June 20, 2017
Commodity Futures Trading Commision Event: Market Risk Advisory Committee Meeting
Key Topics & Takeaways
- CFTC-EC Equivalence Agreement: CFTC Acting Chair Giancarlo noted the upcoming one-year anniversary of the agreement between the CFTC and the European Commission (EC) regarding central counterparty clearing house (CCP) equivalence, and stressed that the CFTC has remained committed to the agreement and the importance of it. He then stated that regardless of the outcome of the Brexit negotiations, the CFTC does not “contemplate any change to the CFTC-EC Equivalence Agreement.”
- Resolution Authority and Bankruptcy: CFTC Commissioner Bowen asked the panel if resolution authority and bankruptcy provisions are effective tools. One panelist replied that there are “only a handful of ways the bankruptcy model would improve a terrible situation,” and it may be due to stakeholders in the clearing venture being unable to collaborate in an effective manner. They continued that they are unsure what more there is to do by the resolution authority that has not been or cannot be done by stakeholders.
- Brexit’s Impact on the Derivatives Markets: BlackRock’s Kiely acknowledged that it appears Brexit has been priced into the markets to some extent and will mainly be constrained to the UK, where many event risks are still lingering in the market that could possibly result in a significant disruption. Chatham Financial’s Zubrod added that end users look at the derivatives market as a source of comfort rather than fear, as they are the tools used to mitigate against the uncertainties that are created by events like Brexit. He continued that not a lot of information is known for Brexit impact right now, but that there will probably be some shocks as the process happens.
- Christopher Giancarlo, Acting Chairman, CFTC
- Sharon Bowen, Commissioner, CFTC
- Glenn Schmeltz, Acting Associate Director, Division of Clearing and Risk
- Joseph Miller, Assistant Director, Division of Clearing and Risk
- Hugh J. Rooney, Assistant Director, Division of Clearing and Risk
- Robert Steigerwald, Senior Policy Advisor, Financial Markets, Federal Reserve Bank of Chicago
- Sayee Srinivasan, Chief Economist, Office of the Chief Economist
- Richard Haynes, Supervisory Research Analyst, Office of the Chief Economist
Acting Chairman Christopher Giancarlo, Commodity Futures Trading Commission (CFTC)
Acting Chairman Giancarlo introduced the main topic of today’s discussion: the increased use of clearing for swaps transactions. He explained that additional resources would be “very beneficial” to the Commission, and that they would not only strengthen the CFTC’s examinations capabilities, but also enable the staff to keep up with the increased number and value of swaps cleared by the designated clearing organizations (DCOs). Giancarlo also noted that the complexity of these DCO’s has increased significantly, which has led to the increase in complexity of the Commission’s oversight responsibilities.
Giancarlo went on to note that the risks posed by instruments such as credit default swaps (CDS) differ from that of interest rate swaps (IRS), and as such, that DCO’s have created many individualized margin models and other risk management tools to address these respective risks. Giancarlo next raised issues regarding the supplemental leverage ratio (SLR), highlighting two steps towards improving the application of SLR toward swap clearing and reducing capital costs for clearing members: 1) excluding customer cash collateral held at the central counterparty clearing house (CCP) from the bank’s leverage calculation; and 2) taking customer collateral held at the CCP into account in computing potential future exposure in a manner consistent with the Basel Committee on Bank Supervision’s standardized approach to counterparty credit risk. Giancarlo stated his belief that if these are successfully implemented, there will be a significant increase in trading activity, and that these reductions in cost will create a more stable financial system.
Giancarlo next highlighted that DCO’s are expanding services around the world, stating that the Commission would work to support such expansion through information sharing and discussions with their foreign regulatory counterparts regarding cybersecurity, liquidity risk management and default management, among other issues. He then mentioned the European Commission’s (EC’s) proposed amendment of European Market Infrastructure Regulation (EMIR) to regulate third country CCPs that was released last week, adding that European officials must take “great care” as the amendment is considered.
Lastly, Giancarlo mentioned the upcoming one-year anniversary of the agreement between the CFTC and the EC regarding CCP equivalence, and stressed that the CFTC has remained committed to the agreement and the importance of it. He then stated that regardless of the outcome of the Brexit negotiations, the CFTC does not “contemplate any change to the CFTC-EC Equivalence Agreement.”
Panel 1: Risk Surveillance Activities of CFTC’s Division of Clearing and Risk
Division of Clearing and Risk Presentation Glenn Schmeltz, Acting Associate Director of the Division of Clearing and Risk, explained that the Division strives to conduct independent assessments of the risks posed by market participants, mainly through stress tests, and discussed the responsibilities of the Risk Surveillance Branch (RSB). He explained that the daily data the RSB receives continues to increase, that the data comes from 19 DCOs across multiple market segments and that the RSB hopes to identify the magnitude of significant positions using stress tests and comparing the risks to assets.
