[Senate Hearing 112-163]
[From the U.S. Government Publishing Office]
S. Hrg. 112-163
DERIVATIVES CLEARINGHOUSES: OPPORTUNITIES AND CHALLENGES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING THE OPPORTUNITIES AND CHALLENGES OF DERIVATIVES
CLEARINGHOUSES
__________
MAY 25, 2011
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Levon Bagramian, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Director
(ii)
?
C O N T E N T S
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WEDNESDAY, MAY 25, 2011
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Toomey............................................... 2
Senator Crapo................................................ 3
WITNESSES
Christopher Edmonds, President, ICE Trust........................ 5
Prepared statement........................................... 37
Responses to written questions of:
Chairman Reed............................................ 61
Terrence A. Duffy, Executive Chairman, CME Group Inc............. 6
Prepared statement........................................... 39
Benn Steil, Senior Fellow and Director of International
Economics, Council on Foreign Relations........................ 19
Prepared statement........................................... 46
Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of
Finance, Tepper School of Business, Carnegie Mellon University. 21
Prepared statement........................................... 49
Clifford Lewis, Executive Vice President, State Street Global
Markets........................................................ 23
Prepared statement........................................... 52
Don Thompson, Managing Director and Associate General Counsel,
JPMorgan Chase & Co............................................ 24
Prepared statement........................................... 53
James Cawley, Cofounder, Swaps and Derivatives Market Association 25
Prepared statement........................................... 59
Responses to written questions of:
Chairman Reed............................................ 71
Additional Material Supplied for the Record
Letter submitted by Thomas C. Deas, Jr., Vice President and
Treasurer, FMC Corporation..................................... 113
(iii)
DERIVATIVES CLEARINGHOUSES: OPPORTUNITIES AND CHALLENGES
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WEDNESDAY, MAY 25, 2011
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:35 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order, and I want
to welcome everyone to the hearing this morning on
``Derivatives Clearinghouses: Opportunities and Challenges.''
The financial crisis revealed some significant weaknesses in
our financial sector, and one of the most problematic was the
over-the-counter derivatives market. Derivatives contracts
involve the transfer of risk from one party to another.
The total notational value of over-the-counter derivatives
outstanding at year end increased 645 percent from 1998 to
2008, a significant increase. Looking at it another way, back
in 1998 and 1999, derivatives were a relatively small part of
the market, but by 2008 they were a huge and continue to be a
huge part of the market.
According to the Bank of International Settlements, in
December 31, 2010, the total notional amount outstanding was
$601 trillion with a market value of $21 trillion, so there are
huge potential benefits or dangers to the financial system.
The sheer number and amount of over-the-counter derivatives
transactions which were not regulated by the SEC or CFTC proved
to be an accelerant during the financial crisis.
Uncollateralized losses built up. By September 2008, one of the
world's largest insurers, AIG, was on the verge of bankruptcy,
triggered by its tremendous investment in credit default swaps.
AIG had agreed to pay counterparties in its derivatives
transactions if certain credit events occurred. A series of
market events required AIG to post billions in collateral--
collateral it did not have. The imminent default of AIG would
have cascaded throughout the U.S. economy, encompassing private
companies, local and State governments, and retirement plans.
Accordingly, the Government provided hundreds of billions of
dollars in extraordinary relief to AIG, most of which was paid
to AIG counterparties. American taxpayers were exposed to
billions of dollars in potential losses.
As a result of that incident, and others, the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010
developed new rules for the over-the-counter derivatives market
to insulate both the U.S. economy and the American taxpayer
from any future extraordinary losses in this area. The new
rules of the road require the use of centralized derivatives
clearing organizations, or clearinghouses. Clearinghouses are
not a new invention. They have been a part of financial
transactions for a long time, dating back to European coffee
and grain exchanges of the late 19th century and in the United
States the 1883 creation of the Chicago Board of Trade and the
futures market. It later became the Board of Trade Clearing
Corporation and serves as the counterparty in all transactions
on the exchange.
Clearinghouses place themselves in the middle of
transactions, reducing counterparty risk by mutualizing
exposure. Clearinghouses transact business with clearinghouse
members, and customer losses are absorbed by these members.
Clearinghouses deal with risk by constantly evaluating and
requiring the posting of margin or collateral as insurance.
In the deficiency Wall Street Reform Act, the mandate to
creating clear standardized derivatives is the foundation upon
which a more transparent and competitive swaps market may begin
to flourish. Clearinghouses and swap execution facilities,
SEFs, should allow for better price discovery, more efficient
allocation of capital, and a healthier and more resilient
derivatives sector.
The purpose of this hearing is to examine both the
opportunities and challenges posed by a marketplace dependent
upon clearinghouses.
How do we ensure that the clearinghouses themselves do not
become significant risks to our economy? What issues affect
their safety and soundness? What are the best practices of
structuring, governing, and controlling derivatives
clearinghouses? How do we minimize conflicts of interest? What
barriers to clearinghouse membership or services exist?
All of us have a vested interest in making sure these new
derivatives clearinghouses function safely and fairly, and we
know from past experience that market players are concerned
principally with their own positions and do not always think of
the market as a whole when they recommend what the new rules of
the road should be. Hopefully our hearing this morning will be
focused and help everyone focus on the bigger issue: making
sure that these risks do not again overflow onto the American
taxpayer.
I look forward to hearing from all of our witnesses this
morning on these issues.
Before I introduce our first panel, I would like to
recognize Senator Toomey, if he has any comments, and then our
other colleagues.
STATEMENT OF SENATOR PATRICK J. TOOMEY
Senator Toomey. Thank you very much, Mr. Chairman, and
thank you for deciding to do this hearing. I think this is a
very important topic. I want to thank the witnesses for being
here. I will just make a brief observation.
I might be the only former derivatives trader on this
panel--on this side, anyway--and as such, I just want to
observe that with the obvious and very significant exception of
AIG, I think the reality of the derivatives market during the
financial crisis was that both the OTC derivatives market and
the exchange-traded derivatives actually for the most part
functioned extremely well. They both have played an enormously
important role in allowing financial and nonfinancial
institutions to manage risk, and as such, the evolution of
derivatives since I was involved in this industry back in the
1980s to more recent days has been enormously constructive for
our economy, for the allocation of capital, and for the
management of risk.
We have now decided, for better or for worse, that all
over-the-counter derivatives--or I should say most over-the-
counter derivatives are going to be cleared and executed
through exchanges going forward. And I just think it is very,
very important that we do this in a very cautious fashion, that
we have--this is a very complex process. It has enormous
implications, and I just hope that we will do this in a very
thoughtful, careful, and I would say, in terms of the
implementation of these regulations, Mr. Chairman, I think it
is very important that we do this sequentially rather than
trying to do this all at once because the sheer volume of
regulations is staggering. And in addition to doing it
sequentially, I think it is important that we do it over a
period of time that is long enough for us to work out the kinks
and to allow the market participants to adjust to this very,
very new regulatory environment.
I am confident we can do that. I think it is necessary that
we take that approach so that the tremendous benefits to the
economy from these tools do not get eroded.
Thank you very much, Mr. Chairman.
Chairman Reed. Thanks, Senator Toomey.
Before I recognize Senator Moran, the Ranking Member has
arrived, and I would like to recognize Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Well, thank you, Senator Reed. I apologize.
I got hung up, and I appreciate you going ahead and not
waiting. I apologize for any inconvenience.
Federal Reserve Chairman Ben Bernanke's speech in April
provides a good perspective, I think, on both the opportunities
and the challenges of clearing. He said, `` . . . by
centralizing and standardizing specific classes of financial
transactions, clearinghouses reduce the costs and operational
risks of clearing and settlement among multiple market
participants . . . . However, the flip side of the
centralization of clearing and settlement activities in
clearinghouses is the concentration of substantial financial
and operational risk in a small number of organizations, a
development with potentially important systemic implications.''
In formulating clearinghouse regulations and conducting
oversight, regulators need to fully understand the complexity,
the interconnectedness, and the potential for systemic risk for
clearinghouses. The decisions that regulators and
clearinghouses make regarding risk management will have
significant implications for the soundness of our financial
system.
It is important that the regulators and the market
participants look carefully at both the individual proposed
rules and how the overall interaction of all the proposed
regulations designed by the different regulators either fit
together or cause unintended consequences. This is not a simple
task, and I would encourage the regulators to take the
necessary time to get the rules right by incorporating the
meaningful public comments and economic analysis in their
proposed rules.
I remain concerned that the mandatory clearing requirement
could force clearinghouses to take on risk that is not
adequately understood or managed. Some of the international
regulators have indicated a preference that derivatives
denominated in their respective countries or traded by entities
subject to their authority be cleared via clearinghouses in
their respective jurisdictions.
What kind of systemic risks and regulatory challenges does
this create? American manufacturing companies, energy
producers, and farming groups, otherwise known as end users,
have testified before Congress that if they were required to
clear their over-the-counter risk management transactions, they
would lose the benefits of customization, and the cost to them
of cash collateralization would be much more significant and in
some cases insurmountable.
At this point the regulators continue to send mixed signals
on how end users will be treated. Our witnesses today will
provide a broad spectrum of views on these and other issues,
and I appreciate their time and thoughtfulness in answering
these questions. And, again, Mr. Chairman, I appreciate your
holding this hearing today.
Chairman Reed. Thank you very much, Senator Crapo.
Senator Moran.
Senator Moran. Chairman Reed, thank you very much. I have
no opening statement. I am interested in hearing what our
witnesses have to say. I have a 10 o'clock Financial Services
and General Government Subcommittee on a similar topic, and I
will be departing shortly.
Chairman Reed. Thank you very much, Senator.
I think just to reinforce what both Senator Crapo and
Senator Toomey said, this is an opportunity and a challenge in
terms of getting this right. I think we want to have it done
right. That is why we are having this hearing and will have
other hearings because we have to listen to industry experts
and experts from academia and from other areas. And I suspect
after this hearing we will have more questions, and we will
have other hearings, but I think we have to get it right. I
concur.
Let me just say that all the testimony of the witnesses
will be made, without objection, part of the record, so there
is no need to read every word. If you would like to summarize
or abridge in any way, please feel free to do that. Your
testimony will be part of the record. Let me introduce the
first panel.
Chris Edmonds is president of the ICE Trust, the wholly
owned credit default swap clearinghouse of international
exchange. Mr. Edmonds was named to his post in February 2010.
As president of ICE Trust, Mr. Edmonds oversees ICE's U.S.
credit derivatives clearing operations. Prior to joining ICE,
Mr. Edmonds was chief executive officer of the International
Derivatives Exchange Group, LLC, a clearinghouse for interest
rate swaps.
Terrence Duffy has served as the executive chairman of CME
Group since 2006 when he first became an officer of CME.
Previous to his current position, he served as chairman of the
CME Board from 2002 to 2006 and as vice chairman from 1998 to
2002. He also has been president of TDA Trading Incorporated
since 1981.
Mr. Edmonds, you may begin.
STATEMENT OF CHRISTOPHER EDMONDS, PRESIDENT, ICE TRUST
Mr. Edmonds. Chairman Reed, Ranking Member Crapo, I am
Chris Edmonds, president of ICE Trust, a limited purpose New
York bank operating as a clearinghouse for credit default
swaps. I very much appreciate the opportunity to appear before
you today to testify on clearing over-the-counter derivatives.
As background, ICE Trust serves as the leading U.S.
clearinghouse for credit default swaps, having cleared
approximately $11 trillion in gross notional value since March
9, 2009. Globally, ICE Trust and our European counterpart have
cleared more than $18 trillion in CDS since the financial
crisis.
ICE's experience in energy and credit derivatives
demonstrates that when clearing is offered to a market, the
market overwhelmingly chooses to clear its products. Over the
next few months, the mandatory clearing and trading provisions
of Dodd-Frank should take effect, and market participants will
be forced to clear over-the-counter derivatives as a matter of
law.
While ICE supports the clearing principles of Dodd-Frank,
we respectfully submit that the regulators responsible for
determining which contracts must be cleared should consider any
mandate carefully. ICE believes the best path to meet this goal
is to allow clearinghouses and market participants to find the
best way to clear markets within defined principles, as opposed
to promulgating prescriptive rules. In addition, regulators
should make certain unnecessary regulatory hurdles and other
impediments are removed.
For example, one key regulatory hurdle to clearing is
cooperation between regulators. Many over-the-counter
derivatives, especially credit default swaps, have
characteristics of securities and commodities. Close regulatory
cooperation between the CFTC and the SEC is necessary, and
required by law, in order to make sure that market participants
have legal certainty, including bankruptcy certainty. This is
particularly important in regards to portfolio margining
allowing security-based and commodity-based derivatives to be
held in the same account and margined in a holistic manner and
subject to a single bankruptcy regime. Historically, the CFTC
and SEC have had little success creating portfolio margining.
Without portfolio margining relief for CDS specifically, the
unintended regulatory divide will create significant and
noticeable setbacks for the implementation of Dodd-Frank.
Appropriate regulation of clearinghouses is of utmost
importance to the financial system. Pursuant to Dodd-Frank,
clearinghouses will be a key part of the efforts to decrease
systemic risk in the derivatives markets. In overseeing
clearinghouses, regulators must be prudential, understanding
their markets, and tailoring regulation to ensure market
integrity and consumer protection.
It is also vital to recognize that the over-the-counter
derivatives markets are global. The U.S. regulators must work
within international regulators from a common set of regulatory
principles. Dodd-Frank has created significant uncertainty over
whether a transaction will be subject to U.S. regulation or
foreign regulation. This lack of clarity may begin to have an
impact on markets, reducing liquidity and hampering regulatory
reform efforts because market participants are unsure which
laws apply. Therefore, harmonizing regulatory systems across
geographies and giving market participants clarity is of utmost
importance.
Earlier this month, the CFTC and SEC held a roundtable to
hear views on the implementation of Dodd-Frank. As the CFTC and
SEC have come to realize, the legislation cannot take effect
all at once.
ICE believes that regulators should pursue an aggressive
timetable to implement most sections of Dodd-Frank as soon as
possible. While Dodd-Frank requires an enormous effort from
both market participants and regulators, the cost of
uncertainty is much greater. ICE has suggested to regulators
that they pursue a phased implementation plan. This approach
has broad-based support from market participants and should
motivate quicker adoption by the industry.
Flexibility is central to meeting the implementation goals.
Regulators have an immense burden to implement Dodd-Frank, but
creating a one-size-fits-all prescriptive system of regulations
will only increase the burden as regulators will be required to
constantly consider exemptions for markets that do not quite
fit the proposed model.
Likewise, market participants will have an easier time
meeting implementation goals if they have the freedom to meet
the goals of Dodd-Frank without radically modifying their
operations to meet prescriptive rules.
Mr. Chairman, thank you again for the opportunity to share
our views with you. I would be happy to answer any questions
you or this Committee may have.
Chairman Reed. Thank you.
Mr. Duffy.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP
INC.
Mr. Duffy. Chairman Reed, Ranking Member Crapo, Members of
the Subcommittee, I am Terry Duffy, executive chairman of CME
Group, which includes our clearinghouse and four exchanges: the
CME, the CBOT, NYMEX, and COMEX.
The clearing mandate for OTC swaps should be staged in
measured steps. The Committee asked five important questions
that deserve direct answers.
First, the safety and soundness of clearinghouses is a
major focus of Dodd-Frank. The core principles compel
clearinghouses to have adequate financial resources,
comprehensive risk management procedures, and safeguards
against system failures. In addition, Dodd-Frank includes eight
core principles dealing with the safety and soundness of
clearinghouses. The CFTC is authorized to bring a clearinghouse
into compliance. However, the CFTC's proposed new rules are so
rigid that many impair the flexibility necessary to preserve
the safety and soundness of clearinghouses. Indeed, the CFTC's
proposed rules governing systemically important clearinghouses
increase this systemic risk.
Regarding the second question, swaps clearing and futures
clearing are variations on the same theme. If a swaps contract
and a futures contract have similar volatility and trade in a
mature liquid market, the considerations for clearing the
contracts are identical. This should be the case for major
plain-vanilla swaps. Thinly traded swaps present more difficult
problems. Our clearinghouse aims to overcome these problems
through its admission and risk management processes.
The third question in regards to unique attributes of
certain asset classes that should be highlighted, the key to
safety and soundness is risk management based on volatility,
liquidity, and other characteristics of the market for a swap
in a normal and stressed circumstance. Futures on U.S. debt and
eurodollars are easy to liquidate in the event of a default.
The same should hold true for interest rate swaps based on
U.S., UK, and European Union instruments.
As we look at the fourth question, the CFTC should hold off
implementing the proposed rules respecting ownership,
governance, and control of clearinghouses. They can and should
wait until there is evidence that specific limitations in Dodd-
Frank do not adequately control the potential problem.
The core principles for clearinghouses provide ample
protections against potential conflicts of interest. They are
clear, comprehensive, and easily enforced by the Commission as
needed. Section 5(b) of the Commodity Exchange Act specifically
ensures fairness respecting participant and product
eligibility, appropriate governance and fitness standards,
prevention of conflicts of interest, and appropriate
composition of governing boards. Dodd-Frank's core principles,
coupled with CFTC's enhanced enforcement powers, are sufficient
to guard against conflicts of interest.
The fifth question, end users of swaps with sufficient
credit and resources to enter into a swap will experience no
barrier to clearing under Dodd-Frank. A firm that seeks to act
as a clearing member of a swaps clearinghouse must meet the
operational and financial requirements of that clearinghouse.
These requirements should be set sufficiently high to meet the
clearinghouse's obligations under Dodd-Frank's core principles
for DCOs.
Dodd-Frank's requirements regarding safety and soundness
modify a clearinghouse's obligation to grant open access to any
potential clearing member. The issues of managing a default
involving immature or illiquid swaps contracts require higher
admission standards than those for a futures clearinghouse.
I appreciate the time this morning. I look forward to
answering your questions.
Chairman Reed. Thank you very much, gentlemen, for both of
your excellent testimonies.
We are all concerned about safety and soundness. I think
that is a point of departure. We do not want to create a
structure in response to a financial crisis that could
precipitate another financial crisis if it is not handled well,
so that is the starting point.
But there are some other aspects, too, in terms of the
overall scheme of Dodd-Frank. The notion was to pull as many
possible derivatives onto, first, a clearing platform, and then
within the authority of Dodd-Frank, the regulators could direct
that the standardized products--some could be specifically or
should be traded. So there is that progression to a trading
platform.
But both of you have alluded to the issue of potential
conflicts of interest in bringing particular products on to the
clearing platform. Right now over-the-counter derivatives are a
very lucrative business, specialized derivatives, and there
have been at least questions raised about whether there are
proper incentives, proper rules so that the maximum number of
derivatives products will be cleared; i.e., people making the
decisions have an incentive perhaps to keep things off because
there is a more lucrative product over the counter rather than
a clearing platform and a trading platform.
Both gentlemen, Mr. Edmonds and Mr. Duffy, can you address
this issue of how do you ensure that there is the fullest
possible universe of products being cleared?
Mr. Edmonds. Mr. Chairman, I believe the way to answer that
question is these are points-in-time conversations. The
standardization of the credit default swap market, for example,
has been an evolution going on for, you know, we will call it
10 years or so to get to the standardization product set that
you put in there, investment grade pieces of an index, the
investment grade single names, and then there is a whole list
of other names that we may want to clear in the future that at
the end of the day do not lend themselves to clearing based on
the current tool sets that are available to clearinghouses.
If you ask me the question of where we are going to start,
we have done a lot to get started in that direction. Where we
go is all about innovation and competition between, you know,
the different service providers that act in those markets. I am
certain that, you know, every day those that Mr. Duffy and I
compete with are looking for new ways to bring something else
to the clearing which will require us to respond, and the same
thing happens to Mr. Duffy on other products that they have a
dominant market share in at this point in time.
So for us, this is about what do we need to get the most
systemic risk out of the gate to begin with. If you look at the
creation of ICE Trust back in the fall of 2008 and in the first
quarter of 2009, the products that represented the most
liquidity, the most systemic risk, we were trying to put in the
clearinghouse impacting the most active market participants at
that point in time. Things will evolve, and we will manage that
evolution through commercial reasons because it is good for our
shareholders and good for our business.
Chairman Reed. Well, one of the aspects particular with ICE
is that the owners--that might not be the most precise term--
are also the broker-dealer banks generally, and they have, I
would think, conflicting incentives. One is to get
standardization products onto your platform, but also to keep
lucrative over-the-counter products in their own trading, which
does not have to be cleared. And that is a tension that would
not exist if your organization was composed not of the broker-
dealer banks but of other financial entities if it was a truly
independent entity.
Does that sort of compound or complicate your specific
dilemma?
Mr. Edmonds. Well, I want to take issue with who the owners
are, and we are a wholly owned subsidiary of a publicly traded
company, so there are all sorts of rules and regulations
around, you know, who owns what. I mean, certainly we have a
partnership with our membership, not dissimilar to any other
clearinghouse that operates in the United States or, for that
matter, around the globe. There are only 120-plus or so
entities registered with the CFTC that can be a clearing
member. We started with nine. We are up to 15. We continue to
grow that, and make no mistake, we want as many of those
clearing members as we possibly can.
That does not mean all of those clearing members actually
use the product that we offer. Some will over time. Some will
make the decision to make the investment to enter these markets
as time progresses. Some have not made that decision today.
Others are being opportunistic, seeing that the opportunity
represented by the changes with regard to Dodd-Frank are the
time for them to make that investment and come that direction.
You know, we are completely open access. Our rule book has
said we are open access from day one. You provide us with two
matched trades an accountants gets, we clear and reduce the
systemic risk associated with that.
So, you know, I appreciate the point. I think you will have
an opportunity on the second panel to ask folks what motivates
them of what they want to keep cleared versus noncleared. From
the commercial aspects of ICE Trust, we absolutely are
incentivized to clear as much as we possibly can, both in
product and the number of times that product is cleared.
Chairman Reed. Mr. Duffy.
Mr. Duffy. Well, there are a couple questions I would like
to answer for you, sir, on what should be cleared and what
should not be cleared. The plain-vanilla swaps that are being
traded today over the counter are obviously prepared to be
cleared, so my colleague over here has already demonstrated
some of the numbers that they have done in the credit market.
The interest rate market is obviously much easier to even
clear. So some of those plain-vanilla swaps are prepared to be
cleared.
Some of the illiquid products or the products that Senator
Crapo had mentioned that are really some of the issues that we
have, and I'm sure ICE also. If we today are going to collect 5
days' margin for some of these products that we are going to
have in our clearinghouse, that might not even be the tip of
the iceberg for some of these illiquid products. So you just
cannot bring them into clearing to blow up the whole system.
So we do a very rigorous risk management system, so we
think that bringing the plain-vanilla swaps in first--and as it
relates to what some have alleged is a cartel or whatever you
want to call the banks in these clearinghouses, I think you are
not giving the customer enough sophistication here. When these
products become more vanilla-like, they want more transparency
associated with them. They will demand that that happen with
that product. It is really the illiquid products that are not
conducive for clearing today. So I do not think anybody is
trying to hold them out from clearing. I think if the customer,
when they trade them, they know what is being traded. The more
that is being traded, they want to make certain that they are
getting the best possible price also. And the only way they can
do that is to seed the market.
So I do think there is an incentive for the clearinghouses
and the owners of those clearinghouses to bring them in as they
see fit.
Chairman Reed. Just one other point. Sometimes the
complexity of these products is such that the customer, even
sophisticated customers, are not quite sure what their best
choice is, and many times the information or the structuring is
being done not by the customer but by the broker-dealer or the
financial institution.
Again, I guess the heart of this question is, Is there real
sort of pressure by the market and by you to demand more
simplified products that can, in fact, be usually identified by
customers and preferred by customers? Is that----
Mr. Edmonds. The simple answer to that is yes. The more
standard we can make the products, the easier it is for those
products to move into the systems. I mean, there are other
service providers that link up to our clearinghouse, both for
Mr. Duffy and myself, that they have a responsibility to take
this information to perform analytics on this information and
to take it downstream to the other user base, the folks you are
talking about that need access to this.
The more simplified we can make those standards, the easier
it is for them to more quickly adopt those types of instruments
and put them into the supported category. When they are in the
supported category, we have the opportunity to realize our
commercial interest and generate more revenue from that. So
certainly the interests are aligned from that perspective.
Chairman Reed. Thank you very much. Thank you.
Senator Crapo, please.
Senator Crapo. Thank you, Mr. Chairman, and Mr. Edmonds and
Mr. Duffy, I appreciate you being here.
I want to focus my questions on the end user issue.
Frankly, as I try to navigate what the regulators are saying
with regard to end users, I am not sure that I understand
exactly what the proposal on the table is as to how we will
treat end users. So my first question to you is, how do you
understand the treatment of end users under what we see now
from the various proposed rules?
Mr. Duffy. My understanding, Senator, is that any
nonfinancial party would be considered an end user and thus
exempt from the clearing mandate. So, example, IBM, a company
like that, would be exempt from the clearing mandate. If they
make the trade, obviously, with a dealer, both parties are
exempt because you cannot put one side of the trade into the
clearinghouse and leave the other side out, so it would leave
an unbalanced book. My understanding is anybody that is
nonfinancial is exempt in the end user category.
Senator Crapo. Mr. Edmonds, is that your understanding, as
well?
Mr. Edmonds. That would be my understanding. I would add to
that, there are some requirements in there for those types of
transactions Mr. Duffy----
Senator Crapo. Like the margin requirements?
Mr. Edmonds. You would have margin requirements between the
broker-dealer and the end user. So the cost to the end user
still has an upward trend under that model.
Senator Crapo. And with regard to the margin requirements,
is it clear to you what that is among the various regulators in
the proposals we have out today? In other words----
Mr. Edmonds. I do not think we have enough clarify of what
direction they are headed. I mean, there have been some
conversations at this point in time as it relates to, you know,
it cannot be any less than what a similar product on the
clearinghouse or some benchmark that the regulators could look
to to begin establishing those, but I do not think that we have
gotten to a point where it is final enough for people to do the
cost-benefit analysis yet.
Senator Crapo. So if I were to look at two of the important
issues related to end users, one, their ability to have a
customized product, and two, the impact of margin requirements,
would you say that you feel that there is adequate protection
for those who need a customized product, that they would not be
subject to the requirement?
Mr. Duffy. That would be my understanding of the way the
law reads, sir.
