[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]


                    HEARING TO REVIEW THE IMPACT OF
                   CAPITAL AND MARGIN REQUIREMENTS ON
                               END-USERS

=======================================================================

                                HEARING

                               BEFORE THE

        SUBCOMMITTEE ON COMMODITY EXCHANGES, ENERGY, AND CREDIT

                                 OF THE

                        COMMITTEE ON AGRICULTURE
                        HOUSE OF REPRESENTATIVES

                    ONE HUNDRED FOURTEENTH CONGRESS

                             SECOND SESSION

                               __________

                             APRIL 28, 2016

                               __________

                           Serial No. 114-50


          Printed for the use of the Committee on Agriculture
                         agriculture.house.gov
                         
                         
                               ____________
                               
                               
                        U.S. GOVERNMENT PUBLISHING OFFICE
20-029 PDF                  WASHINGTON : 2016                        


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                        COMMITTEE ON AGRICULTURE

                  K. MICHAEL CONAWAY, Texas, Chairman

RANDY NEUGEBAUER, Texas,             COLLIN C. PETERSON, Minnesota, 
    Vice Chairman                    Ranking Minority Member
BOB GOODLATTE, Virginia              DAVID SCOTT, Georgia
FRANK D. LUCAS, Oklahoma             JIM COSTA, California
STEVE KING, Iowa                     TIMOTHY J. WALZ, Minnesota
MIKE ROGERS, Alabama                 MARCIA L. FUDGE, Ohio
GLENN THOMPSON, Pennsylvania         JAMES P. McGOVERN, Massachusetts
BOB GIBBS, Ohio                      SUZAN K. DelBENE, Washington
AUSTIN SCOTT, Georgia                FILEMON VELA, Texas
ERIC A. ``RICK'' CRAWFORD, Arkansas  MICHELLE LUJAN GRISHAM, New Mexico
SCOTT DesJARLAIS, Tennessee          ANN M. KUSTER, New Hampshire
CHRISTOPHER P. GIBSON, New York      RICHARD M. NOLAN, Minnesota
VICKY HARTZLER, Missouri             CHERI BUSTOS, Illinois
DAN BENISHEK, Michigan               SEAN PATRICK MALONEY, New York
JEFF DENHAM, California              ANN KIRKPATRICK, Arizona
DOUG LaMALFA, California             PETE AGUILAR, California
RODNEY DAVIS, Illinois               STACEY E. PLASKETT, Virgin Islands
TED S. YOHO, Florida                 ALMA S. ADAMS, North Carolina
JACKIE WALORSKI, Indiana             GWEN GRAHAM, Florida
RICK W. ALLEN, Georgia               BRAD ASHFORD, Nebraska
MIKE BOST, Illinois
DAVID ROUZER, North Carolina
RALPH LEE ABRAHAM, Louisiana
JOHN R. MOOLENAAR, Michigan
DAN NEWHOUSE, Washington
TRENT KELLY, Mississippi

                                 ______

                    Scott C. Graves, Staff Director

                Robert L. Larew, Minority Staff Director

                                 ______

        Subcommittee on Commodity Exchanges, Energy, and Credit

                    AUSTIN SCOTT, Georgia, Chairman

BOB GOODLATTE, Virginia              DAVID SCOTT, Georgia, Ranking 
FRANK D. LUCAS, Oklahoma             Minority Member
RANDY NEUGEBAUER, Texas              FILEMON VELA, Texas
MIKE ROGERS, Alabama                 SEAN PATRICK MALONEY, New York
DOUG LaMALFA, California             ANN KIRKPATRICK, Arizona
RODNEY DAVIS, Illinois               PETE AGUILAR, California
TRENT KELLY, Mississippi

                                  (ii)
                            
                            
                            
                            C O N T E N T S

                              ----------                              
                                                                   Page
Conaway, Hon. K. Michael, a Representative in Congress from 
  Texas, opening statement.......................................    39
Scott, Hon. Austin, a Representative in Congress from Georgia, 
  opening statement..............................................     1
    Prepared statement...........................................     2
Scott, Hon. David, a Representative in Congress from Georgia, 
  opening statement..............................................     3

                               Witnesses

Lukken, Hon. Walter L., President and Chief Executive Officer, 
  Futures Industry Association, Washington, D.C..................     4
    Prepared statement...........................................     5
O'Malia, Hon. Scott D., Chief Executive Officer, International 
  Swaps and Derivatives Association, Inc., New York, NY..........     8
    Prepared statement...........................................    10
Deas, Jr., Thomas C., representative, Center for Capital Markets 
  Competitiveness, U.S. Chamber of Commerce; representative, 
  Coalition for Derivatives End-Users, Washington, D.C...........    21
    Prepared statement...........................................    23
Gellasch, Tyler, Founder, Myrtle Makena, LLC, Homestead, PA......    27
    Prepared statement...........................................    29

 
                    HEARING TO REVIEW THE IMPACT OF
                   CAPITAL AND MARGIN REQUIREMENTS ON
                              END-USERS

                              ----------                              


                        THURSDAY, APRIL 28, 2016

                  House of Representatives,
   Subcommittee on Commodity Exchanges, Energy, and Credit,
                                  Committee on Agriculture,
                                                   Washington, D.C.
    The Subcommittee met, pursuant to call, at 10:00 a.m., in 
Room 1300 of the Longworth House Office Building, Hon. Austin 
Scott of Georgia [Chairman of the Subcommittee] presiding.
    Members present: Representatives Austin Scott of Georgia, 
Lucas, LaMalfa, Davis, Kelly, Conaway (ex officio), David Scott 
of Georgia, Vela, and Kirkpatrick.
    Staff present: Caleb Crosswhite, Darryl Blakey, Kevin Webb, 
Stephanie Addison, Faisal Siddiqui, John Konya, Matthew 
MacKenzie, Nicole Scott, and Carly Reedholm.

  OPENING STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN 
                     CONGRESS FROM GEORGIA

    The Chairman. Well, good morning. Thank you for joining the 
Commodity Exchanges, Energy, and Credit Subcommittee for 
today's hearing, which is the second in a series to examine the 
implementation of Dodd-Frank over the past 5 years. In 
February, we held our first hearing to talk about swap data 
standards and transparency. During today's hearing, we will 
talk about the unintended consequences of some of the most 
important regulations following the financial crisis, the new 
capital standards and margin requirements for banks, non-bank 
swap dealers, and other market participants.
    On a fundamental level, derivatives markets exist for 
hedgers, for those businesses and people who have risks that 
they seek to manage. And on the Agriculture Committee, we often 
think about the businesses that serve the farm economy and 
their ability to manage the risks they shoulder on behalf of 
their agricultural clients. But there are producers, 
manufacturers, merchants, pensions, insurers, and other 
businesses across our country that face similar challenges 
managing their commodity, foreign exchange, interest rate, and 
credit risks.
    While Congress has been explicit in its efforts to exempt 
these end-users from much of the regulatory burdens associated 
with Dodd-Frank, these rules could have impacts on end-users if 
they drive intermediaries, like futures commission merchants 
and swap dealers, from the markets. If this happens, hedgers 
will see their spreads widen, their fees increase, and 
liquidity fall.
    Without question, the financial crisis could have been 
tempered with stronger capital rules and margin requirements. 
And today's hearing isn't about the purpose or need for capital 
and margin standards; instead, it is about the outsized 
consequences of small decisions made when designing these 
rules. These decisions, things like how to account for margin 
or the differences between cash and cash-equivalents, may seem 
small to regulators, but they will be deeply impactful to main 
street businesses that rely on derivatives markets to manage 
their risks.
    Regulation is about choices. Each rulemaking is built from 
a thousand little decisions that are supposed to add up to a 
desired outcome. Over the past 5 years, financial regulators 
have been busy making a lot of decisions, but it isn't entirely 
clear if we are reaching the outcome that was intended.
    Today, we will examine those decisions and compare the 
outcome to Congress' longstanding goal to protect end-users 
from bearing the burdens of the financial crisis. Protecting 
end-users does not need to be a zero-sum game. I believe we can 
both build resilient markets and protect end-users from 
unnecessary burdens.
    I want to close by thanking our witnesses for the time they 
have spent preparing and traveling to be with us today. The 
Subcommittee appreciates your willingness to share your talents 
and expertise with us today.
    [The prepared statement of Mr. Austin Scott follows:]

 Prepared Statement of Hon. Austin Scott, a Representative in Congress 
                              from Georgia
    Good morning. Thank you for joining the Commodity Exchanges, 
Energy, and Credit Subcommittee for today's hearing, which is the 
second in a series to examine the implementation of Dodd-Frank over the 
past 5 years. In February, we held our first hearing to talk about swap 
data standards and transparency. During today's hearing, we'll talk 
about the unintended consequences of some of the most important 
regulations following the financial crisis: the new capital standards 
and margin requirements for banks, non-bank swap dealers, and other 
market participants.
    On a fundamental level, derivatives markets exist for hedgers, for 
those businesses and people who have risks that they seek to manage.
    On the Agriculture Committee, we often think about the businesses 
that serve the farm economy and their ability to manage the risks they 
shoulder on behalf of their agricultural clients. But there are 
producers, manufacturers, merchants, pensions, insurers, and other 
businesses across our country that face similar challenges managing 
their commodity, foreign exchange, interest rate, and credit risks.
    While Congress has been explicit in its efforts to exempt these 
end-users from much of the regulatory burdens associated with Dodd-
Frank, these rules could have impacts on end-users if they drive 
intermediaries, like futures commission merchants and swap dealers, 
from the markets.
    If this happens, hedgers will see their spreads widen, their fees 
increase, and liquidity fall.
    Without question, the financial crisis could have been tempered 
with stronger capital rules and margin requirements. So, today's 
hearing isn't about the purpose or need for capital and margin 
standards. Instead, it's about the outsized consequences of small 
decisions made when designing these rules. These decisions--things like 
how to account for margin or the difference between cash and cash-
equivalents--may seem small to regulators, but they will be deeply 
impactful to main street businesses that rely on derivatives markets to 
manage their risks.
    Regulation is about choices. Each rulemaking is built from a 
thousand little decisions that are supposed to add up to a desired 
outcome. Over the past 5 years, financial regulators have been busy 
making a lot of decisions, but it isn't entirely clear if we're 
reaching the outcome that was intended.
    Today, we will examine those decisions and compare the outcome to 
Congress' longstanding goal to protect end-users from bearing the 
burdens of the financial crisis. Protecting end-users does not need to 
be a zero-sum game. I believe we can both build resilient markets and 
protect end-users from unnecessary burdens.
    I want to close by thanking our witnesses for the time they've 
spent preparing and traveling to be with us today. The Subcommittee 
appreciates your willingness to share your talents and expertise with 
us today.
    With that, I'll turn to our Ranking Member, Mr. Scott, for any 
remarks he might have.

    The Chairman. With that, I will turn to our Ranking Member, 
Mr. Scott, for any remarks he might have.

  OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN 
                     CONGRESS FROM GEORGIA

    Mr. David Scott of Georgia. Thank you, Mr. Chairman. And I 
want to welcome all of our distinguished witnesses. We are 
looking forward to your expert testimony in this very, very 
important area of the impact of capital and margin requirements 
on end-users.
    Today's hearing is very, very important, mainly to finding 
that right balance between high enough capital and margin 
requirements to keep the system safe, and low enough capital 
and margin requirements to ensure that the system is profitable 
for everyone in the industry.
    Our Committee took particular and very great pains over the 
years to exempt end-users from the margin and capital 
requirements necessary to reform the derivatives markets, for 
the simple reason that the farmers, the ranchers, other end-
users, manufacturers, did absolutely nothing to cause the 
financial crisis. And we feel, on our Committee, that it is our 
job to make sure that this spirit continues in any regulations 
in the future. They had nothing to do with the financial 
crisis, and that must always be taken into consideration.
    Over the years, I have been very, very concerned about 
cross-border transactions, and I am very pleased with the 
ongoing work of Chairman Massad, who is doing a fine job over 
at the CFTC. But Chairman Massad has had a tough, tough battle 
in dealing with the issue of the European Union equivalency. 
And so I am looking forward very much to getting your 
evaluation of that, where you see the progress going, because 
if we do not solve this situation with the equivalency issue 
with the European Union, it is going to put our end-users, our 
manufacturers, our clearinghouses at a very, very serious 
competitive disadvantage.
    And so I look forward to this hearing, and I want to thank 
Chairman Scott for, again, pulling together a very, very timely 
hearing. We are dealing on the derivatives case with an $700 
trillion piece of the world's economy. Many people do not know 
it is that large. That is huge, and it is growing exponentially 
every single day, and that is why this hearing is very 
important.
    And I thank you, Mr. Chairman, and I yield back.
    The Chairman. Thank you, Mr. Scott.
    I would like to welcome our witnesses to the table. We have 
the Honorable Walter Lukken, President and Chief Executive 
Officer of the Futures Industry Association in Washington, 
D.C., we have the Honorable Scott O'Malia, Chief Executive 
Officer, International Swaps and Derivatives Association, 
Incorporated, New York, New York; Mr. Thomas Deas, 
representative of the Center for Capital Markets 
Competitiveness and Coalition for Derivatives End-Users; and 
Mr. Tyler Gellasch, Founder of Myrtle Makena, LLC, Homestead, 
Pennsylvania.
    Mr. Lukken, please begin when you are ready.

    STATEMENT OF HON. WALTER L. LUKKEN, PRESIDENT AND CHIEF 
              EXECUTIVE OFFICER, FUTURES INDUSTRY
                 ASSOCIATION, WASHINGTON, D.C.

    Mr. Lukken. Mr. Chairman, Ranking Member Scott, and Members 
of the Subcommittee, thank you for this opportunity to testify 
on the impact of margin and bank capital on the cleared 
derivatives markets.
    I am President and CEO of FIA, a trade association for the 
futures, options, and centrally cleared derivatives markets. 
Both margin and bank capital play an important role in 
protecting the safety and soundness of the financial system. 
Since the financial crisis, their roles have been heightened 
with the G20 leaders' commitment to both enhance bank capital, 
and require the clearing, and thus, margining of standardized 
OTC products through regulated clearinghouses.
    While capital and margin are both tools in protecting the 
financial system, it is important to distinguish the two, as 
each serves a specific function in meeting this important goal.
    Bank capital is the amount of funds that a banking 
institution holds in reserve to support its banking activities. 
Required by national banking regulators under international 
standards set by the Basel Committee on Bank Supervision, bank 
capital serves as a stable financial cushion to absorb 
unexpected losses by banks. Margin, on the other hand, aims to 
protect the safety and soundness of the futures and cleared 
derivatives markets, rather than specific institutions. 
Customers that utilize the futures or cleared derivatives 
markets to hedge their risks are required to clear such 
transaction through a clearinghouse, and in order to do so, 
must post margin with a clearing member. The clearing member, 
in turn, manages this collection of margin from its customers, 
and guarantees the customers' transactions with a 
clearinghouse. The customers' margin is simply a performance 
bond that ensures customers make good on their transactions, 
which offsets the clearing member's exposure to the 
clearinghouse.
    Many of the largest clearing members are also affiliated 
with prudentially regulated banks, and thus, are required to 
hold sufficient capital to ensure their firm, and thus, the 
system, is protected. As large financial institutions, these 
banks are subject to both CFTC regulation for their future 
commission merchant clearing business, as well as bank capital 
regulations under the oversight of the Federal Reserve, the 
FDIC, and the OCC. These U.S. bank regulators, consistent with 
standards set by the Basel Committee, are now implementing a 
new type of capital provision known as the leverage ratio. Part 
of the goal of the leverage ratio is to set a simple, non-risk-
based floor for capital, including measuring the exposures 
arising from futures options and other derivatives 
transactions. Unfortunately, the leverage ratio fails to 
properly recognize that customer margin posted to a bank-
affiliated clearing member offsets the bank's actual exposure 
to the clearinghouse.
    The very nature of customer margin is to reduce the 
exposure of losses to the clearing member and the 
clearinghouse. In recent years, the CFTC, under your oversight, 
has made significant improvements to enhance customer margin to 
ensure it is always the first line of protection to offset 
losses during a default. If left unfixed, the leverage ratio 
will result in an inaccurate measurement of the actual economic 
exposure of the bank, and assign unwarranted capital charges on 
its clearing business. This will lead to higher costs for end-
users and hedgers in our markets. Given these new capital 
constraints, bank clearing members are already beginning to 
limit the amount and types of clients that they accept to 
clear. We also believe the leverage ratio will lead to further 
consolidation among clearing members, resulting in fewer 
players supporting the safety and soundness of the 
clearinghouse.
    In the U.S., clearing members have decreased from 94 
clearing firms 10 years ago, to only 55 today. While there are 
several factors contributing to this consolidation, capital has 
been recently cited by several clearing member banks who have 
now exited the clearing business.
    Perhaps the most concerning consequence for this Committee 
surrounds the leverage ratio's impact on a clearinghouse's 
ability to move or port client positions from a defaulting 
clearing member to another healthy clearing member during a 
crisis. If porting cannot be achieved due to capital 
constraints, clearinghouses will be forced to liquidate in a 
fire sale client positions during volatile market conditions, 
adding unnecessary stress to an unstable marketplace. After 
all, the ability of clearinghouses to move customer positions 
during the failure of Lehman Brothers in 2008 is one of the 
fundamental reasons that policymakers in the G20 determined to 
expand clearing to OTC products.
    In closing, I would encourage the U.S. regulatory community 
to work together through the Basel process in determining how 
our margin and bank capital regulations can work in context. 
Without a fix, recent efforts by the G20 to increase the use of 
clearing may be in jeopardy, and customers in the futures and 
cleared swaps markets may face higher costs and less access to 
these risk management markets.
    Thank you very much, and I look forward to your questions.
    [The prepared statement of Mr. Lukken follows:]

