By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.
Originally published on Tabb Forum
Earlier, I covered a report to the OTC Derivatives Regulatory Group (ODRG) meeting on resolving the international requirements for derivatives reform that the G20 passed in 2009. As it happens, the Financial Stability Board (FSB) published a report card on this same subject on April 15.
It shouldn’t surprise us that the cross-border aspect of derivatives reform is so much in the news today, since that is where the next big efforts will have to be made. Global market participants that are still heavily focused on Dodd-Frank are in danger of missing the bus, which is getting ready to leave the station.
The report card doesn’t start off on a positive note. It reads:
“While progress has been made in moving these markets towards centralised infrastructure, less than half of the FSB member jurisdictions currently have legislative and regulatory frameworks in place to implement the G20 commitments and there remains significant scope for increases in trade reporting, central clearing, and exchange and electronic platform trading in global OTC derivatives markets.”
Like a reproachful teacher, the FSB takes the jurisdictions to task for their slow progress:
“The FSB reiterates that, even though standards are still being finalized in a few areas, sufficient international guidance is overall available to jurisdictions to decide and implement policy frameworks for ensuring the G20 commitments are fully met in their jurisdictions, and that any necessary reforms to regulatory frameworks should be made without delay. This includes ensuring that there are no legal barriers to reporting all OTC derivatives contracts to trade repositories (TRs) and to the central clearing and organised platform trading of standardised OTC derivatives contracts... The FSB urges jurisdictions to clarify their respective approaches to cross-border activity, and to resolve any conflicts and inconsistencies as quickly as possible to provide certainty to stakeholders.”
Then the report gets into the details of the three major efforts: reporting, clearing, and centralized trading. Inreporting, the FSB points out one of the biggest problems to date: the lack of standardization in reporting data. “Only a small number of jurisdictions are placing obligations on market participants relating to non-centrally cleared transactions, such as trade confirmation timelines, portfolio reconciliation and compression, and trade valuation practices,” according to the report.
It also emphasizes another significant reporting issue, access to trade data by cross-border regulators. “Reporting a counterparty’s identity to TRs may be limited by domestic privacy laws, blocking statutes, confidentiality provisions and other domestic laws,” the FSB says. It also urges the jurisdictions to “continue to monitor the development of or changes in such laws and their proposed reporting requirements to ensure that any planned reforms adequately address barriers to reporting OTC derivatives transactions.”
With regard to clearing, the report says, “Jurisdictions must rapidly implement the G20 commitment to centrally clear all standardised products, in order to reduce systemic risk and to minimise risks of regulatory arbitrage between jurisdictions.” It points out three reasons why the clearing mandate hasn’t been completely adopted:
“Insufficient standardization. Some jurisdictions consider that currently there are not sufficiently standardized OTC derivatives products in their jurisdictions for central clearing to be viable.
“Availability of CCPs. Even where standardization is sufficient for central clearing to be viable, some jurisdictions report practical difficulties in implementation because no CCP is accessible by market participants located in their jurisdiction that offers clearing for the OTC derivatives products most actively traded in their markets.
“Use of incentives. Some jurisdictions have indicated that they expect that central clearing of standardized OTC derivatives will occur in their jurisdictions without mandatory obligations, due in part to the various incentives that market participants will face, including, for example, the requirements under the Basel III framework for banks and the margining requirements for non-centrally cleared trades.”
The FSB is skeptical of the reliance on incentives, and urges jurisdictions that do so to “recognise there is a risk that jurisdictions that have applied mandatory requirements may not regard their regime as equivalent. As international work increasingly focuses on implementation monitoring, the FSB will pay particular attention to the risk of regulatory arbitrage resulting from differences in jurisdictions’ implementation of central clearing reforms, across those jurisdictions imposing mandatory obligations and those that have not.”