Senator Crapo. So, then, the real question would be, what
is the impact of the margin requirements, whatever they may be,
on this portion of our market. Is that a fair question?
Mr. Edmonds. I do not see any way that it cannot increase
the cost of trade.
Mr. Duffy. Well, I would also suggest that even though they
would be exempt from the margin requirements under the end user
exemption, there are still capital requirements they have to
face with the broker-dealer that could be simply called
something else, such as margin. So it may be that they are
pledging their cornfields instead of capital or cash for
margin, but they are still putting up something on behalf of
those transactions.
Senator Crapo. And you would agree, also, Mr. Duffy,
though, that it will undoubtedly drive up the cost of these
transactions?
Mr. Duffy. I do not know if margin will drive up the cost
of these transactions, only because I have looked at the growth
in the futures business that has had margin with it
historically and we have been able to grow at 20-some-odd
percent year over year for the last 40 years, 35 years now, and
people have participated in the marketplace, been able to do
risk management just fine with the margin requirements that we
have in place today.
Senator Crapo. Mr. Edmonds, would you----
Mr. Edmonds. I would agree with Mr. Duffy on the growth of
the futures market. The difference here is, these same types of
customized transactions are happening today and this margin is
not being collected. So at least there is a time value of money
associated with the collateral they are going to have to post
in some form or fashion, or the lien they are going to put on
the cornfield or whatever that is going to put in there. There
is an intrinsic cost, whether it is the drafting of a legal
agreement, the execution of that legal agreement, you know, the
lien and things that you need in order do that. So while they
may not be a direct cost as the picture that Mr. Duffy wants to
paint, there is going to be some intrinsic cost associated with
just managing the additional requirements that are forthcoming.
Senator Crapo. It seems to me that that is going to be a
significant impact on capital formation in these companies,
that at least a lot of them are claiming this to be the case.
Do you believe that this increased cost that you see, Mr.
Edmonds, would increase safety or soundness of the transactions
over the current status quo?
Mr. Edmonds. Just to clarify the question, for the end user
or for the market as a whole?
Senator Crapo. I would say for the market as a whole.
Mr. Edmonds. Certainly, more collateralized positions have
a safety benefit and a soundness benefit associated with that.
I mean, if you take the earlier comments by the Chairman as it
related to AIG and the developments we experienced there, that
was a market that was under-collateralized, or not
collateralized at all in some cases, and they were very
customized products, that at some point in time had collateral
been associated with those positions and there had been an
adequate mark-to-market based of those positions based on the
collateral on hand, we would have seen the difficulties being
perpetrated by those positions sooner.
Senator Crapo. I understand that. I guess the way I am
looking at this, though, I can understand that if you were to
require 100 percent collateral for every transaction, you would
certainly increase safety and soundness of the overall market
for those transactions. You might not be increasing it in
incrementally justifiable levels by doing so. And those in the
end user community often disagree with being lumped in with the
AIG situation, claiming that their industries and their markets
had nothing to do with the crisis we faced and that the safety
and soundness issues that we are seeking to solve there simply
do not exist, or to any significant level, in their markets.
How would you address that?
Mr. Duffy. Well, I would agree with that, and I think that
the end users have put on a very good case why they should have
exemptions to the Dodd-Frank Act, and I think, obviously, they
are getting them. Our position at CME has been from the
beginning, for the last several years, we never believed that
there should be a mandatory clearing component to Dodd-Frank.
We thought there should be capital incentives for clearing and
then a different capital charge for noncleared products. So we
never supported it. But the law is what the law is today and we
are dealing with it.
So I think that the end users being carved out the way they
are, they have done a good job putting their case forward and
they deserve the exemption. They did not cause it, I agree with
that, nor did the futures industry cause this problem. We had a
housing bubble and under-capitalized credit default swaps.
Senator Crapo. Thank you. Mr. Edmonds, do you want to say
anything before----
Mr. Edmonds. The only thing I would say to that is to do
the cost-benefit analysis, Senator, you are looking for, I
think the rules around margin need to come out.
Senator Crapo. Thank you. I appreciate that observation.
Chairman Reed. Senator Merkley.
Senator Merkley. Thank you, Mr. Chair, and thank you all
for your testimony.
Mr. Duffy, in your testimony, you noted that the futures
market performed flawlessly during the financial crisis, and I
was wondering if you could take and expand on what went right
and what insights that might give us in seeking to regulate the
rest of the derivatives markets.
Mr. Duffy. And again, the futures market is different from
the OTC market. The plain vanilla swaps are closer to the
futures market. Some of the products that got us in trouble are
these illiquid products that even a clearinghouse today would
not be able to risk manage during the crisis.
So we were able to function flawlessly during the crisis
because of a couple things that we have deployed for over 100
years, and that is to do risk management on a real-time basis.
So we make certain that the people who are losing money put up
the money. The people who are ahead in the market receive that
money. So we would go back and forth all day long at a zero sum
outcome, and I think that is very important when you have this
type of notional values going back and forth in both futures
markets and over-the-counter markets. So that is why we
operated flawlessly, because the risk management discipline
that we have put into our company over the last 100-plus years.
Again, I do not know if that would have stopped the crisis,
sir, of 2008, because the problem, as I said earlier, was not
futures markets. It was not plain vanilla swaps. It was
illiquid swaps. It was illiquid credit default swaps. It was
under-collateralized swaps in a bubble in some other markets.
Senator Merkley. My colleague was asking about kind of the
impacts on capital formation and putting up margins. I was
reading in this article, the CEO of Robinson Oil who noted that
when he uses derivatives like swaps and options to create fixed
plans, he just has no idea how much lower his prices possibly
should be because the fees are not disclosed, there is not a
clearing function. And he says, quote, ``At the end of the day,
I do not know if I got a fair price or really what they are
charging me.'' How does one tradeoff kind of understanding
essentially the efficiencies of an open competitive market in
providing derivatives risk management, if you will, at a lower
price, versus the issues of capital formation margins that was
being raised by my colleague?
Mr. Duffy. I think the gentleman that asked the question
has a very good question because it is very hard to distinguish
what the costs are when you are doing an over-the-counter
transaction such as that. On a regulated futures exchange, it
is completely transparent. All the fees and everything are seen
up front so you know exactly what you are doing ahead of time.
So in our world, sir, he would not have that same question.
And I cannot answer the question in the over-the-counter only
because there has been a lack of transparency in these markets.
Senator Merkley. OK, great. Anything you would like to add,
Mr. Edmonds? OK.
Chairman Reed. Senator Toomey.
Senator Toomey. Thank you very much, Mr. Chairman.
A couple of things I just wanted to follow up on from the
previous questions. One, would it be fair to say that--and Mr.
Duffy in particular, I think you alluded to this--that there
are some kinds of transactions that probably just never belong
on a clearinghouse, right? If they are not uniform, if there is
not sufficient liquidity, then it is just not a good fit. Is
that a fair statement?
Mr. Duffy. That is exactly fair, sir.
Senator Toomey. Yes. So it seems to me that we will always
have a category of over-the-counter derivatives and it would be
up to end users to decide whether the customization that they
get in return for something over the counter outweighs the fact
that there is not as much transparency, and that is a decision
that individuals will make.
Mr. Duffy. We agree.
Senator Toomey. OK. The other point I wanted to make,
follow up on my colleague, Senator Crapo's point, is I do think
it is--and I know this does not directly affect you gentlemen.
My understanding, though, is that the promulgation of the
regulations does create the possibility that end users will
have margin requirements in some cases, but not necessarily be
required to use clearinghouse, but have margin requirements,
and I do think that is a potentially big problem.
As to whether or not an end user should have a margin
requirement, I think that is a credit decision that should be
made by the counterparty. The counterparties are capable of
making that decision, and the cost to an end user that is not--
especially a nonfinancial that does not have ready access to
the kind of cash that is necessary for a margin call, could
actually make the hedging exercise prohibitively impractical.
And so I am very concerned. In fact, Senator Johanns and I have
introduced legislation that would deal with this which would
really specify and make it clear that this requirement would
not apply to end users. But I digress.
To get to the point that I wanted to ask of you, Davis Polk
has put together a memo that suggests that there are 175 new
derivatives provisions coming out of Dodd-Frank. I do not think
that is comprehensive yet. I think that is what we have so far.
And it just seems to me that it is really, really important
that we sequence the implementation in a thoughtful way and
over a long enough period of time that this is manageable,
because it strikes me that it could be very problematic if we
tried to do this too suddenly.
Now, you have both indicated importance of sequencing and I
know you have given a lot of thought to that, but could you
just underscore, how important is it that the sequencing be
right, and specifically, could there be some market disruptions
if the sequencing is not done appropriately?
Mr. Edmonds. I do believe there will be market disruptions
if it is not done appropriately. Certainly, doing it all at
once, the problems with going all at once is you are going to
have everyone scrambling with a finite bandwidth, both from
service providers and both their own internal allocation of
resources. We talk about the cost it would take for folks to
respond to that. It would be insurmountable at that point in
time. So what you will see is you will see liquidity, I think,
move away at that point in time. That is a real risk.
The purpose of Dodd-Frank was to remove systemic risk. We
have got to get to a point that we understand what products
have the systemic--represent the systemic risk, how they can be
cleared, how they can be standardized or not standardized, and
if they are not standardized, what are the capital charges
associated with that. And then once you get those things
figured out, then you have got some opportunity for people to
see that in a transparent manner, whether it is standard or
nonstandard. That means more products being traded in a listed
environment, other products not being traded but being reported
to the STR function that was in Dodd-Frank, and things of that
nature.
Then you get to a point where execution becomes a lot
easier to implement over time, because people know what the
product is. They know what the product specification requires
them to do as a buyer or seller. They know how it is going to
be margined. They can properly do capital planning around that.
Mr. Duffy. I agree with what Mr. Edmonds said, sir. I think
if we do not implement sequencing properly, such as putting
plain vanilla swaps out first and making certain that it is not
only dealer-to-dealer, but dealer-to-client at the same exact
time so there is no disadvantage to the client to get forced
into going where the dealer wants him to go, I think that is
important.
But also, there are some provisions that the CFTC, that
they are trying to put forward, such as systemically important
DCOs which would require a firm like ours, if we were in that
category, to put up two of our largest clients' defaults. So
what would it do? It would introduce a participant to go to a
less capitalized clearinghouse that would not have the onerous
of CME because we are a systemically important organization.
That is in there.
There is also risk that if we have the $50 million, which
Chairman Gensler would like to have, put forward to allow
people to participate in the clearing of swaps and we had that
implemented and we were to have a default and these people were
not able to participate in the default, this is another issue
that could introduce more systemic risk to the system.
So there are a couple flaws. We are trying to get away from
systemic risk. We are concerned that if we push this without
doing the proper sequencing, we will introduce more systemic
risk.
Senator Toomey. Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Toomey.
Senator Kirk.
Senator Kirk. Thank you. I am obviously representing the
Chicagoland area, where these markets, and be able to set up a
database and exchange where buyers', sellers' prices are
disclosed in real time is critical to real-time risk
management.
I wonder, Mr. Duffy, if you could specifically describe
your foreign competition. If we have a danger of over-
regulating, customers will simply manage their risk in markets
overseas. Who is on your heels and who is hoping that the
Congress gets this wrong so that you are too heavily encumbered
to serve customers and then would pick up the business
overseas?
Mr. Duffy. Well, I think there are a couple that would like
to see that. Maybe one sitting to my right would like to see
that with his London operation. There are obviously
participants throughout Europe that compete with the CME Group,
that compete with Intercontinental Exchange, also. They have
not gone forward with any regulation whatsoever. We have passed
Dodd-Frank in this country. I believe that we have to be very
careful. I like being a leader, but at the same time, let us do
it in a judicious fashion. Let us just not overreact, try to
implement the whole Act in 2 days.
I am very concerned about the regulatory arbitrage,
Senator, that could occur, and the business getting taken off
of the U.S. markets, putting onto foreign jurisdictions. These
banks have books all over the world. They do not need to be in
the U.S. So if they are a non-U.S. bank, they can be in Europe
participating in these markets without being subjected to the
laws of Dodd-Frank. Not only do they put CME at a disadvantage,
they are going to put U.S. banks at a disadvantage.
Senator Kirk. Right. And then correct me if I am wrong, but
my impression of European and Chinese interests are that their
feeling about Dodd-Frank-related regulation is we are
completely for it, but ``apres vous, Gaston.'' You guys go
ahead and kill your markets first. Oh, by the way, we are right
behind you. We are going to kill our markets as fast as you
kill yours----
Mr. Duffy. I think----
Senator Kirk. ----fully knowing that they are not going to
do that, and then they will pick up this business and the
employment will transfer outside the United States.
Mr. Duffy. I absolutely think that is the most realistic
fear that we have, and I think if people do not recognize it,
they are just in denial. These markets have grown. They have
matured throughout Asia. They have grown and matured throughout
Europe. They are looking for us to make this gigantic mistake.
That is why it is critically important that we implement this
law in the way that makes sense.
Senator Kirk. So can you describe--characterize the
implementation of Dodd-Frank-related activities affecting
similar markets in Europe.
Mr. Duffy. Do you want to address that or do you want me
to?
Mr. Edmonds. You can start.
Mr. Duffy. OK. So the question would be, how does Dodd-
Frank affect----
Senator Kirk. No. Tell me the progress of them putting
similar regulations----
Mr. Duffy. There is no progress there. There is no progress
in Europe. The G20 has made some noise that they are going to
come up with a proposal sometime this summer. I have seen
nothing coming out of the European Commission or regulators
that they are going to support any particular new laws. One of
the things they did say as it relates to position limits that
obviously affects both of us, that they have recognized if, in
fact, they see a problem in a market, they have the right to
step in. That is about all I have seen coming out of Europe,
and as far as Asia goes, I have seen absolutely zero----
Senator Kirk. And have any of them been open about saying,
we are hoping the Americans cripple their markets?
Mr. Duffy. I do not know if they have been open about it,
but I am pretty certain a lot of the participants in London and
other places of the world are very much hoping that happens.
Mr. Edmonds. Senator, they hold a free option right now. I
mean, we are sprinting down to this implementation, trying to
get as much done as possible, trying to get the market to
behave. They get a full menu. They are going to have the chance
to pick what they like and what they do not like. There is no
obligation for them to implement that.
Mr. Duffy. Right.
Mr. Edmonds. But they have already said that their time
line is much further than ours. They have already said that
this is a 2012 and after type of event. I mean, if you look at
the G20 comments that Mr. Duffy made reference to, this is not
something they are trying to get done yet this calendar year.
This is something they are going to start talking about in
earnest next year, and that was to give us complete time to
create the menu for them to choose from.
Senator Kirk. So would you rather be them or us right now
if you were trying to build a business and add clients?
Mr. Edmonds. I believe that the, from my personal--my
personal belief is that we ought to let the commercial
competition that takes place with very established businesses
with very clean track records take--and do that. And there will
be other innovators that come into this market. There will be
others who step in. But if they are going to rely on
prescriptive rules to step in, well, we had better hope that
the prescriptive rules have captured everything that could
possibly go wrong----
Senator Kirk. Which----
Mr. Duffy. I would rather be us, sir. I mean, I think this
is obviously the greatest country in the world. It has got a
great, dynamic financial services industry. I would hope that
the Congress recognizes that and lets the regulators know that.
Let us compete globally. I like being a leader. I think that if
we implement small portions of Dodd-Frank, like I said, in a
judicious way, I think the rest of the world would have no
choice but to follow on a few of these things. I think if we
overreach, which has been what the regulator has been doing,
that is when our European competition will destroy us, on the
overreaching of the regulators. So right now, I would rather be
us, if we do it right.
Senator Kirk. Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Kirk.
Gentlemen, thank you for your excellent testimony. I
presume and I know that we will be meeting again, because this
issue of implementation is critical and your advice and your
insights are absolutely essential to get this right, so thank
you both very much.
Mr. Edmonds. Thank you, sir.
Chairman Reed. Let me call up the second panel.
[Pause.]
Chairman Reed. I would like to welcome the second panel and
begin by introducing Dr. Benn Steil. Dr. Steil is Senior Fellow
and Director of International Economics at the Council of
Foreign Relations in New York. He is also the founding editor
of International Finance, a scholarly ISI accredited economics
journal, as well as a cofounder and managing member of
Efficient Frontiers LLC, a markets consultancy. Dr. Steil's
most recent book, Money, Markets, and Sovereignty, was awarded
the 2010 Hayek Book Prize. Welcome, Dr. Steil. Thank you.
Dr. Chester Spatt will be introduced by my colleague,
Senator Patrick Toomey of Pennsylvania.
Senator Toomey. Thank you very much, Chairman Reed, for
this opportunity to welcome Dr. Chester Spatt, the Pamela R.
and Kenneth B. Dunn Professor of Finance at the Tepper School
of Business at Carnegie Mellon University and Director of its
Center for Financial Markets. The Tepper School consistently
ranks among the Nation's very best business schools and Dr.
Spatt has taught at the university since 1979. Dr. Spatt also
served as the Chief Economist and Director of the Office of
Economic Analysis at the SEC from 2004 through 2007.
In addition to that, he has served as Executive Editor and
one of the founding editors of the Review of Financial Studies,
President and a member of the founding committee of the Society
for Financial Studies, and President of the Western Finance
Association. His coauthored 2004 paper in the Journal of
Finance on asset allocation won TIAA-CREF's Paul Samuelson
award for the best publication on lifelong financial security.
Dr. Spatt earned his Ph.D. in economics from the University
of Pennsylvania and his undergraduate degree from Princeton
University.
Dr. Spatt, we are pleased that you could be with us today
and I look forward to your testimony.
Mr. Spatt. Thank you for that very kind introduction.
Chairman Reed. Our next witness is Mr. Cliff Lewis. Mr.
Lewis is Executive Vice President of the State Street Global
Markets, State Street's investment research and trading arm. In
that capacity, he is responsible for the e-Exchange business,
which provides electronic trading solutions for foreign
exchange, precious metals, cash, U.S. Treasury securities,
futures, money markets, and exchange traded funds. Mr. Lewis
joined State Street in 2006 as part of the acquisition of
Currenex, where he served as Chief Executive Officer. Welcome.
Mr. Don Thompson is Managing Director and Associate General
Counsel at JPMorgan Chase and Company. He is cohead of JPM's
Derivatives Practice Group and Legal Department and cochair of
the ISDA Documentation Committee. Since 1985, he has
represented JPM in its full range of derivatives activities,
with a focus on regulatory documentation and litigation
matters.
Mr. James Cawley is a founder of the Swaps and Derivatives
Market Association, an industry trade group with over 20-plus
dealer and clearing broker members that advocate open access
and transparency in centrally cleared interest rate swap and
credit derivatives markets. He is also the CEO of Javelin
Capital Markets, an electronic execution venue of OTC
derivatives that expects to register as a Swaps Execution
Facility, or SEF. Previously, Mr. Cawley was the founder and
CEO of IDX Capital, a New York-based electronic trading
platform for credit default swaps executed between dealers, so
welcome, Mr. Cawley.
Dr. Steil, please begin.
STATEMENT OF BENN STEIL, SENIOR FELLOW AND DIRECTOR OF
INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS
Mr. Steil. Thank you, Mr. Chairman----
Chairman Reed. Could you turn on your microphone, Doctor,
and let me for the record once again state, all of your
statements are part of the record. Feel free to summarize and
abridge.
Dr. Steil.
Mr. Steil. Thank you, Mr. Chairman, Ranking Member Crapo,
Members of the Committee. I appreciate the opportunity to
testify here this morning.
The collapse of Lehman Brothers and AIG in September of
2008 highlighted the importance of regulatory reforms that go
beyond trying to prevent individual financial institutions from
failing. We need reforms that act to make our markets more
resilient in the face of such failures, what engineers and risk
managers call ``safe-fail'' approaches to risk management. Well
capitalized and regulated central derivatives clearinghouses to
track exposures, to net trades and to novate them, to collect
proper margin on a timely basis, and to absorb default risk
have historically provided the best example of successful safe-
fail risk management in the derivatives industry.
Encouraging a shift in derivatives trading from OTC markets
without central clearing to organized Government-regulated
markets with central clearing is challenging, however, for two
reasons. First, the dealers that dominate the OTC derivatives
business have no incentive to accommodate such a shift. Dealers
earn approximately $55 billion in annual revenues from
bilateral OTC derivatives trading. Some of the largest can earn
up to 16 percent of their revenues from such trading. It is
natural that dealers should resist a movement in trading
activity onto exchanges and clearinghouses.
Where compelled by regulation to accommodate it, dealers
can also be expected to take measures to control the structure
of and limit direct access to the clearing operations. The use
of measures such as unnecessarily high capital requirements in
order to keep smaller competitors or buy-side institutions from
participating directly as clearinghouse members are to be
expected. Indeed, trading infrastructure providers organized as
exclusive mutual societies of major banks or dealers have a
long history of restricting market access.
For example, in the foreign exchange markets, the bank-
controlled CLS settlement system has long resisted initiatives
by exchanges and other trading service providers to prenet
trades through a third-party clearing system prior to
settlement. Such netting would significantly reduce FX trading
costs for many market participants, but would also reduce the
settlement revenues generated by CLS and reduce the trade
intermediation profits of the largest FX dealing banks.
There are, therefore, solid grounds for regulators to apply
basic antitrust principles to the clearing and settlement
businesses in order to ensure that market access is not being
unduly restricted by membership or ownership limitations that
cannot be justified on safety and soundness grounds.
Second, some types of derivatives contracts do not lend
themselves to centralized clearing as well as others.
Customized contracts or contracts which are functionally
equivalent to insurance contracts on rare events are examples.
Since it can be difficult for policy makers or regulators to
determine definitively whether given contracts, new types of
which are being created all the time, are well suited for
central clearing, it is appropriate to put in place certain
basic trading regulations in the OTC markets that will serve
both to make such trading less likely to produce another AIG
disaster and to encourage the movement of trading in suitable
products onto central clearinghouses. Two such measures would
be to apply higher regulatory capital requirements for
noncleared trades in consequence of the higher counterparty
risk implied by such trades and to mandate trade registration
and collateral management by a regulated third party, such as
an exchange.
In establishing the regulatory standards for the clearing
of derivatives transactions, it is imperative for lawmakers and
regulators to be fully conscious of the fact that the
derivatives market is effectively international rather than
national and that it is exceptionally easy for market
participants to change the legal domicile of their trading
activities with a keystroke or a simple change of trading
algorithm.
In this regard, I would highlight two important areas of
concern. First, the three major world authorities controlling
the structure of the derivatives clearing business--the SEC,
the CFTC, and the European Commission--each take a very
different view of the matter. Historically, the SEC has applied
what I would term the utility model to the industry. The CFTC
has applied what I would term the silo model. And the European
Commission has applied what I would term the spaghetti model.
The SEC's utility model favors institutions operated
outside the individual exchanges, in particular the DTC and the
equities markets and the OCC and the options markets. This
approach has generally performed well in terms of safety and
soundness and in encouraging competition among exchanges. It
performs poorly, however, in terms of encouraging innovation in
clearing and settlement services.
The CFTC's silo model allows the individual exchanges to
control their own clearinghouses. This approach has also
performed well in terms of safety and soundness. The CFTC's
model also encourages innovation in product development in a
way in which the SEC's model does not. This is because CFTC-
regulated futures exchanges can capture the benefits of product
innovation in terms of generating trading volumes, whereas SEC-
regulated options exchanges risk seeing trading volumes in new
products migrate to other exchanges, all of which use clearing
services provided by the OCC. On balance, I believe the CFTC's
model is the more appropriate for the derivatives industry.
The second point I would like to make regarding the global
nature of the derivatives trading industry is that certain
measures to curb speculative activity being debated here in
Washington are likely to push trading activity off-exchange,
precisely the opposite of Congress' intent. For example, a so-
called Tobin tax on futures transactions at the level being
discussed last year, two basis points or 0.02 percent, would be
equivalent to over 400 times the CME transaction fee on Euro-
dollar futures. It should go without saying that a tax this
large relative to the current transaction fee on the underlying
contract would push all of this activity into alternative
jurisdictions.
Likewise, commodity market position limits, if not
harmonized with UK and other national authorities, will merely
push such trading outside the CFTC's jurisdiction. There is
already an active regulatory arbitrage on oil and natural gas
futures between the CME's NYMEX exchange, which trades such
contracts under CFTC regulation, and the Intercontinental
Exchange, which trades such contracts under FSA regulation in
London. In short, we must be extraordinarily cautious not to
undermine Congress' worthy goal of bringing more derivatives
trading under the purview of U.S.-regulated exchanges and
clearinghouses by inadvertently providing major market
participants incentives to do precisely the opposite.
Thank you, Mr. Chairman.
Chairman Reed. Thank you.
Dr. Spatt, please.
STATEMENT OF CHESTER S. SPATT, PAMELA R. AND KENNETH B. DUNN
PROFESSOR OF FINANCE, TEPPER SCHOOL OF BUSINESS, CARNEGIE
MELLON UNIVERSITY
Mr. Spatt. Thank you, Chairman Reed and Ranking Member
Crapo. I am pleased and honored to have an opportunity to
present my views to the Senate Subcommittee this morning. As
Senator Toomey's introduction indicated, I am a chaired
professor at the Tepper School of Business at Carnegie Mellon
University in Pittsburgh and I also served as Chief Economist
of the U.S. Securities and Exchange Commission from July 2004
to July 2007. My expertise as a faculty member include such
areas as trading mechanisms, derivative securities, asset
valuation, financial regulation, and the financial crisis.
I think the focus on clearing through central
counterparties is a natural one and one in which I am
sympathetic, potentially both to reduce contagion associated
with counterparty risk and to make the structure of risk more
transparent. However, it is unclear to me whether the extent of
use of clearinghouses, especially the extent of mandatory
clearing currently envisioned, will lead ultimately to a
reduction in systemic risk in the event of a future crisis. I
think it is very important to manage carefully the risk within
the clearinghouse. I also think it is important that fees for
holding uncleared derivatives reflect economic costs and not be
punitive to avoid creating artificial concentration of risk
within the clearinghouse.
The clearinghouse is subject to considerable moral hazard
and systemic risk, because (a) there is a strong incentive for
market participants to trade with weak counterparties, (b)
concentration of risk in the central clearinghouse, and (c)
margining would likely need to ratchet up in the context of a
crisis. I believe that central clearing could potentially raise
systemic risk substantially.
