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

                    DODD-FRANK TURNS FIVE: ASSESSING THE
                     PROGRESS OF GLOBAL DERIVATIVES
                                    REFORMS

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

                                    HEARING

                                   BEFORE THE

                            COMMITTEE ON AGRICULTURE
                            HOUSE OF REPRESENTATIVES

                        ONE HUNDRED FOURTEENTH CONGRESS

                                 FIRST SESSION

                                   __________

                                 JULY 29, 2015

                                   __________

                               Serial No. 114-24

    [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

                                      (ii)
                                 C O N T E N T S

                                  ----------
                                                                       Page
    Conaway, Hon. K. Michael, a Representative in Congress from
      Texas, opening statement.......................................     1
        Prepared statement...........................................     3
    Peterson, Hon. Collin C., a Representative in Congress from
      Minnesota, opening statement...................................     4

                                   Witnesses

    Duffy, Hon. Terrence A., Executive Chairman and President, CME
      Group, Chicago, IL.............................................     5
        Prepared statement...........................................     6
    O'Malia, Hon. Scott D., Chief Executive Officer, International
      Swaps and Derivatives Association, Inc., New York, NY..........     9
        Prepared statement...........................................    11
    Edmonds, Christopher S., Senior Vice President, Financial
      Markets, IntercontinentalExchange, Inc., Chicago, IL...........    22
        Prepared statement...........................................    23
        Supplementary material.......................................    67
        Submitted reports............................................    89
    Thompson, Larry E., Vice Chairman and General Counsel, Depository
      Trust and Clearing Corporation, New York, NY...................    25
        Prepared statement...........................................    26
    Parsons, Ph.D., John E., Senior Lecturer, Sloan School of
      Management, Massachusetts Institute of Technology, Cambridge,
      MA.............................................................    41
        Prepared statement...........................................    42

                     DODD-FRANK TURNS FIVE: ASSESSING THE
                      PROGRESS OF GLOBAL DERIVATIVES
                                    REFORMS

                                  ----------

                            WEDNESDAY, JULY 29, 2015

                              House of Representatives,
                                      Committee on Agriculture,
                                                       Washington, D.C.
        The Committee met, pursuant to call, at 10:01 a.m., in Room
    1300 of the Longworth House Office Building, Hon. K. Michael
    Conaway [Chairman of the Committee] presiding.
        Members present: Representatives Conaway, Rogers, Gibbs,
    Austin Scott of Georgia, Davis, Yoho, Allen, Bost, Abraham,
    Moolenaar, Newhouse, Kelly, Peterson, Walz, McGovern, DelBene,
    Vela, Kuster, Nolan, Bustos, Kirkpatrick, Plaskett, Adams,
    Graham, and Ashford.
        Staff present: Caleb Crosswhite, Carly Reedholm, Haley
    Graves, Jackie Barber, Kevin Webb, Mollie Wilken, Paul Balzano,
    Scott C. Graves, Faisal Siddiqui, Liz Friedlander, Matthew
    MacKenzie, and Nicole Scott.

