February 14, 2018
House Financial Services Subcommittee on Capital Markets, Securities, and Investment “Legislative Proposals Regarding Derivatives”
Key Topics & Takeaways
- De Minimis Threshold: Rep. Randy Hultgren (R-Ill.) asked about making changes to the de minimis threshold for swap dealers (SD) and security-based swap dealers (SBSD). SIFMA’s Ken Bentsen replied that more data is needed before the CFTC de minimis threshold is amended, explaining that while larger banks are “well beyond the level,” smaller dealers may not be able to stay in business due to the added compliance costs associated with registration as an SD.
- Regulatory Harmonization: Rep. Ted Budd (R-N.C.) noted that differing regulatory timelines between the CFTC and SEC create inconsistencies and redundancies, to which Bentsen stressed that harmonization “is a good thing.” ISDA CEO Scott O’Malia explained that a safe harbor approach would be beneficial, and Bentsen agreed, , further cautioning against approaches that would put the agencies in the position of “starting all over again.”
- Inter-affiliate Transactions: Rep. Frank Lucas (R-Okla.) asked Bentsen to explain the purpose of inter-affiliate transactions. Bentsen replied that banks will do inter-affiliate swaps to better manage and mitigate risks. He continued that while other regulators do not require initial margin on inter-affiliate transactions, U.S. Prudential Regulators uniquely do, and that the current framework traps capital that could be allocated elsewhere.
- Supplemental Leverage Ratio: Rep. Blaine Luetkemeyer (R-Mo.) noted that the CFTC calculated that the offset for initial client margin is less than a one percent decrease in the overall capital reserve, and asked if the financial system could withstand the change, to which O’Malia replied “yes.” Bentsen stated that such a change would drive more businesses into central clearing, and Thomas C. Deas, on the behalf of the Coalition for Derivatives End-Users, added that if initial margin is not in capital calculations, it seems “out of sync” with economic realities and “will get us off track.”
- The Honorable Kenneth E. Bentsen, Jr., President & CEO, SIFMA
- Thomas C. Deas, Chairman, National Association of Corporate Treasurers, on behalf of the Coalition for Derivatives End-Users
- Andy Green, Managing Director of Economic Policy, Center for American Progress
- Scott O’Malia, Chief Executive Officer, ISDA
- H.R. 4659, To require the appropriate Federal banking agencies to recognize the exposure-reducing nature of client margin for cleared derivatives.
- H.R._____, To direct the Securities and Exchange Commission and Commodity Futures Trading Commission to review and harmonize rules relating to the regulation of over-the-counter swaps.
- H.R._____, To amend the Dodd-Frank Wall Street Reform and Consumer Protection Act to establish an exemption from the credit valuation adjustment calculation for uncleared derivatives transactions with end-users so that United States companies are not disadvantaged, and for other purposes.
- H.R._____, To amend the Securities Exchange Act of 1934 and the Commodity Exchange Act to remove unfairness in the scope of end-user relief for end users hedging bona fide business risks, and for other purposes.
- H.R._____, To amend the Securities Exchange Act of 1934 and the Commodity Exchange Act to clarify the relief from mandatory clearing available to centralized treasury units of nonfinancial affiliates, and for other purposes.
- H.R._____, To amend the Securities Exchange Act of 1934 and the Commodity Exchange Act to exempt swap transactions between affiliated entities from the swaps rules issued by the Securities and Exchange Commission and Commodity Futures Trading Commission.
- H.R._____, To amend the Securities Exchange Act of 1934 and the Commodity Exchange Act to align margin and clearing requirements by clarifying the definition of “financial entity”, and for other purposes.
- H.R._____, To amend the Securities Exchange Act of 1934 and the Commodity Exchange Act to encourage risk mitigation by excluding all hedging swaps from the swap dealer de minimis threshold, and for other purposes.
- H.R._____, To provide clarity regarding the de minimis exception annual thresholds for swap dealers and security-based swap dealers, and for other purposes.