   Prepared Statement of Hon. Walter L. Lukken, President and Chief 
   Executive Officer, Futures Industry Association, Washington, D.C.
Introduction
    Chairman Scott, Ranking Member Scott, and Members of the 
Subcommittee, thank you for the opportunity to discuss capital and 
margin matters impacting the derivatives industry. I am the President 
and Chief Executive Officer of FIA. FIA is the leading global trade 
organization for the futures, options and centrally cleared derivatives 
markets, with offices in London, Singapore and Washington, D.C. FIA's 
membership includes clearing firms, exchanges, clearinghouses, trading 
firms and commodities specialists from more than 48 countries as well 
as technology vendors, lawyers and other professionals serving the 
industry. FIA's mission is to support open, transparent and competitive 
markets, protect and enhance the integrity of the financial system and 
to promote high standards of professional conduct. As the principal 
members of derivatives clearinghouses worldwide, FIA's clearing firm 
members help reduce systemic risk in global financial markets.
    Clearing ensures that parties to a transaction are protected from 
the failure of a buyer or seller to perform its obligations, thus 
minimizing the risk of a counterparty default. The clearinghouse is 
able to take on this role because it is backed by the collective funds 
of its clearing members who also guarantee the performance of their 
clients to make good on their transactions. To protect against default, 
clearinghouses require that all transactions are secured with 
appropriate margin. Clearing members, acting as agents for their 
customers, collect this margin and segregate it away from their own 
funds as required by the Commodity Exchange Act. They have long 
performed this function for futures customers, who have historically 
been required to clear their transactions. More recently, under the 
``Dodd-Frank Act'' (Dodd-Frank) in the U.S. and the ``European Market 
Infrastructure Regulation'' (EMIR) in Europe, policymakers determined 
to extend the clearing requirement beyond futures and options to 
certain over-the-counter swaps, and as such, the role of the clearing 
member has expanded. Despite this expansion, over the 10 year period 
between 2004 and 2014, the clearing member community in the U.S. has 
decreased from 190 firms to 76 firms.
    While there are several factors contributing to this consolidation, 
today I want to focus on how recent Basel III capital requirements for 
prudentially regulated clearing members are lessening clearing options 
for end-user customers who use futures and cleared swaps to manage 
their business risks. These capital requirements have made it difficult 
for many clearing member banks to offer clearing services to their 
clients--a result that seems at odds with recent efforts by the Group 
of 20 nations (G20) to increase the use of clearing as a counterparty 
risk mitigation tool.
    At issue is the Basel leverage ratio, a measurement tool used by 
banking regulators to determine the amount of leverage that should be 
backed by capital. Unfortunately, the Basel leverage ratio fails to 
properly recognize that client margin posted to a bank-affiliated 
clearing member belongs to the customer, and is provided by the 
customer to offset the bank's exposure to the clearinghouse. It does 
not belong to the bank. The assumption that this customer margin can be 
used by the bank without restriction runs counter to the Commodity 
Exchange Act and Commodity Futures Trading Commission (CFTC) 
regulations.
    The amount of capital under the Basel leverage ratio required to be 
held for clearing is estimated between $32 Billion and $66 billion. 
Once more products are subjected to clearing under the new G20 clearing 
mandates those estimates increase to a range of $126 billion and $265 
billion. End-user clients are beginning to feel the impacts of these 
costs, which are likely to increase over time as Basel capital 
requirements are fully implemented.
Background--Basel Leverage Ratio
    One of the central reforms to bank capital requirements following 
the financial crisis was the decision by the Basel Committee on Bank 
Supervision (Basel Committee) to implement a new type of leverage ratio 
on a global basis. In January 2014, the Basel Committee finalized its 
leverage ratio standard. Based on this standard, the Basel leverage 
ratio was implemented in the United States by the Federal Reserve 
Board, the Federal Deposit Insurance Corporation (FDIC), and the Office 
of the Comptroller of the Currency (OCC). While the leverage ratio will 
technically not become a legally binding requirement on the largest 
U.S. banks until January 2018, it already is effectively being 
implemented by the banks as a result of mandatory reporting 
requirements and market expectations. Other jurisdictions, including 
the European Union, Japan and Switzerland, are also in the process of 
implementing leverage ratio standards based on the Basel leverage 
ratio.
    This Basel leverage ratio would require a bank to hold a minimum 
amount of capital relative to not only its on-balance sheet assets, but 
also to its off-balance sheet exposures arising from futures, options, 
and other derivative transactions. The Basel leverage ratio was 
designed to be ``a simple, transparent, non-risk based leverage ratio 
to act as a credible supplementary measure to the risk-based capital 
requirements''.\1\ While FIA supports the goals of stronger capital 
requirements and recognizes the leverage ratio of the Basel III 
requirements as an important backstop to keep leverage in check, we 
also believe the Basel leverage ratio should accurately reflect the 
actual economic exposures of the banking entity.
---------------------------------------------------------------------------
    \1\ Basel Committee on Banking Supervision--Basel III leverage 
ratio framework and disclosure requirements, January 2014.
---------------------------------------------------------------------------
    As currently measured, we believe the exposure measure under the 
leverage ratio is artificially inflated to capture more than actual 
economic exposures with respect to cleared derivatives transactions. In 
particular, this real and significant overstatement of actual economic 
exposure arises from the failure of the Basel leverage ratio measure to 
recognize the exposure-reducing effect of segregated client margin 
posted to the bank in the limited context of centrally cleared 
derivatives transactions. The inflated economic exposure results in 
unwarranted capital costs.
Failure to Recognize Customer Margin
    The Basel leverage ratio has failed to properly consider the 
exposure-reducing effect of customer margin posted to a prudentially-
regulated banking entity that is acting as an agent to facilitate 
derivatives clearing services on behalf of the client. Such customer 
margin is posted to a bank-affiliated clearing member to ensure that 
the clearing member's exposure to the clearinghouse is lessened while 
also allowing the customer access to the cleared derivatives markets' 
risk management tools. That is, an end-user that utilizes the futures 
market to hedge its business risks is required to clear such a 
transaction through a clearinghouse, and in order to do so it must post 
margin through a clearing member for the purpose of offsetting exposure 
to the clearinghouse. Oftentimes, the clearing member is affiliated 
with a bank. Furthermore, Congress, and more specifically this 
Committee, through the Commodity Exchange Act, requires the clearing 
member to treat margin received from a customer for cleared derivatives 
transactions as belonging to the customer and segregated from the 
clearing member's own funds. Yet the Basel leverage ratio does not 
recognize this margin for its intended purpose--these are customer 
funds provided specifically to offset the bank-affiliated clearing 
member's exposure in their obligation to pay the clearinghouse on 
behalf of the customer. Such customer margin should therefore be 
considered an offset in determining the bank's exposure.
    Unlike making loans or taking deposits, guaranteeing client trades 
exposes the bank to losses only to the extent that the margin collected 
is insufficient to cover the clients' obligations. Indeed, to make sure 
that such margin is always available to absorb losses arising from the 
customer's transaction, CFTC rules require that it be posted in the 
form of either cash or extremely safe and liquid securities such as 
U.S. Treasuries and that such margin be clearly segregated from the 
bank's own money. These are customer funds provided specifically by the 
customer to offset the clearing member's exposure arising from its 
obligation to pay the clearinghouse on behalf of the customer. Such 
customer margin should therefore be considered as an offset in 
determining the bank's exposure. That is, the very nature of initial 
margin posted by a derivatives customer is solely exposure-reducing 
with respect to the clearing member's cleared derivatives exposure.
    Given these longstanding regulatory requirements and the exposure-
reducing function of margin, it stands to reason that the Basel 
leverage ratio should recognize segregated client margin as reducing a 
clearing member bank's actual economic exposure to a clearinghouse for 
purpose of measuring exposure. Nevertheless, the Basel leverage ratio 
does not recognize this plainly exposure-reducing effect when 
calculating the clearing member's exposure.
    Recently the Basel Committee has proposed to refine its leverage 
ratio's calculation of exposure for derivatives. While the Basel 
Committee did not propose to include an offset for initial client 
margin in cleared derivatives transactions, the Committee requested 
information on whether the Basel leverage ratio's failure to recognize 
client margin will harm the cleared derivatives market. We plan to 
submit a comment letter with data showing that the failure to recognize 
the exposure-reducing effect of initial margin will adversely impact 
clearing members' business, customers' access to cleared derivatives, 
competition, and systemic risk. In fact, many of these effects can 
already be observed in the market.\2\
---------------------------------------------------------------------------
    \2\ See, e.g., SIFMA AMG Submits Comments to the Basel Committee on 
Banking Supervision on Higher Prices and Reduced Access to Clearing 
Experienced by Asset Managers (Feb. 1, 2016), available at http://
www.sifma.org/issues/item.aspx?id=8589958563.
---------------------------------------------------------------------------
    To be clear, this has nothing to do with trades undertaken by banks 
on their own account. Our concerns solely relate to trades that banks 
clear on behalf of their clients.
Negative Consequences
    Left unchanged, the Basel leverage ratio will undermine recent 
financial regulatory reforms by discouraging banks from participating 
in the clearing business, thereby reducing access to clearing and 
limiting hedging opportunities for end-users. The failure of the Basel 
leverage ratio to recognize the exposure-reducing effect of segregated 
margin will substantially and unnecessarily increase the amount of 
required capital that will need to be allocated to the clearing 
businesses within these banking institutions. Banks will be less likely 
to take on new clients for derivatives clearing. Such a significant 
increase in required capital will also greatly increase costs for end-
users, including pension funds and businesses across a wide variety of 
industries that rely on derivatives for risk management purposes, 
including agricultural businesses and manufacturers. As a result, 
market participants may be less likely to use cleared derivatives for 
hedging and other risk management purposes or, as a result of mandatory 
clearing obligations for some derivatives, some market participants may 
not be in a position to hedge their underlying risks.
    FIA represents bank and non-bank clearing members and I can assure 
you that this situation is not one that will benefit the non-bank 
clearing firm. In fact, many non-bank clearing members--those clearing 
members not subject to Basel III capital requirements--have weighed in 
to explain their inability to assume the clearing volume currently done 
through banks due to their own balance sheet constraints. Moreover, 
these non-bank clearing members are concerned about the broader market 
impacts that may arise as a result of fewer access points to the 
cleared derivatives markets. This harms farmers seeking to manage 
commodity price fluctuations, commercial companies wishing to lock in 
prices as they distribute their goods, and pension funds using 
derivatives to enhance workers' retirement benefits. The negative 
impacts to the real economy are significant.
    In addition, the liquidity and portability of cleared derivatives 
markets could be significantly impaired, which would substantially 
increase systemic risk. The lack of an offset would severely limit the 
ability of banks to purchase portfolios of cleared derivatives from 
other distressed clearing members--including distressed banks. This 
will leave clearinghouses and customers of any failing clearing member 
with an added strain during an already stressful situation. Moreover, 
as the levels of margin required by clearinghouses increase in times of 
stress, Basel leverage ratio capital costs will correspondingly 
increase, aggravating the constraint on portfolio purchases. Such a 
constraint on providing liquidity to stressed markets would accelerate 
downward price pressure at exactly the wrong moment, thereby increasing 
risk to the system.
    Significantly increased capital costs will also likely result in 
market exit by some derivatives clearing members that will find the 
business no longer economically viable in terms of producing a 
sufficiently high return on equity. The resulting industry 
consolidation would increase systemic risk by concentrating derivatives 
clearing activities in fewer clearing member banks and potentially 
reduce end-user access to the risk mitigation benefits of central 
clearing.
    The consequences I have just outlined are fundamentally 
inconsistent with market regulators' global policies designed to 
enhance the appropriate use of centrally cleared derivatives. In 
various speeches CFTC Chairman Massad has expressed concern about the 
Basel leverage ratio's treatment of initial margin for client cleared 
derivatives and the resulting declining population of clearing members 
as well as systemic concerns related to the portability of client 
positions and margin funds.
Conclusion
    While we were disappointed the Basel Committee's consultation did 
not include a client margin offset, we were encouraged that the Basel 
Committee identified the issue in its consultation, and is seeking 
further evidence and data on the impact of the Basel leverage ratio on 
client clearing and on banks' business models during the consultation 
period. FIA is working with its members and other trade associations on 
its response to the Basel Committee's proposed revisions, including 
obtaining evidence and data on the impact of the standard.
    As part of our response to the Basel Committee, we will identify a 
number of options to recognize the risk-reducing effects of initial 
margin. These proposals will be consistent with the goals of the Basel 
Committee in establishing the Basel leverage ratio. We are hopeful the 
Basel Committee will recognize our concerns. FIA appreciates the 
Subcommittee's interest in ensuring that banking regulations do not run 
counter to the well-established benefits for clients of cleared futures 
or the new G20 clearing obligations for swaps.

 STATEMENT OF HON. SCOTT D. O'MALIA, CHIEF EXECUTIVE OFFICER, 
              INTERNATIONAL SWAPS AND DERIVATIVES
                ASSOCIATION, INC., NEW YORK, NY

    Mr. O'Malia. Chairman Scott, Ranking Member Scott, and 
Members of the Subcommittee, thank you for the opportunity to 
testify here today.
    I would like to thank the Committee for holding this timely 
hearing to discuss the ramifications of two major reforms; bank 
capital and liquidity rules, and the margin requirements for 
non-cleared trades. Both will have a massive and profound 
impact on the derivative end-users.
    In my testimony, I would like to explain the findings ISDA 
has produced to determine the cost impact of the capital rules, 
and will emphasize the need for a comprehensive and cumulative 
impact assessment. I will also provide an update on the 
implementation of the margin rules, and the steps ISDA is 
taking to ensure these are implemented in a cost-effective 
manner.
    Substantial progress has been made to ensure that the 
financial system is more robust. The implementation of Basel 
2.5 and Basel III means banks now hold more and better quality 
capital than ever before. An additional capital surcharge is 
being implemented for systemically important banks, and a 
resolution framework is being put in place to wind down failed 
banks without taxpayer assistance. This is on top of the global 
derivatives market infrastructure reforms, including data 
reporting, trading, and clearing.
    While many aspects of the new rules have been finalized, 
core aspects of the Basel reform agenda, such as the leverage 
ratio, net stable funding ratio, fundamental review of the 
trading book, are still evolving. As it stands, these reforms 
look to significantly increase costs for banks, and may 
negatively impact the liquidity of these markets and the 
ability of banks to lend and provide crucial hedging services 
to corporate pension funds and asset managers.
    Recent ISDA analysis suggests that the compliance with just 
one of the rules, the NSFR, will require the banking industry 
to raise additional long-term funding. We are concerned that 
the cumulative impact of the different parts of the banking 
capital reform are still unknown, and it is our belief that 
regulators shoulder undertake a cumulative impact assessment, 
posthaste. Given the continuing concerns about economic growth 
and job creation, legislators, supervisors, and market 
participants need to understand the cumulative impacts of the 
regulatory changes before they are implemented.
    When it comes to the health of the global economy, I think 
the old tailor's saying holds true: measure twice and cut once. 
At this moment, we are cutting our cloth in the dark. ISDA has 
been working hard to understand the impacts of the individual 
rules, and over the past year we have conducted eight impact 
studies. In each case, these studies have indicated sizeable 
increases in capital, on top of the increases that have already 
occurred as part of Basel III. We have also found the impact 
was not uniform across all banks, with certain businesses hit 
particularly hard. One good example is the leverage ratio and 
its effect on client clearing business. As it stands, the rule 
fails to recognize the risk-reducing impact of the initial 
margin posted by customers, and this has proved detrimental to 
the economics of client clearing, and is in direct conflict 
with the G20 objectives of central clearing.
    Now let me turn to the final rules regarding the margin for 
non-cleared trades. As I noted earlier, these rules will have a 
significant cost impact on non-cleared products. According to 
the analysis published by the CFTC, the industry may have to 
set aside over $300 billion of initial margin to meet these 
requirements. ISDA has worked closely with the market at the 
global level to prepare for implementation, and I am proud to 
say that ISDA and its members have accomplished a great deal. 
First, we have established a standard initial margin model 
called ISDA SIMM, which all participants can use to calculate 
the initial margin requirements. This is nothing short of 
revolutionary for the over-the-counter market. Second, we have 
worked to draw up a revised margin documentation that is 
compliant with the collateral and segregation rules. Third, we 
have established a robust governance structure to allow for the 
necessary evolution of the model, and to provide regulators 
complete transparency into the model development process. 
Despite these efforts, challenges remain. The deadline for 
implementation of the initial margin requirements for the 
largest banks is September 2016. The variation margin, big 
bang, is set for March of 2017, which affects all market 
participants.
    There are still a few important items that need to fall 
into place to ensure that the market can move forward 
confidently. First, regulators need to send a clear signal that 
the ISDA SIMM is fit for purpose, and banks can confidently 
begin to apply this model before the 2016 deadline. Second, 
regulators must finalize the cross-border rules, which will 
result in the recognition of comparable jurisdictions. To date, 
the CFTC cross-border margin rules have not been approved, and 
if it is not rectified as soon as possible, the hard work to 
unify the rules under the Basel Committee IOSCO at that level 
will be undermined. In addition, ISDA will not be able to 
complete the necessary documentation that will assist dealers 
in determining whether their clients fall within scope of the 
margin rules by the time the rules go final.
    And I appreciate the Committee's interest in ensuring that 
the G20 reforms are implemented in a cost-effective manner, and 
this ensures that end-users have access to global capital 
markets and derivatives markets. You can be confident that ISDA 
will continue to work to develop the data on the capital rules 
to contribute to a safe but cost-effective capital structure, 
as well as facilitate the transition to a new margin regime 
that is fully transparent and effective.
    I am happy to answer any of your questions. Thank you.
    [The prepared statement of Mr. O'Malia follows:]