Finally, on centralized trading, the report recognizes that this is perhaps the most difficult requirement, acknowledging that:
“Only a very small number of jurisdictions have requirements in force in this area. Many jurisdictions indicate that reform efforts are first being focused on implementing reporting and clearing requirements, or that further analysis is required of market liquidity before implementing trading requirements. However, this should not delay the enactment of legislation and regulation that would permit the implementation of trading requirements once they are determined to be appropriate for particular products.”
So the FSB gives the member jurisdictions a barely passing grade in derivatives reform, and, like a diligent teacher sending a note home, “The FSB Chairman has written to all member jurisdictions requesting confirmation that legislation and regulation for reporting to trade repositories are in place, as well as their committed timetables to complete all OTC derivatives reforms. He stressed that the need for prompt action on TRs should not in any way diminish the need for rapid completion of reforms in other areas, such as central clearing, capital and margining, and trading on exchanges or electronic platforms.”
Of course, as any teacher can attest, the parents have to take the warnings to heart or there will be no improvement in the classroom. The big question with this report card is: Will the jurisdictions care, or will they drop it in the trash on the way home?
Just two days after the CFTC’s mandatory clearing rules for OTC derivatives went into effect, sparking a litany of industry commentary and a threat from Bloomberg to file suit against the CFTC over swap collateral rules, ISDA is out with a paper making the case for the role of non-cleared OTC derivatives in the global economy.
The paper lends some industry support to the premise that onerous collateral requirements could ultimately harm the swaps market. In its press release, ISDA writes:
The International Swaps and Derivatives Association, Inc. (ISDA) today announced the publication of a paper, Non-Cleared OTC Derivatives: Their Importance to the Global Economy.
The non-cleared segment of the over-the-counter (OTC) derivatives market includes many important products with significant value to the economy. These products enable industrial companies and governments to effectively finance and manage risk in their operations and activities and help pension funds meet their obligations to retirees. They help support economic growth by enabling banks to lend to corporate and individual customers. They play a vital role in virtually every industry – from financial services to international trade to home mortgages.
Current regulatory proposals regarding margin requirements for non-cleared OTC derivatives pose significant threats to the continued functioning of this vital market segment. Such proposals also fail to fully consider the lessons learned regarding margin practices during the recent financial crisis.
The paper explains what non-cleared OTC derivatives are, who uses them and why. It outlines the evolution of clearing in the OTC derivatives markets, why some – but not all – OTC derivatives will be cleared, the types and benefits of non-cleared OTC derivatives and the impact of the regulatory proposals in this area.
To download the full paper, visit the ISDA website by clicking here
Word is out that the CFTC is considering a reduction in its “minimum five RFQ” rule, which would require investors to solicit a minimum of five quotes in order to transact business on a swap execution facility (SEF). Industry players such as Tradeweb have already added to the dialog drawing attention to a recent Financial Times story on a confidential CFTC memo, saying:
Mark Wetjen, seen as the swing vote on the five-person Commodity Futures Trading Commission, recommended this week in a confidential agency memorandum that the CFTC alter its proposed rule regarding derivatives marketplaces, or “swap execution facilities”, according to people who have seen the document.
Mr Wetjen is proposing to abandon a proposal – which was vehemently opposed by the largest global banks – to require institutional investors to solicit prices, or “requests for quote”, from five dealers.
On Tuesday, ISDA added its voice to the discussion with a post on its derivatiViews blog, which echoes the notion that overly stringent quote limits will increase transaction costs and constrain liquidity. We’ve included the full post here:
Why Limit Customer Choice on SEFs?
Originally published on derivatiViews on March 5, 2013
Last week we published the results of a survey of buy-side firms on proposals to mandate how many quotes must be requested when utilizing a swap execution facility (SEF). The CFTC proposal would require a minimum of five quotes and the entire industry has been waiting to see what the final rules will say on this point.
The survey, which we conducted with the Asset Manager Group of SIFMA with additional input from the Managed Funds Association, indicates overwhelmingly that the five quote minimum requirement will mean higher transaction costs, wider spreads, constrained liquidity, exposing of investment strategies, migration to different markets and use of alternative products that are not traded on SEFs.
