[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW THE IMPACT OF G20 CLEARING AND TRADE EXECUTION
REQUIREMENTS
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON COMMODITY EXCHANGES, ENERGY, AND CREDIT
OF THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTEENTH CONGRESS
SECOND SESSION
__________
JUNE 14, 2016
__________
Serial No. 114-53
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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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
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Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 73
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 5
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
Duffy, Hon. Terrence A., Executive Chairman and President, CME
Group Inc., Chicago, IL........................................ 5
Prepared statement........................................... 7
Submitted questions.......................................... 79
Edmonds, Christopher S., Senior Vice President, Financial
Markets, Intercontinental Exchange, Inc., Chicago, IL.......... 9
Prepared statement........................................... 11
Submitted questions.......................................... 80
Rosenberg, Marnie J., Global Head, Clearinghouse Risk and
Strategy, JPMorgan Chase & Co., New York, NY................... 13
Prepared statement........................................... 15
Submitted questions.......................................... 80
Merkel, J.D., Stephen M., Executive Vice President, General
Counsel and Secretary, BGC Partners, Inc.; Director, Wholesale
Markets Brokers' Association, Americas, New York, NY........... 25
Prepared statement........................................... 27
Submitted questions.......................................... 82
Berger, Stephen John, Director, Government and Regulatory Policy,
Citadel, LLC, New York, NY; on behalf of Managed Funds
Association.................................................... 45
Prepared statement........................................... 46
Submitted questions.......................................... 84
Zubrod, Luke D., Director, Risk and Regulatory Advisory Services,
Chatham Financial, Kenneth Square, PA.......................... 57
Prepared statement........................................... 59
Submitted questions.......................................... 87
HEARING TO REVIEW THE IMPACT OF G20 CLEARING AND TRADE EXECUTION
REQUIREMENTS
----------
TUESDAY, JUNE 14, 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, Neugebauer, Rogers, LaMalfa, Davis, Kelly, Conaway (ex
officio), David Scott of Georgia, Vela, Kirkpatrick, Aguilar,
and Peterson (ex officio).
Staff present: Caleb Crosswhite, Darryl Blakey, Kevin Webb,
Paul Balzano, Stephanie Addison, Faisal Siddiqui, John Konya,
Liz Friedlander, Matthew MacKenzie, Nicole Scott, and Carly
Reedholm.
STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF GEORGIA
The Chairman. Good morning. This hearing of the Committee
on Agriculture, to review the impact of G20 clearing and trade
execution requirements, will come to order.
Good morning. Thank you for joining the Commodity
Exchanges, Energy, and Credit Subcommittee for our last
installment of our three-part hearing series examining the
implementation of the derivatives market reforms envisioned by
world leaders following the 2008 global financial crisis.
Today, we will wrap up the series with a focus on clearing and
trade execution requirements.
Throughout this series, we have reiterated many times that
our goal is not an indictment of the reform objectives, but
rather an analysis of its implementation by United States
regulators and the interaction of the U.S. regulatory regime
with that of other global jurisdictions. A vibrant and
resilient derivatives marketplace is crucial for the market
participants and end-users who rely on it to manage their
diverse business risks. It is also critical for the consumers,
Americans in the Eighth District of Georgia and across the
nation, who rely on the price stability afforded by these risk
management practices.
Crucially, the global nature of this marketplace cannot be
taken for granted. Regulations must not unnecessarily fragment
the market, defining liquidity pools by borders instead of
market needs. We have already had many conversations on cross-
border equivalence and recognition in the clearing space.
While we are encouraged by recent steps toward U.S.-EU
regulatory harmonization of clearinghouses, applications to
European Securities and Market Authority for U.S.
clearinghouses to be recognized remain outstanding with a
quickly approaching deadline. I am told this will be done soon,
but this process has taken far too long.
Equivalence recognition and substituted compliance
decisions must be resolved more quickly. Regulators need to be
working now to prevent similar protracted negotiations for
trade execution facilities in the future.
We are glad to have witnesses before us today who can
expound on the changes to the clearing ecosystem. While
transaction clearing has long played a role in the marketplace,
Dodd-Frank swaps clearing mandate has significantly expanded
the volume of cleared transactions. I am sure that the insights
and perspectives offered today will be vital as we think
through the related implications of resilience and recovery of
clearinghouses in times of market stress. Many questions have
been raised about the workability of the CFTC's trade execution
rules. Do they accurately reflect Congressional intent, and
sufficiently take into account the intricacies of the
marketplace they regulate, do they restrict market access for
the end-users who need to meet specific and custom hedging
needs, and perhaps most importantly, do they impose arbitrary
barriers to trading that diminishes liquidity? We look forward
to exploring these and other issues more deeply today.
In developing their market reform framework, G20 leaders
were clear about the need for global regulators to collaborate
and coordinate on these rules. They saw consistent
implementation of reforms as preventing regulatory arbitrage,
protecting financial stability, and promoting competition and
innovation. This too is the standard by which we measure our
regulatory progress.
With that, I want to welcome our panel of accomplished
witnesses who bring their diverse viewpoints on clearing and
trade execution. Thank you each for the time and effort you put
into being here today. We look forward to leaving here with a
deeper understanding of the issues at hand.
[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 our last installment of our three-
part hearing series examining the implementation of the derivatives
market reforms envisioned by world leaders following the 2008 global
financial crisis. Today, we will wrap up the series with a focus on
clearing and trade execution requirements.
Throughout this series, we've reiterated many times that our goal
is not an indictment of the reform objectives, but rather an analysis
of their implementation by United States regulators and the interaction
of the U.S. regulatory regime with that of other global jurisdictions.
A vibrant and resilient derivatives marketplace is crucial for the
market participants and end-users who rely on it to manage their
diverse business risks. It is also critical for the consumers,
Americans in the Eighth District of Georgia and across the nation, who
rely on the price stability afforded by these risk management
practices.
Crucially, the global nature of this marketplace cannot be taken
for granted. Regulations must not unnecessarily fragment the market,
defining liquidity pools by borders instead of market needs. We have
already had many conversations on cross-border equivalence and
recognition in the clearing space.
While we are encouraged by recent steps toward U.S.-EU regulatory
harmonization for clearinghouses, applications to the European
Securities and Markets Authority for U.S. clearinghouses to be
recognized remain outstanding with a quickly approaching deadline. I'm
told this will be done soon, but this process has taken far too long.
Equivalence, recognition, and substituted compliance decisions must be
resolved more quickly. Regulators need to be working now to prevent
similar protracted negotiations for trade execution facilities in the
future.
We are glad to have witnesses before us today who can expound on
the changes to the clearing ecosystem. While transaction clearing has
long played a role in the marketplace, Dodd-Frank's swaps clearing
mandate has significantly expanded the volume of cleared transactions.
I'm sure that the insights and perspectives offered today will be
vital as we think through the related implications for resilience and
recovery of clearinghouses in times of market stress.
Many questions have been raised about the workability of the CFTC's
trade execution rules.
Do they accurately reflect Congressional intent and
sufficiently take into account the intricacies of the
marketplace they regulate?
Do they restrict market access for the end-users who need to
meet specific and custom hedging needs?
And perhaps most importantly, do they impose arbitrary
barriers to trading that diminishes liquidity? We look forward
to exploring these and other issues more deeply today.
In developing their market reform framework, G20 leaders were clear
about the need for global regulators to collaborate and coordinate on
these rules. They saw consistent implementation of reforms as
preventing regulatory arbitrage, protecting financial stability, and
promoting competition and innovation. This, too, is the standard by
which we measure our regulatory progress.
With that, I want to welcome our panel of accomplished witnesses
who bring their diverse viewpoints on clearing and trade execution.
Thank you each for the time and effort you put into being here
today. We look forward to leaving here with a deeper understanding of
the issues at hand.
I'll recognize our Ranking Member, Mr. Scott, for any remarks he'd
like to make.
The Chairman. And I will recognize our Ranking Member, Mr.
Scott, for any remarks he would like to make.
OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN
CONGRESS FROM GEORGIA
Mr. David Scott of Georgia. Thank you, Chairman Scott. It
is a pleasure to be here. This is indeed an important and very
timely hearing.
As we know, the derivatives and swaps market that we are
dealing with is an $600+ trillion piece of the world's economy.
It is very complex, complicated, and oftentimes all too
confusing. So I thought we might give just a little background
to sort of set the stage for how we got here.
As you all remember, after the financial crisis the
derivatives markets were dramatically transformed by Title VII
in the Dodd-Frank Act. And Title VII falls directly under the
purview of this Committee. It is a section relating to
derivatives, the large swaths of CFTC and SEC mandates. These
are our regulators in this area. And one of our major concerns
is to make sure that our two regulatory agencies themselves can
harmonize and make sure, and that is a very important mandate
for our Committee to make sure of. This included rulemakings
pertaining to clearing, trade executions, reporting, and
transparency obligations.
Then we come back a little earlier in 2009, the G20
proposed reforms to the derivatives markets with a particular
emphasis on making sure a global standard is met so that
harmonization in our rules could be met. The United States'
response to this G20 summit was Dodd-Frank, while other
countries have implemented their own laws with varying
timelines, which creates another problem. This mismatch in
timing has led to a slew of equivalency problems, none greater
than what is happening in the European Union. For example, the
EU will soon implement a rule that is not, and could not be as
strong as the United States' rule. And given the global nature
of our world's derivatives markets, equivalency problems have
led to many market participants going from one place to
another.
And so on Tuesday, May 24, the CFTC issued a final rule
that applies to the Commission's margin requirements for
uncleared swaps in the context of cross-border transactions.
This rule would limit the ability of banks and other traders to
move swaps businesses abroad to avoid U.S. trading
requirements. And this is something we need to hear from you,
how it impacts our industry. The rule requires that offshore
units of U.S. banks adhere to CFTC margin rules, even in cases
where the unit's American parents aren't explicitly off the
hook for trades.
Now, just to refresh your memory, swaps did get a bad name
during the financial crisis because of a certain swap called
the credit default swap. It is a key over-the-counter
derivative. During that crisis, if you recall, AIG issued a
huge amount of CDS contracts, paying out similar to an
insurance contract, when collateralized debt obligations
collapsed. This was hugely speculative, and has since been
corrected because a version of it has been targeted by U.S.
policymakers for greater oversight and transparency because
they played a central role in the financial crisis.
So we come to December 2015. Now, CFTC finalized rules to
set collateral or margin requirements on trade between swap
dealers and other firms that aren't done through
clearinghouses. This is what is referred to as uncleared swaps,
and makes a multi-trillion dollar swaps market that isn't
backed by a central clearinghouse. However, this December 25
rule did not set guidelines for cross-border swaps. As written,
the swaps were guaranteed by the foreign counterparty, the
swaps were exempt from U.S. margin requirements, and because of
this, U.S. banks have been restructuring their contracts to de-
guarantee these swap transactions, and any liability for these
swaps would then lie solely with the offshore operation. Now,
most of this was moved to London.
And so now, we are in a situation where we want to hear
from you pertaining to this rule, and to share with this
Committee concerns that you in the industry have. Regardless of
what we do here, it is you, it is the clearinghouses, it is the
market participants who have to make all of this work.
So, Mr. Chairman, I look forward to a good hearing, an
important and timely hearing, and thank you for the time.
The Chairman. Thank you, Mr. Scott. And I understand Mr.
Peterson, the Ranking Member of the full Committee, has a
statement that he would like to be recognized to make.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. Thank you, Mr. Chairman. And I will be brief.
And I want to thank the panel of witnesses for joining us
today.
When we wrote Title VII of Dodd-Frank, we incorporated
goals set by the G20 in response to the market's failure. We
also took into account the risks posed by an opaque, top-heavy
swaps market. We required standardized swaps to be cleared and
to be traded in an environment, with multiple market
participants making both bids and offers. That clearing
requirement has now been met and we have brought stability to
the market.
I am looking forward to discussing the trade execution
issue today because I don't believe we have achieved the goal
that we set in Dodd-Frank in terms of the way that swaps are
traded. Not much has changed. In some ways, the marketplace is
worse now than it was before the crisis. The four largest
dealers control 90 percent of all the swaps traded. The pre-
crisis market structure, where they served clients in one
market, and deal nearly exclusively with each other in the
secondary market, still exists. So I hope today's hearing can
help us understand why this is the case, and I look forward to
your testimony. I yield back my time.
The Chairman. The chair would remind other Members to
submit their opening statements for the record so the witnesses
may begin their testimony, and to ensure that there is ample
time for questions.
I would like to welcome our witnesses to the table. First,
we have the Honorable Terrence Duffy, Executive Chairman and
President of the CME Group, from Chicago, Illinois. We have Mr.
Christopher Edmonds, Senior Vice President, Financial Markets,
Intercontinental Exchange, Chicago, Illinois; Ms. Marnie
Rosenberg, Global Head, Clearinghouse Risk and Strategy,
JPMorgan Chase and Company, New York, New York; Mr. Stephen
Merkel, Executive Vice President, General Counsel and
Secretary, BGC Partners, Incorporated, New York, New York, on
behalf of the Wholesale Markets Brokers' Association; Mr.
Stephen John Berger, Director, Government and Regulatory
Policy, Citadel, LLC, New York, New York, on behalf of the
Managed Funds Association; Mr. Luke Zubrod, Director, Risk and
Regulatory Advisory Services, Chatham Financial, Kenneth
Square, Pennsylvania.
Mr. Duffy, please begin when you are ready.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
PRESIDENT, CME GROUP, INC., CHICAGO, IL
Mr. Duffy. Thank you, Mr. Chairman. Chairman Scott, and
Ranking Member Scott, Members of the Subcommittee, I am Terry
Duffy, the Executive Chairman and President of CME Group, and I
thank you for the opportunity to testify today regarding the
G20 clearing and trading commitments.
These commitments were meant to create a global regulatory
framework; however, some G20 nations have not implemented core
elements of the G20 reforms consistently. For example,
regulatory requirements for clearinghouses have not been
defined on a coordinated basis. This has the potential to
create inconsistency, uncertainty, and disruption to the smooth
functioning of global derivatives markets.
Fortunately, negotiations between the U.S. and the EU on
equivalence were successfully resolved in February. That is
when the European Commission originally granted the CFTC
equivalent status. The European Securities Market Authority is
now implementing that agreement. It is ensuring that the CME
clearing is recognized as equivalent in advance of the June 21
date for European clearing mandate.
I want to applaud Chairman Massad and his European
counterparts for working through their differences and reaching
a positive outcome. However, the process took too long. This
created considerable uncertainty for European participants
wanting to clear products in the United States. We encourage
global regulators to avoid this kind of potential market
disruption in the future. They should implement long-term
solutions. They should not force markets to go through a
national equivalence and recognition process every few years.
Otherwise, regulation will artificially influence liquidity,
price discovery, and risk management. It will disadvantage
individual markets in an increasingly competitive global
marketplace.
Beyond equivalence, the global clearing mandates have also
led to increased focus on clearinghouses' risk management. In
2012 and 2013, enhanced risk management standards were adopted
for clearinghouses. More recently, there has been a focus on
recovery and resolution. Central clearing increases
transparency, reduces systemic risk, and strengthens the
financial system. Clearing members and market participants
bring risk to the clearinghouse through their trading
activities. In contrast, a clearinghouse's core function is to
manage that risk. We don't create the risks.
Clearinghouses are responsible for ensuring the overall
safety and soundness of their markets. CME Clearing uses a
number of tools to monitor and limit the risk it manages. These
include its safeguards packages and waterfall structure. They
provide a firewall against a potential systemic impact of a
failing clearing member. These tools have proven themselves to
be extremely effective in stressed markets and during the worse
financial crisis in memory.
We have long supported first loss contributions to each of
our financial safeguard packages. This further aligns our
interests with those of market participants. We are committed
to ensuring that the capital contributions from clearing
members, as well as CME, will be sufficient to avoid the
mutualization of losses in a default situation. As a result,
when addressing a clearing member failure, CME Clearing has
never had to access the default fund contribution of a failing
clearing member, the mutualized capital of its clearing
members, or the capital that CME has in its default fund.
Effective risk management must strike a balance between
initial margins, clearinghouse contribution capital, and
clearing member guarantee fund contributions. This ensures that
all market participants have appropriate incentives to manage
risk across the markets.
Before closing, I want to mention the leverage ratio rule
adopted by the Basel Committee and the Federal Reserve. It is
an example of a regulation that is at odds with the G20
commitments to clearing. The leverage ratio will make clearing
more expensive and less accessible. Why? Because it fails to
recognize how customer collateral, appropriately segregated,
reduces exposures. The Basel Committee recently proposed
changes to the rule, but they stopped short of endorsing a
segregated collateral offset for client-cleared derivatives.
Customer collateral is legally required to be segregated,
reduces exposures, and cannot be used to increase a clearing
member's leverage. Without such an offset, clearing costs will
increase. Further, moving the clients of defaulted clearing
members will be much more difficult.
I thank you for your time and attention this morning, and I
look forward to answering any questions you may have of me.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
President, CME Group, Inc., Chicago, IL
The G20 commitments were meant to create a global regulatory
framework. However, some G20 nations have not implemented the core
elements of the G20 regulatory reforms consistently. This lack of
coordination has the potential to create inconsistency, uncertainty,
and potential harm to the efficient functioning of U.S. and global
derivatives markets.
Equivalency and Recognition
As one example of this inconsistency, regulatory requirements for
clearinghouses have not been defined on a coordinated basis.
Fortunately, the negotiations between the U.S. and EU on equivalence
were successfully resolved in February, when the European Commission
officially granted the CFTC ``equivalent'' status. The European
Securities Markets Authority is now implementing that agreement by
ensuring that CME Clearing is recognized as equivalent in advance of
the June 21 start date for the European clearing mandate.
However, the process for U.S. clearinghouses obtaining equivalence
and recognition in Europe has taken far too long. While we applaud
Chairman Massad and his European counterparts for working through their
differences and reaching a positive outcome, we encourage policymakers
on both sides of the Atlantic to ensure that market participants do not
have to deal with the uncertainty created by such long delays in
reaching a cross-border agreement. This requires agreement among global
regulators to implement long-term solutions for increasingly global
markets and not force markets to go through national equivalence and
recognition processes every few years.
If this is not the case, then regulation will artificially
influence liquidity, price discovery and risk management, and
competitively disadvantage individual markets in an increasingly
competitive global marketplace.
Risk Management through Central Clearing
Congress has taken important steps toward strengthening the U.S.
financial system post financial crisis. By way of example, a clearing
mandate has been imposed for certain swaps--requiring that they be
cleared through central clearinghouses like CME Clearing. These reforms
increase transparency and reduce systemic risk by using the best
practices of central clearing in the broader financial markets.
A clearinghouse's core function is risk management--not trading or
other types of risk creation. Unlike clearing members and market
participants, clearinghouses do not bring risk to the clearing system.
Instead, clearinghouses are responsible for ensuring the overall safety
and soundness of their markets.
Clearinghouses, like CME Clearing, utilize a number of tools, such
as the financial safeguards package and waterfall structure, to monitor
and limit the risks brought by its clearing members and customers and
to limit the systemic impact of a failing clearing member. These tools
have been tested in stressed markets and have demonstrated their
effectiveness against the worst financial crises in memory. CME
Clearing has never had to access a defaulting clearing member's default
fund contribution, CME's own contributed capital, or the mutualized
capital of its clearing members to address a clearing member default.
At its core, the clearing mandate and other related financial reforms
were driven by a decision by the G20 that the robust performance by
clearinghouses during the financial crisis suggested that their market
structure and risk management should be a template for the financial
markets, going forward.
In response to the swaps clearing mandate, some have called for
greater scrutiny of clearinghouse risk management, including the amount
of capital that clearinghouses should be required to hold. We support
best practices in risk management. It is critical, however, to
recognize that the central clearing mandate was adopted due to
clearinghouse resiliency during the financial crisis. Furthermore, the
CFTC and other global regulators have significantly enhanced the risk
management standards applied to clearinghouses beyond those which
performed robustly during the financial crisis. The failure to
recognize the increased resiliency of clearinghouses following these
changes potentially risks distracting the regulatory focus away from
less robust areas of the financial markets.
Unlike the participants in our markets, risk management is the core
function of CME Clearing and we have strong motivation to ensure
clearing member contributions and our own capital contributions will be
sufficient to avoid the mutualization of losses in a default situation.
Effective risk management must strike the appropriate balance between
initial margins, clearinghouse contributed capital, and clearing member
guaranty fund contributions to ensure that all market participants have
appropriate incentives to manage risk across the market. CME Clearing
has long advocated for clearinghouses to make meaningful, first-loss
contributions to their financial safeguards packages. CME Clearing
makes a sizeable contribution to each of its financial safeguards
packages, which works to align our interests with those of our market
participants.
In addition, CME Clearing regularly publishes public disclosures
describing its risk management practices and measuring its available
financial resources in compliance with local and international
standards and best practices. This provides the market significant
transparency into our risk management practices.
Some have also called for the introduction of a framework for
addressing any losses that exceed the clearinghouse's financial
resources. CME Group supports U.S. and international efforts to
introduce robust recovery and resolution regimes for clearinghouses.
However, we caution that no two clearinghouses are the same and the
recovery and resolution framework should be tailored to the specific
characteristics of each clearinghouse while ensuring that the tools
prescribed are appropriately calibrated.
Clearinghouses should retain flexibility in designing their
recovery tools to take into account dynamic market conditions, and the
specific products and markets they serve. Clearinghouses must also have
the flexibility and discretion to implement their recovery tools and
maintain the ability to use all possible tools available to them prior
to resolution.
Moreover, clearinghouses have the foremost expertise in managing
the risks of the markets which they clear; therefore, we believe that a
clearinghouse should only be put in resolution when the recovery
process is exhausted. In addition to this expertise, the incentives of
clearinghouses are aligned with overall market stability making them
the appropriate pre-resolution decision-maker on the steps needed to
recover their markets.
In some jurisdictions it is suggested that initial margin
collateral provided by market participants should be used other than
for its sole, intended purpose as collateral for cleared positions, but
as a means to allocate losses or as a temporary source of liquidity.
This is commonly referred to as ``haircutting'' initial margin
collateral. CME Group strongly opposes the haircutting of initial
margin collateral whether during recovery or resolution, both as
unlawful in regards to clients under the Commodity Exchange Act and
Dodd-Frank Act and as a matter of policy, due to its destabilizing
impact on markets and its negative capital impacts.
Collateral haircutting directly impacts participants in pension
funds and other end-users by appropriating their assets which are not
designed to address mutualized risk and such appropriation is
prohibited under U.S. law. Effectively, the haircutting of client
collateral amounts to a taxpayer bailout due to the fact that the
assets of participants in pension plans, the very people we are trying
to protect, are put up as client collateral and would be at risk of
appropriation if the haircutting of client collateral were permitted.
Haircutting of client collateral also creates a lack of incentive
for market participants to actively participate in the default
management process. CME Clearing is a strong supporter of sound risk
management underpinned by the belief that market participants must be
incentivized to manage the risks they create.
We encourage Congress to avoid inappropriate shifts in costs to
end-users and reduction in clearing member incentives to actively
manage their risk. The appropriate balance must be struck between
initial margins, clearinghouse contributed capital, and clearing member
guaranty fund contributions to ensure that all market participants have
appropriate incentives to manage risk across the market.
Leverage Ratio
Finally, highlighting a regulatory inconsistency with regard to the
G20 commitments, the supplemental leverage ratio rule adopted by the
Basel Committee and the Federal Reserve is directly at odds with the
G20 commitment to clearing.
Plainly speaking, the supplemental leverage ratio will make
clearing more expensive and less accessible given its failure to
recognize appropriately segregated client collateral in the centrally
cleared derivatives markets. Customer collateral is required by law to
be segregated, reduces exposures, and cannot be used to increase
leverage. The Basel Committee has recently proposed changes to its
leverage ratio framework; however it has stopped short of endorsing
client collateral offsets for client cleared derivatives. Continued
failure to do so will needlessly make more difficult a clearing firm's
ability to accept a portfolio of fully margined clients of a defaulted
clearing member.
The Chairman. All right, Mr. Edmonds.
STATEMENT OF CHRISTOPHER S. EDMONDS, SENIOR VICE PRESIDENT,
FINANCIAL MARKETS, INTERCONTINENTAL
EXCHANGE, INC., CHICAGO, IL
Mr. Edmonds. Chairman Scott, Ranking Member Scott, I am
Chris Edmonds, Senior Vice President, Financial Markets, for
Intercontinental Exchange, or ICE. I appreciate the opportunity
to appear before you today, and discuss the role of clearing
and trade execution.
Since launching an electronic over-the-counter energy
marketplace in 2000 in Atlanta, Georgia, ICE has expanded both
in the U.S. and internationally. Over the past 16 years, we
have acquired or founded derivative exchanges and
clearinghouses in the U.S., Europe, Singapore, and Canada. ICE
has a successful and innovative history clearing exchange-
traded derivatives, and OTC derivatives such as energy and
credit default swaps, or CDS. In 2008, ICE launched the first
new clearinghouse in the UK in over a century; ICE Clear
Europe, which clears energy, credit, and interest rate
derivatives. We launched our CDS clearinghouse; ICE Clear
Credit, in 2009, and it has since converted to a derivatives
clearing organization following the implementation of Dodd-
Frank.
Following the financial crisis in 2008, global financial
ministers decided, to the extent possible, the OTC derivative
market should be cleared. Global regulators recognized that a
clearinghouse, by acting as a central counterparty to
transactions, minimizes bilateral risk. As a result of
increased clearing, market participants are realizing that
moving uncleared positions and clearing creates both
operational and capital efficiencies. For example, since 2009,
ICE Clear Credit and ICE Clear Europe have cleared more than
$78 trillion in CDS notional, but through compression and
netting, currently maintain a combined open interest of
approximately $1.5 trillion, significantly reducing the
bilateral credit exposure among market participants, and
reducing systemic risk.
Ironically, despite mandate-driven and natural growth in
the volume of cleared contracts, the number of futures
commission merchants, or FCMs, available to provide clearing
services for end-users has dropped from 190 to 76 in recent
years. The bulk of derivatives clearing is now concentrated in
a few bank-owned FCMs. These firms are constrained by the
proposed requirement under Basel III that banks hold regulatory
capital against clearing customer margin on their balance
sheet, even though the customer margin is posted to a
clearinghouse and held on a segregated basis.
ICE has joined a group of concerned market participants to
encourage the Basel Committee to reconsider and refine aspects
of this rule. We appreciate the several Members of this
Subcommittee who have helped us raise the issue with banking
regulators. The Basel Committee recently indicated it may
rethink its position, and has requested further comment on the
proposal. ICE and the broader derivatives industry are hopeful
the Basel Committee will recognize segregated and the risk-
reducing nature of customer funds that are restricted on bank
balance sheets.
We are also pleased European and U.S. regulators reached an
agreement on margin equivalence standards for CCPs in their
respective jurisdictions. Further coordination between
regulators is still required to ensure that these standards do
not create opportunities for regulatory arbitrage or balkanize
global markets. But this first step brings important regulatory
certainty to clearing customers.
We are also hopeful the global regulators will reach
agreement on equivalence between trade execution platforms
within a reasonable timeframe. Over the past decade, ICE has
invested heavily in our clearinghouse technology and risk
management practices. ICE has kept pace with, and often
preceded regulatory reforms, new global rules, and
international standards that have been established with respect
to risk controls, levels of protection, and proper functioning
of clearinghouses. We have worked closely with regulators,
clearing members, and end-users to implement clearing models
that meet or exceed modern regulatory reforms and international
standards. The result is an even more robust clearing model
that includes many ICE-led initiatives such as the introduction
of skin-in-the-game, or the contribution by clearinghouses of
designated amounts of their own capital for the default
waterfall.
ICE clearinghouses are subject to extensive regulatory
oversight and strong corporate governance requirements,
exercised largely through risk and advisory committees, and
independent boards of directors. Risk committees include
representatives from our clearing member firms, and in some
cases, end clients. ICE clearinghouses regularly conduct margin
back-testing, default fund stress testing, and liquidity stress
testing, the results of which are reviewed by clearing members
and regulators. The ICE clearinghouses also provide public
disclosure of their margin back-testing, default fund stress
testing, and liquidity stress testing as part of their
compliance with the CPMI-IOSCO public quantitative disclosure
standards. The rules, practices, and procedures of ICE's
clearinghouses are fully transparent and publicly disclosed in
a consistent manner. Any material change to ICE's clearing
processes are subject to rigorous internal governance review,
as well as applicable regulatory review and approval.
Thank you for the opportunity to share our views with you,
and I would be happy to answer any questions you and the
Members of the Subcommittee may have.
[The prepared statement of Mr. Edmonds follows:]
Prepared Statement of Christopher S. Edmonds, Senior Vice President,
Financial Markets, Intercontinental Exchange, Inc., Chicago, IL
Introduction
Chairman Scott, Ranking Member Scott, I am Chris Edmonds, Senior
Vice President, Financial Markets for Intercontinental Exchange, or
ICE. I appreciate the opportunity to appear before you today to discuss
the role of clearing and trade execution.
Background
Since launching an electronic over-the-counter (OTC) energy
marketplace in 2000 in Atlanta, Georgia, ICE has expanded both in the
U.S. and internationally. Over the past sixteen years, we have acquired
or founded derivatives exchanges and clearing houses in the U.S.,
Europe, Singapore and Canada. In 2013, ICE acquired the New York Stock
Exchange, which added equity and equity options exchanges to our
business. Through our global operations, ICE's exchanges and clearing
houses are directly regulated by the U.S. Commodity Futures Trading
Commission (CFTC), the Securities and Exchange Commission (SEC), the
Bank of England, the UK Financial Conduct Authority and the Monetary
Authority of Singapore, among others.
ICE has a successful and innovative history clearing exchange
traded derivatives and OTC derivatives such as energy and credit
default swaps (CDS). ICE Clear Credit (ICC) began operating as a trust
company in 2009 under the supervision of the Federal Reserve Board and
the New York State Banking Department and converted to a derivatives
clearing organization (DCO) following implementation of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (DFA). In 2008, ICE
launched ICE Clear Europe (ICEU), the first new clearing house in the
UK in over a century. ICEU clears derivatives in several asset classes
including energy, agriculture, interest rates and credit. In total, ICE
owns and operates six clearing houses in North America, Europe and
Asia.
Current Clearing Environment
Observers frequently point to a lack of cleared derivative
contracts as a significant factor in the broad reach and complexity of
the 2008 financial crisis. The disciplined and transparent risk
management practices (including uniform collateral requirements and the
daily marking-to-market of losses) associated with regulated cleared
contracts serves to reduce systemic risk. Whereas, opaque bilateral OTC
derivative transactions result in counterparty exposures that can
become hard to unwind when the market experiences a period of
widespread stress. A clearing house, by acting as a central
counterparty (CCP) to transactions, minimizes bilateral risk by
compressing derivative exposures. For example, since 2009, ICC and ICEU
have cleared more than $78 trillion in CDS notional, but through
compression currently maintain a combined open interest of $1.5
trillion, significantly reducing bilateral credit exposure among market
participants and reducing systemic risk.
ICE Global Cleared Activity--Gross Notional vs. Open Interest
In response to the financial crisis, the G20 finance ministers
decided that, to the extent possible, the OTC derivative market should
be cleared. Congress followed suit with the DFA, which created a
clearing requirement for liquid standardized derivatives. Today,
certain U.S. and European CDS indices and certain interest rate swaps
are mandated for clearing by the CFTC. The European Market
Infrastructure Regulation (EMIR) created a similar clearing mandate for
Europe. As a result of increased clearing, market participants are
realizing that moving uncleared positions into clearing results in
risk, operational and capital efficiencies.
Basel-Fueled Headwinds
Ironically, despite mandate-driven and natural growth in the volume
of cleared contracts, the number of futures commission merchants (FCM)
available to provide clearing services for end-users has dropped
considerably in recent years. What had been an industry of 190 firms in
2004 was reduced to 76 firms by 2014, according to the Futures Industry
Association. The bulk of derivatives clearing is now concentrated in a
few bank owned global FCMs. These firms are constrained by the proposed
Basel Committee on Banking Supervision's leverage ratio framework
(Basel III). Basel III requires a bank to hold regulatory capital
against clearing customer margin on its balance sheet notwithstanding
that the customer margin is posted to a clearing house and held at the
clearing house on a segregated basis. This Basel III capital
requirement makes it more expensive for banks to offer clearing
services, at the very time clearing capacity is shrinking and customer
demand is increasing. Further, Basel III makes the transfer (or
porting) of client positions much more difficult as banks must perform
an assessment of their capital costs before accepting a client position
transfer. This will complicate default resolution as banks will be less
likely to accept client positions from a defaulting clearing member.
ICE has joined a group of concerned FCMs, end-users and other
clearing house operators to encourage the Basel Committee to reconsider
and refine aspects of the rule which is set to become final at the
start of 2017. CFTC regulations already prohibit banks from using
customer margin funds in any way other than to mitigate the risk
reflected in customer positions. The Basel committee recently indicated
it may rethink this position and has requested further comment on the
proposal. ICE and the broader derivatives industry are hopeful the
Basel Committee will recognize the segregated and risk reducing nature
of customer funds that are restricted on bank balance sheets.
Regulatory Coordination
Earlier this year, European and U.S. regulators reached an
important milestone on margin equivalence standards for CCPs in their
respective jurisdictions. This determination encourages continued
cross-border activity and will help prevent a fragmentation of
liquidity for related contracts. Further coordination between the
regulators is still required to ensure the standards do not create
opportunities for regulatory arbitrage or balkanize global markets, but
this first step brings important regulatory certainty to clearing
customers. We are also hopeful that global regulators will reach
agreement on equivalence between trade execution platforms within a
reasonable timeframe.
Since the enactment of the DFA, ICE has also worked with the CFTC
and the SEC to provide CDS market participants the benefits of capital
efficiency that can come with the portfolio margining of risk off-
setting positions.\1\ The SEC developed a portfolio margining regime
that requires each clearing member to create its own set of portfolio
margining standards. Under these rules, there has been some progress in
single name clearing but uncertainty remains. We look forward to
working with the SEC to resolve the questions still limiting market
participants' ability to use these critical risk management tools.
---------------------------------------------------------------------------
\1\ CDS Index instruments are subject to CFTC regulation, while CDS
single name instruments are subject to SEC regulation, therefore a
coordinated effort was required to provide for portfolio margining for
CDS.
---------------------------------------------------------------------------
CCP Operation and Role in the Financial System
The central counterparty clearing model is effective and has been
relied upon in futures markets for more than 100 years. The recent
introduction of mandatory clearing obligations for certain swaps has
increased awareness around clearing and the significant benefits it
brings to the capital markets. Over the past 100 years, clearing house
risk management practices have been repeatedly tested and have
performed as designed in resolving clearing member defaults.
