exists in the banking context and that CCP users should engage fully with the CCPs to address any concerns.
Shunsuke Shirakawa – FSA
Shunsuke Shirakawa, Deputy Commissioner for International Affairs at the Government of Japan’s Financial Services Agency (FSA), said it appears that risk is being concentrated at a small number of CCPs as central clearing mandates are being implemented.
Shirakawa noted that the PFMIs do not outline details of stress testing and, thus, it is an important step for international standard setters to be engaged on this topic to avoid unnecessary conflicts. While Shirakawa said that intentional standards are important for large global CCPs, he noted that one-size will not fit all, because there are many small CCPs operating in only in domestic markets. He said that a more flexible framework should be established for these smaller clearinghouses to limit impediments for new entrants and allow development of local CCPs.
Panel 1 – GMAC Discussion
Stress Test Methodology
David Weisbrod, CEO of LCH.Clearnet Group, said that there should be standardized stress scenarios for clearinghouses that include transparency, simplicity, and comparability. He said that regulators should give thought to segregation of assets because “lumping all assets into a single default fund has its risks” and added that stress tests should address auction procedures.
Wallace Turbeville, Fellow at Demos, said that there is a “strong sentiment” that whatever methodology regulators come up with for stress testing, is not actually what would happen in reality. He then stressed that “real comparability should be about the outcome” and whether CCPs are equally safe and sound.
Wasserman distinguished between standards for stress testing and standardized stress tests, explaining that it is “well possible to come to agreement on standards” but that coming to agreement on “evergreen standardized stress tests” that would operate across jurisdictions would be “very difficult indeed.” He expressed concern that having a standardized stress test could lead to CCPs “teaching to the test” where current market conditions are not reflected and good test results would give a “false sense of security.”
Governance
Commissioner Bowen asked why governance would not be part of standards, in terms of who conducts the stress tests.
Bailey said that governance is an “incredibly important part of stress testing” and that IOSCO should consider this as a part of its work.
Thomas Book, CEO of Eurex Clearing AG, noted that the role of stress testing is to define the guarantee fund and determine the mutualized component, which is a cost component for clearing members. He said that full transparency will promote competition among clearinghouses because the mutualized losses are a cost clearing member, and noted there is a conflict of interest that needs to be considered. He worried that regional differences in standards would cause risk to be allocated to areas where standards and costs are lower.
Arthur Leiz, Managing Director, Goldman Sachs Asset Management, noted that in bi-lateral transactions a company can face many different counter-parties but that under clearing mandates, the number of ultimate counter-parties is limited to the CCPs. He said because of this, transparency on metrics of CCPs should be published to enable his firm to determine which CCP he would want to deal with.
Wasserman explained that CCP “skin in the game” could come in the form of an increase in resources, to increase the total default fund or replace the contributions of clearing members, or align interests by having the clearing members own the clearinghouse.
Planta said that “skin in the game” is a good incentive and that if shareholders never pay, the incentive will be to set up margin and collateral requirements in a way to attract the most business. He added that there is “no magic number” for where to set the contribution level but said an appropriate level would be one based on prudential considerations rather than competitive ones.
Bailey said “it’s clear that skin in the game should act as an incentive” but that it should be calibrated to provide the appropriate incentive. He added that it is important to consider where the CCP contribution is located in the default waterfall, saying there has been a strong argument that it should be before mutualization occurs. He noted, however, that there is merit in considering if whether this capital should be further down in the waterfall.
Shirakawa highlighted that CCP operators can be sources of operational and business risk and that they should have incentives to conduct proper risk management, but also noted that “skin in the game” can put expensive burdens on CCP operators in times of market stress.
Marquardt said that “the debate continues” on whether “skin in the game” should be included in international frameworks and that there should not be any decreases in required CCP resources. He stressed that if CCP capital is contributed earlier in the waterfall, then others should not be allowed to withdraw their resources and warned if the CCP contribution is too large and high up in the waterfall it could “go broke” covering clearing member defaults.
James J. Hill, Managing Director, Global Credit Derivatives Officer at Morgan Stanley, said that CCP capital contributions should be above non-defaulting members in the waterfall but said this does not need to be mandated by regulation. He also stated that the clearing members and a properly incentivized CCP owner should be allowed to assess risk and set proper “skin in the game” levels. He said that mandating a certain level could lead to costs that are ultimately born by clearing members and the buy-side.