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

        The Chairman. Good morning. This hearing on the Committee
    on Agriculture, Dodd-Frank Turns Five: Assessing the Progress
    of Global Derivatives Reforms, will come to order. Please join
    me in a brief prayer. Heavenly Father, we thank you, Lord, for
    the privileges of being able to represent the folks we
    represent for our districts. We ask, Lord, that we honor that
    trust that they put in us as we consider things before the
    Committee today. Give us wisdom, and knowledge, and discernment
    that we might come to the right conclusions. Forgive us where
    we fail, Lord. We ask these things in Jesus's name, amen.
        Thank you for being here today and joining us in this full
    Committee hearing. The 2008 financial crisis prompted global
    leaders to re-evaluate the regulatory regime for derivatives.
    In Pittsburgh, and again in Cannes, global leaders set out five
    categories of reforms--clearing, margining, electronic
    execution, data reporting, and capital standards--they all
    agreed would make derivatives markets much safer. Perhaps most
    importantly, though, the G20 leaders recognized the global
    nature of swaps markets, and sought to ensure that national
    regulators coordinated these reform efforts.
        In 2008, at the close of the first G20 summit in
    Washington, the assembled heads of state declared: ``our
    financial markets are global in scope, therefore intensified
    international cooperation among regulators, and strengthening
    of international standards were necessary, and their consistent
    implementation is necessary to protect against adverse cross-
    border, regional and global developments affecting
    international financial stability. Regulators must ensure that
    their actions support market discipline, avoid potentially
    adverse impacts on other countries, including regulatory
    arbitrage, and support competition, dynamism, and innovation in
    the marketplace.''
        G20 leaders continued to push for cooperation, and
    cooperation between regulators, at every subsequent G20
    meeting, including in the joint announcement following the 2013
    St. Petersburg summit, where G20 leaders spoke about the
    importance of deferring to national regulators. They said, ``We
    agree that jurisdictions and regulators should be able to defer
    to each other, when it is justified, by the quality of the
    respective regulatory and enforcement regimes based on similar
    outcomes, in a non-discriminatory way, paying due respect to
    home country regulation regimes.''
        As we mark the fifth anniversary of the Dodd-Frank Act, it
    is important that we take stock of where we were and where we
    are trying to get to by enacting this legislation. The G20 laid
    out a road map that demanded international action to respond to
    an international crisis, but left it to national regulators to
    implement that vision. Over the past several years the
    Agriculture Committee has heard from market participants, CFTC
    Commissioners, and even foreign regulators about the struggles
    national regulators are having living up to the proclamations
    of the G20.
        Today the Committee is concerned that the lack of
    coordination and harmonization is jeopardizing the
    implementation of these promised and widely sought reforms to
    global swaps markets. If we get these reforms wrong, we will
    permanently disrupt global financial markets, trapping
    liquidity behind regulatory barriers, and preventing end-users
    from seeking out their best risk management counterparts.
    Splintering global financial markets through regulatory pride-
    of-authorship is not reform, it is bureaucratic hubris. If that
    is the ultimate outcome of the Dodd-Frank Act, regulators will
    have squandered the responsibility to which they were
    entrusted. Today we will begin to examine the progress global
    regulators have made with derivatives reforms and what work
    remains to be done, where the perils are for market
    participants. And I look forward to the testimony of our
    witnesses.
        In the background of this debate looms the continued
    inaction of the Congress on the expired authorization of the
    CFTC. I consider it a failure of our institution to allow
    Federal agencies to operate outside the traditional budget
    process of authorization, appropriation, and oversight. That is
    why I set an ambitious agenda this spring to re-authorize all
    of our expired or expiring programs and agencies. Together we
    got our work done, we moved the four bills through the
    Committee and the House floor, re-authorizing everything within
    our jurisdiction that needed to be done this year.
        For the CFTC, this Committee has done its work twice over
    the past 2 years, and moved two bipartisan re-authorization
    packages through the House of Representatives, with no
    corresponding action in the Senate. Despite the lack of
    authorization, appropriations to the agencies have increased,
    from $194 million at the end of Fiscal Year 2013 to $250
    million this year, a 29 percent increase in 2 years.
        To that end, I want to publicly state I am opposed to any
    increase in funding for the Commission until it is re-
    authorized. Both the House and the Senate Appropriations
    Committee have proposed level funding for the agency, and I do
    not believe it is appropriate to have any conversation that
    moves that line, while so many end-users and good government
    issues remain outstanding and unresolved. This is not a
    position I take lightly, which I hope highlights the importance
    in which I hold the re-authorization of every agency and
    program under the jurisdiction of this Committee.
        [The prepared statement of Mr. Conaway follows:]

      Prepared Statement of Hon. K. Michael Conaway, a Representative in
                              Congress from Texas
        Thank you all for joining us today and welcome to today's full
    Committee hearing, Dodd-Frank Turns Five: Assessing the Progress of
    Global Derivatives Reforms.
        The 2008 financial crisis prompted global leaders to reevaluate the
    regulatory regime for derivatives. In Pittsburgh and again in Cannes,
    global leaders set out five categories of reforms--clearing, margining,
    electronic execution, data reporting, and capital standards--they all
    agreed would make derivatives markets safer.
        Perhaps most importantly though, the G20 Leaders recognized the
    global nature of swaps markets and sought to ensure that national
    regulators coordinated these reform efforts. In 2008, at the close of
    the first G20 Summit in Washington, the assembled Heads of State
    declared:

              . . . our financial markets are global in scope, therefore,
            intensified international cooperation among regulators and
            strengthening of international standards, where necessary, and
            their consistent implementation is necessary to protect against
            adverse cross-border, regional and global developments
            affecting international financial stability. Regulators must
            ensure that their actions support market discipline, avoid
            potentially adverse impacts on other countries, including
            regulatory arbitrage, and support competition, dynamism and
            innovation in the marketplace.

        G20 leaders continued to push for cooperation and coordination
    between regulators at every subsequent G20 meeting, including in the
    joint announcement following the 2013 St. Petersburg Summit, where the
    G20 Leaders spoke about the importance of deferring to national
    regulators:

              ``We agree that jurisdictions and regulators should be able
            to defer to each other when it is justified by the quality of
            their respective regulatory and enforcement regimes, based on
            similar outcomes, in a non-discriminatory way, paying due
            respect to home country regulation regimes.''