- H.R._____, To clarify the definition of “financial end user” as it applies to parent and holding companies.
- H.R._____, To exclude non-U.S. regulated funds from the definition of “United States person” and ensure consistent application of title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to cross-border security-based swap and swap transactions, and for other purposes.
Rep. Bill Huizenga (R-Mich.), Subcommittee Chairman
In his opening statement, Huizenga briefly described the role derivatives play in the financial system, and how both the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) have jurisdiction over the derivatives markets. He expressed displeasure that Title VII of the Dodd-Frank Act has created a “fragmented regulatory scheme” for derivatives, noting the lack of agency harmonization between the CFTC and SEC when issuing rules, and how such discrepancies make it difficult for market participants to comply. Huizenga then introduced the bills that would be discussed during the hearing.
Rep. Carolyn Maloney (D-N.Y.), Subcommittee Ranking Member
In her opening statement, Maloney asserted that derivatives “played a central part” inthe financial crisis. She continued that Dodd-Frank created a regulatory regime for derivatives that protect against futures crisises. Maloney acknowledged that end-users are exempt from many parts of Title VII, and that the House Financial Services Committee specifically tweaked the law to protect end-users through the Terrorism Risk Insurance Act. She then stated that any changes proposed by many of the bills under consideration would need to meet a high bar.
The Honorable Kenneth E. Bentsen, Jr., President & CEO, SIFMA
In his testimony, Bentsen explained that inter-affiliate swaps do not raise systemic risk concerns, as they do not create new exposure or increase the interconnectedness between third parties – rather they allow market participants to better manage risks. He further noted his support legislative efforts to fix problems with the treatment of inter-affiliate trasnactions as long as it is applied across all U.S. regulators. Bentsen then pivoted to agency harmonization, highlighting the importance of addressing conflicts between regulators and with other legal regimes and the need to remain consistent with international standards (such as margin and reporting requirements), as such efforts will help create a level playing field. He further noted that recognition that other regulatory regimes and requirements may achieve comparable outcomes would serve avoid any uncertainty or complexity associated for market participants in meeting requirements. Bentsen expressed support for the efforts of SEC and CFTC Chairmen Jay Clayton and Christopher Giancarlo in working on agency harmonization. Bentsen then noted SIFMA’s support for H.R. 4659, as it would deduct client initial margin from the ratio’s denominator, arguing that the current SLR does not recognize an offset for initial margin. Lastly, he commented that the when creating the de minimis threshold, the CFTC did not have necessary data at the time, so they were conservative in setting their thresholds, and that any changes to the current thresholds must be supported by sufficient data.
Thomas C. Deas, Chairman, National Association of Corporate Treasurers, on behalf of the Coalition for Derivatives End-Users
In his testimony, Deas noted his support for the transparency that Dodd-Frank created in the derivatives market, but explained that some of the provisions increase costs to end-users who are merely offsetting their business risk. He stated his support for the credit valuation adjustment (CVA) proposal, noting that the current framework places American companies at a competitive disadvantage. Deas then discussed the proposal regarding the definition of “financial entity”, stating that proposals that follow European and Asian thresholds should be supported. He next discussed the inter-affiliate and central treasury unit (CTU) proposals, stating that unintended economic burdens have a direct impact on money that could be used to build inventories, conduct research and development, and other beneficial uses.
Andy Green, Managing Director of Economic Policy, Center for American Progress
In his testimony, Green argued that the unregulated derivatives market was the central cause of the 2008 financial crisis, and that the current Title VII regime brings stability and transparency to the swaps market. He continued that any legislative proposal to undo portions of Title VII should overcome “heavy burden” to change what is in place. Green argued that the proposals being discussed today “go in the wrong direction,” and that “far more needs to be done” to study and identify challenges in the Title VII space, stating the need for additional institutional data. He concluded that reducing regulations will not help competition, and that the market is better when it is robustly regulated.