Is this what regulatory reform was intended to achieve?
The fact is, the creation of SEFs was intended to provide a third way of trading derivatives, fitting along a spectrum that included the traditional means of OTC derivative trade execution on the one hand and the exchange traded world on the other. Sitting in the middle of that spectrum would allow SEFs to blend the best of both worlds. If SEFs are not sufficiently different from the former or too much like the latter, we would fall short of one of the goals of the G20 and the Dodd-Frank Act.
Dictating, and in the process limiting, customer choice does not seem to us to be a good way to achieve those goals. A minimum quote requirement takes the decision out of the hands of the users of the products with no clear demonstration that better pricing, lower costs or greater liquidity would result.
And who is more able to opine on such matters than the participating firms in the survey? Asset managers, hedge funds, insurance companies, pensions, foundations, endowments, corporates and others, together holding nearly $18 trillion in assets responded to the survey. Does someone other than those institutions know better than they what suits the needs of their accounts and investors?
SEFs can and should flourish, if we get the regulatory structure right. Many firms are eagerly awaiting the final rules from the CFTC so that they can begin final preparations to register as SEFs and launch their offerings. Rigid requirements with no demonstration of benefits, such as minimum quote requirements, will only weigh down these innovative offerings.
Let’s not burden SEFs and their many potential customers before they even get up and running.
By Larry Thompson
Originally published on Tabb Forum
While the debate over the Chicago Mercantile Exchange’s proposed Rule 1001 has, in some cases, been mischaracterized as a battle between the CME and DTCC, nothing could be further from the truth. The reality is that this is a battle between CME and a wide cross section of financial market participants, industry associations and interested third parties that do not want their freedom to choose how to report their swaps transactions blocked by regulatory fiat.
In fact, more than a dozen comment letters opposing the proposed rule were filed with the Commodity Futures Trading Commission (CFTC) last month, including by groups representing corporate end users that represent the bulk of domestic energy production and natural gas supply; traditional investment managers representing a significant portion of retirement savings and pension funds for U.S. workers; and multiple financial services trade groups. As evidenced by these comment letters, proposed Rule 1001 would decrease transparency for investors and regulators; increase complexity, costs and risk for financial institutions; and undermine core principles of the Dodd-Frank Act.
While market participants have varying reasons for choosing a swap data repository (SDR), the common denominator is their desire to choose where they report data.
Unfortunately, the proposed rule would allow CME (and potentially other DCOs) to inappropriately bundle SDR and clearing services. This is problematic because it would effectively allow CME to dictate to market participants where their swaps data is sent – a concern that a coalition of energy end users addressed in their comment letter, stating, “[M]arket participants who are reporting parties must have the ability to direct data related to their transactions to any swap data repository regardless of where the transactions are executed or cleared.”
If the CFTC approves the proposed rule and injects itself into market decisions, it would be compromising choice in the SDR market rather than allowing competition, market forces and innovation to determine how swaps counterparties choose an SDR, as was clearly envisioned by Dodd-Frank.
Deutsche Bank highlighted this concern in its comment letter to the CFTC, arguing that: “[T]he Proposed Rule would effectively eliminate reporting counterparties’ choice of SDR in contravention of Commission Regulations and related guidance, statutory principles of fair and open access to clearing services and regulatory prohibitions on anticompetitive practices by DCOs and SDRs.”
Market participants have expressed concern about where their swaps data is stored and accessed by regulators – not to mention that they are frustrated by the added complexity and costs that the CME’s proposed rule would have on the reporting process. The proposal would not only alter well-established rules promulgated by the Commission to date, it also would disrupt the significant preparations already made by market participants to report to their preferred SDR.
As The International Swaps and Derivatives Association (ISDA) explained in its comment letter, “[M]arket participants have made considerable investments in building and testing connectivity to their chosen SDRs not just to comply with reporting obligations but also to enhance their ability to manage other processes, including internal risk management and responding to ad hoc queries from multiple regulators in a timely and efficient manner.”