 Prepared Statement of Hon. Scott D. O'Malia, Chief Executive Officer, 
  International Swaps and Derivatives Association, Inc., New York, NY
    Chairman Scott, Ranking Member Scott, and Members of the 
Subcommittee. Thank you for the opportunity to testify today.
    I would like to thank the Committee for holding this timely hearing 
to discuss the ramifications of the last two rule-sets associated with 
the Group of 20 (G20) derivatives reforms--bank capital and liquidity 
rules, and margin requirements for non-cleared derivatives trades. Both 
will have a profound impact on derivatives end-users.
    The capital and liquidity rules, which are being developed by the 
Basel Committee on Banking Supervision, will be implemented through to 
2019. The margin rules kick in from September this year, and will be 
fully phased in by 2020.
    My testimony today will address these two important rules. I will 
explain the findings ISDA and its members have produced to determine 
the cost impact of individual capital rules, and will emphasize the 
need for a comprehensive cumulative impact assessment encompassing all 
elements of the bank capital and liquidity reforms. I will also provide 
a progress update on the implementation of the margin rules, and the 
steps ISDA is taking to help regulators and market participants comply 
with them in a cost-effective and transparent manner.
Executive Summary
    Over the past 6 years, substantial progress has been made to ensure 
the financial system is more robust. The implementation of the Basel 
2.5 and Basel III capital and liquidity reforms means that banks now 
hold more and better quality capital than ever before. The amount of 
common equity capital at the largest U.S. banks has more than doubled 
since the crisis. Liquidity requirements are also being phased in to 
reduce reliance on short-term borrowing and bolster reserves of high-
quality liquid assets.
    This is on top of derivatives market structure reforms that have 
been introduced by the Commodity Futures Trading Commission (CFTC) and, 
to some extent, the Securities and Exchange Commission (SEC), which 
include swap dealer registration, data reporting, trading and clearing 
mandates. In addition, a resolution framework is now being put in place 
to manage and allow for the orderly resolution of a bank without the 
need for taxpayer assistance.
    But while many aspects of the new rules have been finalized and are 
already implemented, core elements of the Basel reform agenda, such as 
the leverage ratio, net stable funding ratio (NSFR) and the Fundamental 
Review of the Trading Book (FRTB), are still evolving.
    As it stands, these reforms look set to significantly increase 
costs for banks, and may negatively impact the liquidity of derivatives 
markets and the ability of banks to lend and provide crucial hedging 
products to corporate end-users, pension funds and asset managers.
    We are concerned that the overall effect of the different parts of 
the bank capital reform program is unknown, and it is our belief that 
regulators should undertake a cumulative impact assessment post haste. 
When it comes to the health of the global financial system and economy, 
I think the old tailor's saying holds true--measure twice, cut once.
    At the moment, we are cutting our cloth in the dark. Given 
continuing concerns about economic growth and job creation, 
legislators, supervisors and market participants need to understand the 
cumulative effect of the regulatory changes before they are fully 
implemented so we can prevent any significant negative impact to the 
real economy.
    ISDA has been working hard to understand the impact of the 
individual elements of the rules. Over the past year, we have conducted 
eight impact studies on new capital and liquidity measures. In each 
case, those studies have indicated sizeable increases in capital or 
funding requirements for banks, on top of the increases that have 
already occurred as part of Basel III.
    There is literally no one who has any clear idea what the aggregate 
impact of each of these rules will be. So far, each new measure has 
been looked at in isolation, without considering how it will interact 
with other parts of the capital framework.
    Significantly, ISDA's analysis shows the impact is not uniform 
across all banks, with certain business lines hit particularly hard. We 
therefore believe it is crucial that policy-makers not only view the 
final capital rules through the prism of the overall impact on capital 
levels, but also assess the effect on individual business lines.
    That's because the impact of the new rules on individual business 
units or product areas could be disproportionate, and the difference 
between a bank choosing to stay the course or exit the business. One 
good example is the leverage ratio and its effect on client clearing 
businesses. As it stands, the rule fails to recognize the risk-reducing 
effect of initial margin posted by the customer. This has proved 
detrimental to the economics of client clearing and is in direct 
conflict with the G20 goals to encourage central clearing of 
derivatives.
    Having provided my high-level recommendations on the capital and 
liquidity rules, I'd now like to turn to the final rules regarding 
margin for non-cleared derivatives.
    As I noted earlier, these rules will have a significant cost impact 
on non-cleared derivatives trades. According to analysis published by 
the Federal Reserve and the CFTC, the industry may have to set aside 
over $300 billion in initial margin to meet the requirements.
    ISDA has worked closely with the market at a global level to 
prepare for implementation. I am proud to say ISDA and its members have 
accomplished a great deal.
    First, we have developed a standard initial margin model called the 
ISDA SIMM that all participants can use to calculate initial margin 
requirements. In a bilateral setting, having a central resource that 
can do this and resolve any disputes over initial margin calls will be 
vitally useful for all counterparties.
    Second, we've worked to draw up revised margin documentation that 
is compliant with the rules, and we're developing a protocol to allow 
market participants to make changes to their outstanding margin 
agreements as efficiently as possible. This is essential for all market 
participants to exchange margin in an orderly and legally compliant 
way.
    Third, we have established a completely transparent and robust 
governance structure to allow for the necessary evolution of the model, 
providing both regulators and market participants the confidence that 
the model is appropriately updated and available for regulatory review 
and validation.
    Despite these efforts, challenges remain. In particular, there are 
concerns about how the margin rules will work on a cross-border basis. 
The requirements were drawn up at a global level by the Basel Committee 
and the International Organization of Securities Commissions (IOSCO) 
before being implemented by national regulators. That's a process we 
support, and has meant the various national rules are largely 
consistent.
    But differences do exist in the detail, in everything from scope of 
the products and entities covered by the rules to settlement times. 
This means it is vital that substituted compliance decisions are based 
on broad outcomes, rather than rule-by-rule comparisons with overseas 
requirements.
    The deadline for implementation of the initial margin requirements 
for the largest banks (Phase I) is approaching on September 1, 2016. 
Following this date is the variation margin `big bang' on March 1, 
2017, which affects all market participants.
    There are a few items that need to fall into place to ensure the 
market can move forward confidently with these last rules.
    First, regulators need to send a clear signal that the ISDA SIMM is 
fit for purpose and banks can confidently begin to apply this model to 
comply with the September 2016 deadline.
    Second, the CFTC must finalize its cross-border margin rules to 
ensure substituted compliance determinations can be made for overseas 
rules that achieve similar outcomes.
    These substituted compliance decisions also should be taken 
quickly. Another 3 year wait for a substituted compliance or 
equivalence determination, as happened with the U.S./EU central 
counterparty (CCP) equivalency standoff, will hobble cross-border 
trading and further contribute to the fragmentation of global 
derivatives markets.
          * * * * *
    I'd like to address each of these issues in more detail. Before I 
do, I would like to stress that ISDA supports the intention of the 
capital reforms to strengthen the resilience of the banking system. We 
also support the safe and efficient use of collateral to reduce risk in 
the bilateral derivatives market.
    In fact, ISDA has worked with its members to drive this objective 
for most of its 31 year history. We've also worked closely with our 
members over the past 3 years to develop the infrastructure, technology 
and documentation to ensure the new margin rules for non-cleared 
derivatives can be implemented with minimum disruption to the market.
    This is consistent with our mission statement: ISDA fosters safe 
and efficient derivatives markets to facilitate effective risk 
management for all users of derivative products. In fact, our strategy 
statement was recently modified to emphasize the importance of ensuring 
a prudent and consistent regulatory capital and margin framework.\1\
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    \1\ ISDA mission and strategy statement: http://www2.isda.org/
about-isda/mission-state-
ment/.
---------------------------------------------------------------------------
    Since ISDA's inception, we have worked to reduce credit and legal 
risks in the derivatives market and to promote sound risk management 
practices and processes. This includes the development of the ISDA 
Master Agreement, the standard legal agreement for derivatives, as well 
as our work to ensure the enforceability of netting. We currently have 
more than 850 members in 67 countries. Over 40% of our members are buy-
side firms.
          * * * * *
    While ISDA represents the full cross-section of the derivatives 
market, including banks, exchanges, CCPs, asset managers, pension funds 
and supranationals, I would like to focus on the impact the capital 
rules will have on the banking sector.
    Banks play a hugely significant role in the U.S. economy. They 
provide access to capital markets and underwrite debt and equity 
issuances to ensure companies can raise the financing they require to 
expand their businesses. They provide the hedging and risk management 
tools that enable U.S. firms to export their goods and services 
worldwide.
    They provide loans to companies large and small to ensure they have 
the capital they need to grow. According to recent figures from the 
Federal Reserve, banks currently have more than $2 trillion in 
commercial and industrial loans outstanding. To put that into context, 
it's roughly the same as the GDP of India. That translates into 
business investment, jobs and economic growth.
    Banks also provide risk management services to those end-user 
companies, creating balance-sheet stability and allowing them to 
improve their planning. The certainty that hedging provides gives 
companies the confidence to invest in future growth and create new 
jobs.
    Given the vital role that banks play in our economy, it's important 
they are safe and resilient. And, since the crisis, a huge amount of 
effort has gone into making sure that they are.
    Banks now have to hold much higher levels of capital than before 
the crisis--and that capital is required to be of much higher quality, 
ensuring it is able to absorb losses. Banks have also had to introduce 
new capital conservation and countercyclical buffers, along with the 
implementation of a capital surcharge for systemically important banks. 
They now have to explicitly hold capital against the risk of a 
derivatives counterparty default, and they are in the process of 
rolling out new liquidity requirements that are meant to ensure they 
have a sufficient stock of assets to withstand a sudden shock in market 
liquidity.
    According to the Federal Reserve, common equity capital at the 
largest eight U.S. banks has more than doubled since 2008, representing 
an increase of nearly $500 billion.\2\ Their stock of high-quality 
liquid assets has also increased considerably, rising by approximately 
\2/3\.
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    \2\ Federal Reserve Chair Janet L. Yellen, Before the Committee on 
Financial Services, U.S. House of Representatives, Washington, D.C., 
November 4, 2015: http://www.federalreserve.gov/newsevents/testimony/
yellen20151104a.htm.
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    While significant improvements have already been made to the 
capital framework, a number of other reforms are either in the 
consultation phase or have been finalized but not yet implemented. 
Given the increases in capital that have already occurred since the 
crisis, policy-makers have recently been at pains to stress that 
further refinements should not result in a significant rise in capital 
across the banking sector.
    In recent months, that message has been given by the G20,\3\ the 
Financial Stability Board (FSB),\4\ the Group of Central Bank Governors 
and Heads of Supervision (GHOS),\5\ and the Basel Committee itself.\6\
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    \3\ G20 Finance Ministers and Central Bank Governors Meeting, 
Shanghai, February 27, 2016: http://www.g20.utoronto.ca/2016/160227-
finance-en.html.
    \4\ FSB to G20 Finance Ministers and Central Bank Governors, 
February 22, 2016: http://www.fsb.org/wp-content/uploads/FSB-Chair-
letter-to-G20-Ministers-and-Governors-February-2016.pdf.
    \5\ Basel Committee press release, January 11, 2016: http://
www.bis.org/press/p160111.htm.
    \6\ Basel Committee press release, March 24, 2016: http://
www.bis.org/press/p160324.htm.
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    ISDA entirely supports this stance. While changes were needed in 
the wake of the financial crisis to bolster the capital held by banks, 
it's important this capital is commensurate with risk. Asking banks to 
hold ever higher amounts of capital could strangle bank lending, their 
ability to underwrite debt and equity, and their willingness to provide 
hedging services to end-users. An economy requires capital and 
investment to thrive. Choke off the supply of financing, and economic 
growth will be put at risk.
    Unfortunately, recent studies by ISDA suggest that several new 
measures will result in increases in capital. While each of the 
increases on their own may not result in a significant increase in 
capital across the banking sector, they do have an impact on certain 
business lines that are important for end-user financing and hedging.
    Crucially, though, it's currently not possible to say for sure how 
much the new measures, in aggregate, will increase capital requirements 
across the banking sector. That's because an overall impact study has 
not been conducted on the full set of capital, liquidity and leverage 
rules. While the potential for such a study has been limited during the 
rule-development phase, we believe a comprehensive analysis is now 
possible and necessary in order to help regulators and policy-makers 
calibrate the rules at an appropriate level.
    ISDA would like to highlight several areas that we believe warrant 
further attention.
Leverage Ratio
    The central clearing of derivatives transactions is a key objective 
of the G20 derivatives reforms and a central tenet of the Dodd-Frank 
Act. The leverage ratio is a non-risk based measure meant to complement 
risk-based bank capital requirements, and is designed to act as a 
backstop.
    In its current form, however, the leverage ratio acts to 
disincentivize clearing. That's because it doesn't take client margin 
into account when determining the exposures banks face as a result of 
their client clearing businesses.
    Senior figures in the regulatory community already recognize this. 
In December last year, Mark Carney, the Governor of the Bank of 
England, noted that the current stance of the leverage ratio makes 
clearing more challenging, and ``increases concentration, reduces 
diversity and reduces financial stability for the system''.\7\ Timothy 
Massad, Chairman of the CFTC, has also echoed these sentiments.\8\
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    \7\ Risk, December 8, 2015: http://www.risk.net/risk-magazine/news/
2438242/carney-leverage-ratio-could-limit-clearing-benefits.
    \8\ http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-31.
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    Properly segregated client cash collateral is not a source of 
leverage and risk exposure. However, as currently proposed, the rule 
would require firms to include these amounts in their calculations. 
This is unreasonable, as cash collateral mitigates risk. Strict rules 
exist to protect this collateral and ensure it cannot be used to fund 
the bank's own operations. Instead, it can only be used to further the 
customer's activities or resolve a customer default. As such, it acts 
to reduce the exposure related to a bank's clearing business by 
covering any losses that may be left by a defaulting client.
    The failure of the leverage ratio to recognize the risk-mitigating 
effect of segregated client cash collateral could mean the amount of 
capital needed to support client clearing services increases 
considerably. The end result is that the economics of client clearing 
would make it extremely difficult for banks to provide this service and 
may cause them to pull out of the market, harming liquidity and 
limiting opportunities for end-users. This perverse outcome runs 
counter to the objective set by the G20, as implemented by Congress in 
the Dodd-Frank Act, to encourage central clearing.
    ISDA has been drawing attention to this issue for some time, and 
the Basel Committee recently reopened the leverage ratio for 
consultation. As part of that consultation, the Basel Committee said it 
would collect data to study the impact of the leverage ratio on client 
clearing, with a view to potentially recognizing the exposure-reducing 
effect of initial margin posted by the client.
    We welcome that development--although it is disappointing that the 
consultation will not consider the recognition of initial margin more 
broadly. We will work with members to provide the necessary data for 
this consultation. Clearing has become a significant part of the 
derivatives market, so it's incredibly important we get this measure 
right.
Trading Book Capital
    The Basel Committee's FRTB is intended to overhaul trading book 
capital rules, replacing the mix of measures currently in place with a 
more coherent set of requirements. The changes were primarily targeted 
at improving coherence and consistency in the market risk framework. 
Market risk capital levels were raised significantly in the immediate 
aftermath of the crisis through a package of measures known as Basel 
2.5. Raising capital further was not a stated objective of the FRTB.
    Nonetheless, the Basel Committee has estimated the revised market 
risk standard would result in a weighted mean increase of approximately 
40% in total market risk capital requirements. But that estimate is 
based on a recalibration of quantitative-impact-study data from an 
earlier version of the rules.
    To better understand the effect, ISDA recently led an industry 
impact study based on data submitted by 21 banks. The industry results 
show that market risk capital will increase by at least 50% compared to 
current levels. However, this assumes all banks will receive internal 
model approval for all their trading desks. If all banks do not receive 
internal model approval for all trading desks, market risk capital 
would increase by 2.4 times. ISDA believes the end result will be 
somewhere in between.
    Importantly, our study shows a massive cliff effect between 
standardized and internal models. If a particular desk were to lose 
regulatory approval to use internal models, capital requirements could 
immediately increase by multiple times. To give an example, losing 
internal model approval under the new rules would result in a 6.2 times 
increase in capital for FX desks and a 4.1 times increase for equity 
desks.\9\
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    \9\ These numbers exclude the so-called residual risk add-on, non-
modellable risk factors and diversification across risk classes under 
internal models.
---------------------------------------------------------------------------
    Let me put that into context. Both FX and equity desks are 
important for end-user hedging and financing. FX trades allow U.S. 
companies operating or selling products in foreign countries to obtain 
financing in the U.S., which is typically more cost effective, and 
enable them to limit their exposure to foreign currency fluctuations. A 
sudden, overnight increase in capital requirements of between four and 
six times could stymie the ability of a bank to continue offering that 
service, at least in the short-term. We believe these rules should be 
carefully reconsidered to prevent lasting harm to actors in the real 
economy. (Please see Annex I for a more in-depth consideration of the 
impact of the FRTB.)
    ISDA welcomes the extensive engagement the Basel Committee has had 
with the industry during the development phase of the trading book 
rules. We have proposed technical modifications and refinements 
throughout the process, and will continue to provide feedback during 
the monitoring phase.
Net Stable Funding Ratio
    The NSFR is designed to ensure banks fund their activities with 
sufficiently stable sources of funding to avoid liquidity mismatches.
    ISDA supports the intention of this rule. One of the issues raised 
by the financial crisis was the gap between short-term borrowings of 
banks versus their long-term lending. Even ahead of this rule coming 
into effect in January 2018, banks have significantly reduced their 
reliance on short-term wholesale financing.\10\
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    \10\ Federal Reserve Chair Janet L. Yellen, Before the Committee on 
Financial Services, U.S. House of Representatives, Washington, D.C., 
November 4, 2015: http://www.federalreserve.gov/newsevents/testimony/
yellen20151104a.htm.
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    Nonetheless, we are concerned about the impact of the NSFR on the 
derivatives business, and believe the rule as it stands will hinder the 
ability of end-users to access hedging products.
    In particular, the rule currently requires banks to hold extra 
stable funding equal to 20% of derivatives liabilities, without taking 
into account any margin posted. This measure was not offered for public 
notice and comment, and the impact was never studied. ISDA understands 
the need to capture contingent liquidity risks, but the rule in its 
current form is overly conservative and duplicates other measures that 
already capture contingent liquidity risks to some extent, such as the 
liquidity coverage ratio. We therefore believe the 20% blanket add-on 
should be replaced with something more risk sensitive and properly 
calibrated.
    We also are concerned by the lack of recognition of high quality 
liquid assets (HQLAs) received as margin. This means that U.S. 
Treasuries, which count as cash equivalents in the liquidity coverage 
ratio, are treated as if they were illiquid assets with no funding 
value. We believe the NSFR should give funding benefit for HQLAs like 
U.S. Treasuries.
    The U.S. banking agencies released a proposed rule earlier this 
week. We will review this rule and update the Committee of any new 
developments.
Internal Models
    ISDA believes capital requirements should be globally consistent, 
coherent and proportionate to the risk of a given activity.
    As a result, we're concerned about the regulatory shift away from 
internal models that have been utilized under supervision by Prudential 
Regulators. Internal models are the cornerstone of prudent risk 
management, as they enable banks to identify and appropriately measure 
risk across various dimensions.
    The move away from internal models has occurred in several areas: 
the recent decision by the Basel Committee to restrict the use of 
internal models for credit risk-weighted assets; the ditching of the 
advanced measurement approach for operational risk and the use of 
models for CVA; and the proposal to introduce capital floors, 
potentially on both the inputs and outputs of capital models.
    Some regulators have highlighted complexity and variation in risk-
weighted assets (RWAs) as a rationale for wanting to restrict the use 
of internal models. ISDA understands these concerns, but believes there 
are ways to address trepidation about RWA variability without 
eliminating internal models--through greater consistency and 
transparency of model inputs, or through ongoing benchmarking exercises 
that help regulators better understand the source of any differences in 
the way banks value their portfolios.
    We need to strike the right balance between standardization and the 
ability of banks to maintain focus and expertise in identifying and 
appropriately measuring the underlying risks in their businesses.
    Internal models are much more sensitive to risk and better align 
with how banks actually manage their business. In comparison, 
standardized models are relatively blunt, meaning the required capital 
charge for holding a particular asset might not adequately reflect its 
risk. This can lead to poor decision-making: a bank might choose to 
pull back from low-risk assets, counterparties or businesses where 
capital costs are relatively high. Conversely, they might opt to invest 
in higher-risk assets that appear attractive from a capital standpoint.
    These issues were what prompted the Basel Committee to create 
incentives for the use of risk-sensitive internal models in the first 
place via Basel II. All models, standard or risk-based, have inherent 
weaknesses, but increasing transparency and applying benchmark testing 
can identify possible shortcomings. It simply isn't necessary to 
reverse course from Basel II and insist on an over-simplified standard 
model.
    We believe, as a general point, that capital levels should reflect 
risk as closely as possible. A less risk-sensitive capital framework 
leads to the possibility of a misallocation of capital and an increase 
in systemic risk by encouraging herding behavior in the market. This 
raises the possibility of all market participants failing to identify 
emerging risks that do not necessarily exist today. Making decisions in 
a business that is intrinsically about taking and managing risk, based 
on a capital framework that is being made purposely less risk 
sensitive, creates its own hazards.
    Along these lines, we were pleased to see the Committee recognize 
the value of internal models in its bill reauthorizing the Commodity 
Exchange Act.\11\ Unfortunately, the CFTC's current approach for 
internal model approval in its proposed capital rule makes it 
impossible for entities that are not subsidiaries of U.S. bank holding 
companies or SEC-registered security-based swap dealers to seek CFTC 
model approval (see Annex II). This highlights the need for further 
dialogue between the House, Senate, the CFTC and the SEC on this 
subject.
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    \11\ H.R. 2289, the Commodity End-User Relief Act.
---------------------------------------------------------------------------
    Overall, a non-risk-based capital framework is also likely to lead 
to a rise in total capital requirements across the bank--essentially 
because standardized models tend to be more conservative.
Margin for Non-Cleared Derivatives
    I would now like to turn to the margin rules.
    As I mentioned in my introductory remarks, the implementation of 
margin rules for non-cleared derivatives from September will mark the 
completion of the last of the 2009-2011 G20 derivatives reform 
objectives. From that date, the largest banks will be required to 
exchange initial and variation margin on their non-cleared derivatives 
trades. All other entities covered by the rules will be subject to 
variation margin requirements beginning next March, with initial margin 
obligations phased in over a 4 year period.
    ISDA has worked tirelessly for the past 3 years to prepare for 
implementation, and efforts have stepped up since U.S. Prudential 
Regulators and the CFTC published their respective final rules at the 
end of last year.
ISDA Standard Initial Margin Model (ISDA SIMM)
    A central part of this project is the development of the ISDA SIMM, 
which will be available for firms to use to calculate how much initial 
margin needs to be exchanged. The model is now finished from a design 
perspective. ISDA has been touring the globe in recent months, showing 
the methodology to regulators, alongside a transparent governance 
structure, in order to smooth the path to implementation. We have 
shared all the data that went into the development of this model, along 
with the calibration, the back-testing results and independent 
validation confirming the model meets the requirements of a one-tailed 
99% confidence interval over a 10 day horizon.
    We have found the U.S. Prudential regulators,\12\ the CFTC\13\ and 
the European Supervisory Authorities' Joint Assessment Team\14\ to be 
thoroughly engaged and knowledgeable. However, as the implementation 
date of September 1, 2016 draws closer, it is important that regulators 
move quickly to acknowledge that the ISDA SIMM is fit for service. 
Without the ISDA SIMM, firms are likely to utilize the fallback 
solution of standard tables, which were developed by the Basel 
Committee and IOSCO as the most conservative approach and are more 
costly.
---------------------------------------------------------------------------
    \12\ Federal Reserve, Office of the Comptroller of the Currency, 
Federal Deposit Insurance Corporation.
    \13\ The National Futures Association, which was recently 
designated by the CFTC to oversee the model application.
    \14\ The Joint Assessment Team was established in early 2015, with 
the aim to assess the compliance of the different initial margin models 
to the requirements of the draft joint regulatory technical standards 
on the European Market Infrastructure Regulation and the Basel 
Committee-IOSCO framework: https://www.esma.europa.eu/sites/default/
files/library/2015/11/2015-1381_-
_annex_to_the_statement_by_steven_maijoor_esas_joint_committee_-
_econ_hearing_
14_september_2015.pdf.
---------------------------------------------------------------------------
    Phase I banks have already begun their operational builds in 
preparation for the September 1, 2016 implementation date. Timely 
approval of the model at the firm-level is critical.
Credit Support Annex--Facilitating the Flow of Margin
    Another big focus has been preparing for the necessary revisions to 
ISDA credit support documentation in each jurisdiction. We're making 
very good progress here, and the first margin-compliant document was 
published earlier this month. ISDA is also developing a protocol to 
ensure the changes can be made to outstanding agreements as efficiently 
as possible.
    There's still a lot that still needs to be done, but ISDA is 
working hard to deliver solutions in advance of the regulatory 
mandates.
    There is one impediment that is standing in the way--the lack of 
final rules from the CFTC regarding the application of U.S. rules 
abroad. Without these rules, we cannot complete the legal agreements to 
facilitate the exchange of collateral. This is important to meet the 
September 1, 2016 implementation deadline.
Finalizing the Cross-Border Rules
    While the margin rules were developed and agreed at a global level, 
the national proposals published by U.S., European and Japanese 
regulators initially contained a number of important differences. 
Variations even emerged between the proposals issued by U.S. Prudential 
Regulators and the CFTC.
    In letters to national authorities,\15\ ISDA highlighted those 
differences and suggested a more globally consistent approach. 
Ultimately, many of the biggest variations were ironed out in the final 
rules--but some still remain.
---------------------------------------------------------------------------
    \15\ http://www2.isda.org/functional-areas/wgmr-implementation/.
---------------------------------------------------------------------------
    Let me first address the inconsistencies among international rules. 
Final rules from U.S. Prudential Regulators and the CFTC require 
variation margin to be settled the day after execution of the trade, or 
T+1. This approach is more or less mirrored in European rules. In 
comparison, Japanese proposals require variation margin to be exchanged 
as soon as practically possible, while Singapore and Hong Kong 
regulators have proposed T+2 and T+3, respectively.
    These differences matter, and the tighter time frame set by U.S. 
and European regulators will make it practically difficult for U.S. 
firms to trade with Asian counterparties.
    There are also differences in the treatment of non-netting 
jurisdictions, the scope of instrument coverage, and the scope of 
applicability. These variations add to the complexity of complying with 
the rules in multiple jurisdictions.
    Turning to the U.S. rules, the CFTC's cross-border margin proposal 
is inconsistent with current CFTC cross-border guidance for swaps that 
are cleared and executed on a swap execution facility (SEF). Unlike the 
cross-border guidance, the CFTC cross-border margin proposal defines 
`U.S. person' as entities that have a ``significant nexus'' to the 
U.S., even if they are domiciled or organized outside the U.S. It also 
includes a different interpretation of non-U.S. entities guaranteed by 
a U.S. person. This interpretation may lead to a single trade being 
subject to margin rules in multiple jurisdictions.
    In addition, U.S. prudential rules appear to recognize that a non-
cleared swaps transaction arranged by personnel or agents of non-U.S. 
banks located in the U.S. would be excluded from mandatory margining. 
However, this contrasts with the position taken in the CFTC cross-
border guidance, which imposes clearing, SEF-trading and reporting 
requirements on trades between a non-U.S. swap dealer and a non-U.S. 
person if those transactions are arranged, negotiated or executed in 
the U.S. This requirement is currently subject to no-action relief,\16\ 
but that relief expires in September. The CFTC should reconcile its 
cross-border guidance and the cross-border margin proposal with U.S. 
prudential rules to ensure consistency for all swaps rules.
---------------------------------------------------------------------------
    \16\ CFTC Letter No. 15-48: http://www.cftc.gov/idc/groups/public/
@lrlettergeneral/documents/letter/15-48.pdf.
---------------------------------------------------------------------------
    On a positive note, we appreciate that the CFTC allows for a 
substituted compliance regime in its cross-border margin proposal. 
Under that proposal, swap dealers and major swap participants would be 
able to post margin under foreign rules when trading with a non-U.S. 
counterparty not guaranteed by a U.S. person--but that would depend on 
those foreign rules being deemed comparable with U.S. requirements. 
Market participants are concerned about the timing of these 
comparability determinations given the proximity of the implementation 
date. No determinations have been made so far with respect to margin 
rules, and the market has had no guidance on whether such 
determinations might be forthcoming.
    Under the proposed cross-border margin rules, substituted 
compliance will be granted if the rules of foreign jurisdictions are 
consistent with the Basel Committee-IOSCO standards, which is positive. 
We are concerned, however, that the final rules will require an 
element-by-element analysis of overseas regimes.
    ISDA believes that substituted compliance should be determined by 
whether a jurisdiction is consistent on an outcomes basis with the 
Basel Committee-IOSCO margin recommendation.
    While U.S. Prudential Regulators included requirements for cross-
border trades in their final rules, the CFTC has yet to publish its 
final rule. With the new regime scheduled for implementation from 
September, it means there's just 4 months to issue the final rule and 
make substituted compliance decisions. Timing is critical as ISDA is 
developing the legal documentation that will assist market participants 
in determining whether they will fall within the scope of the margin 
rules. Without the CFTC's final cross-border margin rule, it will be 
difficult for ISDA to finalize these documents by the effective date of 
the rules.
    We urge the CFTC to publish its final cross-border margin rule as 
soon as possible to maximize the possibility of substituted compliance 
decisions before the rules of other jurisdictions become effective.
Conclusion
    To sum up, banks today are significantly stronger and more 
resilient than they were before the crisis. Capital levels have already 
increased significantly. But a balance needs to be struck between 
making banks ever stronger by layering on additional capital and 
encouraging them to lend and facilitate hedging transactions.
    As the Commissioner of the Japanese Financial Services Agency, 
Nobuchika Mori, said at ISDA's annual general meeting in Tokyo earlier 
this month:

          ``We had better think carefully whether thick walls are 
        enough to attain our dual goal of financial stability and 
        growth. The Japanese heavy battleships Yamato and Musashi had 
        the thickest walls, but we know that they were not resilient 
        against air power. Instead of blindly trusting the thickness of 
        the walls, we need to assess and strengthen the entire 
        framework of prudential regulatory and supervisory policy.'' 
        \17\
---------------------------------------------------------------------------
    \17\ Keynote address ``From static regulation to dynamic 
supervision'' by Nobuchika Mori, Commissioner, Financial Services 
Agency, Japan at ISDA's 31st Annual General Meeting, Tokyo, April 13, 
2016: http://www2.isda.org/attachment/ODI5OQ==/JFSA%20Speech.pdf.

    Global regulatory bodies have recognized this fact, and have called 
for further refinements to the capital framework to be made without 
significantly increasing capital across the banking sector.
    However, ISDA studies have shown that new requirements will result 
in higher capital levels. How much is too much? At what point is the 
balance overly skewed in one direction, to the detriment of growth?
    At the moment, no one knows.
    ISDA believes a comprehensive impact study is necessary in order to 
provide regulators the information they need to make this decision. 
That study should cover all facets of the regulatory framework and 
consider the impact on all derivatives counterparties to ensure 
regulators are fully aware of the implications of further change.
    Finally, ISDA is doing all it can to ensure the infrastructure, 
systems and documentation are in place to facilitate implementation of 
new margining requirements from September. But we remain concerned 
about cross-border implications. It is vital the substituted compliance 
framework is based on broad outcomes, rather than a line-by-line 
comparison of national rule-sets. We also urge the CFTC to issue its 
final rules as soon as possible.
    I would like to close by expressing my sincere appreciation of the 
Committee's work and its commitment to exploring the impact of Dodd-
Frank implementation through these hearings.
    Thank you.
                                Annex I
derivatiViews
From the Executive Office of ISDA
FRTB: One Piece of the Capital Puzzle \18\
---------------------------------------------------------------------------
    \18\ ISDA derivatiViews, April 21, 2016: https://
isda.derivativiews.org/2016/04/21/frtb-one-piece-of-the-capital-puzzle/
 
---------------------------------------------------------------------------
    With any jigsaw puzzle, it takes time before the full picture 
starts to become visible. Look at any single piece in isolation, and 
the picture is unrecognizable. Slot several of the pieces into place, 
and the image slowly starts to take shape.
    A comparison of sorts can be made with the package of capital, 
leverage and liquidity reforms being introduced by the Basel Committee 
on Banking Supervision. The Group of 20 (G20) has set out the picture 
it wants to end up with: a Basel III framework with an increase in the 
level and quality of capital banks must hold compared with the pre-
crisis Basel II.
    But the G20 has also decreed that any work to refine and calibrate 
elements of the Basel III rules prior to their finalization and 
implementation should be made without further significantly increasing 
overall capital requirements across the banking sector. (http://
www.g20.utoronto.ca/2016/160227-finance-en.html) This is where it's 
hard to see how the pieces come together.
    The latest segment of the capital jigsaw to be slotted into place 
is the Fundamental Review of the Trading Book (FRTB), an initiative to 
overhaul market risk requirements. In its January publication of the 
final FRTB framework, the Basel Committee estimated the revised 
standard would result in a weighted mean increase of approximately 40% 
in total market risk capital requirements. That estimate, though, was 
based on a recalibration of quantitative-impact-study data from an 
earlier version of the rules.
    As a result, ISDA decided to lead an additional industry study [2] 
(http://www2.isda.org/attachment/ODM0OA==/QIS4 2015 FRTB Refresh 
Report_Spotlight__FINAL.pdf) based on data from 21 banks to determine 
the impact of the final requirements--and the results were unveiled at 
ISDA's 31st annual general meeting in Tokyo last week.
    The study shows an overall increase in market risk capital of 
between 1.5 and 2.4 times compared to current market risk capital. The 
lowest estimate of 1.5 times assumes all banks will receive internal 
model approval for all desks. If all banks fail the internal model 
tests for all trading desks, market risk capital would increase by 2.4 
times. ISDA believes the end result will be somewhere in between, but 
this will depend on two key variables: interpretation of rules on a so-
called P&L attribution test and whether the calibration of capital 
floors applies to market risk.
    The former is particularly important--and currently problematic. 
Under the FRTB, banks have to apply for regulatory approval to use 
internal models for each trading desk, with approval dependent on 
passing a P&L attribution test (essentially comparing internal capital 
systems with front-office models). But there is currently a lack of 
clarity over how this test will work in practice, while banks have not 
had time to develop the infrastructure that would enable them to 
produce the data required for the test.
    Without more certainty on the methodology, and without knowing 
whether or at what level capital floors will be set, it is difficult to 
accurately estimate the ultimate impact. But it is unlikely all banks 
will receive internal model approval for all desks, meaning the end 
result may be closer to 2.4 times than 1.5 times.
    Crucially, the study shows the final FRTB framework hasn't 
eliminated a cliff effect between standardized and internal models. If 
a particular desk loses model approval, capital requirements could 
immediately increase by multiple times. This had been something the 
Basel Committee had wanted to eliminate.
    The FX and equity markets are most affected. Losing internal model 
approval under the new rules would result in a 6.2 times increase in 
capital for FX desks and a 4.1 times increase for equity desks.\19\
---------------------------------------------------------------------------
    \19\ These numbers exclude the so-called residual risk add-on, non-
modellable risk factors and diversification across risk classes under 
internal models.
---------------------------------------------------------------------------
    These are big increases, and come on top of the jump in capital 
requirements already envisaged in Basel III. The question is whether 
this single piece of the jigsaw suggests the final picture will be out 
of line with what the G20 expects. To put it more simply, will this 
piece, when combined with other changes in the capital framework, 
ultimately result in further significant increases in capital across 
the banking sector? The honest answer is that no one knows.
    We do, however, know that large increases in capital could mean 
certain business lines end up becoming uneconomic. This could severely 
affect the ability of banks to provide risk management services and 
reduce the availability of financing for borrowers. At a time when some 
jurisdictions are increasingly focused on initiatives to generate and 
sustain economic growth, that's a concern.
Summary of the Industry Study on the Final FRTB Rules \20\
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    \20\ http://www2.isda.org/attachment/ODM0OA==/
QIS4%202015%20%20FRTB%20Refresh
%20Report_Spotlight__FINAL.pdf
---------------------------------------------------------------------------
FRTB QIS4 Refresh_Spotlight
  b Significant step in right direction--Highlights:

    d SA methodology overall capital charge is 2.4 compared to current 
            market risk capital (QIS4: 4.2); and

    d Residual risk add on in standard rules has reduced to 6% (QIS4: 
            49%) of total SA capital.

  b NMRF remains a big component of internal models approach capital 
        charge 30% (QIS4: 29%)

  b Cliff effect between standard rules and internal models remains 
        because:

    d Banks were asked to assume most desks obtain model approvals in 
            the QIS instructions. In reality most banks are likely to 
            lose model approval for a number of desks due to stringent 
            tests;

    d Capital floors based on some percentage of standardized approach 
            will be imposed; and

    d Cliff effect between the IMA and SA varies materially between and 
            within risk classes, which may result in significant 
            reallocation of capital and business activity.