        As we mark the fifth anniversary of the Dodd-Frank Act, it is
    important that we take stock of where we were and where we were trying
    to get to by enacting this legislation. The G20 laid out a roadmap that
    demanded international action to respond to an international crisis,
    but left it to national regulators to implement that vision.
        Over the past several years, the Agriculture Committee has heard
    from market participants, CFTC Commissioners, and even foreign
    regulators about the struggles national regulators are having living up
    to the proclamations of the G20. Today, the Committee is concerned that
    the lack of coordination and harmonization is jeopardizing the
    implementation of these promised and widely supported reforms to global
    swaps markets.
        If we get these reforms wrong, we will permanently disrupt global
    financial markets, trapping liquidity behind regulatory barriers and
    preventing end-users from seeking out their best risk management
    counterparts. Splintering global financial markets through regulatory
    pride-of-authorship is not reform, it is bureaucratic hubris. If that
    is the ultimate outcome of the Dodd-Frank Act, regulators will have
    squandered the responsibility with which they have been entrusted.
        Today, we'll begin to examine what progress global regulators have
    made with derivatives reforms, what work remains to be done, and where
    the pitfalls are for market participants. I look forward to the
    testimony of our witnesses.
        In the background of this debate looms the continued inaction of
    Congress on the expired authorization the CFTC. I consider it a failure
    of our institution to allow Federal agencies to operate outside of the
    traditional budget process of authorization, appropriation, and
    oversight. That is why I set an ambitious agenda this spring to
    reauthorize all of our expired or expiring programs and agencies.
    Together, we got our work done and we've moved four bills through this
    Committee and the House floor reauthorizing everything within our
    jurisdiction that we need to this year.
        For the CFTC, this Committee has done its work twice over the past
    2 years and moved two bipartisan reauthorization packages through the
    House of Representatives, with no corresponding action in the Senate.
    Despite the lack of authorization, appropriations to the agency have
    increased from $194 million at the end of FY 2013 to $250 million this
    year, an increase of 29% in 2 years.
        To that end, I want to publicly state I am opposed to any increase
    in funding for the Commission until it is reauthorized. Both the House
    and Senate Appropriations Committees have proposed level funding for
    the agency, and I do not believe it is appropriate to have any
    conversation that moves that line while so many end-user and good-
    government issues remain outstanding and unresolved. This is not a
    position I take lightly, which I hope highlights the importance in
    which I hold the reauthorization of every agency or program under the
    jurisdiction of this Committee.

        The Chairman.With that, I yield to the Ranking Member for
    any opening statement he has.

    OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
                       IN CONGRESS FROM MINNESOTA

        Mr. Peterson. Well, thank you, Mr. Chairman, and I thank
    the panel for being here to visit with us today. It has, as you
    said, been about 7 years since the financial crisis, and 5
    years since this Committee finished our work on Title VII of
    Dodd-Frank. In that time the CFTC has finished 50 of the 60
    rules required by Title VII. Central clearing, margin, price
    transparency are now the rule, rather than the exception, in
    the swaps market. And as a result of Title VII the derivatives
    market, as a whole, is now much safer for end-users, consumers,
    market participants and taxpayers than they were 7 years ago.
        Still, there is much work to be done. I look forward to
    hearing our witnesses' views on the areas that need more work,
    particularly what they feel would be the most appropriate role
    for Congress to support Chairman Massad in his efforts to
    coordinate the CFTC's rules with those of foreign regulators. I
    think he has done a good job. He has been a good leader in that
    effort, and I do want to make sure that whatever action we take
    enhances that effort, and the progress that he has made.
        I also want to hear the witnesses' views on how we can help
    to improve the Dodd-Frank's trade data reporting regime.
    Reporting is very important, and it is non-controversial, but
    it is no secret that it isn't working as well as it should,
    that something needs to be done in that area. So, again, Mr.
    Chairman, thank you for the hearing, and I yield back.
        The Chairman. I thank the gentleman. The chair would
    request that other Members submit their opening statements for
    the record so that our witnesses may begin testimony to ensure
    there is ample time for questions.
        I would like to welcome to our witness table today Mr.
    Terry Duffy, Executive Chairman and President of CME Group,
    Chicago Illinois, Mr. Scott O'Malia, the Chief Executive
    Officer, International Swaps and Derivatives Association, Inc.
    of New York, Mr. Christopher Edmonds, Senior Vice President,
    Financial Markets, IntercontinentalExchange in Chicago, Mr.
    Larry Thompson, Vice Chairman and General Counsel, Depository
    Trust and Cleaning Corporation of New York, and Dr. John
    Parsons, Senior Lecturer, MIT Sloan School of Management,
    Cambridge, Massachusetts.
        Mr. Duffy, you may begin when you are ready.

      STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
                   PRESIDENT, CME GROUP, CHICAGO, IL

        Mr. Duffy. Thank you, Chairman Conaway, Ranking Member
    Peterson, Members of the Committee. I appreciate the
    opportunity to offer CME Group's perspective on the G20
    commitments, and whether the U.S. and global regulators are
    meeting them.
        Since Congress passed the Dodd-Frank Act, the U.S. has
    imposed a clearing mandate for certain swaps. Today they are
    traded transparently on futures exchanges and SEFs, which are
    swaps execution facilities, cleared through central clearing
    houses, and reported. These developments represent progress
    towards the goals of the G20 to strengthen the financial system
    through reforms that increase transparency and reduce systemic
    risk.
        But the point of the G20 commitments was also to create a
    global framework. As of today, many G20 nations have not
    implemented the core elements of the G20 regulatory reforms
    that the U.S. has in our Dodd-Frank Act. This lack of
    coordination has led to policies that have created
    inconsistency, uncertainty, and the potential to harm efficient
    functioning of the U.S. and global derivatives markets.
        A few examples would be, first, in the European Union, the
    current lack of recognition for U.S. clearing houses will
    prevent EU participants from clearing EU mandated products in
    the United States. This will prevent U.S. clearing houses from
    competing for this global business. And it is clearly unfair,
    given the way the European and other foreign clearing houses
    have been able to compete for U.S. business arising from our
    Dodd-Frank mandate.
        Of equal concern, the lack of recognition of U.S. exchanges
    by the European Union has begun to drive some trading out of
    the United States. I suggested to this Committee many years
    ago, when I was testifying, that this was exactly what was
    going to happen, and we are seeing that happen today. I am
    hopeful that the U.S. and European Union will achieve
    resolution on the equivalence issue in the coming months. This
    would give participants the regulatory certainty they need to
    effectively manage their global risks.
        Second, global coordination is also essential for an
    effective position limits regime. If the CFTC adopts an overly
    prescriptive position limits rule when other G20 nations have
    not, price discovery and risk management for U.S. commodities
    will likely move abroad. For end-users that stay in the United
    States, their cost to hedge will be significantly higher due to
    the potential lack of liquidity, and the spread is widening.
        Before closing I want to raise one other issue that is
    contrary to the objectives of the G20 commitments, and that is
    the leverage ratio rule adopted by the Basel Committee and the
    U.S. Federal Reserve. The rule mistakenly fails to recognize
    the risk reducing effect of segregated margin. Instead, the
    rule penalizes the use of central clearing houses by banks on
    behalf of their clients. It forces banks to overstate their
    leverage exposure, and hold more capital against their client
    clearing activities. This is the case even when those
    activities cannot, as a matter of law, increase the bank's
    leverage exposure.
        Under this rule, the current calculation of leverage ratio
    results in better treatment for higher risk products, such as
    credit default swaps, versus agriculture or other commodity
    futures. This makes absolutely no practical sense whatsoever.
    Making clearing more expensive, and less successful, for end-
    users is directly contrary to the objectives of the G20
    commitments. For the G20 commitments to work globally, each
    member nation needs to have a workable cross-border regulatory
    framework. CFTC Chairman Timothy Massad has been a leader in
    working with his counterparts among the G20 member nations to
    address that.
        In closing, an effective cross-border regulatory framework
    does not mean that regulators of G20 nations must be identical.
    The key is to whether each nation's rules achieve the G20
    commitments. In the global market, the goal should be for
    nations to adopt frameworks that lead to consistent regulation,
    and the results that allow for appropriate substitutable
    compliance. I want to thank the Chairman and the Members of the
    Committee for the time. I look forward to answering your
    questions.
        [The prepared statement of Mr. Duffy follows:]

     Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
                       President, CME Group, Chicago, IL
        Good morning Chairman Conaway, Ranking Member Peterson. I am Terry
    Duffy, Executive Chairman and President of CME Group.\1\ Thank you for
    the opportunity to offer our perspective on the G20 commitments and
    whether U.S. and global regulators are meeting them.
    ---------------------------------------------------------------------------
        \1\ CME Group Inc. is the holding company for four exchanges, CME,
    the Board of Trade of the City of Chicago Inc. (``CBOT''), the New York
    Mercantile Exchange, Inc. (``NYMEX''), and the Commodity Exchange, Inc.
    (``COMEX'') (collectively, the ``CME Group Exchanges''). The CME Group
    Exchanges offer a wide range of benchmark products across all major
    asset classes, including derivatives based on interest rates, equity
    indexes, foreign exchange, energy, metals, agricultural commodities,
    and alternative investment products. The CME Group Exchanges serve the
    hedging, risk management, and trading needs of our global customer base
    by facilitating transactions through the CME Group Globex electronic
    trading platform, our open outcry trading facilities in New York and
    Chicago, and through privately negotiated transactions subject to
    exchange rules.
    ---------------------------------------------------------------------------
        As we know, the G20 Leaders agreed in 2009 to strengthen the
    financial system through reforms that increase transparency and reduce
    systemic risk in the over-the-counter (OTC) derivatives market. To
    achieve these commitments, the G20 agreed to implement reforms
    requiring:

       Reporting: All OTC derivatives should be reported;

       Trading and Clearing: All standardized OTC derivatives
            should be traded on exchanges or electronic trading platforms,
            and cleared through central counterparties; and

       Margin and Capital: Uncleared OTC derivatives should be
            subject to higher capital requirements and minimum margin
            requirements should be developed.

