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CFTC MRAC Meeting

Commodity Futures Trading Commission

Market Risk Advisory Committee Meeting

Monday, June 27, 2016 

Key Topics & Takeaways

  • Industry Coordination: Market participants highlighted the importance of communication and dialogue between central counterparty clearing houses (CCPs), market participants and regulators, in order to ensure coordination during times of market stress.  CME Group’s Taylor noted that there are many ways CCPs can coordinate in times of crisis and that communication can be improved between regulators of global systemically important banks (G-SIBs) and CCPs.
  • Single Point of Entry: A committee member asked what the FDIC thinks about the impact of G-SIB resolution in terms of the relationship to continuity of services to a CCP, custodian, settlement, or otherwise. The FDIC’s Held explained that under the single point of entry (SPOE) strategy that the FDIC has put forward, the top tier holding company would be placed into receivership, but operating companies will be able to stay open and operate business as usual. He stressed that if losses are not more than the loss absorbing capacity of the corporation than the SPOE is feasible.
  • Congressional Intent: Taylor asked if Congress intended for the resolution process to apply to CCPs. The FDIC’s Starke replied that he does not believe Congress intended to exclude CCPs because the CFTC was not a key turner. Starke also mentioned that one does not need to be designated under Title l to be subject to Title ll. 

Speakers

Opening Remarks

CFTC Chairman Timothy Massad noted that the Commission has been closely monitoring markets in response to the UK’s vote to exit the EU and that it would continue to work with exchanges, clearinghouses and other regulators to ensure the proper functioning of the markets. Massad went on to highlight the “Three Rs” for central counterparty clearing houses (CCPs) – resiliency, recovery and resolution – explaining that these topics are a priority for the Commission and regulators around the world, as evidenced by the international agreement to implement the four-part work plan to examine clearinghouse resiliency standards, recovery and resolution planning, and interdependencies among clearinghouses and clearing members. 

Commissioner J. Christopher Giancarlo applauded Commissioner Bowen’s efforts as sponsor of the Market Risk Advisory Committee (MRAC), and mentioned that the Committee exemplifies the CFTC’s commitment to examine and understand market risk, as well as look for ways to mitigate its impact on market environments. 

Commissioner Sharon Bowen recognized that regulators will need to make many decisions in response to the recent British referendum, and that industry participants will look to develop a better sense of the temporary versus long-lasting impact, pointing to the MRAC as a key source of such analysis for the CFTC. Bowen gave an overview of what would be discussed during the panels, emphasizing the importance of coordination between the FDIC and CFTC in order to avoid duplication or the undermining of mutual efforts. 

Panel 1: Enhancing CCP Coordination in Default Management – Discussion of Draft Recommendations of the CCP Risk Management Subcommittee

CCP Communication
Kimberly Taylor of CME   Group expressed that communication is an important element of market stability, noting coordination efforts among the industry, regulatory community and CCPs globally in times of crisis. She said, however, that there is interest in firming up industry recommendations with respect to the default management process, recommending that there needs to be routine contact between key market players during normal times, to ensure that default management branches of clearing houses have strong communication channels in place during times of actual crisis. 

Dennis McLaughlin stressed that communication between regulators, market participants and CCPs is imperative. 

Kevin McClear of ICE echoed their views, and noted that CCPs currently have good relationships and communicate regularly via channels already in place. 

Coordination of Trader Scheduling
Taylorpointed out that CCPs require a different process to liquidate over-the-counter (OTC) products versus liquid futures, explaining that OTC products are largely auctioned. She continued that there should be better coordination with traders in the market for the purpose of hedging and running the auction process, and that it would be valuable to coordinate the rotation of clearing members serving on various default management committees, adding that this could help alleviate the default management process from further straining the markets.  Taylor said that CME and ICE have already started to work on coordinating the rotation of traders and expected other clearinghouses to join in.  

McLaughlin and Taylor   agreed, adding that there is not a need to have one trader for every firm on the default management committee of every CCP. 

McClear highlighted concerns regarding clearing members’ resources, noting that as CCPs have become more familiar with the market, there might not be a need for three traders and that maybe two or one is the appropriate number. 

Susan O’Flynn   from Morgan Stanley suggested that it was incumbent on the clearing members to centralize coordination efforts to ensure that there is scrutiny as to what resources are being committed, and what is needed to manage and trade house risk. 

Joint Default Drills
Taylor said that CCPs endeavor to drill together during times of crisis for the goal of collectively managing systematic risk facing the industry.  She explained that the default management process works towards CCP resiliency, but in the case of failure, it may serve as the first step towards CCP recovery. 

McLaughlinexpressed that it was a good practice to coordinate logistically in terms of seconding traders, but there was a limit to coordination because of the need to auction off positions in the market in the event of default, such as a situation where two CCPs are trying to auction off a similar position.  McLaughlin felt that regulators could play a role to help coordinate instances like this, given their broader view of markets. 

McClear noted that clearing houses regularly conduct formal default drills individually, and suggested that there may be need for a similar effort across CCPs. 

