Commodity Futures Trading Commission Market Risk Advisory Committee Meeting
U.S. Commodity Futures Trading Commission
Market Risk Advisory Committee Meeting
Wednesday, December 11, 2019
Opening Statements
Commissioner Rostin Behnam
In his opening statement, Behnam provided a brief overview of the topics to be discussed and praised the Market Risk Advisory Committee (MRAC) and the relevant subcommittees. He noted that while many challenges remain in terms of transitioning away from the London Inter-bank Offered Rate (LIBOR), he is proud of the work and progress made by the MRAC on this front, specifically referencing the MRAC’s approval of plain English disclosures for new derivatives referencing LIBOR and other IBORs. He concluded by stressing that a significant amount of work needs to be done given the fact that the Alternative Reference Rates Committee’s (ARRC) paced transition plan assumes significant transition to the Secured Overnight Financing Rate (SOFR) in 2020.
Chairman Heath Tarbert
In his opening statement, Tarbert announced that the Commodity Futures Trading Commission (CFTC) will be providing LIBOR-transition related relief. He continued that CFTC staff is working to publish a series of relevant no-action letters by December 20, 2019 that will remove many of the barriers to converting legacy LIBOR swaps to SOFR. Specifically, this relief will cover amendments to existing swaps that either add a fallback provision or change the reference rate to SOFR or another risk-free rate.
He then emphasized the threat of “zombie LIBOR,” a scenario in which LIBOR exists but is not representative of a real rate. This would result in a situation where swaps would be priced against a seemingly alive rate but one that has no integrity as a true benchmark. He noted that a variety of proposals are currently being considered to avoid this scenario. Tarbert concluded by emphasizing that LIBOR is going away and failing to transition away from LIBOR not only presents a source of risk for individual firms, but also systemic risk.
Report from the Market Structure Subcommittee
Panel Presentation
Lisa Shemie, Subcommittee Co-Chairman, Associate General Counsel, Chief Legal Officer- Cboe FX Markets and Cboe SEF, Cboe Global Markets, stated that the subcommittee is examining issues related to market structure driving forces. She continued that the subcommittee has set forth a list of discussion topics to be addressed over the next six months. Shemie opined that the subcommittee will offer recommendations to better inform the Commission on trading, clearing and reporting. She said the subcommittee will be broken into these subcategories and focus on appropriate topics such as swap dealers trading or FX obligations for clearing mandates. She added that the subcommittee will work to collaborate with other committees at the Commission.
Stephen Berger, Subcommittee Co-Chairman, Managing Director and Global Head of Government & Regularity Policy, Citadel added that there will be several conversations in the separate working groups, specifically noting the debate that will be conducted regarding self-certifications for swap obligations in the trading working group. He continued that in the clearings space, discussions around swaps market and futures markets have focused on Basel capital requirement and disincentives. Berger emphasized that the subcommittee is examining block trade thresholds, an enhancement to the structure of swaps and futures markets, as well as position limits and clearing member concentration access. He also echoed Shemie’s point about potential overlap across the Commission.
Question and Answer
Members of the MRAC made comments and asked questions about long term impacts, the collaboration between committees, as well as structure and timing. Shemie responded that after the initial subcommittee meeting in January, the goal was to discuss issue priorities and areas of agreement and push out recommendations to the Commission within six months. She continued that the subcommittee will seek input from market participants and other committees. Berger added that the subcommittee will strive to create recommendations based on a unified voice and principles.
Report from the CCP Risk and Governance Subcommittee
Panel Presentation
Lee Betsill, Subcommittee Co-Chairman, Managing Director and Chief Risk Officer, CME Group, stated that the subcommittee is working to deliver an actionable recommendation with detailed best practices to enhance clearing derivatives. He said the subcommittee will focus on CCP resilience and stress testing for network counterparties, CCP risk, resilience and governance structures, as well as governance and capital issues. Betsill added that the subcommittee will divide CCP risk, resilience and governance structures, and governance and capital into two working groups to increase focus and discussion on each issue subset.
Alicia Crighton, Subcommittee Co-Chairman, Chief Operating Officer, Prime Services, U.S. Clearing, Goldman Sachs, Futures Industry Association added that certain areas have, and will continue to have, the potential to be a challenge for agreement within the subcommittee. She expressed that the debate around margins will be an issue area that will require continued dialogue. Crighton said that the subcommittee will work to provide the Commission with updates and a set of substantive recommendations by mid-2020.
Question and Answer
Members of the MRAC raised concerns about potential systemic risks, best practices, margin capital requirements, CCP and bank default regulations and framework, as well as the potential adoption of new reporting processes for data sharing. In response to an inquiry as to how the subcommittee working groups will operate, Crighton responded that the resilience working group will discuss topics such as margin, liquidity, stress testing and other principles of default management. She continued that the governance and corporate working group would consider topics such as CCP capital and default resources, non-default losses and governance structure. She added that she anticipates conversations and recommendations to be consensus driven.