Over the past decade, ICE has invested heavily in our clearing
house technology and risk management practices. ICE has kept pace with
and often preceded regulatory reforms, new global rules, and
international standards \2\ that have been established with respect to
risk controls, levels of protection and proper functioning of clearing
houses. We have worked closely with regulators, clearing members and
end-users to implement clearing models that meet or exceed modern
regulatory reforms and international standards. The result is an even
more robust clearing model that includes many ICE-led initiatives, such
as the introduction of ``skin-in-the-game,'' the clearing house's
contribution of a designated amount of its own capital to the default
waterfall.
---------------------------------------------------------------------------
\2\ Committee on Payment and Settlement Systems, International
Organization of Securities Commissioners (CPSS-IOSCO), Principles of
Financial Market Infrastructures (April 2012). http://www.bis.org/publ/
cpss101a.pdf.
---------------------------------------------------------------------------
ICE clearing houses are subject to extensive regulatory oversight
and strong corporate governance requirements, exercised largely through
risk and advisory committees and independent boards of directors.\3\
Risk committees include representatives from clearing member firms and,
in some cases, end clients. ICE clearing houses regularly conduct
margin back-testing, default fund stress testing, and liquidity stress
testing, the results of which are reviewed by clearing members and
regulators. In addition, the clearing houses' margin, guaranty fund and
liquidity methodologies are independently validated on a routine basis.
---------------------------------------------------------------------------
\3\ For an overview of the risk governance at ICE clearing houses
see: ICE Clear Europe--www.theice.com/clear-europe/risk-management; ICE
Clear U.S.--www.theice.com/clear-us/regulation; ICE Clear Credit:--
www.theice.com/clear-credit/regulation.
---------------------------------------------------------------------------
The rules, practices and procedures of ICE's clearing houses are
fully transparent and are publicly disclosed in a consistent manner, as
set out within the CPMI-IOSCO Principles for Financial Market
Infrastructures (PFMIs) \4\ and various regulatory requirements. Any
material changes to ICE's clearing processes are subject to rigorous
internal governance as well as applicable regulatory review and
approval.\5\
---------------------------------------------------------------------------
\4\ Supra, nt. 2.
\5\ For an overview of ICE central clearing operations and
governance see: https://www.theice.com/publicdocs/
Central_Clearing_Reducing_Systemic_Risk.pdf.
---------------------------------------------------------------------------
Conclusion
ICE has always been and continues to be a strong proponent of open
and competitive markets, and of appropriate regulatory oversight of
those markets. As an operator of global futures and derivatives
markets, ICE understands the importance of ensuring the utmost
confidence in its markets. To that end, we have continuously worked
with regulatory bodies in the U.S. and abroad to ensure they have
access to all relevant information available to ICE regarding trade
execution and clearing activity on our markets. ICE continues to work
closely with governments and regulators at home and abroad to address
the evolving regulatory challenges presented by derivatives markets and
will continue to work cooperatively for solutions that promote the best
and safest marketplaces.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you and Members of the
Subcommittee may have.
The Chairman. Thank you, Mr. Edmonds.
Ms. Rosenberg.
STATEMENT OF MARNIE J. ROSENBERG, GLOBAL HEAD, CLEARINGHOUSE
RISK AND STRATEGY, JPMorgan CHASE & CO., NEW YORK, NY
Ms. Rosenberg. Thank you for holding this hearing, and
extending JPMorgan Chase the opportunity to present our views
on implementation of the G20 derivative reforms.
My name is Marnie Rosenberg, and I am the Global Head of
Clearinghouse Risk within JPMorgan Chase's Independent Risk
Management Function. Our firm is a leading provider of access
to clearing across the globe.
The clearing mandate has benefitted the system overall by
reducing risk and enhancing transparency. On the other hand, it
has further concentrated risk in a small number of large global
CCPs, and increased interconnectedness within the system.
Today, one of the critical public policy issues for
regulators and policymakers is ensuring that CCP risk
management and governance frameworks are appropriately aligned
and effective for the systemic role that CCPs have assumed.
I lead a team that focuses on identifying, mitigating, and
reducing our firm's CCP membership risks, and it is from this
perspective that I raise three key questions for policymakers
today. First, are CCPs sufficiently resilient to withstand the
default of one or more clearing members, or a major loss
arising from an operational failure or a cybersecurity attack?
Second, do CCPs have adequate plans and resources to recover
from such a loss to carry on offering critical services? And
finally, if they can't recover, do they have credible
resolution plans to continue to provide critical services, and
ensure a CCP's failure does not cause broader market
instability or require taxpayer assistant. Regulators,
including the CFTC, have made significant progress in
addressing these questions, but there remains widespread
agreement that there should be more done.
The starting block for resilient CCPs is a strong,
effective risk governance framework. Each CCP makes the
decisions with respect to how they manage risk, including
setting membership and eligible collateral requirements,
establishing margin levels and overall financial safeguards,
and determining the products that they offer for clearing. At
the same time, clearing members bear the capital consequences
of loss through the collective funds they provide to the CCP
for loss mutualization. Therefore, risk governance rules should
evolve to ensure that those that bear potential losses have a
meaningful voice with how risk is managed.
This can be achieved by mandatory and meaningful
consultation and inclusion of clearing members in the decision-
making process, enhanced and consistent risk committee
standards, and appropriate levels of a CCP's own resources at
risk, often referred to as skin-in-the-game.
Robust and transparent stress testing is critical to
ensuring a CCP has sufficient resources should a clearing
member default. CCP-designed stress test frameworks should be
subject to more prescriptive global standards, and the testing
methodology should be more transparent to clearing members.
This is critical for clearing members to identify and manage
the risk inherent in using a specific CCP. Specifically,
regulatory-driven stress tests would provide oversight and
inform supervisory requirements by evaluating the adequacy of
the CCP's financial safeguards. Results of these tests should
be disclosed. We look forward to U.S. regulatory support on
this front as global standards are developed over the next
year.
While resiliency is important, it is also crucial to ensure
collectively that CCPs can recover from a threat to their
viability in order for them to continue to provide core
services to the market and avoid systemic contagion. But a
CCP's ability to allocate losses to clearing members through
recovery tools, such as cash calls on members, must be very
limited and subject to predetermined and predictable limits,
otherwise, they can be pro-cyclical and have a destabilizing
effect on the broader market. Moreover, bank regulators today
expect and demand it.
Last, well-defined plans and pre-established resources to
resolve systemically important CCPs in the case of an event are
still needed. If a CCP is no longer a viable entity, it must be
resolved in a manner that is not disruptive to the marketplace,
and without public support. An effective resolution plan does
not result in wind-down or liquidation, it means having tools
and resources to replenish the default fund and regulatory
capital, and reopen for business with a recapitalized CCP that
can continue to provide these critical services to the market.
Thank you, and I look forward to taking questions.
[The prepared statement of Ms. Rosenberg follows:]
Prepared Statement of Marnie J. Rosenberg, Global Head, Clearinghouse
Risk and Strategy, JPMorgan Chase & Co., New York, NY
Introduction
Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee, thank you for holding this hearing and for extending
JPMorgan Chase the opportunity to present our views. My name is Marnie
Rosenberg, and I am the Global Head of Clearinghouse Risk and Strategy
within JPMorgan Chase's independent Risk Management Function.
We appreciate the Committee's leadership in holding this series of
hearings to review implementation of the derivatives reforms agreed by
the Group of Twenty (G20) in 2009.\1\ It is and will continue to be
important to ensure the objectives of increased transparency and a
reduction in systemic risk are being met, while also monitoring the
impact on the derivatives markets and the ability for businesses to
access those markets to manage risk.
---------------------------------------------------------------------------
\1\ http://www.g20.utoronto.ca/2009/2009communique0925.html.
---------------------------------------------------------------------------
As this Committee knows well, American companies use futures and
swaps to manage a wide variety of risks they encounter in their day-to-
day business, such as interest rate risk when companies borrow money,
currency risk when they sell their goods overseas or commodity risk
posed by fluctuations in prices of raw materials used in production.
JPMorgan works with companies from all industry sectors who seek to
hedge their risks in the swaps markets, which allows them to do so in a
flexible and customized manner that is not possible in the exchange-
traded markets. We serve end-users by providing liquidity, financing
and customized risk management solutions across markets, including
energy, metals and agricultural markets.
In addition, JPMorgan is a leading provider of access to clearing
across the globe, with fifty-four memberships at forty-two clearing
houses, or ``CCPs'' that offer futures and/or swaps clearing. In
addition to its clearing memberships, JPMorgan provides services
directly to CCPs globally, acting as a liquidity provider, cash
manager, investment advisor, settlement bank and custodian.
I lead a team that focuses on understanding current and proposed
CCP structures and identifying, mitigating and reducing membership risk
and exposures to enhance how JPMorgan measures and manages our exposure
to CCPs. We apply this experience and expertise to develop policy
recommendations on CCP risk issues and to proactively engage in policy
discussions affecting CCPs to best ensure a safe and sound financial
system.
Today, I will focus on the importance of robust risk management
frameworks at CCPs to the safety and soundness of the financial system.
Overview of State of Reform
Following the financial crisis, the leaders of the G20 nations
agreed to a series of measures to increase the transparency of the
over-the-counter (OTC) derivatives market and to reduce systemic risk.
The reforms agreed to by the G20 included clearing of standardized OTC
derivatives through CCPs, trading of standardized OTC derivatives on
electronic platforms where appropriate, higher capital and minimum
margin requirements on non-centrally cleared contracts, and requiring
that all OTC derivatives transactions be reported to trade
repositories.
Global initiatives have been underway to implement these changes
for some time and they are in various states of legislation,
regulation, and implementation. Many of these reforms have brought
significant progress in a number of key areas, including: mandatory
registration and regulation of swap dealers; mandatory clearing of
standardized contracts between financial firms; greater pre- and post-
trade transparency through public reporting requirements; and execution
of certain standardized contracts on swap execution facilities (SEFs).
The Commodity Futures Trading Commission (CFTC) has written and
adopted the bulk of regulations required to implement swaps market
reforms under Title VII of the Dodd-Frank Act. These and other reforms,
taken together, have reduced risk in the system and have facilitated
greater transparency for regulators and market participants. They have
also fundamentally altered the market structure of swaps: how and where
these instruments are traded, the economics of transactions, the nature
of products available to American companies and the liquidity and
efficiency of these markets. And as I will discuss later in my
testimony, mandatory clearing, in particular, has intensified the
importance among regulators and market participants for CCP risk
management standards across all clearinghouses, not just those that
clear derivatives. This development is a positive outcome for overall
market stability but our work is not yet complete. CCPs have now become
deeply interconnected and core to our derivatives markets but we have
yet to fully evolve their risk management and governance models to
reflect this increasingly critical role.
This change in market structure is demonstrated by the fact that,
for the interest rate swap markets as of the first quarter of 2016,
82.5% of the average daily notional value is now centrally cleared, and
nearly \1/2\ of the average daily trading activity is executed on a
swap execution facility.\2\ In contrast, in 2013, only 57.7% of the
average daily notional value of interest rate swaps market was
centrally cleared.
---------------------------------------------------------------------------
\2\ http://www2.isda.org/functional-areas/research/research-notes/.
---------------------------------------------------------------------------
Now that the rules are largely in place and cleared volumes have
increased, it is important for the CFTC and other policymakers to: (1)
consider the implications of the changes to the derivatives markets,
such as the growing importance of central counterparties to financial
stability, and fragmentation in swaps markets; (2) review how emerging
risks might best be managed and mitigated; and (3) determine whether
adjustments to the rules or additional guidance may be appropriate to
ensure the markets continue to meet the needs of all market
participants.
The following observations and recommendations should be considered
as the Committee and the CFTC continue their ongoing work in this area:
Mandatory clearing requirements can reduce risk in the
derivatives markets. As the volume of centrally-cleared
contracts has increased, however, so has the importance of CCPs
as sources of systemic risk. Expectations are that CCPs will
only continue to grow in size, importance and inter-
connectedness.
Inter-connectedness among systemically-important CCPs and
clearing members has increased across jurisdictions. Global
CCPs share a common set of large members, raising the
likelihood that a default at one CCP will have a cascading
effect across the globe. These connections must be mapped and
well-understood, and broader industry preparedness is needed to
ensure that member default can be contained.
It is critical for policymakers, regulators and market
participants to review the existing CCP risk management,
governance and oversight models to ensure they are commensurate
with the systemic risk they now pose. Stakeholders need to
ensure that sufficient safeguards are in place to promote the
resilience of CCPs, and that there are robust plans in place to
manage extreme stresses to the financial strength of a CCP
without the use of public money. Similarly, operational
resiliency is of paramount importance, requiring strong
operational risk and cybersecurity risk management.
Specifically:
CCPs should be subject to enhanced resiliency
standards.
Effective risk governance is the fundamental building
block for resilient
CCPs. CCPs should be subject to global minimum governance
standards
and ``skin in the game'' requirements to promote
effective alignment of in-
terests and proper risk management.
CCPs should be transparent to market participants
regarding their risk
methodologies used to size their aggregate financial
safeguards. Higher
minimum standards are needed for CCP stress testing
frameworks, and
standard regulatory-driven, disclosed stress test
frameworks should be im-
plemented to provide confidence in the adequacy of loss
absorbing resources
held by CCPs.
Regulators, CCPs and clearing members globally should
work together to
implement and test default management protocols in a
coordinated manner
across CCPs.
Robust recovery tools should avoid pro-cyclicality and
market destabilization.
A CCP's ability to make cash calls on its members as
part of recovery must
be very limited and subject to a consistent global
standard.
Use of novel recovery tools, such as contract tear-up or
gains haircutting,
have the potential to impose unpredictable losses on
participants and
should be limited in CCP recovery and overseen by an
impartial authority.
Resolution plans should ensure continuity of clearing
services while minimizing risks to financial stability and
to taxpayers.
At the same time, new capital requirements under the
leverage ratio do not adequately reflect exposure from cleared
derivatives and have made it difficult for many clearing member
banks to offer clearing services. End-users are beginning to
feel the impact of this constraint through reduced access to
clearing and increased costs.\3\ This creates a distinct
tension between the safety and soundness objectives of
prudential regulators and those of market regulators, like the
CFTC, responsible for implementing the G20's clearing mandate
to reduce risk in the derivatives markets.
---------------------------------------------------------------------------
\3\ http://www.sifma.org/issues/item.aspx?id=8589958563; http://
www.commoditymkts.org/wpcontent/uploads/2015/11/CMC-MFA-Leverage-Ratio-
Letter-End-User-Impact-Final.pdf.
The recent agreement between the CFTC and the European
Commission with regard to recognition of U.S.-based CCPs by
European authorities was a critical development in ensuring a
global market for swaps. It also underscores the importance of
cross-border coordination on an ongoing basis among regulators
around the world, particularly as U.S. and EU authorities begin
---------------------------------------------------------------------------
discussions related to trading venue equivalence.
Finally, the use of SEFs is an important mechanism for
enhancing transparency in the swaps markets. Minor adjustments
to the CFTC's rules setting out the process for determining
swaps mandated to be traded on a SEF and the modes of execution
permitted would help to mitigate unnecessary reductions in
liquidity that have been widely observed since the SEF rules
went into effect.
The New Clearing Ecosystem
I. CCP Resiliency, Recovery and Resolution
One of the key components of the G20 agenda on derivatives reforms
was mandating the use of CCPsfor the clearing of all standardized OTC
derivatives contracts. A CCP interposes itself betweencounterparties to
a derivatives transaction, whereby the CCP becomes the buyer to every
seller and theseller to every buyer. The use of CCPs creates numerous
benefits for market participants and thefinancial system by providing
for centralized risk management and processing as well as risk
reductionthrough collateralization of trades and multilateral netting.
The increased use of CCPs has led to concentration of credit,
liquidity, operational and legal risk arising from OTC derivatives in a
small number of the large global CCPs. These risks are now centrally
managed by CCPs themselves and market participants must rely upon CCPs
to maintain appropriate membership criteria and risk management
standards, and conduct ongoing, adequate member due diligence. This
dependency upon CCPs to maintain strong risk management standards
existed prior to the introduction of mandatory swaps clearing but has
now become more pressing as mandatory clearing in multiple
jurisdictions has led to further concentration of risk while, at the
same time, market participants no longer have the option to execute and
clear bilaterally if they become concerned with a CCP's risk management
protocols. While mandatory clearing has been in effect in the U.S. for
nearly 3 years, market participants will need to begin complying with
the European Union's (EU) clearing requirement for OTC derivatives
products later this month.\4\ Other jurisdictions have also moved
forward with mandating the use of CCPs for certain standardized OTC
derivatives. Further, as rules imposing margin requirements on swaps
that are not cleared are implemented beginning in September 2016, an
even greater use of CCPs is anticipated from market participants
seeking to voluntarily clear additional products to benefit from margin
efficiencies and multilateral netting that can be gained through
clearing.
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\4\ https://www.esma.europa.eu/regulation/post-trading/otc-
derivatives-and-clearing-obligation.
---------------------------------------------------------------------------
Due to JPMorgan's role as a significant clearer in global
derivatives markets, it is imperative that we understand our own
exposure and risks to CCPs, and evaluate how and whether the current
regulatory and legal structures for CCPs are sufficiently suited to
their growing importance to the financial system. This is why JPMorgan
published a paper in 2014 called ``What is the Resolution Plan'' for
CCPs.\5\
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\5\ https://www.jpmorganchase.com/corporate/About-JPMC/document/
resolution-plan-ccps.pdf.
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In the current derivatives clearing ``ecosystem'', policymakers and
market participants need to address some key questions:
Are CCPs sufficiently resilient that they can withstand a
clearing member(s) default or major loss through sufficiently
strong first line of defense measures: are membership criteria
robust, is eligible collateral limited to the highest quality
liquid assets and are products that are cleared sufficiently
liquid, standard, and suitable for clearing?
Do CCPs have adequate plans to recover from such a loss and
carry on offering critical services?
If CCPs can't recover, do they have adequate plans to
continue to provide critical services and ensure the failure of
a CCP does not cause wider market instability or require
taxpayer assistance?
In response, we have come a long way, but more work is needed.
Currently, CCPs are expected to meet higher regulatory and risk
management standards, including internationally agreed to standards
published by the Committee on Payments and Market Infrastructure (CPMI)
and the International Organization of Securities Commissions (CPMI-
IOSCO) in 2012, referred to as the Principles for Financial Market
Infrastructures (PFMIs) \6\ as implemented in the U.S. by CFTC
rulemakings under authorities in Title VII and Title VIII of the Dodd-
Frank Act. Nevertheless, regulators around the world have acknowledged
that more work is needed, and CCPs have become a high priority on the
agenda for global financial regulatory standard-setting bodies,
including the Financial Stability Board and CPMI-IOSCO and we expect
this focus to continue. These bodies are largely comprised of
regulators, central bankers and in some cases, finance ministries from
the U.S. and around the world.
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\6\ http://www.bis.org/cpmi/publ/d101a.pdf.
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CCPs Should be Subject to Enhanced Resiliency Standards
A resilient CCP should have the ability to withstand severe stress
events such as clearing member defaults, and this can be achieved by
having strong membership requirements to ensure the soundness of its
clearing members while also ensuring fair and open access, robust risk
management standards and adequate capital and liquidity resources. A
resilient CCP must also be able to have sufficient controls and
protections in place to withstand significant losses stemming from non-
default events, such as fraud or a cybersecurity attack.
There are four key recommendations on how to improve CCP resiliency
and strengthen the clearing ecosystem:
(1) Effective risk governance is the cornerstone of resilient CCPs.
CCPs should be subject to global minimum risk governance
standards and ``skin in the game'' requirements to promote
effective alignment of interests and to incentivize strong
risk management.
Many CCPs have migrated from being utilities owned by members to
private for-profit institutions. This shift introduces an inherent
tension and potential conflict of interest between a CCP's role as a
market utility that can mutualize potential losses among its members
and its commercial objectives to increase revenues and earnings/
dividends for its shareholders and market share. The fact that its
members bear the losses also introduces an element of moral hazard.
CCPs make key decisions impacting the risk profile of the CCP and
its membership, with respect to the products that can be cleared, the
members who participate in the CCP, the framework used to mitigate the
risk brought in by participants, the type of collateral that can be
posted and the aggregate amount of safeguards to maintain. However, it
is clearing members of the CCPs that bear the capital consequences of
any losses, through the collective funds (the ``default fund'') they
provide to the CCP for loss mutualization. Therefore, CCP risk
governance structures should evolve to ensure that those that bear
potential losses and market risk as part of default management have a
meaningful voice with regard to how risk is brought into the CCPs.
Governance needs to be commensurate with the changed role of CCPs and
the new responsibilities that CCPs have within the financial system.
This can be achieved by mandatory, meaningful consultation and
inclusion in the decision making process for clearing members,
availability of appropriate, funded amounts of a CCP's own resources
(``skin in the game'') and increased capital available at the end of
the waterfall.
Governance. Members themselves must have more of a say in material
risk decisions that are made by the CCP as it impacts their own capital
contributions through the default fund. Current U.S. regulation does
not require CCPs to incorporate and demonstrate input from clearing
members or CCP risk committees early in the process with respect to key
risk management decisions impacting clearing members' liability. CCPs
globally should therefore be required to obtain input from their
clearing members and the CCP's relevant risk committees on all material
risk matters such as products that can be cleared, changes to loss
mutualization rules, and post-default risk management decisions. CCPs
should be required to maintain records and report any conflicts between
CCP decision, risk committee opinion and clearing member views. In
addition, consistent global standards are needed with respect to a
CCP's risk committees. Risk committees should be required to have
clearly-defined mandates, diverse memberships, and minimum member
qualifications. The risk committee representatives should provide an
independent, expert opinion on a CCP's risk management strategy and the
impact of a CCP's actions on CCP and member stability, market integrity
and clients.\7\ If the views of a CCP's risk committee are not
incorporated by the CCP in making key risk management decisions, the
CCP should be required to document and disclose to regulators how the
risk committee's views have been addressed.
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\7\ https://www.theclearinghouse.org/issues/articles/2015/09/
20150918-tch-comments-to-cpmi-iosco-on-ccp-riskgovernance.
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``Skin-in-the-game''. CCPs should be subject to a meaningful risk-
based minimum contribution to the guarantee fund ahead of non-
defaulting members called ``skin in the game'' (SITG). While many CCPs
currently contribute such capital to their overall financial
safeguards, the current level of CCP contributions, at generally less
than 5% of the member default fund, are not sufficient. The CFTC
currently does not require CCPs to have minimum SITG capital
contributions. CPMI-IOSCO is expected to issue a market consultation
this year to set global standards, which is a welcome and positive
development. Having a risk-based, minimum level of SITG would
appropriately align incentives amongst the CCP and its members and
ensure proper risk management and governance. Aligning and scaling CCP
contributions with those of the largest clearing members will also help
to ensure that membership requirements remain strong and will limit the
possibility that any single member becomes too large as a proportion of
total risk.
CCP Capital. The current minimum CFTC and global capital
requirements for CCPs should be reviewed. Currently, CCPs are required
to cover at least 6 months of operating expenses under CPMI-IOSCO
standards and twelve months under CFTC requirements. This is primarily
meant to cover business and operating risk and any losses that arise by
a non-member default event such as cyber risk, technology failure, or
fraud. However, CCP capital should be available for both default and
non-default losses. Members should not be responsible for non-default
losses. This should be the responsibility of the CCP's shareholders.
The size and impact of such events are untested and the current capital
levels may be insufficient to cover losses. Sufficient standards are
needed to address operational risk, and in particular, cyber-risk
through investments in expertise and ensuring infrastructures to handle
these risks are adequate. This is front and center on the international
regulatory agenda and the work done by CPMI-IOSCO and the CFTC to
address these risks through consultations on cybersecurity and
operational controls is another welcome and positive development.
(2) CCPs should be more transparent to market participants regarding
risk methodologies used to size their aggregate financial
resources to cover the largest single (or two) member
defaults.\8\
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\8\ http://www.bis.org/cpmi/publ/d101a.pdf.
Clearing members and their clients must have access to and
transparency around the methodologies used by CCPs to develop financial
safeguards in order to identify and manage the risks inherent in using
a specific CCP. For example, transparency regarding stress scenarios
used by a CCP to determine the size of financial safeguards is
necessary to provide clarity to participants on whether the CCP has
sufficient resources to absorb default losses.
While the industry has made significant progress on CCP
transparency over the last 3 years, more must be done. Regulators
around the world continue to voice support for market participants'
calls for transparency and now require public disclosures through the
CPMI-IOSCO quantitative disclosures standard that was published in
February 2015.\9\ Current, standard disclosures are useful to
participants on many levels but these disclosures alone are not
sufficient as they do not permit CCP users to replicate margin models
and do not provide details of the stress scenarios that a CCP has
determined it will be able to withstand. The more market participants
can adequately measure and manage their credit risks to CCPs, the more
confidence the system will have that CCPs have sufficient resources to
withstand a crisis.
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\9\ http://www.bis.org/cpmi/publ/d125.pdf.
(3) More prescriptive, minimum global standards are needed to govern
CCP stress testing along with the establishment of standard
regulatory-driven, disclosed stress test frameworks to
provide confidence in the adequacy of aggregate financial
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safeguards held by CCPs.
Adequate stress testing of CCP members and their client portfolios
is key to evaluating whether a CCP has sufficient resources should a
clearing member(s) default. To ensure this, a CCP's financial
safeguards should be sized based on CCP-designed stress test frameworks
that are subject to minimum and more prescriptive standards that are
transparent to clearing members and other market participants. In
addition, there should be regulatory-driven stress tests that then
provide oversight and inform supervisory requirements by evaluating the
adequacy of the CCP's financial safeguards with appropriate
consequences should a CCP fail the test.
There has been significant progress towards enhanced standards for
stress testing,\10\ and CPMI-IOSCO is expected to issue a consultation
with additional guidance for CCPs in the third quarter of 2016. In
addition, European regulators recently conducted stress tests of CCPs
in Europe, and it is important that such a framework is extended to
CCPs globally.
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\10\ In July of 2015, ISDA sent a letter to CPMI-IOSCO setting out
the industry's principles for CCP stress testing: www.isda.org.
(4) Regulators, CCPs and clearing members globally should work
together to develop, implement and test standard default
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management protocols in a coordinated manner across CCPs.
It is important for policymakers to consider that a large clearing
member default could occur simultaneously at multiple CCPs and that
CCPs are highly dependent upon non-defaulting members to help manage
the default, participate in the default management process and absorb
the defaulter's portfolio with its associated market risks. A CCP's
dependency upon the resources and expertise of its broader membership
to achieve a successful default management outcome cannot be
underestimated, and market and prudential regulators, CCPs and all of
their participants have a vested interest in making sure this happens.
Currently, while each CCP tests its default management protocols with
its members through default management fire drills, these drills are
done in isolation and not in collaboration with other CCPs. An extreme
market stress event that occurs across CCPs in multiple jurisdictions
could severely constrain the ability of non defaulting members to
respond effectively. In order to ensure market preparedness for such an
event, a coordinated approach to drills under the joint oversight of
relevant regulators, and a push for more standardized default
management protocols among global CCPs is necessary. As an example, a
recent joint default management exercise run by UK and German
authorities coordinated across two CCPs, LCH and Eurex, was an
important step in the right direction. However, more is needed,
including involvement of U.S. CCPs and authorities in future work. This
will be a topic at an upcoming Market Risk Advisory Committee meeting
at the CFTC, for example, which is a very welcome development.
Robust Recovery Tools Should Avoid Pro-Cyclicality and Market
Destabilization
Focusing on CCP resilience is a necessary first step, but it is not
sufficient on its own. To the extent that resiliency measures are not
sufficient, CCPs are required to have robust recovery plans that ensure
continuity. ``Recovery'' refers to the ability of a CCP to recover from
a threat to its viability so that it can continue providing its
critical services without entering into resolution or insolvency. While
efforts are appropriately focused on reducing the likelihood of any CCP
entering recovery, it is important that CCPs are prepared through
comprehensive and effective recovery plans that are also transparent,
measurable and acceptable to members who bear the majority of the risk.
In 2013, the CFTC adopted rules requiring systemically important
CCPs to comply with international standards for CCPs, including a
requirement to maintain viable recovery plans. Since that time, U.S.
CCPs have been revising their end of waterfall rules to put in place
robust processes, agreements and defined tools to support recovery.
Clearly defined, transparent, and robust ex ante CCP recovery plans
that do not lead to destabilizing and pro-cyclical effects are
essential. Specifically:
(1) A CCP's ability to make cash calls on its members as part of
recovery must be very limited and be subject to a
consistent global standard.
Currently, CPMI-IOSCO and the CFTC do not prescribe rules with
respect to the number of cash calls that a CCP can impose upon its
members. This has led to CCPs implementing varied rules which make it
difficult for members to measure and manage their own exposures. The
interconnectedness among CCPs suggests that there could be multiple,
simultaneous cash calls on the same clearing members. In the absence of
limits, the cash calls may not be reliable, particularly in a stressed
market, and could lead to liquidity and funding issues that would be
vectors for further financial instability.
(2) Use of novel recovery tools, such as contract tear-up or gains
haircutting, have the potential to impose unpredictable
losses on participants and should be limited in CCP
recovery and overseen by an impartial authority.
Gains haircutting is a tool for allocating losses in recovery that
is being implemented by CCPs to satisfy their regulatory requirement to
ensure comprehensive loss allocation. This tool allows CCPs to reduce
any payments it owes to participants. Most importantly, it could lead
to disproportionate distribution of losses to certain market
participants, which could in turn incentivize such participants to take
actions with respect to their positions that are destabilizing or
otherwise inhibit the CCP's recovery.
Similarly, CCPs have proposed partial tear-up as a way to restore
the CCP to a matched book should default management protocols fail to
successfully liquidate the defaulter's portfolio. The CCP would tear-up
positions of the defaulter and those non-defaulting participants that
hold equal and offsetting positions at a price determined by the CCP.
Because this tool would be used during a period of illiquidity,
establishing a fair market price would be quite challenging and
subjective on the part of the CCP.
A CCP's decision to use recovery tools like gains haircutting and
partial tear-up should be overseen by an impartial authority, and
require compensation to be paid by the CCP to participants who suffer
losses. While the CPMI-IOSCO recovery report already contemplates
compensation in particular, U.S. regulators should consider issuing
guidance in this regard.
Resolution plans should ensure continuity of clearing services
while minimizing risks to financial stability and to taxpayers.
If a CCP is no longer a viable entity for the performance of its
critical functions, it should be resolved in a manner that is not
disruptive to the marketplace, is not reliant on taxpayer assistance
and allows for operational continuity of a newly capitalized entity
under new ownership that can continue its critical functions.
The trigger point for resolution should be the point at which the
exercise of recovery tools becomes too destabilizing for the market,
threatens the sustainability of the CCP or when the CCP is otherwise
near or in default. As opposed to recovery, a resolution would be
managed by resolution authorities, such as the Federal Deposit
Insurance Corporation (FDIC) in the U.S., and could lead to a change in
ownership, a write-down of the CCP's equity and the replacement of the
CCP's management.
Resolution authorities should develop public sector playbooks or
action plans that facilitate continuity, are made available to
participants on a confidential basis, address default and non-default
losses and provide resolution authorities with appropriate flexibility
to determine the entity to be put in resolution. In addition, CCP
resolution plans should not interfere with the resolution plans of
clearing members, or lead to contagion in other services or segments
cleared by the CCP, and should minimize risks to market participants
and the broader financial system. CCP resolution plans should also
specify ex-ante resources for the recapitalization of the CCP with
respect to both regulatory capital as well as default fund
replenishment so that it can re-open for business and provide its
critical services without taxpayer assistance.\11\
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\11\ The Clearing House and the International Swaps and Derivatives
Association recommended in a recent industry paper that authorities
should consider the ``implementation by CCPs of arrangements to
maintain replenishment resources that could be used to backstop the
timely replenishment of the default fund on an interim basis (or any
failure of a clearing member to perform its replenishment
obligation).''
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The resolution regime in the U.S. currently provides for CCPs to be
resolved under Title II of Dodd-Frank, but it does not provide any
further framework regarding the tools or resources that can be used to
resolve CCPs. Further work needs to be done to confirm how a Title II
resolution would be effectuated for the different ownership and capital
structures of systemically-important CCPs.
Recognizing the need for greater prescription, the Financial
Stability Board (FSB) is expected to consult later this year on further
guidance on strategies and tools for CCP resolution, such as the
resources that can be used, the structure to be adopted, the legal
framework to be applied, the authority responsible for resolution, and
cross-border coordination issues in the context of a CCP resolution.
U.S. regulators should issue new guidance in line with the FSB's
recommendations, which would also support future equivalence
discussions with various jurisdictions.
II. Capital Constraints are Reducing Access to Clearing for Market
Participants
This Committee and the CFTC should be complimented for their
leadership in examining the impact of the leverage ratio on the cost of
clearing for end-users and other market participants. Clearing members
are fully responsible to the CCP for the performance of the
transactions they clear for their clients, and clearing members collect
margin from those clients to offset their exposure to them. The margin
collected by clearing members is segregated from our own funds as
required by the Commodity Exchange Act and firms cannot leverage it.
The Basel Committee's leverage ratio proposal, however, does not
recognize the exposure reducing effect of the margin collected, and
does not allow firms to offset off-balance exposure arising from client
transactions against the value of the margin maintained in segregation.
This approach creates a disincentive for many clearing member banks
to offer clearing services due to the higher capital requirements, a
result at odds with the G20 mandate to move more derivatives into
central clearing. End-users are already seeing the effects of this
approach, as there are fewer banks offering clearing services and end-
users are already seeing the price of clearing increase.\12\
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\12\ http://www.sifma.org/issues/item.aspx?id=8589958563; http://
www.commoditymkts.org/wpcontent/uploads/2015/11/CMC-MFA-Leverage-Ratio-
Letter-End-User-Impact-Final.pdf
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In its recent consultation regarding revisions to the leverage
ratio, the Basel Committee did seek input from stakeholders regarding
the impact of the failure to recognize initial margin as an offset, on
the cost of clearing. An industry-wide response is being prepared to
demonstrate the reduction in access to clearing for end-users, and we
appreciate and look forward to the continued support of this Committee.
III. Mutual Recognition of CCPs is Key to a Global Derivatives Market
The G20 leaders' 2009 agreement on derivative reform included a
commitment to undertake reform without causing market fragmentation.
This is an important goal given the global nature of the derivatives
market. In practice, despite common objectives, technical and legal
differences in national rule implementation have led to concerns around
regulatory conflicts, inconsistencies, arbitrage, gaps and duplicative
requirements which could undermine this goal. Subsequent G20
communiques have emphasized the need for regulators to address these
issues.
The lengthy negotiation between U.S. and EU authorities on EU
recognition of U.S.-based CCPs regulated by the CFTC illustrates the
challenges faced. Policymakers had struggled to reach agreement due in
part to differences in the applicable initial margin regimes in each
jurisdiction. Following negotiations lasting over 2 years, in February
2016, the CFTC and European Commission announced a ``Common Approach''
regarding requirements for CCPs.\13\ This was a welcome development,
alleviating prolonged uncertainty which had been detrimental for market
participants in the U.S. and EU, as well as in other jurisdictions
seeking recognition in these markets.