Industry trade groups have raised concern regarding the impact of the proposed rule on fragmentation and regulatory oversight. This point was reinforced by The Association of Institutional Investors (AII), which argued that: “CME’s Proposed Rule 1001 … undermines the goals of the Dodd-Frank Act by reducing the ability of regulators to view consolidated positions and patterns of abusive trading. It also undermines the ability of the buy-side to effectively manage risk through monitoring data reported to SDRs.”
The Wholesale Market Brokers’ Association, Americas (WMBAA) cautioned that: “CME’s proposed approach would violate the Part 45 Rules, fragment swap transaction data, and frustrate the Commission’s efforts to record the entirety of one swap in a single location.”
Market participants remain rightly concerned about the anti-competitive ramifications of Rule 1001. A coalition of energy end users said: “A competitive SDR reporting process … lowers the cost of reporting for counterparties and fosters efficient interfaces for end users[.]” The letter continues: “It is critical that reporting alternatives compete on a level playing field and that reporting swap data is not so costly or burdensome that liquidity is harmed or end users are discouraged from participating in the market. Competition among SDRs is the best way to avoid these problems while ensuring that regulators receive accurate market data.”
The WMBAA also stated in its comment letter that the proposed rule is inconsistent with the competitive landscape envisioned by Dodd-Frank because it promotes the bundling of regulatory services and “set[s] the . . . precedent for the combining of DCO and mandated [swap data repository] services as ‘one stop shopping’ in OTC markets.” The WMBAA expressed concern that: “[T]he logical expansion of this market structure would be to permit the combination of trade clearing services and trade execution services,” which would “seriously disadvantage . . . trade execution platforms without affiliated clearing houses” and “further [reduce] market competition.”
While regulators and investors rely on the integrity, timeliness and accuracy of market data, the proposed rule would increase the likelihood for misreporting and misunderstanding reported data. As a result, additional risk would be introduced to an already complicated system. In its comment letter, J.P. Morgan Chase & Co. highlighted concern regarding risk: “Anticompetitive tying arrangements such as CME’s proposed Rule 1001 would likely increase operational and systemic risk.”
When you strip the rhetoric away, the debate over proposed Rule 1001 is really a choice between empowering CME to dictate decisions on behalf of market participants and properly implementing the objectives of Dodd-Frank to enhance transparency and mitigate risk to ensure the safety and soundness of the capital markets. All investors and regulators have a stake in the outcome. But don’t take our word for it – listen to what market participants are saying.
By Mayra Rodriguez Valladares, MRV Associates
Originally published on Tabb Forum
There is renewed interest in emerging markets -- primarily due to the fact that the top emerging markets are growing while growth in the so-called developed countries has been anemic and, in some European countries, declining. Yet financial regulatory developments should also generate investor interest in emerging markets, since banks in developed markets may have a hard time expanding or even sustaining their forays in emerging markets as they try to comply with Dodd-Frank, Basel III and European regulations. Meanwhile, domestic economic data and foreign banks’ financial and regulatory woes point to very good growth opportunities for emerging market banks (see chart, below).
Exhibit 1: Projected Average Real GDP Growth, 2005-2050
State of Financial Regulations
Even though many of Basel III’s components have been watered down or delayed, the EU and US have reiterated that they are committed to implementing the regulation. Banks have been deleveraging for the past three years in order to be able to comply with stricter capital requirements and with Dodd-Frank’s Volcker Rule; even though the Volcker Rule has not been finalized to date, banks including Goldman Sachs and Morgan Stanley have divested from some US assets, such as hedge funds and commodity units. More recently, both Citibank and HSBC have been closing down some offices in emerging markets and are still looking to sell some assets in those markets.