------------------------------------------------------------------------
                                                  SA to IMA *
------------------------------------------------------------------------
     Interest rate risk                                   3.0
     Credit spread risk                                   2.0
            Equity risk                                   4.1
         Commodity risk                                   2.9
  Foreign exchange risk                                   6.2
------------------------------------------------------------------------
* SA excluding residual risk add on & IMA excluding NMRF.
* Results based on data contributed by 21 banks, refreshing earlier QIS4
  analysis based on final FRTB rules.

  b Charges on securitization products improved in the final text, 
        however, when looking at capital for the securitization 
        portfolio including hedges, we see a significant increase in 
        capital versus current levels.

  b The results of P&L Attribution test and the calibration of the 
        capital floor based on standard rules need to be considered to 
        assess the full capital impact and how the change will 
        translate to bank business models.
        
        
                                Annex II
    Under the CFTC's proposed capital rule, non-bank swap dealers that 
are subsidiaries of an entity with capital models approved by the 
Federal Reserve or SEC can seek CFTC approval of such internal models 
to calculate their related CFTC capital requirements.
    Unfortunately, this approach leaves some ISDA members with no 
ability to seek CFTC model approval to calculate regulatory capital 
requirements. Specifically, those members that are neither a subsidiary 
of a U.S. bank holding company nor an SEC-registered security-based 
swap dealer will be unable to seek CFTC model approval. This holds true 
for swap dealers that are subsidiaries of non-U.S. financial 
institutions subject to robust home-country prudential regulation in a 
jurisdiction that is a member of the G20 or a member of the Basel 
Committee.
    Without an approved model, a swap dealer will be required to use a 
rigid standardized approach to calculate capital and margin 
requirements. The significantly higher costs associated with the 
standardized approach would make continued swap activity severely cost-
prohibitive. The significant cost increase will result in higher costs 
for end-users and create an unlevel playing field among dealers engaged 
in the same business, in the same markets, with the same customers. We 
do not believe that an aim of the Dodd-Frank Act was to cause 
significantly higher costs for end-users, or for regulators to pick 
winners and losers among swap dealers and major swap participants. 
Nonetheless, these are the likely outcomes if model approval is unduly 
restricted.
    We understand there has been a productive dialogue between the 
CFTC, SEC and market participants on these issues and we encourage it 
to continue. ISDA also appreciates that the House and Senate CFTC 
reauthorization bills provide for consultation between regulators on 
models, and authorize non-bank swap dealers to use comparable models to 
the extent bank swap dealers use an approved model.

    The Chairman. Mr. Deas.

       STATEMENT OF THOMAS C. DEAS, Jr., REPRESENTATIVE,
  CENTER FOR CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF 
COMMERCE; REPRESENTATIVE, COALITION FOR DERIVATIVES END-USERS, 
                        WASHINGTON, D.C.

    Mr. Deas. Good morning, Chairman Scott, Ranking Member 
Scott, and Members of the Subcommittee.
    I am Tom Deas, testifying on behalf of the U.S. Chamber's 
Center for Capital Markets Competitiveness and the Coalition 
for Derivatives End-Users. I am also Chairman of the National 
Association of Corporate Treasurers.
    The Chamber and the Coalition for Derivative End-Users, 
along with NACT, represent hundreds of companies across the 
country that employ derivatives to manage risk in our day-to-
day business activities.
    First, let me sincerely thank, both the Chairman, the 
Ranking Member, and the Members of this Committee for doing so 
much to protect derivative end-users from the burdens of 
unnecessary regulation. When it comes to main street 
businesses, the Members of this Committee have worked together 
to get things done. Last year, you led the charge in enacting 
both the end-user margin bill and the centralized treasury unit 
bill, directly benefitting the end-user community. We sincerely 
appreciate these efforts.
    Congress did this because they recognized that end-users do 
not engage in the kind of risky, speculative derivatives 
activity that became evident during the financial crisis. End-
users comprise less than ten percent of the derivatives 
markets, and we use derivatives to hedge the risks in our day-
to-day business activity. We are offsetting risks, not creating 
new ones.
    We support the Dodd-Frank Act's goal of increasing 
transparency in, and reducing systemic risks of, the 
derivatives markets. However, at this point, almost 6 years 
after passage of the Act, there are still areas where the 
continuing uncertainty compels end-users to appeal for 
legislative and regulatory relief. End-users are also seeing 
the cumulative impacts of the elaborate web of new rules and 
regulations, including those placed on our counterparties; that 
is, rules that require our counterparties to meet certain tests 
regarding capital, liquidity, and margin, are leading to 
significant realized and potential impacts on end-users. 
Despite being exempted from the capital and margin 
requirements, end-users still face the distinct possibility 
that our hedging activities will become too costly because of 
the new and higher capital requirements, margin and liquidity 
requirements, imposed on our counterparties.
    For example, under the net stable funding ratio, long-term 
funding costs will discourage dealer involvement in 
derivatives, thereby reducing available counterparties and 
liquidity for end-users. We understand the banking regulators 
have proposed their net stable funding ratio rule this week, 
and we are in the process of reviewing it and its impacts on 
end-users.
    Another example is the supplemental leverage ratio, which 
does not permit the clearing member to receive credit for the 
segregated initial margin posted by its end-user customers. The 
failure of the SLR to recognize the risk-reducing effect of 
segregated client collateral will likely lead to fewer banks 
willing to provide clearing services for customers, and will 
likely increase costs to end-users generally.
    Differences in the credit valuation adjustment risk capital 
charge between the United States and other jurisdictions, such 
as Europe, also create competitive disadvantages. Europe 
provides an exemption that avoids the CVA charge being factored 
onto the pricing, and passed on to end-users, however, in the 
United States no such exemption exists, leading to the 
potential for large pricing differences when trading with U.S. 
compared to EU banks.
    Many end-users engage in derivatives with both non-bank, as 
well as bank swap dealers, and we are concerned about the 
impact on liquidity of certain restrictions on models for non-
bank swap dealers, which would not permit the use of internal 
models for computing market risks, and counterparty credit 
charges for capital purposes. This approach requires non-bank 
swap dealers to hold significantly more regulatory capital, 
which ultimately will force them potentially to exit the 
business, leaving end-users with fewer choices for access to 
risk mitigation tools.
    To summarize, end-users are concerned about the apparent 
disparity between an exemption from clearing and margin 
requirements on the one hand, and the pass-through costs 
resulting from new capital and liquidity rules imposed on their 
counterparties. We also fear that cross-border regulatory 
uncertainty and conflict could put American companies at an 
economic disadvantage. Although these capital and liquidity 
rules do not create affirmative requirements directly on end-
users, they, nevertheless, create real impacts and costs. The 
imposition of unnecessary burdens on end-users restricts job 
growth, decreases investment, and undermines our 
competitiveness around the globe, leading to material 
cumulative impacts on corporate end-users and our economy.
    Thank you again for your attention to the needs of end-user 
companies.
    [The prepared statement of Mr. Deas follows:]

 Prepared Statement of Thomas C. Deas, Jr., Representative, Center for
       Capital Markets Competitiveness, U.S. Chamber of Commerce;
 Representative, Coalition for Derivatives End-Users, Washington, D.C.
          The U.S. Chamber of Commerce is the world's largest business 
        federation, representing the interests of more than three 
        million businesses of all sizes, sectors, and regions, as well 
        as state and local chambers and industry associations. The 
        Chamber is dedicated to promoting, protecting, and defending 
        America's free enterprise system.
          More than 96% of Chamber member companies have fewer than 100 
        employees, and many of the nation's largest companies are also 
        active members. We are therefore cognizant not only of the 
        challenges facing smaller businesses, but also those facing the 
        business community at large.
          Besides representing a cross section of the American business 
        community with respect to the number of employees, major 
        classifications of American business--e.g., manufacturing, 
        retailing, services, construction, wholesalers, and finance--
        are represented. The Chamber has membership in all 50 states.
          The Chamber's international reach is substantial as well. We 
        believe that global interdependence provides opportunities, not 
        threats. In addition to the American Chambers of Commerce 
        abroad, an increasing number of our members engage in the 
        export and import of both goods and services and have ongoing 
        investment activities. The Chamber favors strengthened 
        international competitiveness and opposes artificial U.S. and 
        foreign barriers to international business.
          The Coalition for Derivatives End-Users represents the views 
        of end-user companies that employ derivatives to manage risks. 
        Hundreds of companies and business associations have been 
        active in the Coalition on both legislative and regulatory 
        matters and our message is straightforward: financial 
        regulatory measures should promote economic stability and 
        transparency without imposing undue burdens on derivatives end-
        users, who are the engines of the economy. Imposing unnecessary 
        regulation on derivatives end-users, parties that did not 
        contribute to the financial crisis, would fuel economic 
        instability, restrict job growth, decrease productive 
        investment and hamper U.S. competitiveness in the global 
        economy.

    Mr. Chairman, Ranking Member Scott, other Members of the 
Subcommittee, thank you for inviting me to testify at this important 
hearing, which focuses on matters of significant concern to the end-
user community. I am Thomas C. Deas, Jr., Chairman of the National 
Association of Corporate Treasurers, an organization of treasury 
professionals from several hundred of the largest public and private 
companies in the country. I am testifying today on behalf of both the 
U.S. Chamber of Commerce (``Chamber'') and the Coalition for 
Derivatives End-Users (``Coalition''). The Chamber is the world's 
largest business federation, representing the interests of more than 
three million businesses of all sizes, sectors, and regions. The 
Coalition includes more than 300 end-user companies and trade 
associations, including the National Association of Corporate 
Treasurers. Collectively, the Chamber and the Coalition represent a 
wide and diverse population of domestic and international commercial 
businesses and trade associations.
    As detailed below, we strongly believe that there are many capital 
and liquidity requirements impacting our counterparties that will 
directly impede the ability of end-users to effectively manage risks 
and result in higher costs for the end-user community, and ultimately 
consumers. Specifically, these include:

   The Net Stable Funding Ratio;

   The Supplemental Leverage Ratio;

   Restrictions on Models for Non-Bank Swap Dealers;

   Competitive Issues Surrounding the Credit Valuation 
        Adjustment;

   The Swap Dealer De Minimis Threshold; and

   The Cumulative Impact of Capital Rulemakings on End-Users
Background
    The Chamber's mission is to ensure America's global leadership in 
capital formation by supporting robust capital markets that are the 
most fair, transparent, efficient, and innovative in the world. As part 
of that mission, the Chamber recognizes the acute need for commercial 
end-users to effectively manage risk. Similarly, the Coalition, 
representing the engines of our domestic and global economy, has 
consistently supported financial regulatory measures that promote 
economic stability and transparency without imposing undue burdens on 
derivatives end-users.
    At the outset, let me thank the Members of this Subcommittee and 
the full Committee for their bipartisan efforts and focus on ensuring 
that Main Street businesses have the tools and access to capital 
necessary to operate and grow. Last year, you led the charge in 
enacting key legislation to protect end-users, including the end-user 
margin bill, which clarified that end-users are not subject to margin 
requirements for their uncleared swaps, and the centralized treasury 
unit bill, which helped ensure that end-users can continue to use a 
risk-reducing best practice. Similarly, the Commodity End-User Relief 
Act includes several provisions that will provide immediate relief to 
end-users who rely on risk management tools to keep their operations 
and businesses running during times of uncertain volatility.
    Despite these laudable efforts, however, end-users still face the 
distinct possibility that their hedging activities will become too 
costly because of new and higher capital, margin and liquidity 
requirements imposed on their bank and non-bank counterparties. In 
essence, this means that the significant progress Congress has made to 
ensure that end-users do not bear the brunt of costs associated with 
derivatives risk management, including exemptions from clearing and 
margin requirements, are pyrrhic victories. In particular, I wish to 
highlight the impact of the following capital and liquidity 
requirements, which have resulted either in higher costs for end-users 
(or will do so once fully implemented) or will incentivize end-user 
counterparties to leave the market altogether.
Net Stable Funding Ratio
    The Chamber and the Coalition believe that the Basel Committee of 
Banking Supervision's net stable funding ratio (``NSFR'') which would 
lead to billions in additional funding requirements for derivatives 
activities, does not take into account the impacts on end-users. This 
is especially concerning given that many of the provisions of the NSFR 
would further restrict end-users' ability to hedge by increasing the 
cost of risk management and could lead to decreased liquidity in the 
derivatives markets. We understand that the Prudential Banking 
Regulators released their proposed rules on the NSFR earlier this week 
and we will be carefully reviewing their proposals and evaluating the 
impact on end-users.
    In particular, the concern is two-fold: (1) long-term funding costs 
required under the NSFR limit and discourage dealer involvement in 
derivatives and derivatives-related transactions, effectively reducing 
liquidity in the market that end-users rely on to hedge risk; and (2) 
costs associated with capital-raising in a less liquid market would 
inevitably be borne by derivatives end-users and consumers. The 
immediate impact of the NSFR can already be seen as fewer bank 
counterparties are willing to extend longer-term credit, including in 
the form of swaps used to hedge long-term exposures. Additionally, the 
costs to hedge are likely to be passed on to end-user companies in the 
form of increased fees or transaction costs, less favorable terms, and 
collateral requirements.\1\
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    \1\ A January 2015 study of the OTC derivatives market by Oliver 
Wyman concluded that the NSFR's treatment of OTC derivatives would 
require an additional $500 billion in long-term funding, generating $5-
$8 billion in incremental costs to the industry, with a cost increase 
of 10-15% for derivatives transactions.
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    These concerns are particularly reflected in the add-on costs 
associated with counterparty payables; the treatment of 
uncollateralized receivables; the lack of collateral offsetting 
provisions; and the liquidity squeeze related to the treatment of 
corporate debt. For example, requiring dealer counterparties to provide 
required stable funding for 20% of the negative replacement cost of 
derivative liabilities (before deducting variation margin posted) is a 
clear example of the direct burdens that would affect end-users' 
ability to efficiently mitigate risk.
    Another concern under the NSFR is the treatment of dealers with 
respect to uncollateralized net receivables, which could require 100% 
long-term funding. As we are now seeing, end-users are being required 
to collateralize transactions with cash margin to meet the stringent 
Basel III leverage ratio requirements. Or, if a dealer counterparty did 
not demand collateral, the costs of long-term funding could simply be 
passed on to end-users through embedded derivatives fees.
    Moreover, we believe that disproportionate discounting of 
collateral posted forces dealers to mitigate costs elsewhere. As a 
result, in implementing the NSFR, the Prudential Banking Regulators 
should align collateral posted by commercial end-users with long-term 
funding obligations under NSFR. This is particularly true because, 
while most end-users are exempted from posting margin for their 
derivatives with bank counterparties, the ``back to back'' hedges 
entered into by banks to offset end-user transactions are still subject 
to mandatory clearing and margin requirements. Consequently, the costs 
borne by banks to offset end-user transactions are passed on to the 
very end-users that were meant to be exempt from the costs of mandatory 
clearing and margin requirements--and ultimately to consumers.
    Further, the NSFR's treatment of corporate debt could hinder end-
user capital raising efforts. The NSFR does not take into account the 
maturity of end-user-issued debt when determining a dealer's required 
stable funding and would restrict liquidity in the corporate debt 
markets by requiring dealers to raise 50-85% long-term funding to 
support their inventory, which would discourage market making. End-
users rely on market-based funding and the importance of liquid markets 
for corporate bonds and commercial paper (``CP''). To cite a real-world 
example of the costs and diminished liquidity from these rules, many 
corporate treasuries issue CP daily to balance their funding 
requirements. If they are faced with a same-day payment that they 
identify too late in the day to complete a placement in the market of 
the required CP, their bank CP dealer frequently will take the paper 
overnight for its own account and fund-out the requirement the next 
day. The NSFR rules require the bank to hold 85% of that overnight 
funding as long-term funding--at a cost over ten times the overnight 
amount. Ultimately this liquidity will no longer be available to end-
user treasury departments. Accordingly, the Prudential Banking 
Regulators should carefully consider the impact of the NSFR's 50-85% 
long-term funding requirements on end-users.
Supplemental Leverage Ratio
    The supplemental leverage ratio (``SLR'') penalizes high quality 
assets and acts as a disincentive to market participants to provide 
clearing services. The SLR does not permit the clearing member to take 
``credit'' for the segregated initial margin posted by its customer 
that is expressly for the purpose of limiting the clearing member's 
exposure to derivatives. Further, segregated initial margin in the form 
of cash may be required to be added to a clearing member's balance 
sheet exposure, requiring additional capital. The overall result of the 
SLR seems to ignore the fact that for derivatives cleared on behalf of 
a customer, the customer's segregated initial margin must be held to 
margin the customer's positions and cannot be used as leverage by the 
clearing firm.
    Ultimately, the failure of the SLR to recognize the risk-reducing 
effect of segregated client collateral will likely lead to fewer banks 
willing to provide clearing services for customers, thus constraining 
the ability of end-users that clear derivatives to access central 
clearing. Further, even end-users that do not clear their derivatives 
will likely see the impact of the SLR in the form of increased costs 
for hedging, as their bank counterparties will see their clearing costs 
increase on their back to back hedges and will pass those costs along 
to end-users. We are hopeful that regulators can work together to get 
this right in the United States and abroad.
Restrictions on Models for Non-Bank Swap Dealers
    Another significant issue directly impacts non-bank swap dealers, 
many of which routinely do business with end-users. As proposed in 
2011, the CFTC's capital rules for non-bank swap dealers do not permit 
the use of internal models for computing market risk and counterparty 
credit risk charges for capital purposes. Instead, they must use the 
``standardized approach,'' which measures market risk according to 
standards established by the Basel Committee on Banking Supervision, 
generally requiring capital for both ``general'' and ``specific'' 
risks.
    These two approaches differ significantly, particularly with 
respect to dealing in commodity derivatives. For many asset classes, 
non-bank swap dealers using the standardized approach would be required 
to hold regulatory capital potentially hundreds of times more than swap 
dealers using the internal models approach. This regulatory disparity 
will ultimately force those dealers to exit the business, leaving end-
users with fewer choices for access to risk mitigation tools. Moreover, 
the disparity creates an unlevel playing field between bank and non-
bank dealers participating in the same markets, ultimately resulting in 
higher costs for end-users.
    In this respect, Section 311 of the Commodity End-Users Relief Act 
would permit the use of comparable financial models by non-bank swap 
dealers and major swap participants. This provision would help ensure 
comparability in capital requirements across all swap dealers (whether 
bank or non-bank) and eliminate a commercial disparity that only raises 
costs on end-users that decide to do business with non-bank swap 
dealers.
Competitive Issues Surrounding the Credit Valuation Adjustment
    European policymakers have implemented capital charges on 
derivatives positions significantly more favorable to end-users than 
the U.S. Prudential Banking Regulators. The European approach 
recognizes that end-users' hedging activities are in fact reducing 
risks, and accordingly, exempts end-user derivatives transactions from 
the credit valuation adjustment (``CVA'') risk capital charge, which 
would otherwise require the calculation and subsequent holding of 
capital to mitigate counterparty credit risk in a derivatives 
transaction. The absence of a U.S. exemption puts American companies at 
a meaningful competitive disadvantage compared to our European 
competitors.
    In particular, we note that lack of a CVA exemption forces end-
users to enter into credit support enhancement agreements that a bank 
would normally not deem necessary in the absence of regulation. If 
banks require collateral, end-users may be put in the position of 
borrowing from financial institutions to finance the margining 
associated with those transactions, resulting merely in a shift of risk 
between financial institutions. This result contradicts the objective 
of facilitating end-user access to capital, drives costs directly to 
end-users, and does nothing to mitigate risk within the financial 
system, as the risk is simply being transferred from one bank to 
another.
Swap Dealer De Minimis Threshold
    Finally, we believe that the CFTC should follow clear Congressional 
intent and promptly draft an interim final rule that makes clear that 
the swap dealer de minimis exception threshold shall remain at the $8 
billion gross notional level or be raised. The Chamber and Coalition 
are concerned that any decrease below the current $8 billion level 
could reduce liquidity and the availability of counterparties for end-
users to trade with, thereby concentrating risk in fewer counterparties 
and negatively impacting end-users' ability to hedge.
    Indeed, we believe that the swap dealer de minimis exception should 
remain broad enough to exclude swap dealing activities that do not rise 
to the level of systemic significance, either because the level of 
activity or the type of transaction. Lowering the threshold from the $8 
billion gross notional amount would needlessly and unnecessarily 
capture a significant number of additional market participants and 
require them to register as swap dealers or, more likely, reduce their 
available products and services to derivatives end-users to ensure they 
remain below the thresholds.
    Any decrease from the current threshold would likely cause a 
further consolidation of swap dealing activities, reducing 
competitiveness and potentially increasing risk. Such changes to the 
market would reduce liquidity to end-users, reduce counterparty 
selection and increase interconnectedness of counterparties--results 
that run contrary to the goals of the Dodd-Frank Act.
    In this respect, we fully support Section 310 of the Commodity End-
Users Relief Act, which would set the de minimis threshold of swap 
dealing at $8 billion. This section would ensure that the de minimis 
threshold could only be amended or changed through a new affirmative 
rulemaking by the CFTC.
Cumulative Impact of Capital Rulemakings on End-Users
    In summary, we believe the legislative intent of the Dodd-Frank Act 
was to exempt end-users from having to use their own capital for 
mandatory margining of derivatives transactions, diverting these funds 
from investment in business expansion and ultimately costing jobs. The 
imposition of additional capital requirements by U.S. Prudential 
Banking Regulators would undermine this intent by forcing our bank 
counterparties to hold much more of their own capital in reserve 
against end-users' derivatives positions, passing on the increased 
costs to these end-users.
    The larger point, which I know this Subcommittee appreciates, is 
that the cumulative effect of new derivatives regulation threatens to 
impose undue burdens on end-users. The indirect but potentially even 
more onerous regulation of end-users through bank capital and liquidity 
requirements serves to discourage end-user risk management through 
hedging and would effectively negate the benefits of Congress's clear 
intent to exempt end-users from margin requirements. The importance of 
smart prudential regulation that promotes Main Street business has been 
echoed by Members of Congress, including by Chairman Conaway, who has 
noted that bipartisan efforts must ``protect end-users from being roped 
into reporting, registration, or regulatory requirements that are 
inappropriate for the level of risk they can impose on financial 
markets. It is clear that end-users did not cause the financial crisis, 
they do not pose a systemic risk to the U.S. financial markets, and 
they should not be treated like financial entities.'' \2\
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    \2\ Press Release, Congressman Conaway Praises Approval of the 
Customer Protection and End User Relief Act, U.S. Representative Mike 
Conaway (Apr. 9, 2014), available at http://agriculture.house.gov/news/
documentsingle.aspx?DocumentID=1110.
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    We need a regulatory system that allows Main Street to effectively 
use derivatives to hedge commercial risk, resulting in key economic 
benefits; one that allows businesses--from manufacturing to healthcare 
to agriculture to energy to technology--to improve their planning and 
forecasting, manage unforeseen and uncontrollable events, offer more 
stable prices to consumers and contribute to economic growth. End-users 
are entering into derivatives to mitigate the business risks they face 
in their day-to-day business activities. In this respect they are 
fundamentally different from swap dealers who maintain an open book of 
exposures against which posting of cash margin is not unwarranted. 
However, when rules intended to apply to swap dealers directly or 
indirectly burden end-users, it is the end-user segment of our economy 
that bears the higher costs. The imposition of unnecessary burdens on 
end-user businesses restricts job growth, decreases investment and 
undermines our competitiveness in Europe and elsewhere across the 
globe--leading to material cumulative impacts on corporate end-users 
and our economy.
    Thank you and I am happy to address any questions that you may 
have.