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\13\ http://www.cftc.gov/PressRoom/PressReleases/
cftc_euapproach021016.
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The agreement between EU and U.S. authorities is critical to
mitigating unnecessary reductions in cross-border trading and market
liquidity by ensuring market participants across both continents have
continued access to CCPs in each other's markets, and to prevent
European banks from facing punitive capital requirements for exposures
to U.S.-based CCPs.
The process will help to instruct and streamline future equivalence
and substituted compliance determinations between U.S., EU and other
authorities, particularly with respect to equivalence for trading
venues and substituted compliance for clearing, trade execution and
margin requirements, to ensure that derivative markets remain global,
liquid and resilient. It is important that regulators focus on thematic
and outcomes-based determinations, rather than pursuing a granular
element-by-element approach. It is also important to recognize that
markets are global and that the global economy benefits most if capital
is able to freely flow across those markets.
Trade Execution and the Implementation of the SEF Mandate
I. Evolution in Swaps Execution
Title VII of the Dodd-Frank Act established a comprehensive
regulatory framework for swap trading platforms with the intent of
furthering two policy objectives: (1) increasing pre-trade transparency
to market participants before the point of execution; and (2) promoting
trading on regulated exchanges. To achieve these objectives, Title VII
created new types of trading facilities for swap execution known as
swap execution facilities (``SEFs''), established core principles for
the orderly and efficient operation of SEFs and introduced a
requirement that certain swaps subject to the trade execution
requirement in Section 2(h)(8) of the Commodity Exchange Act (``CEA'')
be traded on or pursuant to the rules of a SEF or traditional exchanges
(designated contract market (``DCM'')).
In June 2013, the CFTC adopted final rules that, among other
things, defined which trading facilities and platforms must register as
SEFs, established prescriptive requirements for SEFs to operate in
accordance with SEF core principles and, although not expressly
required by Dodd-Frank, created a process for determining which swaps
are subject to the CFTC's trading mandate (``Mandated Swaps''). That
process is commonly known as the ``made available to trade'' or ``MAT''
process. The CFTC's final rules' further required that all multiple-to-
multiple trading platforms that list swaps to register as SEFs, even if
those platforms do not offer Mandated Swaps for trading.
Since the CFTC's final trade execution rules came into force in
October 2013 and the introduction of SEFs the CFTC's reforms have
brought greater transparency, better price information and significant
enhancements to market integrity. Notwithstanding these achievements,
research shows that global derivatives markets have fragmented along
geographic lines.\14\
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\14\ https://www2.isda.org/functional-areas/research/research-
notes/.
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These rules require all electronic trading platforms that provide
access to U.S. investors for swap execution to register with the CFTC
as SEFs. Under the CFTC's final rules, Mandated Swaps must be executed
on a SEF or DCM through an electronic order book or a request-for-quote
system that operates in conjunction with an order book.\15\ This
trading requirement has fundamentally changed the trading protocols and
widely-accepted trading practices that were in place for market
participants before the adoption of the CFTC's final rules.
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\15\ A request-for-quote system is a type of electronic bidding
solicitation in which a requester (i.e., a client) seeks bids from
several dealers to provide a price quote for the execution of a
particular swap.
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In February 2014, the first series of swaps became subject to the
CFTC's trading mandate. As of that date, all U.S. persons (and non-U.S.
persons trading with U.S. persons) had to trade Mandated Swaps on
registered SEFs or DCMs and all SEFs and DCMs that listed Mandated
Swaps were required to do so in accordance with the CFTC's final rules.
II. Market Impact of the CFTC's Final Rules
In effect, since the CFTC's trade execution requirements are
restrictive and burdensome, non-U.S. market participants are choosing
not to trade on SEFs. In addition, since the CFTC has not establish a
process of recognizing non-U.S. trading venues that are subject to
comparable regulatory oversight, U.S. participants have limited access
to these non-U.S. based platforms and arguably non-U.S. liquidity
pools.
These unintended consequences are most evident in the global
interest rate swap markets which have inhibited market participants
from getting better pricing on derivatives resulting from varying
levels of market fragmentation. This pattern is most persistent in
euro-denominated interest rate swaps (IRS), where the vast majority of
trading activity occurs between European dealers. ISDA research finds
that 91.2% of cleared euro IRS activity in the European interdealer
market was transacted between European counterparties in December 2015.
In September 2013, immediately prior to the introduction of the SEF
rules, this figure stood at 70.7%.\16\
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\16\ https://www2.isda.org/functional-areas/research/research-
notes/.
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Although concerns over best pricing have been discussed for almost
3 years, there are no signs currently that this trend is reversing.
CFTC Chairman Massad's recent statements that suggest the CFTC is
planning to make some adjustments to their final trade execution rules
are welcome and important for promoting market efficiency. In this
regard, market participants have put forth recommendations to improve
pricing and restore liquidity in the derivatives markets, while still
achieving the objectives of the reforms.
III. Market Participants Want Additional Choice in Execution and
Greater Flexibility in SEF Rules
As noted above, the CFTC's final rules require SEFs to provide
execution methods that may include either an order book (similar to an
exchange) or a request for quote to a minimum of three participants.
Many of our U.S. clients want flexible trading requirements and
protocols that will provide competitive and efficient execution based
on the unique characteristics of a particular product.
The Dodd-Frank Act does not require that SEFs only execute
transactions by means of an order book or a request-for-quote system to
three. Such a restrictive interpretation contradicts Congressional
intent to allow swaps to be traded by ``any means of interstate
commerce,'' discourages trading of swaps on SEFs and hurts pre-trade
price transparency.\17\ The CFTC's restrictive interpretation makes it
difficult to achieve the broad goal of global swaps trading envisioned
by the G20 member countries. In Europe, policymakers and regulators
intend to allow derivative contracts that are subject to the trading
obligation to be traded on a number of centralized venues, which offer
more flexible methods of execution than provided for under the CFTC's
SEF rules.
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\17\ 7 U.S.C. 1a(50) (2015).
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There are achievable ways in which to reduce the undesirable
regulatory outcomes that threaten the efficient functioning of the
swaps markets, reduce barriers to market access for U.S. market
participants looking to trade abroad and for non-U.S. market
participants wishing to trade efficiently in the United States, and
minimize roadblocks to an effective cross-border regulatory regime,
while preserving increased transparency and market integrity.
The CFTC should consider amending its rules to allow the CFTC,
under certain circumstances, to approve additional methods of execution
for Mandated Swaps. In addition, adjusting SEFs' execution models could
facilitate a path toward achieving a substituted compliance regime for
derivatives trading.
IV. The MAT Process Should Give the CFTC Decision-Making Authority With
Regard to Products Mandated To Be SEF Traded, and Market
Participants Should Have the Opportunity To Provide Input
Under the current MAT process, a SEF or DCM files with the CFTC,
identifying the swap or swaps that will be subject to the CFTC's
trading mandate. The only requirements or regulatory standards that the
SEF's or DCM's analysis must meet are that: (1) the swaps in the
submission must already be subject to mandatory clearing; and (2) the
submission must consider one of six factors, broadly defined. Depending
on the type of submission, in either 10 or 30 days following the
official filing date, the SEF's MAT determination becomes law and
applies to all SEFs, DCMs and market participants. SEFs are for-profit
entities and this framework does not appropriately balance their
commercial interests with the needs of market participants nor does it
provide the CFTC with an adequate voice in the approval process.
Specifically:
The MAT process should require SEFs to provide a more
granular explanation as to why a particular swap contains the
requisite trading liquidity for mandatory trading. For example,
SEFs should present additional quantitative and qualitative
data as part of their MAT determination assessment.
The public should be given the opportunity to provide
comments to a SEF's MAT determination submission through a
public consultation process.
The CFTC and not SEFs should make the final decision as to
when a swap should be considered to be a Mandated Swap.
The CFTC should view a swap's availability for mandatory
trading as a fluid determination. The SEF rules do not provide
sufficient flexibility to both SEFs and SEF users to remove a
certain swap from a MAT determination if the trading
characteristics of the swap change such that it is no longer
suited for trading through a SEF's order book or through a
request for quote to three participants.
Market participants understand the CFTC is actively evaluating
reforms to the MAT process and such refinements would be welcome.
IV. Trading Venue Equivalence Will Reduce the Risk of Further Market
Fragmentation and Promote Trading Liquidity Between U.S. and
Non-U.S. Markets
Other jurisdictions are at various stages of developing their own
trade execution regulatory regimes. For example, the EU is in the
process of developing its trading proposals, and its trading obligation
is not expected to be implemented until 2018. Notwithstanding that
foreign regulatory regimes are in their formative stages, it is
encouraging that the CFTC has begun coordinating with foreign
regulators to facilitate mutual recognition of trading platforms and
trading requirements.
To reduce the risk of market fragmentation and to enhance trading
liquidity between U.S. and non-U.S. markets, the CFTC should apply the
principles outlined in the Final Report issued by IOSCO Task Force on
Cross-Border Regulation and recognize and highlight the broad
commonalities between the U.S. and foreign regulatory regimes, rather
than focus on the more technical, line-by-line differences between the
underlying rules.
The CFTC should compare its final trading rules with foreign
regulations designed to achieve corresponding regulatory outcomes.
Where these requirements are satisfied, the CFTC should provide that
the foreign trading venues are exempt from SEF registration and
compliance with the SEF rules, and that where a swap is subject to the
CFTC's trading mandate, the parties to such a swap may satisfy the
obligation to comply with the CFTC's trading mandate by executing such
a swap on a foreign trading venue in accordance with applicable rules,
regardless of their status as a U.S. person or otherwise.
Congress directed the CFTC to exempt a trading venue from CFTC
registration if the CFTC finds that the facility is ``subject to
comparable, comprehensive supervision and regulation on a consolidated
basis by . . . the appropriate governmental authorities in the home
country of the facility.'' This creates concerns about the competitive
harm to American companies resulting from differences in final
regulations, the gap in implementation dates in Europe and other
jurisdictions as well as confusion over the extraterritorial
application of these provisions. Congress provided the CFTC with broad
authority to exempt platforms to adopt such a restrictive approach to
mutual recognition. To that end, market participants see this authority
as a helpful mechanism by which Congress intended the CFTC to pursue a
more flexible approach based on global regulatory collaboration.
The work the CFTC and EU regulators have undertaken to date
discussing these issues is important. In February 2016, both regulators
announced the U.S./EU Common Approach, which market participants hope
will result in greater harmonization of global trade execution
standards.
Conclusion
We thank the Committee for the opportunity to share this
perspective and we offer our assistance to policymakers in addressing
issues that promote the viability of markets critical to end-users and
economic growth.
With the implementation of mandatory central clearing, CCPs have
become an increasingly important component in the overall safety and
soundness of the financial system. It is therefore critical that
policymakers and market participants ensure the risk management
frameworks in place at CCPs are sufficiently robust to reflect this
enhanced role, particularly as central clearing is no longer optional
for many market participants seeking to manage risk.
Similarly, it is important for regulators to review the various new
requirements, with regard to both market reforms and new prudential
standards, to understand any interconnections and ensure objectives are
aligned. The leverage ratio's failure to recognize the exposure
reducing effect of initial margin for client clearing is an example
where regulatory objectives are at odds and it is already manifesting
in reduced access to clearing services for some market participants.
Last, minor adjustments to the CFTC's SEF rules would support
market efficiency, while maintaining the core objectives of enhanced
transparency and market integrity.
The Chairman. All right, thank you, Ms. Rosenberg.
Mr. Merkel.
STATEMENT OF STEPHEN M. MERKEL, J.D., EXECUTIVE VICE PRESIDENT,
GENERAL COUNSEL AND SECRETARY, BGC PARTNERS, INC.; DIRECTOR,
WHOLESALE MARKETS
BROKERS' ASSOCIATION, AMERICAS, NEW YORK, NY
Mr. Merkel. Thank you, Chairman Scott, Ranking Member
Scott, and Members of the Subcommittee.
My name is Stephen Merkel. My company, BGC Partners, is a
leading global intermediary to the wholesale financial markets.
I am testifying today as a Director and former Chairman of the
Wholesale Markets Brokers' Association, Americas, an
independent industry body, representing the largest interdealer
brokers. Each of our members has a CFTC-registered swap
execution facility, or SEF.
Mr. Chairman, it has been a long, strange trip, from the
early versions of what would ultimately result in the Dodd-
Frank Act, to the current state of affairs. Generally speaking,
nothing has gone as planned.
The SEF rules demonstrate an interpretation inconsistent
with the new Commodity Exchange Act statutory authority. The
subsequent SEF registration process highlighted numerous
defects in the rules. As a result of these detours, we found,
and find, ourselves in an environment of regulatory
uncertainty, fragmented liquidity, and a need for course
corrections by the CFTC.
Looking forward, and putting it simply, we all need to
support the CFTC to fine-tune its rules and enjoy harmonious
relationships around the world.
I credit highly the dedicated CFTC staff who completed an
enormous amount of work, designing and implementing the
architecture for a regulatory regime. CFTC staff has helped us
through the registration process to become a SEF, accommodated
us through the issuance of no-action letters, staff guidance,
and interpretative statements. Unfortunately, this reactive and
ad hoc process cannot easily cover every problem or need, and
fails to provide the same regulatory certainty as APA compliant
rules.
My written testimony references a series of outstanding
substantive issues that need to be resolved. We are encouraged
by Chairman Massad's recent statement that CFTC will seek to
codify the existing no-action letters under the formal
rulemaking process, and we urge them to address a wider set of
issues in that release.
There have also been pronounced market implications.
Liquidity has fragment by jurisdiction as non-U.S. participants
seek to avoid Dodd-Frank.
My written testimony cites the recent ISDA research and the
Bank of England staff study on this point. The research warns
that there is no sign of this trend reversing.
This arrangement is not sustainable, nor is it consistent
with the visions set forth in Pittsburgh in 2009. Because this
is a new regulatory framework, the CFTC should regularly
analyze market data to study the impact of its rules. If ISDA
and the Bank of England can do this, the CFTC should too. The
research should be published, conclusions publicly commented
on, and the resulting product should inform future policy
initiatives.
The path forward for any future mutual recognition process
will need to resolve the awkward regulatory relationship among
jurisdictions. Current comparison of Dodd-Frank in MiFID II
raises questions about whether the two can coexist, including
the CFTC's past failed attempt to institute a qualified
multilateral trading facility regime.
There are also divergent approaches to the permitted
methods of execution with, for example, MiFID explicitly
identifying auction protocols. Furthermore, the CFTC's reliance
on no-action relief is a procedural tool that is not recognized
in Europe.
Mr. Chairman, I hope this Subcommittee will encourage the
CFTC to make mutual recognition and equivalency a high
priority.
I would be pleased to answer your questions. Thank you.
[The prepared statement of Mr. Merkel follows:]
Prepared Statement of Stephen M. Merkel, J.D., Executive Vice
President, General Counsel and Secretary, BGC Partners, Inc.; Director,
Wholesale Markets Brokers' Association, Americas, New York, NY
Introduction
Chairman Scott, Ranking Member Scott, and Members of the
Subcommittee, thank you for providing this opportunity to participate
in today's hearing.
My name is Stephen Merkel. I am the Executive Vice President,
General Counsel and Secretary of BGC Partners, Inc. (``BGC Partners''),
a leading global intermediary to the wholesale financial markets,
specializing in the brokering of a broad range of financial products,
including fixed income, interest rate derivative, foreign exchange,
equity, equity derivative, credit derivative, listed futures,
commodity, and structured product markets. BGC Partners was created in
August 2004, when Cantor Fitzgerald separated its voice and electronic
interdealer brokerage business from its dealer activities.
I am testifying today in my capacity as a Director and former
Chairman of the Wholesale Markets Brokers' Association, Americas (the
``WMBAA''), which represents BGC Partners, GFI Group, Tradition, and
Tullett Prebon.\1\ Each of the WMBAA member firms has registered a swap
execution facility (``SEF'') with the Commodity Futures Trading
Commission (``CFTC''). For each of the last 7 years, we have
collectively hosted a 1 day conference in Washington or New York
appropriately entitled ``SEFCON'' that explores the top issues facing
our industry and over-the-counter (``OTC'') markets from both a
domestic and global perspective. The WMBAA extends thanks to the
Chairman and other Members of the Agriculture Committee who have
attended and shared their thoughts at this marquee event.
---------------------------------------------------------------------------
\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers. The founding members of the group--BGC
Partners, GFI Group, Tradition, and Tullett Prebon--operate globally,
including in the North American wholesale markets, in a broad range of
financial products, and have received permanent registration as swap
execution facilities. The WMBAA membership collectively employs
approximately 4,000 people in the United States; not only in New York
City, but in Stamford and Norwalk, Connecticut; Chicago, Illinois;
Jersey City and Piscataway, New Jersey; Raleigh, North Carolina; Juno
Beach, Florida; Burlington, Massachusetts; and Dallas, Houston, and
Sugar Land, Texas. For more information, please see www.wmbaa.com.
---------------------------------------------------------------------------
Thank you for inviting me to speak with you about the ongoing
implementation of the September 2009 Pittsburgh G20 commitments to
improve OTC derivatives markets.\2\ The WMBAA remains supportive of
coordinated global efforts to promote trading on regulated venues,
central counterparty clearing, and public reporting of standardized OTC
derivative contracts in order to ``improve transparency in the
derivatives markets, mitigate systemic risk, and protect against market
abuse.'' \3\
---------------------------------------------------------------------------
\2\ See Leaders' Statement, the Pittsburgh Summit, September 24-25,
2009, available at
https://www.treasury.gov/resource-center/international/g7-g20/
Documents/pittsburgh_sum
mit_leaders_statement_250909.pdf.
\3\ Id.
---------------------------------------------------------------------------
I welcome the chance to update you from the WMBAA's perspective as
it relates to implementation of trade execution regulations and the
impact on global market conditions.
In my written testimony, I will focus on the following points:
First, the primary driver of the G20 commitments was to
address systemic risk to our financial system. Trade execution
in and of itself was not and has never been singled out as
contributing to the financial crisis.
Second, while not without challenges or material shifts in
pre-existing market structure, markets are gradually adjusting
to the new regulatory landscape and the new SEF trading
environment. There remain significant efforts to ensure a
globally coordinated approach is ultimately put in place. The
CFTC should continue to review its rules, analyze their impact
on market conditions, with quantifiable metrics, and adjust the
regulations as appropriate.
Third, important lessons should be learned from the
prolonged clearinghouse mutual recognition negotiations so that
trade execution venues do not have to endure the same
experience. With liquidity provision services offered by SEFs
in the United States (``U.S.''), multilateral trading
facilities (``MTFs''), soon to be recognized organized trading
facilities (``OTFs'') in Europe, introducing brokers,
traditional broker-dealers, and others, global regulators
should more carefully coordinate regulatory efforts so as to
not fragment markets, reduce liquidity, and increase costs to
users by rupturing the existing methods by which U.S. and non-
U.S. swap dealers, international banks, global asset managers,
and end-users access competitive, transparent OTC markets in
the U.S. or in other jurisdictions. We have already witnessed
liquidity move across borders. Global regulatory gaps have not
only promoted bifurcation of trading patterns but can be
exploited to the detriment of investors.
Finally, while some key implementation issues remain with
the CFTC's SEF rules, and I will highlight several today, the
WMBAA remains hopeful that many of these outstanding issues can
be resolved by the regulatory agencies. I will explain how the
CFTC interpreted clear Congressional intent to fashion a
flexible swap trading regime into a prescriptive, artificially
restrictive rule set and, to date, has not fully evaluated the
impact of its rules on market quality. Although continued
oversight and vigilance, such as this hearing, remain needed on
an ongoing basis, it is also our hope that that Congress will
not have to be called upon to reiterate through new legislation
its previously stated desire for a flexible, technology-neutral
trade execution framework that encourages innovation and
fosters liquidity formation.
I. The Transition to OTC Trading on Regulated Platforms Is Proceeding,
But Not Without Challenges
While the CFTC's SEF rules were implemented in 2013, the first
``made available to trade'' or ``MAT'' determination did not become
effective until February 2014. That determination, which can only be
initiated by a SEF petition, is the first step towards requiring that a
certain swap be traded on a SEF. Currently, the mandatory trade
execution requirement only applies to certain interest rate and credit
default swaps. Accordingly, in those markets, we have seen increased
market reliance on SEFs to facilitate trading in these products.
Indeed, a recent International Swaps and Derivatives Association
(``ISDA'') study found that more than \1/2\ of average daily interest
rate derivatives trading activity was executed on a SEF during the
first quarter.\4\ For the credit default swap index market, SEF trading
accounted for 78.8% of average daily trade counts and 78.1% of average
daily notional volume.\5\
---------------------------------------------------------------------------
\4\ See ISDA SwapsInfo First Quarter 2016 Review, June 2016
(stating ``[m]ore than half of average daily IRD trading activity was
executed on a [SEF] during the first quarter: 52.6% by trade count and
56.0% by notional volume''), available at http://www2.isda.org/
attachment/ODQxNg==/SwapsInfo%20First%20Quarter%202016%20Review%20.pdf.
\5\ See id.
---------------------------------------------------------------------------
These statistics, coupled with statements of support for regulated,
transparent intermediation of OTC derivatives by the buy-side
institutions such as mutual funds, pension funds, insurance firms,\6\
and other market participants suggest a broad adjustment to rules
implemented in support of the G20 mandate to promote regulated swap
trade execution as a replacement for purely bilateral trade activity.
---------------------------------------------------------------------------
\6\ See Letter from Timothy W. Cameron and Lindsey Weber Keljo,
Asset Management Group, Securities Industry and Financial Markets
Association to the CFTC, May 11, 2015, available at http://
www.sifma.org/commentletters/2015/sifma-amg-submits-comments-to-the-
cftc-in-response-to-commissioner-giancarlo-s-white-paper-and-in-
regards-to-the-sef-regulatory-framework/.
---------------------------------------------------------------------------
However, while the ISDA research indicates that market participants
have migrated towards regulated intermediation in selected
marketplaces, there are serious global market structure issues across
the derivative markets generally that remain unresolved.
In the U.S., for example, there are now 21-fully registered SEFs,
one temporarily-registered SEF, and two SEFs with applications still
pending. This means, just in the U.S. alone, domestic market
participants must choose among 24 different venues to access liquidity.
For each SEF, market participants have to review and compare individual
rule books, analyze different cost structures, and complete the legal
and technical components of onboarding before executing the first
trade.
While the ISDA statistics and large number of recently-registered
SEFs may suggest a smooth transition to the SEF regime, I will share
with the Subcommittee some of the troublesome compliance and
interpretative issues related to swap trading that still remain. Some
of these issues will likely be dealt with through CFTC staff
interpretation of existing regulations and others will require changes
to the rules. Regardless, the complexities of connecting market
participants--with varying technological sophistication and available
resources--with SEFs, clearinghouses, credit hubs, swap data
repositories, and other critical market infrastructure, require
agreement among these entities about how to best comply with the
ruleset adopted by the CFTC, as well as those forthcoming rules from
the Securities and Exchange Commission (``SEC'') for security-based
swaps and corresponding regulation in Europe and Asia. With more
clarity from regulators and consensus among market participants, the
smoother the ongoing transition to the new rules will be.
II. The Global Swap Trading Landscape Requires Global Coordination; Any
Other Approach Will Harm Financial Markets
A. SEF Rules Have Fragmented Global Market Liquidity
As intermediaries of financial products and operators of regulated
exchange venues around the world, WMBAA members have observed firsthand
the pronounced fragmentation caused by the CFTC's SEF rules.
Anecdotally, we have seen market participants refrain from transacting
with counterparties in certain jurisdictions to avoid the CFTC's
regulatory burdens.
For example, rather than submit to U.S. regulation, a wide spectrum
of non-U.S. entities either withdrew from U.S. trading venues or
refused to trade with U.S. person counterparties to reduce activity
that would be attributed towards the ``swap dealer'' or ``major swap
participant'' thresholds which carry significant and costly
obligations. As a result, liquidity has been formed by jurisdiction.
Trading has become more regionalized with, for example, Euro and
British Pound interest rate swaps traded almost exclusively among non-
U.S. counterparties and away from SEFs, while U.S. Dollar interest rate
swaps are now almost exclusively traded in the U.S.\7\
---------------------------------------------------------------------------
\7\ See ISDA Research Note: Cross-Border Fragmentation of Global
Interest Rate Derivatives: Second Half 2015 Update, May 2016, available
at http://www2.isda.org/attachment/ODM4NQ==/Fragmentation%20FINAL1.pdf.
---------------------------------------------------------------------------
Last month, ISDA also published its ``Second Half 2015 Update''
analyzing the cross-border fragmentation of global interest rate
derivatives. ISDA concludes that ``[t]he fracturing of the global
interest rate swaps market that emerged in the aftermath of U.S. [SEF]
rules coming into force in October 2013 shows no signs of reversing''
and that ``some liquidity pools continue to be split on U.S. and non-
U.S. lines.'' \8\ Specifically, ISDA found that ``91.2% of cleared euro
interest rate swap (`IRS') activity in the European interdealer market
was transacted between European counterparties in December 2015,''
compared with 70.7% just before the CFTC's SEF rules went into effect
in September 2013.\9\
---------------------------------------------------------------------------
\8\ Id.
\9\ Id.
---------------------------------------------------------------------------
Other analysis of market data reaches the same conclusion. For
instance, a recent Bank of England staff working paper found that:
the introduction of the SEF trading mandate reduced the
proportion of trading taking place between U.S. and non-U.S.
persons, particularly for EUR denominated swaps. This suggests
that some non-U.S. persons became less willing to trade with
U.S. persons as this would require them to trade on a SEF.
Thus, an effect of the new regulation was increased
geographical fragmentation of the global swap market.\10\
---------------------------------------------------------------------------
\10\ Benos, Evangelos, Richard Payne and Michalis Vasios, Bank of
England Staff Working Paper No. 580, Centralized trading, transparency
and interest rate swap market liquidity: evidence from the
implementation of the Dodd-Frank Act, available at http://
www.bankofengland.co.uk/research/Documents/workingpapers/2016/
swp580.pdf, page 2.
The Bank of England staff did not just identify fragmented markets.
The paper also concludes that SEF trading brings benefits to investors.
Namely, ``as a result of SEF trading, activity increases and liquidity
improves across the swap market, with the improvement being largest for
[U.S. Dollar] mandated contracts which are most affected by the
mandate. The associated reduction in execution costs is economically
significant.'' \11\
---------------------------------------------------------------------------
\11\ Id.
---------------------------------------------------------------------------
B. Policymakers Must Improve the Mutual Recognition Process
While the CFTC SEF registration process may be complete (with the
SEC's corresponding security-based SEF regime still outstanding), the
impeding MiFID II January 2018 target compliance date makes it vital
that any trade execution regulatory gaps among the principal
jurisdictions be resolved in the coming months.
This Subcommittee and my fellow witnesses are all familiar with the
issue of clearinghouse equivalence, having explored the topic in many
prior hearings.\12\ We were pleased to see the announcement of a common
approach for central clearing counterparties in February 2016.\13\
However, as CFTC Commissioner J. Christopher Giancarlo has noted, the
equivalence debate for U.S.-registered SEFs/security-based SEFs versus
MTFs, OTFs, and other versions of registered trading venues outside the
U.S. could lead to another ``equivalency standoff.'' \14\
---------------------------------------------------------------------------
\12\ See Testimony of Terrance A. Duffy before the House Committee
on Agriculture Subcommittee on Commodity Exchanges, Energy, and Credit,
Hearing on CFTC Reauthorization, March 25, 2015, available at http://
agriculture.house.gov/uploadedfiles/duffy_testimony.pdf; see also
Testimony of Chairman Timothy G. Massad before the U.S. House Committee
on Agriculture, February 10, 2016, available at http://
agriculture.house.gov/uploadedfiles/massad_testimony.pdf.
\13\ The United States Commodity Futures Trading Commission and the
European Commission: Common approach for transatlantic CCPs, February
10, 2016, available at http://www.cftc.gov/idc/groups/public/@newsroom/
documents/speechandtestimony/eu_cftcstatement.pdf.
\14\ See Six Month Progress Report on CFTC Swaps Trading Rules:
Incomplete Action and Fragmented Markets, August 4, 2015, available at
http://www.cftc.gov/PressRoom/SpeechesTestimony/
giancarlostatement080415.
---------------------------------------------------------------------------
Furthermore, the CFTC's past efforts to provide a ``qualified'' MTF
regime for execution platforms operating within the EU where U.S.
person entities would be allowed to execute off-SEF \15\ failed
because, among other reasons, the proposed terms allowed the CFTC to
unilaterally remove the relief at any time. The proposal also did not
attract participants because, under the terms of the relief, an MTF
would be required to comply with the CFTC's SEF regime not just for
trades involving U.S. counterparties or U.S.-regulated products, but
even for trades executed between European counterparties on a European-
regulated product through a European trading venue. That expansive
overreach went too far for already-regulated market participants to
agree to a second layer of regulatory burdens.
---------------------------------------------------------------------------
\15\ CFTC No-Action Letter No. 14-46, April 9, 2014, available at
http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/
letter/14-46.pdf.
---------------------------------------------------------------------------
Therefore, while multiple EU-based execution venues, including all
WMBAA member firms, were prepared to meet the necessary qualifications
for both the CFTC and the UK's Financial Conduct Authority, this
proposal did not result in any European intermediaries agreeing to
submit it and its participants to comprehensive CFTC oversight. The
global derivative markets can ill afford a repeat of this scenario in
the equivalence negotiations leading up to MiFID II implementation,
especially because the European regulatory regime does not offer the
flexibility of no-action relief and, therefore, an avoidable
polarization of liquidity pools may become permanent if an agreement is
not reached prior to January 2018. We urge the Subcommittee to
prioritize execution equivalence as the primary tool to counter the
increasingly well-entrenched trend for liquidity to be split along
regional lines.
As we have seen, the paralyzing impact this delay in coordination
and overall uncertainty can bring to clearinghouses with the
accompanying segregation of trading, the same (if not worse) could
happen if the current opportunity to shape execution equivalence
between the U.S. and the EU is squandered. Of course, the costs will be
borne by liquidity providers, asset managers, and end-users who rely on
intermediaries to provide this vital function, as they will receive
fragmented, less competitive bids and offers due to barriers erected by
uncoordinated cross-border rules. All of these artificial blockages to
natural liquidity formation result in higher costs to investors who are
meant to be the ultimate beneficiary of the reforms instituted by the
Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-Frank
Act'').\16\
---------------------------------------------------------------------------
\16\ Public Law 111-203, 124 Stat. 1376 (2010).
---------------------------------------------------------------------------
Subsequent to the G20 summit in Pittsburgh and well before the
adoption of the Dodd-Frank Act, WMBAA members and other trading firms
were preparing for what would ultimately result in the current SEF
regime. There has been nearly a decade of time, energy, and resources
devoted to post-financial crisis regulatory reform that has been
replicated in other G20 jurisdictions. These parallel work streams
should have resulted in a comprehensive, consistent, and coordinated
global oversight framework that promotes market liquidity and function
while meeting public policy objectives.
Yet, to date, that has not occurred. Some global financial services
companies have created and registered separate entities in various
jurisdictions purely to avoid being subject to SEF terms and
conditions. Some intermediaries have submitted their European platforms
for U.S. oversight in a splintered fashion. And, most recently, the
CFTC received an application for a jointly-registered SEF and MTF.
While market participants remain tentative and unsure as to how the G20
global trade execution implementation permutations will play out, this
also suggests uncertainty among the trading venues themselves.
III. Examples of Necessary Regulatory Improvements to the CFTC SEF
Regime
The WMBAA has long publicly supported a flexible, principles-based
approach to the implementation of the Dodd-Frank Act trade execution
framework. In that light, we continue to harbor reservations about some
of the technical points related to the CFTC's interpretation of certain
provisions of the Dodd-Frank Act and the staff's reading of the
implementing regulations in terms of satisfactory policies and
procedures. Furthermore, while other global regulatory bodies and
industry associations, like the Bank of England and ISDA, have engaged
in an empirically-based evaluation of the swap trading rules on market
conditions, the CFTC has not yet published any data-driven analysis of
their own rules. We strongly believe that should be completed,
published for market feedback, and result in appropriate changes to the
rules.
As I said at the outset, we remain hopeful that many of these can
be resolved at the agency level. But we very much appreciate this
Subcommittee's interest in these very important issues and its
continued oversight of the CFTC's work.
The current mix of statute, rules, no-action letters, staff
guidance, and interpretive statements does not provide sufficiently
predictable regulatory certainty for SEFs to plan, invest, and grow
domestically or to be able to incorporate SEF activity within global
operations. As long-standing businesses placed under a novel regulatory
scheme, it is vital to know objectively not just the practical
implications of rules but how they may be interpreted on a permanent
basis similar to rules adopted under the Administrative Procedure Act.
Staff or Division letters and guidance are informative, but can be
revoked or amended at any time without any due process protections. The
Subcommittee should remain aware of the Commission's reliance on these
measures and protect against their overuse.
Chairman Massad has said, even recently, that the CFTC has ``fine-
tuned'' some of its rules through no-action letter relief and will
``consider a codification of those adjustments, and potentially other
changes to enhance SEF trading and participation.'' \17\ The WMBAA
welcomes this approach as an initial step as the formalization in rule
text provides additional reliability. However, the WMBAA also believes
that more substantive, comprehensive changes are likely necessary on a
wider range of issues than simply codifying a few existing no-action
letters. We agree with Chairman Massad that the CFTC should work to
create ``the foundation for the market to thrive'' and ``permit
innovation, freedom and competition.'' \18\
---------------------------------------------------------------------------
\17\ Statement of Chairman Timothy Massad before the CFTC's Market
Risk Advisory Committee, April 26, 2016, available at http://
www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement042616.
\18\ Remarks of Chairman Timothy Massad before the ISDA 30th Annual
General Meeting, April 23, 2015, available at http://www.cftc.gov/
PressRoom/SpeechesTestimony/opamassad-17.
---------------------------------------------------------------------------
To assist the Commission in its review of changes to enhance SEF
trading and participation, in March of this year, the WMBAA submitted a
comprehensive list of issues to Chairman Massad. That letter is
attached to my testimony today. We look forward to participating in a
productive dialogue with Chairman Massad, his fellow Commissioners, and
the hard-working CFTC staff.
Briefly, I would like to highlight a few issues set forth in the
WMBAA's March 2016 letter.
Explicit regulatory certainty with respect to flexible modes of
execution. The SEF definition, as set forth in the Dodd-Frank Act,\19\
is intentionally broad, flexible, and contemplates a wide array of
execution methods. The implementing CFTC regulation artificially
restricts permitted methods of liquidity formation and execution to an
order book or request for quote (``RFQ'').\20\ First, this is
problematic because it is inconsistent with the clear language of the
statute. Second, this approach may prevent or discourage certain
technologies from facilitating trading through a registered SEF.