Foreign banks -- especially European institutions -- have argued that financial regulations will make it difficult for them to lend to emerging markets. If banks from developed markets do curtail trade and project finance deals in emerging markets, foreign shadow financial institutions might step in; but emerging market banks are well poised to step in to pick up some of the transactions typically dominated by the large foreign banks.
Exhibit 2: Highlights of Current Size of Banking Sector
ource: Institute of International Finance, 30 January 2013
In years to come, it will probably be retail banking that will grow the most in emerging markets, given how underdeveloped consumer and mortgage lending have been in those markets. Until recently, emerging market corporations have been much more reliant on loans and traditional forms of financing. Yet there are signs of increasing bond and stock issuance in some key emerging market countries.
As of 2012, emerging market bond issues account for almost a third of all global bond issuances; this is a significant jump from a decade ago. Moreover, while the majority of issues are concentrated in banks, increasingly there are issuers from other sectors. All of these corporations are prime targets for emerging market bank services.
While presently foreign banks dominate about 50% of equity offerings and 45% of bond offerings, domestic banks also want to compete against foreign financial institutions to underwrite these transactions. As foreign banks are under more and more pressure to improve their risk management and capital ratios, it would not be surprising if they focus more domestically than in emerging markets. Given the lingering effects of the 2008 financial crisis, bank supervisors in emerging markets are watching very carefully how securities and derivatives transactions expand in their markets.
Emerging Market Bank Risks: What to Watch For
Like investors in any other bank, investors in and counterparties to emerging market banks should analyze very carefully the country and economic risks in the home country of the emerging market bank. Also, analyzing emerging market banks’ credit risk is extremely important since credit risk is often not well identified, measured, controlled or monitored at many developed market banks, not to mention emerging market institutions. Operational risk management at emerging market banks tends to be a very weak area since even understanding operational risk is a pretty new concept in these countries.
If emerging market banks start to grow, that will pose challenges to bank supervisors in emerging markets; bank supervisory agencies in emerging markets tend to be even more understaffed and short of resources than those in developed markets. Importantly, most supervisors in emerging markets have a background in accounting or economics -- sorely lacking are examiners who have solid experience in risk management, risk-based supervision, political science, financial modeling, or even finance, all fields that are very useful for good on-site and off-site bank exam teams.
Exhibit 4: Banking Return on Asset Ratios (Source: Fitch)
Many emerging market supervisors are either compliance-based or in transition to a risk-based supervisory framework, which, while imperfect, is a better framework to supervise whether banks are adequately capitalized to supervise unexpected losses. Investing in or being a counterparty to emerging market banks requires good due diligence that cannot be outsourced to anyone. Yet it is in those banks that growth opportunities lie for the next decade -- at least.
From the Editor
There is a new phenomenon afoot among commentators and in financial media to predict the demise of the swaps market, with most prognosticators placing their bets on the futures industry as the likely beneficiary.
As derivatives reform news junkies, we have to admit that this story has a good plot: Dodd-Frank puts onerous restrictions on swaps market participants. Rather than wrestle with reform, dealers flock to greener pastures. And poof! futures are the hot new thing.
Alas, few things in life – let alone financial derivatives market structure – are quite so simple, despite the intentions of clever headline writers. Take, for example, this provocative headline and lede from Tabb Group’s Adam Sussman from December 2012:
“The Demise of Interest Rate Swaps: The interest rate swap is in trouble. A regulatory preference for standardized products that are centrally cleared and traded on an exchange is the antithesis of the highly flexible, privately negotiated swaps market. Analysis of the initiatives announced by the Chicago Mercantile Exchange (CME), Eris Exchange and the Intercontinental Exchange (ICE) show that the significant advantages of standardized products over swaps include margin, trading and regulatory designations.
Strong words! But, before you start thinking of clever epitaphs for the IRS market, consider the concluding paragraph of Sussman’s article:
“However, even if the new contracts deliver reasonable basis risk relative to the swap, there remain behavioral barriers to adoption. Firms understand when and how to use and trade swaps – suddenly switching to swap futures has real and intangible costs that will take time to overcome. In other words, there are enough differences in the needs of market participants to warrant the introduction of new products while sustaining the current swaps market.”