Scott O’Malia, Chief Executive Officer, ISDA
In his testimony, O’Malia explained there should not be a “rollback in progress,” but there are areas where regulations do not align, are redundant and unnecessarily increase costs. He noted that while it would be ideal for the CFTC and SEC to have identical regulations, it would be difficult to accomplish, and instead recommended a safe harbor approach where market participants in compliance with one set of regulations could be granted a safe harbor for the analogous rule sets of the other agency. O’Malia also noted the bipartisan support for the CFTC to exempt inter-affiliate swaps from certain regulatory requirements, but pointed out that the U.S. Prudential Regulators have not provided the same, which creates competitive disadvantage for firms conducting business in the U.S. He then pivoted to reducing operational complexity and costs, specifically through the treatment of margin in the SLR, adding that current policy disincentivizes clearing. Lastly, O’Malia stated that Congress can have an immediate impact on regulatory relief for market participants through the CVA, exemption for CTUs, and the de minimis threshold proposals.
Question & Answer
Huizenga began the questioning portion by asking how end-users differ from other participants in the over-the-counter swap markets, and whether they contributed to the financial crisis. Deas replied that with end-users, the exposure of day-to-day business risk and the derivative contracts are matched exactly. He continued that end-users only make up 10 percent of the derivatives markets and do not contribute to systemic risk.
Maloney discussed two of the end-user proposals, and asked Green if it is appropriate to treat commodity pools and private funds as end-users. “Absolutely not,” replied Green, adding that it is “quite inappropriate” to extend end-user treatment to them.
Huizenga asked for the panelists thoughts on the Administration’s FY19Budget that gives the CFTC authority to issue fees on derivatives. O’Malia replied that the idea has come up previously but always rejected due to the imposition of additional cost to risk management.
Maloney stressed that there should be a “high burden of proof” for there to be changes made to derivatives rules and asked if any of the proposals before the subcommittee today meet such a standard, to which Green replied, “[n]o.”
Credit Valuation Adjustment
Rep. Randy Hultgren (R-Ill.) asked if it is practical for CVA to apply to derivatives transactions for end-users transacting for hedging purposes, noting that the Basel framework excludes hedging from the calculation. O’Malia replied that capital rules were developed globally, for the purpose of having a consistent regulatory framework, adding the importance of aligning rules in a “comprehensive, consistent way.” He continued that he believes U.S. market participants, including end-users, are disadvantaged compared to non-U.S. competitors due to the unintended consequences of the current CVA treatment, adding that it increases costs to end-users.
Rep. Warren Davidson (R-Ohio) asked if the EU approach to CVA plays a role in fostering a competitive disadvantage for the U.S. Bentsen replied that there are underlying problems with Basel’s approach to the CVA in and of itself, and that the U.S., Canada and other jurisdictions have raised concerns. He continued that it is “not helpful” to have different versions of the CVA in the global marketplace and noted his hope that the issue is resolved and there is once more a uniform standard.
Hultgren noted CFTC Commissioner Brian Quintenz’s speech at a recent conference where he focused on updating the de minimis exemption for SDs and SBSDs. Bentsen replied that more data is needed before the CFTC de minimis threshold should amended, explaining that while larger banks are “well beyond the level,” smaller dealers may not be able to stay in business due to the added compliance costs associated with registration as an SD.
Cross Border Rules
Rep. Brad Sherman (D-Calif.) asked how the CFTC and SEC can achieve their regulatory objectives in areas where there are conflicts in international rules, such as data privacy. Bentsen replied that the CFTC and SEC are currently dealing with global problems such as data reporting, adding that while the CFTC is “trying to be more accommodative,” the SEC is “struggling,” and more work needs to be done. He continued that the problem will only become more complicated with Brexit.