Finally, and importantly given the ongoing work to achieve global
harmonization, the restriction on execution methods is narrower than
those clearly permitted under MiFID II, which may ultimately drive
derivatives trading away from the U.S.
---------------------------------------------------------------------------
\19\ See CEA 1a(50) (``a trading system or platform in which
multiple participants have the ability to execute or trade swaps by
accepting bids and offers made by multiple participants in the facility
or system, through any means of interstate commerce, including any
trading facility, that--(A) facilitates the execution of swaps between
persons; and (B) is not a designated contract market.'').
\20\ The traditional RFQ trading protocol, where a single market
participant solicits a bid or offer from at least three other market
participants, seems to fall short of the ``multiple to multiple''
component of the SEF definition.
---------------------------------------------------------------------------
The WMBAA urges the CFTC to make clear that SEFs may operate other
protocols besides order books or RFQs, including Trading Facilities,
under the Commodity Exchange Act (``CEA''). For example, auction-type
systems such as BGC Partners' VolumeMatch meet the CEA definition of
trading facility and, therefore, should be explicitly permitted as an
acceptable execution method for Required Transactions. It has been our
experience that these new trading protocols continue to gain favor in
the marketplace as an alternative to order book and RFQ trading and
more effectively promote competitive price discovery for interested
parties.
Made Available to Trade. The WMBAA believes the MAT process should
be amended. While SEFs should commence the review through the filing of
the petition, the petition's approval should not be a ``negative
consent'' process. The CFTC's Part 40 rules' 10 day negative consent
process starts with a presumption of approval and removes any real
discretion or judgment from the CFTC's hands. The MAT determinations
are important and should benefit from more careful analysis of a wider
set of information rather than being subject to the single submission
of an individual SEF.
Rather, the CFTC should have the responsibility of making the
determination based on objective criteria and subject to public notice
and comment on the petition. The factors that the CFTC considers in
deciding whether to impose a SEF trading mandate should be consistent
with the process and analysis followed by other global financial market
regulators in order to prevent any bifurcation of the swap markets and
regulatory arbitrage.
SEF Position Limit or Position Accountability Regimes. The Dodd-
Frank Act requires SEFs to ``adopt for each of the contracts of the
facility, as is necessary and appropriate, position limitations or
position accountability for speculators'' and then to ``[m]onitor
positions established on or through the [SEF] for compliance with the
limit set by the Commission and the limit, if any, set by the [SEF].''
\21\ The WMBAA and the broader SEF community, including a SEF chief
compliance officer working group, have engaged with the CFTC on this
issue. Both the National Futures Association and the WMBAA have
authored white papers on the topic.
---------------------------------------------------------------------------
\21\ CEA 5h(f)(6).
---------------------------------------------------------------------------
Simply put, SEFs, as competitive trading platforms, do not possess
information about a trader's overall position in any given swap or its
underlying instrument or commodity because of the inherently
competitive nature of swap trading. A SEF is not a centralized
exchange; each SEF is one of multiple competitive platforms
facilitating trading activity in fungible financial products that can
and does move easily from one venue to another. Unlike listed futures
and options where trading and clearing is vertically integrated and
each centralized exchange has information about positions in the
marketplace for any specific contract, each SEF only has information
about swap transactions that take place on its individual facility and
has no access to information as to whether a particular trade on the
facility adds to an existing market-wide position or whether it offsets
all or part of an existing position in that swap.
The CFTC should specify that SEFs are not obligated to impose
position limits or accountability until such time as the CFTC
determines that such measures are ``necessary and appropriate,''
especially because unified position information is available at the
swap data repository level where all SEF trade data is maintained.
Further, implementing position limitations or position accountability
is not necessary and appropriate at this time because, it has not been
proven that such limits are an effective tool for detecting and
preventing manipulation and other abuses for swaps.
SEFs accept and take seriously their obligation as market operators
to ensure they provide reliable, resilient venues to access competitive
pricing. This includes monitoring for manipulation and other abusive
trading activity that takes place on each individual facility which
will continue in earnest as part of our responsibility to meet existing
SEF core principles.
SEF Financial Resource Requirements. The CEA requires all SEFs to
have ``adequate financial, operational, and managerial resources.''
During the SEF registration review process, we learned that CFTC staff
believe that all SEF employees are considered part of the SEF's
financial obligation, regardless of the employment arrangement (e.g.,
at-will, contractual, or guaranteed salary). As a result, SEFs with
voice-based systems face significantly higher financial resources
commitments than those facilities that only provide electronic trading
access. The Dodd-Frank Act does not dictate this outcome. From a public
policy standpoint, it prevents investment and growth if a SEF must
freeze capital to help pay at-will or contracted staff for a full year
when, in reality, the SEF does not have that liability to simply
``discharge each responsibility of the [SEF].''
We continue to discuss with the CFTC and staff a more realistic,
flexible interpretation that promotes all types of swap trading and
only attributes the financial resource requirement to cover the fixed
costs associated with compliant SEF operation and solely those required
to ensure compliant operations. We think that is a more appropriate
approach than factoring in variable costs and costs related to staff
that are not core to a compliant operating structure and who would not
be associated with the SEF for the currently-required 12 month
timeframe in the event of a change to the business. One possible
solution involves relying on a rule provision that delegates the CFTC's
authority on this issue to the Director of the Division of Market
Oversight. We look forward to continued engagement with the CFTC on
this issue.
IV. Conclusion
Mr. Chairman, the WMBAA appreciates the opportunity to appear today
and discuss the ongoing work to implement the G20 mandates. We look
forward to continued work on these developments with Congress, the
CFTC, the SEC, and regulatory bodies around the world.
I would be pleased to answer any questions you may have.
Appendix
March 11, 2016
Hon. Timothy Massad,
Chairman,
Commodity Futures Trading Commission,
Washington, D.C.
Re: Swap Execution Facility Regulations, Made Available to Trade
Determinations, and Swap Trading Requirements
Dear Chairman Massad:
Since the promulgation of the regulations governing swap execution
facilities (``SEFs'') pursuant to the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the ``Dodd-Frank Act''), Commissioners of the
Commodity Futures Trading Commission (``CFTC'' or ``Commission'') have
discussed the Commission's consideration of potential revisions to
various aspects of its swap regulations, including those reforms
related to SEFs and trade execution. For example, you have stated that
the Commission is ``focused on issues concerning trading on [SEFs],''
and that you ``will ask the Commission to consider a number of rule
changes to enhance SEF trading and participation.'' \1\ Calls for the
Commission to consider potential revisions to its Dodd-Frank Act
regulations have also been raised by Commissioner Bowen \2\ and
Commissioner Giancarlo.\3\ In addition, Commission staff has indicated
that they are considering potential no-action relief or guidance with
respect to issues that market participants have identified as
problematic.
---------------------------------------------------------------------------
\1\ See Keynote Remarks before the Institute of International
Bankers Annual Washington Conference (Mar. 7, 2016).
\2\ See Statement of Commissioner Bowen, Dec. 1, 2014 (stating that
``the best way of viewing changes to [the CFTC's Dodd-Frank Act
rulemakings] is not that [the CFTC is] tweaking them, but rather that
[the CFTC is] enhancing them. Sometimes that may mean making the rules
more cost-effective and leaner, but at other times that will mean
making them stronger than before. Enhancing a rule can mean reducing
burdens to business while strengthening protections for the public''),
available at http://www.cftc.gov/PressRoom/SpeechesTestimony/
bowenstatement120114.
\3\ See Commissioner Giancarlo White Paper, ``Pro-Reform
Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank''
(Jan. 29, 2015), available at http://www.cftc.gov/ucm/groups/public/
@newsroom/documents/file/sefwhitepaper012915.pdf; see also Statement of
Commissioner Giancarlo, Six Month Progress Report on CFTC Swaps Trading
Rules: Incomplete Action and Fragmented Markets (Aug. 4, 2015),
available at http://www.cftc.gov/PressRoom/SpeechesTestimony/
giancarlostatement080415.
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The Wholesale Markets Brokers' Association, Americas (``WMBAA'')
\4\ appreciates the Commission's careful and deliberative approach to
the regulation of SEFs and extends its appreciation to the Commission
for granting permanent registration to each of the member firms' SEFs
earlier this year. This milestone represents a significant step toward
firmly establishing the regulatory regime for mandatory trade execution
as envisioned by the Dodd-Frank Act and providing market participants
with further much-needed regulatory certainty. Against the backdrop of
permanent SEF registration, the WMBAA looks forward to continuing to
work with the Commission and its staff on all matters pertaining to
SEFs, including on any future CFTC rulemakings, amendments, guidance,
or interpretations related to trade execution and SEFs, to ensure that
the regulations are implemented in accordance with the underlying
statutory intent and accomplish the Dodd-Frank Act's goal of
``promot[ing] the trading of swaps on swap execution facilities.''
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\4\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers. The founding members of the group--BGC
Partners, GFI Group, Tradition, and Tullett Prebon--operate globally,
including in the North American wholesale markets, in a broad range of
financial products, and have received temporary registration as swap
execution facilities. The WMBAA membership collectively employs
approximately 4,000 people in the United States; not only in New York
City, but in Stamford and Norwalk, Connecticut; Chicago, Illinois;
Jersey City and Piscataway, New Jersey; Raleigh, North Carolina; Juno
Beach, Florida; Burlington, Massachusetts; and Dallas, Houston, and
Sugar Land, Texas. For more information, please see www.wmbaa.com.
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The WMBAA supports the Commissioners' recognition that the
regulations should be assessed and reconsidered on an ongoing basis. In
particular, the WMBAA supports Commission efforts to ``formalize
through notice-and-comment rulemaking a number of the `no-action'
positions the staff has taken, such as simplifying the confirmation
process, streamlining the process for correcting error trades, and
others.'' \5\ We support the regulatory certainty that formal rule
changes would provide to issues related to SEF confirmation and
reporting, trades deemed void ab initio,\6\ and trading of block trades
``on facility.'' The WMBAA also recognizes that certain reporting
requirements may merit reconsideration, including the ``embargo rule,''
and would welcome the opportunity to discuss such issues further with
the Commission.
---------------------------------------------------------------------------
\5\ See Keynote Remarks of Chairman Massad before the Institute of
International Bankers Annual Washington Conference (Mar. 7, 2016).
\6\ Revised regulations should permit SEFs to correct clerical or
operational errors on swaps rejected for clearing. In addition, if a
swap has been accepted by a DCO for clearing, and a clerical or
operational error is subsequently identified, the regulations should
permit a SEF to correct the error in the trade without initiating a
``new trades, old terms'' offset and resubmission, provided that the
DCO has the operational capability to permit such a correction.
---------------------------------------------------------------------------
Further, to assist the Commission and its staff in its assessment
of the SEF regulations, the WMBAA respectfully offers the attached
matrix in Appendix A, which we have prepared based on our expertise as
over-the-counter market operators for over 25 years and a combined
tenure in the industry of over 100 years, and our experience to date
with the implementation of the SEF related rules. For each of the
following topics, the matrix notes the relevant statutory provision,
describes the implementation issue experienced by market participants,
references the relevant CFTC rule or staff advisory, and suggests a
potential recommendation to address the issue. The topics are not
presented in order of importance, but rather represent the regulatory
implementation issues that the WMBAA members are addressing:
Methods of execution;
Made available to trade process;
Audit trail requirements for voice-based executions;
Position limits; \7\
---------------------------------------------------------------------------
\7\ A WMBAA white paper on position limits, which was submitted to
the Division of Market Oversight staff, is attached hereto as Appendix
B.
---------------------------------------------------------------------------
Financial resource requirements;
Cross-border issues;
Margin requirements;
Embargo rule; and
SEF record-keeping requirement.
In addition to the specific issues addressed in the matrix, the
WMBAA recommends that the Commission examine the commercial impact of
its SEF regulations and other rules on the swap market. Specifically,
wherever possible, the Commission should seek to ensure a level playing
field between the futures and swap markets for commercially-equivalent
risk management contracts by not permitting any unfair regulatory
advantage to either market. The WMBAA believes that such regulatory
instances, in which a swap market requirement that results in
additional costs or creates disincentives for trading swaps relative to
the futures market equivalent, should be reconsidered by the
Commission.
Last, to the extent that Commission action to modify certain swap-
related regulations are constrained by statutory language under the
Dodd-Frank Act, the WMBAA would welcome the opportunity to work with
the Commission to advocate for appropriate legislative changes before
Congress. However, the attached list includes solely those issues which
the WMBAA believes can be addressed through regulatory action.
* * * * *
We welcome the opportunity to discuss these comments with you at
your convenience. Please feel free to contact the undersigned with any
questions you may have on our comments.
Sincerely,
William Shields,
Chairman, WMBAA.
cc:
The Honorable Sharon Bowen, Commissioner;
Mr. Vince McGonagle, Director, Division of Market Oversight.
appendix a: cftc part 37 sef regulations: recommended revisions
--------------------------------------------------------------------------------------------------------------------------------------------------------
Relevant Statutory Provision Issue CFTC Regulation Proposed Solution/Revision
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 1(a)(50)
``The term `swap execution
facility' means a trading system or
platform in which multiple
participants have the ability to
execute or trade swaps by accepting
bids and offers made by multiple
participants in the facility or
system, through any means of
interstate commerce, including any
trading facility, that--
Methods of Execution
Rule 37.9(a)(2)
Add a new clause ``(C)'' to the
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 2(h)(8)
``(A) In general.--With respect
to transactions involving swaps
subject to the clearing requirement
of paragraph (1), counterparties
shall--
(i) execute the transaction on
a board of trade designated as a
contract mar-
ket . . .; or
(ii) execute the transaction on
a [registered SEF] or a swap
execution facility that is exempt
from registration . . .
Made Available to Trade Process Rule 37.10(a)(1): ``Required Amend the made available to trade
(B) Exception.--The requirements
[above] shall not apply if no board
of trade or [SEF] makes the swap
available to trade or for swap
transactions subject to the clearing
exception . . . .''
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 5h(f)(2)(B)(ii) (Core Principle Voice Audit Trail Rule 37.205 Revise the rules or provide guidance
2) CFTC staff has expressed a desire Commission rule 37.205 sets forth related to audit trail requirements
that SEFs must be able to store the audit trail requirement for for voice-based executions on SEFs
``A [SEF] shall . . . establish recordings of oral communications in SEFs to ``capture and retain all to account for the unique
and enforce trading, trade a digital database and convert such audit trail data necessary to characteristics of voice execution
processing, and participation rules recordings into searchable text. detect, investigate, and prevent and to recognize the currently
that will deter abuses and have the In addition, CFTC staff has explored customer and market abuses.'' available technologies. Any such
capacity to detect, investigate, and the concept of requiring SEFs to The Commission requires that such new rules or guidance would
enforce those rules, including means record or access not only the data is ``sufficient to reconstruct supplement the existing audit trail
. . . to capture information that communications between the SEF's all indications of interest, requirements that are tailored to
may be used in establishing whether employees and their customers, and requests for quotes, orders, and electronic execution and should
rule violations have occurred.'' any communications between trades within a reasonable period more accurately reflect a
employees, but also the of time and to provide evidence of ``technology-neutral'' approach to
communications of Introducing any violations of the rules of the SEF execution.
Brokers. Introducing Brokers already [SEF].'' Further, an audit trail In accordance with the preamble
have the obligation under NFA rules must also permit a SEF to ``track a discussion to the final rule, the
to record communications and SEFs customer order from the time of WMBAA believes that ``the intent of
have access to such information receipt through fill, allocation, the final rules is to require that
pursuant to their rulebooks. or other disposition, and shall a SEF establish and maintain an
include both order and trade effective audit trail program, not
data.'' to dictate the method or form for
The elements of an acceptable audit maintaining such information.
trail program involve (1) original Importantly, the rule, by not being
source documents, (2) electronic prescriptive, provides SEFs with
transaction history database, (3) flexibility to determine the manner
electronic analysis capability, and and the technology necessary and
(4) safe storage capability. appropriate to meet the
requirements'' (emphasis added). 78
Fed. Reg. 33,476, 33,518 (June 4,
2013).
The WMBAA further recommends that
the CFTC consider whether the audit
trail requirements may be satisfied
based on exception or risk-based
SEF reviews.
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 5h(f)(6) (Core Principle 6) Position Limits Rule 37.600 Specify that SEFs are not obligated
SEFs do not possess information about Same as statutory provision to impose position limits or
``(a) . . . a [SEF] that is a a trader's position in any given accountability until such time as
trading facility shall adopt for swap or its underlying instrument or the Commission determines that such
each of the contracts of the commodity. Rather, SEFs only have measures are ``necessary and
facility, as is necessary and information about swap transactions appropriate.''
appropriate, position limitations or that take place on their individual Implementing position limitations or
position accountability for facilities and have no way of position accountability is not
speculators. knowing whether a particular trade necessary and appropriate at this
(b) Position limits. For any on the facility adds to an existing time because, for example: (1)
contract that is subject to a market-wide position or whether it unlike futures and options where
position limitation established by offsets all or part of an existing trading and clearing is vertically
the Commission . . . the [SEF] position in that swap. integrated and each DCM has
shall: (1) Set its position In addition, if SEFs were required to information about positions in the
limitation at a level no higher than adopt position limits, market marketplace for any specific
the Commission limitation; and (2) participants might abuse such contract, they are not an effective
Monitor positions established on or limits. For example, if five SEFs tool for detecting and preventing
through the [SEF] for compliance that offer a particular product set manipulation and other abuses for
with the limit set by the Commission their respective limits at a level swaps; and (2) individual SEFs do
and the limit, if any, set by the established by the CFTC, the overall not possess information about a
[SEF].'' aggregate position available to trader's position in any given swap
market participants via trading on and, therefore, have no basis of
such SEFs would be five times reference as to how and when a
greater than the level set by the position limit should be set.
CFTC. As such, market participants In addition to these comments, the
could take advantage of this WMBAA has submitted to the Division
structure by spreading their of Market Oversight (``DMO'') staff
transactions across multiple SEFs a white paper explaining why a SEF
and DCOs when reaching the limit set position limits and position
by each. While staff has accountability regime is neither
acknowledged that, in lieu of necessary nor appropriate.\8\
position limits, SEFs may establish Rather than imposing a position
accountability provisions related to limits regime, the WMBAA
trades rather than positions, the respectfully reminds the Commission
details of such accountability that a SEF is subject to regulatory
mechanisms and how accountability requirements to provide data to the
levels would be set are yet unclear. Commission, including data related
to the trading activity on the SEF,
to assist the Commission with
monitoring compliance with Federal
speculative position limits.\9\
\8\ The WMBAA white paper is attached
as Appendix B.
\9\ This approach was endorsed by a
group of SEFs. See SEF CCO Group
Discussion Document Regarding SEF
Core Principle 6--Position Limits
and Position Accountability (May 21,
2015).
A SEF CCO working group, consisting
of CCOs of 18 then-provisionally
registered SEFs, commissioned the
National Futures Association
(``NFA'') to conduct a study
regarding swap position limits and
position accountability. The NFA
study suggested that the swap
market might not lend itself to
notional transaction size position
or accountability levels at the SEF
level. While this study did not
offer an official disposition as to
the necessity or appropriateness of
position accountability levels at
the SEF level, it presented data
suggesting that such position
limits or accountability levels
will do little to ``reduce the
potential threat of market
manipulation or congestion,'' the
stated goal of the Core Principle.
The SEF CCO working group provided
DMO staff with a synopsis of this
study in the form of a discussion
document.
As an alternative to the above
proposed solution, the WMBAA would
welcome specific guidance on how
SEFs can practically comply with an
accountability provision,
reflecting that: (1) SEFs do not
possess position information; and
(2) swaps are fungible in terms of
being traded on multiple venues and
cleared by multiple DCOs. Any
accountability level(s) should be
established by the CFTC, taking
into account the entirety of market
activity in a product (both on and
off SEFs), and such established
level(s) should be applied
uniformly to all SEFs.
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 5h(f)(13) (Core Principle 13) SEF Financial Resources Rule 37.1300 Flexibly interpret the SEF financial
CFTC staff has indicated its Same as statutory provision resources requirements to reflect
``(A) In general.--The [SEF] preliminary belief that all SEF that SEFs are execution venues only
shall have adequate financial, employees are considered part of the and do not ensure contract
operational, and managerial financial obligation, regardless of performance, making their
resources to discharge each the employment arrangement, e.g., at- commercial viability less relevant
responsibility of the [SEF]. will, contractual, and guaranteed on a post-transaction basis.
(B) Determination of resource salary. As a result, SEFs with voice- As the Commission has delegated
adequacy.--The financial resources based systems face significantly authority to the DMO Director on
of a [SEF] shall be considered to be higher financial resources issues pertaining to SEF financial
adequate if the value of the commitments than those facilities resources, the WMBAA looks forward
financial resources exceeds the that only provide electronic trading to working with Commission staff to
total amount that would enable the access. appropriately account for the
[SEF] to cover the operating costs The Commission's rules do not following considerations in
of the [SEF] for a 1 year period, as recognize that: (1) SEFs do not refining the SEF rules, including
calculated on a rolling basis.'' possess or maintain client funds or with respect to creating an
open interest; (2) there is no appropriate methodology for
practical need for any individual computing projected operating
SEF to maintain sufficient resources costs. See Rule 37.1307.
for a period of 1 year after an The SEF financial resources
event that results in the closure of requirement should focus on the
a SEF, as a SEF could wind down its fixed costs associated with
operations in a much shorter time compliant SEF operation and solely
period; and (3) for SEFs with voice those required to ensure compliant
brokers, such voice brokers are not operations, rather than the
necessary to ensure operation of a variable costs and costs related to
compliant SEF and could be removed staff that are not core to a
at any point and for any reason compliant operating structure. The
without impacting the SEF's ability WMBAA notes that the costs
to satisfy the Core Principles. associated with employing SEF
brokers constitute variable costs
and are not core to the compliance
regime and the operations of a SEF,
or necessary or required to operate
a compliant SEF, as is demonstrated
by other registered SEFs that do
not employ brokers. Therefore,
costs related to employing SEF
brokers should be excluded from the
financial resources calculation.
Contrary to DMO letter 15-26, any
salary or compensation for SEF
employee-brokers should not be
included in the calculation of
projected operating expenses.
In addition, the WMBAA has submitted
information to DMO staff regarding
liquid assets and would welcome any
further communication as needed for
a rule revision to reduce the
burden from 6 months' liquid assets
to 3 months' liquid assets.
Any modification of the financial
resource rules should take into
account the fact that the exit of
an individual SEF (or brokers
within an operational SEF) would
not have broad market-wide or
systemic effects on the swap
marketplace. This is because the
trades previously executed on the
SEF would have been fully processed
and reported, and the positions
resulting from all trades would be
unaffected, as they are held either
at a DCO for cleared trades or with
the counterparties for uncleared
trades. Moreover, if a SEF were to
experience difficulty or choose to
exit the marketplace, the wind-down
process would occur quickly. As
SEFs do not hold positions, the
unwind process would take no longer
than a few months.
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 2(i) Cross-Border Concerns DSIO Advisory No. 13-69
The scope of the Commission's cross-
``The provisions of this Act border guidance is far reaching such
relating to swaps . . . (including that a permitted transaction
any rule prescribed or regulation involving two non-U.S.
promulgated under that Act), shall counterparties may be subject to SEF
not apply to activities outside the execution under footnote 88.
United States unless those This interpretation has had the
activities-- practical effect of bifurcating
(1) have a direct and markets based on the participants'
significant connection with jurisdictions, impeding liquidity
activities in, or effect on, and redirecting activity away from
commerce of the United States; or SEFs and, as a result, away from
(2) contravene such rules or U.S. markets and the oversight of
regulations as the Commission may U.S. regulators.
prescribe or promulgate as are
necessary or appropriate to
prevent the evasion of any
provision of this Act . . . .''
Address cross-border issues through
In addition, while non-U.S. swap
dealers located in the U.S. have
received no-action relief from the
execution mandate, no corresponding
relief has been issued with respect
to platforms operating in an
execution capacity for such non-
U.S. swap dealers located in the
U.S., adding to the uncertainty
around the implementation of rules.
In the interest of stability, no-
action relief should be equally
granted to participants and
platforms where applicable.
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 5b(c)(2)(D)(iv) Margin Requirements Rule 39.13(g)(2)(ii):
CFTC rules related to margin provide
``Margin requirements.--The a significant commercial advantage
margin required from each member and to futures over swaps. Specifically,
participant of a derivatives the CFTC's rules provide a 5 day
clearing organization shall be margin liquidation period for
sufficient to cover potential financial swaps, while all futures
exposures in normal market have a 1 day margin liquidation
conditions.'' period.
Re-examine the Part 39 margin
(A) A minimum liquidation time
that is 1 day for futures and
options;
(B) A minimum liquidation time
that is 1 day for swaps on
agricultural commodities, energy
commodities, and metals;
(C) A minimum liquidation time
that is 5 days for all other
swaps . . . .'' (emphasis added).
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 2(a)(13)(D) Embargo Rule Rule 43.3(b)(3)(i)
As a result of the embargo rule, SEFs
``The Commission may require and DCMs that would like to continue
registered entities to publicly to permit work-ups may face workflow
disseminate the swap transaction and issues because they cannot share
pricing data required to be reported trade information with their
under this paragraph.'' customers until such information is
transmitted to an SDR. Such delays
can have a material effect on market
liquidity.
To operate efficiently and
competitively, information which
reflects current market activity
must be available to all market
participants without any disruptive
pauses for the occurrence of other
regulatory activities. Every market
participant must have real-time
information on executed trades for
the entire marketplace to ensure
effective price discovery so that
they can make informed trading
decisions. This allows the market to
operate properly as a single
liquidity pool. In addition, those
SEFs that rely on a third party to
transmit information to SDRs are
further hindered by the embargo rule
in their ability to make available
to all market participants current
market information.
While the WMBAA appreciates the
--------------------------------------------------------------------------------------------------------------------------------------------------------
CEA 5h(f)(10)
``Recordkeeping and reporting.--
SEF record-keeping Requirement Rule 45.2(c):
Provide guidance to SEFs as to what
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appendix b: wmbaa white paper regarding position limits
White Paper: SEF Position Limits and Accountability Regimes are Neither
Necessary Nor Appropriate
May 21, 2015
I. Introduction
The Wholesale Markets Brokers Association, Americas,\1\ the leading
industry organization representing the interdealer broker industry,
provides this White Paper to explain why a position limits or position
accountability regime for swap execution facilities (``SEFs'') is
neither necessary nor appropriate.
---------------------------------------------------------------------------
\1\ The WMBAA is an independent industry body representing the
largest inter-dealer brokers operating in the North American wholesale
markets across a broad range of financial products. The five founding
members of the group are: BGC Partners; GFI Group; ICAP; Tradition; and
Tullett Prebon. The WMBAA membership collectively employs approximately
4,000 people in the United States; not only in New York City, but in
Stamford, Connecticut; Chicago, Illinois; Louisville, Kentucky; Jersey
City, New Jersey; Raleigh, North Carolina; and Houston and Sugar Land,
Texas. For more information, please see www.wmbaa.org.
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Section 5h of the Commodity Exchange Act (``CEA''), as added by the
2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-
Frank''), includes a series of core principles for SEFs. In the 5 years
since Dodd-Frank was adopted, the Commodity Futures Trading Commission
(``CFTC'' or ``Commission'') has worked to implement Section 5h of the
CEA, adopting final regulations related to the core principles and
other requirements for SEFs, including core principle number 6--
position limits or accountability. An applicant SEF must comply with
core principles to receive its permanent registration from the CFTC.
In practice, as explained in this White Paper, an overly
prescriptive interpretation of this core principle would be unworkable,
cost-intensive, and without any readily identifiable public policy
benefits. While there have been calls for Congressional review of core
principle 6,\2\ the WMBAA believes, at this point, the Commission
should consider a regulatory solution.
---------------------------------------------------------------------------
\2\ See Pro-Reform Reconsideration of the CFTC Swaps Trading Rules:
Return to Dodd-Frank, CFTC Commissioner J. Christopher Giancarlo White
Paper (Jan. 29, 2015), at 45, available at http://www.cftc.gov/ucm/
groups/public/@newsroom/documents/file/sefwhitepaper012915.pdf.
---------------------------------------------------------------------------
The approach described herein has been recently endorsed by a
coalition of SEFs \3\ and key industry groups.\4\ The WMBAA supports
such arguments, particularly that:
---------------------------------------------------------------------------
\3\ See SEF CCO Group Discussion Document Regarding SEF Core
Principle 6--Position Limits and Position Accountability, May 21, 2015.
\4\ See Letter from the International Swaps and Derivatives
Association and the Securities Industry and Financial Markets
Association to Ms. Melissa Jurgens, Secretary, CFTC (Feb. 10, 2014),
available at http://www.sifma.org/commentletters/2014/sifma-and-isda-
submit-comments-to-the-cftc-on-position-limits-for-derivatives/.
The Commission should exempt SEFs from any requirement to
enforce compliance with Federal limits or to establish SEF
limits for contracts subject to Federal limits. As an
alternative to setting position limits, SEFs should only be
required to provide data to the Commission to assist it in
monitoring compliance with Federal speculative position
limits.\5\
---------------------------------------------------------------------------
\5\ Id. at 35.
The SEF marketplace is still in its formative years. The CFTC has
not yet adopted a position limits regime for swaps. The Commission
should tread carefully to avoid the imposition of a rigid, unworkable
requirement that, without adequate cost-benefit analysis, may harm the
development of these markets. Rather, as suggested by Chairman Timothy
Massad, the CFTC should work to create ``the foundation for the market
to thrive'' and ``permit innovation, freedom and competition.'' \6\
---------------------------------------------------------------------------
\6\ Remarks of CFTC Chairman Timothy Massad before the ISDA 30th
Annual General Meeting (Apr. 23, 2015), available at http://
www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-17.
---------------------------------------------------------------------------
II. Background
A. Position Limits, Position Accountability
The CFTC glossary defines a position limit as ``[t]he maximum
position, either net long or net short, in one commodity future (or
option) or in all futures (or options) of one commodity combined that
may be held or controlled by one person (other than a person eligible
for a hedge exemption) as prescribed by an exchange and/or by the
CFTC.'' Fundamentally, a position limit caps the size of a position
that a trader may hold or control for speculative purposes in a
derivatives contract in a particular commodity. There are three
elements of the regulatory framework for position limits: the levels of
the limits, the exemptions from the limits (such as for hedging), and
the policy on aggregating accounts. While the CFTC has set certain
commodity position limits, it has not yet established position limits
for swaps.
By contrast, the CFTC glossary defines position accountability as
``[a] rule adopted by an exchange in lieu of position limits requiring
persons holding a certain number of outstanding contracts to report the
nature of the position, trading strategy, and hedging information of
the position to the exchange, upon request of the exchange.'' Position
accountability does not, by definition, impose a hard limitation on
traders' speculative derivatives positions in a commodity. Instead,
position accountability provisions grant the exchange additional powers
to protect its markets, including the ability to obtain additional
information from the trader and to limit the size of a trader's
position, when a trader's derivatives position exceeds a specified
level.
B. SEFs and Position Limits
Core principle 6--codified as CEA Section 5h(f)(6)--mandates that a
SEF ``that is a trading facility'' must ``adopt for each of the
contracts of the facility, as is necessary and appropriate, position
limitations or position accountability for speculators.'' \7\
Furthermore, ``[f]or any contract that is subject to a position
limitation established by the Commission pursuant to section 4a(a) of
the [CEA], the [SEF] shall (i) set its position limitation at a level
no higher than the Commission limitation; and (ii) monitor positions
established on or through the [SEF] for compliance with the limit set
by the Commission and the limit, if any, set by the [SEF].'' \8\
---------------------------------------------------------------------------
\7\ Commodity Exchange Act (``CEA'') 5h(f)(6).
\8\ Id.
---------------------------------------------------------------------------
The CFTC promulgated rule 37.600 by codifying the statutory
language.\9\ In the preamble to the final SEF rule, the CFTC noted that
``[s]everal commenters stated that SEFs will have difficulty enforcing
position limitations'' because ``SEFs will lack knowledge of a market
participant's activity on other venues, and that will prevent a SEF
from being able to calculate the true position of a market
participant.'' \10\ Furthermore, the CFTC describes the guidance and
acceptable practices in appendix B to the part 37 rules as giving
``reasonable discretion to comply with 37.600.'' \11\
---------------------------------------------------------------------------
\9\ 17 CFR 37.600.
\10\ Core Principles and Other Requirements for Swap Execution
Facilities, 78 Fed. Reg. 33,476, 33533 (June 4, 2013).
\11\ Id.
---------------------------------------------------------------------------
With respect to core principle 6, the guidance in Appendix B states
that:
For Required Transactions, a SEF may demonstrate compliance
by setting and enforcing position limitations or position
accountability levels only with respect to trading on the SEF's
own market. For example, a SEF could satisfy the position
accountability requirement by setting up a compliance program
that continuously monitors the trading activity of its market
participants and has procedures in place for remedying any
violations of position levels.
For Permitted Transactions, a SEF may demonstrate compliance
by setting and enforcing position accountability levels or
sending the Commission a list of Permitted Transactions traded
on the SEF. Therefore, a SEF is not required to monitor its
market participants' activity on other venues with respect to
monitoring position limits.\12\
---------------------------------------------------------------------------
\12\ Id. at 33601.
---------------------------------------------------------------------------
III. Role of Exchange-Set Position Limits and Position Accountability
In contrast to SEFs and position limits, the CFTC has historically
adopted position limits for certain agricultural commodities and also
has required exchanges, as part of their self-regulatory
responsibilities, to adopt position limits or position accountability
provisions in their market surveillance programs. Unlike the OTC swap
market, futures contracts traded on exchange are owned and exclusively
listed by an exchange. They are unique contracts that are unavailable
anywhere else.
When the CFTC first promulgated speculative position limits, it
noted that ``the capacity of any contract to absorb the establishment
and liquidation of large speculative positions in an orderly manner is
related to the relative size of such positions, i.e., the capacity of
the market is not unlimited.'' \13\ In the early 1990s, the CFTC
adopted rules allowing exchanges to establish position accountability
provisions, in lieu of position limits, for contracts that had been
subject to exchange-set speculative position limits.
---------------------------------------------------------------------------
\13\ Establishment of Speculative Position Limits, 46 Fed Reg.
50938 (Oct. 16, 1981).
---------------------------------------------------------------------------
Exchange-based position limits have been adopted by designated
contract markets (``DCMs''), or futures exchanges, and the position
limits (or position accountability) provisions have been enforced
through exchange rulebooks and their role as a self-regulatory
organization conducting market surveillance programs. These protections
serve as a prophylactic tool to reduce the threats of market power and
to ensure the integrity of and orderly trading in the derivatives
market. Exchange-set position limit and position accountability rules
help prevent traders from accumulating concentrated positions that
could disrupt a market and cause artificial prices and disorderly
trading, such as purposefully through the exercise of market power by
the position holder (e.g., actual or attempted manipulation) or to
prevent one trader from negatively impacting market stability by
liquidating too large of a position.
