June 27, 2017
House Committee of Agriculture: Clearing the Next Crisis – Resilience, Recovery, and Resolution of Derivative Clearinghouses
Key Topics & Takeaways
- Access to the Fed: Chairman Conway (R-Texas) asked what would happen to a clearinghouse and its customers should two or more major banks fail. Salzman explained that tests are run regularly that include “far out but plausible” scenarios that are large enough to “bring down” a clearinghouse, and that clearinghouses are passing the tests. He continued that they have plans for settling in U.S. treasuries instead of cash should banks fail, but that it is “not a good way to do things,” stressing the need for access to the Fed to borrow on treasuries faster than current law.
- Supplemental Leverage Ratio: Ranking Member Peterson (D-Minn.) stressed his concern that the SLR “gets it wrong,” adding that Fed Governor Jerome Powell suggested that it will be changed, and asked how regulators may be able to fix it. Steigerwald replied that it is a “complicated topic,” but that in emergency circumstances where a clearing member has failed, it is essential for customer accounts to be “smoothly, swiftly, and safely” sent to a solvent, operating clearing member, which would currently be impaired by the SLR. Dabbs added that for derivatives cleared for clients, the risk of the instrument is recognized but not the risk of the deposit the client provided, and that effective policy would be to use initial margin a client provides as a deduction from the overall risk of the instrument.
- EU/U.S. Equivalence Determination: Rep. Scott (D-Ga.) discussed the EU’s proposed additional standards for clearinghouse regulation, which will tie into Brexit, and asked if it will threaten the equivalence determination between the U.S. and EU. Hill replied that the proposal contains two tiers of products, that that while they do not worry about tier one, tier two is “very broad” with a “wide breadth of possibilities.” He continued that it is difficult to say if it will threaten the equivalency determination, as it “has the possibility to.”
- Robert Steigerwald, Senior Policy Advisor, Financial Markets Group, Federal Reserve Bank of Chicago
- Scott A. Hill, Chief Financial Officer, Intercontinental Exchange
- Jerrold E. Salzman, Of Counsel, Skadden, Arps, Slate, Meagher & Flom, on behalf of CME Group
- John Dabbs, Global Head of Prime Derivatives, Credit Suisse
- Amias Moore Gerety, Special Advisor at QED Investors, Former Assistant Secretary for Financial Institutions – U.S. Treasury Department
House Agriculture Committee Chairman Michael Conway (R-Texas) opened his remarks describing the focus of the hearing, which is to examine the work done by regulators and market participants to safeguard derivatives clearinghouses and prepare for potential future disruptions. Conway explained that the failure of a major clearinghouse would be “unprecedented,” and even while the probability is remote, preparedness is necessary. He went on to explain the importance of the hearing, as it would provide the Committee with a better understanding of the work that has been done to prepare for a future financial crisis, as well as how regulators are prepared to respond in the event such planning has failed. Conway further discussed clearinghouse recovery, highlighting that there are other factors outside of the clearinghouse’s control that may impact the process, such as the availability of liquidity, impact of regulations like the Supplemental Leverage Ratio (SLR), and the stability of the broader economy. Lastly, Conway stated that consideration of what regulatory tools are available to respond is key.
Ranking Member Collin Peterson (D-Minn.) stated that central clearing is the “backbone of the futures industry,” arguing that it is important to discuss the current policies and how clearinghouses are prepared for future crises, rather than reviewing issues in the middle of a financial crisis.
Robert Steigerwald, Senior Policy Advisor, Financial Markets Group, Federal Reserve Bank of Chicago
Robert Steigerwald began his testimony by supporting the position of central bank account services and emergency liquidity support to clearinghouses. He explained that clearinghouses rely heavily on the immediate availability of liquidity, especially in situations when the private sector does not have the ability to do so. Steigerwald also stressed the crucial role that central banks play in the financial system, as they are the “lender of last resort.” He explained that time-critical liquidity (the transformation of credit risk to liquidity risk) is a “positive trade off” but that they must have the appropriate institutions available to provide liquidity. Steigerwald expresses concern for the increasingly connected current financial system and stated his belief that these issues reflect it. He then stated that Central Clearing Parties (CCPs) are susceptible to liquidity risk due to daily settlement exchanges. However, Steigerwald stressed that CCPs can remain solvent, even in the most extreme market situations.