Leiz said that an appropriate framework for determining “skin in the game” would ensure it is “sized according to the guarantee fund appropriately and also appropriately sized versus the revenue stream that [the CCP is] earning from that product”
Sunil Cutinho, President, CME Clearing, noted that as a CCPs contribution to the waterfall increases, it reduces the contributions of other participants in the waterfall. He agreed that CCP contributions should be the first after a defaulter’s funds but said regulators should be consider the “risk substitution effect” of CCP contributions.
Richard Berliand, Member, Supervisory Board, Deutsche Börse AG, said there has been debate about what form capital contributions can take, noting that some have suggested insurance as an alternative to equity.
Wasserman noted that CCPs need payments on a same-day basis and that insurance funds might pose an availability problem. Cutinho agreed with these concerns and added that if the insurance vehicles are not pre-funded or they have contingent funding they may not be able to pay out in the default of multiple members. He said pre-funded capital could address this but that pre-funding does not provide enough return for investors.
Panel 2 – Margin for Uncleared Swaps
Carlene Kim – CFTC
Carlene Kim, CFTC Deputy General Counsel, noted that the CFTC published proposed rules on margin for uncleared swaps as well as an advance notice of proposed rulemaking (ANPR) on three approaches to cross-border application of CFTC swaps rules. She explained that the first of these approaches is a transaction level approach consistent with the Commission’s cross-border guidance; the second is the approach proposed by the Prudential Regulators; and the third approach would apply margin rules at an entity-level.
Kim stated that it is important “to calibrate the cross-border application of the margin rules to mitigate potential for conflict or duplication with other jurisdictions.” She said the CFTC staff is “closely consulting and coordinating” with the prudential regulators and “has participated in numerous bilateral and multi-lateral discussions” with foreign regulatory authorities, including the EU and Japan.
Sean Campbell – Fed
Sean Campbell, Deputy Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System, stressed “the focus on safety and soundness is a key consideration throughout the entire rulemaking” and explained that the prudential regulators’ proposal would not apply to “foreign-foreign” transactions, where both the swap dealer and its counterparty are not organized under U.S. law and not guaranteed by a U.S. entity. Campbell added that allowing for substituted compliance with comparable foreign regulatory regimes would allow for a “good deal” of competition across global markets and would not “impair the safety and soundness requirements of the rule.”
Angie Karna, Managing Director, Legal Department, Nomura Securities International, Inc., said that the “foreign-foreign” scenario under the proposal is very important to her firm and stressed that due to the “tremendous amount of international dialogue” round this rulemaking there should be “the maximum opportunity for findings of substituted compliance.” She later added that her firm likes the broader view of substituted compliance under the prudential approach, but that the transaction level approach “made the most sense” when looking at the possibilities of conflicts among the various other rules.
Eric Litvack, Chairman of the Board, ISDA, said that if “jurisdictional conflict” and “competitive disparities” are not eliminated “we are likely to find ourselves splitting the global markets” into “regional silos,” adding that partial substituted compliance under the entity level approach and prudential approach will not eliminate these conflicts. He said that a transaction level approach “has the most chance of achieving uniformity in margin requirements” and is “preferable from the standpoint of mitigating compliance costs and reducing opportunities for regulatory arbitrage.”
Turbeville responded that margining is an entity level activity and that “it doesn’t matter if a swap dealer is dealing with a non-U.S. person” because that activity can impair the integrity of the U.S. market in the same way as a transaction with a U.S. person.
Chris Allen, Managing Director and Global Head of Regulatory Strategy, Barclays, agreed that the prudential regulators’ approach “increases the instances in which effective substituted compliance” will be available and said that alignment of the approaches between the CFTC and the prudential regulators would “be appealing in terms of reducing conflicts and fragmentation.”
Adam Cooper, Chief Legal Officer, Citadel, said that the prudential regulators’ definition of foreign is not accurate and does not mirror that of the CFTC. He said that the “proper characterization of U.S. nexus” is that the “principle place of business” is in the U.S. He then said that using the transaction level approach “makes the most sense,” noting that the industry has invested in building an infrastructure transaction level compliance reporting and said entity level requirements would be costly and “potentially disruptive.”
George Harrington, Global Head, Fixed Income Trading, Bloomberg, said that the underlying liquidity of the products should be taken into consideration under the rulemaking to ensure the margin requirements are not too burdensome, which could create competitive disadvantages and drive business overseas.
Clive Christison, Regional Business Leader of Integrated Supply and Trading, BP, stressed that the uncleared swaps market is critical for commodities and market participant hedging. He said that there should be one set of rules for all market participants “regardless of whether counter party is domiciled” and added that the prudential approach is likely to be more aligned with other rules.