Wait, you mean there is room for both swaps and futures in the global derivatives marketplace? That’s quite the disclaimer to offset a headline that sounds the death knell for today’s derivatives market structure.
Still, the conjecture continues. In the latest installment of the “futurization narrative”, Bloomberg’s Matthew Leising reported the following headline: “Energy Swaps Migrating to Futures on Dodd-Frank Rules.” The article goes on to quote an expert:
“Dodd-Frank has this phobia of swaps and imposes more onerous requirements on swap dealers,’ said Craig Pirrong, director of the Global Energy Management Institute at the University of Houston. In a direct response to the rules, companies are avoiding higher collateral, capital and trading expenses to ‘get the same trades and risk-management benefit’ with futures, he said.”
Once again, a cursory read of the first two or three paragraphs of this article would seem to suggest that regulatory reform has defeated the swap.
Until you read further into the Bloomberg article to find a quote from someone who knows a thing or two about financial markets:
“Interest-rate or credit swaps are less likely to follow the path of energy swaps into futures because it’s harder for banks and other financial firms to stay below the $8 billion threshold," Terrence Duffy, executive chairman of CME Group, said in a Jan. 17 interview in New York.
Even with more business coming to futures because of Dodd-Frank, ‘the swaps market’s not going away,’ Duffy said.
The fact is: derivatives markets will continue to evolve, both in response to Dodd-Frank and in spite of it. Some traders will favor futures to offset certain risks; some will favor IRS swaps for others, but market structure is not a zero sum game with a winner and a loser. That doesn’t always make the best headline, of course, but it does make for a dynamic environment for skilled professionals to navigate and innovate.
It is imperative that the regulators address this issue in the next several roundtables and meetings, but before you start placing bets on one horse to win the great derivatives market structure derby that much of the financial media and analysts are purporting, make sure there’s actually a race.
Wednesday afternoon next week, TABB Group will host a range of fixed income and derivatives industry experts at its third annual fixed income forum at the TimesCenter in New York. Fixed Income 2013: Liquidity, Products, Platforms expects to draw more than 400 buy- and sell-side market participants together to discuss new products, market liquidity and business models that are emerging to address changes in the fixed income and derivatives universe.
Among the featured guest speakers at the conference are Tabb Group’s Will Rhode and Adam Sussman, Robert Burke, head of global OTC clearing at Bank of America, Jack Hattem, managing director and senior portfolio manger at BlackRock and Tradeweb CEO Lee Olesky. CFTC Commissioner Scott O’Malia will deliver the keynote address.
Topics covered will include the role of technology in attracting liquidity in SEFs and how buy-side firms will source liquidity in secondary markets following Basel III and QE.
DerivAlert will be on hand, reporting live from the event. Follow us on Twitter @DerivAlert for live tweets from the floor, or click here to register.
By Mayra Rodriguez Valladares, MRV Associates
Originally published on Tabb Forum
Recently, a number of articles and white papers have focused on central clearing parties (CCPs) and have renewed market and regulatory interest in these often large and globally interconnected financial institutions. Derivatives clearing entities have gained enormous importance since the G-20 at its Pittsburgh Summit in September 2009 agreed that over-the-counter (OTC) derivatives should be cleared; this agreement gave rise to new derivatives clearing requirements both under The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the European Market Infrastructure Regulation (EMIR). As more derivatives go through clearing houses, it is imperative that clearing entities not only be adequately regulated, but also that regulators conduct risk-based supervision of these entities (and not just a compliance-based approach) to ensure that they have an adequate capital cushion to sustain unexpected losses.
What is a Designated Clearing Entity?