Rep. Trey Hollingsworth (R-Ind.) asked about cross border rules in relation to privacy and blocking laws, and asked how U.S. regulators should work to ensure “harmony” between different jurisdictions. Bentsen stated that it is “hard to believe this can’t be worked out,” and explained that the U.S. open market system adds capital and liquidity to the markets. He noted that when there are foreign rules that conflict with domestic rules, it can preclude an entity from providing services in the U.S., which “doesn’t benefit us.” O’Malia replied that the CFTC and SEC are working on this issue, as the agencies do not want to put the U.S. at a disadvantage when it comes to attracting capital.
Rep. Ann Wagner (R-Mo.) noted the recent Treasury Report on Capital Markets that called on the CFTC and SEC to jointly eliminate redundant rulemakings, and asked for examples of how the differing approaches by the agencies has created inconsistencies. Bentsen replied that there are a lot of rules the SEC has not finished yet, and in some cases it seems that they are not moving in the same direction as the CFTC. He added that the CFTC and SEC Chairmen need to seek ways to harmonize. O’Malia added that there are operational challenges with dual regulations, and stressed the idea of a safe harbor approach where the agencies work together.
Wagner noted the U.S. and EU have reach regulatory equivalence determinations for rules, and asked if it makes sense for the CFTC and SEC to do the same with the U.S. framework, to which Bentsen replied “absolutely.”
Rep. Ted Budd (R-N.C.) noted the differing regulatory timelines between the CFTC and SEC create inconsistencies and redundancies, to which Bentsen stressed that harmonization “is a good thing” and expressed concern where inconsistencies arise. O’Malia explained that having differing rules with the CFTC and SEC makes swap dealer rules “that much more difficult,” and that a safe harbor approach would be beneficial. Bentsen agreed that the safe harbor approach is a good idea, and cautioned the agencies from mandating and “starting all over again.”
Rep. Stephen Lynch (D-Mass.) spoke about the proposal that would provide for certain exemptions from requirements for swaps between affiliates, stating that Federal Deposit Insurance Corporation (FDIC) Vice Chairman Thomas Hoenig has raised concern over such an idea. Green replied that it is an “extremely dangerous area” and that the proposal would undermine protections set in place to protect U.S. taxpayers. He continued that there is a “very real risk” of creating a loophole to allow foreign funnel trades which would provide an advantage over U.S. market participants.
Rep. Frank Lucas (R-Okla.) noted that he sponsored an amendment to the CFTC Reauthorization bill that would exempt inter-affiliate transactions from initial margin requirements, and asked Bentsen to explain why affiliates would want to enter into such transactions. Rep. Frank Lucas (R-Okla.) asked Bentsen to explain the purpose of inter-affiliate transactions. Bentsen replied that banks will do inter-affiliate swaps to better manage and mitigate risks. He continued that while other regulators do not require initial margin on inter-affiliate transactions, U.S. Prudential Regulators uniquely do, and that the current framework traps capital that could be allocated elsewhere.
Supplemental Leverage Ratio
Rep. David Scott (D-Ga.) stated that he is the Democratic leader on H.R. 4659, which would force banking regulators to recognize the exposure reducing nature of client margin for cleared derivatives, adding that if client margin is included in the SLR calculation, it puts clearing houses “at a very distinct disadvantage.” Bentsen replied that it is “counterintuitive” and one of many problems that need to be fixed with the calculation.
Rep. Blaine Luetkemeyer (R-Mo.) noted that the CFTC calculated that the offset for initial client margin is less than a one percent decrease in the overall capital reserve, and asked if the financial system could withstand the change, to which O’Malia replied “yes.” Green referenced comments by Hoenig that the simplicity of the SLR is “what gives it value.” Bentsen stated that such a change would drive more businesses into central clearing, adding that the idea has support from Giancarlo and former CFTC Chair Timothy Massad. Deas added that if initial margin is not calculated in determining capital, it seems “out of sync” with economic realities and “will get us off track.”
For more information on this hearing, please click here.