    The Chairman. Mr. Gellasch.

   STATEMENT OF TYLER GELLASCH, FOUNDER, MYRTLE MAKENA, LLC, 
                         HOMESTEAD, PA

    Mr. Gellasch. Chairman Scott, Ranking Member Scott, 
Chairman Conaway, and other Members of the Committee, thank you 
for inviting me here today.
    The testimony I am going to give today represents my views, 
and not those of the trade association or others members.
    And I agree with your remarks. I actually believe that we 
can have more resilient markets and still protect end-users. 
And I also want to start today by recognizing the obvious; that 
inadequate regulation of derivatives turned the mortgage crisis 
into a worldwide financial meltdown. And in response to that 
crisis, regulators around the world designed rules to make our 
markets more fair, more transparent, more stable, and less 
likely to cause the next financial crisis.
    I think it is clear they have actually done that. But 
unlike some of my colleagues here today, I want to share with 
you that these important reforms are not actually having a 
profound negative impact on real end-users. And the elaborate 
web of rules, that my colleagues referenced a moment ago, don't 
actually apply to them, and in part because of your hard work, 
but in part because of smart choices also made by our 
regulators.
    Today's topic focuses largely on margin and capital, and I 
think that is actually the most important part of the crisis. 
The largest firms, AIG and the banks, had hundreds of billions 
of dollars on their balance sheets, and yet they still were not 
able to weather the storm, in large part because they had 
inadequate margin from their counterparties, and they had 
inadequate capital to absorb the losses, so the taxpayers did.
    And I want to explore for a moment exactly what margin and 
capital are. As Mr. Lukken said, margin is the first line of 
defense for a counterparty. It is an asset often extremely 
liquid in securities that are used to satisfy the obligation. 
And it has been a hallmark of our capital markets for decades 
around the world, and it is actually the only reason to promote 
liquidity in times of financial stress. Capital, by contrast, 
ensures that the firm has enough of its own, not borrowed, 
money to meet the foreseeable obligations; essentially, to stay 
solvent. If margin is the first line of defense for a 
counterparty in the time of a crisis, then capital and leverage 
limits are the last before the bailout.
    Once the crisis hit, everyone realized that we needed more 
margin and capital in the system, and the G20 summits focused 
squarely on those issues. And that is actually what Dodd-Frank 
did as well. And now we are hearing from many of the largest 
banks and financial firms and their trade groups here, that the 
requirements on them will have, and I will again use their 
words, profound negative impacts, or impede the ability of end-
users to manage their risks. And I am here to say I 
respectfully disagree, and the reason is, frankly, simple math. 
And let me use an example from real life that I am familiar 
with, and it is a real commercial end-user, it was a parts 
supplier in Michigan who has a $100,000 loan with an interest 
rate risk associated with that, and they want to engage in 
perhaps a swap to fix that risk. So now they go to a bank with 
a 7\1/2\ percent capital requirement. Okay. So the real risk 
for them may be just $1,000, the actual full risk. So the 
market value is $1,000. The capital for that is about $75, 7\1/
2\ percent of that. But we are not even talking about the $75 
on this $100,000 swap. We are talking about the difference 
between that being borrowed money and that being the financial 
firm's own money.
    So what is the difference there? That is actually about 
$7\1/2\. So what we are really talking about on a $100,000 swap 
is an incremental cost to the bank or to the large financial 
firm of basically a ham sandwich downstairs. That is the amount 
of money we are actually talking about. That is the profound 
impact of the cost that we are worried about being passed on to 
the end-users.
    Again, the end-user itself isn't posting any margin. It is 
not posting any capital. It doesn't have to keep those things. 
And those folks were appropriately exempted from the 
regulation.
    So one thing I want to take a few moments to talk about is 
who are the financial firms. Obviously, we have the largest 
banks who are familiar with capital and margin requirements 
that have applied to them for decades, but we also have the 
largest financial services firms. We have the insurance 
companies, we have the hedge funds, mutual funds, the futures 
commission merchants, we have those folks. I would argue that 
actually that bucket is precisely the bucket that these rules 
are designed to target, and the reason is AIG, Long-Term 
Capital Management, MF Global, those are the firms that we 
actually do have to worry about. And for them, margin and 
capital rules, some of them may apply, and some of them are not 
very familiar with it, and I recognize that.
    And then, of course, we have the real end-users, the 
farmers cooperatives, the manufacturers, they had nothing to do 
with this crisis, and no one agrees that they did. What is 
interesting is we are doing our best now, and with your 
Committee's great work, making sure that these rules don't 
apply to them.
    The last point I want to make is something that my 
colleagues also referenced with respect to the cross-border 
issues. I share the concerns with both mutual recognition and 
making sure that our regulators work collaboratively around the 
globe.
    With respect to whether or not we exempt, or our regulators 
cede jurisdiction to others, I would say be very careful. It 
was, in fact, the London trading desks of some of the largest 
firms that led to some of the large losses, so I would urge 
them to be careful.
    Again, thank you for inviting me here today, and I look 
forward to any questions.
    [The prepared statement of Mr. Gellasch follows:]

  Prepared Statement of Tyler Gellasch, Founder, Myrtle Makena, LLC, 
                             Homestead, PA
    Chairman Conaway, Ranking Member Peterson, Chairman Scott, Ranking 
Member Scott, and other Members of the Committee, thank you for 
inviting me here today.
    Effective derivatives regulation is an incredibly important topic 
for our economy, and one in which I have deep interest. A little more 
than 7 years ago, I left private law practice and joined the Senate 
staff at a time when our country was facing the worst financial crisis 
in generations. As counsel to a senior United States Senator who also 
chaired the Senate Permanent Subcommittee on Investigations, I had the 
privilege of assisting the Senator with investigating the causes of the 
crisis and crafting legislation designed to prevent future crises. 
Later, I had the privilege of helping regulators carefully implement 
that legislation as intended.
    I now run a small consulting firm, Myrtle Makena, and also serve as 
Executive Director of the Healthy Markets Association, an investor-
focused nonprofit coalition focused on equity market structure issues. 
The testimony I give today represents my own views, and not necessarily 
those of my association or its members.
The Financial Crisis
    This Committee is continuing a conversation that began in earnest 
as the world was coming to grips with the worldwide financial meltdown. 
Beginning in the fall of 2008, over the course of just a few months, 
U.S. regulators began pouring several trillion dollars into the 
financial markets to help prop up and save some of the largest 
financial firms.\1\ Many people remember the $700 billion Troubled 
Asset Relief Program (TARP), which pumped tens of billions of dollars 
into AIG, Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, 
Morgan Stanley, Wells Fargo, and others.\2\
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    \1\ The U.S. Government and regulators used more than a dozen new 
and previously existing programs (and more than 21,000 transactions) to 
provide trillions of dollars in assistance to U.S. and foreign 
financial institutions to promote liquidity and prevent a financial 
collapse. That's on top of the FDIC and Treasury Department extending 
guarantees to trillions of dollars in assets for a range of 
institutions and markets. See, e.g., Press Release, Department of the 
Treasury, Treasury Announces Temporary Guarantee Program for Money 
Market Funds (Sept. 29, 2OO8), available at http://www.treasury.gov/
press-center/press-releases/Pages/hp1161.aspx; see also, Temporary 
Liquidity Guarantee Program: Fourth Quarter 2010, FDIC.
    \2\ See, https://www.treasury.gov/initiatives/financial-stability/
reports/Pages/TARP-Housing-Transaction-Reports.aspx.
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    But why did AIG \3\ and the banks need rescuing in the first place? 
What went wrong? How could these enormous firms, with hundreds of 
billions of dollars on their balance sheets--and billions more off 
their balance sheets--suddenly teeter on the brink of collapse? The 
answer is why we're here: margin and capital. Or more importantly, it 
was the lack of them.
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    \3\ Other non-bank financial firms also suffered enormous losses. 
Some were bailed out (directly or indirectly), while others were not. 
For example, Lehman Brothers Holdings Inc., with more than 209 
registered subsidiaries spanning 21 countries, was not bailed out, 
leaving courts around the world wrestling with how to apply more than 
80 different jurisdictions' insolvency laws to untangle more than 
900,000 outstanding derivatives contracts. Michael J. Fleming and Asani 
Sarkar, The Failure Resolution of Lehman Brothers, Federal Reserve Bank 
of New York Economic Policy Review (Dec. 2014), available at https://
www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf.
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    It is worth recalling how that happened. Beginning in the 1990s, 
the swaps market grew rapidly as a remarkably efficient way to transfer 
risk between parties.\4\ And while many people appreciate that a 
mortgage crisis precipitated the financial crisis, what most people 
don't know (or at least didn't until The Big Short) was how bad 
mortgages on Main Street actually helped cause a financial crisis on 
Wall Street. That happened through big bets, particularly in swaps, and 
lack of margin and capital to back up those bets.\5\
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    \4\ These efforts were aided by increased financial engineering, 
standardization of terms and basic contracts (such as the development 
of the ISDA Master Agreement, Credit Support Annex, and CDS Model), and 
deregulation. See also Futures Trading Practices Act of 1992 and the 
Commodity Futures Modernization Act of 2000.
    \5\ For example, suppose I borrow $10 from Lending Corp and promise 
to pay it back $11 next year. Lending Corp might be worried that I 
won't pay it back. So Lending Corp could buy insurance, called a credit 
default swap, from Swap Corp. This swap may cost Lending Corp 25. Swap 
Corp collects 25 today, and if I don't pay back Lending Corp in 1 
year, Swap Corp pays Lending Corp $11. Either way, Lending Corp should 
make a 7.5% return on its loan to me ($11-$0.25). That seems reasonable 
enough.
    Now suppose ten other firms all buy the same ``insurance'', even if 
they don't have any interest in my repaying Lending Corp? They're just 
speculating on me repaying Lending Corp. Each time, Swap Corp will 
dutifully collect their 25, giving it $2.25.
    If I repay Lending Corp, Lending Corp gets its $11, and Swap Corp 
will keep its $2.25 in payments. But what if I don't repay Lending 
Corp? Swap Corp will suddenly owe $110. Unless Swap Corp has 
significant backup capital, Swap Corp may not have enough money to pay 
up. After all, it only took in $2.25. And what about Lending Corp and 
the other ten firms, who may now be relying on that $110 to pay their 
bills? There's the potential for chaos.
    Swap out the name Swap Corp from my example and call it AIG. In the 
run up to the crisis, AIG sold this type of default insurance on 
billions of dollars of mortgage-related products. It dutifully 
collected the quarters, but when it came time to pay up the dollars, it 
didn't have the money.
    This highly stylized example is also overly conservative. In many 
instances, the party selling protection (e.g., AIG), charged 
significantly less than the 2.5% suggested above. This premium was 
often sold as basis points, often settling well-below 1%. The rapid 
rise in perceived risk of default may often lead to a rapid rise in CDS 
premium rates. Still, the overall rates were below what one might 
suggest. For example, during the Greek debt crisis days of 2010, 5 year 
CDS on Greek sovereign debt jumped to a little over 4%. The impacts of 
these changes, however, are often dramatic on the borrower, as the 
increased CDS prices are often priced into the sales of new debt.
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    The Senate Permanent Subcommittee on Investigations conducted a 
years-long bipartisan investigation into figuring out how bad mortgages 
turned into a global financial crisis, and wrote up its findings in a 
comprehensive staff report.\6\ So too did the Financial Crisis Inquiry 
Commission.\7\ Other Congressional committees, prosecutors and 
regulators also researched the issues. They all found that financial 
firms had created financial instruments linked to mortgages that 
increased the level of risk and leverage to financial firms--in 
particular, because of inadequate margin and capital.
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    \6\ Wall Street and the Financial Crisis: Anatomy of a Financial 
Collapse, Homeland Security and Government Affairs, Permanent 
Subcommittee on Investigations, Majority and Minority Staff Report, 
(Apr. 13, 2011) (``Senate Financial Crisis Report'').
    \7\ Final Report of the National Commission on the Causes of the 
Financial and Economic Crisis in the United States, Financial Crisis 
Inquiry Commission, (2011), available at https://www.gpo.gov/fdsys/pkg/
GPO-FCIC/pdf/GPO-FCIC.pdf.
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    Because these financial instruments were traded with so little 
margin and the firms had so little capital, once any doubt was raised 
about the ability of the other side to pay up, it immediately imperiled 
the liquidity--and quickly, the solvency--of the entire system.
    In many ways, what the government did in 2008 and early 2009 was 
funnel money to all of the major financial firms so they could make 
good on their bets. For AIG, this meant that taxpayers effectively gave 
AIG enough money to post margin and pay its bets,\8\ while also buying 
out some of the bets directly.\9\ Thus, AIG's collapse may be thought 
of as a poster child for what happens when there are inadequate 
counterparty credit protections--again, margin and capital.\10\
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    \8\ Press Release, AIG Discloses Counterparties to CDS, GIA, and 
Securities Lending Transactions, American International Group, Inc., 
March 15, 2009, (``AIG Press Release''), Attachment A. For example, 
after receiving billions in TARP funds in September 2008, AIG used a 
whopping $52 billion to support trading done by its London-based 
Financial Products group. Of that, it funneled $22.4 billion to its 
counterparties as collateral for CDS trades and another $12.1 billion 
paying back municipalities. That doesn't count the $43.7 billion used 
to pay back firms (largely banks) with securities lending deals, nor 
the $29.6 billion a Federal Reserve-sponsored financing unit, Maiden 
Lane III, used to pay AIG and its counterparties for its CDS contracts. 
AIG Press Release. For just the CDS collateral bets, AIG paid out as 
CDS collateral $4.1 billion to Societe Generale, $2.6 billion to 
Deutsche Bank, $2.5 billion to Goldman Sachs, and $1.8 billion to 
Merrill Lynch. AIG Press Release, Attachment A.
    \9\ See, e.g., AIG Press Release, Attachment B (reflecting payments 
of $6.9 billion to Societe Generale, $5.6 billion to Goldman Sachs, 
$3.1 billion to Merrill Lynch, and $2.8 billion to Deutsche Bank).
    \10\ As Senator Chris Dodd stated in early 2010, ``But what was 
once a way for companies to hedge against sudden price shocks has 
become a profit center in and of itself, and it can be a dangerous one 
as well, when dealers and other large market participants don't hold 
enough capital to back up their risky best and regulators don't have 
information about where the risks lie. AIG was a classic example, of 
course, where that happened.'' 156 Cong. Rec. S5828-01 (July 14, 2010) 
(statement of Hon. Chris Dodd, U.S. Senator). Interestingly, AIG was 
warned before the collapse that its bets were bad. The model for Ryan 
Gosling's character from The Big Short, Greg Lippmann, told Senate 
investigators that he spent hundreds of hours trying to convince AIG to 
stop buying RMBS and CDOs, and stop selling single name credit default 
swaps (CDS) on those securities. Senate Financial Crisis Report, at 
343.
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Regulatory Response to Financial Crisis--Increasing Margin and Capital 
        for Derivatives Trading
    Almost immediately, governments around the world recognized that 
swaps and those who trade a significant amount of them needed to be 
better regulated. In September 2009, the G20 Summit in Pittsburgh 
reflected a commitment by world leaders to strengthen the international 
financial regulatory system by, amongst other things:

   Building high quality capital and mitigating pro-
        cyclicality;

   Improving over-the-counter derivatives markets, including by 
        requiring ``non-centrally cleared contracts . . . to higher 
        capital requirements''; and

   Addressing cross-border resolutions and systemically 
        important financial institutions by year-end 2010.\11\
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    \11\ G20 Leaders Statement: The Pittsburgh Summit (Sept. 2009).

    By that time, we in the United States were already working on 
parallel legislation to make many of those enhancements. The key 
components to reform, now embodied by the Dodd-Frank Act, were 
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generally:

   Imposing a comprehensive reporting regime to ensure that 
        regulators (and firms) would have a better understanding of the 
        number, scope, and nature of derivatives trades;

   Reducing counterparty credit risks, by increasing clearing, 
        margin and capital requirements;

   Reducing systemic risks by enhancing capital requirements; 
        and

   Enhancing market integrity by improving business conduct, 
        increasing transparency, and expanding authorities to police 
        market abuses.