Report from the Climate-Related Market Risk Subcommittee
Panel Presentation
Bob Litterman, Subcommittee Chairman, Founding Partner and Risk Committee Chairman, Kepos Capital, expressed his desire to produce a CFTC risk management recommendation guide addressing climate-related risks. He said that based on his research, there is a need to address climate change-related risks, costs, as well as tools for mitigation and incentives. Litterman said recommendations will include a focus on the integration of climate-related stress testing and financial reporting, financial risks associated with transitions, and consideration for corporate analysis and management.
When asked about working groups and consensus-driven conversations, Litterman stated that he believes the subcommittee will be broken into different workstreams with cross-division and consensus-driven input. He added that he hopes to meet a June 2020 deadline for providing the Commission with recommendations.
Report from the Interest Rate Benchmark Reform Subcommittee
Panel Presentation
Thomas Wipf, Subcommittee Chairman and Vice Chairman, Institutional Securities, Morgan Stanley, presented an update from the subcommittee and recapped key developments, both regulatory and market driven, in the LIBOR transition. He specifically referenced key regulatory events such as the U.S. Prudential Regulators publishing proposed amendments to their uncleared margin rules in order to provide broad-based relief for interest rate reform. He also noted the U.S. Treasury and IRS proposing broad relief from tax implications of converting trades to new risk-free-rates (RFRs). He then outlined market developments such as the International Swaps and Derivatives Association (ISDA) putting forth the results of their consultation on final parameters for benchmark fallback discussions, the ARRC publishing a practical implementation checklist to help market participants with the LIBOR transition, as well as the ongoing efforts of the clearinghouses to refine their proposals for how they will adjust discounting and price alignment interest. Wipf then introduced the three panel presentations that would examine Legacy Libor Swaps and Initial Margin Findings, ISDA Developments and CCP Adjustments to Discounting & Price Alignment Interest. He continued that he expects the discussion of coordination between the clearinghouses on their respective Singe Step proposals will be ongoing for the next several weeks and months. He reiterated the subcommittee’s request for the MRAC to consider the merits of hosting a public table-top demonstration of this transition and how this transparency into the process will benefit the market and market participants.
Legacy LIBOR Swaps & Initial Margin Findings
Panel Presentation
Richard Haynes, Supervisory Research Analyst, Office of the Chief Economist (CFTC), presented a summary of the CFTC Office of the Chief Economist’s research paper titled “Legacy Swaps under the CFTC’s Uncleared Margin and Clearing Rules.” He noted that as markets adjust to comply with new rules, including the exchange of variation margin for all uncleared swaps and the phasing-in of initial margin exchange for all uncleared swaps, market participants have asked for clarification regarding existing legacy swaps that were executed prior to the implementation of these rules and therefore not subject to the new requirements. He continued that the transition from LIBOR to SOFR has generated a variety of regulatory questions, specifically as to whether this would cause legacy swaps to lose their status. Haynes said that without relief, after a transition such as LIBOR to SOFR, these swaps would no longer hold legacy status and, though there is no SOFR clearing mandate, could be faced with uncleared initial margin (IM) requirements. He noted that once these derivatives contracts are shifted from IBORs to their replacements, initial margin would need to be posted for the counterparties that are at that point phased in, which is likely to be a significant subset depending on transition timing. In seeking to estimate the amount of IM that might be needed, this examination made use of the standardized grid method, the method commonly used by counterparty pairs that cannot, or choose not to, use the Standard Initial Model Margin Model (SIMM). As such, he stated that this examination found that the IM requirement on all covered SD/non-SD swaps would be roughly $100 billion.
Biswarup Chatterjee, Interest Rate Benchmark Reform Subcommittee Initial Margin Working Group Leader, Global Head of Markets BCE Management, Citigroup, summarized the progress of the working group and noted that the $100 billion amount presented by Richard will be spread out across all the counterparties, participants and swap dealers, covering a significantly meaningful amount of market participants. He continued that while the grid method model pointed to an initial margin number amounting to roughly $100 billion, using the SIMM model would result in an initial margin in the $40 billion range. Both Chatterjee and Haynes noted that there are a number of caveats that account for the disparity between these two amounts including the fact that the grid model estimate assumes that no IM is currently being posted voluntarily and that any margin that is already being exchanged, even absent a mandate, would lower the marginal cost of IM posting assuming legacy status is lost. They state that even an initial margin number on the lower range of these two estimates represents a significant impact and encouraged the Commission and other regulators continue to look into this issue. They recommended that the MRAC approve the considerations of the working group and recommended that the Commission consider the findings in their effort, analysis and ultimately their recommendations regarding any relief.