Scott A. Hill, Chief Financial Officer, Intercontinental Exchange Scott Hill began his testimony by guaranteeing the safety and the risk-reducing benefits of central clearing. He stated that over the last 10 years, there have been many global financial reforms for over-the-counter (OTC) derivatives. Hill then explained that market participants have realized that they can create capital and operational efficiencies by moving uncleared positions into clearing. He assured the Committee that ICE has worked closely with regulators, end-users, and clearing members to uphold international standards. More specifically, Hill described the multiple types of testing they conduct, along with making their rules and procedures transparent to the public. Similarly, he mentioned that ICE has a transparent and robust recovery plan in case of a default. Hill closed by stating that even though the number of cleared contracts has increased, the amount of futures commission merchants (FCMs) has dropped significantly, from 200 to 60 in only a couple of years, and credited the requirements under Basel III for that substantial decrease.
Jerrold E. Salzman, Of Counsel, Skadden, Arps, Slate, Meagher & Flom, on behalf of CME Group
Jerrold Salzman chose to forego his written testimony and instead echoed Hill and Steigerwald’s comments. He stated that a clearinghouse is not a risk-taking enterprise, instead, it is the intermediary between the buyer and the seller. Salzman broke down the issue and explained that a failure of a member would not increase the risk of the system. More specifically, he explained that a member of the clearinghouse is required to buy into a guarantee fund based on the amount of risk that member brings., and that the money is then safely held in a clearinghouse. Salzman continued that the clearinghouse then evaluates the market daily to see if the member is losing or making money on a position; if the member is making money on that day, the clearinghouse pays them, and if they lose money, the member pays the clearinghouse, which eliminates the risk of failure. Additionally, Salzman explained that the clearinghouse does risk-based compliance reviews to ensure the stability of the clearing members’ finances. Lastly, Salzman assures the Committee that the clearinghouse system is so strong and reliable, that even if four large banks failed at the same time, they would have enough money to cover the situation.
John Dabbs, Global Head of Prime Derivatives, Credit Suisse
John Dabbs began his testimony by highlighting two major areas in need of improvement: CCP resiliency and end-user access. He continued that even though many products are not required to be cleared, they are still being cleared voluntarily, which allows more access for clients to cleared CCPs, contributing to their safety and soundness. Next, Dabbs explained that for each cleared swap facilitated on behalf of a client, there is a guarantee on the client’s financial obligations, and provides default fund contributions to a CCP relative to the client’s risk. He then discussed “small tweaks” that would result in additional access and increased resiliency to the cleared markets, to include regulations including a “safeguard package” requiring all CCPs have resources for the Cover Two standard, all CCPs (both systemically important and not) having access to the Fed for deposits, and systemically important derivatives clearing organizations (SIDCOs) having access to the Fed “to borrow on a secure basis for converting U.S. sovereign debt into cash in a time of stress.” Dabbs continued that in addition to CCPs having skin in the game, there should be certain incentives for clearing members staying in CCPs during a resolution or recovery scenario (and then be repaid). He closed by stressing that the clearing model “is not broken, it is functioning quite well.”
Amias Moore Gerety, Special Advisor at QED Investors, Former Assistant Secretary for Financial Institutions – U.S. Treasury Department
Amias Gerety explained in his testimony that Dodd-Frank has made the derivatives markets and the economy more safe and stable. He then listed several Dodd-Frank reforms that have been accomplished, to include giving the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) the authority to oversee the derivatives markets, requiring transparency before and after trades for all derivatives transactions, and having capital and margin rules for all derivatives dealers. Gerety stressed that preserving stability and safety gains must be the primary obligation, in addition to preserving Title II of the Dodd-Frank Act, as eliminating the Orderly Liquidation Authority (OLA) would be “deeply irresponsible to taxpayers.” He then listed ongoing challenges policy makers face, to include coordinating across multiple CCPs, cross-border cooperation and creating incentives for positive risk management and recovery prior to reaching resolution, stressing that “much work remains to be done.”
Question & Answer
Access to the Fed Conway asked what would happen to a clearinghouse and its customers should two or more major banks fail. Salzman explained that tests are run regularly that include “far out but plausible” scenarios that are large enough to “bring down” a clearinghouse, and that clearinghouses are passing the tests. He continued that they have plans for settling in U.S. treasuries instead of cash should banks fail, but that it is “not a good way to do things,” stressing the need for access to the Fed to borrow on treasuries faster than current law.
Conway noted criticism that enabling such access to the Fed would result in taxpayers bailing them out, and asked what the credit risk is to the Fed should a clearinghouse swap treasuries for cash. Salzman replied that there is “zero” risk to the Fed, as they will immediately be two percent ahead once they receive treasuries (as long as taxpayers and the federal government “make good” on their debt).
Conway then asked what the risk to taxpayers would be for allowing clearinghouses to “park” excess collateral in assets at the Fed. Steigerwald replied that there is no additional risk, and that such liquidity would be “extremely short-term.” He continued that financial institutions would not be able to survive without such immediate liquidity.