These rules obligate an exchange, as part of its market
surveillance effort, to take account of large positions in their market
either by imposing hard limits on traders' speculative positions or, in
the case of position accountability, by providing exchanges with ways
to address the market impact of large positions.
IV. SEFs Cannot Adopt an Exchange-Centric Position Limits or
Accountability Regime
Exchange-based surveillance and position limit and position
accountability regimes focus on market participants' concentrated
speculative positions. CFTC staff has stated that ``an acceptable
market surveillance program should regularly collect and evaluate
market data to determine whether markets are responding to the forces
of supply and demand. An exchange also should have routine access to
the positions and trading of its market participants.'' \14\
---------------------------------------------------------------------------
\14\ See CFTC Division of Market Oversight, Rule Enforcement Review
of ICE Futures U.S. (July 22, 2014), at 4, available at http://
www.cftc.gov/ucm/groups/public/@otherif/documents/ifdocs/
icemarksurrer072214.pdf.
---------------------------------------------------------------------------
Exchanges can readily adopt and enforce position limits or position
accountability provisions for futures and futures options because they
have the means to carry out this oversight function. As mentioned
before, exchanges own their contracts, the trading of which is only
allowed on its respective exchange, and exchanges also own and operate
the derivatives clearing organizations (``DCOs''), or direct trades to
specified DCOs, that process and become the counterparty to each
transaction executed on the exchange. Further, unlike futures on
physical commodities for which the underlying products are in limited
supply, the financial instruments underlying swaps subject to the trade
execution mandate (interest rate and credit default swap indices)
generally have very large or nearly inexhaustible deliverable supplies
and a cash market sufficiently liquid to render swaps traded on those
instruments highly unlikely to be susceptible to the threat of
manipulation.
Exchanges also have ``large trader reporting systems'' \15\
designed to obtain current information about traders' positions in
their derivatives markets. Futures exchanges possess data showing the
positions held by all reportable traders for each trading day based on
reports from clearing members, futures commission merchants, and
foreign brokers detailing close-of-business position data. Each futures
exchange's ``large trader reporting system'' also provides information
on the account's ownership and control and identifies futures and
options traders who trade for the account. By assigning unique
identification numbers to each trader, futures exchanges can aggregate
traders' positions across different accounts at multiple clearing
members to include the positions of all related affiliates.
---------------------------------------------------------------------------
\15\ See Large Trader Reporting Program, http://www.cftc.gov/
IndustryOversight/MarketSurveillance/LargeTraderReportingProgram/ltrp.
---------------------------------------------------------------------------
By contrast, SEFs are trading platforms that merely foster
liquidity for swap execution. They do not have any ownership or
proprietary control over the products bought and sold on their
platforms. SEFs do not hold customer funds. They do not guarantee
performance by counterparties. And, most importantly as discussed
below, SEFs do not possess information about a trader's position in any
given swap.
A. Position Limits
Under Section 4a of the CEA, the Commission is required to
establish position limits only after it determines that such position
limits are necessary and appropriate. To date, the CFTC has not made
that determination for financial swaps and, as a result, has not
established position limits for these products. However, even if such
limits were put in place, SEFs are limited in their ability to monitor
for position limits violations. SEFs can only monitor market activity
for those transactions that take place on its trading system or
facility. A SEF only has information about trading activity on its
facility and does not possess, and has limited means to obtain,
information about its participants' positions in swaps from activity on
other venues. There are currently 24 applicant SEFs, making it
impossible for any one SEF to know how its participants may transact on
the 23 other platforms.
In practice, while a participant may enter into a transaction of
size on one SEF, the SEF has no way of knowing if the participant has
offset (or increased) its position in the swap through trading on other
platforms. A swap that is listed and traded on one SEF may, unbeknownst
to that SEF, be traded on other SEFs, DCMs, or bilaterally between
counterparties away from any SEF or DCM. As a result, SEFs and DCMs
listing swaps do not possess information about a trader's position in
any given swap.
Position limit information is more appropriately collected by other
segments of the swap market, including market participants, DCOs, and
swap data repositories (``SDRs''). However, even a DCO or SDR would
only have information about traders' cleared positions or reported
positions at its individual organization. Only the participants
themselves would have information about their overall cleared and
uncleared swaps position in a market.
As a result, it is the WMBAA's view that only the CFTC (or a self-
regulatory body possessing position information about swap market
participants from SDR and DCO reports) can effectively police the swaps
market to detect position limit violations and have the enforcement
tools to take meaningful action to deal with violations. Imposing a
position-based requirement on SEFs would be ineffective and would incur
significant redundancies, potential miscounting or double counting of
trades, and significant impediments related to data standards among the
24 applicant SEFs. In addition, if all of the SEFs set their individual
position limit thresholds equal to the not-yet adopted CFTC's limits,
this regime could encourage ``gaming'' by market participants who could
spread their activity across SEFs to avoid triggering a ``limit check''
by any one SEF.
B. Position Accountability
As the National Futures Association (``NFA'') recently concluded
after conducting a data-driven analysis, position accountability levels
will do little to ``reduce the potential threat of market manipulation
or congestion, the stated goal of the [SEF core principles].'' \16\
---------------------------------------------------------------------------
\16\ NFA Swap Accountability Levels Study (Apr. 2, 2015).
---------------------------------------------------------------------------
The WMBAA believes the concept of a SEF position accountability
regime is flawed. Most importantly, as discussed above, position
accountability is meaningful as a market surveillance tool only in the
context of centralized marketplaces such as exchanges, which is due to
the fact that they own the products traded and possess information
about traders' actual positions in the relevant derivatives
marketplace. Because SEFs do not own products, and therefore do not
possess the same position information, it is not necessary or
appropriate for SEFs to adopt position accountability.
Moreover, recognizing the impracticability of SEFs adopting
position limits or position accountability regimes, there have been
suggestions that SEFs adopt, in effect, ``trading accountability''
provisions as a means of complying with core principle 6 (i.e., SEFs
would institute enhanced oversight of and data gathering from a trader
based solely on trading activity or the size of transactions). This
suggestion is problematic for two reasons. First, the CEA, as amended
by Dodd-Frank, does not contemplate a trading activity-based
accountability regime, but rather contemplates a position management-
focused component. Furthermore, there is no clear metric available for
SEFs to conduct a position accountability framework. As identified by
the NFA in its recent report, ``[n]otional transaction size alone is a
misleading measure of risk.'' \17\ The NFA further concluded that ``the
swap market might not lend itself to notional transaction size
accountability levels at the SEF level.'' \18\
---------------------------------------------------------------------------
\17\ Id.
\18\ Id.
---------------------------------------------------------------------------
V. Conclusions
The WMBAA has always supported efforts to promote stability,
efficiency, transparency, and competition in furtherance of Dodd-
Frank's goal to promote the trading of swaps on SEFs. This includes
taking steps to minimize threats posed to swap markets, including
market manipulation from concentrated positions in a certain swap.
For the reasons previously stated, however, the WMBAA does not
believe that a SEF-based position limit or position accountability
regime is necessary or appropriate to meet the purposes set forth in
Dodd-Frank.
The WMBAA members and other competitor SEFs want to be part of the
solution. These venues are bound by a series of core principles to
ensure fair, vibrant markets. They provide daily CFTC Part 16 lists of
transactions to the CFTC, and they transmit full trade details to SDRs
pursuant to their Part 43 and Part 45 confirmation and reporting
obligations. These data transmissions provide the CFTC with the ability
to combine data across SEFs to monitor large positions and address
position limit violations should the CFTC determine to establish
position limits or position accountability provisions for swap
contracts.
In considering ways to monitor swap markets for excessive
positions, only the CFTC, or a CFTC designated neutral third-party
self-regulatory organization would be in the position to collect,
maintain, and synthesize the data to perform this function in an
efficient, cost-sensitive manner. SEFs operating within the unique
framework of the execution-only, competitive SEF landscape, in contrast
to the vertically-integrated futures market structure, are ill-suited
to establish a position limits or accountability regime.
The Chairman. Thank you, Mr. Merkel.
Mr. Berger.
STATEMENT OF STEPHEN JOHN BERGER, DIRECTOR,
GOVERNMENT AND REGULATORY POLICY, CITADEL, LLC, NEW YORK, NY;
ON BEHALF OF MANAGED FUNDS
ASSOCIATION
Mr. Berger. Thank you. Chairman Scott, Ranking Member
Scott, Members of the Subcommittee, my name is Stephen Berger,
and I am the Director of Government and Regulatory Policy at
Citadel.
Citadel is a leading global financial institution that
manages hedge funds and provides capital market services.
I am here today on behalf of the Managed Funds Association
and its members, and I am pleased to provide testimony as part
of the Committee's review of the impact of the G20 clearing and
trade execution requirements.
MFA represents the majority of the world's largest hedge
funds, and is the primary advocate for sound business practices
and thoughtful regulation of the industry. MFA continues to
support reforms to the OTC derivatives markets, including
central clearing and trading on open, transparent venues. These
reforms have reduced systemic risk, increased protections for
investors, promoted competition, and strengthened our nation's
financial markets.
I would like to highlight a few recommendations from my
written statement that I believe would further help realize
these benefits. With respect to clearing, MFA has been a
consistent advocate for the central clearing of OTC derivatives
transactions. Clearing replaces the interconnected web of
counterparty exposures with a safer system where all
participants face a well-regulated clearinghouse. This reduces
systemic risk and enhances the stability and efficiency of our
markets. Clearing also benefits investors by mitigating
counterparty credit risk, increasing transparency, and
facilitating greater choice of trading counterparties and
platforms.
In the U.S., clearing has been successfully implemented for
a significant portion of the interest rate swap and index
credit default swap markets. In the U.S. today, approximately
75 percent of these swap transactions are cleared, compared to
only 16 percent in 2007. Notably, over the past several years,
investors have successfully cleared hundreds of trillions of
dollars worth of swap transactions. Nevertheless, there are two
areas where further progress should be made.
First, customer clearing in the U.S. must remain affordable
and robust. MFA is concerned that the Basel Committee's
leverage framework will needlessly, but significantly, increase
the cost of clearing for customers by failing to recognize the
exposure-reducing effects of segregated customer initial
margin. The Basel leverage ratio should be modified so that it
provides an offset for customer initial margin, posted to a
clearinghouse or segregated under U.S. rules.
Second, further work is required from the CFTC and the SEC
to implement a viable portfolio margining regime for the CDS
market. The Dodd-Frank Act specifically sought to promote
portfolio margining, which allows customers to realize margin
efficiencies by recognizing offsetting risks within their
portfolios. However, the interim framework that exists today
falls short of meeting this goal, and has adversely impacted
customer clearing.
Looking forward, MFA supports further efforts to expand
central clearing to interest rate swaps denominated in all of
the G10 currencies, and to harmonize these requirements
globally. While the U.S. was the first to implement central
clearing, many other jurisdictions have made substantial
progress in their own implementation. Notably, Europe is
beginning to phase in central clearing this year, and the scope
of the European clearing obligation is nearly identical to that
in the U.S.
Turning now to the implementation of the G20 trade
execution requirements. MFA continues to support transitioning
the trading of standardized liquid cleared swaps and to swap
execution facilities that provide impartial access and
facilitate straight-through processing to clearing. This
transition promises to benefit investors by increasing market
efficiency, competition, transparency, and liquidity. Recent
research by the Bank of England concluded that the
implementation of reforms in the U.S. interest rate swaps
market yielded significant improvements in pricing and
liquidity.
Although the SEF market continues to evolve, a two-tier
structure unfortunately persists, preventing investors from
fully participating in all of the various SEF liquidity pools.
This two-tier market, which reserves certain liquidity pools
for dealers only, and confines investors to others, hinders
choice and competition, and frustrates the core principle of
impartial access. A key roadblock perpetuating the two-tier SEF
marketplace is the practice of post-trade name give-up where
the identities of counterparties to otherwise anonymous trades
are revealed or given up post-trade. This is a legacy practice
that no longer serves any legitimate purpose for cleared swaps
where counterparties face clearinghouses and not each other.
However, by systematically revealing private trading
information, name give-up deters investors from participating
on those SEFs that employ it, namely, the historically dealer-
to-dealer SEFs. We believe regulatory action is needed to
remove this impediment to investors and partial access to all
SEFs.
We appreciate the Committee's oversight of derivatives
clearing and trading, and I thank you for the opportunity to
speak here today. I would be happy to answer any questions.
[The prepared statement of Mr. Berger follows:]
Prepared Statement of Stephen John Berger, Director, Government and
Regulatory Policy, Citadel, LLC, New York, NY; on Behalf of Managed
Funds Association
Chairman Scott, Ranking Member Scott, my name is Stephen Berger and
I am the Director, Government & Regulatory Policy, of Citadel LLC.
Citadel is a global financial firm built around world-class talent,
sound risk management, and innovative market-leading technology. For
more than a quarter of a century, Citadel's hedge funds and capital
markets platforms have delivered meaningful and measurable results to
top-tier investors and clients around the world. Citadel operates in
all major asset classes and financial markets, with offices in the
world's leading financial centers, including Chicago, New York, San
Francisco, Boston, London, Hong Kong, and Shanghai.
I am here today to speak on behalf of Managed Funds Association
(``MFA'') and its members regarding the impact of the G20 clearing and
trade execution requirements for OTC derivatives. MFA represents the
majority of the world's largest hedge funds and is the primary advocate
for sound business practices for hedge funds, funds of funds, managed
futures funds, and service providers. MFA's members manage a
substantial portion of the approximately $3 trillion invested in hedge
funds around the world. Our members serve pensions, university
endowments, and other institutions.
MFA's members are among the most sophisticated investors and play
an important role in our financial system. They are active participants
in the commodity and securities markets, including over-the-counter
(``OTC'') derivatives markets. They provide liquidity and price
discovery to capital markets, capital to companies seeking to grow or
improve their businesses, and important investment options to investors
seeking to increase portfolio returns with less risk, such as pension
funds trying to meet their future obligations to plan beneficiaries.
MFA members engage in a variety of investment strategies across many
different asset classes. As investors, MFA members help dampen market
volatility by providing liquidity and pricing efficiency across many
markets. Hedge fund managers are fiduciaries that invest funds on
behalf of institutional and high-net worth investors. Our members'
skills help their customers plan for retirement, honor pension
obligations, and fund scholarships, among other important goals.
As part of their asset management strategies, MFA members are
active participants in the derivatives markets, and have consistently
supported reforms to the OTC derivatives markets in Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-Frank
Act'') that mitigate systemic risk, increase transparency, and promote
an open, competitive, and level playing field. We welcomed the market's
transition to central clearing for liquid, standardized swaps that
occurred over the course of 2013, and actively engaged in the market's
evolution of trading liquid, standardized, cleared swaps on registered
swap execution facilities (``SEFs'') that commenced in 2014.
As a result, MFA has a strong interest in the successful
implementation of central clearing and organized trade execution in the
OTC derivatives markets, which further the goals of the G20 and the
Dodd-Frank Act to mitigate systemic risk and provide open and
accessible markets for investors. In this respect, we believe there are
several additional steps that the Commodity Futures Trading Commission
(``CFTC'') should take to promote further central clearing and the
market's transition to trading on SEFs. These steps include: (1)
expanding mandatory central clearing of interest rate swaps (``IRS'')
to include swaps denominated in all the G10 currencies; (2) further
working with the Securities and Exchange Commission (``SEC'') to
develop a viable portfolio margining regime for cleared credit default
swaps (``CDS'') as mandated by Congress in the Dodd-Frank Act, (3)
codifying existing CFTC staff guidance addressing impartial access to
SEFs; (4) clearly prohibiting post-trade name disclosure by SEFs that
offer anonymous execution of cleared swaps; and (5) making certain
other targeted amendments to its final SEF rules to improve the overall
trading regime. In addition, we believe the Basel Committee on Banking
Supervision (``Basel Committee'') should modify its treatment of
segregated initial margin for centrally cleared derivatives for
purposes of the Basel III leverage ratio to ensure that central
clearing remains affordable for customers.
On behalf of MFA, I appreciate the Committee's review and oversight
of the impact of the G20 clearing and trade execution requirements. MFA
has consistently provided constructive comments and suggestions to
regulators to help implement these mandates. We believe our comments
are consistent with the Committee's public policy goals and will
further enhance the benefits of OTC derivatives markets. As active
participants in the U.S. markets for OTC derivatives, we would like to
work with the G20 countries, Congress, the Committee, the CFTC, and all
other interested parties to further the optimal implementation of the
clearing and trade execution rules, which will reduce systemic risk,
ensure affordable and impartial access to our financial markets, and
strengthen our nation's economy.
Central Clearing and Its U.S. Implementation
MFA has consistently supported policymakers' efforts to reduce
systemic risk in the derivatives markets by transitioning standardized
and liquid OTC derivative contracts into central clearing. The
implementation of central clearing was a central goal of the 2009 G20
commitments and the U.S. has been at the forefront of the move to
central clearing.
MFA believes that central clearing has reduced systemic risk by
eliminating the complex, interconnected web of counterparty exposures
and replacing it with a safer system where all counterparties face a
single well-regulated central counterparty (``CCP''). Today, the
prominent CCPs serving the U.S. market are operated by CME Group
(``CME''), the Intercontinental Exchange, Inc. (``ICE''), and
LCH.Clearnet (``LCH''). While not all derivatives products have
sufficient liquidity to merit being made subject to the mandatory
clearing requirement, in the U.S., we have seen the successful
implementation of central clearing for a significant portion of the IRS
and index CDS markets.
The progress in implementing central clearing in the U.S. has been
impressive. According to CFTC Chairman Timothy Massad, approximately
75% of outstanding U.S. swap transactions (measured by notional value)
are being cleared, as compared to only 16% in 2007.\1\ In particular,
the progress in implementing central clearing for end-users and other
customers of OTC derivatives has been notable. LCH has approximately
$21.3 trillion notional of customer IRS transactions outstanding.\2\ At
CME, open interest in IRS is approximately $17.7 \3\ trillion notional,
and predominantly driven by customers. Finally, ICE has cleared
approximately $20.8 trillion notional of index CDS for customers.\4\
---------------------------------------------------------------------------
\1\ Remarks of Timothy G. Massad before the Swaps Execution
Facilities Conference (SEFCON V), November 12, 2014, available at:
http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-4.
\2\ See LCH Daily Volumes--SwapClear Global, available at: http://
www.lch.com/en/asset-classes/otc-interest-rate-derivatives/volumes/
daily-volumes-swapclear-global.
\3\ See CME Open Volume Tracker, available at: http://
www.cmegroup.com/education/cme-volume-oi-records.html.
\4\ See https://www.theice.com/clear-credit.
---------------------------------------------------------------------------
As a result, in MFA's view, the implementation of central clearing
in the U.S., thus far, has been successful and made our financial
system much safer. In particular, we believe that central clearing has
greatly benefitted the market by:
Mitigating systemic risk and reducing the risk of contagion;
Providing a mechanism for the orderly unwind of the
portfolio of a defaulting market participant that is also
designed to protect non-defaulting customers from losses;
Promoting discipline with respect to margin and collateral
practices;
Improving market transparency;
Increasing competition among potential trading
counterparties and liquidity providers; and
Supporting the migration of trading onto more open,
transparent, trading venues.
In addition, the CFTC has enhanced the integrity of the execution-
to-clearing workflow by implementing straight-through processing
(``STP'') requirements. The CFTC's STP rules require clearing members
to conduct pre-execution credit checks in order to pre-empt post-
execution rejections of trades submitted for clearing, and to establish
strict timeframes around how quickly an executed trade must be
submitted to, and accepted or rejected by, a CCP. As a result, these
STP requirements strengthen market resilience, enhance risk management,
protect investors by reducing counterparty risk, and promote overall
market transparency and efficiency. Importantly, the CFTC's STP rules
established a standard that has now been adopted by the European Union
(``EU'') in the context of implementing the Markets in Financial
Instruments Directive (``MiFID II'').
While not all of the G20 countries have implemented mandatory
clearing requirements, we appreciate the positive steps taken by many
countries to achieve harmonization and implementation of central
clearing on a global basis. For example, mandatory central clearing of
certain OTC derivatives will begin in the EU later this month. In
addition, central clearing has already begun in Australia and Mexico,
and is expected to begin soon in other countries, including Canada,
Hong Kong, Singapore, and Switzerland. Notably, in light of these
global developments, the CFTC has recently proposed to expand the
central clearing requirement in the U.S. to harmonize with these
foreign jurisdictions.\5\ Last, we applaud the CFTC and the European
Commission for reaching an agreement on a common approach to the
regulation of CCPs earlier this year.\6\ This agreement will help to
ensure that the G20 goal of global, harmonized OTC derivatives
regulation is fully achieved.
---------------------------------------------------------------------------
\5\ See CFTC notice of proposed rulemaking on ``Clearing
Requirement Determination under Section 2(h) of the CEA for Interest
Rate Swaps'' (``CFTC Additional IRS Proposal''), available at: http://
www.cftc.gov/idc/groups/public/@newsroom/documents/file/
federalregister060916.pdf.
\6\ See The United States Commodity Futures Trading Commission and
the European Commission: Common approach for transatlantic CCPs, 10
February 2016, available at: http://www.cftc.gov/idc/groups/public/
@newsroom/documents/speechandtestimony/eu_cftcstate
ment.pdf.
---------------------------------------------------------------------------
Expanding Central Clearing of IRS to Other Currencies
Consistent with the CFTC Additional IRS Proposal, MFA supports the
expansion of central clearing to IRS denominated in additional
currencies.
Under current CFTC rules, the clearing requirement applies only to
IRS denominated in the G4 currencies, which include U.S. Dollars,
Euros, Japanese Yen, and British Pound Sterling. MFA believes that the
clearing mandate should be expanded to include IRS denominated in all
of the G10 currencies \7\ because those additional IRS classes are
traded in significant volumes globally.
---------------------------------------------------------------------------
\7\ The G10 currencies are the U.S. Dollar (USD), Euro (EUR),
Japanese Yen (JPY), British Pound (GBP), Swiss Franc (CHF), Australian
Dollar (AUD), New Zealand Dollar (NZD), Canadian Dollar (CAD), Swedish
Krona (SEK), and Norwegian Krone (NOK).
---------------------------------------------------------------------------
The CFTC Additional IRS Proposal to expand the clearing mandate
would apply to IRS denominated in Australian dollars, Swiss francs,
Canadian dollars, Mexican pesos, Polish zloty, Swedish Krona, Norwegian
Krone, Hong Kong dollars, and Singapore dollars. The European
Commission has also recently adopted final regulatory technical
standards that expand the EU clearing mandate to IRS denominated in
Polish zloty, Swedish Krona, and Norwegian Krone.\8\ The CME and LCH
already clear IRS denominated in these currencies and market
participants already voluntarily clear a significant amount of these
instruments.
---------------------------------------------------------------------------
\8\ See European Commission Delegated Regulation (EU) . . ./. . .
of 10.6.2016 supplementing Regulation (EU) No 648/2012 of the European
Parliament and of the Council with regard to regulatory technical
standards on the clearing obligation, 10 June 2016, available at:
http://ec.europa.eu/finance/financial-markets/docs/derivatives/160610-
delegated-regulation_en.pdf.
---------------------------------------------------------------------------
Consistent with the goal of reducing systemic risk through the
international convergence of central clearing, MFA believes that
transitioning IRS denominated in the G10 currencies to the clearing
requirement is appropriate and timely.
Ensuring the Affordability of Customer Clearing
Customers are a vital part of the derivatives markets and have been
critical to the success of central clearing in the U.S. While some
clearing of swaps between dealers existed prior to enactment of the
Dodd-Frank Act, artificial barriers to entry prevented customers from
similarly participating in the cleared swaps market. Implementation of
the central clearing requirement eliminated many of those artificial
barriers and resulted in substantial customer clearing.
However, at present, swaps customers exclusively access CCPs
indirectly through clearing members, rather than becoming direct
members of CCPs, for a variety of reasons, both financial and
operational. MFA expects the demand for clearing services to increase
as regulators in different jurisdictions fully implement their
respective mandatory clearing initiatives. As a result, it is critical
that customer clearing services remain available at an affordable price
to ensure that customers have fair and equal access to CCPs.
MFA has strong concerns about the Basel Committee's treatment of
segregated initial margin for centrally cleared derivatives exposure
under the Basel III leverage ratio (``Leverage Ratio'') because it
threatens the ability of customers to use centrally cleared derivatives
and could limit the ability of end-users to hedge their risks.
CCPs' risk management methodologies are predicated on the
collection of initial margin and variation margin from clearing members
and customers in order to collateralize potential exposure. In
addition, direct clearing members guarantee payment of their customers'
obligations to the CCP. Because the initial margin is the customer's
money,\9\ CFTC rules require clearing members to segregate customer
funds from the clearing member's own assets.
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\9\ Under CFTC rules, a clearing member must separately account
for, and segregate as belonging to the customer, all money, securities
and property it receives from a customer as margin. See 17 CFR 1.20-
1.30; 17 CFR 22.2-22.7; see also CFTC Chairman Timothy Massad,
Testimony before the U.S. House Committee on Agriculture (Feb. 12,
2015).
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While the Basel Committee's framework captures a clearing member's
guarantee to the CCP as an off-balance sheet exposure, the Leverage
Ratio fails to provide an offset that recognizes the exposure-reducing
effect of customers' segregated initial margin. According to the Basel
Committee, the reason for the lack of an offset for customer initial
margin is that segregated customer initial margin not only offsets
exposures, but also can be used by the clearing member for further
leverage. In the U.S., segregation rules severely restrict the ability
of initial margin to be held in anything other than extremely low-risk
and extremely liquid assets, assuring that it is always available to
absorb losses ahead of the bank.\10\ Moreover, the substantial majority
of segregated initial margin is posted to the CCP, and therefore, is
entirely outside the control of the clearing member.\11\
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\10\ In the United States, segregated margin cannot be reinvested
except for investments in low-risk and highly liquid assets, such as
U.S. government securities, managed ``with the objectives of preserving
principal and maintaining liquidity''. See 17 CFR 1.25(b).
\11\ Applicable U.S. margin and CCP regulations result in a
significant majority of margin being passed onto the CCP. Although
margin rules vary across jurisdictions outside of the U.S., non-U.S.
margin frameworks for centrally cleared derivatives generally result in
a substantial portion of margin held at the CCP rather than the
clearing member.
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The Leverage Ratio's failure to recognize the purpose of segregated
initial margin is a threat to the use of cleared derivatives by
customers. Because of the lack of offset, clearing members will incur
large Leverage Ratio exposures, which will likely raise prices for
customer clearing significantly. The Leverage Ratio, as currently
structured, is estimated to increase significantly the cost of using
cleared derivatives.\12\ This substantial cost increase may cause
customers to reduce their hedging activities to levels that are
inadequate to manage their risk, which could result in price increases
and volatility for food, gasoline, and other consumer goods.
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\12\ The Commodity Markets Council (``CMC'') estimates that the
Leverage Ratio, as currently structured, would increase the cost of
using cleared derivatives by more than five times current levels. This
estimate is based on conversations by CMC members with clearing
members. The increase in costs would be due to increased fees for
cleared derivatives. CMC and MFA members also anticipate incurring
business costs due to their diminished ability to hedge commercial and
financial risks. See also, Fiona Maxwell, Non-bank FCMs unlikely to
fill OTC gap, Risk, Oct. 7, 2015, available at: http://www.risk.net/
risk-magazine/news/2429225/non-bank-fcms-unlikely-to-fill-otc-gap#.
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Therefore, to ensure the continued affordability and robustness of
customer clearing in the U.S., we respectfully request that the
Committee encourage the Basel Committee to modify the Leverage Ratio by
providing an offset for clearing members to the extent that customer
initial margin is posted to the CCP, or is segregated under the U.S.
regulatory regime.
Ensuring a Viable Portfolio Margining Regime
The Dodd-Frank Act divided jurisdiction over OTC derivatives
between the CFTC and the SEC. For CDS, the CFTC has jurisdiction over
most CDS indices, while the SEC has jurisdiction over single-name CDS.
The CFTC has mandated clearing of certain CDS indices, but the SEC has
not yet issued a clearing mandate for single-name CDS. However, a
number of MFA members would like to voluntarily clear single-name CDS
in order to take advantage of the portfolio margining benefits arising
from offsetting positions in cleared index CDS and single-name CDS.
Portfolio margining simply means recognizing the offsetting
positions within a cleared OTC derivatives portfolio, resulting in
margin efficiencies. Section 713 of the Dodd-Frank Act specifically
encouraged the SEC and the CFTC to work together to implement a
regulatory framework that facilitates portfolio margining.
ICE has an offering that enables market participants to clear both
index CDS and single-name CDS in a CFTC-regulated account under the
Commodity Exchange Act, as amended (``CEA''). In 2011, both agencies
issued orders approving ICE's portfolio margining regime for dealers'
proprietary CDS positions. Over a year later, both agencies approved
ICE's portfolio margining regime for customers. However, the SEC's
approval order imposed a number of conditions on ICE and clearing
member firms seeking to offer a CDS customer portfolio margining
program.
Notably, each clearing member firm is required to establish its own
margin methodology that is different from the margin methodology of the
CCP and must submit its margin methodology to the SEC for review and
approval. The requirement for each clearing member to have its own
margin methodology undermines one of the fundamental benefits of
central clearing, which is the ability for all market participants to
rely on the same, fully vetted and approved margin methodology
maintained by the CCP. In addition, it reduces transparency for
clearing customers, as it is difficult to evaluate and compare the
different margin methodologies separately established by each clearing
member.
In our view, the requirements imposed by the SEC have delayed
voluntary buy-side clearing of single-name CDS, with resulting adverse
effects on trading volume and liquidity. We urge the SEC to use the
CCP's vetted and approved margin methodology as the baseline, with
clearing members able to collect additional margin as they deem
appropriate according to their assessment of a clearing customer's
credit risk. This approach will enable a viable portfolio margining
regime for cleared CDS as mandated by Congress in the Dodd-Frank Act.
Swap Execution Facilities and the Trade Execution Requirement
MFA continues to support the Dodd-Frank Act's goal of transitioning
the trading of standardized, liquid, cleared swaps onto SEFs that
provide open and impartial access and enable the emergence of an ``all-
to-all'' market (where multiple market participants are able to meet
and transact). MFA believes the CFTC SEF framework benefits the swaps
market and its participants by increasing market efficiency,
competition, transparency and liquidity. In fact, according to recent
Bank of England research, the implementation of the clearing and
trading reforms in the U.S. interest rate swaps market has already
yielded significant improvements in pricing and liquidity, with market
participants saving as much as $20-$40 million per day, of which $7-$13
million is being saved by market end-users alone per day.\13\
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\13\ See Staff Working Paper No. 580 ``Centralized trading,
transparency and interest rate swap market liquidity: evidence from the
implementation of the Dodd-Frank Act'', Bank of England (January 2016),
available at: http://www.bankofengland.co.uk/research/Documents/
workingpapers/2016/swp580.pdf.
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While the SEF market continues to evolve, MFA believes the current
SEF regime can be enhanced by the CFTC taking certain additional steps
to address the current two-tier market structure and the legacy
practice of post-trade name disclosure on SEFs that offer anonymous
execution of cleared swaps.
Two-Tier Market
Nearly 3 years after the launch of the SEF marketplace, MFA is
concerned that the swaps market remains bifurcated between ``dealer-to-
dealer'' or inter-dealer broker (``IDB'') SEFs that exclude most buy-
side firms and ``dealer-to-customer'' (or ``D2C'') SEFs.
IDB SEFs: In one tier, the IDB SEFs offer central limit
order books (``CLOBs'') and voice-brokered request-for-quote
(``RFQ'') models, among others, with trading on an anonymous
basis but the identities of counterparties revealed post-trade.
While IDB SEFs may have onboarded a number of buy-side firms,
there is no meaningful buy-side trade execution and
participation on IDB SEFs.
D2C SEFs: In the second tier, D2C SEFs offer electronic RFQ
systems, which effectively require the buy-side to trade with
dealers by requesting quotes on a name-disclosed basis.
Although D2C SEFs provide order books, there is more limited
liquidity available. Nearly all SEF trading volume by the buy-
side occurs on two dominant D2C SEFs via name-disclosed RFQ.
This two-tier market structure prevents the buy-side from accessing
important pools of liquidity for cleared swaps, including the liquid
order books. This market structure also confines the buy-side to a
``price-taker'' role, rather than providing the opportunity to become a
``price-maker'' as well.
MFA believes that the persistence of the two-tier swaps trading
market structure ``status quo'' is contrary to Congress's reform goals.
It is inconsistent with the Dodd-Frank Act's express impartial access
requirement for SEFs.\14\ In our view, the status quo needs to change
to improve competition and market liquidity.
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\14\ Pub. L. 111-203, 124 Stat. 1376 (2010). Section 733 of the
Dodd-Frank Act amends the CEA to require, in pertinent part, that SEFs
both establish and enforce participation rules and have the capacity to
enforce those rules, including the means to provide market participants
with impartial access to the market. See also CFTC rule 37.202 in the
CFTC final rule on ``Core Principles and Other Requirements for Swap
Execution Facilities'', 78 Fed. Reg. 33476, 33587 (June 4, 2013),
available at: https://www.gpo.gov/fdsys/pkg/FR-2013-06-04/pdf/2013-
12242.pdf.
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Impartial access has contributed to the health and vitality of
several other significant markets (such as equities and futures
markets, where any participant can ``make'' or ``take'' prices). By
contrast, the two-tier swaps market structure perpetuates traditional
dealers' control of liquidity and protects their role as exclusive
``price makers''. It also limits the manner and extent to which buy-
side participants may interact in the swaps market. Such structural
limitations on liquidity provision and risk transfer may increase the
likelihood of market volatility and instability over the long term. The
willingness and capacity of traditional dealers to allocate balance
sheet (i.e., for dealers to use their own funds) to swaps market-making
activities appears to be diminishing in certain respects. This trend
will likely continue over time as traditional dealers continue to
restructure their businesses post-financial crisis and adapt to new
capital, leverage, and liquidity requirements under Basel III and
similar rules. Without swaps market reforms that facilitate impartial
access to all SEFs and encourage alternative forms of price formation
and liquidity provision and greater diversity of participation (among
participants and modes of interaction), MFA fears that the U.S. swaps
market could risk greater volatility and dislocation in times of market
stress.
Congress designed the swaps market reforms under Title VII of the
Dodd-Frank Act to produce a more competitive and transparent swaps
market structure. Based on the examples set by other significant
trading markets noted above, MFA believes that true impartial access,
once implemented and enforced, will provide a stronger foundation for
U.S. swaps market liquidity and enhance price transparency in the U.S.
swaps market. This outcome will contribute beneficial effects to the
nation's economy.
Post-Trade Name Give-Up
A key mechanism suppressing buy-side trading on IDB SEFs and
directly contributing to the current two-tier market structure in the
U.S. is the legacy practice of post-trade name disclosure (or ``give
up''). We believe that a SEF that imposes access limitations that deter
buy-side participation in its market contravenes the impartial access
requirement. Even though otherwise eligible buy-side participants have
access to all SEFs in theory, the loss of anonymity caused by the
continuation of post-trade name disclosure is a strong disincentive to
buy-side participation in IDB SEFs in practice.