    Each of these areas is complex, and the details have taken time to 
iron out. For example, one area I know of interest to many of you is 
how the supplemental leverage ratio may impact liquidity for some end-
users. In the same vein, Title III of the Terrorism Risk Insurance 
Program Reauthorization Act of 2015 exempted certain swaps from margin 
requirements.\12\ Making sure the true ``end-users'' are not unduly 
negatively impacted by the new rules is an important goal. That said, I 
generally think the current rules do a very good job of that.
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    \12\ This mandate was implemented as an interim final rule, which 
became effective on April 1, 2016. See Margin Requirements for 
Uncleared Swaps for Swap Dealers and Major Swap Participants, Commodity 
Futures Trading Commission, 81 Fed. Reg. 636 (Jan. 6, 2016).
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    Now, after 6 years of discussions, proposals, and court battles, 
many of the rules are just now being finalized.\13\ In one of the most 
important rulemakings completed since the financial crisis, the U.S. 
Prudential Regulators and the CFTC have recently finalized margin 
rules.\14\ While some aspects of the rules have been practically 
mandated for years through safety and soundness supervision, the 
provisions technically are coming on-line over the next year or so.
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    \13\ Foreign regulators are engaged in a similarly slow process, as 
many of their rules are also not yet in effect, and may be yet again 
delayed beyond 2017. Silla Brush and John Detrixhe, EU Weighs Softer 
Derivatives Rules as MiFID Delay Bogs Down, Bloomberg, Apr. 16, 2016.
    \14\ Margin and Capital Requirements for Covered Swap Entities, 
Office of the Comptroller of the Currency, Treasury, Board of Governors 
of the Federal Reserve System, Federal Deposit Insurance Corporation, 
Farm Credit Administration, and the Federal Housing Finance Agency, 80 
Fed. Reg. 74840 (Nov. 30, 2015); see also Margin Requirements for 
Uncleared Swaps for Swap Dealers and Major Swap Participants, Commodity 
Futures Trading Commission, 81 Fed. Reg. 636 (Jan. 6, 2016). In 
general, the Prudential Regulators (e.g., the Board of Governors of the 
Federal Reserve System) are setting the capital and margin rules for 
the swap dealers and major swap participants under their purview, and 
the markets regulators (e.g., the CFTC) are setting the same rules for 
the swap dealers and major swap participants under their purview. These 
rules are not the same, nor would necessarily I expect them to be, 
given the different regulators and regulated entities.
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Role of Margin and Capital Requirements
    Ensuring swaps transactions have sufficient margin and capital is 
at the center of the reform effort--precisely because those who lived 
through it saw how dangerous the lack thereof was to the system.\15\ 
But why is that? Why do margin and capital play such an important role 
in the experts' approach to addressing the regulatory failings of the 
2008 financial crisis? In no small part, it is because they address the 
systemic breakdowns of 2008. Both serve the same ultimate goal of 
ensuring that parties are able to meet their financial obligations, but 
they each go about achieving their objectives in different ways.
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    \15\ See G20 Leaders Statement: The Pittsburgh Summit (Sept. 2009).
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    For the benefit of those watching at home, margin is just 
collateral. Just like the collateral of the home reduces the bank's 
risk of the borrower's default on a mortgage, so too does margin 
directly reduce the risk that the trading counterparty won't pay--often 
called counterparty credit risk.
    Most commonly, this margin is broken into two components--initial 
and variation. The initial margin is what the participants pay at the 
beginning of the relationship. The variation margin changes as the 
values of the relevant trading positions change, such as due to the 
regular fluctuations of our many markets. As a party looks increasingly 
likely to pay up, the margin could and should increase to reflect that, 
because if it did not, the other party would be more exposed 
financially to the risk of its counterparty not paying--again, its 
counterparty credit risk.\16\ However, margin often comes with a direct 
cost to the party required to post it. Margin is typically in the form 
of cash, Treasuries, or other extremely liquid, stable value 
securities. This provides a stable and known value, but it also 
provides effectively no return for the party posting it. It isn't able 
to help them right now, nor is it likely to grow much in value. This 
often leads many firms to resist having to post margin.
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    \16\ Here, for simplicity, I treat both initial and variation 
margin collectively as margin. However, it should be noted that the 
ratio of obligations between the two may be significant. And there is 
no clear-cut ``right'' mix. Policymakers may elect to require lower 
initial margin in return for requiring greater sensitivity and higher 
potential variation margin. This comes with increased variability in 
margin costs for participants. Conversely, increasing initial margin 
may be accompanied by decreased variation margin requirements. This may 
stabilize margin level for participants, but may also result in higher 
overall margin levels and costs.
---------------------------------------------------------------------------
    That said, because of its efficacy at reducing counterparty credit 
risk, margin has been a hallmark of capital and derivatives markets for 
nearly a century. Why? Because, at its most basic form, margin enables 
market liquidity in a highly efficient way. By posting margin, multiple 
parties can trade with each other without massive amounts of due 
diligence, a costly and time consuming endeavor. Put another way, 
without margin, parties are trading with each other only to the extent 
that they fully trust the other party will pay them back, even if they 
go bust.\17\
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    \17\ Notably, derivatives enjoy highly preferential treatment under 
the bankruptcy code, making them far more likely to be paid in the 
event of bankruptcy than other types of liabilities, such as pensions 
(or even secured creditors). This treatment may both incentivize the 
use of derivatives, but it also may lead to sub-optimal social or 
financial outcomes, something that U.S. Senator Elizabeth Warren has 
highlighted when proposing to repeal this treatment. See, e.g., 
Interview of Elizabeth Warren, U.S. Senator, C-SPAN, Nov. 13, 2013, 
available at http://www.c-span.org/video/?c4473182/senator-warren-
derivatives-seniority-bankruptcy. For a review of some of the economic 
impacts of this special treatment, see Patrick Bolton and Martin 
Oehmke, Should Derivatives Be Privileged in Bankruptcy?, Journal of 
Finance (2015), available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2023227. Preferential treatment notwithstanding, 
some might also say that the 2008 financial crisis proved that the 
ultimate guarantors of those private and implicit promises are the 
American taxpayer.
---------------------------------------------------------------------------
    In the over-the-counter (OTC) markets, the amount of collateral 
required and the quality of collateral has evolved significantly over 
the past several years. Before the crisis, financial firms, of course, 
would regularly pledge collateral, but the amount was typically 
relatively low. Many non-financial firms previously were able to trade 
without pledging any collateral (the increased risk was just priced 
into the contract). To the extent collateral was pledged, it could be 
working assets.
    Not requiring margin is effectively an embedded loan. There is 
nothing inherently wrong with embedding a loan in a trading 
transaction, but we should be clear about what it is in practice: the 
party not requiring margin is taking the risk that it will not get paid 
back. It is reasonable to expect that a financial firm in most 
circumstances will be able to manage the risks of extending that type 
of credit to an ordinarily sized, non-financial end-user. That is 
essentially their business, after all. Moreover, those trades make up a 
relatively modest part of the overall trading going on in these 
markets.
    Since the crisis, and in response to regulatory efforts around the 
world, an increasing percentage of derivatives trades are centrally 
cleared. As centralized clearing has taken root, the total collateral 
used to support non-cleared derivatives has fallen.\18\ Non-financial 
firms still generally aren't required by regulators to post margin or 
maintain specific capital.
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    \18\ International Swaps and Derivatives Association, Inc., ISDA 
Margin Survey 2015, at 3 (Aug. 2015) (reflecting a decrease from $5.34 
trillion in 2013 to $5.01 trillion in 2014).
---------------------------------------------------------------------------
    Overall, the amount of collateral and the quality of the collateral 
required across the system has generally increased, in part driven by 
renewed oversight from banking supervisors and in part driven by market 
demands on counterparties, including through central clearinghouses. 
Thus, between the increase in centralized clearing and the increase in 
amount and quality of collateral in non-cleared trades, the risk that a 
party will be unable to pay up on its trade is today much lower than it 
was just a few years ago.
    Capital, by contrast, indirectly reduces counterparty credit risk 
by ensuring that a firm generally has enough assets to pay all of its 
reasonably foreseeable obligations. This is particularly important for 
a derivatives dealer, such as a bank or firm like AIG, since this 
protects from concentration risks that trade-specific margin 
requirements may not adequately address. Here, adequate capital 
requirements help supplement margin rules. If margin is the first line 
of defense, capital is the last.
    Capital also has one big advantage over margin. Unlike margin, 
which typically produces little or no financial return for the posting 
party, capital is not pledged away, nor is it necessarily in super-
stable, super-low yielding assets. It can, and often will, provide a 
modest return to the holder.
Disparate Impacts of Margin and Capital Requirements on Different Types 
        of Firms
    Before specifically addressing some of the concerns about market 
impacts of margin and capital rules, I want to acknowledge the distinct 
differences between firms engaged in swaps trading, and how margin and 
capital requirements might impact them differently.
    First, there are the largest banks and bank-affiliated firms. For 
these firms, financial assets are relatively easy to come by. They are, 
after all, financial institutions with relatively low borrowing costs 
and often-excellent access to a wide array of assets.\19\ They also 
have complex oversight and risk management systems (including 
sophisticated risk modeling systems) \20\ that allow them to monitor 
and manage their cash-flow requirements. In addition, they have 
historically conditioned to having capital and margin requirements. For 
these firms, incremental increases on margin or capital requirements 
are not likely to have profound impacts on how they do business. 
Changing margin and capital rules can, however, impact their overall 
profitability to the extent that it may restrict their leverage and 
increase costs for accessing high-quality assets.
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    \19\ In response to the financial crisis, however, regulators 
around the world, particularly banking and Prudential Regulators, have 
taken steps to improve the quality and quantity of capital held by 
financial firms.
    \20\ Bank regulatory capital requirements, and compliance with 
them, have in recent years become increasingly complex, and model-
driven. However, the efficacy of these models to provide meaningful 
evaluations of risk is nevertheless limited in many respects. For 
example, even basic metrics, such as Value-at-Risk, may be 
significantly altered by revisions to how the calculations are made, or 
the values of the inputs. For a detailed case study of potential 
failures of risk modeling, please see JPMorgan Chase Whale Trades: A 
Case History of Derivatives Risks and Abuses, Homeland Security and 
Government Affairs, Permanent Subcommittee on Investigations, Majority 
and Minority Staff Report, at 165-213, (Mar. 15, 2013).
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    Next, outside of the handful of the mega-banks, there are the other 
financial firms. These firms are likely regulated by the Commodity 
Futures Trading Commission and the Securities and Exchange Commission. 
They have traditionally operated under much less proscriptive capital 
regulatory regimes than banks, a fact that was highlighted by the 
collapses of Lehman Brothers, MF Global, and Bear Stearns. In addition, 
depending upon their business, these firms may not have significant 
amounts of liquid assets readily available for posting margin. Of 
course, some of these firms are deeply involved in swaps trading, and 
may have material swaps exposures, while most do not. Some are very 
familiar with posting liquid assets as margin while others are not. 
Further, while some of these firms may have sophisticated trade and 
risk management systems, including complex modeling capabilities, most 
do not.\21\
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    \21\ One of the key issues facing a firm under U.S. rules is 
determining whether it has ``material swap exposures.'' However, I 
understand that some non-bank financial firms may have difficulty in 
making such a determination without significant revisions to their 
oversight systems or outside assistance.
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    Finally, we have the non-financial firms. They include farmers, 
agricultural firms, manufacturers, and thousands of other firms that we 
might think of as the true ``end-users''. If properly defined, these 
firms comprise a very small percentage of overall swaps trading. And 
for them, margin or capital rules would seem unnecessary, 
inappropriate, and unduly burdensome. In addition, many do not 
typically have liquid financial assets available to use for posting 
margin, nor do they typically operate under a concept of regulatory 
capital. Imposing these limitations may have profoundly negative 
impacts on their operations. That's why Congress and regulators have 
already generally exempted these firms from the margin and capital 
requirements.
Regulations, Liquidity, and Costs
    Many have worried that banking and derivative regulations may 
reduce the number of counterparties, decrease liquidity, and increase 
costs for market participants.\22\ To date, I have seen no evidence of 
margin and capital requirements disrupting markets or increasing costs 
for ``end-users.''
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    \22\ It is important to note that ``liquidity'' has no precise 
definition. For my purposes, I define it as the ``ability to rapidly 
execute sizable securities transactions at a low cost and with a 
limited price impact.'' Global Financial Stability Report, 
International Monetary Fund, at 53 (Oct. 2015) (``IMF Global Financial 
Stability Report''), available at https://www.imf.org/External/Pubs/FT/
GFSR/2015/02/pdf/text.pdf.
---------------------------------------------------------------------------
    Of course, concerns about the potential impacts of new rules on 
liquidity and costs are equally present in a broad swath of financial 
markets, including Treasuries, corporate bonds, and equities.\23\ The 
results of the limited studies so far have been encouraging.
---------------------------------------------------------------------------
    \23\ For example, in the Omnibus appropriations bill this past 
year, Congress directed the Securities and Exchange Commission's 
Division of Economic and Risk Analysis to provide Congress with a 
report on the impact of the Volcker Rule and other regulations, such as 
Basel III, on ``(1) access to capital for consumers, investors, and 
businesses, and (2) market liquidity, to include U.S. Treasury markets 
and corporate debt.'' As one of the drafters of both the Volcker Rule 
legislation and the multi-agency rule to implement it, I will be 
interested in this study's findings.
---------------------------------------------------------------------------
    Despite dire prognostications, these reforms seem to not be 
negatively impacting liquidity. According to the International Monetary 
Fund, liquidity measures in the bond markets in the U.S., Europe, and 
even emerging market economies are generally better than 2007 
levels.\24\ For example, when experts at the Federal Reserve Bank of 
New York looked late last year at the corporate bond markets, they 
found that liquidity is better than it has been at any time since the 
financial crisis.\25\ Bid-ask spreads are tighter than they have been 
in years and trading price impacts are way down.\26\ All while dealer 
inventories have fallen.\27\ So the sky hasn't exactly fallen--unless 
you're a bank with declining inventories and trading revenues. Even 
then, decreased bank revenues may be more of the results of stable 
asset prices, a near zero interest rate environment, and other non-
regulatory factors.\28\
---------------------------------------------------------------------------
    \24\ IMF Global Financial Stability Report, at 58.
    \25\ Tobias Adrian, et. al, Has Corporate Bond Liquidity Declined?, 
Liberty Street Blog, Federal Reserve Bank of New York, Oct. 5, 2015, 
available at http://libertystreeteconomics.newyorkfed.org/2015/10/has-
us-corporate-bond-market-liquidity-deteriorated.html#.Vx2DtHopko0 
(looking at corporate bond markets).
    \26\ Id.
    \27\ Id.
    \28\ IMF Global Financial Stability Report, at 67 (``Risk appetite 
and funding liquidity seem to be the main drivers [of bond market 
liquidity], but indirectly the results point to an important role for 
monetary policy.'').
---------------------------------------------------------------------------
    Coming back to the swaps world, despite dire warnings of the demise 
of all liquidity and skyrocketing costs, to date, there doesn't seem to 
be much of any impact on the real ``end-users''--the farmers and 
manufacturers. Indeed, a recent study by the Bank of England found that 
enhanced swaps requirements from Dodd-Frank, including central 
clearing--which itself includes margin and certain other requirements 
on members--as well as trades through swap execution facilities, 
resulted in enhanced market liquidity and a significant reduction in 
execution costs.\29\
---------------------------------------------------------------------------
    \29\ Evangelos Benos et. al, Centralized trading, transparency and 
interest rate swap market liquidity: evidence from the implementation 
of the Dodd-Frank Act, Staff Working Paper No. 580, (January 2016), 
available at http://www.bankofengland.co.uk/research/Documents/
workingpapers/2016/swp580.pdf. (finding significant cost savings in the 
interest rate swaps markets as a result of these changes).
---------------------------------------------------------------------------
    Additional facts bear out the story that effective derivatives 
regulation is beginning to work without imposing new negative 
ramifications on the markets.
    First, the OTC derivatives market is still enormous. According to 
the Bank of International Settlements, the total notional amount of OTC 
derivatives outstanding at the end of June 2015 was $553 trillion,\30\ 
about 79% of which involved interest rate derivatives.\31\ The gross 
market value of these positions was $15.5 trillion.\32\
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    \30\ Bank of International Settlements, OTC derivatives statistics 
at end-June 2015, at 1 (Nov. 2015), available at http://www.bis.org/
publ/otc_hy1511.pdf.
    \31\ Id., at 2.
    \32\ Id., at 1.
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    Second, true ``end-users'' are almost entirely exempted from new 
derivatives rules, including the margin and capital requirements.
    Third, to date, I have seen no credible study demonstrating 
increased costs or burdens on ``end-users'' resulting from these 
regulations. The writing has been on the wall--even if not the final 
rules--for more than 6 years. Margin and capital have been increasing 
for years now, and yet end-users still seem to be able to trade what 
they need.\33\
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    \33\ I note that much of the single name CDS market remains largely 
stalled. That said, to the extent that the products served a valuable 
purpose, I expect there to be continued use of other financial products 
to hedge credit risks, as well as continued efforts to restart the CDS 
products. The IntercontinentalExchange's buyside-centric CDS trading 
platform announced last August is a timely example. Mike Kentz, ICE 
plans single-name CDS platform, Reuters, Aug. 31, 2015, available at 
http://www.reuters.com/article/markets-derivatives-cds-
idUSL1N1161A520150831. In fact, in a headline that echoes from the run-
up to the financial crisis, it was recently reported that due to 
``tightness'' in the availability of some asset-backed securities, some 
investors may be increasingly turning to credit derivatives. See, Joy 
Wiltermuth, Investors Turn to CMBS derivatives for liquidity, Reuters, 
Apr. 22, 2016, available at http://www.reuters.com/article/usa-
corpbonds-abs-idUSL5N17N4TL (reflecting that total notional values in 
derivative CMBX contracts increased from $141 billion to $181 billion 
from 2015 to 2016).
---------------------------------------------------------------------------
    Fourth, the mix of firms providing swaps trading services has been 
changing for a long time before the advent of new regulations. The 
largest banks unquestionably have traditionally enjoyed a huge 
advantage in the trading markets, with extremely low funding costs, 
large balance sheets, and sophisticated trading and risk management 
operations. Those advantages have helped drive consolidation here, just 
as it has in other financial services areas--and it is not unique to 
derivatives trading.
    How margin and capital rules will impact that consolidation, 
however, remains unclear. I understand this Subcommittee has heard from 
some non-bank financial firms that new rules--particularly for capital 
requirements--may unnecessarily restrict their ability to engage in 
swaps trading.\34\ On the other hand, some large banks themselves and 
outside consultants have started modeling out whether and how they 
might be better off spinning out some or all of their derivatives 
trading operations to avoid the new rules.
---------------------------------------------------------------------------
    \34\ See, e.g., CFTC Reauthorization, Before the House Committee on 
Agriculture, Subcommittee on Commodity Exchanges, Energy and Credit, 
114th Cong. (2015) (statement of Mark Maurer, Chief Executive Officer, 
INTL FCStone Markets, LLC), available at http://agriculture.house.gov/
uploadedfiles/maurer_testimony.pdf.
---------------------------------------------------------------------------
    To me, it is at least worth exploring whether isolating derivatives 
trading operations in separately capitalized firms that are outside of 
the taxpayer-protected banks could be beneficial for the markets and to 
removing an implicit taxpayer subsidy for the largest participants. 
Nevertheless, I suspect the key funding and capital advantages of the 
largest banks will ultimately prevail as they have since well before 
the crisis.
    In sum, the new rules don't seem to be changing much other than 
simply imposing moderately enhanced protections for counterparties at 
the cost of moderately higher margin and capital for the major players 
in these markets.
International Regulatory Coordination and Cross-Border Regulation
    As the financial crisis unfolded, regulators around the world 
immediately recognized that swaps regulation needed to be effectively 
coordinated across national boundaries.
    AIG was a New York-based firm whose London-based Financial Products 
unit brought down its worldwide operations. But this was not the first 
or the last U.S.-based firm to suffer from financial troubles resulting 
from trading done abroad. In fact, offshore derivatives trading has 
played key roles in collapses ranging from Enron to Lehman Brothers. 
And in 2012, it was the London-based trading group of JPMorgan Chase 
using ``excess deposits'' to trade illiquid credit derivatives that 
cost it approximately $6.2 billion. In each case, the U.S. firm was on 
the hook for losses.
    Regulators have been acutely aware of these instances, and the 
risks of regulatory gaps and arbitrage. The Pittsburgh Summit laid out 
the blueprint for the G20. In the United States, Congress empowered the 
regulators by saying that they could regulate swaps trading that has 
``a direct and significant connection with activities in, or effect on, 
commerce in the United States.'' \35\ This broad jurisdictional 
authorization was deemed critical, because, as a CFTC Chief Economist 
later put it, ``risks taken by foreign affiliates, subsidiaries, and 
branches of U.S. parent companies are usually borne by the U.S. 
parent.'' \36\
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    \35\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Pub. L. 111-203,  722, (2010).
    \36\ Declaration of Sayee Srinivasan, Chief Economist, Commodity 
Futures Trading Commission, Mar. 14, 2014 (cited in Securities Industry 
and Financial Markets Association, et. al, v. CFTC, Civ. N. 13-1916, 5 
(Sept. 16, 2013), available at https://secure.fia.org/downloads/
SIFMAvCFTCOpinion.pdf).
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    The creation of artificial jurisdictional divides between different 
international regulators poses one of the greatest risks to effective 
oversight of these markets. The largest financial firms have dozens, if 
not hundreds, of affiliated entities around the world, all designed to 
support the overall business. If a firm can avoid capital requirements 
or margin rules by simply shifting its trading, technology, or basic 
reporting structure to another jurisdiction, it may likely do it. But 
the risks may still remain where they were before. Policymakers and 
regulators in the United States should be cautious about exempting 
foreign branches or affiliates of U.S.-based firms from any of our 
rules, but margin and capital in particular.\37\
---------------------------------------------------------------------------
    \37\ U.S. regulators have proposed to link application of many 
aspects of the Dodd-Frank-related reforms to the presence or absence of 
a ``guarantee.'' See, e.g., Margin Requirements for Uncleared Swaps for 
Swap Dealers and Major Swap Participants--Cross-Border Application of 
the Margin Requirements, Commodity Futures Trading Commission, 80 Fed. 
Reg. 41376 (July 14, 2014). Legislators and experts have long expressed 
concerns that this could easily lead to the ``de-guaranteeing'' of 
swaps, while not changing any of the fundamental relationships between 
affiliated entities. See, e.g., Letter from Jeff Merkley, U.S. Senator, 
et. al, to Hon. Gary Gensler, Chairman, CFTC, et. al, July 3, 2013, 
available at https://www.merkley.senate.gov/news/press-releases/
senators-urge-cftc-sec-to-close-major-swaps-loophole-and-prevent-
bailouts-from-implied-us-guarantees-on-swaps; see also Letter from 
Americans for Financial Reform to Hon. Tim Massad, Chairman, Commodity 
Futures Trading Commission, and Mary Jo White, Chair, Securities and 
Exchange Commission, Nov. 25, 2014, available at http://
ourfinancialsecurity.org/wp-content/uploads/2014/11/De-Guaranteeing-
Letter1.pdf. The CFTC sought to address some of these risks by 
finalizing guidance on its definition of ``U.S. person'' in July 2013. 
Interpretive Guidance and Policy Statement Regarding Compliance With 
Certain Swap Regulations, Commodity Futures Trading Commission, 78 Fed. 
Reg. 45292 (July 26, 2013). These risks could also be more effectively 
addressed through the imposition of appropriate margin requirements for 
trades done by foreign affiliates.
---------------------------------------------------------------------------
    To date, the U.S. regulators have been extremely active in 
collaborative international efforts to impose largely similar 
derivatives oversight regimes around the world.
    U.S. policymakers and regulators should continue the work, and the 
recent mutual recognition determination is a great step forward. 
However, I would strongly recommend against further delaying 
implementation of critical reforms on the grounds of imposing rules 
only where there may be complete international consensus. Foreign 
regulators are no more immune to lobbying efforts from the largest 
financial firms than those in the U.S. And we must be cognizant that 
multinational firms may seek to play domestic and foreign regulators 
off each other.
    Last, while different regimes may be similar, they are not 
identical. While some regulators may focus heavily on margin, others 
may focus more on capital. Some regimes place greater emphasis on 
reporting requirements than others. This is natural, as it is within 
our fifty states to see differences in any number of regulatory areas.
Path Forward
    U.S. regulators and policymakers should not forget the lessons of 
the past decade, where inadequate regulation of derivatives blew whale-
sized holes through the balance sheets of some of the largest financial 
firms in the world, forcing regulators and U.S. taxpayers to step into 
the markets with trillions of dollars just to save the world's 
economies.
    It seems only fitting that, in the aftermath, regulators have 
worked together to develop comprehensive regulatory regimes to:

   Improve reporting of derivatives so firms and regulators can 
        better understand their exposures and risks;

   Reduce counterparty credit risks by pressing for more 
        centralized clearing and imposing basic capital and leverage 
        restrictions; and

   Reducing systemic risks by imposing heightened capital and 
        leverage requirements on financial firms.

    These are important goals. I urge you to keep the pressure on the 
regulators to get the job done. We are in mile 25 of this marathon. Now 
is the time to finish implementing these essential rules to protect 
U.S. businesses, municipalities, and families. I have confidence that, 
with your support, our regulators will be able to implement smart and 
effective derivatives rules that will continue to promote--not hinder--
our economy.
    Thank you for the opportunity to speak with you today, and I look 
forward to any questions.