        Since Congress passed the Dodd-Frank Act in 2009, the U.S. has made
    tremendous progress towards fulfilling its G20 Commitments. A clearing
    mandate has been implemented for certain rates and credit default
    swaps, swaps are trading on execution venues, and swaps are reported to
    trade repositories.
        There is more work to be done. A core tenet of the G20 Commitments
    was to develop a global framework for the regulation of OTC
    derivatives. The lack of consistency in both substance and timing of
    regulatory reforms between the U.S. and other G20 nations that have yet
    to implement many OTC regulatory reforms has led to uncertainty and the
    potential for harm to the efficient functioning of the U.S. and global
    derivatives markets. We and the other G20 nations must move carefully
    to avoid undermining this objective.
        Here are a few examples where policymakers and regulators must work
    to better align national and international policies governing the
    regulation of OTC derivatives markets.
    EU Equivalency Standards
        Among the most critical issues facing the CFTC today is the
    potential for the United States to be denied status as a country whose
    regulations are equivalent to Europe's. CME operates futures exchanges,
    clearinghouses and reporting facilities in the U.S. and United Kingdom,
    and our U.S. futures products reach over 150 jurisdictions across the
    globe. Cross-border access is a core part of our global business
    strategy. CME has long been a strong supporter of mutual recognition
    regimes that (i) eliminate legal uncertainty, (ii) allow cross-border
    markets to continue operating without actual or threatened disruption,
    (iii) afford U.S.-based and foreign-based markets and market
    participants equal flexibility, and (iv) promote a level playing field.
        Historically, both the U.S. and EU have mutually recognized each
    other's regulatory regimes to promote cross-border access. Recently,
    however, the European Commission has taken a different approach. Under
    European law, U.S. clearinghouses and exchanges--like CME--must first
    be recognized by European regulators in order to be treated the same as
    EU clearinghouses and exchanges. The European Commission is
    conditioning its recognition of U.S. derivatives laws as equivalent to
    European law on demands for harmful regulatory changes by the U.S. that
    would impose competitive burdens on U.S., but not EU, clearinghouses
    and exchanges, and would harm both U.S. and EU market participants.
    This refusal to recognize U.S. derivatives laws as equivalent is
    already having a negative impact on liquidity in our markets by
    creating trading disincentives and barriers to entry. As a result,
    diminished liquidity leads to higher hedging costs for commercial end-
    users in the U.S. and ultimately higher commodity prices paid by U.S.
    consumers.
        After more than 2 years of negotiation and delay, the EU still has
    refused to grant U.S. equivalence. Since his arrival at the CFTC,
    Chairman Massad has been a tremendous leader in working toward a
    solution that avoids market disruption and affords U.S. and foreign-
    based markets equal flexibility. Yet, the EU continues to hold up the
    U.S. equivalence determination over the single issue of differing
    initial margining standards for clearinghouses. The specific U.S.
    margin standards in question are an important component, but not the
    only component, of a robust regulatory structure under the CFTC's
    oversight. And even considering just this component of the margin
    standards, the U.S. rules generally require equal, if not more, margin
    to be posted with clearinghouses to offset exposures than is the case
    under the EU rules. We applaud Chairman Massad's effective testimony on
    this issue before the European Parliament last May. Nonetheless, the
    European Commission has thus far insisted that the U.S. accept EU
    margin requirements. As Chairman Massad recently stated, ``[The CFTC
    has] offered a substituted compliance framework for clearinghouse
    regulation which was [the European Commission's] principal concern. I
    believe there is ample basis for [the European Commission] to make a
    determination of equivalence and I hope that they will do so soon.''
        By contrast, the European Commission recently granted
    ``equivalent'' status to several jurisdictions in Asia, including
    Singapore, which has the same margin regime as the U.S. Treating the
    U.S. as not equivalent when the European Commission has deemed the same
    margin requirements equivalent in Singapore illustrates clearly the
    hypocritical and inconsistent position the European Commission is
    taking.
    Harmonized Global Framework
        For the G20 Commitments to succeed globally, each member nation
    needs to have a workable cross-border regulatory framework. Chairman
    Massad has been a leader in working with his counterparts among the G20
    member nations to achieve that. An effective cross-border regulatory
    framework does not require each nation's law to be identical; this is
    unrealistic and unnecessary. Instead, the goal is to adopt frameworks
    that lead to consistent regulatory outcomes and allow for appropriate
    substituted compliance.
        Unfortunately, recognition for U.S. clearinghouses will not end the
    cross-border regulatory debate between the U.S. and EU. Some of the key
    policy issues that will have to be resolved among the G20 nations in
    the next few years include:

       Benchmark administrators--Equivalence provisions for
            benchmark administrators are being debated in the European
            benchmark process. Benchmarks integrity is necessary for market
            confidence, and therefore should be regulated so that they are
            not readily susceptible to manipulation. However, I agree with
            Chairman Massad that direct government involvement, as employed
            by the EU, is not the solution.