Auctions
Taylor stated that circumstances during past crises have shown the benefits of standardizing auctions to help reduce confusion, and further referenced the work of the Default Management Working Group, highlighting a document that outlines uniform CCP terminology for default management auctions. 

McLaughlin felt that the standardized formats and templates were helpful for auctions but said it was important to look to and minimize the underlying reasons as to why an auction might fail in the first place, such as a lopsided market. 

McClear expressed support for the Uniform Terminology Agreement, but felt that it needed to be incorporated into the respective CCPs’ processes for it to be effective, adding that ICE is using this document to build out the specifications of an automated default management system.

CCP Coordination

Taylor said that there are many ways CCPs can coordinate in times of crisis and that communication can be improved between regulators of G-SIBs and CCPs. She noted that the failure of multiple global systemically important banks (G-SIBs) is the only thing that could threaten the ongoing viability of the CCP mechanism and emphasized that the more information CCPs had from supervisors of G-SIBs, the better positioned they would be to manage defaults.  Taylor noted the ongoing discussions regarding coordination in the porting of customers.  

McLaughlin said that the porting of customers has become problematic because of regulatory capital requirements, and that it would be useful if there was some alleviation of the requirements to ease the onboarding process.  

Committee member Clifford Lewis of Eurex Clearing   indicated that there has been a huge amount of bottom-up coordination that has improved coordination across different CCPs.  He mentioned that Brexit is an excellent example of how the system is working and demonstrates the benefit of centralizing risk. Lastly, Lewis opined that it is important to get margining regimes right in advance of a crisis, noting that portfolio margining is a huge part of trying to prevent a default and simplifying the default process.  

Committee member Kristin Walters of Black Rock said that the handling of Brexit should not give false confidence and that market participants should be concerned regarding more unexpected events, but agreed that the market responded in a highly coordinated way that it is moving in the right direction.  She emphasized the importance of having discussions to address the porting process.  

Taylor expressed concerns regarding customer porting, highlighting that the way the leverage ratio treats the margin of customers is problematic even during normal circumstances, but is even more so during times of crisis.

Barriers to CCP Coordination
Taylor expressed the view that there is a difference of opinion among CCPs on whether operational, legal, logistical or other barriers impede coordination, but that given CME Group’s Memorandum of Understanding with various global CCPs, it would be able to share enough information about its exposures during a time of crisis. She suggested that across various jurisdictions, CCPs should be able to share information during crisis management. 

McLaughlin added that the CFTC could help address this obstacle since the agency knows the positions of CCPs and can decide whether market participants should talk. 

McClear took a more cautionary view of coordination, especially in regards to coordinating an auction.  He emphasized that the different regulations, laws, jurisdictions and bankruptcy regimes make it difficult to achieve a coordinated auction, implying that cooperation of the regulators, lawmakers, clearing members and market participants would be critical.  

Taylor raised concerns that there might be a situation where resolution would be tempted to preempt recovery and said we should guard against this across the system so that CCPs can use their recovery tools to return to a state where they are functioning in their roles in the marketplace. She also suggested that the plans for the recovery and resolution process not be laid out in a step-by-step list, but encouraged the industry to treat these plans as tool kits that accommodate a particular situation. 

Walters emphasized that the goal is always recovery, but resolution may be necessary in some instances. She felt that a similar process administered by the FDIC when recovery is no longer possible should be followed for CCPs, and that variation margin should never be used in any part of default because it belongs to non-defaulting clients.  Walters continued that the one exception would be an auction where variation margin would need to be used over a 24-hour period to stabilize and close out all positions.  She further expressed that more transparency around the loss absorbing capacity calculation is important.  

McClear emphasized the importance of understanding clearing house risk management practices and said that it should be allowed for the clearinghouse rule book to be applied before the resolution authority steps in.

CFTC’s Role
Taylor expressed that the CFTC has an important role to ensure that resolution does not preempt recovery, and that the entry of resolution authorities should only be done at an appropriate time.  

McLaughlin stated that the porting “puzzle” is the largest problem for the industry and welcomed the CFTC’s help dealing with this issue. 

Lewis   explained that the CFTC should focus on the portability issue and US bankruptcy provisions. 

Chairman Massad agreed with the panel that resolution should not preempt recovery, nor should resolution planning create incentives that undermine recovery.

Panel 2: FDIC Staff Presentation on G-SIB Resolution

Overview of Title II
Herbert Held from the FDIC gave an overview of Dodd Frank’s Title II, explaining that it provides a backup for the Bankruptcy Code in Title I. He continued that the goals under Title II are to minimize the systemic risk of the failure, ensure the costs of the failure are born by the owners, creditors and financial industry rather than taxpayers, and that culpable management is removed. Held then stated that Title II gives the FDIC many of the same powers over systemically important financial institutions (SIFIs) that they have in managing failed bank receiverships, but that under Dodd Frank the FDIC has a “complicated looking process” for invoking their authority. 