Joseph Miller, Assistant Director of the Division of Clearing and Risk, discussed the results of several techniques, processes and reports that the RSB conducts, which includes the position risk summary report, futures equivalent delta position reports and reports to identify notable short option positions. Regarding stress testing, he explained that they use a combination of proprietary and vendor risk management systems that interface, and discussed examples of stress test results. Miller then discussed the margin backtesting program and gave examples of special projects that are being conducted, including a multi-CCP default exercise between CME, Euroex and LCH that started on April 24, 2017.
Hugh J. Rooney, Assistant Director of the Division of Clearing and Risk, gave an overview of Regulation 1.73, which is the CFTC regulation for risk management that impacts clearing members who are also registered as futures commission merchants (FCMs). He discussed the audit process, including audit planning and the initial review, as well as the on-site review. Rooney then discussed some of the typical findings, including liquidation analysis and interpretation margin adequacy evaluation. He stated that the benefits of the program are its “unique” view of positions across many DCOs, as its relationships with the day-to-day risk personnel.
Information Sharing Richard Miller from the American Council of Life Insurers (ACLI) asked about information sharing protocols with other regulators. Rooney explained that there are not currently any procedures, but that as events happen the regulators work together, adding that the cooperation comes mainly through the examinations group rather than the risk surveillance branch.
Margin Models Marcus Stanley from Americans for Financial Reform (AFR) asked if the RSB is relying on the clearing house’s internal margin models to translate different scenarios. Schmeltz replied that one of the RSB teams reviews the changes to margin models and approves them prior to going into effect, and that there is an ongoing monitoring of the margin models.
Liquidation Exercises Dale Michaels from the Options Clearing Corporation (OCC) asked about the liquidation exercises that clearing members perform and what the RSB is looking for. Rooney explained that as Regulation 1.73 is carried out, the RSB asks clearing members to show them how they are complying, and that the RSB has not found a clearing member that has been deficient so far.
Panel 2: An Economic Perspective on the Clearing Regulatory Framework
Presentation Robert Steigerwald from the Federal Reserve Bank of Chicago stressed the need to think critically about policy issues, and that understanding the importance of policy tradeoffs is “necessary for good policy making.” Sayee Srinivasan from the Office of the Chief Economist explained that there is not yet much of a conceptual framework in the research community to systemically study, and that it is a “work in progress.” He added that when thinking about CCPs and skin in the game, there is an argument that more capital is better, and that CCP and clearing member (CH) incentives are conditional on regulations – but that “we need to know where we are today” to answer the argument.
Richard Haynes from the Office of the Chief Economist then explained that academic literature is sometimes one-sided, and that regulators, policy makers, and market participants must take this into account when making decisions based on such literature. He then listed several areas of tradeoffs that are “interesting” to him, including risk management and risk distribution and relative incentives of different market actors. Haynes discussed that while clearing can reduce risks, it can also transform risks, and explained that there are clear benefits to moving to clearing for standardized products as put forward in the G20 mandate. He also noted that while CCPs can reduce counterparty risks, they can also increase liquidity demands.
CCP Capital Elaine Kiely from BlackRock argued that there is a lack of research that addresses the issue of CCP capital, and that suggested that the regulatory and academic community should provide that information. She continued that it is critical to realize CCPs as for-profit entities when conducting an analysis, as they provide a service that firms pay for.
Resolution Authority and Bankruptcy CFTC Commissioner Sharon Bowen asked the panel if resolution authority and bankruptcy provisions are effective tools. One panelist replied that there are “only a handful of ways the bankruptcy model would improve a terrible situation,” and it may be due to stakeholders in the clearing venture being unable to collaborate in an effective manner. They continued that they are unsure what more there is to do by the resolution authority that has not been or cannot be done by stakeholders.
Stanley discussed the recent Treasury report and asked about liquidity planning for the bankruptcy or resolution of a major entity, as well as the living will process. Srinivasan explained that while most economic models work during normal market conditions, economists “do not have much to say” during crisis situations. He continued that when people want to have more rules for managing the resolution of CCPs, it “gives [him] pause.”
Haircutting Tools Marnie Rosenberg from JPMorgan expressed concerns regarding initial margin and variation gains margin haircutting as tools, and stressed that additional academic research should be done with quantitative impact studies to evaluate capital across the financial system from a CCP perspective.
Panel 3: Market Input – Brexit’s Effects on Markets
Have Markets Accurately Accounted for the Risk Posed by Brexit?
Kiely acknowledged that it appears Brexit has been priced into the markets to some extent and will mainly be constrained to the UK, where many event risks are still lingering in the market that could possibly result in a significant disruption.
Luke Zubrod from Chatham Financial explained that end users look at the derivatives market as a source of comfort rather than fear, as they are the tools used to mitigate against the uncertainties that are created by events like Brexit. He continued that not a lot of information is known for Brexit impact right now, but that there will probably be some shocks as the process happens.