International Swaps and Derivatives Association, Inc. (ISDA) Developments
Panel Presentation
Ann Battle, Interest Rate Benchmark Reform Subcommittee Disclosure Working Group Leader, Assistant General Counsel, ISDA, provided an update on the work that ISDA is doing on their derivatives fallback consultations, including pre-cessation triggers and the parameters for benchmark fallback adjustments. She gave an overview of ISDA’s role in providing the standard definitions and rate options that are used in the non-cleared, and many cases cleared, OTC derivatives market and what counterparties select as a floating rate. She noted that in publishing these in a standard place, ISDA has the ability to update them on a standard, centralized basis to include more robust fallbacks. She continued that fallbacks are extremely important in the effort to move the market away from LIBOR. Battle said that these amended and restated floating rate options will generally include the following: the existing price source information; a statement identifying the objective triggers for a ‘permanent cessation’ that would activate the selective fallbacks and; a description of the fallback that would apply upon the occurrence of that trigger, which will be the adjusted RFR plus the spread adjustment. She continued that ISDA will also publish a protocol to facilitate inclusion of the amended definitions (the definitions with fallbacks) into existing derivative transactions that were entered into prior to publication of the relevant supplement. She further stated that 1.) adherents to the protocol will agree that derivatives transactions that were entered into with other adherents prior to publication of the relevant supplement will be based on the relevant amended floating rate options in the 2006 ISDA definitions and 2.) existing derivatives transactions entered into prior to the date of the relevant supplement amending the 2006 ISDA definitions between counterparties that do not both adhere to the protocol, or otherwise agree to include the amended definitions in their transactions, will not include the fallbacks. She noted that the spread adjustment will differ across different IBOR tenors and that it is calculated over the five-year period prior to the relevant announcement or publication triggering the fallback provisions, but will not take effect until fallback rates actually apply. She stated that ISDA is moving forward with implementation of permanent cessation fallbacks and that they will simultaneously work with regulators and industry to increase market understanding of the implications of LIBOR being deemed non-representative while attempting to build a consensus on how to implement pre-cessation fallbacks.
Battle said that after a formal process, Bloomberg has been selected to publish the fallback adjustments and the relevant spread adjustment in the same way that LIBOR and other benchmarks are currently published today. Regarding timing, Battle stated that in Q1 2020, ISDA and Bloomberg will finalize full methodologies for fallback rates while ISDA publishes amendments to the 2006 ISDA Definitions and protocol for legacy transactions. In Q2 2020, Bloomberg will publish adjustment and fallback rates while the amendments to the 2006 ISDA definitions and amendments made by protocol take effect. She concluded that progress will be made on pre-cessation issues and the development of a documentation solution will occur one the market has additional information identified ins ISDA’s December 2019 letter to the FSB OSSG.
Question and Answer
Lee Betsil, CME Group, noted that any efforts on pre-cessation should be market driven and that the CCPs require greater clarity on this front moving forward. Dennis McLaughlin, LCH Group, stated that it is important that benchmarks are representative of the underlying market.
Frank Hayden, Calpine Corporation, and Craig Messinger, Virtu Financial, commented on Bloomberg being selected as the vendor that will publish these adjustments. Both stressed that this information must be offered in a way that is both commercially viable and offers the greatest coverage to the market.
The MRAC approved the recommendation from the Interest Rate Benchmark Reform Subcommittee to approve the initial margin impact findings and for such findings to be submitted for consideration by the Commission via voice vote.
Follow Up Discussion on Central Counterparty Adjustments to Discounting/Price Alignment Interest Environment
Panel Presentation
Dennis McLaughlin, Interest Rate Benchmark Reform Subcommittee Member, Chief Risk Officer, LCH and Agha Mirza, Interest Rate Benchmark Reform Subcommittee Member, Managing Director and Global Head of Interest Rate Products, CME Group presented an update on their respective institution’s proposals for transitioning price alignment interest and discounting for U.S. dollar OTC cleared swaps to SOFR.
McLaughlin noted that while LCH’s proposal remains subject to further consultation, governance, legal and regulatory review, they have attempted to design a compensation process that is as simple and straightforward as possible. Specifically, LCH is proposing that 1.) compensation for the valuation and risk change will be provided as a combination of cash and compensating swaps; 2.) client accounts will be able to elect cash-only if they choose to do so via their clearing broker; 3.) an auction will be used to facilitate the cash-only election and to determine the cash compensating amounts; and 4.) LCH is targeting all USD-discounted positions in SwapClear to be in scope, including non-deliverable currencies. Importantly, McLaughlin stated that LCH is targeting the conversion to take place on or around October 17th, 2020.
Mirza began by stating that CME Group believes that the migration of the discounting and price alignment environment for cleared USD interest rate swaps to SOFR, in accordance with the ARRC Paced Transition Plan, will foster liquidity across the SOFR term structure. He continued that CME is targeting the transition to take place on October 16th, 2020, aiming to both accelerate the timeline outlined in the ARRC Paced Transition Plan while coordinating with LCH and providing adequate notice to market participants in order to facilitate an orderly transition. Mirza stated that in order to neutralize value transfer attributable to the change in the discounting basis, the special valuation cycle that CME plans to conduct on October 16th, 2020 will include a cash adjustment that is equal and opposite to the resultant change in the net present value of each cleared interest rate swap product. He continued that in order to facilitate smooth operational processing, market participants will be able to choose to have basis swaps booked as either float-versus-float basis swaps or as pairs of fixed-versus-float swaps with equal and opposite fixed cash flows. He concluded that effective October 19th, 2020, and thereafter, CME will apply SOFR-basis discounting/PA to all cleared USD interest rate swap products.
The MRAC approved the recommendation from the Interest Rate Benchmark Reform Subcommittee to hold a table-top exercise simulating the October 2020 transition to SOFR via voice vote.
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