       Trading venues--Although much of the cross-border
            equivalence discussions have focused on new execution venues
            for swaps, the existing licenses for non-European futures
            exchanges, including CME Group exchanges, will also be reviewed
            against new European rules for trading venues under MiFID II.

       Position Limits--I have previously testified about the
            importance of the CFTC's position limits policy to risk
            management for end-users and commodity prices. Getting this
            policy right extends beyond U.S. borders. This necessarily
            requires global coordination between the CFTC and other G20
            nations. If the CFTC adopts an overly prescriptive position
            limits rule when other G20 nations have not, price discovery
            and risk management for U.S. commodities will likely move
            abroad. For end-users that stay in U.S. markets, their cost to
            hedge will be significantly higher due to potential lack of
            liquidity and wider spreads.

          Commercial end-users are critical to the development and success
            of physical commodity markets nationally and internationally.
            As with other regulatory policies adopted by regulators, it is
            necessary for us to ensure that final position limit rules do
            not unduly restrict commercial hedging activity or
            unnecessarily increase costs. In this regard, it is critical
            that global policy makers ensure that hedge exemptions are not
            too narrow or overly cumbersome to obtain. Moreover, global
            policy makers must ensure that position limits policy does not
            undermine the integrity of commodity derivatives benchmarks. In
            particular, global position limits policies must not incent
            price discovery to move from physical delivery markets to
            linked cash-settled markets, where there is no index or other
            independent means for assuring that the cash-settled products
            are not readily susceptible to manipulation.
    Supplemental Leverage Ratio
        In addition to harmonizing global frameworks, international
    regulators must also ensure that global regulations further G20 policy
    objectives and commitments rather than work against them. A key example
    of global regulations frustrating G20 commitments is the impact of the
    Basel III Supplemental Leverage Ratio and its potential to undermine
    the use of central clearing to mitigate systemic risk.
        The Federal Reserve, in consultation with the Basel Committee on
    Banking Supervision, last year adopted the Supplemental Leverage Ratio
    rule intended to limit the amount of leverage that the largest banking
    organizations can hold on their balance sheets. By keeping balance
    sheet leverage low, regulators seek to further mitigate systemic risk
    in the event of a default, including for a bank that is a clearing
    member of a central clearing counterparty such as CME Group.
        The rule as adopted will increase costs for end-users by up to five
    times to clear trades due to clearing members having to pass along the
    cost of the additional capital they must hold to meet the rule's
    requirements. In fact, under the current leverage ratio framework,
    capital costs for agricultural products are two times more expensive
    than for credit default swaps. These excess capital costs have already
    contributed to the decision by some clearing members to exit the market
    altogether, thus concentrating risk among a smaller pool of central
    counterparties. Higher clearing costs and fewer clearing members will
    only exacerbate, not mitigate, the risks central clearing is intended
    to address.
        The Supplemental Leverage Ratio's main flaw is that it overstates
    clearing member leverage exposures because it does not allow clearing
    members to net segregated margin held for a cleared trade against the
    clearing member's exposure on the trade. It is directly at odds with
    the requirements of the Commodity Exchange Act that (1) client margin
    be strictly segregated from clearing member and clearing house own
    funds at all times and (2) investment of client margin is subject to
    significant restrictions (including that it must always be segregated,
    and only limited investments are permitted). In fact, not only are
    clearing members significantly restricted in their treatment of
    customer margin, but the majority of customer margin actually gets
    passed on to the clearing house, which results in the margin being
    completely outside of the clearing member control.
        Despite these clear regulatory restrictions, the Supplemental
    Leverage Ratio rule does not permit banks or bank-affiliated clearing
    members to offset their cleared derivatives exposures on behalf of
    their customers with the segregated margin posted by those customers,
    based on the Basel Committee's mistaken rationale that banks and bank
    affiliates have the ability to use customer margin for purposes other
    than to offset the cleared derivatives exposure of those customers.
        CME Group appreciates the steps this Committee and CFTC Chairman
    Massad have taken in recent months to address this issue with
    Prudential Regulators in the U.S., and we are hopeful that the Basel
    Committee and Prudential Regulators will consider proposed solutions
    that we and others in the industry have been discussing with them since
    the rule was adopted.
    Conclusion
        CME Group is concerned that as more time passes without consensus
    on developing a global framework, regulation will artificially
    influence liquidity, price discovery and risk management. We also are
    concerned that continued uncertainty in these areas will competitively
    disadvantage U.S. markets--far beyond just clearinghouses--in an
    increasingly competitive global marketplace.