Rep. Austin Scott (R-Ga.) asked what would happen should clearinghouses lose access to account services at the Fed. Hill explained that if they were not able to deposit cash at the Fed, they would create relationships with other financial institutions that could take the deposits, but that it is a “rational policy decision” to provide access to the Fed, as they make the system more secure.
Supplemental Leverage Ratio Peterson stressed his concern that the SLR “gets it wrong,” adding that Fed Governor Jerome Powell suggested that it will be changed, and asked how regulators may be able to fix it. Steigerwald replied that it is a “complicated topic,” but that in emergency circumstances where a clearing member has failed, it is essential for customer accounts to be “smoothly, swiftly, and safely” sent to a solvent, operating clearing member, which would currently be impaired by the SLR. Dabbs added that for derivatives cleared for clients, the risk of the instrument is recognized but not the risk of the deposit the client provided, and that effective policy would be to use initial margin a client provides as a deduction from the overall risk of the instrument.
Repo Market Peterson noted criticism that the repo market is a “weak spot.” Salzman replied that the repo market is used by people who have securities but need cash, and that it is usually an overnight market. He continued that clearinghouse need cash immediately, and noted his concern that the repo market will be the first place to fail in a crisis due to not being able to use securities to get cash. Salzman then echoed his desire for access to the Fed due to its unlimited liquidity. Hill added that they established committed repo facilities for clearinghouses in the event of a crisis, and noted that the Fed can provide backstop services as a last step to ensure liquidity continues to flow.
Systemically Important Designation Austin Scott asked if it makes sense to treat systemically important clearinghouses different from non-designated ones. Hill replied that it does not, and gave an example of one of their designated clearinghouses. He continued that it is not about the return, but rather the security of deposits, and that they are looking for their customers to be able to have the same access to the secure deposit services available for systemically important institutions.
Cross-Border Impact Rep. David Scott (D-Ga.) discussed the EU’s proposed additional standards for clearinghouse regulation, which will tie into Brexit, and asked if it will threaten the equivalence determination between the U.S. and EU. Hill replied that the proposal contains a two-tier system for non-EU clearinghouses, that that while they do not worry about tier one, tier two is “very broad” with a “wide breadth of possibilities.” He continued that it is difficult to say if it will threaten the equivalency determination, as it “has the possibility to.”
Rep. James Comer (R-Ky.) noted the “significant margin callsâ” from clearinghouses during Brexit and asked what lessons were learned when it comes to risk management. Steigerwald explained that Brexit was an example of a time when an “exceptional” amount of “time critical obligations” was needed from the market. Salzman added that the ability to meet those obligations was not a problem at every clearinghouse. Dabbs then explained that every clearinghouse uniquely responded, and that it showed the importance of stress tests and real-life examples as they are better than “behind the scenes” tests. Hill added that Brexit “created a lot of volatility” and that the outcome was “unexpected,” though it showed that “the system works,” stressing the importance of cross-border communication and regulation.
Financial Choice Act Austin Scott referred to the Financial CHOICE Act that would repeal Titles II and VIII and asked how damaging it would be. Salzman explained the importance of Title VIII giving access to the Fed accounts, and Title II’s authority to wind down a clearinghouse, adding that there are “some interesting things” in the legislation.
Rep. Ann Kuster (D-N.H.) asked what the impact would be on clearinghouse and the swaps market should the CHOICE Act become law. Gerety stressed that in a severe financial crisis, “there is no other opportunity other than Title II,” but that the CHOICE Act eliminates this. He continued that Title VIII “is the key” to allowing for account services from the Fed.
Kuster then asked if the CFTC would be able to resolve a failed clearinghouse. Salzman explained that “it could be done” by the CFTC, but that it is not current law, and that if Title II goes away, a total liquidation under bankruptcy would happen.
Rep. Rick Allen (R-Ga.) asked if regional and community banks conduct business with clearinghouses, to which Salzman replied that small banks come to clearinghouses indirectly through big banks. Allen then asked if the CHOICE Act impacts big banks. Salzman replied that it does not. Gerety stressed the importance of “simplify[ing] the world” for community banks, and that any community bank that has interest rate risk will “find its place” in the global financial markets, adding that when community banks manage risk they rely on the “stability and strength of CCPs.”
Rep. Al Lawson, Jr. (D-Fla.) noted his concern with overturning Dodd-Frank and asked what role clearinghouses may have in mitigating the impact of another financial crisis. Gerety replied that strong tools are needed to mitigate a financial crisis, and that CCPs play a “critical role” in the movement from bilateral arrangements to clearing, as they act as “very significant buffers.”