When market participants or journalists are talking about CCPs, they are referring to what the CFTC, SEC, and the Federal Reserve call Designated Clearing Entities (DCEs). DCEs are either Derivatives Clearing Organizations (DCOs) registered with the CFTC under Section V of the Commodities Exchange Act or a Clearing Agency (CA) registered with the SEC under Section 17A of the Securities Exchange Act, 1934.
In the derivatives world, a central clearing party is usually a DCO. According to the CFTC, a DCO is “a clearinghouse, clearing association, clearing corporation, or similar entity that enables each party to an agreement, contract, or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants.”
As of the end of November 2012, 14 companies are registered as DCOs in the US, according to the CFTC:
- Cantor Clearinghouse, L.P.
- Chicago Mercantile Exchange, Inc.
- Clearing Corporation
- ICE Clear Credit
- ICE Clear Europe Limited
- ICE Clear US, Inc.
- Kansas City Board of Trade Clearing Corporation
- LCH.Clearnet LLC
- LCH.Clearnet Ltd.
- MGE Clearing House
- Natural Gas Exchange Inc.
- New York Portfolio Clearing, LLC
- North American Derivatives Exchange, Inc.
- Options Clearing Corporation
Designated Clearing Entities are regulated by the CFTC or the SEC. Dodd-Frank’s Title VIII, Section 813, requires the SEC and CFTC to coordinate with the Board of Governors of the Federal Reserve to develop joint risk management supervision programs for clearing entities designated as systemically important, such as the CME or ICE, by the Financial Stability Oversight Council.
In the US, just about any type of financial institution can apply to become a DCO. Any DCO comes under the CFTC’s core principles, which require that they have:
- Adequate financial, operational, and managerial resources.
- Appropriate standards for participant and product eligibility.
- Adequate and appropriate risk management capabilities.
- Ability to complete settlements on a timely basis under varying circumstances.
- Standards and procedures to protect member and participant funds.
- Efficient and fair default rules and procedures.
- Adequate rule enforcement and dispute resolution procedures.
- Adequate and appropriate systems safeguards, emergency procedures, and plans for disaster recovery.
- Obligation to provide necessary reports to allow the CFTC to oversee clearinghouse activities.
- Maintenance of all business records for five years in a form acceptable to the CFTC.
- Publication of clearinghouse rules and operating procedures.
- Participation in appropriate domestic and international information-sharing agreements.
- Avoidance of actions that are unreasonable restraints of trade or that impose anti-competitive burdens.
- Governance arrangements and fitness standards.
- Rules to minimize conflicts of interest in the DCO's decision-making process, and a process for resolving any conflicts.
- Composition of governing boards to include market participants.
- Well founded legal framework for the activities of the DCO.
DCOs and Risk-Based Supervision
It is tremendously important that the CFTC not simply examine DCOs using a compliance based approach that is just making sure that clearing entities follow rules and principles. The CFTC should strengthen how they conduct risk-based on- and off-site supervisions of DCOs, particularly given their increasing role as systemically important financial institutions. A risk-based supervision approach entails that the CFTC would evaluate how a DCO identifies, measures, controls, and monitors its macro risks (country and economic) and its financial risks (credit, market, operational, liquidity, legal, and reputational) across all legal entities and geographic locations. Risk-based supervision allows regulators to focus on an organization’s problem areas and on those entities that have higher risks.
The CFTC increasingly has professionals coming from varied backgrounds, which is a great asset for risk-based exams. The best exam teams have expertise in risk-based supervision, finance, legal matters, accounting, derivatives, and risk measurement models. Examiners should be evaluating carefully the background of DCOs’ board of directors and senior management for signs of their risk philosophy, policies, and procedures and how they communicate them to all staff members. It is critical that examiners analyze the financial safeguards and account segregation at DCOs.
Moreover, evaluating the way that DCOs credit risk committees conduct due diligence on potential and existing members’ credit quality is very important. These credit groups should not just look at members’ financials, but when possible also their market signals, such as credit spreads and stock prices. Given the confluence of Basel III, Dodd-Frank, and EMIR, the pressure to have highly marketable, liquid, and unencumbered collateral is critical. Examiners need to make sure that DCOs accept only the highest-quality collateral and that if anything else – such as corporate bonds, stocks, or gold -- is accepted, that DCOs make transparent how they calculate haircuts.