Powers Available to the FDIC
Penfield Starke from the FDIC then described the powers available to the FDIC as a receiver for G-SIBs, and that the process for G-SIB resolution and CCP resolution is “somewhat different” due to different facts. He continued that due to the lack of accountability to manage failed companies during the last financial crisis, accountability is one of the major tenants of Title II. Starke explained that there is also a priority of payments scheme in Title II that looks similar to the bankruptcy scheme, except rather than all wage earners being given priority, all wage earners other than senior executives and directors are subordinated. 

Orderly Liquidation Fund
Regarding the orderly liquidation fund (OLF), Starke explained that the FDIC uses the fund in resolution activities under Title II, and that when dealing with G-SIB or CCP failures, temporary public funding could be “very valuable” in the short-run, stressing that it is not unlimited. He further explained that it is intended that the FDIC initially get a fairly small amount (10 percent) based on the assets on the most recent financial statements of the failed company, but that they can then borrow based on the fair value of the assets available for repayment within 30 days. 

International Engagement
Charlton Templeton of the FDIC then discussed international engagement in the event of the failure of a G-SIB. He explained that there are three ways to address G-SIB resolution obstacles: 1) Bilateral engagement; 2) Multilateral outreach; and 3) Institutional-specific engagement. For bilateral engagement with key foreign authorities, Templeton stated that there is an ongoing dialogue, complete information sharing agreements, and tabletop exercises to better understand concerns and issues. For multilateral outreach, he discussed the different work streams involved, to include the co-chair of the Financial Stability Board (FSB) Cross-Border Crisis Management Group for banks being from the FDIC. Lastly, for institutional-specific engagement, Templeton discussed the different crisis management groups that have been created, made up of different firms, and that there is firm-specific information sharing with cooperation agreement. 

Questions from the Committee
A committee member asked what the FDIC thinks about the impact of G-SIB resolution in terms of the relationship to continuity of services to a CCP, custodian, settlement, or otherwise. Held explained that under the single point of entry (SPOE) strategy that the FDIC has put forward, the top tier holding company would be placed into receivership, but operating companies will be able to stay open and operate business as usual. He stressed that if losses are not more than the loss absorbing capacity of the corporation than the SPOE is feasible. 

It was then asked if a failing clearing member in bankruptcy would be expected to have any capacity to provide liquidity to the clearing house. Held explained that part of liquidity planning includes estimating the amount of liquidity that would be needed to keep membership in the financial market utilities going, which is figured into living wills and liquidity calculations. He continued that if the projection is correct, there should be sufficient liquidity on hand to prevent a default. 

When asked what is included as an asset of the CCP that could be loaned against, Starke replied that it is a “fairly aggressive definition” and that assets held in trust would not be included, as well as assets “ring fenced” by another jurisdiction, but most everything else would be included. Starke added that clearing memberships would also be included. 

Panel 3: CFTC & FDIC Staff Presentation on CCP Resolution

Jeffery Bandman of the CFTC noted that work on a resolution has an element of continuity and it will be the Division of Clearing and Risks’s (DCR’s) main focus for the remainder of the year. Bandman said that he hoped to provide public guidance on recovery rules and plans in the near future, and stated that it is important to focus on context and how much has already been agreed on and worked on. 

Robert Wasserman of the CFTC stated that a lot of coordination took place among different entities to create the Financial Market Infrastructure (FMI) Annex.  Specifically, he noted that there was a “tight” relationship between the recovery and resolution. Wasserman talked about the objectives of the FMI Annex, including financial stability, continuity of critical FMI functions, and avoiding exposure to tax payer loss.  He also explained what an effective resolution regime for FMIs should accomplish. The aspects of timing that goes into putting an entity into resolution were also reviewed. Lastly, Wasserman discussed the specific powers of the resolution authority. 

Starke mentioned that he hoped to have a discussion with the industry regarding CCP resolutions at the end of the summer. As far as timing, Starke noted that the goal should be to not go in too early and that the best resolution is one that does not happen.  He also mentioned that temporary financing should not be provided by a resolution regime, but instead, he believed that there should be more cash calls available. 

Questions from the Committee
Committee member Clifford Lewis asked whether the same team in the FDIC is working on the DCO and resolution process and treatment of FCMs in a bank resolution process. Lewis then proceeded to ask whether it would be expected that the banks going down would have transferred its FCM customers prior to reaching resolution phase, or whether this would happen in resolution. In response, Held stated that his section deals with resolution planning and they work with banks and DCOs. He noted that whether his clients would be ported prior to resolution or after is circumstantial. 

Taylor asked if Congress intended for this process to apply to CCPs. Starke replied that he does not believe Congress intended to exclude CCPs because the CFTC was not a key turner. Starke also mentioned that one does not need to be designated under Title l to be subject to Title ll.   

A Committee member mentioned that he read academic literature that argued that resolution authority does not apply to DCOs and wanted to know if there is a counter argument. In response, a panelist argued that is very clear that the Bankruptcy Code applies to DCOs and they fit clearly within that statutory framework. 

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