The practice of post-trade name give-up originates in anonymous
markets for uncleared swaps. Participants in the uncleared swaps market
reasonably need to limit the firms with which they may trade in order
to manage counterparty credit risk. Further, to record each new
bilateral swap with a given counterparty on their books, participants
need to learn the identity of the counterparty with whom they were
matched. Thus, post-trade name disclosure and the attendant limitations
on interactions among market participants are justified in the
uncleared swaps markets where counterparties have credit exposure to
each other.
While the practice may have served a purpose prior to the
implementation of the current swaps trading and clearing regime, today
it needlessly reveals the identities of counterparties to otherwise
anonymous cleared trades. In the early days of the cleared swaps
market, counterparties used post-trade name disclosure to coordinate
submission of trades to clearing after trade execution. However, the
successful implementation of STP for SEF-executed trades, including the
pre-trade credit check process, has eliminated any need to use post-
trade name disclosure to either manage counterparty credit risk or
facilitate clearing submission. Post-trade name disclosure nevertheless
continues to occur as a routine practice on IDB SEFs.
MFA strongly believes that for swaps that are anonymously executed
and then immediately cleared, there is no legitimate reason for a party
to the cleared swap to know the identity of its original executing
counterparty. Once the CCP accepts the trade for clearing, the trade
exists only as a cleared trade. The obligations to perform on a cleared
trade run only between the CCP and the party to the trade (and, where
applicable, its agent clearing member). In a cleared trade, the CCP is
the sole counterparty to each of the original transacting parties, and,
again, the original transacting parties have no rights or
responsibilities with respect to each other.
As a result, we firmly believe that the legacy practice of post-
trade name disclosure no longer has a legitimate commercial,
operational, credit or legal justification in cleared swap markets
where transacting parties face the clearinghouse and are not exposed to
each other's credit risk following trade execution.
Adverse Effects of Post-Trade Name Disclosure in the Current Swaps
Trading and Clearing Regime
Among its other adverse effects, post-trade name disclosure is a
source of random and uncontrolled ``information leakage'' of private
information on SEFs that offer anonymous execution of cleared swaps. It
deters buy-side firms from trading on IDB SEFs because it reveals a
firm's private trading positions and trading strategies to competitors
or dealers. By doing so, post-trade name disclosure appears
inconsistent with CFTC rules prohibiting access to private trading
information. In contrast, when a buy-side firm discloses its identity
and trading interests in the RFQ market, a buy-side firm has control of
the associated ``information leakage'' because it can choose to whom it
sends an RFQ.
Prohibiting post-trade name disclosure on SEFs would protect the
privacy of an original counterparty's identifying information as
required by CFTC rule 49.17(f)(2), as amended. In response to concerns
that MFA and other market participants raised that the identity of
counterparties to anonymously executed swap trades could be
inadvertently revealed post-trade by a swap data repository (``SDR''),
the CFTC voted unanimously to adopt an interim final rule that amended
the scope of CFTC rule 49.17(f)(2) by making explicit the limitation on
counterparty access to data and information related to an anonymously
executed, cleared swap that applies to SDRs by virtue of the privacy
requirements of CEA section 21(c)(6). Without further regulatory action
to prohibit the practice of post-trade name disclosure, a counterparty
can continue to obtain the identities of its original transacting
parties from the SEF or from the affirmation hub that processes the
SEF's trades, even though the SDR is required to protect the privacy of
such information. Because section 21(c)(6) of the CEA mandates the
privacy requirement imposed under CFTC rule 49.17(f)(2), MFA believes
that allowing a SEF to facilitate or permit post-trade name disclosure
frustrates clear Congressional intent.
Post-trade name disclosure also perpetuates informational and
trading advantages for traditional dealers that benefit from their
ability to access and achieve full visibility into both the inter-
dealer and dealer-to-customer markets. Buy-side firms do not have true
impartial access to the IDB SEFs that offer anonymous execution through
CLOBs and other execution models due to the continued practice of post-
trade name disclosure. MFA believes that the continuation of this
practice creates an uneven playing field and impairs competition, as it
reduces pre-trade price transparency for otherwise qualified buy-side
market participants and restricts their ability to trade certain swap
products anonymously.
Due to the nature of liquidity in swap markets, it is unlikely that
the market will resolve this artificial barrier to buy-side
participation on IDB SEFs on its own. Post-trade name disclosure
appears inconsistent with the letter and intent of the Dodd-Frank Act's
swaps market reforms and CFTC rules, and in our view the CFTC has ample
authority to prohibit this practice. MFA believes that regulatory
action to prohibit post-trade name disclosure would increase the volume
of buy-side trading on SEFs as it would attract more users and thus
more trading volume to these platforms, and allow more flexible and
efficient execution of both outright swaps and package transactions.
While some argue that market dynamics will address post-trade name
disclosure and its adverse effects, we respectfully disagree.
Commercial and competitive dynamics make it difficult for any one IDB
SEF to disable post-trade name disclosure unilaterally, as traditional
dealers that opposed such a change might easily shift their trading to
other IDB SEFs. This is a classic case where only the regulator can
readily bring competition and fairness to the market by eliminating
post-trade name disclosure on any SEF that offers anonymous execution
of cleared swaps. Doing so will increase the diversity, breadth, and
depth of liquidity on SEFs and thereby reduce the potential for market
volatility and disruptions.
MFA is aware of several arguments to preserve the practice of post-
trade name disclosure on IDB SEFs. We summarize below our counter-
arguments based on the extensive swaps trading experience of many MFA
members.
Post-Trade Name Disclosure is Not Necessary to Deter
``Gaming''. Some have argued that the practice of post-trade
name disclosure should be preserved to prevent buy-side firms
from ``gaming'' the market. Proponents of this view claim that
buy-side firms could post a low resting bid (or high resting
offer) in an anonymous CLOB, and then solicit a dealer through
an RFQ to motivate the dealer to lower its price in reliance
upon the price level posted in the CLOB. This theoretical risk
exists in any market that employs both anonymous and disclosed
trading protocols and historically, has not risen to a level of
serious concern. The Treasury securities and foreign exchange
markets, for example, have operated for years with both
anonymous and disclosed execution channels, and participants
have been able to trade across both without concerns of gaming.
Nothing about the swaps market necessitates a different
policing paradigm from other markets. Further, SEF CLOBs
require market participants to post firm resting bids/offers.
SEF participants that attempt to ``game'' dealers on pricing
would be at risk of their firm offers being matched, resulting
in potentially unfavorable positions. The likelihood of
detection for engaging in any gaming behavior, regardless of
whether or not a SEF uses post-trade name disclosure in its
market, also serves as a strong deterrent. Such actions carry
serious reputational and enforcement risks that buy-side market
participants naturally avoid.
Post-Trade Name Disclosure Does Not Facilitate Dealer
Capital Allocation. Contrary to some claims, MFA believes that
post-trade name disclosure does not help dealers in allocating
their capital among their customer base. In an anonymously
executed market, there is no affirmative decision by a dealer
to direct business to a particular counterparty based on a pre-
existing relationship, or to reward loyal customers with better
prices--the parties are transacting only on the basis of
anonymously posted bids and offers. The pricing for a
particular swap does not change when the parties' identities
are disclosed to each other post-execution. MFA does not expect
that the elimination of post-trade name disclosure will have
any impact on future pricing of such swap trades, because
trading decisions are not based on the identity of the
counterparty to begin with.
Concerns that Dealers Will Provide Less Liquidity to Markets
Without Post-Trade Name Disclosure Lack Precedent in Similar
Markets. In electronic order-driven trading markets, it should
not matter whether a dealer's counterparty is another dealer or
a buy-side firm. Thus, these markets should remain anonymous to
create a level playing field for all participants. Further, as
the willingness and capacity of traditional dealers to allocate
balance sheet to swaps market-making activities appears to be
diminishing in certain respects due to Basel III's higher
capital requirements, regulatory steps that promote impartial
access to all SEFs encourage alternative forms of price
formation and liquidity provision and greater diversity of
participation (among participants and modes of interaction).
These steps are essential investments for building a more
robust and competitive swaps market in our country.
In MFA's view, the unintended consequence of regulatory inaction
may be increased volatility in the U.S. swaps market. It is time for
the CFTC to exercise its regulatory authority to prohibit post-trade
name disclosure for anonymously executed, cleared swaps. By doing so,
the CFTC will promote the transition to SEFs that operate in accordance
with Dodd-Frank's contemplated reforms for the U.S. swaps market. We
anticipate that regulatory prohibition of this practice will encourage
greater voluntary trading by buy-side firms on IDB SEFs and make the
SEF regime more attractive internationally, as a result of the true
impartial access to these markets.
MFA petitioned the CFTC for this rule change as well as other rule
changes to improve the SEF regime, as discussed below. We respectfully
urge the Committee to support such changes at the CFTC.
Proposed SEF-Related Rule Amendments
MFA urges the CFTC to modify and update its SEF-related rules in
light of experience with SEF trading. In October 2015, MFA submitted a
petition to the CFTC to amend certain provisions of its regulations
related to OTC derivatives trading on SEFs, based on MFA members'
experiences to date and the ``lessons learned'' through the
implementation process.\15\ MFA's proposed amendments would: (1) codify
existing CFTC staff guidance around the implementation of the CFTC's
impartial access requirements; (2) codify existing CFTC staff guidance
around the implementation of the CFTC's STP requirements; (3) clearly
prohibit post-trade name disclosure by SEFs for swaps that are executed
anonymously; (4) facilitate SEF execution of package transactions by
requiring the package transaction as a whole to become ``made available
to trade'' in order to be subject to the CFTC's trade execution
requirement; (5) provide a mandatory public comment period for every
``made available to trade'' (``MAT'') determination submission by a SEF
under Part 40 of the CFTC's regulations; (6) establish a clear process
for determining when a swap product should no longer be considered
available to trade on a SEF; (7) codify existing CFTC staff guidance
and no-action relief around rejection of swaps from clearing and
resubmission for operational and clerical errors; (8) clarify the order
interaction requirements between different SEF trading protocols; and
(9) modify the definition of ``block trade'' in Part 43 of the CFTC's
regulations to authorize on-SEF execution of a block trade as a
``permitted transaction'' as defined in section 37.9(c) in order to
facilitate pre-execution credit checks of block trades that are
intended to be cleared.
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\15\ See MFA Petition for Rulemaking to Amend Certain CFTC
Regulations in Parts 1 (General Regulations under the Commodity
Exchange Act), 39 (Derivatives Clearing Organizations, Subpart B--
Compliance with Core Principles) and 43 (Real-Time Public Reporting),
submitted to Mr. Christopher Kirkpatrick, Secretary of the Commission,
on October 22, 2105, available at: https://www.managedfunds.org/wp-
content/uploads/2015/10/CFTC-Petition-for-SEF-Rules-Amendments-MFA-
Final-Letter-with-Appendix-A-Oct-22-2015.pdf.
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In addition, in subsequent discussions with the CFTC, the MFA also
advocated for increased mandatory disclosure from SEFs regarding
trading protocols, fees, and governance.
I will review MFA's supporting arguments for each of MFA's proposed
amendments, other than our rationales for the requested rule to
prohibit post-trade name give-up discussed above.
Codify Existing CFTC Staff Guidance: Impartial Access
MFA's proposed amendments to section 37.202(c) would codify
existing staff guidance to prohibit the use of enablement mechanisms
and breakage agreements for swaps that are intended to be cleared on
SEFs. A SEF that requires or permits such arrangements imposes barriers
to the buy-side's access to that SEF and contravenes the CFTC's
impartial access requirements. In addition, our proposed amendments
prohibit a SEF from limiting access to certain types of eligible
contract participants in a discriminatory manner. Such access
limitations could be based on the manner in which certain types of
eligible contract participants typically interact in the market,
anticipated levels of trading activity, or entity registration status.
These and other status-based access criteria also act as artificial
barriers to the buy-side's access to SEFs.
Codify Existing CFTC Staff Guidance: STP
MFA's proposed amendments to section 1.73 would codify existing
CFTC staff guidance clarifying the pre-execution risk management
requirements for clearing futures commission merchants (``FCM'') and
the obligation for SEFs to facilitate compliance with these
requirements.
Consistent with current CFTC staff guidance, MFA's proposed
amendments to section 1.74 would establish an outer boundary of 60
seconds after submission of a trade to the clearing FCM for acceptance
for clearing. Our proposed amendments would retain the current timing
standard of ``as quickly as technologically practicable if fully
automated systems were used'' (``ASATP'') to require timing reductions
for clearing acceptance from the 60 second outer boundary that
continuing improvements in technology will enable.
Finally, consistent with current CFTC staff guidance, MFA's
proposed amendments to section 39.12(b)(7) would establish an outer
boundary of 10 seconds after submission of any trade for clearing to a
CCP for the CCP to accept or reject a trade for clearing. Our proposed
amendments would retain the ASATP standard to require timing reductions
for clearing acceptance from the 10 second outer boundary that
continuing technology improvements will enable.
More Clearly Address Package Transactions in MAT Determination Process
MFA's proposed amendments to section 37.9 would revise the
definition of a ``required transaction'' to include ``any transaction
involving a stand-alone swap or any package transaction that is subject
to the trade execution requirement in section 2(h)(8) of the [CEA]''.
We would also define a ``package transaction'' as follows:
Package transaction means a transaction involving two or more
instruments: (1) that is executed between two or more
counterparties; (2) that is priced or quoted as one economic
transaction with simultaneous or near simultaneous execution of
all components; (3) where the execution of each component is
contingent upon the execution of all other components; and (4)
where the risk of the offsetting components is reasonably
equivalent.
A transaction meeting this definition would not be deemed a required
transaction, unless the package transaction as a whole has become
subject to the CFTC's trade execution requirement in section 2(h)(8) of
the CEA.
Based on the implementation experiences of MFA members, we believe
a determination should be made regarding the liquidity characteristics
of the package transaction as a whole. This approach would avoid the
need for CFTC staff to resort to issuing serial no-action relief as the
industry continues to work on the remaining execution challenges and
infrastructure solutions for certain types of package transactions.
This approach differs from the current process, where a MAT
determination has implications not only for the execution of a given
swap on a stand-alone basis, but also for all package transactions that
include such a swap. Both the liquidity profile and the ability of
market infrastructure to facilitate trading of swaps executed on a
stand-alone basis versus as part of a package transaction can vary
widely. Therefore, our changes to section 37.10 would require SEFs to
apply the CFTC's MAT criteria separately at the package level to avoid
execution challenges and the need for extended or permanent staff no-
action relief from the trade execution requirement for certain types of
package transactions.
Provide Public Comment Period for MAT Determinations
MFA's proposed amendments would require a public comment period
with respect to each MAT determination submission by a SEF. We believe
a mandatory public comment period would provide market participants
with a critical opportunity to inform the CFTC as to a swap product's
suitability and the industry's technological and operational readiness
to move the product from the OTC market to SEF trading. We also believe
that our proposed amendments would enable the CFTC to perform a more
meaningful oversight role, furthering international harmonization.
Establish a Process for de-MAT Determinations
MFA's proposed amendments would establish a clear process for
determining when a stand-alone swap or package transaction is no longer
available to trade on a SEF (a ``de-MAT determination''), based on the
CFTC's current six MAT factors. We believe the CFTC should administer
this process by retaining its authority to make such a determination on
an annual basis or if the CFTC receives notice of de-listing
submissions from at least two SEFs for a particular swap. Consistent
with our request for MAT determinations, our proposed amendments would
also require a public comment period to further inform the CFTC's
consideration of any de-MAT determination.
We believe that a separate de-MAT determination process would serve
as an important check-and-balance mechanism, rather than a process that
relies exclusively on determinations of SEFs. If none of the six MAT
factors support a determination that a stand-alone swap or a package
transaction is made available to trade, as confirmed objectively by the
CFTC's broader view of market trading data for the product in question,
the CFTC should issue a public de-MAT determination order that will
suspend the trade execution requirement for that product. That
suspension would apply universally to all SEFs.
Codify Existing CFTC Staff Guidance and No-Action Relief: Rejection
from Clearing and Resubmission
MFA's proposed amendments would codify, with clarifying
modifications, existing CFTC staff no-action letter 15-24 that
facilitates the correction of operational or clerical errors made in
the submission of a swap to clearing. Specifically, the current no-
action letter authorizes the resubmission of a corrected trade that
matches the terms and conditions of the erroneous trade, other than the
relevant operational or clerical error and the time of execution. MFA's
proposed amendments would also further codify the treatment of an
intended-to-be-cleared swap that is rejected from clearing (i.e., void
ab initio), which MFA strongly supports.
We note that ESMA included both void ab initio and a resubmission
procedure in its published regulatory technical standards under MiFID
II. As a result, codifying these points would further harmonization
between SEFs and MiFID II trading venues.
Clarify RFQ and Order Interaction
MFA's proposed amendments to section 37.9(a)(3)(i) involve the
CFTC's requirement that firm bids and offers must be taken into account
and communicated to an RFQ requester along with the RFQ responses.
These amendments would further clarify that any firm bid or offer that
is communicated to an RFQ requester in this situation must be provided
in an executable form so that the RFQ requester can easily access such
price if so desired. In addition, as SEFs continue to make innovations
in trading protocols, it is important that the order interaction
requirement not be construed so narrowly as to render it inapplicable
for these new trading protocols. As a result, these amendments would
clarify that a SEF must communicate to an RFQ requester any firm bid or
offer pertaining to the same instrument resting on any of the SEF's
markets, trading systems or platforms. We believe these amendments
promote pre-trade price transparency by ensuring the RFQ requester has
the ability to view and access competitive firm quotes anywhere on the
SEF.
Codify Existing CFTC Staff No-Action Relief: Eliminate ``Occurs Away''
Requirement for Authorized On-SEF Execution of Block Trades
MFA's proposed amendments would codify, with modification, existing
CFTC staff no-action letter 14-118 by eliminating the ``occurs away''
requirement for block trades. More specifically, our proposed
amendments would expressly authorize on-SEF execution of any block
trade as a permitted transaction. By doing so, a block trade can be
executed by RFQ to 1 or by voice to facilitate the requisite pre-
execution credit checks of block trades that are intended to be
cleared.
Increased Mandatory Disclosure from SEFs regarding Trading Protocols,
Fees, and Governance
In November 2015, the CFTC issued a notice of proposed rulemaking
regarding ``Regulation Automated Trading'', which included a provision
requiring a designated contract market (``DCM'') to provide additional
public information regarding its market maker and trading incentive
programs. MFA supported such requirement and, in addition, recommended
that the CFTC require SEFs to make similar types of market maker and
trading incentive program disclosures. Applying these transparency
requirements to SEFs would level the playing field with DCMs, as DCMs
may directly compete with SEFs by listing swaps or economically similar
contracts. MFA believes that such disclosure requirements will provide
investors and the broader public with more information and transparency
into DCM and SEF market maker and trading incentive programs, and we
agree with the CFTC that such disclosure will enhance market integrity.
Further, it is our view that market participants can benefit from
greater transparency from SEFs regarding other important aspects of
their offering, including trading protocols, fees, and governance.
Ensuring that this type of information is consistently provided to
market participants, will level the playing field and ensure that all
investors can make informed decisions regarding whether to join a
particular platform.
Conclusion
On behalf of MFA, I appreciate the Committee's review of the impact
of the G20 clearing and trade execution requirements. As discussed, we
believe that the CFTC should expand mandatory central clearing to IRS
denominated in all G10 currencies. We also believe that the CFTC should
engage in further rulemaking to ensure anonymous and impartial access
to SEFs so as to promote an open, competitive, and level playing field.
In addition, we respectfully ask Congress to encourage the Basel
Committee to modify the Basel III leverage ratio to ensure that central
clearing remains affordable for customers. We believe that, by
promoting central clearing and organized trade execution in the OTC
derivatives markets, these measures will advance the G20's and
Congress's goal of reducing systemic risk.
MFA is committed to working with Members and staff of Congress, the
Committee, and regulators to reduce systemic risk, ensure affordable
and impartial access to our financial markets, and strengthen our
nation's economy. Thank you for the opportunity to appear before you
today. I would be happy to answer any questions that you may have.
The Chairman. Thank you, Mr. Berger.
Mr. Zubrod.
STATEMENT OF LUKE D. ZUBROD, DIRECTOR, RISK AND
REGULATORY ADVISORY SERVICES, CHATHAM FINANCIAL, KENNETH
SQUARE, PA
Mr. Zubrod. Good morning, Chairman Scott, Ranking Member
Scott, and Members of the Subcommittee. I thank you for the
opportunity to testify today regarding certain derivatives-
related aspects of Dodd-Frank.
My name is Luke Zubrod, and I am a Director at Chatham
Financial. Chatham is an independent firm providing advice and
services to businesses that use derivatives to reduce their
interest rate, foreign currency, and commodity price risks.
Based in Pennsylvania, we serve 1,800 firms globally, including
clients in every state represented by Members of this
Subcommittee.
Our clients' risk reduction activity benefits the global
economy by allowing a range of businesses, from manufacturing
to agriculture, to real estate to financial services, to
improve planning and forecasting, and offer more stable prices
to consumers and a more stable contribution to economic growth.
Chatham appreciates this body's bipartisan efforts to
address key concerns of non-financial end-users following the
passage of Dodd-Frank, including efforts to clarify that margin
and clearing requirements should not apply to nonfinancial end-
users and their centralized treasury units. These efforts were
instrumental in eliminating key barriers to efficient access of
the derivatives market.
Today, I will identify two similar barriers affecting a
range of financial end-users that use low volumes of
derivatives to reduce risk. In particular, clearing and margin
requirements when applied to those transacting low volumes of
OTC derivatives deter such end-users from managing their risks,
cause them to manage their risks poorly, or dictate that they
do so at significant expense.
Chatham's clients facing unwarranted burdens due to
clearing and/or margin requirements touch a wide variety of
industries, including corporates deemed to be financial in
nature, real estate and infrastructure funds that make cross-
border investments in buildings, railroads, ports, et cetera,
regional banks that are contemplating using derivatives to
serve their customers, reduce risk, or compete with larger
banks in their footprints, microfinance funds whose capital is
directed toward enabling the world's poor to lift themselves
and their families from poverty in developing countries.
The first burden such firms face relates to the cost of
clearing for such low volume users. Clearing members typically
charge minimum monthly fees to establish a relationship that
would enable a customer to comply with the clearing mandate.
These fees vary by firm and customer, but typical fees amount
to $100,000 per year or more. A firm hedging interest rate
risks for a single 5 year bank loan will thus obligate itself
to $\1/2\ million in fees over that period, just to have the
privilege of hedging in the OTC markets.
The second burden relates to risk imposed by the margin
requirements which expose a company to liquidity risk that many
firms are unwilling to take on. Liquidity risk is the risk that
a sudden sharp movement in market conditions could force a
company to come up with sums of cash that are significant to
the company on short notice. In an extreme case, such margin
calls could cause a firm to default on an obligation.
Consider a firm with a 5 year interest rate risk, concerned
that in today's historically low interest rate environment,
increasing rates could adversely affect their ability to make
payroll. Such a firm could fully eliminate such risk by
entering into a 5 year interest rate swap to lock in a fixed
interest rate. On $100 million, 5 year swap, subject to
clearing or margin requirements, a firm would need to post
approximately $2 million at inception, which could grow to as
much as $12 million in a normally stressed market, and $25
million in an extremely stressed market, such as was seen
during the financial crisis. These costs and risks create
unintended consequences by negatively impacting the risk
management decisions many firms make, causing them to stop
hedging and retain risks that may harm business performance or
even firm viability, hedge poorly in ways that cause them to
retain risk, or hedge at significant expense and attempt to
pass on cost to customers.
While the benefits of clearing were widely understood when
Congress enacted the clearing mandate, the costs were not. We
now understand clearing to be a system that simply does not
accommodate small and low-volume users. The consequence is that
entities whose derivatives use has no ability to undermine
financial stability are cut off from properly or effectively
managing their risks. Small financial end-users are essentially
thrown into a raging sea of market volatility without a
dependable life preserver.
These concerns could easily be addressed if Congress
exempted low-volume users from clearing and margin requirements
via a financial entities de minimis exception. Such an
exception could be narrowly tailored to ensure that firms that
meaningfully contribute to systemic risk would not be eligible.
Such an approach is consistent with approaches adopted or
proposed by Australia, Canada, Japan, and Singapore.
Thank you for the opportunity to testify today, and I am
happy to address any questions you may have.
[The prepared statement of Mr. Zubrod follows:]
Prepared Statement of Luke D. Zubrod, Director, Risk and Regulatory
Advisory Services, Chatham Financial, Kenneth Square, PA
Good afternoon, Chairman Scott, Ranking Member Scott, and Members
of the Subcommittee. I thank you for the opportunity to testify today
regarding aspects of the Dodd-Frank Act that emanated from the G20
agenda for OTC derivatives. My name is Luke Zubrod and I am a Director
at Chatham Financial (``Chatham''). Chatham is an independent advisory
and technology firm providing services to businesses that use
derivatives to reduce their interest rate, foreign currency and
commodity price risks (``end-users''). A global firm based in
Pennsylvania, Chatham serves as a trusted advisor to over 1,800 end-
user clients annually ranging from Fortune 100 companies to small
businesses, including clients headquartered or doing business in every
state represented by Members of this Subcommittee. Since our founding
in 1991, we have advised clients on nearly $4 trillion in hedging
transactions.
Chatham's clients rely on derivatives to reduce business risks, not
for trading or speculative purposes. This risk reduction activity
benefits the global economy, by allowing a range of businesses--from
manufacturing to agriculture to real estate to financial services--to
improve planning and forecasting, and offer more stable prices to
consumers and a more stable contribution to economic growth.
Chatham supports the Dodd-Frank Act's aims of reducing systemic
risk and increasing transparency in the derivatives market. We also
appreciate the bipartisan efforts of this body to ensure that
regulatory burdens are proportionately applied, taking into account an
entity's potential ability to jeopardize financial stability. In
particular, we appreciate efforts to address key concerns of
nonfinancial end-users following the passage of Dodd-Frank, including
efforts to clarify that margin and clearing requirements should not
apply to such end-users and their centralized treasury units. These
efforts were instrumental in eliminating key barriers to efficient
access of the derivatives market.
Today, I will identify two similar barriers affecting a range of
financial end-users that use low volumes of derivatives to reduce risk.
In particular, clearing and margin requirements, when applied to those
transacting low volumes of OTC derivatives, deter such end-users from
managing their risks, cause them to manage their risks poorly or
dictate that they manage such risks at significant expense. Indeed, per
transaction costs for low-volume users are especially high when
compared to the costs applicable to larger users--a fact that is at
odds with their relative contributions to systemic risk.
Chatham's clients facing unwarranted burdens due to clearing and/or
margin requirements touch a wide variety of industries, including the
following:
Corporates deemed to be financial in nature under Title VII
(e.g., technology companies that process certain types of
payments);
Real estate and infrastructure funds that make cross-border
investments in buildings, railroads, ports and other such
physical assets;
Regional banks that use limited quantities of derivatives
products or are contemplating using such products to serve
their customers, reduce risk or compete with larger banks in
their footprints, and that do not otherwise qualify for the
small bank exemption; [and]
Microfinance funds whose capital is directed toward enabling
the world's poor to lift themselves and their families from
poverty in developing countries.
While the businesses in which these firms engage vary widely, such
firms share at least two characteristics: they (1) use derivatives to
manage and reduce risk and (2) do not use quantities of derivatives
that are sufficient to jeopardize financial market stability.
Let's consider the burdens such firms face, assess whether such
burdens are necessary for the mitigation of systemic risk and consider
what actions might alleviate unnecessary burdens.
The first burden relates to the cost of clearing for low-volume
users. Clearing members typically charge minimum monthly fees to
establish a relationship that would enable a customer to comply with
the clearing mandate. These fees vary by firm and customer but typical
fees amount to $100,000 per year or more. Consider a firm that does not
qualify for the end-user exception and needs to hedge a single interest
rate risk over a 5 year period, as might be the case for a firm
entering into a variable rate bank loan. That firm will obligate itself
to $\1/2\ million in fees over that period just to have the privilege
of hedging in the OTC derivatives market.
The second burden relates to risk imposed by the margin
requirements applicable to cleared swaps and soon to be applicable to
swaps that are not centrally cleared. Margin requirements expose a
company to new risks that many firms are unwilling to take on--
especially liquidity risk. Liquidity risk is the risk that a sudden
sharp movement in market conditions could cause a company, via a margin
call, to come up with sums of cash that are significant to the company
on short notice. In an extreme case, such a margin call could cause a
firm to default on an obligation. At a minimum, a firm will need to
hold back funds that it might otherwise invest in its business to
ensure it has enough cash on hand to meet margin calls.
Consider the aforementioned firm with a 5 year interest rate risk.
Such a firm might be concerned that in today's historically low
interest rate environment, increasing rates could adversely affect
their ability to make payroll. In the OTC derivatives market, such a
firm could fully eliminate such risk by entering into a 5 year interest
rate swap to lock in a fixed interest rate. Prior to the clearing
mandate, such a firm might have been able to negotiate a credit
arrangement that did not require it to post cash margin. Rather, banks
were able to manage credit risk to such borrowers through a variety of
other means. The borrower was able to enter into the swap without any
up-front fees--all costs associated with the swap were included in the
fixed interest rate paid to the bank. On a $100 million swap, a firm
would need to post approximately $2 million at inception, which could
grow to as much as $25 million in a stressed market such as was seen
during the financial crisis (or approximately $12 million in normalized
market conditions). These amounts are illustrative of liquidity risks
and would not need to be diverted from productive use if a firm were
exempt from the clearing and margin requirements.
These costs and risks create unintended consequences by negatively
impacting the risk management decisions many firms make. In particular,
a firm's risk management behavior may change in three ways: the firm
may (1) stop hedging, (2) hedge poorly or (3) hedge expensively.
1. Stop Hedging: Some firms respond to the high cost of clearing and
margining by choosing not to hedge, retaining risk in their
businesses that could unnecessarily jeopardize business
performance or, in extreme cases, even a firm's viability.
2. Hedge Poorly: Some firms enter into risk management products that
force them to retain some risks. For example, some firms
avoid the liquidity risk associated with cleared and
margined swaps by managing their risks with products like
options that do not create uncertain demands on a company's
cash. While this may satisfy a firm's risk management
objective in the short term, option products generally
become very expensive when hedging for longer periods, and
so companies often buy less protection, increasing their
exposure to financial market gyrations over the long-term.
2. Hedge Expensively: Some firms may proceed with entering into
cleared swaps, but incur the substantial costs to do so.
This in turn increases the cost of their services and/or
dampens their ability to deliver returns to investors like
pension funds.
While the benefits of clearing were widely understood when Congress
enacted the clearing mandate, the costs were not. We now understand
central clearing to be a system that simply does not accommodate small
and low-volume users. The consequence is that entities whose
derivatives use has no ability to undermine financial stability are cut
off from properly or effectively managing their risks. Small financial
end-users are essentially thrown into a raging see of market volatility
without a dependable life preserver.
These concerns could easily be addressed if Congress exempted low-
volume users from clearing and margin requirements via a financial
entities de minimis exception. Such an exception could be narrowly
tailored to ensure that firms that meaningfully contribute to systemic
risk would not be eligible. Congress has already recognized the
principle underlying such an exception in Title VII of Dodd-Frank.
However, that principle was narrowly applied to small banks and credit
unions (i.e., those with less than $10 billion in assets) and does not
include the various types of market participants identified in this
testimony.
Numerous foreign governments, including Australia, Canada, Japan
and Singapore, have exempted or proposed to exempt a range of financial
entities whose transaction volumes are relatively small from their
clearing and/or margining rules, effectively acknowledging the burdens
such requirements create for smaller entities and the limited public
policy benefits of encompassing such entities within the requirements'
scope.
On the basis of the evidence now available on the cost of clearing
and margin, the extent to which such costs adversely affect low-volume
users, the recognition that such entities have limited ability to
undermine financial stability, and the extent to which foreign
governments have similarly exempted low-volume users, we urge
policymakers to enact a financial entities de minimis exception from
clearing and margin requirements. We believe such a policy would
provide needed relief without increasing systemic risk.
We appreciate your attention to these concerns and look forward to
supporting the Subcommittee's efforts to ensure that derivatives
regulations, while fully reflecting the policy objectives of Dodd-
Frank, do not unnecessarily burden American businesses, jeopardize
economic growth, or harm job creation by creating barriers to tools
used to reduce the risk of investing in the economy.
Thank you for the opportunity to testify today and I am happy to
address any questions you may have.
The Chairman. Thank you. Thank you all for your testimony.
The chair 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.
I now recognize myself for 5 minutes.
Mr. Edmonds, as we start this hearing, I want to put part
of today's conversation about recovery and resolution in
context. U.S. clearinghouses are robust financial institutions
with significant financial resources at their disposal. The
recovery or resolution of a clearinghouse like ICE or CME would
be unprecedented. Can you describe what would have to happen to
exhaust the resources of a major clearinghouse like ICE?
Mr. Edmonds. So let's back up and remember that we all
serve international customers, and given the European
regulation around qualified CCPs coming out of the European
equivalence debate that we have had, means that if you are
deemed systemically important, either you have to meet that if
you are a European clearinghouse, or you are going to
voluntarily subscribe to those types of robust structures. So
that means that simultaneously two of your largest members are
defaulting on exactly the same day, at the same time. And your
model right now has to be able to support enough collateral to
hold against that happening.
So if you ask me what happens if we are not going to be
able to survive that, it is going to be more than what those
standards are, obviously, to get to that point. And that means
you are going to be in a very stressed market situation, one
that is likely unprecedented. If you look back at the history
of the 2008 crisis, you are going to find yourself in a
position where we all stress test to what those events were,
the price shocks that we saw to the marketplace and the
instruments that we held or we do hold now, based on a
historical look back to that. So we know we can sustain two. We
know we can sustain likely more than that, but we have to prove
every day that we have tool sets in order to survive that.
If you ask me what happens if it is five or six, I am not
sure you are worried about us at that point in time. There is a
bigger problem going on in the global financial markets at that
point in time. But the short answer is you have to be able to
cover at least more than two going down at the same time.
The Chairman. Ms. Rosenberg, clearinghouses are bigger
today, but as we talked about at our last hearing, clearing
members are also required to hold more capital than they did
before the crisis. How has this changed your concerns about
clearinghouse risk?
Ms. Rosenberg. Thank you for the question. I would just
reiterate one point that my colleagues here at the table also
made, is that in terms of capital that we have to hold against
the guarantee that we provide on behalf of our customers to the
clearinghouse. We are currently facing a situation with the
leverage ratio where the cash that we receive from our
customers is actually risk-reducing because it offsets the
exposure that we have to the clearinghouse. And so that has
been an impact from our standpoint in terms of the capital that
we need to hold, and as a result, we are seeing a contraction
with several other clearing members actually exiting the
market, and there is greater concentration with respect to the
market, which is not a good thing for end-users.