In fact, Federal Reserve Chairman Ben Bernanke attributed
the lack of failure of a clearinghouse during the financial
crisis to ``good luck'' in an important speech that he
presented at the Atlanta Federal Reserve conference in April.
In fact, he quoted a Mark Twain character as emphasizing the
theme, that ``if you put all your eggs in one basket, you had
better watch that basket.'' I think that is the core of the
issue involving clearinghouses.
Now, I think everyone agrees that it is important that
clearinghouses not receive ``too big to fail'' types of
guarantees. In fact, Chairman Gensler testified before the full
Committee to that effect in mid-April. But I think that
emphasizes the importance of having strong risk management. I
think strong risk management is absolutely essential to the
potential success of the clearinghouse model. And indeed, while
it is a delicate balance, I would emphasize the importance of
strong risk management, even at the expense of other values.
The governance of the clearinghouse should reflect strong
incentives to control risk. It is important that the leadership
and the governance of the clearinghouse reflect strong
incentives, and in particular, I think artificial requirements
that most of the directors be independent directors are a push
in the wrong direction. It is important that governance,
including board governance and risk committee composition,
reflect incentives. Much of the commentary of regulators has
focused upon more abstract notions of ``conflict of interest.''
Incentives are very important. Proposals to absolve small
members of the clearinghouse of their duties or to allow them
to outsource their duties, are illustrative of some of the
incentive problems that I would envision potentially in terms
of the operation of the clearinghouse. Incentives are
absolutely crucial.
Analogously, regulators are focused upon access to the
clearinghouse by investing firms. Indeed, I think access is an
important issue but I would resolve tradeoffs in favor of
strong risk management. It is actually interesting that in the
equity context, the SEC actually adopted last fall a role
basically eliminating direct unfettered customer access because
of the importance in the equity context of managing risk and
making sure orders were properly vetted by member firms; I view
that as an analogous type of issue to those in the
clearinghouse space.
There are strong analogies, as well, with respect to the
payments system. My Carnegie Mellon colleague Marvin
Goodfriend, for example, points out how both in the private
clearinghouse system before the creation of the Federal Reserve
and then in the Federal Reserve System itself, direct access is
not allowed to the payments system essentially as a mechanism
to protect the integrity of the system.
Finally, my underlying view on these issues is also
strongly informed by the relevance of economic principles for
the structuring of the clearinghouse, and I do think it is
important that we be sensitive to the economic consequences of
these contemplated rulemakings as we move forward on these
important issues.
Chairman Reed. Thank you very much, Doctor.
Mr. Lewis, please.
STATEMENT OF CLIFFORD LEWIS, EXECUTIVE VICE PRESIDENT, STATE
STREET GLOBAL MARKETS
Mr. Lewis. Thank you, Senator. Chairman Reed, Ranking
Member Crapo, other Members of the Committee, thank you for the
opportunity to testify today. Let me also express my
appreciation for the work that has been done by your staff and
yourselves and Congress, the CFTC, and the SEC on the Dodd-
Frank implementation.
State Street is one of the world's largest custodial banks.
We administer over $21 trillion--that is trillion with a
``t''--dollars of other people's money. That makes us one of
the world's largest processors of derivative transactions today
and it is why we are very interested in the topic you all are
working on.
Now, let me say at the outset that we at State Street
support the Dodd-Frank mandates for both derivatives clearing
and execution. We believe that if the rules are properly
implemented, these changes will bring big benefits to our
customers who are investors, investors like pension funds,
endowments, and mutual funds. At the same time, we have to
report that our investor clients are extremely concerned by
current regulatory uncertainty and the potentially significant
incremental costs that may result from the new rules.
Now, let me also emphasize that in relation to central
clearing, the key issue for State Street is effective
implementation of Dodd-Frank's requirement that clearinghouses,
and I quote, ``permit fair and open access.'' A couple specific
comments.
First, we support the CFTC's participant eligibility rules
as proposed. Specifically, we are very concerned that some
clearinghouses could try to carry forward their current
restrictive membership requirements that bear no relationship
to risk reduction, in direct contradiction of Dodd-Frank.
Second, clearing members obviously need the financial and
operational resources to execute their duties to customers and
the clearinghouse. But strong capital rules should be risk-
based rather than arbitrary. Senator Toomey rightfully
emphasized that the current model of futures markets
clearinghouses worked well during the crisis. The successful
wind-down of Lehman as well as other such disasters indicates
that that model, which includes participation in the
liquidation process of an open auction system, not limited to
one subset of market participants, is unsurprisingly the most
successful and reliable.
Third, both the clearing and execution mandates, we
believe, should go into effect at the same time. Clearing is
most value adding and, frankly, safest only when tied to
execution. We do not really see how a safe central
clearinghouse exists independent of liquid and transparent
markets.
Fourth, regulations governing clearinghouse memberships
obviously have to be coordinated globally. A number of you have
already recognized the fact that there are a tremendous amount
of U.S. jobs at stake. There is also the fact that regulatory
arbitrage would completely undermine and perhaps, in fact,
worsen the current risk situation.
Finally, we would make an operational point as sort of
plumbers in the financial market, which is that at least 6
months is going to be required--at least 6 months is going to
be required--once the rules are completely finalized for our
customers to be ready to actually implement them, and I say at
least 6 months.
In conclusion, let me just emphasize that we at State
Street stand ready to help Congress, the Administration, and
the regulators as the process of rule writing and
implementation goes forward. And let me also point out that
State Street, and obviously we are not alone in that, is
spending very, very large amounts of money to prepare for the
implementation of Dodd-Frank and that we are investing this way
because we believe these rules, again, if properly implemented,
will bring major benefits to our investor clients.
Thank you.
Chairman Reed. Thank you very much.
Mr. Thompson.
STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND ASSOCIATE
GENERAL COUNSEL, JPMORGAN CHASE & CO.
Mr. Thompson. Chairman Reed, Ranking Member Crapo, and
Members of the Subcommittee, my name is Don Thompson. Thank you
for inviting me to testify today.
JPMorgan has been an active participant in the development
and management of clearinghouses. We have direct membership in
77 clearinghouses covering a variety of markets, such as listed
and over-the-counter OTC derivatives and equity and fixed-
income securities. We are committed to clearing over-the-
counter derivatives transactions, have been clearing dealer-to-
dealer OTC transactions for over a decade. Today, we clear over
90 percent of the eligibility interdealer interest rate and CDS
transactions that we execute. At the same time, we have also
made significant investments in our client clearing franchise,
which we expect to grow as requirements of clearing under Title
VII become implemented.
While there are a number of critical issues to consider in
determining the appropriate market structure and governance for
clearinghouses, the most critical is guarding against systemic
risk. Questions of membership criteria, risk committee
structure and governance all implicate safety and soundness, so
it is essential that the regulations carefully weigh those
considerations, and I commend the Committee for holding this
hearing to ensure that these proposals are well considered.
As you are aware, the migration of products that were once
traded and managed bilaterally to CCPs will concentrate the
risk for those transactions at clearinghouses. Clearinghouses
do not eliminate credit and market risk arising from over-the-
counter derivatives. They simply concentrate it in a single
venue in significant volume. This concentration of risk,
combined with an increase in aggregate credit and operational
risk at clearinghouses, will result in these institutions
becoming systemically important.
Since these institutions are private for-profit entities,
it is critical that regulations guard against an outcome that
would privatize profits but potentially socialize losses.
Attempts to increase clearing member access or lower clearing
member capital requirement can be responsibly implemented only
if they are coupled with requirements for sound risk management
practices, including appropriate limits on the types of
transactions subject to the clearing mandate, requirements for
members of clearinghouses to have capital contributions
proportional to the risk that they bring into the
clearinghouses, elimination of uncapped liability of clearing
members, and requirements for clearing members to be able to
risk manage transactions they bring into clearinghouses.
We strongly support open access to clearinghouse membership
and believe it can be achieved without compromising risk
management standards. Two critical controls must be in place at
each clearinghouse to support open access, a clear liability
framework that caps member exposure and risk limits that are
real time and proportional to each member's capital.
The approach we advocate here is consistent with the
approach taken by the FSA in their recent comment letter to the
CFTC. The foundation we are proposing would allow clearing
membership to be prudently expanded to firms with modest levels
of capital, including the $50 million minimum requirement
proposed by the CFTC.
Absent proper oversight, clearinghouses are at greater risk
of failure, which could have significant systemic impact.
Failure could result for a number of factors, such as lack of
proper risk management on the part of members from clearing
complex products that cannot be properly valued by the
clearinghouse or for from competitive actions resulting from a
race to the bottom among for-profit CCPs.
Given these risks, we believe that as long as CCPs are
structured as for-profit entities, the primary regulatory focus
should be to ensure that proper risk management, governance,
regulatory oversight, and incentive structures are in place.
It is also worth noting that because derivatives trading
and clearing is a global business, in order to prevent
regulatory arbitrage, rigorous regulatory standards should be
applied consistently in each of the major global markets,
including uniform operating principles and consistent on-the-
ground supervisory approach.
We believe that no institution, including clearing members
and clearinghouses, should be too big to fail. The policy
objectives of the Act would be well served by promoting
systemic stability and ensuring safety and soundness of
clearinghouses and by requiring that these institutions have
adequate capital to absorb losses and sufficient liquidity to
safeguard the system.
JPMorgan is committed to working with Congress, regulators,
and industry participants to ensure that Title VII is
implemented appropriately and effectively. I appreciate the
opportunity to testify before the Subcommittee and look forward
to answering any questions you may have.
Chairman Reed. Thank you, Mr. Thompson.
Mr. Cawley, please.
STATEMENT OF JAMES CAWLEY, COFOUNDER, SWAPS AND DERIVATIVES
MARKET ASSOCIATION
Mr. Cawley. Thank you, Mr. Chairman. Chairman Reed, Ranking
Member Crapo, Members of the Subcommittee, my name is James
Cawley. I am CEO of Javelin Capital Markets, an electronic
trading venue of OTC derivatives that will register as a SEF,
or Swap Execution Facility, under the Dodd-Frank Act. I am also
here to represent the interests of the Swaps and Derivatives
Market Association, which is comprised of multiple independent
derivatives dealers and clearing brokers, some of whom are the
largest in the world.
To ensure that the U.S. taxpayer is never again required to
bail out Wall Street, we must move away from ``too
interconnected to fail,'' where one bank pulls another three
with it in the event of its failure. Equally important, we must
remove the systemic sting currently associated with each
bilateral derivatives contract and that connects financial
firms to each other and thus compel these contracts into
clearing.
In order to have safe and successful central clearing of
OTC derivatives, certain remaining impediments must be removed
such that clearinghouses ensure that they have truly
representative governance structures, offer objective and
proportionate risk models, provide open access to properly
qualified and noncorrelated clearing members, and accept trades
on a real-time and execution-blind basis such that systemic
risk is mitigated while transparency and market liquidity are
increased.
With regard to clearinghouse governance, we support CFTC
core principles O, P, and Q, that require that governance
arrangements be transparent, fair, and representative of the
marketplace. Such governance bodies should represent the
interests of the market as a whole and not just the interests
of a few.
Importantly, clearinghouse membership requirements should
be objective, publicly disclosed, and permit fair and open
access, as Dodd-Frank requires. This is important, because
clearing members act as gatekeepers to clearing, and without
open access to clearing, you will not have universal clearing
adoption, increased transparency, and less than systemic risk.
Clearinghouses should seek to be inclusive and not exclusive in
their membership criteria.
We should dispense with the myth that swaps are somehow
different from other cleared markets and we should not ignore
the vast experience from those markets, that they have to
offer. Importantly, clearinghouses should learn from their own
experience in the listed derivative space of futures and
options. In those markets, central clearing has operated
successfully since the days of post-Civil War reconstruction in
this country, nearly 150 years ago, long before spreadsheets
and risk models. In those markets, counterparty risk is spread
over 100 disparate and noncorrelated clearing firms. It works
well, and no customer has ever lost money due to a clearing
member failure.
To complement broad participation, clearinghouses should
not have unreasonable capital requirements. Capital should be a
function of the risk a member contributes to the system. Simply
put, the more you or your customers trade, the more capital you
should contribute.
The SDMA supports the CFTC's call for clearing broker
capital requirements to be proportionate in scale relative to
the risk introduced to the system. We support the CFTC's call
that a clearing firm's minimum capital be closer to $50 million
rather than closer to the $5 billion or $1 billion threshold
that certain clearinghouses have originally suggested.
Certain clearinghouse operational requirements for
membership that have no bearing on capital or capability should
be seen for what they are, transparent attempts to limit
competition. Specifically, clearing members should not be
required to operate swap dealer desks just so that they can
meet their obligation in the default management process. These
requirements can easily be met contractually through
arrangements with third-party firms or other dealers.
With regard to trade acceptance, clearinghouses and their
constituent clearing member firms should accept trades on an
execution-blind basis. Clearing firms and their constituent
FCMs should be prevented from discriminating against certain
customer trades simply because they dislike the manner in which
they have been executed or the fact that they may be anonymous.
Certain trade counterparties should be precluded from
exploiting current market position to impose documentary
barriers to entry that restrict customer choice of execution
venue, execution method, and dealer choice. Regulators should
remain vigilant to such restrictions on trade and ensure that
they do not manifest themselves in a post-Dodd-Frank world.
The SDMA joins the MFA and supports the CFTC requirement
that trades be accepted into clearing immediately upon
execution. Regulators should be mindful not to allow
clearinghouse workflows to increase and not decrease trade
latency. Such workflows are nothing more than clear attempts to
stifle successful OTC derivative clearing.
In conclusion, the CFTC and the SEC should be commended for
their excellent work. Both agencies have been transparent and
accessible through the entire process and they have adapted to
the industry's suggestion where appropriate. We must move away
from ``too interconnected to fail,'' and as an industry, we
must work together to ensure that OTC derivatives clearing is a
success and that Wall Street never again has to come to Main
Street for another bailout.
Thank you for your time.
Chairman Reed. Thank you very much, gentlemen, for
excellent testimony.
We will proceed with our first round, and if appropriate,
since we have a large panel, we will entertain a second round
if there are additional questions, but let me begin.
Dr. Steil, one of the recurring themes of all the witnesses
has been the globalization of these markets. From your
perspective at the Council on Foreign Relations, I presume you
spend a lot of time looking at overseas markets, as well as
U.S. markets. How would you sort of rate what is going on
overseas relative to what Dodd-Frank is trying to create here
in the United States at this time?
Mr. Steil. I used to be on the board of a European
exchange, so I got to see some of that firsthand. I would
describe the situation in most of the European Union as being
confusion. First of all, there are contradictions across
national jurisdictions. For example, the UK is taking very
different approaches on certain issues, such as bank capital
requirements, from the rest of the European Union.
Second of all, there were regulatory approaches that were
put in place before the financial crisis that are widely seen
now as being inappropriate, but are still being pushed forward
by inertia. I had referred briefly in my testimony, for
example, to the European Commission's spaghetti model approach
for clearinghouses. Prior to the financial crisis, the European
Commission wanted to see clearinghouses compete more against
each other and they felt that the way to do that was to compel
them to provide interoperability, technological linkages, one
to another.
My concern is that that could produce enormous operational
risk that could spread from one institution to another and
could lead to a situation where the clearinghouses compete by
lowering their margin requirements and other prudential
requirements and could undermine their ability to make sure
that we have a safe and sound securities trading system.
So I think we are more advanced over here right now in
terms of having a coherent approach, and although I have
differences on some approaches, I think the thrust is going in
the right direction and it is a matter of refining individual
details.
Chairman Reed. Let me just follow up and ask perhaps the
same question a different way, and also ask Dr. Spatt to
comment. There is a real issue here of, going forward, are we
advantaged by these reforms or disadvantaged, particularly with
the competition with the European Community and with some of
our Asian financial centers. And so your sense going forward,
then I will ask Dr. Spatt.
Mr. Steil. It depends on the individual issue. Let us take
the issue of clearing certain contracts that are traded in
multiple jurisdictions. I mentioned briefly in my testimony
natural gas and oil futures contracts. These contracts are
traded both by the NYMEX exchange, which is owned by the CME,
which is regulated by the CFTC, and by the Intercontinental
Exchange, which interestingly enough, although it is an
American exchange, trades certain of these contracts out of
London, so to speak. Of course, this is a keystroke that
determines jurisdiction----
Chairman Reed. Right.
Mr. Steil. ----under FSA regulations. Margin requirements
can differ on contracts that are traded in different
jurisdictions.
And in terms of the current debate, for example on position
limits on certain commodities, you have seen in the markets
evidence that any time it looks like position limits may be
instituted in the U.S. markets, say in natural gas and oil
contracts, open interest shifts from NYMEX to ICE. I do not
think this is coincidental. There is great concern in the
markets here that if position limits are implemented here and
not overseas, institutions will be forced to liquidate
positions in order to get under those requirements, and so they
start increasing their open interest overseas, and I think that
is the sort of regulatory arbitrage we need to be concerned
about.
Chairman Reed. Dr. Spatt, your comments, and then there
will definitely be a second round because I have questions for
the other panelists, but I want to give my colleagues a chance.
Dr. Spatt?
Mr. Spatt. Thank you, Senator Reed. I share the concerns
about the competitiveness issues. I am certainly struck by the
discussion today about how little movement there has been in
Europe and certainly in Asia on these issues. Even the language
of the G20 has certainly used a much more extended window than
is present in the Dodd-Frank legislation, and there does not
seem to be much movement by Europe and Asia even relative to
the longer window used by the G20.
This whole issue reminds me of a strong parallel that I
observed when I was Chief Economist at the SEC. At the time,
there was a lot of concern about the consequences of Sarbanes-
Oxley for listings and lots of interest on the part of European
companies to de-register from the U.S. environment and a lot of
discussion and debate about that. To the extent that we get it
wrong--and I have fears that we may be getting it wrong--to the
extent that we get it wrong, the concern is basically that a
lot of the business will flow overseas, that the complications
in trading overseas are tiny. There are obviously major market
centers in London and Hong Kong and it is relatively easy for
most sophisticated traders to redirect their orders to what
they consider to be a more appropriate environment.
Chairman Reed. I thank you.
Just before I recognize Senator Crapo, I cannot help but
think this is somewhat ironic, because, of course, AIG's
financial products were located in London so that they could
avoid the ``onerous,'' quote-unquote, regulation and they
began--they were sort of the self-destructive aspect of the
company.
Mr. Spatt. Well, I do think, to the extent that the
Administration views the G20 as an important group, I think it
is important that there be alignment, that does not necessarily
mean to simply match the current form of Dodd-Frank, but I
think it is important that there be regulatory alignment
between the framework in the U.S. and the framework overseas,
and that may involve movement in both directions.
Chairman Reed. Thank you, Doctor.
Senator Crapo.
Senator Crapo. Thank you, Senator Reed.
Mr. Thompson, I would like to return to the end user issues
that I discussed with the first panel a little bit and ask you
if you could explain how the margin requirements on uncleared
groups or swaps will impact end users.
Mr. Thompson. Thank you for that, Senator Crapo. I would
love to be able to do that. The impediment to doing that is as
many times as I have read the regulations, I still do not
entirely understand them because there seems to be an internal
inconsistency in the regulations themselves.
They seem to say, on the one hand, we will not require the
collection of margin from end users by swap dealers. On the
other hand, it says that swap dealers are required to negotiate
agreements with end users which will provide for the mechanics
of transfer of margin with respect to their liabilities under
uncleared swaps.
It seems to me difficult to square those two statements,
and the regulations, as many times as I have read them, do not
square the circle there, so I remain a little confused about
exactly what they require in terms of requiring swap dealers to
collect margin from end users on uncleared swaps.
Senator Crapo. And is this a conflict between the approach
of the SEC and the CFTC versus the approach of the banking
regulators?
Mr. Thompson. I believe that that issue is present both in
the margin release from the banking regulators as well as the
margin release from the CFTC. Both of them require this concept
of swap dealers establishing what they call thresholds,
presumably which will govern the requirement to collect margin
once you get above the threshold. There is very little,
virtually no discussion of how those thresholds are set,
whether they are done in accordance with banks' ordinary and
customary credit practices, whether they will be imposed by
regulators, whether they can be changed by regulators in a
financial crisis. There is a whole level of detail around that
question which is lacking in both releases.
Senator Crapo. From my perspective, and I do not propose
that I am anywhere close to the expert that you or the others
on the panel are to these regulations, but it seems to me from
what I am hearing that--it appears that although there is the
confusion you described, that there seems to be an
understanding that there will be somehow an increased margin
requirement imposed either as a margin requirement or as some
kind of other fee on end users. Is that a fair assumption?
Mr. Thompson. I think it is natural when you have that kind
of ambiguity in otherwise very long and comprehensive
regulatory releases that people who would be affected by that,
most significantly the end user community, would be naturally
suspicious that there is not going to be some requirement
imposed in some form or fashion in connection with their
liabilities under uncleared swaps. So, yes, I think I agree
with you.
Senator Crapo. And if that is the case, I believe, and I do
not want to speak for him, but I believe Mr. Edmonds in the
first panel indicated that that increased margin requirement
would be a cost on end user transactions that would not
necessarily be justified by any appropriate increase in safety
and soundness. He may or may not have intended that. That is
what I heard him say. But what do you think about that? Do you
think that the increased margin costs that would come from what
we have been discussing would be justified in an improvement of
safety and soundness?
Mr. Thompson. Well, when I think about that question, which
is an excellent question, I go back to the statute which
authorizes and directs the prudential regulators to set margin
requirements for uncleared swaps, and in that requirement under
Section 731, there is a requirement that it be appropriate for
the risk.
When you think about end users, your typical corporate
nonfinancial entities, there is no evidence that they
contributed in any significant way to the financial crisis.
Their use of over-the-counter derivatives is almost invariably
risk reducing hedging transactions.
Furthermore, unlike financial firms, which tend to be very
highly correlated, such that when Lehman Brothers gets in
trouble, people start to get the sweats about other financial
entities, when you think about the end user world, it is a
whole host of entities whose credit risk has very low
correlation.
So in my mind, that means that imposing onerous margin
requirements on those types of entities gets you very, very
little reduction in systemic risk and, I would argue, is not
appropriate for the risk.
Senator Crapo. Well, thank you. As I see it, to put it my
way, it seems to me like we are raising the cost of capital and
reducing the availability of capital for very little benefit.
Mr. Thompson. That is certainly what we are hearing from
our clients.
Senator Crapo. Thank you.
Chairman Reed. Senator Merkley.
Senator Merkley. Thank you, Mr. Chair.
Mr. Lewis, I wanted to understand a little bit better the
exchanges that have been set up, CME and ICE. An article from
December in the New York Times noted that State Street has not
yet gained full entry into the derivatives trading club, and it
mentioned other groups like the Bank of New York, MF Global,
Newedge. Is that still pretty much the case, or have things
changed in the course of the last few months?
Mr. Lewis. It varies, and we are talking to the
clearinghouses. I mean, existing clearinghouses, there was no
problem when State Street decided to enter. The new
clearinghouses, many of which that were set up with relatively
limited membership that consisted of the major swap dealers
today, who, as Dr. Steil said, make about $40 billion a year
from market making activities, curiously did not have
membership requirements that would allow State Street to
participate, notwithstanding the fact that our capital ratios
are better than any of the other top 20 banks in the United
States.
Senator Merkley. Right. So I am trying to get a sense,
then, of how does State Street respond. Do you end up utilizing
those exchanges but having to do the deals through those that
are members, or do you simply operate through the other
exchanges?
Mr. Lewis. This is a prospective problem, really, more now.
We find ourselves in the ironic situation of handling the back-
office processing for some of our clients, sort of test trades
at clearinghouses that we were not allowed to join. I think CME
and ICE have got proposals in place, with help from some of the
existing members, including JP, that would let us participate.
I think we still have a continuing problem with SwapClear at
LCH, which apparently has a different model.
Senator Merkley. And so, Mr. Thompson, you do not see any
systemic issues or problems with State Street participating?
Mr. Thompson. Generally speaking, we are supportive of open
access. I am not intimately familiar with the State Street
legal entity which is seeking to join ICE and CME, but I would
just reiterate what I said in my opening statement, which is as
long as clearinghouse membership is proportional to the risk
that clearing members bring into the clearinghouse and as long
as clearing members have demonstrated risk management
capabilities such that they can assist actively in the
management of a clearing member default, we would have no
problem with an entity like that becoming a clearing member of
a clearinghouse that we are a clearing member of.
Senator Merkley. There is a fair amount of discussion of
the question as to whether risk management arguments are being
used really out of proportion to keep other players out of the
exchanges. Do you see kind of an evolution in that argument or
kind of a movement toward risk assumptions that are reasonable
in terms of other folks participating?
Mr. Thompson. Well, what I see in that is, on the part of
many market participants, a recognition, much of which came out
of the experience we had with Lehman Brothers' default and how
the risk management process worked in the LCH, that having the
ability to independently manage risk contributed to a very
successful resolution of the Lehman Brothers bankruptcy with
respect to the $9 trillion of derivatives that it had in LCH.
The LCH mechanic requires all clearing members to be active
bidders for portions of the portfolio of a defaulting clearing
member, which is what Lehman was, and in the LCH Lehman
situation, we were able to reallocate their portfolio among
existing clearing members without going through the first level
in the default waterfall, which is the initial margin posted by
Lehman, thus not putting any member guarantee fund
contributions at risk, and most critically, not imperiling the
solvency of the clearinghouse. So we think risk management is a
very important feature of the landscape.
Senator Merkley. Mr. Lewis, I am going to turn back to you
on this. I mean, one issue is membership in the exchange.
Another is membership in the Risk Committees. The Risk
Committees have a key role in deciding what gets traded on the
exchange, in other words, how broadly, what kind of swaps
derivatives are there.
In terms of the other exchanges that you are members of, do
you also have a role in the Risk Committee, being able to kind
of help shape what gets traded on the exchange?
Mr. Lewis. Yes, and we are most concerned not only for
ourselves, but for the buy-side customers that need to
participate in this who ultimately are at risk in pension funds
and mutual funds need to be represented in these.
I think there is a very complicated aspect as to how to run
the worst-case situation, which is the default of a clearing
member, and that is where there is a distinction between the
practice in the U.S., which worked very successfully, and the
practice which Mr. Thompson just alluded to in LCH in London.