    The Chairman. Before we go into questions, I want to remind 
people that any Member may submit their opening statement for 
the record. I should have mentioned that prior to the 
testimony, I apologize, but anybody who has an opening 
statement is certainly welcome to submit it for the record.
    I would like to remind Members that they will be recognized 
for questioning in order of seniority for Members who were here 
at the start of the hearing. After that, Members will be 
recognized in order of arrival. I appreciate Members' 
understanding.
    Mr. Lukken, so I understand that capital requirements are 
important to the big banks, but this is the Agriculture 
Committee. Why should our nation's farmers and ranchers be 
concerned?
    Mr. Lukken. Well, in the futures markets, a significant 
amount of the cleared business runs through a bank-affiliated 
FCM. If you look at the stats the CFTC puts out, it is 
somewhere in the order of 87 percent of the cleared products 
come through bank-affiliated FCMs. And so this is going to have 
knock-on effects that will affect agricultural customers, who 
will have to pay more as a result of that. Many of them are 
using bank-affiliated clearing members to clear some of their 
business.
    In addition, there is less capacity on behalf of these non-
bank affiliates. So even though, if they reach a capital 
constraint because of the leverage ratio, there is not capacity 
elsewhere to accept these types of positions in non-bank-
affiliated FCMs. So these costs will have to be passed on to 
customers. It's going to be more than a ham sandwich, as Mr. 
Gellasch indicated. I mean the numbers are significant. We are 
estimating somewhere in the order currently of $32 to $66 
billion of costs will be as a result of this. So those costs 
will have to be passed on in significant ways to customers.
    I would like to make the point too that this is not just 
talking about swap products that were in the over-the-counter 
markets that have come into clearing, this is affecting futures 
products; products that have nothing to do with the financial 
crisis are now being taxed as a result of these provisions. 
That affects farms directly and users directly, and should be 
of concern to this Committee.
    The Chairman. Thank you. Mr. O'Malia, in your testimony, 
you stated that the impact of the new rules on individual 
business units or product areas could be disproportionate to 
the difference between a bank choosing to stay the course or 
exit the business.
    Generally speaking, what drives the banks' capital 
allocation decisions?
    Mr. O'Malia. Right now, it is the rules. The rules are 
having a huge impact on where they are going to allocate 
capital. And as Walt pointed out in his testimony, and in mine, 
the leverage ratios are a very good example of that. These 
requirements are going up, and all of these rules in a 
cumulative impact are not being fully assessed. So we have a 
multitude of these rules being developed now that are going to 
be implemented over the next 4 years that individually have 
serious consequences to the investment decisions and the 
capital decisions that each of these banks are going to have to 
make, which will have pass-on effects. I can tell you, in 
developing these rules at the CFTC, we were very cognizant of 
how this would impact end-users, and we worked very hard to 
make sure that the margin rules did not impact end-users. That 
is not the case with the capital rules. There is no exemption 
in the U.S. capital rules for end-users.
    The Chairman. Mr. Deas, the concerns you shared in your 
testimony are highly technical and nuanced. Did the Prudential 
Regulators consult with the hedgers who use derivatives for 
risk management purposes to understand how the rules would 
impact your ability to use these markets, and do you think that 
the regulators understand your concerns?
    Mr. Deas. Mr. Chairman, thank you. Well, certainly, both 
the Chamber and the Coalition for Derivative End-Users have 
been very active in submitting comment letters and other ways 
to make the Prudential Regulators aware of the concerns of end-
users, but I would have to say that there has not necessarily 
been a very active two-way dialogue in that regard.
    The Chairman. Gentlemen, thank you for your testimony.
    I now recognize the gentleman from Georgia, Mr. Scott, for 
5 minutes.
    Mr. David Scott of Georgia. Okay, thank you, Chairman 
Scott.
    I would like to see if we could get to this issue of the 
cross-border. I mean in each of your testimonies you all 
touched upon it, and it is a very, very critical issue.
    Now, we have been wrestling with this equivalency situation 
with the EU for the last, seems like 2 years. It has just been 
ongoing, it was supposed to have been resolved last June, then 
it skipped and they said we will resolve it in October, the 
deadline was stretched to December. So where are we now? How 
serious is this? Mr. Deas, you touched upon it, and each of you 
have, but there is something else that worries me about this. 
You take other countries that the European Union has dealt with 
on equivalency, you take countries like Singapore that have the 
same robust, strong regulatory regime as the United States, 
Australia, as the United States, and they have EU equivalency. 
Now, what is going on over there? Why is this discrimination 
happening by the EU to our United States, when they are 
allowing other regimes with the equal robust regime to come in 
and get that equivalency? Is there something rotten in the 
cotton that we are not hearing about here, because what you 
have, to me, is you have the United States and you have the 
European Union are the two mightiest markets here, and it could 
very well be, maybe European Union is saying, maybe we need to 
cause a little more difficulty here, so that they can get a 
gain on the competitive edge. Am I right or wrong about that?
    Mr. Lukken. I will take a first shot at that. I mean this 
is a very important issue for our industry, because it is a 
global marketplace, as you mentioned. The EU and the United 
States have reached a tentative agreement on that, and that is 
still working its way through the European Commission and the 
European Parliament, but it has to go into effect by a deadline 
in June. The problem is that there was a lack of transparency 
and lack of a process involved with this. Something that should 
have, as you mentioned, taken months, took years in order to 
work its way through.
    That was the derivatives side. The securities side is still 
not decided. The SEC and the EU have not reached a decision on 
equivalence on the securities clearinghouse side. So this is 
still playing itself out. What was as a trade association tried 
to say is let's develop a process. We have due process here in 
the United States, the CFTC has to abide by certain APA 
recognition or APA transparency. There should be a process 
developed here so the EU and the U.S. can enter into these 
decisions, people can voice their concerns, and we can quickly 
get past these things.
    But equivalence does not mean exactly the same. Equivalence 
means that these things are comparable, and we have the same 
outcomes. That is where we tend to stumble between the EU and 
the U.S.
    Mr. O'Malia. Ranking Member Scott, this is a great issue, 
and as Walt pointed out, it is a global market and, therefore, 
we need global rules. We have been working very hard to make 
sure to minimize the differences between the rule-sets, and to 
ensure that you can have comparable regulation. That is what 
was set out in the G20 objectives. That is what we believe is 
the outcome in many of these regulations, as you pointed out, 
with Singapore, the EU as well.
    These rules are not going to be identical. You cannot read 
them word-for-word and come up with identical rules, but the 
outcomes are the same. And so we are pushing very hard, whether 
it is data, whether it is trader execution, how you comply on 
the firm's buy-side, sell-side, end-user, it does not matter. 
We are all working together to make sure you have comparable 
rules.
    One recent frustration is, and I touched on this in my 
testimony, is the CFTC's own rules on cross-border have been 
inconsistent. On one hand, they put out the guidance 2 years 
ago that really kicked off some frustration globally about 
equivalence with the cross-border equivalence decisions 
coming--or that need to come as a result of the non-margin 
rules--or the margin for non-cleared rules, excuse me, they 
have a different position. The definition of U.S. person is 
different. So we would urge the Commission to: first, finalize 
its rules, and then be consistent with the Prudential 
Regulators' regulations that are already out. And then we 
probably ought to go back and re-evaluate the current guidance 
that they have issued.
    Mr. David Scott of Georgia. Right. My time is up, Mr. 
Chairman. If we have another round, I would certainly like to 
come back and ask what impact this controversy is having on our 
end-users.
    The Chairman. We should have time for another round.
    I now recognize the gentleman from Texas, Mr. Conaway, the 
big Chairman, for 5 minutes.

OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE 
                     IN CONGRESS FROM TEXAS