What are the Planning Challenges? Susan O’Flynn from Morgan Stanley explained that trading access to European clients “may no longer be available from a house execution and client perspective,” and that access to European CCPs may be “subject to additional requirements both from a CCP perspective from non-EU institutions (third country institutions),” as well as domestic regulations in jurisdictions where no CCPs are located. She continued that a new European entity will have to be established or an activity will have to be relocated to an existing European entity to continue transactions with European clients, which could also lead to new exchange and clearing memberships to ensure the continuity of the activity. O’Flynn then explained that “significant resources” will be needed internally to go to market structures, and that dealers will have split trading and client coverage over two entities now. She added that the price of execution may be adjusted to absorb the costs and that the planning will become more difficult if the UK CCP “is not retained or if a relocation of European clearing were to occur.”
Kiely explained that the biggest issue is keeping their structure “nimble enough” to respond to requirements as they are created, and that they are looking to clearing members to figure out how the clearing infrastructure will have to be structured, but that right now “there is very limited clarity into what we might need to do.”
What Would be the Effect of Denying Third Country Recognition to CCPs of “Substantial Systemic Importance” on the Derivatives Markets?
Regarding proposals to deny third party recognition unless a CCP relocates to the EU 27, and what that sort of fragmentation could mean for the markets, Clifford Lewis from Eurex Clearing stressed that they are still in the “very early days” of such proposals and that it is uncertain how it will play out. He continued, however, that a cost-benefit analysis may impact how a systemically important clearinghouse operates outside of the euro zone, adding that the operational and legal costs would be “considerable,” and questioned how much additional initial margin would be needed should it happen.
McLaughlin added that the potential to fragment liquidity is not good from the point of view of systemic risk, as there will be fewer members to absorb a default situation. He stressed that should the global liquidity pool be fragmented, and systemic risk will increase. McLaughlin also noted that costs would increase due to losing portfolio margin benefits between currencies, which can be “quite substantial.” He warned that such fragmentation would create an offshore market for euros, as two-thirds of European swaps are cleared between members that are not part of the euro zone.
Michaels noted his fear of potential unintended consequences, as the market does not know the risk of such a political situation and therefore a solution. As for breaking up portfolios, he warned about breaking up diversification and both margin and the clearing fund will go up.
Rosenberg backed a proportionate approach to supporting non-EU CCPs, adding that while she is still evaluating the EC’s proposal, she is concerned about the negative impacts that could arise from denying third country recognition (such as market disruption and liquidity fragmentation). She explained that one of the key benefits to central clearing is the reduction of risk exposure, and that losing netting and trade compression may result in larger aggregate exposures to CCPs across the market. Rosenberg also warned of the “significant challenges” that could occur due to the denial of third country recognition during a crisis.
Kiely explained that while it is not expected that fragmentation will have an impact on the ability or willingness to trade, it will have an impact on pricing and a client’s return, but that they will “adapt and adjust as necessary.”
Another committee member discussed the limited capacity to deal with regulatory changes, and that there are “hugely expensive and time consuming” changes to market structure that the EC is contemplating, in addition to changes in clearing, and cautioned “overload[ing] the system in terms of what it can handle.”
Kim Taylor from CME Group stated that one of the goals of global policy makers is market stability, and that she hopes they understand that disrupting market access “is not good for market stability.” She then echoed Giancarlo’s thoughts that the EC’s proposal should not disrupt the US-EC equivalence agreement.
Are Businesses Moving Operations to EU 27 or Elsewhere Ahead of Brexit? What Challenges are they Facing?
A committee member explained that moving infrastructure or people would take several months or years of planning and execution exercises, and then discussed the impacts on their clients. He questioned how to centralize and manage risk arising from forced localization in trading strategies. O’Flynn echoed his comments.
Kiely added that a forced relocation would negatively impact market liquidity due to capital requirements increasing from an SLR perspective and need for independently capitalized entities across different jurisdictions, adding that it will have a trickle-down effect on their firm’s ability to take and unwind trades.
Edmonds added that most challenges are related to members, as they will have to move certain products from a clearinghouse and go through a “rapid pace of adoption,” causing additional stress on clients and the markets.
How Will the Derivatives Markets Look Post-Brexit?
Lewis noted that Giancarlo is making progress on capital rules that are just as important as issues that are subject to today’s discussion, and that there is a potentially serious divergence in the fundamental approach to regulation between the U.S. and EC that could have grave consequences that are “far more important than Brexit.”
Kiely added that any forced relocation will negatively impact market liquidity, that capital requirements for dealers will rise, and that independently capitalizing dealers across multiple jurisdictions will impact cost and reduce liquidity.
Commissioner Bowen noted her intention to leave the CFTC soon, depending on when a new nominee is considered. She explained that due to the Commission only having two people rather than five, it has made the routine “difficult” and important policy decisions “almost impossible,” adding that the CFTC has been “frozen in place” while the markets they regulate are “moving faster every day.” She stated her hope that the Commission will be full once again in the near future.
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