In the U.S., it is essentially an open auction, and indeed, in
the U.S., the majority of the Lehman positions, not
surprisingly, were bought by nonclearing firms. We would argue
that the most open auction, most market-oriented process for
handling a liquidation makes sense. We would also think that,
occasionally, some of these restrictions have less to do with
safety and more to do with limiting profit opportunity.
Senator Merkley. Thank you very much. Thank you, both of
you.
Chairman Reed. Well, thank you, Senator Merkley.
Let me just address a general question. I will start with
Mr. Thompson, but I wish to call in Mr. Lewis, also, and this
might be terribly unsophisticated, but it strikes me that in an
over-the-counter derivative arrangement, there are substantial
fees charged by the broker-dealer, and part of those fees are
equivalent to margin. They are an attempt to price the risk in
every transaction as risk.
And so when we talk about the end user being assessed a
margin requirement or not assessed a margin requirement, is it
not the reality that there is a built-in risk premium or
something like margin in there, and the question really is, if
there is a requirement under these rules to have a formal
margin or even a contingent margin, the question is really, is
that paid for by the issuing broker-dealer or is it paid for by
the customer, and in these situations where there are no
competitive market, it could be fully passed on to the
customer. Is that more of the question we are dealing with
here, who pays rather than who is covering the risk?
Mr. Thompson. I think there are a couple of levels to that,
so let me just address each of those in turn.
Chairman Reed. Sure.
Mr. Thompson. First of all, the term ``fees'' is often
used, but it is really misleading in the over-the-counter
business, which is not what we call an agency business, where I
sell you a security issued by another. We call it a principal-
to-principal business, where you and I enter into transactions.
And so if we are entering into an interest rate swap, what we
are really--what you are paying is the rate on the fixed rate
that you want to pay on your interest rate swap, for example.
So if you are in open competition with other dealers, you would
select the dealer who requires you to pay the lowest fixed
rate.
Now, embedded in that fixed rate, as you correctly
identify, for transactions that do not involve margin, is
something that we call a credit spread, compensation to the
dealer for the possibility that you may default, and in the
derivatives markets, those credit spreads are risk based. If
you are a hedge fund, you would pay a higher credit spread than
if you are a AAA corporate. That is essentially how it works.
Now, when people talk about the cost of margining
transactions, that is not a cost which is embedded in the fixed
rate of the transaction. What people are referring to there is
the cost to you of coming up with $10 million or $20 million or
whatever the margin requirement is in order for you to be able
to fund the margin requirement that I am going to impose on
you. I hope that clears it up.
Chairman Reed. I think I am going to ask Mr. Cawley to help
clear it up and Mr. Lewis to help clear it up. I think it is an
excellent answer, but your comments, please.
Mr. Cawley. It would be my pleasure, Mr. Chairman, to clear
it up. There are essentially two types of fees that the end
user is charged, some of which are not transparent and some of
which are. There are--and there has been--Senator Toomey and
Senator Crapo correctly discussed the clearing fees, the margin
or, indeed, the capital fees that get held aside for each
individual trade, whether it be within a clearinghouse where it
is an objective fee that is dictated by the risk model of that
clearinghouse or whether it be a subjective fee set by the
broker-dealer that extends a credit relationship to that
entity.
And it is, indeed, the subjectivity of that fee
relationship that got us into trouble in 2008, because dealers,
incumbent dealers essentially extended open fee relationships
to entities such as AIG and then requested the bailout.
But, you know, from the end user standpoint, from what I
have heard from Chairman Gensler, as we participated in
roundtables and had meetings with him and read his public
comments, it is our understanding that there is an exemption
for end users vis-a-vis margin. That said, end users still have
to pay their own way. They do not get a free ride on every
trade that they do. They have to set aside the appropriate
amount of capital for each trade, and that is only fair, and
appropriate within the marketplace.
The argument against that, then, is, well, you know, is
capital formation. Well, is this not going to take money off
our balance sheets if we really had nothing to do with AIG? And
we would say this. Well, you are trading derivatives, so you
have to come in the same way as everybody else.
What you should also look, though, is at the benefits of
the lessened execution fees that can occur. For example, if you
take a standard credit default 5-year trade, if I want to buy
default protection on GECC and I get charged five basis points
in the bid-offer spread for a five million round lot trade,
that is $21,000 per trade. Now, likewise, in the futures world,
the execution fees are ten, maybe $10, $15, $20. So you can see
the contrast between a transparent liquid marketplace and the
lack of transparency in the CDS and the interest rate swap
markets.
Now, the way to benefit, then, is to bring these markets
into a transparent, open, competitive marketplace such that
that $21,000 fee, as one of the gentlemen on the panel
correctly surmised that it is about $40 or $50 billion of
execution fees, you go after--you create competition. You bring
transparency into the marketplace. You bring multiple dealers,
not just five or six or ten dealers, but 30 or 40 or 50 dealers
in to compete. And you open up clearinghouses away not just
from five or six or ten constituent clearing members who also
have execution desks, as well, so there may or may not be a
conflict of interest there, but what you do focus on is the
benefit of taking that $50 billion worth of execution fees and
driving it downwards to ten, leaving the resultant $40 billion
on the balance sheets of corporate America so they can go out
and, indeed, hire people and invest in their respective
companies and industries.
Chairman Reed. Thank you. And, Mr. Lewis, I want your
perspective.
Mr. Lewis. Just very briefly, we talk about end users, as I
say, that are financial institutions that are in this. I think,
by and large, they view this, unfortunately, as completely an
incremental cost. And what I think has been lost is the genius
of the approach, which is really the genius of futures that has
proven this for 100 years, lots of academic research, which is
that a more transparent market is a more efficient market. The
biggest beneficiary of that are the price takers, the
noncorrelated flow, the investors, if you will. The savings of
America are better off if you have a transparent market.
And that is one of the reasons we emphasize so much that
you have to see both sides of the coin between clearing and the
exchange piece, or SEFs, as it is called in this case. I think
the measure of success will be that improved efficiency. The
more rapidly that the clients see that efficiency, the less
political problems there will be. The more obvious the benefits
will be. And I think that it is a win-win.
Alternatively, frankly, if there is not a big improvement
in efficiency, then probably some of these risk products may
not become as important as they are. In fact, some may
disappear.
And the final point I would just observe is that I think
the least likely outcome and a very uncertain outcome is that
the market and the products are going to look like they look
like today. The effect of this is going to be to change things
fundamentally, and I think if you hold to your guns, change
things for the better.
Chairman Reed. Thank you.
Mr. Thompson. Senator Reed, if I might just close with one
additional observation----
Chairman Reed. Sure, and then Professor Spatt. Absolutely.
Mr. Thompson. Yes. When people talk about transparency in
the context of clearing, I think they are confusing things
because you are confusing the clearing side of it, which is how
trades settle and clear, with the execution side of it. And I
think it is worth, on the execution side, to keep in mind that
Dodd-Frank implements a full pretrade transparency for
execution and post-trade transparency for both SEF-executed as
well as non-SEF-executed transactions.
So I think from a public policy perspective, the
transparency argument has been had and decided in favor of full
market transparency. That is a conclusion that we are totally
comfortable with. And so I do not see how changing the clearing
model really can add to the transparency debate which has
already been resolved in favor of full transparency as required
by the statute.
Chairman Reed. Professor Spatt.
Mr. Spatt. Yes, so on two points. First, on the issue of
the SEFs and the CCPs, to the extent that the statute is
obviously requiring post-trade transparency but not universal
exchange trading, the prices from post-trade transparency can
clearly inform collateral issues vis-a-vis the CCP, and those
do not even have to be real time. That is a separate issue from
whether it is real-time disclosure. Those prices could be
disclosed a day later if real-time disclosure is a severe
impediment with respect to liquidity. It seems to me those are
separate.
There is one other point I also wanted to make with respect
to access. The issue of access is not a unique issue with
respect to the derivatives market. In other contexts, there
have been concerns about unfettered access. The SEC late last
year promulgated a rule barring unfettered access by customers
that do not go through intermediaries because of concerns that
that would impose systemic risk on the system, if those orders
were not vetted but had basic kinds of errors. Analogously, in
the history of payment system clearinghouses, both the private
clearinghouse systems prior to the Federal Reserve and the
Federal Reserve, also control access because of issues
associated with default.
Chairman Reed. Thank you.
Dr. Steil, you have a comment. You will get the last word.
Mr. Steil. Two brief observations on end users. First,
generally speaking, I do not like the approach of taking a
certain class of market participants, carving that class out
and saying that exemptions apply there, because traditionally,
when that has been used in other markets, it has produced a
regulatory arbitrage that has itself produced significant
complications and inefficiencies.
Just very briefly, for example, in the UK markets, you have
stamp duty on equity trading and you have a carve-out for
market makers. They do not pay it. So the market makers trade
the stocks, but other sophisticated investors trade substitutes
for the stocks called CFDs, or Contracts for Differences, and
this has led to endless debate about corporate governance. For
example, how do we deal with entities that have significant CFD
exposures to a given company? So I do not like that general
approach.
Second, I think a lot of these end users are either
overstating or misstating their cases in some cases. FMC
Corporation, an end user, testified before your parent
Committee back in April, and I would like to read just one
sentence that the Treasurer said. He said, ``Our banks do not
require FMC to post cash margin to secure mark-to-market
fluctuations in the value of derivatives, but instead price the
overall transaction to take this risk into account.''
Now, this means there is no free lunch. First of all, if
you post margin, you get paid interest on it, so it is not
uncompensated.
Second of all, as you yourself pointed out, if you do not
post margin, you expect the bank to take account of this risk
and, therefore, build it into its price, the bid-ask spread.
And in an untransparent market, you do not know exactly what
that price is.
From my experience with the mutual fund industry, many
traders on the buy side did not like when NASDAQ shifted from
an opaque dealer market structure in the 1990s to a transparent
electronic market structure because then trading cost analysis
was able to distinguish between good traders and bad traders.
And it is my perception that a lot of corporate treasurers do
not want to be subjected to that sort of scrutiny which would
naturally emerge in a more transparent marketplace.
Chairman Reed. Well, thank you very much, gentlemen. This
has been very thoughtful and excellent testimony which will
help us, and it will not be, I am sad to say, the last word on
this topic, but these were all very, very thoughtful words and
I thank you very much.
With that, I would just simply say, some of my colleagues
may have written questions that they would like to submit. One
week from today will be the deadline for my colleagues. We
would ask you, if you do receive written questions, to respond
as quickly as possible.
And again, thank you, and with that, I will adjourn the
hearing. The hearing is adjourned.
[Whereupon, at 11:27 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF CHRISTOPHER EDMONDS
President, ICE Trust
May 25, 2011
Chairman Reed, Ranking Member Crapo, I am Chris Edmonds, President
of ICE Trust, a limited purpose New York bank that operates as a
clearinghouse for credit default swaps. I very much appreciate the
opportunity to appear before you today to testify on clearing OTC
derivatives.
Background
ICE has a long, successful, and innovative history in clearing,
including clearing previously ``unclearable'' over-the-counter (OTC)
derivatives such as energy and credit default swaps. ICE owns and
operates five derivatives clearinghouses: ICE Clear US, a Derivatives
Clearing Organization (DCO) under the Commodity Exchange Act, located
in New York and serving the markets of ICE Clear US; ICE Clear Europe,
a Recognized Clearing House located in London that clears ICE Futures
Europe, ICE's OTC energy markets and European credit default swaps
(CDS); The Clearing Corporation, a DCO and ICE Clear Canada, a
recognized clearinghouse located in Winnipeg, Manitoba, that serves the
markets of ICE Futures Canada. ICE Trust serves as the leading United
States clearinghouse for CDS, having cleared approximately $11 trillion
in gross notional value since it launched on March 9, 2009. Globally,
ICE has cleared more than $18 trillion in credit default swap volume
since the financial crisis.
Clearing is the cornerstone of U.S. and global regulators'
financial reform efforts. Clearing greatly reduces counterparty and
systemic risk in the derivatives markets for standardized contracts. As
an example, since our service came to market we have reduced the
outstanding risk exposure by greater than 90 percent for the products
we offer. In addition, clearing brings transparency, and transparency
is a prerequisite for efficient markets and effective regulation.
Increased liquidity from clearing results in lower transaction costs
and tighter bid/ask spreads, reducing the cost of hedging price risk
and lowering operating costs for businesses. Companies operating DCOs,
like ICE, have led this effort and have been very successful in their
efforts to clear OTC derivatives.
Clearing Over the Counter Derivatives
ICE's experience in energy and credit derivatives demonstrates that
when clearing is offered to a market, the market overwhelmingly chooses
to clear its products. While convincing market participants of the
advantages of clearing is easy, however, the process of clearing an OTC
derivative is difficult. For example, in order to clear an OTC
derivative, the clearinghouse must be able to properly price the
contract for an accurate mark to market. Marking-to-market is a process
common to clearinghouses whereby a clearing participant's position is
priced (marked) on at least a daily basis, and to the extent that the
clearing participant has incurred a loss, the clearing participant must
pay the clearinghouse the amount of the loss. The daily making-to-
market of positions, and the commensurate daily collection of any loss
(known as variation margin), is a unique discipline of clearinghouses
that reduces systemic risk by eliminating the accumulation of losses.
In addition, a clearinghouse must determine the correct size and type
of contract that it will clear, balancing the risk management
objectives of the clearinghouse with the needs of market participants.
Finally, the clearinghouse must model risk for the market in order to
determine how to properly set margin rates. We do this by working in
concert with our clearing firms, who are required to provide accurate
pricing information for OTC products.
For Credit Default Swaps (CDS), which we have cleared since March
2009, we require clearing members to provide accurate and reliable
prices on a daily basis. If a clearing member submits a price that is
out of line with the prices submitted by other clearing members, the
clearing member is subject to being required to enter into a
transaction at the out of line price. Requiring clearing members to
submit to ``executable'' prices compels clearing members to carefully
price the CDS contract. Furthermore, requiring clearing members to
submit accurate and reliable prices limits risk to the clearinghouse by
ensuring that one clearing member can assume another's position in the
event of default. Over the past 10 years, ICE has gained extensive
experience with the clearing process--allowing ICE to grow its business
and reduce system risk by finding new markets and product to clear.
Over the next few months, the mandatory clearing and trading
provisions of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (Dodd-Frank) should take effect, and market participants will be
forced to clear OTC derivatives as a matter of law. ICE respectfully
submits that the regulators responsible for determining which contracts
must be cleared should consider any mandate very carefully. Many
contracts not cleared now are not cleared for good reasons. Some
markets have structural issues where illiquidity makes the contracts
difficult to price. Other markets have regulatory hurdles where two or
more regulators have different ideas on how the market should operate.
ICE generally supports the clearing principles of Dodd-Frank. ICE
believes, however, that the best path to meet this goal is to allow
clearinghouses and market participants to find the best way to clear
markets within defined principles, as opposed to promulgating
prescriptive rules for clearinghouses. Many of the proposed rules
attempt to design a perfect market. Attempts at such market design are
not very likely to work and may delay implementation of clearing
services. At the very worst, these efforts may destroy liquidity in
certain markets. The best way to quickly achieve the clearing
objectives of Dodd-Frank is to make sure those unnecessary regulatory
hurdles and other impediments are removed and to give clearinghouses
and market participants the freedom to create cleared OTC markets.
For example, one key regulatory hurdle to clearing is cooperation
between regulators. Many OTC derivatives, like CDS, have
characteristics of securities and commodities. Close regulatory
cooperation between the CFTC and SEC is necessary, and required by law,
in order to make sure that market participants have legal certainty.
This is particularly important in regards to portfolio margining--
allowing security-based and commodity-based derivatives to be held in
the same account and margined together. Historically, the CFTC and SEC
have had little success creating portfolio margining. After the
implementation of Dodd-Frank, the absence of a clear and economical
portfolio margining regime will discourage CDS clearing.
Regulation of Clearinghouses
Appropriate regulation of clearinghouses is of utmost importance to
the financial system. Pursuant to Dodd-Frank, clearinghouses will be a
key part of the efforts to decrease systemic risk in the derivatives
markets. In order to accomplish this important mission, clearinghouses
must be open and transparent, while exercising proper risk management
controls. However, given the scope, complexity and importance of the
OTC derivatives, ``one-size-fits-all'' regulation will not work.
Flexibility is important, because regulators must be able to anticipate
and respond to future problems--and not just yesterday's crises.
Prescriptive laws and regulations will hamper flexibility and create
regulatory gaps. To be flexible, regulators must be prudential,
understanding their markets and tailoring regulation to ensure market
integrity and consumer protection.
Regulators need clear lines of jurisdiction. Regulators need to
provide certainty that they have the power to take actions to uphold
the public good. Likewise, market participants need the certainty that
their business transactions will not be held to conflicting standards
of conduct. Further, regulatory certainty reduces the possibility of
regulatory arbitrage, or long-term damage to the U.S. financial sector
in a highly competitive global environment.
The need for certainty extends beyond U.S. borders. It is vital to
recognize that the OTC derivatives markets are global: most large
companies in the developed world use derivatives, and they conduct
these transactions with U.S. counterparties. Thus, U.S. regulators must
work with international regulators from a common set of regulatory
principles. Right now, Dodd-Frank has created significant uncertainty
over whether a transaction will be subject to U.S. regulation or
foreign regulation. This lack of clarity may begin to have an impact on
markets, drying up liquidity and hampering regulatory reform efforts
because market participants are unsure which laws apply. Therefore,
harmonizing regulatory systems across countries and giving market
participants is of utmost importance.
Timing of Implementation
Earlier this month, the CFTC and SEC held a roundtable to hear
views on the implementation of Dodd-Frank. Dodd-Frank's effective date
is July 16th or at least 60 days after a final rulemaking, if one is
required. As the CFTC and SEC have come to realize, the legislation
cannot (effectively or practically) take effect all at once.
ICE believes that regulators should pursue an aggressive timetable
to implement most sections of Dodd-Frank as soon as possible. While
Dodd-Frank requires an enormous effort from both market participants
and regulators, the cost of uncertainty is much higher. ICE has
suggested to regulators that they pursue a three-phase implementation
plan. Phase 1 would implement transparency initiatives, including the
important swap reporting and swap data repository regulations. Phase 2
would implement the mandatory clearing and trading requirements,
building on the transparency created by Phase 1. Phase 3 include
everything else, such as non spot month-position limits, which could
constrain the mandatory trading and clearing requirements. This
timeline is similar to what other organizations are suggesting, such as
the Managed Fund Association.
Flexibility is central to meeting these implementation goals.
Regulators have an immense burden to implement Dodd-Frank. Creating a
one-size-fits-all prescriptive system of regulations will only increase
that burden, as regulators will be required to continually consider
exemptions for markets that do not quite fit the regulator's model.
Likewise, market participants will have an easier time meeting
implementation goals if they have the freedom to meet the goals of
Dodd-Frank without radically changing their operations to meet
prescriptive rules.
Conclusion
ICE has always been and continues to be a strong proponent of open
and competitive markets, and of appropriate regulatory oversight of
those markets. As an operator of global futures and OTC markets, and as
a publicly held company, ICE understands the importance of ensuring the
utmost confidence in its markets. To that end, we have continuously
worked with regulatory bodies in the U.S. and abroad in order to ensure
that they have access to all relevant information available to ICE
regarding trading and clearing activity on our markets. We have also
worked closely with Congress and regulators at home and abroad to
address the evolving regulatory challenges presented by derivatives
markets and will continue to work cooperatively for solutions that
promote the best marketplace possible.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
______
PREPARED STATEMENT OF TERRENCE A. DUFFY
Executive Chairman, CME Group Inc.
May 25, 2011
Chairman Reed, Ranking Member Crapo, Members of the Subcommittee,
thank you for the opportunity to respond to the Subcommittee's
questions respecting clearing of swap contracts. I am Terry Duffy,
Executive Chairman of CME Group (``CME Group'' or ``CME''), which is
the world's largest and most diverse derivatives marketplace. CME Group
includes four separate exchanges--Chicago Mercantile Exchange Inc., the
Board of Trade of the City of Chicago, Inc., the New York Mercantile
Exchange, Inc., and the Commodity Exchange, Inc. (together ``CME Group
Exchanges''). The CME Group Exchanges offer the widest range of
benchmark products available across all major asset classes, including
futures and options based on interest rates, equity indexes, foreign
exchange, energy, metals, agricultural commodities, and alternative
investment products. CME also includes CME Clearing, a derivatives
clearing organization (DCO) and one of the largest central counterparty
clearing services in the world; it provides clearing and settlement
services for exchange-traded contracts, as well as for over-the-counter
(OTC) derivatives transactions through CME Clearing and CME
ClearPort'.
The CME Group Exchanges serve the hedging, risk management and
trading needs of our global customer base by facilitating transactions
through the CME Globex' electronic trading platform, our
open outcry trading facilities in New York and Chicago, as well as
through privately negotiated transactions executed in compliance with
the applicable Exchange rules and cleared by CME's clearinghouse. In
addition, CME Group distributes real-time pricing and volume data
through a global distribution network of approximately 500 directly
connected vendor firms serving approximately 400,000 price display
subscribers and hundreds of thousands of additional order entry system
users. CME's proven high reliability, high availability platform
coupled with robust administrative systems represent vast expertise and
performance in managing market center data offerings.
The financial crisis focused well-warranted attention on the lack
of regulation of OTC financial markets. We learned a number of
important lessons and Congress crafted legislation designed to reduce
the likelihood of a repetition of that disaster. However, it is
important to emphasize that regulated futures markets and futures
clearinghouses operated flawlessly. Futures markets performed all of
their essential functions without interruption and, despite failures of
significant financial firms, our clearinghouse experienced no default
and no customers on the futures side lost their collateral or were
unable to immediately transfer positions and continue managing risk.
Dodd-Frank was adopted to impose a new regulatory structure on a
previously opaque and unregulated market--the OTC swaps market. It was
not intended to engineer a new regulatory regime for the already
robustly regulated futures markets.
For example, while Congress granted the Commodity Futures Trading
Commission (CFTC or Commission) the authority to adopt rules respecting
Core Principles, it did not direct it to eliminate principles-based
regulation. Yet the Commission has proposed specific requirements for
multiple Core Principles--almost all Core Principles in the case of
designated contract markets (DCMs) and DCOs--which would eviscerate the
principles-based regime that has fostered the ability of CFTC-regulated
entities to effectively manage risk for the past decade.
We support the overarching goals of DFA to reduce systemic risk
through central clearing and exchange trading of derivatives, to
increase data transparency and price discovery, and to prevent fraud
and market manipulation. Unfortunately, DFA left many important issues
to be resolved by regulators with little or ambiguous direction and set
unnecessarily tight deadlines on rulemakings by the agencies charged
with implementation of the Act. We have concerns about many of these
proposed rulemakings, about which we have previously provided written
testimony to the Senate Banking Committee and other committees of this
Congress. For purposes of this hearing, we will focus on the following
five questions posed to us by this Subcommittee:
1. What issues may affect the safety and soundness of
clearinghouses, and how should those issues be mitigated?
2. What are the similarities and differences with other cleared
products that should be considered when establishing
clearinghouses for swaps?
3. Are there unique attributes of certain asset classes that should
be highlighted when considering adopting a clearing paradigm?
How about unique attributes of certain market participants?
4. What best practices should be considered regarding ownership,
governance, or control of derivatives clearinghouses?
5. What structural and economic barriers affect access to swap
clearing? What must be done to eliminate or reduce those
barriers?
Question 1. What issues may affect the safety and soundness of
clearinghouses, and how should those issues be mitigated?
The safety and soundness of clearinghouses is a major focus of
Dodd-Frank. The Core Principles for derivative clearinghouses compel
DCOs to have adequate financial resources, comprehensive risk
management procedures and safeguards against system failures. In
addition, Dodd-Frank includes eight additional Core Principles dealing
with the safety and soundness of derivative clearinghouses. Moreover,
the CFTC has been granted increased power to force a derivative
clearinghouse to alter a procedure or implement a new procedure if it
is not in compliance with the Core Principles, without the procedural
steps previously required. The rigid rules being proposed by the CFTC
with respect to risk management are unnecessary and destructive of
innovation and competition. Such a prescriptive set of requirements
will force clearinghouses into a rigid methodology for managing risk
and inhibit the ability of individuals best positioned to adapt risk
management methodologies to changing circumstances. The end result of
this would be to increase, rather than reduce risk.
CME Group appreciates the importance to the broader financial
system of a regulatory regime designed to ensure that every DCO can
perform its role as a central counterparty, including performance of
its financial obligations during periods of market stress. In that
regard, the Commission's DCO Core Principles have functioned admirably
and effectively over the years, including during the 2008 financial
crisis. CME Group can support regulations that enhance the Commission's
existing core principle system, if they strike a responsible balance
between establishing general prudential standards and prescriptive
requirements.
On March 21, 2011, CME Group, by its CEO Craig Donohue, filed a
detailed 17-page letter commenting on an additional set of CFTC risk
management requirements for clearinghouses. The letter, which will not
be repeated here, may be accessed at http://comments.cftc.gov/
PublicComments/ViewComment.aspx?id=31993&SearchText=. CME's position on
this issue can be summarized as follows:
The Commission's Notice of Proposed Rulemaking addresses the
critically important topic of risk management practices at
DCOs. Greater use of DCOs for OTC derivatives heightens the
importance of ensuring that risk management at every DCO is
robust and comprehensive. The unique risk characteristics of
OTC derivatives products and markets underscore the importance
of DCOs retaining reasonable discretion and flexibility to
adapt risk management practices as products and markets develop
over time.
Risk management is not an assembly line type of process that
can be commoditized, codified and deployed in such a way as to
ensure that risk management regimes of DCOs remain prudent and
agile. Indeed, very few aspects of risk management can be
standardized across all cleared markets to such an extent that
a rules-based regime can describe each potential condition that
can arise and the necessary actions that can and should be
taken to mitigate risk. CME Group is therefore very concerned
that certain provisions in the proposed regulations would
diminish CME Clearing's ability to effectively manage risk by
requiring each DCO to employ the same rigid, standardized risk
management procedures.