Cybersecurity Rep. Roger Marshall (R-Kan.) asked what panelists are doing when it comes to cybersecurity. Hills stressed that cybersecurity is “at the top of the agenda,” and that they have developed significant disaster recovery and business continuity plans, as well as made “significant investments” in information security. He stated that there “has not be a heavier place of investment” or a topic with more senior management and Board-level attention at the company than cybersecurity. Dabbs echoed Hill’s response, adding that they also conduct employee training. Gerety responded that when at Treasury, they conducted tabletop exercises with the industry and that the action and cooperation between the government and industry was “notable.”
Rep. Darren Soto (D-Fla.) asked if there are multiple places data is stored, to which Salzman replied that they have a second facility over 400 miles from the main facility that can be brought up in under two hours that includes different electrical systems and backup generators that are tested monthly. He added that the CFTC has required Boards to bring in outside experts to lead meeting discussions.
Soto then asked if there have been any successful cyber-attacks on clearinghouses in the past 5-10 years, to which Salzman replied that there are over hundreds of attempts on financial institutions each day, but that there have not been any that have caused a disruption.
Lessons Learned Rep. Tom O’Halleran (D-Ariz.) noted that the markets are now communicating on an international basis, which adds complexity, and asked if the system is better protected today than in 2008. Hill gave an example of the credit default swap (CDS) market in 2008 that had bilateral trades where it was not known who was exposed to whom or what margins were required, but that today over 80 percent of the CDS market is cleared and they know how much collateral is held against such decisions.
Failure of a Clearinghouse Rep. Don Bacon (R-Neb.) asked if the failure of a clearinghouse would be gradual or a surprise, to which Dabbs explained that it would be a “relatively shocking event.”
Bacon then asked when regulators should step in and start resolution powers. Salzman replied that Title II gives resolution authority to the Federal Deposit Insurance Corporation (FDIC), and therefore they would be the regulator to step in, but that the goal is to avoid resolution. He continued that there is a requirement by U.S. and European regulators to have ways to distribute losses and continue working, adding that he does not “know what will happen” should the FDIC do something different from the current plan. Dabbs added that all the regulator would do is distribute leftover funds, but that the CFTC is the expert in the CCP domain and that the Fed should also be at the table to carry out any “extraordinary” actions.
Vice Chairman Glenn Thompson (R-Pa.) asked if panelists shared the concern that Title VIII creates moral hazard for clearing participants. Steigerwald replied that he does not, adding that there is a “critical distinction between solvency and illiquidity,” and that the Fed should have the ability to provide temporary liquidity to sustain the recovery efforts of a clearinghouse.
Thompson asked how the market can continue functioning which a clearinghouse is failing and whether the resolution authority should be empowered to suspend the clearing mandate temporarily. Dabbs replied that it is a “problematic situation,” and that there is a general concern that if a clearing member has a problem, there will be decreased willingness to transact with counterparties on a bilateral basis due to not knowing who the “good bank” and “bad bank” is. He continued that there has been a “large migration” from uncleared markets to cleared markets, and that 10 years from now the size of uncleared markets will be even smaller.
Thompson asked what powers regulators have when dealing with a failing clearinghouse, to which Salzman replied that they have the emergency power to take a range of actions, but that clearinghouses have drafted plans that have steps to take under such circumstances.
Rep. Stacey Plaskett (D-V.I.) asked what impact there would be on clearinghouse resiliency if a crisis happens. Steigerwald explained that CCPs have “extraordinary default management and recovery authority” and that he sees “almost no need for resolution whatsoever.” He continued that clearinghouses have different mechanisms in place to ensure coordination and cooperation with clearing members to preserve value, but that there should not be a fixation on money losses.
Congressional Assistance Rep. Lisa Blunt Rochester (D-Del.) asked if there are changes to the regulation of clearinghouses post-Dodd-Frank that Congress should be aware of. Dabbs explained that creating a temporary mechanism to allow an end-user to make payments to a clearinghouse during the default of their member would make the system easier for regulators to manage and increase the liquidity that a clearinghouse requires at the time, both decreasing the problem and increasing transparency.
Stress Tests Rochester asked what lessons were learned from the stress tests the CFTC conducted on clearinghouses last year. Gerety replied that generally the existing resources across the CCP landscape was sufficient, but that additional work should be done when it comes to interaction effects. He added that a communication element is being added to current stress tests when it comes to who to communicate to and at what time.
Pricing Rep. Neal Dunn (R-Fla.) asked about valuing collateral, to which Salzman replied that clearinghouses revalue treasuries and other kinds of collateral at the end of the day, but that futures are valued intra-day. He continued that clearing members would have to come up with the additional collateral should the value decrease or if there are losses on contracts.
For more information on this hearing, please click here.