DCOs have great exposure to operational risk -- a breach in the day-to-day running of the business due to people, processes, technology and external threats. As DCO volumes rise, there is more scope for operational risk simply by the virtue of the fact that people and systems need to keep up with the changing nature of the business. CFTC examiners need very detailed information from DCO senior management as to what type of data they collect for low-probability, high-adverse-impact events and need to see if DCOs use that information to measure if they are adequately capitalized to sustain unexpected losses.
CFTC examiners should also be analyzing how DCOs conduct stress tests; what liquidity, credit, market, and operational risks they use as inputs in their models; and what DCOs do with stress test results. Additionally, CFTC professionals want to evaluate the quality of business continuity, liquidity plans, and living wills that DCOs draw up.
Importantly, CFTC examiners need to be given resources and tools to undertake their expanded roles. Financial institutions cannot lobby congress to hinder or cut the CFTC’s budget and then complain that the CFTC is not finalizing Dodd-Frank rules fast enough or that they are not regulating and supervising the many entities under their purview. Dodd-Frank is here to stay, and the market, not to mention the global economy, will be helped enormously if derivatives clearing organizations are properly regulated and supervised. DCOs can aid enormously in making the derivatives market more transparent, liquid, and efficient, but only if they are properly supervised as systemically important organizations.
CFTC swaps rules came under criticism in a U.S. House Financial Services subcommittee hearing, today, where congressional lawmakers and representatives of the derivatives industry argued that the viability of the over-the-counter swaps market was being unfairly challenged by the new rules.
Among those who gave written testimony to the Subcommittee were:
Robert Cook, director, Trading and Markets at the SEC, Keith Bailey, managing director at Barclays, Michael Bopp, counsel for the Coalition for Derivatives End-Users, Samara Cohen, managing director at Goldman Sachs. Christopher Giancarlo, executive vice president at GFI Group and chairman of the Wholesale Market Brokers Association Americas, represented coalition known as Companies Supporting Competitive Derivatives Markets, which includes trading platforms Tradeweb Markets, Thomson Reuters, Bloomberg, GFI and ICAP. In his testimony, Giancarlo noted:
“After nearly 2 1/2 years of rulemaking, the CFTC’s cumulative approach to swaps regulation has imposed such high costs on the industry that the U.S. swaps market is on the verge of becoming too costly and too regulated (particularly as compared with futures) to be a viable means for end user to hedge and manage their financing risk.”
Representative Spencer Bachus (R-AL), chairman of the full committee echoed that sentiment:
“If all derivatives were supposed to be traded on an exchange then they would be futures. Derivatives are different from exchange-listed products, and imposing the listed futures or equities market model onto derivatives is not the mandate.”
CFTC Chairman Gary Gensler also testified, reiterating his agency’s efforts to reduce risk to the financial system by mandating centralized clearing, bringing transparency to the marketplace and ensuring that swap dealers and market participants are regulated.
To read Giancarlo’s full testimony, click here.
To read Chairman Gensler’s full testimony, click here.
To view the complete witness list, click here.
SIFMA will host a half-day session of derivatives roundtable discussions next Tuesday, November 27, 2012 at the SIFMA Conference Center in New York. The event is expected to bring asset managers together to inform them of the most pressing issues they should be focused on as they prepare for central clearing of swaps and other key regulatory changes going into effect at year end.
Among the featured guest speakers at the conference are Tabb Group’s Will Rhode, Fidelity Investments’ vice president Matt Nevins, and Goldman Sachs vice present Wendy Yun.
The agenda features a panel discussions entitled “Readiness for Central Clearing,” “CFTC Registration,” and “Business Conduct Standards and Reporting/CICIs.”
To view the full program, please click here.