Consistent with the CFTC's approach in a number of other
rulemakings, regulations proposed in the NPR further the CFTC's
retraction of the highly successful principles-based regime
that has permitted U.S. futures markets to prosper as an engine
of economic growth for this Nation, to a restrictive, rules-
based regime that will stifle growth, innovation, and
flexibility in risk management. As we have noted in comment
letters in response to other proposals, Congress not only
preserved principles-based regulation in the Dodd-Frank Act, it
reinforced the vitality of that regime by expanding the list of
core principles applicable to DCOs. Although DFA granted the
CFTC the authority to adopt regulations with respect to core
principles, it did not direct the CFTC to eliminate principles-
based regulation. Rather, DFA made clear that DCOs were granted
reasonable discretion in establishing the manner in which they
comply with the Core Principles.
Furthermore, certain of the proposed prescriptive regulations
would impose significant costs not only on DCOs and their
clearing members, but on the CFTC, with little or no
corresponding regulatory benefit. In that regard, CME Group is
very concerned that the CFTC has not performed the required
cost/benefit analyses with respect to the rulemaking proposals
in the NPR. Aside from certain information provided in
connection with recordkeeping and reporting requirements, the
``cost/benefit analysis'' with regard to the regulations
proposed in connection with the Core Principles consists of
little more than the following two assertions: (1) ``With
respect to costs, the Commission has determined that the costs
to market participants and the public if these regulations are
not adopted are substantial''; and (2) ``With respect to
benefits, the Commission has determined that the benefits of
the proposed rules are many and substantial''. In requiring the
CFTC to consider costs and benefits of its proposed actions,
Congress requires an actual and concrete estimate of costs of
agency action. The mere uncertainty of cost estimates does not
excuse the CFTC from issuing such an estimate.
The performance of actual and concrete cost/benefit analyses is
particularly important for any regulator proposing to adopt
regulations that would increase the costs of central clearing
of OTC derivatives.
One of the CFTC proposals which causes us great concern is the
CFTC's proposal to establish lower financial resource requirements for
nonsystemically important DCOs, an approach we believe will exacerbate
rather than ameliorate systemic risk. The CFTC relies on Title VIII of
Dodd-Frank in proposing Regulation 39.29, which would require a DCO
that is deemed systemically important (a SIDCO) to comply with
substantially different and higher financial resources requirements
than any DCO that the Financial Stability Oversight Council does not
designate as systemically important. As proposed, Regulation 39.29
would: (1) require a SIDCO to maintain financial resources sufficient
to meet its financial obligations notwithstanding a default by the two
clearing members creating its largest financial exposures; (2) limit a
SIDCO's use of assessment powers to cover financial resources
requirements relating to a default by the clearing member creating its
second largest financial exposure; and (c) for purposes of valuing its
assessment powers, require a SIDCO to apply the same 30-percent haircut
and 20-percent post-haircut cap on assessments as proposed for
nonsystemically important DCOs in Regulation 39.11(d).
Any regulation should subject all DCOs to the same substantive
financial resources requirements, and subject systemically important
DCOs to more frequent stress testing and reporting requirements. We
believe this approach is better designed to achieve Dodd-Franks'
objectives of promoting robust risk management, promoting safety and
soundness, reducing systemic risk and supporting the broader financial
system.
Setting a lower bar for nonsystemically important DCOs with regard
to financial resources requirements (and, presumably, for certain other
DCO core principles, including Core Principle D regarding risk
management) would allow those DCOs to offer lower guaranty fund and
margin requirements. In addition to putting SIDCOs at an unfair
competitive disadvantage, this approach would likely attract additional
volume to at least some nonsystemically important DCOs and transform
them into de facto SIDCOs. However, until such time as they were
designated SIDCOs by the Council and given sufficient time to come into
compliance with the higher requirements for SIDCOs, they would be
operating under the lower and less costly standards for nonsystemically
important DCOs. This would contravene Title VIII's stated objectives of
promoting robust risk management, promoting safety and soundness,
reducing systemic risk and supporting the broader financial system.
CME Group therefore urges that all DCOs be subject to the same
substantive financial resources requirements. We suggest that, rather
than adopting Regulation 39.29 as proposed, the Commission should adopt
a regulation that subjects SIDCOs to more frequent stress testing and
reporting requirements than any DCOs the Council does not designate as
systemically important. For example, a SIDCO might be required to
conduct bi-monthly stress tests of its ability to cover its default
obligations (rather than monthly stress testing, as proposed for all
DCOs), and to submit to the Commission the reports required under
proposed Regulation 39.11(f) on a monthly basis (rather than a
quarterly basis, as proposed for all DCOs). This alternative approach
comports with the Council's recent statement that systemically
important financial market utilities should be ``subject to enhanced
examination, supervision, enforcement and reporting standards and
requirements.''
CME Group is a staunch supporter of robust and comprehensive risk
management practices throughout the cleared derivatives markets. As
further explained below, we are supportive of those aspects of the
proposed regulations that seek to implement appropriate and cost-
effective measures to build upon the principles-based regime the CFTC
has overseen in recent years and that performed admirably during the
recent financial crisis. It is that regime that should be extended to
the cleared swaps markets, and not an untested rules-based regime that,
at least in part, appears to be based upon arbitrary assumptions and
rigid concepts about how DCOs should manage risk.
Question 2. What are the similarities and differences with other
cleared products that should be considered when establishing
clearinghouses for swaps?
If a swap contract and a futures contract have similar volatility
and trade in a mature, liquid market, which should be the case for the
major plain vanilla swaps, the considerations for clearing the
contracts are identical. Thinly traded swaps present more difficult
management processes, which our clearinghouse aims to overcome through
its admission and risk management processes.
This similarity between swaps and futures for a large part of the
OTC market counsels in favor of adopting the clearing rules that have
worked so successfully in futures markets. Indeed, a focus of Dodd-
Frank is to bring the OTC swaps market into a regulatory scheme similar
to that which allowed the futures markets to function flawlessly
throughout the financial crisis. If the CFTC and the SEC are to meet
the goals of Dodd-Frank to transition from the world of unregulated,
uncleared OTC trading to a world more nearly approximating the highly
successful futures model clearing, they should adhere to the principles
which have already proven effective in the management of risk. Instead,
the proposed clearing rules require a significant, untested, and costly
revision of an approach that has proved successful in the futures model
and require that this new model be implemented in an impossibly short
time frame.
For example, it does not make sense to impose an entirely new
regime for segregation of customer assets for swap clearing, which will
impose significant costs on participants and undermine efficient risk
mitigation, when the existing model of futures clearing has provided
100 percent protection against loss due to customer default. In its
Advanced Notice of Proposed Rulemaking (ANPR), however, regarding
segregation of customer funds, the Commission notes that it is
considering imposing an ``individual segregation'' model for customer
funds belonging to swaps customers. A Notice of Proposed Rulemaking on
this subject is forthcoming and appears to impose a form of
``individual segregation'' model for swaps clearing but not for futures
clearing. Such a model would impose unnecessary costs on derivatives
clearing organizations (DCOs) and customers alike. As noted in the
ANPR, DCOs have long followed a model (the ``baseline model'') for
segregation of collateral posted by customers to secure contracts
cleared by a DCO whereby the collateral of multiple futures customers
of a futures commission merchant (FCM) is held together in an omnibus
account. If the FCM defaults to the DCO because of the failure of a
customer to meet its obligations to the FCM, the DCO is permitted (but
not required), in accordance with the DCO's rules and CFTC regulations,
to use the collateral of the FCM's other futures customers in the
omnibus account to satisfy the FCM's net customer futures obligation to
the DCO. Under the baseline model, customer collateral is kept separate
from the property of FCMs and may be used exclusively to ``purchase,
margin, guarantee, secure, transfer, adjust or settle trades, contracts
or commodity option transactions of commodity or option customers.'' A
DCO may not use customer collateral to satisfy obligations related to
an FCM's proprietary account.
In its ANPR, the Commission suggests the possibility of applying a
different customer segregation model to collateral posted by swaps
customers, proposing three separate models, each of which requires some
form of ``individual segregation'' for customer cleared-swap accounts.
Each of these models would severely limit the availability of other
customer funds to a DCO to cure a default by an FCM based on the
failure of a customer to meet its obligations to the DCO. The
imposition of any of these alternative models first, is outside of the
Commission's authority under DFA and second, will result in significant
and unnecessary costs to DCOs as well as to customers--the very
individuals such models are allegedly proposed to protect.
CME Group recognizes that effective protection of customer funds is
critical to participation in the futures and swaps markets. This fact
does not, however, call for a new segregation regime. The baseline
model has performed this function admirably over the years, with no
futures customers suffering a loss as a result of an FCM's bankruptcy
or default. There is no reason to believe it will not operate as well
in the swaps market. DFA did nothing to change this segregation regime
as applied to futures, and as noted above, a focus of DFA is to bring
the OTC swaps market into a regulatory scheme similar to that which
allowed the futures markets to function flawlessly throughout the
financial crisis. To this end, it is unreasonable to believe that
Congress would intend to require a different scheme of segregation of
customer funds and as a result, a different margining and default model
than that currently used in the futures markets. Imposing such a
conflicting model would complicate the function of DCOs intending to
clear both futures and swaps. Indeed, the statutory language adopted in
Section 724 of DFA does nothing to compel such a result.
The imposition of a different customer segregation system could
undermine the intent behind DFA by imposing significantly higher costs
on customers, clearing members, and DCOs intending to clear swaps and
injecting moral hazard into a system at the customer and FCM levels. A
change from the baseline model would interfere with marketplace and
capital efficiency as DCOs may be required to increase security
deposits from clearing members. That is, depending on the exact
methodology employed, DCOs may be forced to ask for more capital from
clearing members. Based on CME Group's initial assessments, these
increases in capital requirements would be substantial. For example,
CME Group's guarantee fund would need to double in size. Aside from
these monetary costs, adoption of a segregation model would create
moral hazard concerns at the FCM level. That is, the use of the new
proposed models could create a disincentive for an FCM to offer the
highest level of risk management to its customers (if the oversight and
management of individual customer risk was shifted to the
clearinghouse) and continue to carry the amount of excess capital they
do today.
Imposition of the suggested systems could increase costs and
decrease participation in the CFTC-regulated cleared-swaps market
because customers may be unable or unwilling to satisfy resultant
substantially increased margin requirements. FCMs would face a variety
of increased indirect costs, such as staffing costs, new systems and
compliance and legal costs and direct costs such as banking and
custodial fees. FCMs would likely, in turn, pass these costs on to
customers. Additionally, smaller FCMs may be forced out of business,
larger FCMs may not have incentive to stay in business, and firms
otherwise qualified to act as FCMs may be unwilling to do so due to the
risk and cost imposed upon the FCM model by individualized segregation.
This could lead to a larger concentration of customer exposures at
fewer FCMs, further increases to margin and guarantee fund
requirements, and further increased costs to customers. All of these
consequences would lead to decreased participation in U.S. futures and
swaps exchanges and result in loss of jobs in the United States.
Question 3. Are there unique attributes of certain asset classes that
should be highlighted when considering adopting a clearing
paradigm? How about unique attributes of certain market
participants?
As noted above, a thorough understanding of the liquidity and other
characteristics of the market for a swap in normal and stressed
circumstances is the key to safety and soundness in clearing. Different
swaps with different liquidity and other varied characteristics, put
simply, carry with them different risks. Interest rate swaps based on
U.S., UK, and EU instruments should be easy to liquidate in the event
of a default as are futures on U.S. debt or Eurodollars. Single name
credit default swaps are expected to require an elaborate preset
process and direct participation for clearing members.
These differences in swaps, as well as the simple fact that Dodd-
Frank imposes a brand new clearing regime on the OTC swaps market,
counsels in favor of a slow phasing-in of swap clearing. The
Commission's proposed rules for mandatory clearing and trading of swaps
should be revised to stage the transition from the existing market
structure so that the participants may make the technical and
documentary changes necessary to avoid technological and legal risks.
We believe that the following template will make the transition to
clearing swaps under DFA the quickest, least costly and most complete
and effective.
Stage 1: Continued Voluntary Clearing.
The Commission's first action must be to avoid impairment
of the current successful clearing process for swaps and swaps
converted to futures.
The Commission should promptly make the requisite finding,
pursuant to Section 5c(b), that a DCO, which is clearing swaps
as of the effective date of DFA, will be permitted to continue
clearing swaps of the same class and will also be permitted to
clear any swap that is economically equivalent to any futures
contract that it was clearing prior to the DFA effective date.
The Commission should approve the collateral and risk
management practices and procedures that were in place as of
the DFA effective date pending further notice. This means that
the traditional form of customer segregation must continue and
any of the proposed alternatives to limit or eliminate fellow-
customer risk must be delayed until all of the remaining stages
for implementing mandatory clearing have been approved. DCOs
must be permitted to operate pursuant to the Core Principles,
as amended by DFA, during this period.
The CFTC should also demonstrate that it will abide by its
commitment to preserve the cross margining benefits currently
available to the users of ClearPort. The Commission should
adopt a regulation that treats any ClearPort product that is
cleared as a future as of the DFA effective date, but which is
subsequently cleared as a swap, as entitled to be carried in a
4d account with customer futures contracts.
Stage 2: Mandatory Clearing of Certain Dollar Denominated Swaps.
Promptly after the effective date of DFA, the Commission
should make an initial determination, pursuant to CEA section
2(h)(2)(A)(i), that all U.S. dollar denominated swaps that are
structurally and economically equivalent to swaps that are
being cleared by a DCO or ICE Trust as of the DFA effective
date are subject to the mandatory clearing requirement. This
determination, if it becomes final, will subject more than 60
percent of the swaps market--that has not been exempted from
the defined term by the Department of Treasury--to mandatory
clearing. Next, ``the Commission shall provide at least a 30-
day public comment period regarding any determination made
under clause (i).'' Section 2(h)(2)(A)(ii)
At this point, section 2(h) provides a clear path for
anyone who objects to the finding to make its views known and
to invoke an additional review process by the Commission,
taking into account the factors described in section 2(h). The
review process should be staged so that final determinations
are made first for the highest volume swaps.
The Commission should not adopt differing start dates for
different classes of traders for mandatory clearing of
particular types of swaps.
This proposal will (i) preserve customer choice in
clearing, (ii) bring the largest volume of swaps into
clearinghouses as soon as possible, and (iii) allocate the
Commission's resources in an efficient manner.
Stage 3: Reconsider and Repropose Regulations Respecting the Operation
of DCOs.
Do not deviate from the Core Principles regulatory regime
without cause.
Do not change the method of customer segregation without
cause (as further discussed above).
Stage 4: Registration of SEFs.
Finalize rules respecting the structure and operation of
SEFs.
Allow an adequate number of days for SEFs to become
operational and to test connections to DCOs, SDRs, and
customers.
Implement mandatory trading requirement.
Stage 5: Mandatory Clearing of Dollar Denominated Swaps Listed for
Clearing Post DFA Effective Date.
Stage 6: Mandatory Clearing of Swaps Denominated in G7 Currencies.
Question 4. What best practices should be considered regarding
ownership, governance, and control of derivatives
clearinghouses?
The extensive rules proposed by the CFTC respecting ownership,
governance and control of derivative clearinghouses can and should wait
until there is evidence that the specific limitations in Dodd-Frank do
not adequately control the potential problem. The Core Principles for
derivative clearinghouses are clear, comprehensive and easily shaped
and enforced by the Commission on an as necessary basis. Section 5b of
the CEA specifically insures: fairness respecting participant and
product eligibility, appropriate governance fitness standards,
prevention of conflicts of interest and appropriate composition of
governing boards. The CFTC drafted these provisions. In the event that
Dodd-Frank does prove insufficient, which is highly unlikely, the
Commission could consider drafting ``best practices'' or safe harbors
for ownership, governance, and control rather than extremely
prescriptive measures like those in the proposed rules.
The Commission's proposed rules regarding the mitigation of
conflicts of interest in DCOs, DCMs and SEFs (Regulated Entities)
exceed its rulemaking authority under DFA and impose constraints on
governance that are unrelated to the purposes of DFA or the CEA.
Section 726 conditions the Commission's right to adopt rules mitigating
conflicts of interest to circumstances where the Commission has made a
finding that the rule is ``necessary and appropriate'' to ``improve the
governance of, or to mitigate systemic risk, promote competition, or
mitigate conflicts of interest in connection with a swap dealer or
major swap participant's conduct of business with, a [Regulated Entity]
that clears or posts swaps or makes swaps available for trading and in
which such swap dealer or major swap participant has a material debt or
equity investment.'' The ``necessary and appropriate'' requirement
constrains the Commission to enact rules that are narrowly tailored to
minimize their burden on the industry. The proposed rules are not
narrowly tailored but rather overbroad, outside of the authority
granted to it by DFA and needlessly burdensome.
The Commission proposed governance rules and ownership limitations
that affect all Regulated Entities, including those in which no swap
dealer has a material debt or equity investment and those that do not
even trade or clear swaps. Moreover, the governance rules proposed have
nothing to do with conflicts of interest, as that term is understood in
the context of corporate governance. Instead, the Commission has
created a concept of ``structural conflicts,'' which has no recognized
meaning outside of the Commission's own declarations and is unrelated
to ``conflict of interest'' as used in the CEA. The Commission proposed
rules to regulate the ownership of voting interests in Regulated
Entities by any member of those Regulated Entities, including members
whose interests are unrelated or even contrary to the interests of the
defined ``enumerated entities.'' In addition, the Commission is
attempting to impose membership condition requirements for a broad
range of committees that are unrelated to the decision making to which
Section 726 was directed.
The Commission's proposed rules are most notably overbroad in that
they address not only ownership issues but the internal structure of
public corporations governed by State law and listing requirements of
SEC regulated national securities exchanges. More specifically, the
proposed regulations set requirements for the composition of corporate
boards, require Regulated Entities to have certain internal committees
of specified compositions and even propose a new definition for a
``public director.'' Such rules in no way relate to the conflict of
interest Congress sought to address through Section 726. Moreover,
these proposed rules improperly intrude into an area of traditional
State sovereignty. It is well established that matters of internal
corporate governance are regulated by the States, specifically the
State of incorporation. Regulators may not enact rules that intrude
into traditional areas of State sovereignty unless Federal law compels
such an intrusion. Here, Section 726 provides no such authorization.
Perhaps most importantly, the proposed structural governance
requirements cannot be ``necessary and appropriate,'' as required by
DFA, because applicable State law renders them completely unnecessary.
State law imposes fiduciary duties on directors of corporations that
mandate that they act in the best interests of the corporation and its
shareholders--not in their own best interests or the best interests of
other entities with whom they may have a relationship. As such,
regardless of how a board or committee is composed, the members must
act in the best interest of the exchange or clearinghouse. The
Commission's concerns--that members, enumerated entities or other
individuals not meeting its definition of ``public director'' will act
in their own interests--and its proposed structural requirements are
wholly unnecessary and impose additional costs on the industry--not to
mention additional enforcement costs--completely needlessly.
Question 5. What structural and economic barriers affect access to swap
clearing? What must be done to eliminate or reduce those
barriers?
An end user of swaps with sufficient credit and resources to enter
into a swap will experience no barrier to clearing under Dodd-Frank. A
firm that seeks to act as a clearing member of a swaps clearinghouse
must meet the operational and financial requirements of that
clearinghouse, which should be set sufficiently high to meet the
clearinghouse's obligations under Dodd-Frank's Core Principles for
DCOs. Dodd-Frank's requirements regarding safety and soundness modify a
clearinghouse's obligation to grant open access to any potential
clearing member. The issues of managing a default involving an immature
or illiquid swap contract require higher admission standards than for a
futures clearinghouse.
The Commission's proposed rules regarding submissions by DCOs
seeking approval to clear swaps may, however, provide a barrier to
access to clearing simply because they impose extreme difficulty and
expense on a DCO seeking to clear a given swap. The proposed
regulations treat an application by a DCO to list a particular swap for
clearing as obliging that DCO to perform due diligence and analysis for
the Commission respecting a broad swath of swaps, as to which the DCO
has no information and no interest in clearing. In effect, a DCO that
wishes to list a new swap would be saddled with the obligation to
collect and analyze significant amounts of information to enable the
Commission to determine whether the swap that is the subject of the
application and any other swap that is within the same ``group,
category, type, or class'' should be subject to the mandatory clearing
requirement.
The proposed regulation eliminates the possibility of a simple,
speedy decision on whether a particular swap transaction can be
cleared--a decision that the DFA surely intended should be made quickly
in the interests of customers who seek the benefits of clearing--and
forces a DCO to participate in an unwieldy, unstructured, and time-
consuming process to determine whether mandatory clearing is required.
Regulation Section 39.5(b)(5) starkly illustrates this outcome. No
application is deemed complete until all of the information that the
Commission needs to make the mandatory clearing decision has been
received. Completion is determined in the sole discretion of the
Commission. This proposed regulation is one among several proposals
that imposes costs and obligations whose effect and impact are contrary
to the purposes of Title VII of DFA. The costs in terms of time and
effort to secure and present the information required by the proposed
regulation would be a significant disincentive to DCOs to voluntarily
undertake to clear a ``new'' swap. This process to enable an exchange
to list a swap for clearing is clearly contrary to the purposes of DFA.
Thank you for allowing us to respond to these important questions.
______
PREPARED STATEMENT OF BENN STEIL
Senior Fellow and Director of International Economics, Council on
Foreign Relations
May 25, 2011
Thank you Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee for the opportunity to present to you this morning my
views on the important subject of derivatives clearing.
The collapse of Lehman Brothers and AIG in September of 2008
highlighted the importance of regulatory reforms that go beyond trying
to prevent individual financial institutions from failing. We need
reforms that act to make our markets more resilient in the face of such
failures--what engineers and risk managers call ``safe-fail''
approaches to risk management. Well capitalized and regulated central
derivatives clearinghouses to track exposures, to net trades and to
novate them, to collect proper margin on a timely basis, and to absorb
default risk have historically provided the best example of successful
``safe-fail'' risk management in the derivatives industry.
Compare the collapse of the large hedge fund Amaranth in 2006 with
the collapse of AIG in 2008. Both were laid low by derivatives
exposures. Yet whereas the failure of Amaranth caused barely a ripple
in the markets, owing to its exposures having been in centrally cleared
exchange-traded natural gas futures contracts, the failure of AIG
precipitated justifiable concerns of widespread market contagion that
ultimately required a massive and enormously controversial Government
intervention and bailout to contain. Had AIG been building derivatives
exposures on-exchange rather than in the OTC markets, its reckless
speculation would have been brought to a halt much earlier owing to
minute-by-minute exposure tracking in the clearinghouse and unambiguous
mark-to-market and margining rules. The long, drawn-out wrangling
between AIG and Goldman Sachs over the collateral required to cover
AIG's deteriorating derivatives positions would never have been
possible had a clearinghouse stood between the two. Furthermore, AIG's
net exposures in the marketplace would not have been the subject of
rumor or surmise, but a simple matter of record at the clearinghouse.
Encouraging a shift in derivatives trading from OTC markets without
central clearing to organized, Government-regulated markets with
central clearing is challenging, however, for two major reasons.
First, the dealers that dominate the OTC derivatives business have
no incentive to accommodate such a shift. Dealers earn approximately
$55 billion in annual revenues from OTC derivatives trading. Some of
the largest earn up to 16 percent of their revenues from such trading.
The movement of such trading onto exchanges and central clearinghouses
has the potential to widen market participation significantly, to
increase the transparency of prices, to reduce trading costs through
the netting of transactions, and in consequence to reduce the trading
profits of the largest dealers materially. It is natural, therefore,
that dealers should resist a movement in trading activity onto
exchanges and clearinghouses. Where compelled by regulation to
accommodate it, dealers can also be expected to take measures to
control the structure of, and limit direct access to, the clearing
operations. The use of measures such as unnecessarily high capital
requirements in order to keep smaller competitors or buy-side
institutions from participating directly as clearinghouse members are
to be expected.
Indeed, trading infrastructure providers organized as exclusive
mutual societies of major banks or dealers have a long history of
restricting market access. For example, in the foreign exchange
markets, the bank-controlled CLS settlement system has long resisted
initiatives by exchanges and other trading service providers to prenet
trades through a third-party clearing system prior to settlement. Such
netting would significantly reduce FX trading costs for many market
participants, but would also reduce the settlement revenues generated
by CLS and reduce the trade intermediation profits of the largest FX
dealing banks. Other settlement service providers such as DTCC have no
incentive to offer competition to CLS, as they are owned by the very
same banks. There are therefore solid grounds for regulators to apply
basic antitrust principles to the clearing and settlement businesses in
order to ensure that market access is not being unduly restricted by
membership or ownership limitations that cannot be justified on safety
and soundness grounds.
Second, some types of derivatives contracts do not lend themselves
to centralized clearing as well as others. Customized contracts, or
contracts which are functionally equivalent to insurance contracts on
rare events, are examples. Since it can be difficult for policy makers
or regulators to determine definitively whether given contracts--new
types of which are being created all the time--are well suited for
central clearing, it is appropriate to put in place certain basic
trading regulations in the OTC markets that will serve both to make
such trading less likely to produce another AIG disaster and to
encourage the movement of trading in suitable products onto central
clearinghouses. Two such measures would be to apply higher regulatory
capital requirements for noncleared trades, in consequence of the
higher counterparty risk implied by such trades, and to mandate trade
registration and collateral management by a regulated third party, such
as an exchange.
In establishing the regulatory standards for the clearing of
derivatives transactions, it is imperative for lawmakers and regulators
to be fully conscious of the fact that the derivatives market is
effectively international, rather than national, and that it is
exceptionally easy for market participants to change the legal domicile
of their trading activities with a keystroke or a simple change of
trading algorithm. In this regard, I would highlight two important
areas of concern.
First, the three major world authorities controlling the structure
of the derivatives clearing business--the SEC, the CFTC, and the
European Commission--each take a very different view of the matter.
Historically, the SEC has applied what I would term the ``utility''
model to the industry, the CFTC has applied what I would term the
``silo'' model, and the European Commission has applied what I would
term the ``spaghetti'' model. The broad benefits of each are depicted
in the matrix below.
The SEC's utility model favors institutions operated outside the
individual exchanges; in particular the DTCC in the equity markets and
the OCC in the options markets. This approach has generally performed
well in terms of safety and soundness, and in encouraging competition
among exchanges. It performs poorly, however, in terms of encouraging
innovation in clearing and settlement services.