    Mr. Conaway. Well, thank you, Chairman. And full and fair 
disclosure, Austin and I finished up the mark-up--last night, 
or early this morning--at about 2:45, so I am not necessarily 
hitting on all four cylinders.
    Belt and suspenders is a phrase that CPAs use a lot, and I 
am a CPA, but as I look at this, net stable funding ratio, 
supplementary Basel 2.5, Basel III, capital surcharges, at what 
point does it get to be too much? Are we overlapping these kind 
of things? And so that is the question, that is more broader to 
look at and step back and see now that we have all these rules 
in place for the most part, what is it we have actually done to 
ourselves, and how has this actually stopped any kind of a 
meltdown, going forward.
    And I would like to get in the weeds a little bit. Scott, 
in your testimony, you talked about the ability of a bank to 
use internal models to calculate their capital requirements. If 
that is eliminated, then it is estimated that they would have 
to come up with 2.4 times as much capital as their internal 
modeling would have described. Are internal models that bad? 
That seems like a pretty dramatic differential between the way 
the regulators would want and the way the banks have seen, 
because they are responsible to the shareholders at the end of 
the day as well. What causes that big difference?
    Mr. O'Malia. Yes, well, it is important to put it in a bit 
of perspective. Following Basel II, regulators came up with the 
idea that, actually, you should have more risk-sensitive models 
appropriate to the bank, and they allowed for internal models 
to be used. And these are supervised, overseen models. These 
are not out of sight and out of mind. The regulators get a look 
at these. And they were developed to be more risk-sensitive, 
which is the appropriate evaluation. In the recent submission 
on the FRTB, fundamental review of the trading book, they have 
a higher standard for internal models. They have potentially 
reduced the ability to use internal models, and the difference 
on various asset classes could see a sizeable increase in 
capital requirements, and as you noted, and our research shows, 
it could be as high as 2.4 times more capital.
    There is no perfect model, and we think that internal 
models should be used, and we are in favor or making them more 
transparent and working with the regulators to ensure that 
standard data is used, benchmarking is used, to make sure that 
they have a high level of confidence in the models so they can 
be used. If you go to a standard model, they are less risk-
sensitive, more conservative, and will require more capital. 
And we want to make sure that we don't have kind of a standard 
model they used, kind of a one-size-fits-all which is 
inappropriate for the industry.
    Mr. Conaway. Got you. Mr. Gellasch, you mentioned, and 
pardon me if I mispronounced your last name, a ham sandwich.
    Mr. Gellasch. Yes.
    Mr. Conaway. Whose hide did that ham sandwich come out of?
    Mr. Gellasch. Pardon?
    Mr. Conaway. Whose hide did that ham sandwich come out of?
    Mr. Gellasch. The banks'. Actually, they are the ones who 
actually have----
    Mr. Conaway. What was their profit margin before the ham 
sandwich?
    Mr. Gellasch. So that is, actually, a really interesting 
question. So if you----
    Mr. Conaway. I guess there is a profit margin too.
    Mr. Gellasch. Pardon?
    Mr. Conaway. Is it okay for the banks to make money?
    Mr. Gellasch. Absolutely.
    Mr. Conaway. Okay.
    Mr. Gellasch. Absolutely.
    Mr. Conaway. So that ham sandwich cost didn't get passed on 
to the end-user?
    Mr. Gellasch. We don't know. And so out of $100,000 swap, 
the $7\1/2\ or so of the incremental cost of having it----
    Mr. Conaway. Is that a number you would multiple by--to get 
to the $8 trillion? In other words, the ham sandwich is a 
pretty trivial amount, obviously, but do they do a lot of 
$100,000 swaps?
    Mr. Gellasch. No, but a lot of end-users do. And so you 
start to talk about $100,000 swaps or $1 million swaps or 
$100,000 swaps, the actual incremental cost here is just the 
incremental cost of, whether or not it is borrowed money or 
whether or not it is their own money. That is the difference 
between the capital. So that is actually the number we have to 
worry about. It is not the total amount of capital that they 
have, it is the cost of that being borrowed money or----
    Mr. Conaway. Give me a perspective. I know what a ham 
sandwich is, but what was the profit margin to the bank before 
the ham sandwich, and is the extra cost of the ham sandwich 
worth them staying in the business?
    Mr. Gellasch. So, yes, and the answer is almost assuredly 
yes. And so the market risk for them was $1,000 on the example 
I used, so the market risk was $1,000 for them. They may very 
well charge, we are talking about hundreds of dollars. So the 
incremental cost to them is literally a few percentage points.
    Mr. Conaway. Okay. They charged $100 for $1,000----
    Mr. Gellasch. They may charge $100 for $1,000 to be willing 
to take that interest----
    Mr. Conaway. And you are pretty confident that that charge 
won't go to $107.50?
    Mr. Gellasch. I can't say I am----
    Mr. Conaway. To the end-user.
    Mr. Gellasch. So the question is how much of that will be 
passed on, and the answer is we haven't seen it. So a lot of 
these rules have actually already been----
    Mr. Conaway. Based on your background, have you ever seen 
anything that wasn't passed on?
    Mr. Gellasch. Yes. To the extent that there are limitations 
on that. I would say, we do have, actually, a relatively 
competitive environment. One of the things we have actually 
seen as some of these rules have come on is in the interest 
rate environment, we have actually seen bid-ask spreads narrow, 
we have actually seen liquidity in some cases actually improve. 
We have actually seen costs come down.
    Mr. Conaway. You keep using the word, and I am way over my 
time, you keep using the word some and I am just trying to get 
a perspective on that, because you are the only person who has 
ever come in here, other than a regulator, that is happy with 
the rules as you seem to be.
    And I yield back.
    Mr. Gellasch. I wouldn't actually say I am as happy as I 
am, but I do think that they are generally very good rules.
    The Chairman. All right, the chair now recognizes the 
gentlelady from Arizona, Mrs. Kirkpatrick.
    Mrs. Kirkpatrick. Thank you. Mr. O'Malia, I want to follow 
up on your comment that one-size-doesn't-fit-all in terms of 
capitalization. Can you give me an example of what you mean by 
that?
    Mr. O'Malia. Sure. Thank you for the question. So the 
analysis we have been doing on the FRTB, and we would be happy 
to provide it, there is an annex in there that does elaborate a 
little bit more on my testimony.
    Mrs. Kirkpatrick. I would appreciate that.
    Mr. O'Malia. Yes. So the analysis we looked at, using the 
internal model, we believe that the FRTB capital model will 
increase capital requirements, risk-weighted basis, 1.5 times. 
Without the ability to use internal models, we believe that 
could go to 2.4 times the capital requirements.
    Now, it is not completely binary. Some banks may be able to 
use capital models, some may not, but it is in that range of 
the capital increase that we have estimated for the FRTB rule 
that was just recently released.
    Now, it would also have, due to our estimates, impacts on 
FX, foreign exchange, you could see in that asset class as well 
as securitization and equities. But as an example, and kind of 
at the high end, FX could go up by 6.4 times, based on our 
analysis. Now, this would be a big impact, and people would use 
FX hedgers, end-users for commercial operations for the global 
operations. Right? They are paying salaries, recouping revenue, 
raising money in different countries. That would have a big 
impact. And keep in mind, these are global rules. These are not 
just U.S.-specific rules. So this affects all the global 
exchanges in dealing with this. So this is not just U.S.-
specific. But those are specific examples that I could give 
you, and we have plenty more details in our more thorough study 
that we have included.
    Mrs. Kirkpatrick. I would appreciate that. Has there ever 
been a situation where a market participant had insufficient 
capital, and if so, what happened?
    Mr. O'Malia. Under the Basel----
    Mrs. Kirkpatrick. Market participant.
    Mr. O'Malia. Yes, well, they have had regulators who insist 
they raise that capital requirement.
    Mrs. Kirkpatrick. But what really happens aside from that, 
I mean in impacts?
    Mr. O'Malia. You have a conversation with your regulator 
and they expect you to put more capital behind it.
    Mrs. Kirkpatrick. But can you give me an example of where 
there was a market participant who did not have enough capital?
    Mr. O'Malia. We can----
    Mr. Lukken. I would just----
    Mrs. Kirkpatrick. Any----
    Mr. Lukken. I mean----
    Mr. O'Malia. Yes.
    Mr. Lukken.--the prudential banking regulators would 
require you either to go out in the debt markets to raise more 
capital, or issue stock to raise more capital, but you would be 
out of compliance with prudentially regulated regulations that 
require a certain amount of minimum capital, and----
    Mrs. Kirkpatrick. I guess what I am trying to find out what 
is a commonsense sort of approach to good capitalization? So 
you are basically saying it is in the hands of the regulators. 
I get that because of the regulations, but I am trying to find 
out are those regulations sensible, is there another standard 
for looking at what makes good capitalizations. That is what I 
am trying to get at.
    Mr. O'Malia. Well, in that case, you and I are looking for 
the same thing. What we see is the individual rules are being 
promulgated and we are watching them individually. What we 
haven't done, and what we would be strong in favor of, is kind 
of looking at the comprehensive. And we have to look at the 
individual business lines as well. The leverage ratio, for 
example, is a tax on clearing that is diametrically opposite 
with what the market regulators have kind of urged market 
participants to do; put more into clearing, which is the right 
thing to do. But then the capital rules kind of send the 
conflicting message in tax and clearing by not recognizing the 
initial margin as risk offsetting.
    Now, the individual rules we will look at and try to assess 
the impacts on individual businesses, and those rules are being 
developed currently. Right? We haven't seen the final rules in 
most cases, and they will be developed and implemented over the 
next 4 years. So we are trying at this point, at this important 
point, before they are fully implemented, let's understand the 
real ramifications of the individual rules on the individual 
businesses, and let's do a cumulative impact to really 
understand the broader economics.
    Mrs. Kirkpatrick. Thank you. That is what I am after. And 
my time is running out, but I would appreciate more information 
on that. I will tell you that it has been my experience that, 
in crafting legislation and regulations, too many times we do 
think that one-size-fits-all, and it doesn't work. So I 
appreciate the panel's testimony.
    I yield back.
    The Chairman. The chair recognizes the gentleman from 
Mississippi, Mr. Kelly, for 5 minutes.
    Mr. Kelly. Thank you, Mr. Chairman. And, Mr. O'Malia, in 
your testimony you say that we need to understand the 
cumulative effect of these regulatory changes on the economy 
before they are fully implemented, and I agree with you. 
However, I am assuming the proponents of the changes would 
argue that the potential adverse effects of the economy could 
be much greater if we don't expeditiously implement the 
changes. How do you respond to such claims?
    Mr. O'Malia. Well, we have time to do that now. There is 
nothing to stop these rules from going forward and doing the 
cumulative impact assessment right now. These are Basel rules, 
they are going be promulgated and moving forward. The leverage 
ratio, fundamental review of the trading book, are near final 
anyway but they have time to be implemented over the next 4 
years.
    We do believe that a cumulative impact assessment, and 
really looking at the individual business line impacts, would 
be informative to understanding the ramifications.
    A lot of people, and with all due respect to Mr. Gellasch 
and his ham sandwich, a lot of these rules have not been fully 
implemented and costed-in. As I mentioned, the non-cleared 
margin rules have yet to take effect. Those are going to have a 
$300 billion impact. These are CFTC numbers, not my numbers, 
CFTC numbers. And those are going to be real ramifications. The 
capital rules are not finished yet, and are going to be phased-
in over the next 4 years. We haven't seen the full price of 
this. We have seen what the cost of clearing has done. We have, 
SIFMA AMG has put out and surveyed their members, $34 trillion 
under management from those asset managers, pension fund 
managers, and they are saying from their membership, yes, we 
are seeing price increases, these are going up, we are seeing 
fewer people that we can deal with in this derivatives 
ecosystem. And it is an ecosystem. Right? You need risk 
managers and you need hedgers, and all of that has to work 
together. And these capital rules, as I said earlier, aren't 
exempting end-users. Right? These costs will be passed on.
    Mr. Kelly. And kind of going back on your line, and 
following up with what Chairman Conaway talked about, it is 
easy to say when things don't generate income or revenue, that 
those costs are passed on to the banks. However, I spent quite 
a bit of my time in the districts speaking with banks and 
constituents, and my experiences have been that most of the 
time, whether it is a ham sandwich or a Mercedes Benz, that 
that cost is generally always passed on to the consumer, 
because the margins keep getting thinner in this world and 
generally that is passed on to the consumers, which basically 
blocks people out from being able to get income that they need. 
Do you agree?
    Mr. O'Malia. I fully agree with you, sir.
    Mr. Kelly. Thank you. Mr. Lukken, why did the G20 call for 
the imposition of margin and higher capital requirements, and 
how does the posting of margin and holding additional capital 
reduce systemic risk?
    Mr. Lukken. Well, the G20 looked at the example of the 
futures markets and how well they worked during the financial 
crisis. And when Lehman Brothers went down, the futures 
business easily moved to other clearing members that were 
healthy and able to accept those positions. So that ability to 
port something from a failing institution to a healthy market 
participant allowed the markets to function, to price discover 
during that process, while some of the over-the-counter markets 
froze up with uncertainty.
    And so they looked at that example and said clearing seemed 
to work during a crisis situation. Let's consider bringing some 
of these products in a more transparent, regulated environment 
that allows for daily posting of margin, so when people put on 
transactions, they are able to put up this performance bond 
that ensures there is money sitting there, cash money regulated 
by the CFTC, in case one of those parties defaults. And that is 
the first line of protection. You talk to any clearinghouse, 
talk to Chairman Massad of the CFTC, it is always there in a 
crisis.
    And what we are asking is simple math. Recognize that it is 
always going to be there during a default, and subtract it from 
the exposure that the bank has to the clearinghouse. It is 
cash. It is easy to measure. It is simple math. So please do 
that so that we are not taxing clearing as these products come 
into this more healthy, regulated environment.
    Mr. Kelly. And I had another question, but I am going to 
run out of time. I thank all you witnesses for being here and 
taking the time to explain this extremely complex math to most 
of us regular folks.
    And, Mr. Chairman, with that, I yield back.
    The Chairman. The chair now recognizes the gentleman from 
Oklahoma, Mr. Lucas, former chair of the full Committee.
    Mr. Lucas. Thank you, Mr. Chairman.
    And one of the great things about the Committee hearing 
process, as the Committee knows, and I am sure our witnesses 
have experienced, there are issues that are so important that 
they have to be discussed and discussed and discussed in order 
to burn it in.
    So in that regard, Mr. Lukken, I would like to turn to you, 
and be specific about once again discussing in the many 
instances where clearinghouse members or banks that are subject 
to the Basel capital rules which require them to hold that 
capital against the guarantee they provide for their clients. 
As I have personally repeatedly said in many of these hearings, 
and in conversations even with Chair Yellen, we can all agree 
that banks have exposure in the event their clients are unable 
to fulfill their obligations, and should hold capital against 
that. We all agree on that, but I am concerned about my 
constituents in the energy and ag business, how are they going 
to find access to their risk management tools if the margin 
posted isn't even recognized under the Basel leverage ratios. 
Would you expand for just a bit on that because, after all, as 
has been discussed here earlier, if the banks don't want to 
participate in this, they don't have to, reducing competition 
and reducing the opportunities for my constituents in the real 
world. Would you expand on that?
    Mr. Lukken. And the effects are not theoretical. We have 
already had four bank clearing members pull out of the 
business, citing that capital is too expensive to continue on 
in this world. There are others on the sidelines that are 
waiting to determine whether these will be implemented, and 
whether it will be fixed by the time these provisions go into 
effect in 2018.
    So this has real consequences on end-users. They may have 
less access to clearing members because there are less choices, 
and as we see in the numbers I cited, they are decreasing 
significantly over the last several years. And that will 
expedite itself if this is not fixed in our community.
    I would want to mention too the costs as banks measure 
this, they measure things in business units. As one of these 
banks may look at this, they will look at the clearing business 
itself and realize that the capital that that clearing business 
has to rent in order to make a return is so expensive because 
of this lack of an offset that it is just we are not willing to 
do that within that business unit of the bank. We have other 
more profitable parts of the bank that we will put that capital 
towards, whatever that might be.
    And so I realize that we talk about some of these costs, 
but the cost to the clearing business is significant. It is not 
a hugely profitable part of these banks, and so these types of 
costs are really bearing down on whether these clearing members 
decide to stay in the business or not.
    Mr. Lucas. And access is critically important to my 
constituents. As we have gone through this downturn in the last 
6 months broadly in ag and energy prices, had those tools not 
have been available to my folks back home to soften this, we 
would be in dramatically worse shape.
    Let's go one step further. In your testimony you note, 
referencing Basel III and the capital requirements, you note 
that the consolidation of the futures commission merchants, 
something like 60 percent over the last 10 years, expand for a 
moment on, in addition to the capital issues, what is driving 
this consolidation within the industry?
    Mr. Lukken. I think it is fixed costs. I mean if you can 
look at whether it is the fixed costs of regulation, more 
volume is necessary to flow through these intermediaries in 
order to make it a profitable business. And so you have people 
who are shuttering businesses, people who are merging, so you 
are seeing that over that period of time where people are 
deciding to either just get out of the business itself or to 
offer to try to merge those businesses in order to get more 
volume to go through those things.
    So that is regulator costs, we realize that, and some of 
those are very important and needed, don't get me wrong, but it 
is capital costs and it is this cumulative effect that Scott 
mentioned. We have to look at all the costs that are being 
thrown onto this system, and that is going to cause less people 
to be participating in that system, by definition.
    Mr. Lucas. So ultimately, if we have an environment where 
no one wants to participate, that means the opportunities for 
my farmers and my energy folks are reduced, and those few 
opportunities come at a higher cost, and they ultimately suffer 
the real prices.
    Mr. Lukken. Absolutely.
    Mr. Lucas. Thank you, Mr. Chairman. I yield back.
    The Chairman. The chair now recognizes the gentleman from 
Illinois, Mr. Davis.
    Mr. Davis. Thank you, Mr. Chairman. And thank you and all 
the witnesses.
    Kind of a follow-up to my colleague, Mr. Kelly, and my 
colleague, Mr. Lucas', line of questioning. Mr. Lukken, now, if 
the banking regulators won't recognize the customer margin as 
reducing the clearing members' exposure, are the Basel 
standards actually discouraging, in your opinion, the 
collection of client margin, and thereby, as Mr. Lucas talked 
about, the effect on his constituents and my constituents, and 
all of our constituents, who want to use this process, are they 
discouraging clearing?
    Mr. Lukken. Yes. We are already seeing certain clearing 
members divorcing themselves of clients in order to reduce the 
capital burden in this area. So as I mentioned, some have 
gotten out of the business. But, beyond that, there are people 
who are shedding clients, off-boarding them in order to get 
into compliance with the standards. So yes, yes, it is 
happening, and yes, it is discouraging clearing.
    Mr. Davis. So you are reducing the amount of clearing 
members that would want to participate in this process for our 
constituents to participate in the futures, the options, the 
swaps market, et cetera, therefore, reducing the number of 
clearing members, which wouldn't that ultimately raise the 
cost?
    Mr. Lukken. Absolutely, and that is what we are seeing.
    Mr. Davis. So much more than a ham sandwich.
    Mr. Lukken. Absolutely. And like I said, this is being 
viewed from the futures side of the business, which is normally 
a small part of these institutions. So it is much bigger cost 
for those business segments than it is for the entirety of the 
bank, which is having a huge impact.
    Mr. Davis. Okay, so premium ham sandwich or the whole hog. 
Well, actually, the whole hog would probably cost less on the 
market, right?
    Mr. Gellasch. Just to add a quick interesting point on 
that. One of the things we have seen is actually the 
consolidation is a real concern. It is actually one that is not 
unique to this. The largest financial institutions have cheaper 
borrowing costs and economies of scale that smaller firms 
simply do not.
    When you talk about whether----
    Mr. Davis. So you would rather us just have the larger 
firms?
    Mr. Gellasch. Absolutely not. The challenge there is the 
same thing we have in this context as we do all other business 
lines that banks and financial firms are engaged in. We have 
seen a consolidation that is not just in the derivatives and 
not just in these markets, but in others as well. We have seen 
that in commercial banking as well.
    One of the things that is really important here is when we 
talk about what that means, what that consolidation means. Does 
it mean higher costs or not. Actually, I would look at is the 
actual cost of doing a trade, what that means in terms of 
pricing, what that means in terms of bid-ask spread for doing 
that trade, and what the implementation cost is for that trade. 
And actually, by those measures, actually, costs are coming 
down, notwithstanding this consolidation. So I just want to 
make that point.
    Mr. Davis. So costs are coming down, consolidations are 
happening, we have in the banking sector, as we have seen in 
the rural area that I represent, there aren't as many community 
banks anymore. It seems to me that we are getting to the point 
where we might actually have too many, we are getting to the 
point where we only have the banks that are too big to fail. 
Are we going to see the same thing on the clearing side, Mr. 
O'Malia?
    Mr. O'Malia. I just find some of this to be, on one hand 
you have the argument that this doesn't cost anything more than 
a ham sandwich, then you are talking about massive dislocation 
and concentration of things. The regulators intended for these 
to have change behavior. Right? They imposed capital 
requirements to increase the quality and the quantity of 
capital. The costs are going up, and they are not going up by a 
little bit or a ham sandwich, they are going up by billions of 
dollars. And to Walt's point, there is consolidation and there 
are people making decisions about whether they are going to be 
in this business or that business, and there will be thousands 
of layoffs as a result of that. That is going to have huge 
ramifications, not to mention the service they are provided.
    And whether it is the Coalition of End-Users or it is SIFMA 
AMG, they are all raising their hand saying, ``Hey, regulator, 
pay attention, the cost to serve my customers or to manage the 
pension funds that we do, is going up. Clearing costs are going 
up.'' The fact that you don't--as a result of capital. And they 
have pointed at the capital rules.
    Mr. Davis. And my constituents----
    Mr. O'Malia. So you can't have it both ways.
    Mr. Davis. And my constituents are losing access to be able 
to participate in this marketplace too, correct? And, Mr. 
O'Malia, I have a question for you really quick. You stated in 
your testimony that we need to understand the cumulative effect 
of these regulatory changes on the economy before they are 
fully implemented. I agree. You just briefly touched on that a 
second ago. I am assuming the proponents of these changes would 
argue that the potential adverse effects on the economy could 
be much greater if we don't expeditiously implement the 
changes. I mean can you expand on that and your testimony a 
little bit?
    Mr. O'Malia. Yes. Well, I guess the proponents shouldn't 
worry if it is only going to cost a ham sandwich, they 
shouldn't be afraid of the facts on this one. So let's move on, 
let's do a cumulative impact study if there is no harm there. 
So the facts are going to tell us where this thing ends up, and 
at the end of the day, we will all be better informed as a 
result of that. And that is exactly where we should be. We 
should understand the cumulative impact as well as the 
individual business line impact.
    Mr. Davis. Thank you. My time has expired, Mr. Chairman.
    The Chairman. The chair recognizes the gentleman from 
California for 5 minutes.
    Mr. LaMalfa. Well, thank you, Mr. Chairman. And my 
constituents would rather that we talk about a tri-tip 
sandwich, given the ranches we have up there, or maybe move on 
from the sandwich.
    Mr. O'Malia, we were talking earlier about the CFTC has yet 
again to put out the final rule on cross-border trades, and the 
implementations that are going to be required for that in 
approximately 4 months, is my understanding, which is a very 
short window of time for the final rule. And so important 
compliance decisions are also needed as well. So if the CFTC 
does not come to a decision in this timeline, and the 
discussions continue to drag on, what would the effects be on 
the uncleared swap marketplace?
    Mr. O'Malia. Confusion, in one word, but it is more complex 
than that. So we would appreciate the CFTC moving expeditiously 
to put out its final rules. We would like them to be as 
consistent as possible with the global framework.
    Mr. LaMalfa. So say it again. You don't want speed, you 
would rather have----
    Mr. O'Malia. No, we do want speed. We want both.
    Mr. LaMalfa. You do want, okay, I heard wrong.
    Mr. O'Malia. We want speed and consistency. Obviously, with 
the end deadline a few months away, it is important that we 
know what the final rules are going to be so we can draft the 
appropriate documentation to link the industry together.
    Mr. LaMalfa. How possible is it going to be that it is 
going to be speedy and consistent at this point?
    Mr. O'Malia. Excuse me. Depends on how soon they get this 
out. If we have the final rules, excuse me----
    Mr. LaMalfa. Yes, take a moment.
    Mr. O'Malia.--sooner rather than later, then we will be in 
much better shape. What we are trying to do is----
    Mr. LaMalfa. Well, how do you feel they are doing on 
issuing them at this point? Do you think they are going to be 
pretty snappy getting them out, or----
    Mr. O'Malia. We don't know. It is up to the Commission to 
figure that one out. And we hope sooner and we hope consistent, 
consistent with the other regulators.
    Mr. LaMalfa. Does it have to be a difficult process, or it 
would be pretty straightforward?
    Mr. O'Malia. I think they are making it more difficult than 
it is.
    Mr. LaMalfa. Yes.
    Mr. O'Malia. It should be more consistent. And 
unfortunately, the CFTC is in a tough position. Either they are 
going to submit rules that are consistent with their original 
guidance 3 years ago on cross-border, or they are going to 
submit rules that are consistent with the Prudential Regulators 
on non-cleared margin. And if they go with the Prudential 
Regulators, then they are inconsistent with their original 
cross-border guidance on who a U.S. person is, and some of 
these other factors. So either way, they really need to kind of 
step back and ultimately revisit their entire cross-border 
strategy, because it is making the entire process more complex. 
It does create some ill will in Europe, which is going to 
create a pushback.
    Mr. LaMalfa. Yes. How big has that pushback been? I mean we 
have been hearing about that for at least a year or more that 
it is a threat. What has the effect been so far, or has it 
really come to pass yet?
    Mr. O'Malia. Well, obviously, the CCP recognition and the 
equivalency took 3 years to get through. I think it is really 
important. Nobody wants to have rules that create gaps. Right? 
We want, and I can understand, and having been a former 
Commissioner, Walt has been a former Commissioner, you want to 
draft rules that are consistent, and you want to make sure that 
you have thought of everything. But that doesn't mean that you 
regulate everything. And we can rely on the global partners 
here because, at the end of the day, they have really developed 
rules that are going to achieve the same outcome. Data 
reporting, largely the same in the outcome, but they can't 
share data because they don't have it in a format that works. 
Trade execution is a big factor that is coming into play with 
the European rules around the corner. We have seen fractured 
liquidity in the markets today. Are you going to fix that or 
are you going to sustain that, is a big question. Are you going 
to recognize a global liquidity pool or are you going to have 
regulatory friction that divides the markets.
    The non-cleared, I would have to give regulators a lot of 
credit on the non-cleared margin. Those rules are as consistent 
as any rule-set they have developed yet today. And the goal has 
been to make sure that we have a global non-margining 
framework. So I do compliment the regulators on that. Now it is 
down to the final strokes. Let's put forward a cross-border 
system that recognizes that they are nearly identical, and we 
move on from there so our members can deal with these rules, 
and you substitute compliance, so you either have to comply 
with the rules in one country or the other, but not both.
    Mr. LaMalfa. Right. That sounds very sensible. Quickly, on 
compliance decisions between outcome-based and element 
approach. You mentioned that a little bit earlier as well. Can 
you elaborate just a little bit on why the outcome-based is the 
preferred approach?
    Mr. O'Malia. Well, let's take, for example, end-user, the 
definition of end-user in the U.S. has one definition and end-
user in Europe has another definition. If you look at that and 
you try to do it on an equivalent basis, you are going to come 
up with a different outcome. You are not going to say those are 
not equivalent end-users. Pension funds, for example, are end-
users in Europe but they are not here. So applying those rules, 
if you go at a very granular level, you are going to find some 
differences, and you can never find equivalency, you can never 
trust the other regime. And, therefore, the industry is left 
compliant with two sets of rules, which is exactly where we are 
on trade execution, exactly where we are on data reporting.
    Mr. LaMalfa. Thank you. Thank you, Mr. Chairman.
    The Chairman. We are going to get a second round of 
questioning. I am going to recognize Mr. Scott from Georgia 
first in that second round.
    Mr. David Scott of Georgia. Yes, thank you. I want to 
continue my first line of questioning, and to pick up on my 
colleague that just spoke on the other side, concerning the 
cross-border, and specifically this situation with the EU.
    And I want to ask you all, is this putting our American 
businesses at a competitive disadvantage right now? That is 
what I want to hear. If you are a clearinghouse, if you are 
someone like ICE, the IntercontinentalExchange, if you are a 
CME, if you are a farmer, if you are a manufacturer, if you are 
an American risk manager, hedge manager, does this uncertainty 
at this moment in time, is this putting our American businesses 
at a disadvantage in the global markets?
    Mr. O'Malia. That is the same question the regulators in 
Europe or in Asia ask their constituents as well. Everybody 
wants to make sure that they protect their industry, they 
protect their people, they protect their markets, and I 
understand that. And that does create tension at the beginning 
of any conversation on equivalence. And they want to make sure 
that they have thought of everything. And we want to make sure 
that the outcomes achieve the same thing, because you do not 
want to have an unlevel playing field that tips one way or 
another.
    Now, we don't have all the rules completed in Europe yet, 
so it is tough to tell on some of these competitive issues 
around trade execution. We did get to an outcome, or we have a 
draft outcome on CCP recognition that would make the 
jurisdictions equivalent.
    Mr. David Scott of Georgia. But if you, Mr. O'Malia, if you 
had to answer my question right now, would you say is this 
uncertainty, this delay year after year, month after month, is 
it putting American businesses at a competitive disadvantage?
    Mr. O'Malia. I would answer yes, I mean because uncertainty 
always leads people to do less of something in order to account 
for that uncertainty. So the outcome, if the United States was 
not recognized by Europe, and it looks like we are going to be, 
there is a transition here, but many of the European banks that 
are members of the CME, of ICE, could not participate in those 
markets. It would be the capital punitive damages would be so 
high that they would just have to be out of the business. And 
again, what does that do? Well, that shrinks choices for 
customers that can't access markets through those clearing 
members, it is going to necessarily raise costs because of 
that. And so yes, it is going to cause an immediate impact.
    Mr. David Scott of Georgia. Right. And do you feel that it 
would be helpful in any way for us here in Congress to begin to 
put on the table and discuss any retaliatory means that might 
be necessary, whether you take them or not, but there ought to 
come a time when we need to stand up for our American 
businesses and say enough of this. We don't deserve this level 
of disrespect for our American businesses. Is there something, 
a message that we can send here in Congress to let them know 
that this has to be straightened out, it is unfair to our 
businesses?
    Mr. O'Malia. Well, your oversight responsibilities on this 
Committee have been helpful. You have talked about this issue 
in several hearings and that has gotten Chairman Massad 
leverage in these negotiations. But, the rest of the government 
is also important. The Treasury Department represents the 
United States in these types of negotiations. So your oversight 
responsibilities have helped to break this logjam, yes.
    Mr. David Scott of Georgia. Yes. I wanted to get to Mr. 
Deas as well in my last minute here, Mr. Deas, because if I 
remember in your testimony, you really hit on this competitive 
disadvantage. What say you about this?
    Mr. Deas. Well, thank you, Representative Scott. It is an 
important issue, and I can tell you that, just to bring it 
home, if we are competing against European companies whose 
regulators have exempted derivatives they enter into from 
higher capital requirements, then we as American companies are 
going to bear a higher cost for hedging the risk inherent in 
our business activity. And we have estimated that the 
difference here could be ten or 15 percent of the hedging 
costs.
    Mr. David Scott of Georgia. Yes.
    Mr. Deas. And we would have to either absorb that cost or 
pass it through to the customer, putting us at a competitive 
disadvantage.
    Mr. David Scott of Georgia. Thank you very much, Mr. 
Chairman, I appreciate that because, especially Europe, because 
if it weren't for America, those folks in Europe would be 
speaking German right now.
    The Chairman. More of them than already are. Yes, sir.
    Thank you, Mr. Scott. I have a couple of questions, Mr. 
O'Malia, that I would like to follow up on. Are margin and 
capital rules complimentary? If so, should they be developed 
and implemented in tandem to minimize regulatory overreach?
    Mr. O'Malia. Right now, they are moving forward in tandem. 
And we ought to look at them for the cumulative impact that 
they are going to be having to the business. They happen to be 
coming in at the same time, and businesses are making very 
difficult decisions right now about how they deploy that 
capital.
    The margin rules are separate, and that is going to have a 
big impact on the pricing of the OTC market. And we have yet to 
see kind of how it will be phased in and what the costs of that 
will be. That will be phased in over the next 4 years. But, now 
is the time to ask ourselves a question about the cumulative 
impacts of these, and spot the problems before we create some 
of these problems that we have identified today.
    The Chairman. You pretty much answered my next question. I 
am going to ask it anyway. You just answered it as no, maybe in 
a little longer manner, but the question is, is that how the 
CFTC and the Prudential Regulators approach their respective 
rulemakings, ensuring that the capital regulations took into 
consideration the risk-producing effects of the margin 
requirements?
    Mr. O'Malia. We would obviously like to see the CFTC get 
their cross-border rules out quickly. That has been a big 
holdup. But by and large, the margin rules on a global basis 
are fairly consistent.
    The Chairman. Has the Basel Committee, the Financial 
Stability Oversight Council, or any other body, undertaken a 
review of the potential cumulative impact of the various margin 
and capital requirements to ensure that those regulations are 
not unduly duplicative or overburdening the markets and their 
participants?
    Mr. O'Malia. Not that I am aware of.
    The Chairman. Thank you, gentlemen, for being here. And the 
chair now recognizes the gentleman from Illinois for 5 minutes.
    Mr. Davis. Thank you, Mr. Chairman.
    Mr. Deas, quickly, I have a question for you.
    Mr. Deas. Yes, sir.
    Mr. Davis. In your testimony, you comment that requiring 
dealing counterparties provide required stable funding for 20 
percent of the negative replacement cost of derivative 
liabilities before deducting the variation margin posted is a 
clear example of the direct burdens that would affect end-
users' ability to efficiently mitigate risk. Can you elaborate, 
since we talked about end-users a lot in this hearing, can you 
elaborate how this requirement directly impacts them?
    Mr. Deas. Congressman, I will be very happy to. Thank you 
for that question.
    Mr. Davis. Thank you.
    Mr. Deas. Well, end-users deal with these banking 
institutions as derivate counterparties who are represented by, 
in some cases, over 200,000 employees. And the only way those 
employees act, or are directed by the management of the bank, 
is to price their derivative transactions, as an example, on 
the incremental cost. So the way it would work in this regard, 
the assessment of the market-to-market risk of an uncleared 
derivative would generate a funding requirement that has to be 
held in reserves equal to 20 percent of that exposure, and 
according to the net stable funding requirements, they have to 
hold 50 to 85 percent of that funding in long-term funding, 
either equity the bank has issued or long-term preferred stock, 
or long-term debt that they have issued, the cost of which has 
to be passed on to end-users. And we estimate that the effect 
of that is to increase the hedging cost by ten to 15 percent.
    Mr. Davis. Ten to 15 percent?
    Mr. Deas. Yes, sir.
    Mr. Davis. Much higher than what we heard in some of the 
testimony earlier today.
    Mr. Deas. Yes, sir.
    Mr. Davis. Thank you. Mr. Lukken, we have had some 
discussion on, and you mentioned in your oral statement that 
other jurisdictions overseas are in the process of implementing 
the leverage ratio standards based on the Basel leverage ratio. 
How far along are the EU, Japan, and Switzerland in 
implementing these new standards based on Basel?
    Mr. Lukken. Well, they are in the midst of--Basel III was 
implemented in 2010, but there are revisions that are out for 
comment right now. And, in fact, they have talked about the 
leverage ratio in that consultation, and they are asking for 
data on whether that should be fixed.
    Europe has taken a different direction on this. Mark 
Carney, who is the Governor of the Bank of England, has come 
out with the same concerns that I am talking about today, which 
is why are we taxing clearing in this capital regime. And so 
the Europeans are thinking about going their own direction. So 
if, indeed, Basel decides not to recognize margin in these 
capital provisions, then Europe may decide to legislate its way 
out and just not implement the leverage ratio to tax clearing. 
That would be very harmful for the markets. We are trying to 
have internationally coordinated standards here through the 
Basel Committee, and if Europe is going its own way and the 
U.S. is punitively taxing clearing, that will end up harming 
U.S. businesses in the long-term.
    So there is a process and this is happening over the next 
several years, but major decisions on this are being made for 
the next several months, and so today's hearing is very 
relevant and timely in that regard.
    Mr. Davis. Okay, and take it a little bit further. Can you 
state for the Committee, you believe, or don't you, that this 
may cause problems for banks that obviously fall under multiple 
jurisdictions?
    Mr. Lukken. Absolutely. This is an international issue, but 
international regulators have differences of opinion on this. 
And so, the fact that there is a disagreement between the 
market regulator, the CFTC on this, and the Prudential 
Regulators here in the United States, that may have 
international consequences on how this standard is put into 
place internationally.
    Mr. Davis. So we have seen that Members of the European 
Parliament, Kay Swinburne, a Welsh Member of the European 
Parliament, has brought up this idea of the EU fixing 
unilaterally the leverage ratio, even if other jurisdictions 
like the U.S. are in opposition. Now, I mean do you foresee 
such an effort there, or do you think, as you just mentioned 
before, that there might be a better compromise through other 
means?
    Mr. Lukken. Well, our hope is that this works its way 
through the Basel process and there is a satisfactory 
resolution, but you have Members like Kay Swinburne, Markus 
Ferber, who I met with last week, as a Member of the Parliament 
in Europe, Jonathan Hill, the European Commissioner that covers 
these markets. I mentioned Mark Carney. So there is growing 
consensus in Europe. I can't predict what their legislature 
will do there, but there is growing consensus that this is a 
problem that needs to be fixed one way or another.
    Mr. Davis. So you would like the agencies to fix it and 
keep the politicians out, right?
    Mr. Lukken. Exactly. Like I said, this is simply measuring 
the actual economic exposure of banks. We are not asking for an 
exception. To me, this is just measuring it right. Let's 
measure what the actual risk is and then let's move on.
    Mr. Davis. And keep the politicians out, just like here.
    Mr. Lukken. Exactly.
    Mr. Davis. Thank you.
    Mr. Lukken. Yes.
    The Chairman. Gentlemen, thank you for being here for this 
review of the impact of capital and margin requirements on end-
users. Before we adjourn, I would like my Ranking Member, Mr. 
Scott, to make any closing remarks he has.
    Mr. David Scott of Georgia. Well, just very briefly, Mr. 
Chairman. This has been a very, very important hearing, and a 
very essential one. But I do hope a message has gone out from 
us Members in Congress, particularly on this cross-border 
thing. First, each of you recognize and articulated that this 
failure to deal with equivalency situation with the EU 
definitely puts the American businesses, manufacturers, end-
users, and all of those, clearinghouses, at a distinct 
competitive disadvantage. And it is my hope, and the reason I 
stressed this is that I served on this Committee, Ranking 
Member, mostly on the Financial Services Committee but I am 
also a Member of the NATO Parliamentary Assembly, and some of 
these same people I deal with also deal with the EU. And that 
is why I want a very strong message going out here today that 
we need to stop this foolishness with discriminating against 
American businesses, or else there will be retaliatory moves 
made.
    The Chairman. Thank you, Mr. Scott.
    Under the rules of the Committee, the record of today's 
hearing will remain open for 10 calendar days to receive 
additional material and supplementary written responses from 
the witnesses to any questions posed by a Member.
    This hearing of the Subcommittee on Commodity Exchanges, 
Energy, and Credit is adjourned.
    [Whereupon, at 11:27 a.m., the Subcommittee was adjourned.]

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