The Chairman. Mr. Duffy, in a speech last year, Chairman
Massad noted that clearinghouse risk couldn't just be
understood in terms of skin-in-the-game, and that you also had
to look at the full picture of policies and practices that
mitigate risk. What policies and practices have changed over
the last 6 years to better manage risk within your
clearinghouse?
Mr. Duffy. Well, there have been a number of different
situations that we have done, and Mr. Edmonds outlined them,
but we are all new to OTC clearing, which is what we are
talking about today. Historically, when you look at CME Group
and our base businesses, which is futures, we have never had a
default to date due to a customer loss. So that is one of the
biggest issues.
When you look at the way things are margined today, since
Dodd-Frank was put into place, we mark-to-market every day, and
we can mark-to-market every hour. The capital that we accept
today is different than it was as little as 5 or 10 years ago,
so it is much more liquid than it was before.
Those are a couple of the different issues that we have
done to bolster our clearinghouse. And we have, again, the risk
management associated with the clearinghouse is critically
important to us. The governance that is associated with our
clearinghouse is important. We are working with agencies
constantly. We are deemed a systemically important financial
market, so these are all different things that we have to
cooperate with and we have done a good job at it.
The Chairman. Thank you. I have a couple of other questions
but I am going to try to hold to the 5 minute rule and come
back for a second round of questions, and try to hold every
Member to that as close as we can.
I will now recognize the Ranking Member, Mr. Scott, for 5
minutes.
Mr. David Scott of Georgia. Thank you, Chairman Scott.
My concern in this entire harmonization cross-border
equivalency issue has been to make sure that our financial
firms, our clearinghouses, our market participants, are not put
in a competitive disadvantage in the global marketplace. Mr.
Duffy, from your testimony I get a sense of rising concern,
even though we have had the December 2015 moved by the CFTC,
and now we have the May 24 rule, but you still have some great
concerns. And from your testimony, as I was reading it, you
said, ``that if this is not the case, then regulation will
artificially influence liquidity, price discovery, risk
management, and competitively disadvantage our market
participants in an increasingly competitive global
marketplace'', which goes to my concern.
So you are telling me that instead of let my heart not be
troubled, you are saying let our hearts be troubled. Could you
tell us why you feel, even in the midst of the great work, and
I tip my hat, that Chairman Massad has done, that you still
have some indigestion on this issue, that you and I both are
very much concerned about.
Mr. Duffy. Thank you, sir. One of the things that I have
noticed in my 36 year career at the CME, and trading for 23 of
those, and then being in management for the last 15, and
especially going through regulation, is uncertainty from market
participants. It is the worst thing you could possibly have is
not knowing what the rules of the road are. So when we talk
about the equivalence equation that was originally done in
February, what happens is they keep bumping up against the
dates, the market participants aren't certain what the rules or
the regs are going to be, what jurisdiction they can
participate in. And that is exactly what happened again under
the equivalence.
Mr. David Scott of Georgia. Yes.
Mr. Duffy. And as you know, we are waiting for the ESMA
recognition, which I referenced in my testimony, which
hopefully we were getting today or tomorrow. But we need to
have that by June 21. So we are trying to keep participants
knowing what their capital costs are going to be, if they are
going to clear at a U.S. entity or not, because they are going
to be completely different if we are not recognized. And we
can't continue to bump up against these dates. Certainty is the
clearest thing I can say to that, sir.
Mr. David Scott of Georgia. All right. And, Mr. Edmonds,
let me ask you, first of all I want you to give me an update on
where we are with equivalence for clearinghouses.
Mr. Edmonds. Well, as Mr. Duffy said, we still have these
dates. So we know where we are going to land the airplane. We
may not know when we are going to land that airplane, is the
easiest way I could give you that analogy.
Mr. David Scott of Georgia. Yes. Okay.
Mr. Edmonds. So the conceptual agreement that the global
regulators have on the equivalence is well understood. It is
still the details in that concept that are causing some people
angst, as you articulated in previous comments on that. Things
like anti-pro-cyclicality measures, you have three different
options that you can use in order to meet the global benchmark.
Well, no one yet knows which of those three everyone is going
to use at a given time. So we know we have to get to that
endpoint, but that endpoint is not there yet, and then while
that endpoint is well defined, the path there is not yet well
defined. That is where we are going to----
Mr. David Scott of Georgia. All right. And, Ms. Rosenberg,
let me ask you, do you think that the clearing mandate that we
have has been a positive development, and if not, or even if
so, what more do you specifically think the CFTC should do?
Ms. Rosenberg. Thank you for the question. I think that the
G20 global derivatives reforms overall have made the system
safer and more resilient and increased transparency.
It has been several years now since global standards have
been developed for clearinghouses. They were set in 2012 by the
global standard setter, CPMI-IOSCO. We believe it is time, and
it has been, and regulators have been taking a step back over
the last 18 months to revisit those standards, as market
participants have raised concerns about different areas. I
spoke about this in my oral remarks, which is CCP risk
governance and capital contributions, stress testing,
specifically setting minimum prescriptive standards for
clearinghouse stress testing, as well as with respect to stress
testing, ensuring that there is a supervisory regulatory-driven
stress test that reviews those financial safeguards to ensure
that they are adequate.
CPMI-IOSCO has taken that feedback onboard from market
participants and is in the process of developing a market
consultation to cover all of these areas; capital, skin-in-the-
game, governance, margin, as well as stress testing. And we
look forward to U.S. regulatory participation and support,
including the CFTC, in those discussions.
Mr. David Scott of Georgia. Thank you very much, Mr.
Chairman.
The Chairman. I now recognize Mr. Lucas.
Mr. Lucas. Thank you, Mr. Chairman. And I appreciate you
holding this hearing. These, obviously, are complex issues, and
it is an example of why it is so important that we hear
directly from the financial sector that is impacted by the
reforms that have taken place in our markets and our market
participants.
I would like to continue the discussion that has been going
on about the CCP risk management and the equivalency, and my
first question I will throw out to the crowd, it becomes quite
clear there is an agreement with the panel that significant
progress has been made in enhancing the standards for risk
management at CCPs, and that global coordination among
regulators in developing those standards. And obviously, the
European Commission is preparing legislation to address CCP
recovery and resolution.
Would the group, and whoever would prefer to go, in what
order I don't care, would you expand for a bit about the
various challenges that the CCP equivalency agreement, that was
just reached between CFTC and European Commission, represent to
your industry and ultimately to your consumers or customers?
Mr. Duffy. I will start. I think that the agreement that we
reached is one of those agreements that, as I said earlier,
took way too long, which could affect the consumers because of
the uncertainty of it. I think that we had to bend it a little
bit here in the United States in order to get deemed
equivalent, which concerns us a little bit. We want to make
certain that our regulators are regulating the U.S. markets,
and not a foreign regulator regulating the U.S. markets. That
is the way I look at it. So I don't want them being our
Prudential Regulator.
There was a lot of back and forth, and hopefully we are in
a place right now, Mr. Edmonds mentioned pro-cyclicality, there
has been a lot of pro-cyclicality back and forth on these
agreements that we never had to adhere to before as a U.S.
entity, that we are adhering to today, in order to be deemed
equivalent in the European Union.
Maybe that is just progress, the way it goes back and
forth; but, overall, it should not hurt the business here in
the United States now that we have gotten to this certain
point.
Mr. Lucas. Absolutely. And that makes me think of Mr.
Scott, the Ranking Member's comment about the disadvantage. I
don't think anyone in this Committee wants the industry and the
United States or the participants here to be put at a
disadvantage. And where are we in those circumstances? And I
throw that again to the rest of the panel.
Ms. Rosenberg. So one of the things going on in Europe
right now is that we expect the European Commission to be
drafting legislation on CCP recovery and resolution. We expect
that to come out close to the end of the year. I suspect it
could go into next year.
In any case, in the U.S. market, we don't require any
specific legislation to implement recovery and resolution
standards. Okay. What we want to make sure about also is that
any legislation that is developed in Europe does not cause
differences with the U.S. rules and legal environment. The
Financial Stability Board is in the process of developing
global standards with respect to resolution planning for
clearinghouses, what the plans, what the guidance should be
around developing those plans for resolution authorities with
respect to CCPs. We would encourage the Europeans and Chairman
Massad, through his discussions with the European Commission,
to ensure that those standards that are developed are
consistent across Europe and U.S. We wouldn't want any
differences and go through another equivalence type of
discussion that we have had, and Mr. Duffy elaborated on.
Mr. Lucas. Mr. Duffy.
Mr. Duffy. Yes, what I think is important is we do have a
resolution recovery and stress testing here on U.S. CCPs that
is overseen by our regulator. I don't disagree with my
colleague, it would be nice to have a uniform approach across
the globe, but what is important to us is that we do have that
within our U.S. regulator right now.
Mr. Lucas. Ms. Rosenberg, let's continue along this vein.
Could you discuss with us for a moment the current models for
stress testing, what weaknesses that might exist, how those
could be addressed, because it seems, and Mr. Edmonds too, for
that matter, it seems that the stress testing process modeling
is absolutely important?
Ms. Rosenberg. Yes, it absolutely is important. And I just
want to mention my partners over here, Mr. Edmonds and Mr.
Duffy, I don't want there to be any perception that the
companies they work for, the stress testing models are not
robust, or anything like that. What I am talking about is, I
have responsibility for overseeing JPMorgan's 50 derivative
clearinghouse memberships globally, and from that perspective,
I will say that the current global standards rules that govern
clearinghouses on stress testing are very light. They
effectively say that clearinghouses should stress test their
portfolios and use scenarios that are extreme but plausible. It
is very light on the prescriptive standards. And so what we
have raised, JPMorgan, other clearing members, as well as end-
users, to the global standard setters, that there needs to be
more prescriptive standards. And that would cover those kinds
of assumptions and basic parameters about how that work should
be done.
Separate from that, we do believe that there should be,
like ESMA has just completed, ESMA is the European regulator
that oversees CCPs in Europe, they just completed a stress
test, overseen by the regulator, across 17 European CCPs. We
believe, and the results were transparent to the market, and we
believe something like that would provide more confidence in
CCP structures.
Mr. Lucas. Mr. Chairman, my time has expired, but if there
is another round, we may continue along this vein.
The Chairman. Yes, sir, and it expired a minute ago.
The chair now recognizes the gentleman from California, Mr.
Aguilar.
Mr. Aguilar. Thank you, Chairman Scott. And I don't want to
be admonished so I will make sure I stick to my time.
Some of my colleagues have gone down this road. And, Mr.
Edmonds, you talked about the global nature of this market,
and, Ms. Rosenberg, you just commented on the same from the
regulatory framework abroad. So I will make this to Mr. Berger,
Mr. Merkel, Ms. Rosenberg, and Mr. Zubrod.
Can we go down that path a little further? I am interested
to know about the financial regulatory structure in other
countries and how that is going to impact the swaps market.
Ms. Rosenberg, you just talked about the European
discussion moving forward, and earlier you talked about
continued discussions in the regulatory structure abroad. Can
we talk about the impact that will have on the U.S. swaps
market?
Ms. Rosenberg. Sure. I am happy to start. Thank you for
that question. That is a very important question.
One of the things we have seen with respect to SEFs and
market liquidity is that there could be certain enhancements
made in the U.S. CFTC rules to curtail the current market
fragmentation that we have seen between Europe and the U.S. We
expect the European regulators to develop specific rules around
SEFs going into next year. And currently, the U.S. rules are
very prescriptive with respect to how swap dealers can execute
trades, and we do believe that there needs to be more
flexibility on that front because we expect that is where the
Europeans are going. And that is very important. And I do
believe that the CFTC and Chairman Massad are very supportive
of this.
Mr. Aguilar. Mr. Merkel?
Mr. Merkel. I would agree with that. What we have seen is
that there were good intentions on the part of the CFTC to try
to lead and try to get other jurisdictions to harmonize forms
of execution. It just didn't work. What ultimately ended up
happening was it chased away non-U.S. participants, and led to
markets developing outside the United States, which did
fragment liquidity. It is not a crisis, just unfortunate, and
doesn't really benefit anyone. From our perspective, we will do
the business wherever it is. We will do it in New York, we will
do it in London. And we will have to see what happens with
MiFID II and how the U.S. agency approaches it. I do think that
one should be realistic and be somewhat courteous of what is
going on in Europe, and understand that they don't have to come
here. And it may well be that we may face a situation in which
at some point U.S. firms aren't going to be able to do business
in Europe as easily, and that would be unfortunate for a number
of reasons. And the best way to do this is to encourage what we
think is starting to occur, which is a different approach that
Chairman Massad is taking, and see what develops.
We are in a cautiously optimistic mode, provided something
happens. If nothing occurs, we are going to have a problem. I
just don't, at the moment, think I might be optimistic, but
that is not likely.
Mr. Aguilar. Thank you. Mr. Berger?
Mr. Berger. We are likewise optimistic that a harmonized
and mutually recognized regime can be put in place for both
clearing and trading. On the clearing front, as I noted in my
opening remarks, the scope of the clearing obligation that is
going to be phased in in Europe beginning this year is
identical in scope to what has been already put in place in the
U.S.
On the execution side, the good news is there is common
architecture that has been developed. Europe has adopted the
same execution of clearing workflow and straight through
processing rules that the CFTC has put in place. And there is a
commitment in both regimes that trading venues should provide
impartial and nondiscriminatory access to all market
participants.
There is a path forward. Obviously, the European regime is
a few years being. Clearing is just being phased in there this
year, and we phased clearing in in 2013. And as other
commenters have noted, the MiFID II reforms, which will affect
trading in Europe, come into effect in 2018. So there is a
timing differential, but the objectives and the end state is
consistent across both.
Mr. Aguilar. Thank you. Mr. Zubrod, real briefly.
Mr. Zubrod. Yes, I will note with respect to my testimony
the comparison with Singapore, Australia, Japan, and Canada,
these are governments who have enacted what amounts to
exceptions to clearing and/or margin in their regimes, and the
implication for them is that such market participants will not
be unnecessarily burdened, whereas those here in U.S. markets
will be by these requirements.
Mr. Aguilar. Thank you. Thank you, Mr. Chairman.
The Chairman. The chair now recognizes Mr. Neugebauer, for
5 minutes.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Duffy and Mr. Edmonds, we have talked a lot about
clearinghouse governance, and so how do you determine what
level of risk a clearinghouse takes on, and then what are your
primary tools that you use to manage that risk?
Mr. Edmonds. Those decisions are made at a risk committee
level, which is part of the defined part of the governance
structure. A recommendation is made, whether it is a new
product, a new member coming into the clearinghouse that is
going to bring their own level of customer flow into the
clearinghouse at the time. And once that decision is made to
launch those new products or to add on that new member, we are
constantly looking at the entire book, the match book. At no
point in time do we run an unmatched book. The only time that
ever happens is if one of the members is defaulting, and our
job at that moment in time is to bring it back to match book as
quickly and as efficiently as possible, with as little
disruption to the marketplace as possible.
Making certain that all of the members that we govern
through the clearinghouse structure and the way it is set up
under the CFTC, that we understand the risks they are bringing,
and the collateral they bring to support that risk on a daily
basis is the function of the clearinghouse, and continues to be
the primary responsibility that we have to the marketplace.
From a tools perspective, this is everything in the
waterfall. Membership, not everyone qualifies. If I have $5 and
you have $5 million, chances are you are a better member than I
am at that day.
Mr. Neugebauer. Yes.
Mr. Edmonds. Okay. Making sure that the qualified members
are there, and making sure there are operational risk controls
there so they can process the customer flow. Our members, who
are very important partners with us, ultimately make the
decision of who gets access to our clearinghouse services. If
they have done a poor job, we need to be able to spot that, and
we need to be able to have a consultation with them. We don't
like this position, it is too concentrated. If it is too
concentrated, there are other premiums of collateral we bring
in there. You may want to hold a very concentrated position,
and we may be able to get comfortable with that, but you might
be collateralizing that more than 100 percent of the risk that
we hold. If that is something you are willing to pay, we will
take that at the end of the day. And then making sure that we
get all the way down through, okay, what happens if it goes the
wrong way. What happens if the collateral wasn't what we
thought it was going to be? How do we manage that process all
through again? Membership committee: It is the same for every
single person. No one is making a bilateral decision. Clearing
member A gets this function. Clearing member B gets a separate
function. Everyone is managed to absolutely the same standard
at all times.
Mr. Duffy. I would just add, I agree with Mr. Edmonds
completely on everything he said there, but I would just add
that one of the things that we have the ability to do under the
Dodd-Frank Act, which was critically important when we are
talking about swaps, is the ability to reject a swap at the
clearinghouse CCP level if we are not comfortable with the risk
that it is bringing into our institution. I think that is
something we use, and margin is another tool that Mr. Edmonds
also referenced. Margin is something that is important for the
CCPs always to have the ability to set. We are not interested
in if the price goes up or down, we are interested in managing
the risk. These are the tools that we have put in place today,
and I am only outlining a couple of them, Mr. Edmonds did a
good job outlining the others, but these are critically
important tools. When you don't have an interest in the market
going up or down, that is who should be setting the margin, and
the ability to reject something that you are not quite sure how
to risk manage is also critically important.
Mr. Neugebauer. The leverage ratio as several of you
alluded to that, and so the question I have is: leverage ratio,
has it caused margins to go up. So, in order to adhere to
whatever the leverage ratio is pegged at, would you get credit
for additional margin that you request from your members?
Mr. Edmonds. Now, that is a bit of the perplexing piece
because the more margin our members collect on their client
positions and post to us, the way the rules currently stand
today, the more capital they have to hold against it. So at a
time where we are trying to encourage more and more individuals
to use clearing services because of the risk-reducing nature of
it, we are adding to that cost. The more collateral we get, the
more the bank clearing members are having to hold against that.
Well, they have to then charge for holding that capital against
that, from a regulatory capital perspective. That increases the
cost to your end-clients. And that is where this thing begins
to spiral out and more people are making the decision today, if
they possibly can, to choose not to be in that situation.
Mr. Neugebauer. That is counterintuitive. In other words,
what you are saying is the less risky you make that position,
the more capital that you have to keep. Do I understand that
correctly?
Mr. Edmonds. You do. And yes, it sounds illogical, and we
are trying to have a logical conversation.
Mr. Neugebauer. Mr. Duffy?
Mr. Duffy. May I just jump in real quick? What I think is
critically important, and Ms. Rosenberg can answer this better
than any of us because this affects her more than anybody, but
what is important is her bank, or any other bank, cannot touch
that collateral that is in the clearinghouse because it is
segregated. There is no reason to have the leverage ratio
charge put up against it. They have no access to that capital
or collateral.
The Chairman. The chair now recognizes Mr. Davis, from
Illinois, for 5 minutes.
Mr. Davis. Thank you. Thank you, Mr. Chairman. And thank
you to everyone for coming here today to talk about this
important issue. A lot of the questions that I had planned to
ask have been asked by my colleagues. And that is the benefit
of being a little further down the seniority ladder, like we
are.
Let me start with you, Mr. Zubrod. Can you go into a little
more detail on the impact to agricultural and energy firms
moving away from the swaps market to the futures market to
possibly hedge their risks?
Mr. Zubrod. It is a good question, and I appreciate its
premise. If I can discern correctly, the premise is that we
should really give due consideration to players who are
involved in helping to provide price stability to the kitchen
table, to energy bills that consumers pay at home. My view on
the key obstacles to smaller players like that in accessing the
markets tends to be focused, again, on the issue of clearing
and margin costs for those smaller players, not necessarily the
obstacles, for example, created by SEFs or other things. There
are legitimate debates about whether or not one needs to be
prescriptive in defining all aspects of how SEFs need to
operate, but that being said, I think that is not the key
obstacle for a lot of the clients that we work with in
accessing the markets. It is the significant costs associated
with clearing and margin.
Mr. Davis. Okay. Do you have any suggestions to address
some of these obstacles?
Mr. Zubrod. Yes, again, for the clearing and margin
requirements, it could be addressed very simply, and the
simplistic solution is to exempt small, low-volume players from
the clearing and margin requirements.
Mr. Davis. Okay. Mr. Duffy. How are you, sir?
Mr. Duffy. I am good, sir. How are you?
Mr. Davis. Good. Nice to see you are on your wing again
here. As many of you know, it was named the Terry Duffy Wing,
one of the last Subcommittee hearings that I had. It was just
me that named it, so sorry, Terry. We don't have a plaque up
yet. Can you fix that, Chairman Scott?
Mr. Duffy, how does the CME strike the appropriate balance
between profits and risk management?
Mr. Duffy. How do they--between what, profits and risk
management?
Mr. Davis. Yes. How does your company strike the balance
between profits and risk management?
Mr. Duffy. Risk management comes first, sir. Without risk
management, we don't have profits. I have said this a million
times over, the credibility of our marketplace is of the utmost
importance to CME Group. We cannot shortcut any of the risk
management tools or protocols that we put into place, or
continue to put into place, or we will not have shareholders.
We do not put profits in front of risk management. Again, this
is something that is near and dear to my heart, and near and
dear to everybody in the organization, because we will not
shortcut that process one cent.
Mr. Davis. And we appreciate that.
And I will yield back the balance of my time, Mr. Chairman.
The Chairman. Thank you, Mr. Davis. I now recognize Mr.
Kelly, from Mississippi, for 5 minutes.
Mr. Kelly. Thank you, Mr. Chairman and Ranking Member
Scott, for having this hearing. And thank you, witnesses, for
being here.
I have been in and out so if I ask you something that has
already been asked, I apologize.
Mr. Davis talks funny beside me, so I know that you guys
can understand my accent much better than his.
Ms. Rosenberg, you were partially answering this when I
walked back in, but if you want to add anything, has the
clearing mandate been a positive development for the market?
Ms. Rosenberg. Thank you for the question. Yes, we believe
it has been a positive development for the market. The G20
reforms have made the system safer and more transparent. And
what we are collectively doing now, market participants as well
as regulators and clearinghouses, are reviewing current
standards. We do expect market consultation at the global level
to come out over the next couple of months to cover many of
these standards that are being revisited, and they include
stress testing, initial margin, governance, as well as recovery
tools. And we look forward to providing that input into that
process.
Mr. Kelly. And kind of as an unintended follow up, I guess,
as a member of many clearinghouses, does your firm have any say
in the products that are cleared in each venue, and do you have
any concerns about the products that might be cleared in the
central clearing counterparties JPMorgan is a member of.
Further, do you think the capital and margin rules are
incentivizing products to be cleared that perhaps shouldn't be?
Ms. Rosenberg. That is near and dear to our firm's heart,
as well as other clearing firms. What I haven't said in my
testimony is that JPMorgan, as a firm, there are employees at
JPMorgan that do sit on clearinghouse risk committees, but that
role that we participate in is as a fiduciary on behalf of the
clearinghouse, or as a market expert. It is not representing us
as a clearing firm. What we have seen, and we think we expect
it to continue to go in this direction, particularly with the
non-cleared margin rules coming out, starting in September,
there is an interest by participants and CCPs to clear more
products. There is going to be a demand to clear more products,
even if they are not mandated, more complex products. And we do
think there needs to be more involvement with key stakeholders,
like members, through a mandatory consultation process early in
determining whether a product is suitable to clearing because
the impact of clearing more complex products could impact our
capital that we contribute through the loss mutualization
process.
Mr. Kelly. Mr. Berger, I am talking about swaps execution
facility, the SEF, can market participants limit themselves to
using only one SEF, or do they need to use multiple SEFs? And
if the latter, if they need to use multiple SEFs, what problems
does that pose?
Mr. Berger. Market participants are free to use one or
multiple SEFs. Many buy-side market participants use the two
SEFs that serve the buy-side community: Bloomberg or Tradeweb,
so many buy-side market participants will use one or both of
those venues. There are probably, serving the interest rate
swap market and the credit default swap market, eight or nine
SEFs that have a decent amount of liquidity. One of the
concerns that the Managed Funds Association has, however, is
that there are really only two SEFs that are truly open and
accessible to customers in the market, and five or six of the
other SEFs that have liquidity have to maintain certain
barriers. So it would be beneficial if investors could access
the full array of swap execution facilities that have
liquidity.
Mr. Kelly. Thank you. And, Mr. Edmonds, we talk a lot about
models and stress testing, but how good are the models and how
do we know that the models developed will work in a time of
stress?
Mr. Edmonds. We have to use the best information available
to us at the time. I will tell you, spending time, in my
previous role at ICE, running the CDS Clearinghouse, we went
back and we continued to look back at the 2008 crisis, and we
looked at that and we said what if it was two times as big,
what if the price differential from the Lehman Brothers'
default and its impact on credit default swaps was 200 percent
of what we witnessed that day. And we still hold enough capital
against that today. If it is 400 percent, we might have a
different conversation, but as I said earlier in one of my
remarks, I might not be the thing you are looking at that day,
it might be a much bigger piece.
Mr. Kelly. And thank you, Mr. Chairman. I yield back.
The Chairman. We are going to go on to our second round of
questioning now. And I yield myself for 5 minutes.
Mr. Berger, members of your firm have been enthusiastic
about the impact of Dodd-Frank on cleared derivatives
transactions, and have worked hard to build a business as a
nontraditional liquidity provider in certain swaps. Do you see
the success of Citadel as the new model for swaps liquidity as
banks retreat from their traditional role in these markets?
Mr. Berger. Just one note up-front, I am here today
representing Citadel's hedge funds businesses, speaking on
behalf of the Managed Funds Association and Citadel Securities,
which conducts swap market-making activities operates
independent of Citadel's hedge funds. That said, a central goal
of the swaps markets reforms was to lower barriers to entry and
increase competition, and that does directly benefit investors
by providing more competitive pricing and more diverse sources
of liquidity beyond the historical incumbent intermediaries in
the marketplace.
The Chairman. Do you think that all swaps markets are
suitable for electronic market-making, and are there any
liquidity challenges created by Dodd-Frank, despite the success
you have seen at Citadel?
Mr. Berger. I don't think all swap markets are suitable for
electronic trading. There are portions of the swap market that
remain uncleared, for example, but the portions of the swap
market that are cleared and that are highly liquid and
transparent, are standardized, liquid, and transparent, are
appropriate to trade on swap execution facilities through
electronic RFQ and order books as well. Research that has
looked at the impact of the migration to SEF trading has shown
that it has improved pricing and liquidity. We have heard
referenced today already to the Bank of England research that
was released earlier this year or, sorry, at the end of last
year, that reached that conclusion, and that research has been
independently validated by some other market researchers,
including Claris. There are tangible benefits that market
participants are realizing from these reforms.
The Chairman. So you think it has improved liquidity, and
you don't see any challenges with liquidity because of it?
Mr. Berger. I think that it has improved pricing and
liquidity, and the challenges that exist with respect to
liquidity in the marketplace are best addressed by ensuring
that more market participants can join all the venues that are
available, and that there are more diverse means of risk
transfer and price discovery. So that a broader array of market
participants who can be both price makers and price takers, and
a more kind of diverse marketplace is the long-term solution to
any liquidity challenges we face today.
The Chairman. All right. Ms. Rosenberg, late last week the
European Union announced that it was delaying its margin for
uncleared swaps rules. Chairman Conaway stated that this is yet
another failure of international cooperation which will have
real consequences for U.S. market participants. How does this
sudden shift in coordination impact a bank like JPMorgan, and
what other potential failures of cooperation are you worried
about?
Ms. Rosenberg. This is a really--pressed the wrong button,
sorry.
The Chairman. That is all right.
Ms. Rosenberg. This is a really important question, and it
is something that policymakers and regulators need to be
focused on. As you mentioned, it is a recent announcement, it
just happened on Friday, and we are still considering the
implications for JPMorgan, but our initial concern is that it
may create disadvantage for U.S. banks. A primary priority for
the industry throughout the development of these margin rules
has been consistency and content and timing. So we don't want a
delay in timing in one jurisdiction that could create undue
burden or lack of competitiveness for U.S. firms.
The Chairman. Mr. Zubrod, if U.S. regulators go it alone
with the uncleared margin rule because the European Union
failed to follow through with its commitments, what will be the
impact of end-users like your clients?
Mr. Zubrod. Sure. Thanks for the question. I would say
global margin rules really reflected the most careful and
deliberate process across all of derivatives regulation to
reach a globally coordinated outcome, and to line up the start
dates globally as well. And it would be valuable to endeavor to
retain a key benefit of that coordination by maintaining those
aligned start dates. Failures to do so will drive imbalances in
counterparty selection that have competitive implications. For
example, if I were a European entity, and I had the choice of
facing a European bank or a U.S. bank, one who was subject to
U.S. margin rules that started earlier, and another who was
subject to European rules that had not yet taken effect, if
those start dates didn't match, I would have the incentive to
transact with the European bank. So that is certainly a real-
world implication of becoming misaligned on those dates, and we
should endeavor to move forward in lockstep with Europe.
The Chairman. Yes. Thank you. I would now recognize Mr.
Conaway, the Chairman of the full Committee.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
Mr. Conaway. Thank you, Mr. Chairman.
I apologize for popping in and out, but thank you all for
being here.
In Chris Giancarlo's white paper in 2015, he was critical
of the limitation on methods of execution available for swap
SEFs which was needed in the G20 rules and/or Dodd-Frank, but
it was a part of the Gensler regime. Can any of you comment on
the impact that that limitation has on the way you do your
business, good or bad? Yes, Mr. Merkel?
Mr. Merkel. Thank you, Mr. Chairman. We would agree with
Commissioner Giancarlo in that respect. We faced at the WMBAA
early on, there had been a bias towards exchanges and towards
electronic marketplaces, and we worked hard to make sure that
Dodd-Frank ultimately provided a technology-neutral approach
with respect to marketplaces that used any means of interstate
commerce. And we thought at that point that the debate was
over, but it turned out it was just beginning. When the
proposed rules came out, they were constrained. They really
were.
They continued to have issues with voice brokerage, there
were issues with respect to trying to put in and prevent
certain matching protocols that otherwise should have been
permitted, and were successful all over the world, but the
agency didn't want. Over time, we were able to work with the
staff to get to a better place, but we continued to have some
regulatory uncertainty. Letters for relief or guidance have
been unanswered. Other areas we are in a tacit form. And you
see that MiFID II has a much more expansive and flexible
approach to execution than you see here. Again, while I am
optimistic that it will all be harmonized, we have noticed that
it has taken time and it has been difficult to get to where we
have finally gotten to with respect to most, but not all, of
the auction protocols. Some of the issue may be that, for the
most part, the agency was used to futures exchanges but not
necessarily over-the-counter markets. And what you see in the
over-the-counter markets are a much broader range of methods of
execution, levels of opacity versus transparency. And what we
see with the swaps markets has been most successful, and
derivatives are most robustly traded, is where you don't limit
the means of execution.
Mr. Conaway. Right. Mr. Edmonds?
Mr. Edmonds. I would echo that point. From a clearinghouse
perspective, certainly, we run exchange businesses and we have
execution protocols, but the goal of the G20 was to reduce the
risk. And the only way you are going to achieve that goal at
the end of the day is to be as open and agnostic as possible of
how that trade is executed. But once it is executed, it goes
into a system that is very regulated, very transparent, and
understood about how the risk is going to be managed. And if we
are going to do things that take us down a path different than
that, we are not going to achieve the ultimate efficiency of
that goal.
Mr. Conaway. The Chairman has asked about the delay by the
Europeans on their uncleared swaps margin. Is there an argument
to be made that the U.S. and the Asian markets should continue
with that implementation date, because these are simply the
biggest banks, dealer-to-dealer, and it really won't have any
real impact? Is there an argument to be made about that as to
why it would not be necessarily a competitive disadvantage to
all the rest of the markets in the world if Europe delays it by
a year? Anybody?
Mr. Duffy. I am sure Ms. Rosenberg can speak as well as
anybody on this issue, but this puts the U.S. banks at a huge
disadvantage to the European banks, just for the example that
was laid out at the end of the table here. I am hopeful that
this implementation date that the U.S. and other countries
around the world are looking at can be postponed in
coordination with the European date. I just think it puts the
U.S. banks at a huge disadvantage.
Mr. Conaway. How would the argument go as to say that if we
make international agreements, and we all agree to a date, and
then when we get right here at the last minute we let the
lowest common denominator drop out, and then we are going to
reward that bad behavior by delaying everybody else. Is there
an argument that way to say, ``Look, we are going to stick with
it, and you guys are going to have to come to the table and get
your job done the way that you should have done it the way we
agreed to a year ago?'' Ms. Rosenberg, or anybody?
Ms. Rosenberg. I was just going to say that the date that
is going to be the most impactful from a U.S. bank perspective
is the phase two when the customers start having to post
noncleared margin. That is later on to next year. As I said, we
haven't looked at the full implications for JPMorgan as a firm
in terms of the impacts, whether it be 6 or 9 months, and we
are happy to provide more feedback on that.
Mr. Conaway. Well, obviously, this just happened Friday,
and there are a lot of folks trying to figure out what we did
to whom on that.
Thank you very much. I appreciate it. Mr. Merkel, did you
have a comment?
Mr. Merkel. It may be obvious, but I did want to make the
point that there is always a trade-off between U.S. regulators
wanting to insist on certain safety prudential or fairness
issues to govern its participants against what the effect would
be on a global basis. And they have to make a judgment at what
point they need to insist upon the virtues and understand what
the negative consequences would be, but it does seem as though
this particular area is one in which one would expect there
should be some flexibility as to the date of implementation.
There does not seem to be a great urgency about it, and there
would seem to be some benefit in trying to see whether or not
there can be coordination globally.
Mr. Conaway. Yes. Mr. Berger, you had a comment?
Mr. Berger. Thank you. I was just going to add that the
timeline in both the U.S. and Europe for the implementation of
these rules is phased in from 2016 to 2020 as originally
envisioned, and the new uncleared margin rules don't hit the
end-user or buy-side community until 2019, based on the
different thresholds they have set. The September 2016 date
that is being discussed now is relevant for counterparties with
above $3 trillion notional in uncleared derivatives
outstanding. That is really a handful of the biggest banks, but
there is not a direct impact at least on the end-user in the
current community.
Mr. Conaway. Yes. Okay. Mr. Chairman, thank you for your
indulgence. I yield back.
The Chairman. Thank you. The chair will now recognize Mr.
Scott.
Mr. David Scott of Georgia. Yes. I want to get clarity now.
The date of implementation is September what did you say?
Mr. Berger. September 1, 2016, is the first implementation
date.
Mr. David Scott of Georgia. Yes. And so, Mr. Duffy, you are
saying that that date puts our U.S. businesses at a competitive
disadvantage if we don't move it back?
Mr. Duffy. It certainly could. Ms. Rosenberg, obviously,
works for a very global bank, and maybe it won't affect their
European business, I am not sure, but the banks that are
primarily U.S. banks, U.S.-regulated banks, it will affect
them. But, the point is, and it is a good point, and the
Chairman raised it, this just came out Friday, details are a
little sketchy, and the implementation date of 2016 and then
followed on by 2017. It goes back to my further point, Mr.