Massad noted the importance of getting the rules that the CFTC adopts “as much as possible the same” as the rules in other jurisdictions. He then asked CFTC staff about the situation where a U.S. firm previously guaranteed swaps transactions of its affiliate but then removed this or “de-guaranteed” these swaps. He mentioned that some participants said this action was done to avoid being subject to trading rules, but stated “this rule to me is fundamentally about risk.” He then asked about the difference between the approaches and if there are similar rules in other jurisdictions.
Kim responded that the CFTC staff is “very much concerned about and definitely mindful of” the de-guarantee issue in trying to develop a proposal for Commission’s consideration. She noted that margin is calculated on an individual transaction basis and is treated as a transaction level requirement in the guidance, but said that in “rethinking this issue and looking at the safety and soundness concerns” the CFTC staff thinks “it may be more appropriate to address it at an entity level.” Kim further explained staff is concerned that too many uncleared swaps of CFTC registered swap dealers may be excluded under the transaction approach and “therefore the risk will come back to the U.S. person and U.S. financial system.” She said the prudential approach limiting the exclusion “to truly pure foreign to foreign” transactions “may be worthwhile considering seriously.”
Wetjen then asked about the proper treatment of inter-affiliate trades “which tend to be international in nature given the way that global firms manage their risk.” He explained that the CFTC proposal imposed both initial and variation margin on these transactions and noted that the CFTC has an exception from the clearing requirement for inter-affiliate trades.
Hill replied that this topic is “one of the easier ones” because it “does have a right answer.” He said that with inter-affiliate trades, “flatten out the risk among the regulated entities” and that if these transactions were too expensive or not permitted, each of the two entities would actually be “off sides,” where one would be long and one short a position. He said that for this reason, the CFTC exempted these trades from the clearing mandate and made a decision that the transactions are an important risk management tool. Hill said “the exact same logic applies with respect to the margin requirement” and that if margin requirements are imposed the CFTC is “effectively eviscerating” the clearing exemption and “making it more expensive than clearing.”
Karna agreed, saying that inter-affiliate trades should not be dis-incentivized. She noted that neither Europe nor Japan imposes initial margin on these transactions and said he firm is concerned about making sure that U.S. clients have access to the “greatest amount of liquidity” and that adding inter-affiliate margin costs in only the United States, and not elsewhere, will result in a decrease of liquidity.
Hill noted that one of the reasons the CFTC is considering this requirement is because the prudential regulators took a different approach due to other banking regulations that require banks to treat their affiliates in the same way they treat third parties. He said this is not applicable to the CFTC.
Campbell said that Hill’s point “is in part correct” that there are other banking regulations to place restrictions on dealings between banks and affiliates and that these are “a relevant consideration.” He added, however that “there are other considerations at play as well,” such as a situation where a bank has an insurance company under its holding company structure that engages in swaps, saying these counterparty risks should be margined.
Doug Hepworth, Independent Account Controller, Gresham Investment Management, said the unmediated application of the proposed rules produces problems of double counting.
Supurna VedBrat, Managing Director, BlackRock, said her firm takes into account the risk of the entity that they are facing for uncleared swaps and said the proposed rule would end up increasing pricing because of double margining or increase costs to end users. She also noted that her firm would need to “re-paper” its operations with European entities, which is not “an easy exercise.”
Turbeville suggested that the CFTC look at previous resolution authority proceedings since the primary strategy is to separate the subsidiaries of a systematically important bank, thus it “might be a good thing if subsidiaries, even though they’re inter-affiliates, were independently margined.” He added that “it is true” that the proposal makes the uncleared transactions more expensive than clearing, and that this policy was intended to discourage this practice.
Caitlin Kline, Derivatives Specialist, Better Markets, said it is not reasonable to assume that an increase in costs of inter-affiliate trades will impact hedging activity, because these transactions will need to done either way.
Litvack said that simulations have shown that the likely cost of having to double margin transactions would be effectively “hundred percent more margin,” that “inevitably would be passed on to the end user or simply discourage hedging.” He added that the proposal also increases risk facing the margin custodian.
Wetjen then asked to what degree the Fed is thinking about: 1) inter-affiliate trades becoming too expensive to the point that they are no longer done; 2) to what degree do these transactions increase the complexity of the firm as a whole; 3) how these transactions affect regulators as supervisors; and 4) if these transactions make revolving a firm more difficult.
Campbell replied that the Fed has received a wide array of comments that raised many of the points discussed at the meeting, including issues on resolution, risk management, and complexity. He said the Fed is “in the process of trying to sort through all those comments and think through those issues.” He added that “there are a lot of subtle issues that arise in the context of these inter-affiliate margin trades that the agencies are working through as we work towards the final rule.”
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