The CFTC's silo model allows the individual exchanges to control
their own clearinghouses. This approach has also performed well in
terms of safety and soundness. The recent decision of the CME to raise
margin requirements on silver trading is evidence of the model working
well, in terms of the exchange placing a premium on the integrity and
solvency of its clearing operations rather than trying to maximize
short-term speculative trading volumes. The CFTC's model also
encourages innovation in product development in a way in which the
SEC's model does not. This is because CFTC-regulated futures exchanges
can capture the benefits of product innovation in terms of generating
trading volumes, whereas SEC-regulated options exchanges risk seeing
trading volumes in new products migrate to other exchanges, all of
which use clearing services provided by the OCC. The CFTC model, in
consequence, does not promote competition from new trading venues in
the same way that the SEC model does. It does, however, promote wider
direct market participation in clearing systems, as demutualized
exchanges have a commercial interest in expanding such access to buy-
side institutions that dealers normally want to exclude. This reduces
trading costs and expands market liquidity.
The European Commission's spaghetti model, enshrined in its so-
called ``Code of Conduct'' for the industry, compels the EU's
clearinghouses to interoperate with each other. It also encourages both
exchanges and clearinghouses to compete against each other. Like the
SEC's model, however, it can be expected to dampen incentives for
product innovation, as clearing competition makes it more difficult for
exchanges that own clearinghouses to maximize their trading and
clearing revenue returns on new product development. More importantly,
this model, I believe, is not conducive to ensuring safety and
soundness, as it encourages clearinghouses to cut margin requirements
and other prudential measures as a way to attract business from, or
prevent business from moving to, other clearinghouses. It also injects
a major element of operational risk into the business, in consequence
of each clearinghouse being vulnerable to failures of technology or
risk management in others.
On balance, I believe that the CFTC's model is the most appropriate
for the derivatives industry, and I believe that the unworkability of
the European Commission's spaghetti approach will ultimately oblige it
to move back in the CFTC's direction. Although the CFTC's approach does
not promote interexchange competition as directly as the SEC's model,
it is important to note that new competitors are, in fact, entering
into the futures business. ELX, founded in 2009, and NYPC, a recent
joint venture between the NYSE and the DTCC which facilitates cross-
margining of multiple products, are now competing with the CME in the
financial futures space.
The second point I would like to make regarding the global nature
of the derivatives trading industry is that certain measures to curb
speculative activity being debated here in Washington are highly likely
to push trading activity ``off exchange''--precisely the opposite of
Congress' intent. For example, a so-called Tobin Tax on futures
transactions at the level being discussed last year, 2 basis points
(0.02 percent), would be equivalent to over 400 times the CME
transaction fee on Eurodollar futures. It should go without saying that
a tax this large, relative to the current transaction fee on the
underlying contract, would push all of this trading off the CME and
into alternative jurisdictions.
Likewise, commodity market position limits, if not harmonized with
UK and other national authorities, will merely push such trading
outside the CFTC's jurisdiction. There is already an active regulatory
arbitrage on oil and natural gas futures between the CME's NYMEX
exchange, which trades such contracts under CFTC regulation, and the
Intercontinental Exchange (ICE), which trades such contracts under FSA
regulation in London. We have seen indications of movement in trading
from NYMEX to ICE in line with market perceptions of the likelihood of
such limits being imposed in the United States. In short, we must be
extraordinarily cautious not to undermine Congress' worthy goal of
bringing more derivatives trading under the purview of U.S.-regulated
exchanges and clearinghouses by inadvertently providing major market
participants incentives to do precisely the opposite.
Thank you, Mr. Chairman, for the opportunity to present my views
today on this important issue.
______
PREPARED STATEMENT OF CHESTER S. SPATT
Pamela R. and Kenneth B. Dunn Professor of Finance, Tepper School of
Business, Carnegie Mellon University
May 25, 2011
I am pleased and honored to have the opportunity to present my
views to the Senate Subcommittee on Securities, Insurance, and
Investment at its hearing today on ``Derivatives Clearinghouse:
Opportunities and Challenges.'' I am the Pamela R. and Kenneth B. Dunn
Professor of Finance at the Tepper School of Business at Carnegie
Mellon University, where I have been a faculty member since 1979. I
also served as the Chief Economist of the U.S. Securities and Exchange
Commission in Washington, DC, from July 2004 until July 2007. My
expertise as a faculty member includes such areas as trading
mechanisms, derivative securities, asset valuation, financial
regulation, and the financial crisis. In addition to my faculty
position my current affiliations include serving as a Research
Associate of the National Bureau of Economic Research, Senior Economic
Advisor to Kalorama Partners, and a member of both the Shadow Financial
Regulatory Committee and Financial Economists Roundtable. I also was
one of the founders and the second Executive Editor of the Review of
Financial Studies, which quickly emerged as one of the preeminent
journals in financial economics, as well as a Past President and
Program Chair of the Western Finance Association.
The changes in how our financial markets trade and clear derivative
securities and swaps that now are being implemented are fundamental to
the design of these markets. In the aftermath of the financial crisis
the focus on migrating standardized swaps and derivatives to clear
through central counterparties (CCPs) is a natural one and one to which
I am sympathetic as an attempt to reduce the contagion associated with
counterparty risk and make the structure of risk much more transparent.
However, it is unclear whether the extent of use of clearinghouses will
ultimately lead to a reduction in systemic risk in the event of a
future crisis. Additionally, it will be crucial to manage carefully the
risks within the clearinghouses. To the extent that risks or the fees
of the clearinghouse are lower compared to uncleared derivatives,
market participants could choose to increase their risk exposures. Of
course, it is important that the fees for holding uncleared derivatives
reflect economic costs and not be punitive to create artificial
concentration of risk within the clearinghouse and also that the
clearinghouse be sensitive to the incentives to dump transactions into
it that are not marked properly.
The clearinghouse structure is potentially subject to considerable
moral hazard as there is a strong incentive for market participants to
trade with weak counterparties (who may offer more favorable pricing),
subject to their eligibility to clear through a centralized
counterparty (CCP). However, at some point a CCP may not be willing to
clear contracts from a weak counterparty because of the risk associated
with the counterparty being unable to deliver on its dynamic margin
obligations on a going forward basis. Then the CCP would be subject to
serious counterparty risk. In situations where trading with weak
counterparties (and effectively with the CCP) is especially attractive
to other market participants, there is a greater risk exposure to the
overall economy. For this reason and also because of the concentration
of risk in the CCP, it is easy to anticipate that central clearing
actually could raise systemic risk substantially in the event of a
financial crisis.
A number of observers have emphasized the absence of clearinghouse
failures in the United States during the recent financial crisis. Of
course, not every potential financial crisis is the same with respect
to its causes, scale or transmission. Consequently, in my judgment we
can only take limited comfort for the future from the absence of
failure of a clearinghouse during the recent financial crisis. Indeed,
Federal Reserve Chairman Ben Bernanke attributed the lack of failure of
a clearinghouse during the financial crisis to ``good luck'' \1\ in a
speech at the recent Atlanta Federal Reserve Bank conference. Of
course, many institutions that were previously thought to be
essentially impervious and under various forms of Federal oversight
either did collapse or would have collapsed without massive Federal
guarantees (including Fannie Mae, Freddie Mac, AIG, Lehman Brothers,
Bear Stearns, Citigroup and Bank of America). It is generally
recognized that clearinghouses can fail, \2\ and indeed, a recent
editorial in the Wall Street Journal \3\ cited such relatively recent
failures as those in France in 1974, Kuala Lumpur (Malaysia) in 1984
and Hong Kong in 1987. The regulatory and supervisory system will
require much more of clearinghouses in the future than during the
recent financial crisis, potentially amplifying their vulnerability. In
his Atlanta Federal Reserve speech Chairman Bernanke summarized this
point as follows, ``As Mark Twain's character Pudd'nhead Wilson once
opined, if you put all your eggs in one basket, you better watch that
basket.'' Of course, this not only highlights the potential importance
of regulatory supervision of the clearinghouse, but also that
clearinghouses should be properly designed to limit their risk
exposure.
---------------------------------------------------------------------------
\1\ Speech at the Federal Reserve Bank of Atlanta conference on
April 4, 2011.
\2\ Roe, M., ``Derivatives Clearinghouses Are No Magic Bullet'',
Wall Street Journal, May 6, 2010.
\3\ ``Pudd'nhead Wilson in Washington'', Wall Street Journal
editorial, April 23-24, 2011, p. A14.
---------------------------------------------------------------------------
One of the challenges confronting the supervisor of the
clearinghouse is whether the clearinghouse could require the
possibility of a ``bailout'' to ward off failure. At hearings of the
Senate Banking Committee in mid-April CFTC Chairman Gary Gensler agreed
that the clearinghouses would not receive ``too big to fail''
guarantees or subsidies. Arguably, this is reflective of a political
environment, which is now quite unsympathetic to the use of such
guarantees. But this highlights the crucial importance of strong risk
management of the central counterparty to avoid the potential collapse
of a major clearinghouse in a financial crisis. While it's a delicate
balance, the importance of strong risk management potentially could be
even at the expense of other values, such as promoting more competitive
pricing of clearinghouse services.
A key role of the clearinghouse is to make trading entities
informationally insensitive to their specific counterparties. At the
same time, there is a danger of a potentially large increase in
systemic risk unless the risk is well managed by the clearinghouse,
because the clearinghouse is a risk management platform that
concentrates the risk in the economy. Thus, the governance of a
clearinghouse must reflect a strong incentive to control risk and
internalize the costs and benefits associated with alternative
collateral standards. Limiting greatly the role of trading firms in the
governance and promoting ``independent directors'' (who would lack the
incentives to focus on managing and minimizing the risk and perhaps in
some instances relevant experience) would create significant challenges
and even reluctance by trading firms to allocate capital to the
clearinghouse and back-stop the risks of the clearinghouse.
Mutualization of risk is essential to the success of a clearinghouse
model and affording protection against the ultimate risks being borne
by society in the form of ``too big to fail'' guarantees. Yet the
commentary of regulators focuses upon the more abstract notion of
``conflicts of interest'' in governance, without explicit focus on the
incentives to control the underlying risks that would arise in the
clearinghouse model. In light of this it is crucial that the governance
of the clearinghouse, including the composition of the Board and
especially the Risk Committee, reflect the importance that the broader
society places on the elimination of ``too big to fail'' guarantees. To
the extent policy makers choose to concentrate risk within a
clearinghouse, it is crucial that the risk management of the
clearinghouse mitigate the underlying systemic risk, including a strong
risk management structure and governance aligned with that goal.
Incentives are crucial to ensure that there is a reasonable attempt
to align the incentives of various parties. For example, in the event
of a crisis clearing members would potentially contribute financial and
human capital to the CCP. It would create incentive problems to absolve
smaller members of these duties (except for the limits related to their
underlying capital contribution) or to allow them to outsource these to
third parties whose incentives would not be aligned. It also is
important to ensure that in the event of a crisis that the clearing
members have funding available for their contingent capital
obligations--to the extent that individual CCPs are unable to monitor
their clearing members along such lines, it may be important for the
regulator to supervise this to avoid a default cascade that would
jeopardize the clearinghouse through a sequence of defaults. In fact,
it's important for the regulator to be sensitive to the complications
that arise from the incentives of a set of profit-maximizing
clearinghouses.
Analogously, regulators are focused upon ``access'' to the
clearinghouse by investing firms--but it is important to recognize that
this is not a traditional trading platform, but an organization in
which mutualization of risks by the membership is fundamental. Indeed,
members should be required to have appropriately high capital pledged
to protect the organization in that they are counterparties whose risk
is being accepted by the clearinghouse and indeed, the members become
the ultimate guarantors through the mutualization of risk.
The issue of ``direct access'' surfaces in a number of different
forms across markets--for example, requiring that orders be presented
through intermediaries would be a way to protect markets against
obvious errors in order presentation. Indeed, because of concerns about
``direct access'' in equity trading the SEC adopted a rule late last
year eliminating direct unfiltered customer access in the order
transmission process due to the systemic risk that would create for our
system of equity clearance and settlement. \4\
---------------------------------------------------------------------------
\4\ ``SEC Adopts New Rule Preventing Unfiltered Market Access'',
Press Release 2010-210, November 3, 2010. http://www.sec.gov/news/
press/2010/2010-210.htm; Also see, discussion in J. Angel, L. Harris,
and C. Spatt, 2011, ``Equity Trading in the 21st Century'', Quarterly
Journal of Finance, 1, 1-53.
---------------------------------------------------------------------------
Another crucial policy choice is whether the clearinghouse would
likely be a recipient of a bailout in the event of a failure in its
risk management. The strong political consensus against the possibility
of a bailout emphasizes the importance of strong risk management by the
clearinghouse and a governance system, including restrictions on access
through nonmembers and a board structure that makes risk management the
central priority. From an economist's perspective this highlights how
restricting direct access is a partial substitute for ``too big to
fail.'' \5\ Using governance and access (as compared to other
governmental regulatory tools) to enhance the competitiveness of
pricing of clearinghouse services comes at the cost of making a bailout
of the clearinghouse more likely.
---------------------------------------------------------------------------
\5\ Analogously, allowing the composition of directors to focus on
risk management incentives and expertise also is a substitute for ``too
big to fail.''
---------------------------------------------------------------------------
The analogy between risk management for a swaps clearinghouse and
that for the clearinghouse for a payments system is striking. In the
payment systems context my colleague Marvin Goodfriend [1990] writes,
\6\ ``[I]t was efficient for private clearinghouses before the Fed to
limit their membership to a relatively exclusive core of banks,
allowing other banks access to the clearing system through agent-member
banks. This suggests that it is efficient for the Fed to restrict
direct access to its national clearing system as well, both to protect
Fed lending generated in the payments systems and to protect the
interbank credit market.'' Goodfriend [1990] also observes that it is
valuable ``to restrict direct access to its national clearing system as
well, to protect Fed daylight overdrafts and the interbank credit
market.'' In the context of a derivatives and swaps clearinghouse
restriction on direct access by nonmembers leads to a system in which
the clearinghouse members are responsible to protect the integrity of
the clearinghouse. In that sense restrictions on direct access help
assure financial stability and protect society against bearing greater
costs from implicit ``too big to fail'' guarantees for the
clearinghouse. If the clearinghouse member has strong incentives to
monitor its customers, by imposing much of the risk created by customer
losses on the introducing member, then a strong compatible risk
management system will result.
---------------------------------------------------------------------------
\6\ M. Goodfriend, 1990, ``Money, Credit, Banking, and Payments
System Policy'', in U.S. Payments System: Efficiency, Risk, and the
Role of the Federal Reserve, edited by David B. Humphrey, Kluwer
Academic Publishers; also reprinted in Federal Reserve Bank of Richmond
Economic Review, January/February 1991, pp. 7-23.
---------------------------------------------------------------------------
The absence of failures of clearinghouses in the financial crisis
has been viewed by some as offering reassurance about the inherent
stability of the clearinghouse model. Indeed, the clearinghouse model
has a number of attractive features, such as, netting of exposures and
greater transparency of risks. At the same time, this model presents
greater sources of vulnerability due to concentration of risk and
greater moral hazard at the customer level because there is no pricing
differential or penalty imposed on weak counterparties as long as they
are acceptable to the clearinghouse. In addition, to the extent that
financial services firms believe they have essentially fully
transferred various risks to the clearinghouse they likely will bear
additional risks (systemic and otherwise) because of their enhanced
risk-bearing capacity. It is extremely important to recognize and
acknowledge the implications of the endogeneity of risk. Improvements
in the management of collective risk potentially will incentivize
financial services firms to take on more risk at the margin. For
example, decisions about leverage will emerge endogenously. It is
important to bring considerable caution and skepticism to discussions
about risk management in the clearinghouses, especially in light of
their broader contemplated role. \7\
---------------------------------------------------------------------------
\7\ For example, see, ``Derivatives, Clearing and Exchange-
Trading'', Statement No. 293 of the Shadow Financial Regulatory
Committee, April 26, 2010, http://fic.wharton.upenn.edu/fic/policy
percent20page/Statement%20No.%20293-
%20Derivatives,%20Clearing%20and%20Exchange%20Trading.pdf.
---------------------------------------------------------------------------
My underlying view on the relevance of economic principles to the
structuring of clearinghouses also highlights the broader point that in
restructuring the derivatives and swaps markets it is important to be
sensitive to the economic consequences of contemplated rulemakings and
undertake cost-benefit analyses that will identify these consequences
and help to inform rule proposals.
______
PREPARED STATEMENT OF CLIFFORD LEWIS
Executive Vice President, State Street Global Markets
May 25, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for the opportunity to testify today regarding
the clearing-related provisions of the Dodd-Frank Wall Street Reform
and Consumer Protection Act.
As an initial comment, I commend the CFTC for their efforts to date
on Dodd-Frank implementation, where they are working on a broad range
of highly complex issues, on a very aggressive timeframe.
State Street is one of the world's largest custodial banks and
processors of derivatives transactions, and we support regulations
which will benefit our customer base of large, buy-side, institutional
investors, such as pension funds, mutual funds, and endowments. We
support the Dodd-Frank mandates for both derivatives clearing and
execution, which we believe will reduce global systemic risk, and,
properly implemented, benefit our institutional investor customer base.
Like most market participants, our buy-side clients are concerned
by the current regulatory uncertainty and the potentially significant
cost and market liquidity impacts that may result from the new rules.
At State Street, we are well positioned to provide our clients with
full-service clearing and other services that can help them realize the
benefits of the new derivatives regime, through enhanced transparency,
more open execution platforms, and central clearing.
In relation to central clearing, the key issue for State Street is
effective implementation of the Dodd-Frank Act's requirement that
clearinghouse membership requirements ``permit fair and open access.''
Open access will reduce systemic risk by avoiding concentration of
clearing activity with a small number of existing ``dealer'' members,
and benefit the buy-side by allowing netting across dealers on swaps
that clear through the same clearinghouse.
State Street intends to pursue membership in a variety of
derivatives clearinghouses, and the Dodd-Frank requirement for open
access is an important element in our ability to increase competition
in the clearing services marketplace.
I'd like to make a few specific recommendations:
First, we support the CFTC's participant eligibility rules as
proposed, but note these rules will require vigilant oversight by the
CFTC. The proposed rules recognize the critical importance of strong
clearinghouse risk management practices, while, at the same time,
permit broader clearinghouse membership, reducing systemic risk and
allowing buy-side market participants to benefit from alternative
clearing member business models. As we noted in our comment letter to
the CFTC, we are concerned that some clearinghouses will carry forward
their current restrictive membership requirements, in direct
contradiction of the spirit and intent of Dodd-Frank.
Second, clearing members must be required to demonstrate the
necessary financial and operational resources to execute their duties
to customers and the clearinghouse. Strong capital rules are important,
but should be risk-based rather than arbitrary dollar amounts. We have
suggested linking capital requirements to other risk-based
clearinghouse measures, such as a multiple of default fund
contributions. Other arbitrary requirements linked to a dealer-specific
business model, such as a minimum swap book, are not risk-based and
will prohibit membership by nondealer firms. Outsourcing of certain
functions should be allowed, provided that the execution risk
associated with such outsourcing rests with the member firm and not the
clearinghouse. By way of example, the current model of the futures
markets showed itself well structured to handle such crises, as the
successful wind-down of Lehman's futures positions by nonmembers
demonstrated at the time of its bankruptcy.
Third, both the clearing and the execution mandates should go into
effect at the same time.
Clearing is most effective when tied to execution, providing market
participants with greater transparency, tighter spreads and cost
reduction. Phasing-in the clearing requirement in advance of the
execution requirement would burden market participants with increased
costs while denying them the corresponding benefits. If some form of
phasing is deemed necessary by the CFTC, it should be done by
instrument and require that as each new instrument is folded under the
regulatory regime, both the clearing and execution requirements attach
simultaneously.
Fourth, to the extent possible, regulations governing clearinghouse
membership rules should be coordinated globally, to avoid regulatory
arbitrage that could frustrate the Dodd-Frank requirements for open
access.
Finally, in order to allow the markets and participants to adjust
to new ways of doing business, we suggest that a 6-month transition
period be given between finalization of the mandatory clearing and
execution rules and mandatory compliance. The final rules will provide
certainty to the markets as to what the new regulatory demands are, and
only then will businesses be in a position to plan and adapt
accordingly.
Again, State Street strongly believes in the importance of the
clearing and execution mandates as spelled out in Dodd-Frank, and we
stand ready to help Congress, the Administration and the regulators as
the process of rule writing and implementation goes forward.
Thank you for the invitation to testify before you today. I will be
happy to take your questions.
______
PREPARED STATEMENT OF DON THOMPSON
Managing Director and Associate General Counsel, JPMorgan Chase & Co.
May 25, 2011
Chairman Reed, Ranking Member Crapo, and Members of the Committee,
my name is Don Thompson, and I am a Managing Director and Associate
General Counsel at JPMorgan Chase & Co (JPMC). I head our derivatives
legal group and have been actively involved in implementation of Title
VII of the Wall Street Reform and Consumer Protection Act (the
``Act''). Thank you for inviting me to testify today on the
opportunities and challenges of derivatives clearinghouses (CCPs).
JPMC has been an active participant in the development and
management of clearinghouses with direct membership in 77
clearinghouses for a variety of markets including listed and over-the-
counter (OTC) derivatives, equity and fixed income securities. We are
committed to clearing OTC derivatives transactions and have been
clearing dealer-to-dealer OTC transactions for a decade. Today major
swap dealers clear over 90 percent of eligible interdealer interest
rate and CDS transactions. At the same time, we have also made
significant investments in our client clearing franchise, which we
expect to grow as the requirements of clearing under Title VII become
implemented.
While there are a number of critical issues to consider in
determining the appropriate market structure and governance for
clearinghouses, the most critical is guarding against systemic risk.
Questions of membership criteria, risk committee structure and
governance all implicate safety and soundness, so it is essential that
regulations carefully weigh these considerations.
As the Committee is aware, the migration of products that were once
traded and managed bilaterally to clearinghouses will concentrate the
risk from these transactions at CCPs. CCPs do not eliminate credit and
market risk arising from derivatives; they simply concentrate it in a
single location in significant volume. This concentration of risk
combined with an increase in aggregated credit and operational risks at
CCPs will result in these institutions becoming systemically important.
Since these institutions are private, for-profit entities, it is
critical that regulations guard against an outcome that would privatize
profits but potentially socialize losses. Attempts to increase clearing
member access or lower clearing member capital requirements can be
responsibly implemented only if they are coupled with requirements for
sound risk management practices. These practices should include
appropriate limits on the types of transactions that are subject to the
clearing mandate, requirements for members of clearinghouses to have
capital contributions proportional to the risk they introduce to the
CCP, elimination of uncapped liability of clearing members and
requirements for clearing members to be able to risk manage the
transactions they bring to the CCP. We strongly support open access to
clearinghouse membership, and believe it can be achieved without
compromising risk management standards. Two critical controls must be
in place at each clearinghouse to support open access: a clear
liability framework that caps each member's exposure, and risk limits
that are real-time and proportional to each member's capital. With this
foundation, the clearing membership can be prudently expanded to firms
with modest levels of capital, including the $50 million minimum
proposed by the CFTC.
Absent proper oversight, CCPs are at greater risk of failure, which
could have significant systemic implications. Failure could result from
a number of factors, such as a member's lack of proper risk management,
from clearing complex products that cannot be properly valued by the
CCP, or from actions resulting from a ``race to the bottom'' among for-
profit CCPs.
Given these risks, we believe that as long as CCPs are structured
as for-profit entities, the primary regulatory focus should be to
ensure that proper risk management, governance, regulatory oversight
and incentive structures are in place, as discussed in greater detail
below.
It is also worth noting that because derivatives trading and
clearing is a global business, in order to prevent arbitrage, rigorous
regulatory standards should be applied consistently in each of the
major global markets, including uniform operating principles and a
consistent on-the-ground supervisory approach.
Safety and Soundness of Clearinghouses
In considering clearinghouse membership requirements and their
impact on clearinghouse safety and soundness, it is important for
policy makers to keep in mind the nature of a clearinghouse. A
clearinghouse is structured to provide for mutual sharing of
counterparty risk among members. Each clearing member is exposed to the
counterparty credit risk of all other members and, by extension, all
clients clearing trades via other members. Clearinghouses themselves
provide a very small portion of the capital which backs the performance
of the clearinghouse, and the vast majority of the financial resources
of a clearinghouse is provided by the members through their
contributions to the guaranty fund as well as collateral posted by the
clearing members. To the extent of their liability, each member is
delegating risk management of its capital to the clearinghouse, which
in many cases is a private, for profit entity. Each member is also
exposed to the capital, liquidity and operational capabilities of other
members, to the client risk introduced by every other member as well as
the risk management processes put in place by those members and by the
clearinghouse. A clearinghouse that is prudently managed must have
adequate margin and guarantee fund resources and must refresh its
calculations daily and intraday to adjust its resources to changing
market conditions.
There are additional measures that should be considered in order to
enhance the safety and soundness of clearinghouses:
1. Clearinghouses should have a credible resolution plan, given
their interconnectedness to the financial markets and the
associated systemic risk implications. Such resolution plans
should be tested regularly and reviewed by regulators.
2. On-site inspections by regulators should be conducted at regular
and frequent intervals. The sufficiency of clearinghouse
financial safeguards should be regularly evaluated against the
results of such tests, and adjusted as appropriate.
3. The liability of clearing members to the clearinghouse should be
clearly ascertainable and capped. Unlimited liability of
members towards the clearinghouse to absorb clearinghouse
losses has the effect of maintaining the solvency of the
clearinghouse at the expense of its participants, a trade-off
that likely would lead to systemic risk concentration, not
mitigation. Unlimited liability is the worst of all worlds:
large financial institutions will be interconnected, but will
have no idea of their exposure to any other particular
institution, and neither the incentive nor the means to
mitigate the risk.
4. In determining the appropriateness of a clearinghouse financial
safeguards package there should also be an appropriate balance
between initial margin and guarantee fund contributions. This
balance should not be allowed to vary significantly across
clearinghouses. If initial margin is set too low, there will be
an incentive to push risky and unbalanced positions through the
clearinghouse as participants recognize that the risk
introduced in the clearinghouse will be subsidized by other
clearing members through guaranty fund contributions. The
amount of initial margin customers are required to post,
together with the degree of protection afforded such margin,
may adversely affect the incentives of customers to select
prudently managed clearinghouses, contributing to moral hazard
and instigating a race to the bottom.