        The Chairman. Thank you, Mr. Duffy. Mr. O'Malia?

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

        Mr. O'Malia. Chairman Conaway, Ranking Member Peterson, and
    Members of the Committee, thank you for the opportunity to
    testify here today. It has now been 5 years since the Dodd-
    Frank Act was signed into law. In that time, significant
    progress has been made in implementing key elements of the Act,
    particularly in derivatives clearing, reporting, and trade
    execution. Today approximately \3/4\ of the interest rate
    derivatives in CDS indexed daily volume is now cleared. More
    than \1/2\ of the interest rate derivatives, and 65 percent of
    CDS indexed volume is traded on a SEF. All swaps are reported
    to a swap data repository, providing regulators with the
    ability to scrutinize individual trades and counterparties, and
    margin and capital requirements are being phased in to further
    mitigate risk.
        Today, the derivatives sector is more transparent than
    before, and counterparty risk has been substantially reduced.
    It has become clear, however, that new challenges have emerged,
    and certain areas need to be re-assessed. The speed with which
    Dodd-Frank was implemented has resulted in significant
    differences in trading, clearing, and reporting, exposing
    derivatives users to duplicative and inconsistent requirements.
    These divergences not only increase compliance costs, but they
    have split liquidity along geographic lines. In other words,
    fractured rules, fractured markets, and fractured liquidity.
    ISDA and its members would suggest several concrete steps that
    could be taken to make Dodd-Frank more effective, and I have
    provided specific recommendations in my written testimony. I
    will go over a few of these highlights right now.
        Broadly, regulators must work to harmonize their rules
    domestically and on a global basis, as they promised in their
    rulemaking. Regulators should set out clear, transparent
    guidelines for achieving equivalence determinations based on
    broad outcomes, not specific rule-based tests. Final rules on
    non-cleared margining are expected soon, and it is vital that
    regulators implement rules that are consistent, and create a
    level playing field, and enable cross-border trading. Upon
    finalization of national rules, adequate time must be provided
    for implementation. ISDA has been leading in the preparation
    efforts, notably through the development of a common initial
    margin methodology, and for the necessary legal and
    documentation changes to support the collateral management and
    segregation.
        With regards to reporting, regulators should agree on
    common reporting requirements within and across jurisdictions,
    and adopt common data standards. ISDA has developed standards
    in common reporting formats that could be used to ensure the
    reporting and analysis of data transactions to be more
    effective. Capital requirements should be globally consistent
    and coherent. The interplay of the various components should be
    comprehensively assessed to ensure that the cumulative impact
    of market liquidity, borrowing costs and the economy as a
    whole, are fully understood. Immediate recognition should be
    given to CCPs that meet the CPMI/IOSCO principles.
        Regulators have recently also turned their attention to CCP
    resiliency. ISDA has been active in this regard, and has
    circulated a letter recommending best practices on stress
    testing. I fear trade execution is the next area where global
    regulators will struggle to harmonize rules. Regulators must
    take steps now to minimize the differences in trade execution
    rules, and to avoid cross-border problems that have occurred in
    clearing and reporting. The CFTC should also take action on
    ISDA's petition to amend the SEF rules in order to increase the
    use of SEFs and facilitate cross-border trading.
        Congress also has a role to play in making necessary
    adjustments to Dodd-Frank. The cross-border approach by the
    CFTC and the SEC should be examined. The approach taken is not
    in line with the CEA, which states U.S. rules should only be
    applied to those activities that have a significant and direct
    effect on U.S. commerce. Congress should closely monitor the
    finalization of the new margin regime to ensure that U.S. rules
    are aligned with those overseas, particularly in the issue of
    inter-affiliate trades. We welcome the recent bipartisan letter
    from Chairman Conaway and Ranking Member Peterson that
    highlight this issue. It is important that banks can manage
    risk on a global basis. Without global rule consistency, we
    will see further market fragmentation as a result of these
    rules.
        Section 21(d) of the CEA, which requires indemnification of
    SDRs, should be repealed, and it is included in your
    legislative reforms. Legislation should clarify that commercial
    end-users that hedge their risk through centralized Treasury
    units should not be denied the end-user clearing exemption,
    also part of your legislation. Congress should continue to use
    its oversight roles in asking regulators to conduct
    quantitative assessments on new capital, liquidity, and
    leverage rules to ensure that the cumulative impact on the
    economy and market liquidity is fully understood.
        Five years on from the enactment of Dodd-Frank, the vast
    majority of the requirements on derivatives have been
    implemented, but differences in the schedule, and in the
    substance of the regulation across jurisdictions have emerged.
    I hope the specific reforms suggested by ISDA in my testimony
    can be implemented to correct the existing problems, and avoid
    international disputes and fragmentation of global markets.
    Thank you for your time. I am happy to answer any questions.
        [The prepared statement of Mr. O'Malia follows:]