Scott, and this is just another example of how we are going to
have uncertainty in the marketplace where the market does not
need uncertainty, it needs clarity. And one of the things that
I have heard here amongst this panel, which, on a whole host of
issues, is we need to have continuity within our European and
Asian counterparts, so we can have one set of rules.
Mr. David Scott of Georgia. I see. And you say, Ms.
Rosenberg?
Ms. Rosenberg. I would just add to what Mr. Duffy just
said, which is, it is very complex. We are looking at our legal
entities, we are looking at our counterparties, we are looking
at where we do swaps and who we do swaps with. In September, it
will impact U.S. banks, which means any counterparty that we do
business with will have to post noncleared margin to us. In
that instance, if our counterparties can operate or trade and
execute with non-U.S. counterparties, where they don't have to
post margin, then they may choose to do so. That is what we are
evaluating right now, what that impact could be.
Mr. David Scott of Georgia. When should we do it? As the
Chairman has said, we have been kicking the can down the road,
kicking the can down the road, kicking the can down the road 3
years, 2 years, I don't know. This Committee does not want to
move in any way, we are very, very, very cautious about putting
our United States companies in at a competitive disadvantage.
And if you all, the banks, the clearinghouses, are agreeing
that this does, let me ask you to describe that competitive
disadvantage if we don't do it. What would that cause you to
do?
Ms. Rosenberg. In terms of how it would impact us,
counterparties could choose to execute a swap and clear a swap
bilaterally with a European counterparty that is not yet
subject to these uncleared margin rules.
Mr. David Scott of Georgia. Okay.
Ms. Rosenberg. I mean that is the base of it. I would say
that our folks internally at JPMorgan, are looking to see how
much of an impact that could be. But, it gets back to the
timing and the differences in timing and there was a real
effort that was put forth to have consistent standards and
consistent timing of implementation to avoid things like this.
Mr. David Scott of Georgia. Yes.
Ms. Rosenberg. So, as I said, we are looking at this, and
we can come back to you with more information once we have done
the full evaluation.
Mr. David Scott of Georgia. Is there a dollar figure, is
there something that is tangible that the regulators, the CFTC
or whoever we would need to talk to about this date, that we
could say X amount of money would be lost? Is there something
we could put our hands around to really show how large and how
significant an impact this would be on our American businesses
if we do not adjust this September date?
Mr. Edmonds. I don't know that we could say a dollar
amount, but you could say that there is a limitation in choice
because if you are going deal, assuming the date doesn't move,
you are going to deal with a U.S. counterparty that is going to
have to charge you some number. You may have the option to deal
with a European entity that is not required to charge you some
number.
Mr. David Scott of Georgia. Yes.
Mr. Edmonds. If you decide that, all things else being
equal, you are just going to take the path of least resistance
as long as you can, that may be fine, but you also may have
much, much less choice as to the number of counterparties that
you can deal with. And the European counterparties realizing
that you have less choice, might have the ability to increase
that cost, for their benefit, to you.
Mr. David Scott of Georgia. I see. Thank you, Mr. Chairman.
The Chairman. The chair now recognizes Mr. Lucas, for 5
minutes.
Mr. Lucas. Thank you, Mr. Chairman. Just in a way of a
follow-up, Mr. Duffy, any more observations about stress test
issues, weaknesses, overcoming those? The earlier discussion we
had, you seemed to have an observation.
Mr. Duffy. On the stress test? The only thing I was
pointing out was that I didn't want to have the perception that
CCPs in the United States don't have stress tests under its
U.S. regulator, which we do. I do agree with Ms. Rosenberg, we
need to have coordination with our European counterparts on
this because of the businesses that they run. JPMorgan, you
said, has 71 different clearing entities that they are
associated with. I understand that part, but the only thing I
was trying to stress was that we do have very rigorous stress
tests that are overseen by our U.S. regulator today, there is
just not a global standard, to Ms. Rosenberg's point.
Mr. Lucas. So it is an ongoing, evolving process you all
are completely engaged in?
Mr. Duffy. It is always going to be ongoing. Absolutely.
Mr. Lucas. With that, Mr. Chairman, I yield back. Thank
you.
The Chairman. Mr. Conaway, do you have any thoughts?
Mr. Conaway. No.
The Chairman. Mr. Scott, I now recognize the Ranking Member
to make any closing remarks he has.
Mr. David Scott of Georgia. Well, again, Mr. Chairman, this
has been a very timely and, quite honestly, necessary hearing.
It has been very revealing. We do have some issues and concerns
here. I do think we need to take under consideration the
concerns that several of the panelists have raised,
particularly, regarding taking a good jaundiced eye look at
this date. We certainly don't want to put our businesses at a
disadvantage. This is an evolving issue, it is complicated, it
is confusing. You are trying to get 20 nations to harmonize,
and do it on a timely basis. We do not want to do anything that
would hurt American businesses. That is just my concern.
I am also concerned about this Basel III situation and the
leverage ratio. I think that that is a serious issue too.
So I come away from this hearing with a heightened sense of
concern. Our Committee needs to make sure we address all these
issues, and make sure we move, communicate with the CFTC and
continue to soldier on. And we hope we can move forward and get
an execution date, but I certainly want to see some of these
issues examined and cleared.
Thank you, Mr. Chairman.
The Chairman. Thank you, Mr. Scott.
Ma'am, gentlemen, thank you for being here and
participating in this hearing.
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 Members.
This hearing of the Subcommittee on Commodity Exchanges,
Energy, and Credit is adjourned.
[Whereupon, at 11:40 a.m., the Subcommittee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Questions
Response from Hon. Terrence A. Duffy, Executive Chairman and President,
CME Group Inc.
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. We are not familiar with the practices of other SEFs.
However, CME Group's SEF operates in strict accord with the SEF Core
principles, including supporting CFTC rules and interpretations
respecting impartial access for all eligible market participants. Our
SEF access rules are transparent and readily available in chapter I of
the SEF rulebook (http://www.cmegroup.com/rulebook/SEF/cme-sef-
rulebook.pdf).
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. CME Group favors fair and impartial access to U.S. based
SEFs and DCMs. We favor cross border harmonization to the extent it is
necessary to permit us to operate for the benefit of customers in other
jurisdictions. We do not believe that harmonization principles will
require U.S. law and regulation to permit practices that are
inconsistent with the existing access standards in this country. It is
our view that harmonization requires a defined level of protection for
customers or institutions. It should not be interpreted to require any
jurisdiction to weaken its market protection standards.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. We agree that episodic liquidity stemmed from the natural
evolution of the market.
While the interest rate swaps that are subject to the trading
mandate are referred to as ``vanilla'' and are comparatively standard
in contrast to more highly customized interest rate swaps, most highly
standardized derivatives products (such as many futures contracts) are
characterized by an even greater degree of standardization than is
present in most ``vanilla'' OTC interest rate swaps. In most cases, a
swap traded today will not be offset by the same swap traded the next
day. This results in very different liquidity characteristics from
futures contracts, which have the same expiration and which are
fungible regardless of the trade date.
The majority of ``vanilla'' interest rate swaps subject to a
trading mandate do not have standardized coupons or dates. Products
with non-standardized coupons and dates can allow market participants
to achieve specific risk management needs, but will typically have a
greater number and variety of instruments traded. This results in
different liquidity formation characteristics than more fully
standardized products that aggregate liquidity of participants across
multiple dates and potential coupon rates.
The emergence of more standardized interest rate swaps, such as MAC
(Market Agreed Coupon) swaps, and the development of related swap
futures by multiple global exchanges are likely to have a significant
impact on the evolution of the swap market toward a more standardized,
liquid trading venue.
Response from Christopher S. Edmonds, Senior Vice President, Financial
Markets, Intercontinental Exchange, Inc.
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. ICE Swap Trade offers a multitude of methods of access
related to credit default swaps including an all to all anonymous
marketplace, broker access and name give ups. By offering various
methods of access, ICE complies with SEF regulations which are intended
to promote fair, non-discriminatory and open access. The ICE Swap Trade
platform will accept a transaction, either cleared or bilateral, as
long as the transaction meets the SEF requirements.
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. The Rules on access to trading venues under MiFID II were
agreed to in the Level 1 legislation. The Level 1 legislation requires
trading venues to have in place transparent and non-discriminatory
rules based on objective criteria which govern access to their
facility. These requirements are comparable to the impartial access
rules for SEFs. ICE believes harmonization between global regulators is
critical and should be a prioritized accordingly.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. ICE agrees that although certain interest rate and credit
default swaps have been standardized and mandated for both execution
and clearing, current regulations have unintentionally created a
bifurcation in these swaps markets. New regulations that require fully
anonymous trading would be necessary to remove this bifurcation.
Response from Marnie J. Rosenberg, Global Head, Clearinghouse Risk and
Strategy, JPMorgan Chase & Co.
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. Yes. All eligible market participants, as defined by each
SEF, are given the same access. Each SEF is responsible for determining
its own participation rules, which apply equally to sell-side and buy-
side participants.
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. As a general matter, global harmonization of rules is
important to ensure well-functioning derivatives markets. We do not
have a view as to how the Committee should prioritize the hypothetical
situation identified.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. There are fundamental differences between the swaps market
and other standardized markets. For example, liquidity in swaps markets
tends to be thinner and more episodic compared to the futures and
equities markets. This episodic liquidity leads to differences in
market structure and a broader range of methods of execution sought by
market participants. The CFTC's rules set out minimum liquidation
periods for initial margin levels that differ between swaps and futures
(currently five days for most cleared swaps and one day for futures),
demonstrating their own view that the liquidity profile of the products
is different.
Question 4. In your testimony you both described the swaps market
as being ``fragmented'' as a result of differences in cross-border
regulatory progress, but you didn't identify who was responsible for
that fragmentation. The latest OCC report on swaps trading finds that
the four largest banks control 91% of the notional market. Are trading
decisions at the firms with that much control of the market responsible
for fragmentation? If not, who else is fragmenting it?
Answer. The four largest banks are not responsible for the
fragmentation, and it would not be accurate to state that those banks
control 91% of the notional market for swaps trading; the OCC report
does not reflect the swaps flow executed by the banks. According to the
latest research from the International Swaps and Derivatives
Association (ISDA), the global interest rate swaps market has
fragmented along jurisdictional lines since the US swap execution
facility rules came into force in October of 2013. This fragmentation
has been most pronounced in the euro-denominated interest rate swaps
markets, where 91.2% of cleared euro IRS activity in the European
interdealer market was transacted between European counterparties in
December 2015. In September 2013, immediately prior to the introduction
of the SEF rules, the figure stood at 70.7%.
This data is an indication that non-U.S. market participants are
choosing to transact less with U.S. persons, or certain foreign
subsidiaries or affiliates of U.S. persons, as such transactions would
be required to be executed on SEF platforms.
Question 5. The CFTC has required trade data to remain anonymous at
the SDR level. What do you feel the impact would be if the CFTC imposed
a requirement that if a trade is entered anonymously it would need to
stay anonymous throughout its life-cycle?
Answer. Venues exist today for anonymous trades to remain anonymous
throughout their life cycle, and therefore there is not a need for the
CFTC to mandate such a requirement. Markets function best with sound
regulation, open competition and customer choice.
Question 6. We have rules in place to ensure a fair, anonymous,
all-to-all swaps markets where multiple participants can make both bids
and offers--that type of structure is much more balanced--and
historically as we've seen with the futures and equity's markets, much
more resilient in times of stress. Please comment on the structural
stability that could be supplied if these markets truly operated in the
anonymous all-to-all manner we intended?
Answer. We respectfully disagree with the two assumptions that
underlie this question: (1) anonymous all-to-all swaps markets are
``much more balanced'' and more resilient in times of stress; and (2)
swaps are similar to futures and equities (we refer you to our response
to Question 3).
Avenues for anonymous all-to-all trading of swaps already exist
alongside trading through Request-for-Quote (RFQ). Thus, customers have
a choice between the two execution methods. Efficient and stable
markets are best achieved through sound regulation and free and open
competition.
Question 7. We wrote the SEF Core Principles to require impartial
access, the CFTC's SEF rule requires impartial access and yet market
participants don't have impartial access to the full market--what needs
to change for all eligible market participants to have the kind of
access we envisioned?
Answer. We refer you to our response to Question 1.
Response from Stephen M. Merkel, J.D., Executive Vice President,
General Counsel and Secretary, BGC Partners, Inc.; Director,
Wholesale Markets Brokers' Association, Americas
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. As envisioned by Congress, the SEF landscape is
competitive, with over two dozen registered trading venues competing
for liquidity and trading activity in the over-the-counter marketplace.
The WMBAA member firms' SEFs are among those platforms. Each of these
SEFs has demonstrated compliance with CFTC regulation 37.202(a) and has
set forth clear criteria for market participants who wish to access its
market and market services.
With any competitive marketplace, customers have the option to
conduct business with an array of companies and different types of
trading platforms. Very few market participants will engage with all 24
SEFs. For each SEF, eligible market participants have to review and
compare individual execution models, rule books, analyze different cost
structures, and consider the legal and technical components of
onboarding when deciding whether to access a market. As the structure
of the market evolves in the aftermath of the credit crisis and
financial regulatory reform implementation, trading methodologies and
structure will continue to evolve as well. True to the Dodd-Frank
statutory intent, we look forward to continued competition among
resilient, innovative trading venues to promote the trading of swaps
through registered intermediaries.
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. As noted in my testimony, OTC swap markets are global in
nature. The WMBAA remains supportive of coordinated global efforts to
promote trading on regulated venues, central counterparty clearing, and
public reporting of standardized OTC derivative contracts in order to
``improve transparency in the derivatives markets, mitigate systemic
risk, and protect against market abuse.'' \1\
---------------------------------------------------------------------------
\1\ See Leaders' Statement, the Pittsburgh Summit, September 24-25,
2009, available at
https://www.treasury.gov/resource-center/international/g7-g20/
Documents/pittsburgh_sum
mit_leaders_statement_250909.pdf.
---------------------------------------------------------------------------
In just the last few years, we have seen liquidity move across
borders forming regional liquidity pools. Global regulators should
carefully coordinate regulatory efforts so as to not fragment markets,
reduce liquidity, and increase costs to users by rupturing the existing
methods by which U.S. and non-U.S. swap dealers, international banks,
global asset managers, and end-users access competitive, transparent
OTC markets in the U.S. or in other jurisdictions. Global regulatory
gaps have not only promoted bifurcation of trading patterns but can be
exploited to the detriment of investors.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. Yes, the swaps market is fundamentally different than other
standardized markets. It is a wholesale market where institutional
market participants can hedge risk exposures. Congress recognized the
distinctions between exchange-traded financial products like futures
and equities, on the one hand, and over-the-counter products such as
swaps. The Dodd-Frank Act provides unique statutory provisions to
preserve and enhance the unique liquidity characteristics,
institutional nature of market participants, and bespoke nature of many
of the instruments.
As referenced in my testimony, a 2011 Federal Reserve Bank of New
York (FRBNY) report found that the vast majority of single-name credit
default swap (CDS) contracts traded less than once per day and index
CDS contracts traded less than ten times per day, but in very large
sizes. Similarly, the vast majority of interest rate swap contracts
traded only once during the 3 month period studied. In comparison, many
more exchange-traded products tend to have continuous liquidity.
Certain Eurodollar futures contracts trade on the Chicago Mercantile
Exchange (CME) over 375,000 times per day.
The FRBNY study affirms that there are different levels of
liquidity in the marketplace, even among ``standardized'' products.
This is why Dodd-Frank correctly ensured flexibility in how market
participants can meet the trading mandate and transact ``through any
means of interstate commerce.''
We support revising the CFTC's swap rules to bring them more in
line with the statutory intent of Dodd-Frank to ``promote SEF trading''
and also to ensure that the global OTC swap market is made more
competitive and resilient, all while protecting the unique market
structure that continues to evolve over time.
Question 4. In your testimony you both described the swaps market
as being ``fragmented'' as a result of differences in cross-border
regulatory progress, but you didn't identify who was responsible for
that fragmentation. The latest OCC report on swaps trading finds that
the four largest banks control 91% of the notional market. Are trading
decisions at the firms with that much control of the market responsible
for fragmentation? If not, who else is fragmenting it?
Answer. As I noted in my testimony, fragmentation is driven by the
CFTC's SEF rules and the lack of regulatory harmonization with respect
to permitted modes of trade execution. Anecdotally, we have seen market
participants refrain from transacting with counterparties in certain
jurisdictions to avoid the CFTC's regulatory burdens. As a result,
liquidity has formed by jurisdiction. Trading has become more
regionalized with Asian, European and U.S. counterparties trading in
separate jurisdictions and with a reduced number of potential
counterparties. My testimony cites to recent ISDA and Bank of England
research supporting these observations.
We have concerns that these regulatory gaps will have a more
pronounced effect as we approach the impending MiFID II January 2018
target compliance date. These differences must be resolved as soon as
possible. We urge the Subcommittee to prioritize execution equivalence
and global coordination as the primary tool to counter the increasingly
well-entrenched trend for liquidity to be split along regional lines.
Question 5. The CFTC has required trade data to remain anonymous at
the SDR level. What do you feel the impact would be if the CFTC imposed
a requirement that if a trade is entered anonymously it would need to
stay anonymous throughout its life-cycle?
Answer. I cannot speculate on the possible market structure impact
this requirement may have if imposed. However, I strongly encourage the
CFTC--for this or any other policy proposal--to engage in data-driven
analysis based on timely, accurate information, to quantify the costs
and benefits of its proposals. These proposals should be published in
the Federal Register for an appropriate public notice and comment
period. These procedural protections will help to produce the soundest
policy and reflect the input of market participants.
The CFTC is the beneficiary of several years of comprehensive swap
market data through SDR reporting. The Commission should closely
consider the value of this information and perform a rigorous review of
the information in light of its policy initiatives. As I said at the
hearing, if ISDA and the Bank of England can conduct research and
publish their findings for public review, the CFTC should too.
Question 6. We have rules in place to ensure a fair, anonymous,
all-to-all swaps markets where multiple participants can make both bids
and offers--that type of structure is much more balanced--and
historically as we've seen with the futures and equity's markets, much
more resilient in times of stress. Please comment on the structural
stability that could be supplied if these markets truly operated in the
anonymous all-to-all manner we intended?
Answer. Please see my response to Question 5.
Question 7. We wrote the SEF Core Principles to require impartial
access, the CFTC's SEF rule requires impartial access and yet market
participants don't have impartial access to the full market--what needs
to change for all eligible market participants to have the kind of
access we envisioned?
Answer. Please see my response to Question 1.
Response from Stephen John Berger, Director, Government and Regulatory
Policy, Citadel, LLC; on behalf of Managed Funds Association
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. The CFTC provided additional clarity regarding the Dodd-
Frank Act's impartial access requirement in the final SEF rules and in
subsequent impartial access guidance issued in November 2013. This
additional guidance from the CFTC has been critical in dismantling
certain barriers that prevented market participants from accessing
certain trading venues for OTC derivatives, such as restrictive access
criteria that limited membership only to banks.
However, we believe that barriers still remain that prevent buy-
side market participants from fully interacting on each and every SEF
in the market. One such significant barrier is the continued use of
post-trade name give-up by the legacy interdealer SEFs. By revealing
counterparty identities post-trade to a swap that was initially
executed anonymously, these legacy interdealer SEFs inhibit buy-side
participation even though buy-side participants are now theoretically
able to join these trading venues.
The practice of post-trade name give-up originated in uncleared
markets, where counterparties needed to know each other's identity in
order to properly book and risk manage the swap. However, for cleared
swaps that are executed anonymously, we believe that there is no
legitimate reason that one party needs to find out the identity of the
other party post-trade, given that both parties immediately face the
clearinghouse and do not have any bilateral counterparty credit
exposure to each other. If two parties agree to execute anonymously,
this choice should be respected throughout the life cycle of the swap.
Post-trade name give-up inhibits buy-side participation on legacy
interdealer SEFs in several ways. First, post-trade name give-up is a
source of random and uncontrolled ``information leakage'' of private
trading positions and strategies, given that participants are not able
to control who they may be matched with when executing anonymously on
the SEF. Second, post-trade name give-up perpetuates the informational
and trading advantages of traditional dealers that benefit from their
ability to access and achieve full visibility into both the inter-
dealer and dealer-to-customer markets. In many cases, buy-side
participants are discouraged from ever even beginning to trade on these
legacy interdealer SEF platforms as long as the practice continues.
MFA therefore believes that impartial access to SEFs will only be
realized once post-trade name gave-up is prohibited for all
anonymously-executed cleared SEF trades.
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. In MFA's view, ensuring impartial access to trading venues
is critical in the continued implementation of the G20 reforms for the
swaps markets. MFA believes that U.S. and European regulators should
push for harmonization with respect to the implementation of impartial
access requirements for trading venues and that this is an achievable,
mutually beneficial priority that will benefit the long-term health and
vitality of the global swaps markets.
Similar to the U.S. impartial access requirement, the European
MiFID II legislation requires trading venues to provide non-
discriminatory access to market participants (see Article 18(3) of the
MiFID II Directive governing multilateral trading facilities (MTFs) and
organized trading facilities (OTFs), and Article 53(1) of the MiFID
Directive \1\ governing regulated markets). As such, there should be no
difference between the two regimes on this topic, though European
regulators may be required to issue additional guidance (similar to the
CFTC's November 2013 impartial access guidance) in order to ensure that
the non-discriminatory access requirement is properly implemented. We
believe that ensuring equivalent standards with respect to the
implementation of impartial access should be a key focus in future
discussions regarding harmonization and regulatory equivalence.
---------------------------------------------------------------------------
\1\ Directive 2014/65/EU of The European Parliament and of the
Council of 15 May 2014 on markets in financial instruments, available
at http://eur-lex.europa.eu/legal-content/EN/ALL/?uri=CELEX:32014L0065.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. MFA disagrees with that characterization for standardized
and liquid cleared swaps. While more bespoke customized swaps may trade
relatively infrequently, experience with the reforms in the U.S. has
shown that a great many cleared swaps are standardized and highly
liquid, and are suitable for SEF trading. In fact, recent Bank of
England research found that the implementation of the clearing and
trading reforms in the USD interest rate swaps market has already
yielded significant improvements in pricing and liquidity for
investors.\2\
---------------------------------------------------------------------------
\2\ See Staff Working Paper No. 580 ``Centralized trading,
transparency and interest rate swap market liquidity: evidence from the
implementation of the Dodd-Frank Act'', Bank of England (January 2016),
available at: http://www.bankofengland.co.uk/research/Documents/
workingpapers/2016/swp580.pdf.
---------------------------------------------------------------------------
As such, MFA does not believe that the current bifurcated, two-
tiered market structure is the ``natural'' evolution of the market. The
two-tier structure impairs pre-trade transparency for buy-side market
participants and prevents buy-side market participants from accessing
important sources of liquidity in the marketplace. This two-tier
structure also confines the buy-side to a ``price-taker'' role, rather
than providing the opportunity to become a ``price-maker'' as well, and
can impair price discovery and competition. In MFA's view, the two-tier
market needs to evolve in order to improve competition and market
liquidity, and fully implementing the Dodd-Frank Act's impartial access
requirement is critical to allowing this evolution to occur.
Question 4. The CFTC has required trade data to remain anonymous at
the SDR level. What do you feel the impact would be if the CFTC imposed
a requirement that if a trade is entered anonymously it would need to
stay anonymous throughout its life-cycle?
Answer. In MFA's view, the imposition of such a requirement would
be consistent with prior CFTC rulemaking to ensure that trade data
remains anonymous at the SDR level. Currently, this CFTC rule is
undermined by the continued use of post-trade name give-up, as a
counterparty can find out the identity of the other party to a trade
from the SEF even though they are prohibited from doing so at the SDR.
If two parties agree to execute anonymously, this choice should be
respected throughout the life cycle of the swap.
As stated above, MFA believes that ending the practice of post-
trade name give-up for anonymously executed cleared swaps will lead to
more buy-side participation on legacy interdealer SEFs. In our view,
impartial access requirements have contributed to healthy liquidity
conditions in several other significant markets, such as the equities
and futures markets. Based on these examples, MFA believes that true
impartial access will provide a stronger foundation for U.S. swaps
market liquidity and enhance price transparency and competition in the
U.S. swaps market.
Question 5. We have rules in place to ensure a fair, anonymous,
all-to-all swaps markets where multiple participants can make both bids
and offers--that type of structure is much more balanced--and
historically as we've seen with the futures and equity's markets, much
more resilient in times of stress. Please comment on the structural
stability that could be supplied if these markets truly operated in the
anonymous all-to-all manner we intended?
Answer. Fully implementing and enforcing the Dodd-Frank Act's
impartial access requirement would allow an all-to-all market for
cleared swaps to emerge (where multiple market participants are able to
meet and transact). In our view, an all-to-all market has contributed
to healthy liquidity conditions in several other significant markets,
such as the equities and futures markets.
By contrast, the current bifurcated two-tier swaps market structure
entrenches traditional dealers as exclusive ``price makers''. It also
limits the manner and extent to which buy-side participants may
interact in the swaps market. Such structural limitations on liquidity
provision and risk transfer may increase the likelihood of market
volatility and instability over the long term. The willingness and
capacity of traditional dealers to allocate balance sheet to swaps
market-making activities appears to be diminishing in certain respects.
This trend will likely continue over time as traditional dealers
continue to restructure their businesses post-financial crisis and
adapt to new capital, leverage, and liquidity requirements under Basel
III and similar rules. Without swaps market reforms that facilitate
impartial access to all SEFs and encourage alternative forms of price
formation and liquidity provision and greater diversity of
participation (among participants and modes of interaction), MFA fears
that the U.S. swaps market could risk greater volatility and
dislocation in times of market stress.
Question 6. We wrote the SEF Core Principles to require impartial
access, the CFTC's SEF rule requires impartial access and yet market
participants don't have impartial access to the full market--what needs
to change for all eligible market participants to have the kind of
access we envisioned?
Answer. MFA would encourage the CFTC to take action to prohibit the
use of post-trade name give-up for cleared swaps executed anonymously
on SEFs. MFA has submitted a petition to the CFTC in this regard and is
hopeful this prohibition will be included in any proposed modifications
to the SEF rules. Without CFTC action, commercial dynamics make it
difficult for any one legacy interdealer SEF to unilaterally stop using
post-trade name give-up while others still do.
In addition, MFA would encourage the CFTC to prioritize the
enforcement of impartial access. It would be useful for the CFTC to
actively monitor the progress of trading reforms in the swaps markets,
and what barriers may continue to affect participation and trading
activity. We also continue to urge the CFTC to finalize dealer
ownership and governance restrictions for SEFs, as otherwise potential
conflicts of interest could arise that inhibit natural market structure
evolution.
Response from Luke D. Zubrod, Director, Risk and Regulatory Advisory
Services, Chatham Financial
Questions Submitted by Hon. Collin C. Peterson, a Representative in
Congress from Minnesota
Question 1. At a recent CFTC Market Risk Advisory Committee meeting
a number of buy-side witnesses testified that the practice of post-
trade name-give up--that is: the removal of anonymity from the market
after execution, has prevented them from participating in the SEFs
offered by the Inter-Dealer Brokers. Further, two class-action lawsuits
alleging anti-trust violations against the largest dealers and several
of the interdealer brokers have been filed in the credit default swap
and interest rate markets respectively. These suits both allege that
the practice of post-trade name give-up has been planned by the largest
participants and forced on to the inter-dealer brokers in restraint of
trade. One of them settled late last year for $2bn.
The SEF Core principles in Dodd Frank require impartial access for
all eligible market participants. The CFTC's SEF Rule mandates that a
SEF must ensure ``impartial access to its markets and market services''
for eligible participants--and that eligibility itself must be set in
an impartial, transparent, fair and non-discriminatory manner.
Do all eligible market participants have impartial access to each
and every SEF? If not, why not?
Answer. The segment of the market Chatham Financial serves has not
had difficulty accessing SEFs. Chatham's clients are end users, and
generally use SEFS to hedge interest rate risk. Thus, we are not in a
position to offer expert insight into the nature of access in the
credit default swap market. End-users generally use derivatives to
manage and reduce risk (i.e., to hedge)--not for speculative or trading
purposes. Those that use derivatives to hedge, generally rely on SEFs
that price transactions via the request for quote (i.e., RFQ) model
because it permits greater flexibility to structure a hedge to offset a
firm-specific risk. While hedgers and those using derivatives for
investment purposes alike could make use of central limit order books
(i.e., CLOB)--the pricing model in which Inter-Dealer Brokers excel--
the RFQ model in which Inter-Dealer Brokers do not play a significant
role is, in our view, best suited for end-user hedgers.
Buy side asset managers use derivatives for both hedging and
investment purposes; thus, the optimal execution method--whether RFQ or
CLOB--may differ from those of other kinds of financial end users, such
as those whom we advise and on whose behalf we transact. As a general
principle, Chatham appreciates the value of anonymous trading and we do
not see a benefit to most end-users of name-disclosed approaches.
However, our experience does not allow us to offer material input on
the question of access to the central limit order books offered by
Inter-Dealer Brokers.
Question 2. There was a great deal of testimony regarding
harmonization with European Rules. However, from published reports a
number of trade organizations representing incumbent firms with
significant market power have been arguing to European regulators and
legislators to make changes to the proposed trade execution regime in
MiFID II. If that effort is successful, we will be asked to harmonize,
or to push the CFTC to harmonize, our clear rules on impartial access
to the SEF marketplace for eligible participants with rules that
include no such mandate. In that eventuality should harmonization still
be our top priority?
Answer. Chatham sees growth in electronic trading in the OTC
derivatives market as a positive development. This growth has been
spurred both by technological advancement and by regulatory mandates in
the U.S. and Europe. The principle benefits of electronic trading are
the ease of facilitating competition and the benefits of straight
through processing, especially where a party transacts in high volumes.
These benefits must be set against the costs of evaluating electronic
marketplaces, reviewing rulebooks of those marketplaces, and setting up
systems to facilitate straight-through processing. Transaction volumes
will often dictate whether the benefits of electronic trading outweigh
the costs. Those that transact in high volumes will generally see
benefits in adopting electronic trading and will often choose to
transact electronically whether or not regulation requires them to do
so.
Chatham believes it is not necessary to tightly prescribe protocols
by which electronic marketplaces operate. The U.S. has generally taken
a more prescriptive approach relative to Europe with respect to trading
protocols imposed on SEFs. For example, U.S. regulations require that a
minimum number of dealers participate in swap auctions via electronic
marketplaces, while requirements on European trading platforms are
subject to lower requirements. We believe the benefits of competition
and straight-through processing can accrue under various protocols and
rule sets, and that the prescriptive approach adopted by the U.S. is
not necessary to ensure a competitive marketplace.
As a general principle, we believe it beneficial to market
participants when regulators globally coordinate and harmonize their
rules--both with respect to their content and timing--and we believe
such efforts with respect to trading rules should be given due
consideration.
Question 3. The swaps we discussed at the hearing are not
customized--they are standardized. Standardized swaps are the only
swaps that are subject to the trading mandate--they are cleared and are
subject to the straight-through-processing requirement. And yet, we
repeatedly hear that the swaps market is fundamentally different than
other standardized markets: that it is characterized by episodic
liquidity and that its bifurcated, two-tiered structure is the
``natural'' evolution of the market. Do you agree or disagree with that
characterization?
Answer. Yes. Bilateral, uncleared swaps (i.e., typically customized
swaps) play an important role in allowing market participants to manage
risk. When risk management is the objective, such swaps are generally
superior to standardized swaps which cannot be customized to perfectly
offset idiosyncratic risks. Absent customized swaps, market
participants would be forced to retain risks that they might otherwise
have been able to transfer. In addition to the economic benefits of
customization, market participants who perfectly match their hedge to
their risk achieve accounting results--via hedge accounting treatment--
that are more consistent with the economic outcome achieved through
hedging. That is, income statement volatility is reduced or eliminated
in line with the risk reducing nature of the hedges.
Additionally, bilateral, uncleared swaps permit customization with
respect to the credit arrangements used to manage risk associated with
the swap. Just as banks are able to accept various forms of collateral
with respect to loans, end-users value their ability with bilateral,
uncleared swaps to customize the credit support arrangements they enter
into with swap dealers. For example, centrally cleared swaps are
secured by initial and variation margin. While bilateral, uncleared
swaps may be similarly secured, end users may negotiate credit support
arrangements that are better tailored to their needs. For example, a
real estate firm may grant a security interest in a real estate asset
to its swap counterparty, who also may serve as lender on loan that the
swap hedges. Real estate firms, among others, own physical assets and
do not carry significant amounts of cash greatly benefit from such
customizable credit arrangements.
At the same time, firms that transact in significant volumes, have
low cost of capital and ready access to liquid resources (e.g., cash
and certain securities) may find that the centrally cleared market
meets their risk management needs. Such participants may prefer the
risk management characteristics of a centralized market.
Thus, we believe a two-tiered market benefits the market and is not
inconsistent with public policy objectives related to systemic risk and
transparency.
Question 4. The CFTC has required trade data to remain anonymous at
the SDR level. What do you feel the impact would be if the CFTC imposed
a requirement that if a trade is entered anonymously it would need to
stay anonymous throughout its life-cycle?
Answer. We believe it appropriate that regulators implement rules
in a manner that prevents market participants from having visibility
into an individual company's positions. However, we believe it
appropriate for regulators to have such visibility with respect to all
positions.
Question 5. We have rules in place to ensure a fair, anonymous,
all-to-all swaps markets where multiple participants can make both bids
and offers--that type of structure is much more balanced--and
historically as we've seen with the futures and equity's markets, much
more resilient in times of stress. Please comment on the structural
stability that could be supplied if these markets truly operated in the
anonymous all-to-all manner we intended?
Answer. We believe that structural stability can be supplied to
these markets without an all-to-all market. Indeed, we believe the
principle contribution of an all-to-all model in the derivatives market
relates more to transparency than it does systemic stability, and even
the transparency benefits can be achieved in ways that are less
prescriptive than a mandated all-to-all market structure. We believe
other mechanisms can adequately address systemic stability concerns,
including clearing, margin and capital requirements. In essence, we
think while there may be benefits in some cases for all-to-all markets,
we do not believe there are sufficient benefits to justify that such a
structure be mandated. Indeed, we believe end-user risk management
objectives are furthered by way of a variety of means of execution.
Question 6. We wrote the SEF Core Principles to require impartial
access, the CFTC's SEF rule requires impartial access and yet market
participants don't have impartial access to the full market--what needs
to change for all eligible market participants to have the kind of
access we envisioned?
Answer. As noted, Chatham's experience - principally focused on
interest rate markets and the RFQ model--does not suggest a significant
concern with impartial access to SEFs. Nonetheless, we think it not
inappropriate for policy makers to carefully consider the concerns of
market participants transacting in other asset classes (e.g., credit
default swaps) and other execution methods (e.g., central limit order
books).
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