Clearinghouse Access
We strongly support regulation aimed at mitigating conflicts of
interest. We also support full implementation of the open access core
principles set out by Congress in the Act with a risk-based framework
that allows clearing members to clear client and house activity in
proportion to their capital. We note that the Lynch amendment, which
would have restricted equity ownership of interests in clearinghouses
and swap execution facilities by swap dealers, was not part of the
final text of the Act passed by Congress and signed by the President;
however, proposed rules include such restrictions.
We believe that all clearinghouses should provide open access to
whoever meets certain minimum objective criteria. In our view, the fact
that a clearinghouse relies almost exclusively on the capital of its
members places a great emphasis on the ability of a member to absorb
any losses resulting from: (a) the house and client risk that a
clearing member introduces into the clearinghouse; and (b)
mutualization of the risks introduced by every other clearing member
and those clearing members' clients. Given the loss mutualization
feature of clearinghouses, we believe that the financial stability of
clearinghouses depends on the requirements that must be satisfied for a
member to qualify as a clearing member. Those criteria, however
defined, should require clearing members to hold a minimum amount of
capital. In addition, it is our view that the way to provide open
access to new clearing members while promoting the safety and soundness
of clearinghouses would be to provide clearing members with the ability
to clear house and client risk in proportion to the amount of capital
available to them as well as to funded margin and guarantee fund
contributions. We do not support any exclusionary practices.
Interaction of Corporate Governance and Risk Management
We support regulations requiring the creation of a risk committee
at all clearinghouses. In addition, we believe it would be appropriate
to provide for the separation of the corporate governance function
(Board of Directors) from the risk management function (Risk Committee)
within a clearinghouse.
Risk Committee
We believe that the Risk Committee should be comprised of a
majority of clearing member representatives, with the remainder open to
clearinghouse and client participation. We support a requirement for at
least 10 percent of the Risk Committee to be composed of client
representatives with relevant expertise, and the balance to be open to
participation by independent representatives. We believe that the main
focus of the Risk Committee should be the preservation of the guarantee
fund that is utilized to safeguard the clearinghouse and its members
against defaults, taking into account prudent risk management
standards, including mitigation of systemic risk. The main focus of the
Board would be to promote the commercial interests of the
clearinghouse. We expect that in most cases the Risk Committee and the
Board would be able to achieve a productive balance between those two
interests. We support a requirement for the Board to consult with the
appropriate regulator prior to rejecting a recommendation by the Risk
Committee on matters of risk. In our view all matters relating to risk
would fall within the purview of the Risk Committee. This would include
all matters related to margin and the sizing of the guarantee fund,
membership criteria and membership application, and the enumeration of
products eligible for clearing. Regulators have identified sound risk
management standards as well as open access as key factors that must be
addressed in determining whether a particular type of swap is suitable
for clearing.
Board of Directors
With respect to the corporate governance function of SEFs,
exchanges, and clearinghouses, we support encouraging a balance of
views being represented on the Board of Directors. We think that a 35
percent requirement for independent directors will be problematic to
implement in practice because it will be difficult to identify a
sufficient number of individuals who are not already involved in the
industry and who have an appropriate level of practical market
experience. In our view the desired balance between different interests
can be achieved by identifying different classes of interested parties
and encouraging a diverse representation of those interests in the
Board of Directors. This would be done by requiring that no single
class of interested parties achieves more than 65 percent of the seats
on the Board. Each SEF, exchange and clearinghouse should be able to
determine how to fill the remainder of the seats. Regulators would
monitor compliance with the letter and the spirit of this provision. In
our opinion, the different classes of interested parties vary depending
on the type of entity: In the case of clearinghouses the classes would
be: (a) clearing members whose capital is at risk if another clearing
member or one of its clients fails; (b) end users, who have an interest
in protecting their collateral and in keeping clearing costs low; and
(c) other investors and infrastructure providers (e.g., technology
providers, SEFs, exchanges, and clearinghouses), who have an interest
in increasing profitability.
In the case of SEFs, the classes would be: (a) liquidity providers;
(b) liquidity takers; and (c) other investors and infrastructure
providers (e.g., technology providers, exchanges, and clearinghouses),
who have an interest in increasing profitability.
In the case of exchanges, the classes would be: (a) liquidity
providers; (b) liquidity takers; and (c) other investors and
infrastructure providers (e.g., technology providers, SEFs, and
clearinghouses), who have an interest in increasing profitability.
These limitations would have the added benefit of promoting
competition and discouraging vertical integration of exchanges, SEFs,
and clearinghouses.
All those who bring risk into the clearinghouse or profit from the
operations of the clearinghouse should have ``skin in the
game''
We think it is essential to the development of a sound clearing
infrastructure that those whose capital is at risk can participate in
the risk management of clearinghouses. Clearinghouses rely almost
exclusively on the margin and guarantee fund contribution of clearing
members to manage systemic risk and counterparty risk.
In a vertically integrated model, shareholders in a holding company
that owns clearinghouses and exchanges (and in the future may also own
SEFs) are exposed to a fraction of the risk that clearing members are
exposed to through loss mutualization. There is no current requirement
for clearinghouses to provide a first loss piece to the financial
waterfall package and in most structures the clearinghouse ``skin in
the game'' contribution is minimal compared with the overall size of
the guarantee fund. For this reason the large majority of the capital
at risk of a clearinghouse is composed of the margin and guarantee fund
contributed by clearing members.
In addition to the financial resources required to satisfy the
financial safeguards core principles set out in the Act we support
introducing a requirement for clearinghouses to carry a first-loss risk
component as well as a mezzanine risk component in the waterfall of
financial safeguards. This would establish a direct link between the
earnings that a clearinghouse derives from cleared activity and the
contribution of that clearinghouse to its own financial safeguards
package. We would support regulations that require a clearinghouse to
retain in a segregated deposit account, on a rolling basis, 50 percent
of the earnings from the previous four years. We observe that this
amount would represent approximately 10 percent of the clearinghouse
enterprise value, therefore achieving a reasonable balance between risk
and reward for clearinghouse shareholders. In addition, it would be
appropriate for at least 50 percent of the retained earnings to have a
first loss position in the financial waterfall. This solution would
accomplish the goal of greater systemic stability, and would scale over
time the contribution by the clearinghouse to its own financial
safeguards package without large decreases or increases at any one
resizing date. We recommend that the clearinghouse contribution be
subject to a minimum floor of $50 million, to provide adequate
protection and provide increased confidence in the markets while market
participants ramp up access to clearing services. In our view this
would incentivize clearinghouses to manage risk in a prudent manner. We
would also support limits on the ability of clearinghouses to upstream
dividends resulting from clearing fees to their holding companies when
a clearing member defaults. The introduction of a first loss position
and the introduction on limits on the upstreaming of dividends for
clearinghouses would result in significant benefits from a systemic
stability point of view.
Limitations on Voting Rights
The best way to promote a successful implementation of the clearing
requirement of the Act is to ensure that clearinghouses are fully
equipped to manage risk in a prudent manner, while providing open
access to clients and clearing members. In order to achieve this
purpose, clearinghouses should be able to attract financial and
intellectual capital from those who have experience in the products
that the clearinghouse intends to clear, as well as from new
participants into the market.
We note that the OTC derivatives market is sufficiently diversified
at present. A market survey published by ISDA on October 25, 2010,
shows that the five largest U.S.-based dealers hold 37 percent of the
outstanding derivatives market (equity, rates, credit). In our view
this data is more representative of the global nature of the OTC
derivatives market than other data that has been quoted out of context
in the debate regarding conflict of interest. That data was focused
exclusively on a restricted number of U.S. institutions and was not
intended to represent a survey of the OTC market, which is global. To
assume that dealers would acquire shareholdings in a clearinghouse or
otherwise gain influence over a clearinghouse with a view to impede or
narrow the implementation of the clearing requirement would be
inconsistent with the reality of today's markets. On the contrary some
participants in the OTC markets have made significant investments into
the capital of clearinghouses well in advance of a legal requirement to
clear being introduced or proposed in the U.S. or in Europe.
At this point in the development of market infrastructure, it is
essential to promote competition between clearinghouses, exchanges, and
SEFs. With respect to clearinghouses, we note that in today's markets
there are a maximum of three clearinghouses per asset class that are
able to clear OTC derivatives. In some asset classes there is no
clearinghouse currently clearing. There is no specific reason to apply
limits only to those who have the expertise and the funds to finance a
clearinghouse and who are exposed to losses if the risk management of
the clearinghouse fails. We believe that preventing those whose capital
is at risk from acquiring the right to vote on the governance of the
entities that perform a key role in the OTC markets is not necessary to
achieve the policy objectives set out by Congress in the Act. For this
reason we support a limit on voting rights that would apply to each
class of market participants irrespective of whether they are clearing
members, SEFs, exchanges, enumerated entities, or other types of
entities or individuals. This would promote open access and greater
competition among clearinghouses.
Given that preference shares and other types of nonvoting shares
are a way to provide liquidity into the clearinghouse and have no
effect on corporate governance, we believe that it would not be
appropriate to apply limitations on the ownership of nonvoting shares.
No Free Riding--Clearing Member Resources
We do not believe that there should be a two-tiered approach to
membership, where some clearing members are subject to loss
mutualization and others are not. A clearinghouse will rely on the
financial resources waterfall set out in CFTC proposed 39.11. This
includes funded guarantee fund contributions by a clearing member. CFTC
proposed 39.11 also contemplates the ability of a clearing
organization to assess a clearing member for additional default fund
contributions. We believe that it is important to make sure that a
clearing member will have sufficient liquid capital to fund additional
guarantee fund assessments, in proportion to house and client business
cleared by that clearing member.
We believe it would be appropriate to require that clearing members
have the ability to provide daily executable binding quotation for all
points in the curve for all products cleared. Clearinghouses must be
able to mark to market all positions at the end of each trading day.
Clearing members must provide daily prices for all points of the
maturity curve rather than relying on whether the cleared product
trades on an exchange or a SEF on that day.
In our view it is essential to require that clearing members have
the operational ability to sustain the flow of client and house
positions into the clearinghouse, including porting books of liquid and
illiquid positions at times of market distress. In times of market
stress or crisis, it is imperative that clearing members be able to act
quickly in order to address the risk management aspects of defaults. By
way of example, if a clearing member fails, the clearinghouse will
conduct an auction to absorb the losses caused by that clearing member
failure. The provision of liquidity by surviving members during that
auction is key to the survival of a clearinghouse that deals in OTC
instruments.
Default management is not a responsibility that can be outsourced
without introducing new risks to the stability of the clearinghouse. We
think third-party pricing and outsourced default management services
can disappear quickly in a crisis, as the provider of the service may
have to focus their resources on their own survival. For this reason we
believe it is preferable that clearing members or their affiliates be
able to participate in the default management process. In the
alternative, we would support a structure that would allow a clearing
member to outsource pricing and default management services to another
provider so long as the third-party provider of pricing and default
management services is not allowed to undertake the provision of those
services to more than one clearing member (including for itself or an
affiliate).
To ensure the correct incentives are in place during an auction of
a failed member's portfolio, we recommend that any loss incurred by the
clearinghouse as a result of the auction be absorbed first by the
guarantee fund contributions of those members that fail to submit a
bid. Any remaining loss should be distributed among the bidding
clearing members in reverse proportion to the strength and size of
their bid. This mechanism will ensure that all members are treated
equally going in to an auction, and that appropriate financial
incentives exist to provide exit liquidity to the clearinghouse. In
addition, we believe this mechanism creates a fair outcome for all
members by subordinating the guarantee fund capital of any bidder that
is subject to a failed outsourcing arrangement.
Guarantee fund assessments ensure members have appropriate liquidity to
meet potential capital calls in a crisis
We support the CFTC proposal requiring clearinghouses to haircut
the value of unfunded assessment and to cap the percentage of the
financial resources package that can be met by the value of
assessments.
We note that CFTC proposed 39.11 also refers to the own capital
contribution of a clearinghouse as a component of the financial
resources package. We believe that it would be appropriate for the
Commission's regulations to provide greater granularity and require
that if a clearinghouse enumerates its own capital as part of the
waterfall, that clearinghouse must provide sufficient assurances that
its capital will be available to meet those obligations and will not be
reallocated to serve other purposes at the discretion of that
clearinghouse.
It should be noted that a clearing member may have committed to
additional assessments at more than one clearinghouse. We believe it
would be appropriate for regulators to adopt a risk-based analysis to
determine the likelihood that a clearing member will be able to meet
its assessment obligations across all clearinghouses.
Systemically Important Clearing Houses
We believe that in the new market structure landscape, that no
entity should be too big to fail. In our view, this principle applies
equally to clearing members, clearinghouses, and clients. Given the
loss mutualization feature of clearing, it is only by requiring each
participant to have skin in the game that we can ensure all the parties
involved in bringing risk into the system have an incentive to act in a
manner that is prudent, safe, and sound. We believe it is appropriate
for members, clients and clearinghouse shareholders to have skin in the
game. This principle is of particular relevance for those entities that
are deemed systemically important by the Financial Stability Oversight
Council pursuant to Title VIII of the Act.
Regulatory Coordination
In our view, coordination between regulators who have authority
over clearinghouses will be a key component of systemic stability. One
significant element will be the ability of regulators to look across
clients, clearing members, exchanges, SEFs, and clearinghouses for any
factors that could increase systemic risks. We think it is appropriate
to monitor the activity of clients, clearing members exchanges, SEFs,
and clearinghouses for undue concentration with a view to identify
those that pose a systemic risk and take action to mitigate problematic
situations before they exert a significant impact on the financial
systems.
Conclusion
We believe that no institution, including clearing members and
clearinghouses, should be too big to fail. The policy objectives of the
Act would be well served by promoting systemic stability and ensuring
safety and soundness of exchanges, SEFs, and clearinghouses, and by
requiring that these institutions have adequate capital to absorb
losses and sufficient liquidity to safeguard the system. JPMC is
committed to working with Congress, regulators, and industry
participants to ensure that Title VII is implemented appropriately and
effectively. I appreciate the opportunity to testify before this
Committee and look forward to answering any questions you may have.
______
PREPARED STATEMENT OF JAMES CAWLEY
Cofounder, Swaps and Derivatives Market Association
May 25, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, my name is James Cawley. I am CEO of Javelin Capital
Markets, an electronic execution venue of OTC derivatives that expects
to register as a SEF (or ``Swaps Execution Facility'') under the Dodd
Frank Act.
I am also here to represent the interests of the Swaps &
Derivatives Market Association or ``SDMA,'' which is comprised of
multiple independent derivatives dealers and clearing brokers, some of
whom are the largest in the world.
Thank you for inviting me to testify today.
To ensure that the U.S. taxpayer is never again required to bail
out Wall Street, we must move away from ``too inter connected to fail''
where one bank pulls another three with it--in the event of its
failure. Equally important, we must remove the systemic ``sting''
currently associated with each bilateral derivatives swap contract that
connects financial firms to each other and thus compel these swaps
contracts into clearinghouses as mandated under the Dodd-Frank Act.
In order to have safe and successful central clearing of OTC
derivatives, certain remaining impediments must be removed such that
clearinghouses ensure that they have truly representative governance
structures, offer objective and proportionate risk models, provide open
access to properly qualified and noncorrelated clearing members and
accept trades on a ``real time'' and ``execution blind'' basis such
that systemic risk is mitigated while transparency and market liquidity
are increased.
Clearinghouse Governance and Membership
With regard to clearinghouse governance, we support CFTC Core
Principles O, P, and Q, that require that governance arrangements be
transparent, fair and representative of the marketplace. Such
governance bodies should represent the interests of the market as a
whole and not just the interests of the few.
Importantly, clearinghouse membership requirements should be
objective, publicly disclosed and permit fair and open access; as Dodd-
Frank requires.
This is important because clearing members act as the
``gatekeepers'' to clearing. Without open access to clearing, you will
not have universal clearing adoption, increased transparency, and
lessened systemic risk.
Clearinghouses should seek to be inclusive, not exclusive in their
membership criteria.
We should dispense with the myth that swaps are somehow different
from other cleared markets and thus the vast experience from those
markets should be ignored.
Instead, clearinghouses should learn from their own experience in
the listed derivatives space--of futures and options.
In those markets, central clearing has operated successfully since
the days of post Civil War Reconstruction nearly 150 years ago; long
before spreadsheets and risk models. In those markets, counterparty
risk is spread over a hundred disparate and noncorrelated clearing
firms. It works well. No customer has ever lost money due to a clearing
member failure.
To complement broad participation, clearinghouses should not have
unreasonable capital requirements. Capital should be a function of the
risk a member contributes to the system; simply put, the more you or
customers trade, the more capital you contribute.
The SDMA supports the CFTC's call for clearing broker capital
requirements to be proportionate and scale relative to the risk
introduced to the system. We support the CFTC's call that a clearing
firm's minimum capital be closer to $50 million, rather than closer to
the $5 billion or $1 billion threshold as certain clearinghouses have
originally suggested.
Certain clearinghouse operational requirements for membership that
have no bearing on capital or capability should be seen for what they
are--transparent attempts to limit competition.
Specifically, clearing members should not be required to operate
swap dealer desks just so they can meet their obligation in the default
management process. These requirements can easily be met contractually
through agreements with third party firms or dealers.
With regard to conflicts of interest within a clearing member,
Dodd-Frank is clear; dealer desks should not be allowed to influence
their clearing member colleagues and strict Chinese walls should exist.
Derivatives Trade Integrity
With regard to trade acceptance, clearinghouses and their
constituent clearing member firms should accept trades on an
``execution blind'' basis. Clearing firms should be prevented from
discriminating against certain customer trades, simply because they
dislike the manner in which they have been executed or the fact that
they may be anonymous.
Certain trade counterparties should be precluded from exploiting
current market position to impose documentary barriers to entry that
restrict customer choice of execution venue, execution method, or
dealer choice. Regulators should remain vigilant to ensure that such
restrictions on trade do not manifest themselves in a post Dodd-Frank
world.
With regard to trade integrity, execution venues, clearing members
and clearinghouses should, as the regulators require, work together to
ensure that executed trades settle or are accepted into clearing as
quickly as possible.
The SDMA, joins with the MFA, and supports the CFTC requirement
that trades be accepted into clearing immediately upon execution or
trade submission. Regulators should be mindful not to allow
clearinghouse workflows that seek to increase and not decrease trade
latency. Such workflows should be seen for what they are--clear
attempts to stifle successful OTC derivative clearing.
Conclusion
In conclusion, the CFTC and the SEC should be commended for their
excellent work. Both agencies have been transparent and accessible
throughout the entire process. They have adapted to industry suggestion
when appropriate.
We must move away from ``too interconnected to fail.'' As an
industry, we must work together to ensure that OTC derivatives clearing
is a success such that Wall Street never again has to come to Main
street for another bail out.
Thank you.
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM CHRISTOPHER EDMONDS
Q.1. Does your swaps clearinghouse have minimum capital
requirements as part of your ownership and governance
standards?
A.1. Yes.
Q.2. If so, what are they?
A.2. ICE Clear Credit's Rule 201(b)(ii), in relevant part,
currently provides that `` . . . no applicant shall be admitted
or permitted to remain, as applicable, as a Participant unless,
in ICE Clear Credit's sole determination:
(1) if it is an FCM or a Broker-Dealer, (A) it has a
minimum of $100 million of Adjusted Net Capital and (B)
it has Excess Net Capital that is greater than 5
percent of the Participant's Required Segregated
Customer Funds; or (2) if it is not an FCM or a Broker
Dealer, it has a minimum of $5 billion in Tangible Net
Equity (provided that in the case of (1) or (2), this
requirement may, at the discretion of ICE Clear Credit,
be met by a Parent if such Parent provides a guarantee
pursuant to Rule 205);
For purposes of this clause (ii):
``Adjusted Net Capital'' for a Participant that is an
FCM, shall be as defined in CFTC Rule 1.17 and as
reported on its Form 1-FR-FCM or FOCUS Report or as
otherwise reported to the CFTC under CFTC Rule 1.12,
and for a Participant that is not an FCM but is a
Broker-Dealer, shall be its ``net capital'' as defined
in SEC Rule 15c3-1 and as reported on its FOCUS Report;
``Excess Net Capital'' for a Participant that is an FCM
or a Broker-Dealer shall equal its ``excess net
capital'' as reported on its Form 1-FR-FCM or FOCUS
Report or as otherwise reported to the CFTC under CFTC
Rule 1.12;
``Participant's Required Segregated Customer Funds''
shall equal (i) the total amount required to be
maintained by such Participant on deposit in segregated
accounts for the benefit of customers pursuant to
Sections 4d(a) and 4d(f) of the CEA and the regulations
thereunder and (without duplication) pursuant to the
rules of relevant clearing organizations for positions
carried on behalf of customers in the cleared OTC
derivative account class plus (ii) the total amount
required to be set aside for customers trading on non-
United States markets pursuant to CFTC Rule 30.7.
``Tangible Net Equity'' shall be computed in accordance
with the Federal Reserve Board's definition of ``Tier 1
capital'' as contained in Federal Reserve Regulation Y
Part 225 Appendix A (or any successor regulation
thereto), in the case of a bank or other Participant
subject to such regulation, or otherwise shall be the
Participant's equity less goodwill and other intangible
assets, as computed under generally accepted accounting
principles.
Q.3. What role do these capital requirements play in managing
clearinghouse and counterparty risk?
A.3. The role of capital is secondary to the initial margin and
guaranty fund collateral that a clearinghouse collects from its
clearing participants, nevertheless, capital requirements are a
fundamental and important component of a clearinghouse risk
management regime. Capital requirements are a measurement of a
clearing participant's ability to meet its financial
obligations to the clearinghouse.
Section 725(c) of Dodd-Frank entitled Core Principles for
Derivatives Clearing Organizations provides in relevant part
that each derivatives clearing organization shall establish
appropriate admission and continuing eligibility standards
including sufficient financial resources to meet obligations
arising from participation in the derivatives clearing
organization.
The Bank for International Settlements in its
Recommendations for Central Counterparties (CCP)
(Recommendation 2: Participant requirements 4.2.2) states in
relevant part ``to reduce the likelihood of a participant's
default and to ensure timely performance by the participant, a
CCP should establish rigorous financial requirements for
participation. Participants are typically required to meet
minimum capital standards. Some CCPs impose more stringent
capital requirements if exposures of or carried by a
participant are large or if the participant is a clearing
participant. Capital requirements for participation may also
take account of the types of products cleared by a CCP . . .
.''
Q.4. How would reducing these capital requirements impact the
risk profile of the clearinghouse, as well as the ability of
new potential clearing members to join the clearinghouse?
A.4. As indicated above, the clearinghouse model relies, in
part, on having adequately capitalized clearing participants in
order to manage its counterparty risk. There is a direct
correlation between the level of an entities regulatory capital
and its ability to meet its counterparty obligations to a
clearinghouse.
Q.5. How is your clearinghouse risk committee constituted? How
many members are there?
A.5. Pursuant to ICE Clear Credit rule 503(a), the composition
of the Risk Committee shall be as follows:
(i) The Risk Committee shall consist of twelve members.
(ii) Each member of the Risk Committee shall have risk
management experience and expertise and shall be
subject to the approval of the Board, such approval not
to be unreasonably withheld, conditioned or delayed.
(iii) Three of the members of the Risk Committee shall
be comprised of (A) a member of the Board who is
independent in accordance with the requirements of each
of the New York Stock Exchange listing standards, the
U.S. Securities Exchange Act of 1934, as amended, and
IntercontinentalExchange, Inc.'s Board of Director
Governance Principles (such requirements, the
``Independence Requirements'' and such member, the
``Independent ICE Manager'') and (B) two officers of
ICE Clear Credit from among the Chief Executive
Officer, President, Chief Financial Officer and Chief
Risk Officer, each appointed by ICE US Holding Company
L.P. (including any successor, the ``ICE Parent''), a
Cayman Islands exempted limited partnership, by written
notice to the Board;
(iv) The other nine members of the Risk Committee will
be appointed as specified below (the ``Participant
Appointees'');
(v) The nine Participant Appointees will include one
member appointed by each Participant Group that
includes or is Affiliated with one of the following:
Bank of America, N.A.; Barclays Bank PLC; Citibank,
N.A.; Credit Suisse Securities (USA) LLC; Deutsche Bank
AG; Goldman Sachs International; JPMorgan Chase Bank,
N.A.; Morgan Stanley Capital Services, Inc.; and UBS
AG. ``Participant Group'' means a Participant and its
Affiliates, if any, such that, if two or more
Participants are Affiliates, collectively they shall
constitute a Participant Group.
(vi) The composition of the Participant Appointees
shall be reconstituted on March 14, 2012, and each one
year anniversary thereafter (or if any such day is not
an ICE Business Day, the next ICE Business Day) as
follows (each such anniversary, a ``Risk Committee
Reconstitution Date,'' and the twelve full consecutive
calendar months (including March through February)
ending at the calendar month-end prior to a Risk
Committee Reconstitution Date, an ``Eligibility
Determination Period'') (subject to paragraph (ii)
above):
(A) among those Participant Groups that have an
incumbent member on the Risk Committee, those
Participant Groups that have the six highest
Participant Activities for the immediately preceding
Eligibility Determination Period (each, a ``Top Six
Incumbent Participant Group'') shall have the right to
retain such member on the Risk Committee until the next
Risk Committee Reconstitution Date;
(B) among the Participant Groups that are not Top Six
Incumbent Participant Groups, the Participant Groups
that have the three highest Participant Activities for
the immediately preceding Eligibility Determination
Period (each, an ``Eligible Participant Group'') shall
have the right to appoint or retain, as applicable, a
member on the Risk Committee until the next Risk
Committee Reconstitution Date;
(C) each Participant Group that has an incumbent member
on the Risk Committee but is not entitled to retain
such member as provided above shall cause its Risk
Committee member to resign or otherwise remove such
member from the Risk Committee effective as of the
applicable Risk Committee Reconstitution Date; and
(D) each Participant Group that has the right to
appoint a member to the Risk Committee as provided
above and that does not have an incumbent member on the
Risk Committee shall notify the Board in writing on or
prior to the applicable Risk Committee Reconstitution
Date of the individual appointed by such Participant
Group to the Risk Committee; provided, however, that
the failure to provide such notice shall not result in
the loss of the right of such Participant Group to
appoint a member to the Risk Committee.
(E) ``Participant Activity'' means, for a specified
Eligibility Determination Period and with respect to a
particular Participant Group, the aggregate volume of
Trades during such time submitted to, and accepted for
clearing by, ICE Clear Credit by members of such
Participant Group, which such volume shall be measured
in terms of aggregate notional amount of Trades so
submitted and accepted. In the event that a Combination
of Participants occurs prior to the applicable Risk
Committee Reconstitution Date, all Participant Activity
of such Participants (and their Affiliates) shall be
aggregated together for purposes of determining the
Participant Activity of the resulting Participant Group
for the corresponding Eligibility Determination Period.
(F) ``Combination'' means any event in which a
Participant (or its Affiliate) obtains Control of
another Participant that was previously not an
Affiliate of such Participant (or any Person that
Controls such other Participant) or a Participant (or
any Person that Controls such Participant) is merged
with another Participant that was previously not an
Affiliate of such Participant (or any Person that
Controls such other Participant).
(vii) Intentionally omitted in Rules for formatting.
(viii) Notwithstanding anything to the contrary herein,
if at any time on or after the DCO/SCA Conversion Date
but prior to the first Risk Committee Reconstitution
Date, there is a Combination involving Participants
where more than one of the relevant Participant Groups
had the right to appoint a member of the Risk
Committee, then, as of the date of consummation of such
Combination, (A) such Participant Groups shall,
collectively, have the right to appoint only one member
of the Risk Committee and the Participant Group
resulting from such Combination shall take all actions
necessary to remove all but one of their previously
appointed members effective as of the date of
consummation of the Combination and (B) the vacanc(ies)
of the Risk Committee will be filled by the Participant
Group(s) that had the highest Participant Activit(ies)
(over the 12-month period from and including March 2010
to and including February 2011) among those
Participants that, as of the date of consummation of
such Combination, did not have the right to appoint a
member to the Risk Committee (in order of the level of
such Participant Activity, from highest to lowest)
effective as of the date of consummation of such
Combination.
(ix) Notwithstanding anything to the contrary herein,
if at any time on or after the first Risk Committee
Reconstitution Date, there is a Combination involving
Participants where more than one of the relevant
Participant Groups had the right to appoint a member of
the Risk Committee, then, as of the date of
consummation of such Combination, (A) such Participant
Groups shall, collectively, have the right to appoint
only one member of the Risk Committee and the
Participant Group resulting from such Combination shall
take all actions necessary to remove all but one of
their previously appointed members effective as of the
date of consummation of the Combination and (B) the
vacanc(ies) of the Risk Committee will be filled by
Participant Group(s) that had the highest Participant
Activit(ies) (over the immediately preceding
Eligibility Determination Period) among those
Participants that, as of the date of consummation of
such Combination, did not have the right to appoint a
member to the Risk Committee (in order of the level of
such Participant Activity, from highest to lowest)
effective as of the date of consummation of such
Combination.
(x) Notwithstanding anything to the contrary herein, if
at any time all Participants in a Participant Group
with the right to appoint a member of the Risk
Committee are in Default or have had their status as
Participant terminated as a result of being a Retiring
Participant, (A) such Participant Group shall
immediately lose the right to appoint a member to the
Risk Committee and (B) at the date of such Default or
termination, the Participant Group that had the highest
Participant Activity (over the period from and
including March 2010 to and including February 2011 or,
if on or after the first Risk Committee Reconstitution
Date, over the immediately preceding Eligibility
Determination Period) among those Participants that, as
of the date of such Default or termination, did not
have the right to appoint a member to the Risk
Committee, shall have the right to appoint a member to
the Risk Committee effective as of the date of such
Default or termination.
(xi) A Participant Group may appoint an individual to
be a member of the Risk Committee only if such
individual is an employee of one of the Participants in
such Participant Group or an Affiliate thereof. Any
member of the Risk Committee may be removed at any
time, with or without cause, by the Participant Group
that appointed such member pursuant to this Rule 503.
In the event a vacancy occurs on the Risk Committee as
a result of the retirement, removal, resignation, or
death of a member thereof, such vacancy shall be filled
by an individual designated by the relevant Participant
Group.
(xii) Within five ICE Business Days of the end of each
Eligibility Determination Period, ICE Clear Credit
shall, based on its books and records, deliver to each
Participant Group a good faith determination of the
identity of (A) the Top Six Incumbent Participant
Groups and (B) the Eligible Participant Groups, and
shall inform each of the Top Six Incumbent Participant
Groups and the Eligible Participant Groups of its right
to appoint a member to the Risk Committee as of the
next Risk Committee Reconstitution Date pursuant to
this Rule; provided, however, that ICE Clear Credit and
its Affiliates, Board and officers shall have no
liability with respect to the delivery of such good
faith determination. For the sake of clarity, such good
faith determination shall identify only the Participant
Groups mentioned above, and shall not set forth the
Participant Activity levels of such Participant Groups.
In the event any Participant Group disputes in good
faith ICE Clear Credit's good faith determination of
the Top Six Incumbent Participant Groups or the
Eligible Participant Groups, the disputing Participant
Group and the Risk Committee shall submit such dispute
for resolution to PricewaterhouseCoopers LLP (or, if
such firm shall decline or is unable to act or is not,
at the time of such submission, independent of ICE
Clear Credit, the disputing Participant Group or any
member of the Risk Committee, to another independent
accounting firm of international reputation mutually
acceptable to the disputing Participant Group and the
Risk Committee) (such firm, the ``Independent
Accounting Firm''), which shall, within 30 ICE Business
Days after such submission, determine and report to ICE
Clear Credit, the disputing Participant Group and the
Risk Committee, and such report shall be final,
conclusive and binding on the disputing Participant
Group, the Risk Committee and ICE Clear Credit. The
disputing Participant Group shall be solely responsible
for the fees and disbursements of the Independent
Accounting Firm. ICE Clear Credit and its Affiliates,
Board and officers shall have no liability in
connection with the determination of the Independent
Accounting Firm.
(xiii) If, by written agreement of the Risk Committee
and the Board, ICE Clear Credit is determined to have
established multiple risk pools (each, a ``Risk
Pool''), ICE Clear Credit will create a new and
separate risk committee for each such Risk Pool. In
such event, (A) each such new risk committee will have,
with respect to its Risk Pool, the same rights,
responsibilities and operational procedures as the Risk
Committee has under this Chapter, and (B) to the extent
practicable, the composition of such other risk
committee will be determined on the same basis as the
Risk Committee is determined hereunder (taking into
account, instead, the applicable volume or usage metric
with respect to such Risk Pool as determined by the
Risk Committee), with the rules for such composition
being determined by the Board, in consultation with the
Risk Committee
Q.6. What role do they have in controlling access to the
clearinghouse?
A.6. Both the Risk Management Committee and the newly
established Risk Management Subcommittee, described below, are
consultative committees and have no authority to accept or deny
clearing participants.
Importantly, the authority to accept or deny clearing
participants vests solely with the ICE Clear Credit Board of
Managers.
Nevertheless, in anticipation of proposed CFTC regulations
relating to the mitigation of conflicts of interest being
promulgated, ICE Clear Credit recently adopted the following
Rules 510 and 511 to establish a Risk Management Subcommittee
that will be consulted prior to determining the standards and
requirements for initial and continuing clearing participant
eligibility and prior to approving or denying clearing
participant applications.
510. Subcommittee Specified Actions.
ICE Clear Credit shall not take nor permit to be taken
any of the following actions without prior consultation
with the Risk Management Subcommittee (``Subcommittee
Specified Actions''):
(a) Determine products eligible for clearing;
(b) Determine the standards and requirements for
initial and continuing Participant eligibility;
(c) Approve or deny (or review approvals or denials of)
Participant applications described in Rule 202 (or any
successor Rule thereto) or the other ICE Provisions;
(d) Modify this Chapter of the Rules or Modify any of
the responsibilities, rights or operations of the Risk
Management Subcommittee or the manner in which the Risk
Management Subcommittee is constituted as set forth in
the Rules.
511. Composition of the Risk Management Subcommittee;
Confidentiality.
(a) The composition of the Risk Management Subcommittee
shall be as follows:
(i) The Risk Management Subcommittee shall consist of
five members.
(ii) Each member of the Risk Management Subcommittee
shall have risk management experience and expertise and
shall be subject to the approval of the Board, such
approval not to be unreasonably withheld, conditioned
or delayed.
(iii) Two of the members of the Risk Management
Subcommittee shall be public directors as defined in
CFTC Rule 1.3(ccc) (``Independent Public Directors'')
appointed by ICE Clear Credit. The Board must make such
finding upon the appointment of the member and as often
as necessary in light of all circumstances relevant to
such member, but in no case less than annually.
(iv) One member of the Risk Management Subcommittee
shall be a Non-Participant Party. Such member will be
nominated by the buy-side Advisory Committee of ICE
Clear Credit.
(v) Two of the members of the Risk Management
Subcommittee shall be composed of representatives of
Participants who are members of the Risk Committee.
Such members shall be nominated by the Risk Committee.
(vi) No member of the Risk Management Subcommittee may
be subject to statutory disqualification under CEA
Section 8a(2) or Section 3(a)(39) of the Securities
Exchange Act, or other applicable CFTC or SEC
regulations.
Q.7. How is ICE Clear Credit planning to satisfy the open
access provisions in the Dodd-Frank Act?
A.7. Since its inception, ICE Trust, now known as ICE Clear
Credit, has supported open access and will continue to do so
pursuant to Dodd-Frank. (It should be noted that from a
business model perspective, it is generally in ICE Clear
Credit's interest to receive more transactions to clear.)
Specifically, ICE Trust Rule 314 (Open Access for Execution
Venues and Trade Process Platforms) previously provided:
ICE Trust shall ensure that there shall be open access
to the clearing system operated by ICE Trust pursuant
to these Rules for all execution venues (including,
without limitation, designated contract markets,
national securities exchanges, swap execution
facilities and security-based swap execution
facilities) and trade processing platforms. ICE Trust
may impose (a) reasonable criteria to determine whether
an execution venue has the capability to deliver the
necessary quality of service to be granted access to
ICE Trust, (b) reasonable criteria to determine whether
a trade processing platform has the capability to
deliver the necessary quality of service to be granted
access to ICE Trust and connected through the ICE Trust
application programming interface, (c) reasonable
requirements as to risk filters and other credit risk
management standards with respect to transactions to be
submitted to ICE Trust for clearing, and (d) reasonable
costs on such execution venues and trade processing
platforms and Participants that use such venues and
platforms; provided that in each case such criteria or
costs shall not unreasonably inhibit such open access
and shall comply with applicable law.
ICE Clear Credit Rule 314 was recently amended slightly to
read as follows:
ICE Clear Credit shall ensure that, consistent with the
requirements of CEA Section 2(h)(1)(B) and Securities
Exchange Act Section 3C(a)(2), there shall be open
access to the clearing system operated by ICE Clear
Credit pursuant to these Rules for all execution venues
(including, without limitation, designated contract
markets, national securities exchanges, swap execution
facilities and security-based swap execution
facilities) and trade processing platforms. ICE Clear
Credit may impose (a) reasonable criteria to determine
whether an execution venue has the capability to
deliver the necessary quality of service to be granted
access to ICE Clear Credit, (b) reasonable criteria to
determine whether a trade processing platform has the
capability to deliver the necessary quality of service
to be granted access to ICE Clear Credit and connected
through the ICE Clear Credit application programming
interface, (c) reasonable requirements as to risk
filters and other credit risk management standards with
respect to transactions to be submitted to ICE Clear
Credit for clearing, and (d) reasonable costs on such
execution venues and trade processing platforms and
Participants that use such venues and platforms;
provided that in each case such criteria or costs shall
not unreasonably inhibit such open access and shall
comply with applicable law.
Q.8. How would you expect the open access provisions to impact
your business model, as well as the overall role of
clearinghouses in the swaps market worldwide?
A.8. As indicated above, ICE Trust, now known as ICE Clear
Credit, has always supported open access. ICE Clear Credit is
agnostic with respect to the execution venue provided that the
execution venue meets ICE Clear Credit's reasonable eligibility
standards and submits transactions to ICE Clear Credit on
behalf of ICE Clear Credit's authorized clearing participants.
Q.9. Given the policy objective of Title VII to increase the
clearing of swaps, how would you structure the implementation
of the new Dodd-Frank clearing requirements to provide the
greatest incentives for market participants to clear their
trades?
A.9. Specifically, clearing participants will be incented to
clear if the Dodd-Frank provisions calling for the CFTC and SEC
to approve portfolio margining between correlated commodity-
based swaps and security-based swaps are implemented. ICE Clear
Credit has submitted to the CFTC and SEC its draft request for
portfolio margin treatment with respect to the commodity-based
swaps (CDS indices) and security-based swaps (single name CDS)
that ICE Clear Credit clears.
More generally, centralized clearing fundamentally reduces
counterparty risk and provides financial stability as a result
of sound and transparent risk management practices. All
clearing participants are required to post collateral in the
form of initial margin and all clearing participants' cleared
positions are marketed-to-market on a daily basis. In addition,
clearing participants are required to contribute to the
clearinghouse's guaranty fund which serves as a mutualized
financial backstop in the event that a clearing participant
should default on its obligations. The implementation of new
Dodd-Frank requirements should be structured in a manner that
promotes the fundamental safety and soundness principles of
centralized clearing.
Q.10. Are there certain entities or asset classes that should
be cleared before others?
A.10. Generally, the more standardized and liquid swaps are
more appropriately cleared.
Q.11. Could you describe the current policies and procedures
used by your clearinghouse to prevent conflicts of interest in
decision making about clearing swap trades?
A.11. See responses to Question 2 above.
Q.12. How do you expect the provisions of the Dodd-Frank Act
that seek to minimize conflicts of interest to impact the
governance and voting composition of your Boards of Directors?
A.12. The provisions of Dodd-Frank relating to conflicts are
unlikely to impact ICE Clear Credit given its corporate
governance structure. The majority of ICE Clear Credit's Board
of Managers are independent (6/11). Three of the remaining
Board members are representatives of ICE management. The
remaining two Board members are representatives of the clearing
participants.
Q.13. How do you ensure that neither a single shareholder nor a
small group of shareholders can dominate the clearinghouse and
determine its policies?
A.13. Technically, ICE Clear Credit has a single shareholder--
ICE Inc. ICE U.S. Holding Company L.P. is the sole member of
ICE Clear Credit. ICE Inc. (a public company) wholly owns the
company that serves as the General Partner (GP) of ICE U.S.
Holding Company L.P. None of the Limited Partners have the
right to elect the Board of Managers of ICE Clear Credit. The
GP of ICE U.S. Holding Company L.P. elects the Board of
Managers of ICE Clear Credit. The Limited Partners of ICE U.S.
Holding (that include the former owners of The Clearing
Corporation) merely maintain a limited economic interest in the
profits of ICE Clear Credit.
Q.14. One concern is that members could restrict access either
directly or indirectly by controlling the ability to enter into
correspondent clearing arrangements. What are the best
approaches to ensuring fair and open access?
A.14. As noted above, the ICE Clear Credit clearing
participants do not govern ICE Clear Credit. Instead, the ICE
Clear Credit Board of Managers, a majority of whom are
independent, govern ICE Clear Credit. Moreover, as noted above,
ICE Clear Credit has an open access policy as codified in its
Rules.
Q.15. Some have argued that members could actually lower risk
controls and be incentivized to take on greater risk positions
in a clearinghouse environment. How does the clearinghouse
management team evaluate the risk controls?
A.15. The clearing participants of a clearinghouse mutualize
the risk of all of the clearing participants as a result of
contributing to the clearinghouse's guaranty fund. Since each
clearing participant's capital is exposed to the risk of other
clearing participants, the clearing participants are
financially incented to ensure that risk controls are
appropriate and are not lowered. In addition, as noted above,
the ICE Clear Credit Board of Mangers is vested with the sole
authority to determine the risk controls of ICE Clear Credit.
Q.16. What incentives exist to ensure risks are properly
evaluated and not exposed to influence from members?
A.16. See above response. It is in the economic interest of
clearing members who serve on the Risk Committee to ensure that
risks are properly evaluated. Nevertheless, at ICE Clear
Credit, the Risk Committee has no authority and is merely a
consultative committee. As noted above, only the ICE Clear
Credit Board of Managers has authority to make risk-related
decisions.
Q.17. It was recently reported that ICE Clear Credit is
reducing its minimum adjusted net capital for members from $1
billion to $50 million (plus $20 million in one-time guarantee
fund contributions and a variable rate on how much the member
exposes the clearinghouse). How does this change balance access
with safety and soundness?
A.17. See response to Question 1 above that references ICE
Clear Credit's current minimum adjusted net capital
requirements. The $50 million number comes from the CFTC's
proposed minimum adjusted net capital requirement. ICE Clear
Credit has not considered lowering its adjusted net capital
requirement to $50 million.
Q.18. Both the U.S. Department of Justice and the European
Commission have become concerned about the possibility of
anticompetitive practices in credit derivatives clearing. In
your opinion, what factors give rise to these concerns?
A.18. ICE Clear Credit does not know and will not speculate
regarding any factors that might give rise to concerns of the
U.S. Department of Justice. ICE Clear Credit respectfully
refers the Committee to the European Commission's press release
dated April 29, 2011.
Q.19. Do those same factors extend to the clearing of other
products? And how should we address those factors?
A.19. Again, ICE Clear Credit does not know and will not
speculate regarding any factors that might give rise to
concerns of the U.S. Department of Justice.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM JAMES CAWLEY
Q.1. What are your perspectives on the current rules proposed
by the CFTC and SEC on the ownership and governance of
clearinghouses? How would reducing minimum capital requirements
for clearinghouse membership impact the risk profiles of
clearinghouses as well as the ability of new potential clearing
members to join clearinghouses?
A.1. Please see the attached SDMA comment regarding
Implementation of Conflicts of Interest Policies and
Procedures, dated June 3, 2011 (hereafter ``Conflicts
Letter'').
Q.2. How do you anticipate clearinghouses will coordinate with
exchanges and swap execution facilities (SEF) on the clearing
and trading of swaps? What would be the positive and negative
impacts of a vertically integrated clearinghouse-SEF model when
compared with more independent role for clearing and execution
venues?
A.2. Please see the attached SDMA comment regarding OTC
Derivative Market Integrity and Real-Time Trade Processing
Requirements, dated June 3, 2011.
Q.3. Both the U.S. Department of Justice and the European
Commission have become concerned about the possibility of
anticompetitive practices in credit derivatives clearing. What
factors give rise to these concerns? Do those same factors
extend to the clearing of other products? And how should we
address those factors?
A.3. There are two key factors that indicate anticompetitive
practices. The first factor is that all or most of the sales
for a particular product or service are provided by a small
number of sellers. This high concentration of market share is
known as ``market power.'' The second factor is high barriers
to entry into the market. Barriers to entry are anything that
prevents a potential competitor's ability to enter the market
and include high capital costs, control of resources and
intellectual property.
All of these factors give rise to concerns in the clearing
of credit derivatives and extend to the clearing of other
products. The clearinghouses that clear credit derivatives have
market power. It is well established that 80 percent of the
market is controlled by 10 dealers. These dealers and the
clearinghouse they control are an oligopoly (i.e., a small
group of firms that exert monopoly like control over the
market). They have sought to maintain their market power
through restrictive clearinghouse participant eligibility
standards.
For further detail on these restrictive standards, and our
thoughts on how to address these issues, please see the
Conflicts Letter.
Q.4. Should there be restrictions on the ownership of
clearinghouses by major swaps dealers? Why or why not?
A.4. Please see the attached SDMA comment regarding
Implementation of Conflicts of Interest Policies and
Procedures, dated June 3, 2011.
Q.5. Is the clearing function a natural monopoly? Why or why
not?
A.5. The clearing function is not a natural monopoly. A natural
monopoly exists in a market where barriers to entry are
substantial costs or the use of infrastructure that cannot be
reasonably duplicated by a competitor. Two examples of this
type of infrastructure are electrical grids and railroad
bridges.
This is not the case in clearing function. Clearing does
not rely upon infrastructure that cannot be reasonably
duplicated. It relies upon capital. There is no limit in the
amount of capital that can be used. Please see the Conflicts
Letter for a discussion of how the use of capital should be
applied to clearing risk.
Q.6. While the benefits of encouraging clearing are widely
acknowledged, increased clearing brings some risks of its own.
What steps would you recommend our regulators take to reduce
and contain systemic risk at clearinghouses?
A.6. Since their inception clearinghouses have played a vital
role in the market by managing the default risk of
counterparties and spreading that risk over the members of the
clearinghouse. This system is most effective when the group of
clearing members is large and uncorrelated, and conversely,
least effective when the group is small and correlated.
Systemic risk is especially problematic in the current
environment where clearinghouses are monopolies controlled by a
handful of highly correlated firms. In the event of clearing
member default where there are a small number of correlated
clearing members there is a greater chance that other clearing
members may also default.
In order to reduce systemic risk the regulators must
require that clearinghouses have a large, noncorrelated group
of clearing members. This can only be accomplished through
clearing membership standards that are based upon fair and open
access. Please see the Conflicts Letter for a further
discussion of this topic.
Q.7. How should regulators properly oversee the dynamic risk
management process in a real-time manner?
A.7. To oversee the dynamic risk management process in real-
time the regulators must have adequate technology resources.
Without adequate technology there can be no real-time
monitoring of any function. Adequate technology has three
components. The first component is technology infrastructure
that meets current industry standards. Second, the regulators
must have direct connectivity to the clearinghouses. Third, the
regulators must have software that can perform real time
monitoring of risk management functions. The software can
either be provided by the clearinghouses to the regulators or a
program developed by the regulators.
ADDENDUM 1
ADDENDUM 2
Additional Material Supplied for the Record
LETTER SUBMITTED BY THOMAS C. DEAS, JR., VICE PRESIDENT AND TREASURER,
FMC CORPORATION
Dear Chairman Johnson and Ranking Member Shelby, I very much
appreciate your having given me the opportunity to present the views of
end users on the complex topic of derivatives reform at the Committee's
hearing on April 12, 2011. I was speaking as the Vice President and
Treasurer of FMC Corporation, as the President of the National
Association of Corporate Treasurers, and on behalf of the Coalition for
Derivatives End Users, on whose steering committee I serve. I also very
much appreciate your efforts on behalf of end users as we join with you
to bring about sensible reform of derivatives.
I would like to respond for the record to comments made at a
subsequent hearing of the Subcommittee on Securities, Insurance, and
Investment on May 25, 2011. Dr. Benn Steil, Senior Fellow and Director
of International Economics of the Council on Foreign Relations asserted
that margining by end users would bring about increased transparency
and that treasurers oppose margin requirements in order to conceal the
inefficiency of their unmargined derivatives transactions.
We believe that Dr. Steil's analysis reflects several flawed
assumptions. For example, he assumes that corporate treasurers do not
have access to market pricing information and also that policy makers
intended margin as a mechanism to address transparency gaps in the
over-the-counter (OTC) derivatives market. Both of these assumptions
are flat wrong.
End users generally value the ability to customize their
derivatives transactions. Because customized derivatives have unique
attributes that affect their price, some have suggested that end users
are unable to discern the appropriate price of a derivative. In fact,
corporate treasurers today have access to tools that allow them to
price unique transaction structures. When corporate treasurers enter
into hedging arrangements to mitigate risk, they utilize these tools to
identify the appropriate price prior to transacting. Moreover, like any
consumer, corporate treasurers comparison shop to ensure they get the
best price. They often do this by conducting competitive auctions that
ensure the best execution is achieved.
Although end users generally execute at the best price available to
them, there are situations in which treasurers may opt to execute
transactions slightly above market levels. Contrary to Dr. Steil's
assertion, such situations are not indicative of a treasurer's
inability to achieve efficient pricing outcomes. For example, a
treasurer generally attempts to mitigate counterparty credit risk by
executing transactions with multiple counterparties. If a given
counterparty is especially competitive in other credit products such as
letters of credit to facilitate foreign trade payments or undrawn
credit lines committed for future use, corporate treasurers may find
that a disproportionate amount of credit risk consisting of future
credit commitments together with derivatives may be with a single
counterparty. An excess concentration of counterparty credit risk will
generally be unacceptable for an end user. In order to spread its
counterparty credit risk across multiple banks, treasurers will often
choose to accept a price from a bank that may be slightly wide of the
best price. Contrary to Dr. Steil's assertion, prudence dictates that
companies weigh not only the price of a given transaction, but also
factors such as counterparty credit risk and even legal risks.
A report published November 1, 2010, by the International Swaps and
Derivatives Association (ISDA) entitled, ``Interest Rate Swap Liquidity
Test'', found that the difference in pricing between the best and worst
quotes for any interest rate swap in their sample was just 1.3 basis
points (a range of from 0.0000 percent to 0.0130 percent). The average
difference between the best and worst quotes for each swap was just
0.38 basis points (0.0038 percent). ISDA concluded that the narrow
spreads between the best and worst quotes attest to an extremely
competitive marketplace for uncleared and unmargined OTC derivatives
and that the benefits to counterparties with collateralized swap
documentation consistent with margining would be ``extremely modest.''
Though end users already have access to pricing information that
enables them to secure efficient market pricing, end users have long
supported efforts to increase transparency in the OTC derivatives
market by increasing access to such information and lowering the cost
of obtaining it. The Dodd-Frank Act and its associated rules employ
several mechanisms aimed at increasing transparency. For example,
regulators have proposed requirements for banks to disclose midmarket
swap prices to their customers. Additionally, Dodd-Frank includes a
real-time reporting requirement and a trading requirement, each aimed
at increasing pricing transparency for market participants.
However, margin was not among the policy tools implemented to
increase pricing transparency. Rather, margin was intended to reduce
systemic risk by dictating that certain market participants back their
trades with cash. It is the cash and committed credit that margin
requirements would tie up, to the detriment of productive investment in
their businesses that concerns corporate treasurers, not any
incremental disclosure that such requirements might bring.
Though we appreciate Dr. Steil's desire to increase transparency in
a manner that benefits end users, we believe his analysis inaccurately
characterizes the motivations of corporate treasurers. In particular,
his analysis ignores the trade-offs inherent in the decisions
treasurers make when managing their risks.
Thank you for your consideration of these comments. Please let me
know if you have any questions or if I can be of assistance in further
elaborating these ideas.