     Prepared Statement of Hon. Scott D. O'Malia, Chief Executive Officer,
      International Swaps and Derivatives Association, Inc., New York, NY
        Chairman Conaway, Ranking Member Peterson, and Members of the
    Committee. Thank you for the opportunity to testify today.
        It has now been 5 years since the Dodd-Frank Wall Street Reform and
    Consumer Protection Act was signed into law. In that time, significant
    progress has been made in implementing key elements of the Dodd-Frank
    Act, particularly in derivatives clearing, reporting and trade
    execution.
        Today, approximately \3/4\ of interest rate derivatives and credit
    default swap (CDS) index average daily notional volumes are now
    cleared. More than \1/2\ of interest rate derivatives and 65% of CDS
    index average daily notional volumes are traded on swap execution
    facilities (SEFs). All swaps are now required by the Commodity Futures
    Trading Commission (CFTC) to be reported to swap data repositories
    (SDRs), providing regulators with the ability to scrutinize individual
    trades and counterparties. Registration requirements are in place for
    swap dealers and major swap participants, with those entities subject
    to strict rules meant to protect their counterparties. And margin and
    capital requirements are being phased in to further mitigate risk.
        Together, this represents a major step forward in the reform of
    derivatives markets. Today, the derivatives sector is more transparent
    than ever before, and counterparty credit risk has been substantially
    reduced.
        It has become clear, however, that new challenges have emerged, and
    that certain areas need to be reassessed. For instance, the speed with
    which Dodd-Frank was implemented has resulted in divergences in the
    timing and substance of national rules. We now see significant
    differences in trading, clearing and reporting requirements, exposing
    derivatives users to duplicative and sometimes inconsistent
    requirements. These divergences not only increase compliance costs, but
    have led to a split in liquidity along geographic lines, which reduces
    choice, increases costs, and could make it more challenging for end-
    users to enter into or unwind large transactions, particularly in
    stressed markets conditions.
        In other words, fractured rules, fractured markets, fractured
    liquidity.
        This is contrary to the G20's 2009 commitments, which specifically
    called for the rules to be implemented in a way that does not fragment
    markets.
        Discrepancies in regulatory reporting and data requirements within
    and across borders also mean no single regulator is currently able to
    get a clear view of global derivatives trading activity. This means a
    key objective of Dodd-Frank has not been fully met.
        Even where global bodies have taken the lead in developing
    regulatory requirements--for instance, the capital requirements and
    margin for non-cleared derivatives--discrepancies have emerged in
    national implementations, creating competitive distortions. In some
    cases, certain elements of the capital rules appear to contradict the
    intentions of other requirements implemented as part of the G20
    objectives. For instance, the U.S. supplementary leverage ratio acts to
    discourage banks from offering client clearing services. As the various
    rules have been developed in isolation, the cumulative impact of the
    capital requirements and the interaction with market-based reforms is
    unknown, and no comprehensive analysis on economic impact or the impact
    on market resilience and economic growth has been undertaken.
        On the margin rules for non-cleared derivatives, a number of
    discrepancies have emerged in national-level proposals, which, in some
    cases, could put firms operating in the U.S. at a competitive
    disadvantage internationally and reduce choice for U.S. end-users
    domestically.
        And while a final framework for the margining of non-cleared
    derivatives was published by the Basel Committee on Banking Supervision
    and International Organization of Securities Commissions (IOSCO) in
    September 2013,\1\ final national-level rules have not yet been
    published. While the International Swaps and Derivatives (ISDA) has
    worked to prepare the industry for implementation, continued progress
    is dependent on the timely publication of final rules by both
    prudential and market regulators. These rules should be consistent.
    ---------------------------------------------------------------------------
        \1\ Margin Requirements for Non-centrally Cleared Derivatives,
    Basel Committee on Banking Supervision, International Organization of
    Securities Commissions, September 2013: http://www.bis.org/publ/
    bcbs261.pdf.
    ---------------------------------------------------------------------------
        I applaud the work that went into developing and implementing this
    ambitious piece of legislation from scratch. The fact that so much was
    done so quickly speaks volumes about the dedication of Congress and its
    staff, as well as the staff at the regulatory agencies. ISDA also
    welcomes the CFTC's flexibility and willingness to react quickly to
    snags by issuing no-action letters.
        But the wide-scale use of exemptive relief is a symptom of larger
    problems that need to be addressed. Ongoing uncertainty regarding Dodd-
    Frank implementation for global market participants and the resulting
    fragmentation of liquidity indicates that Congress and regulators need
    to move quickly to review where changes can be made to ensure the
    financial stability and transparency objectives of Title VII of the
    Dodd-Frank Act are successfully achieved. ISDA and its members would
    suggest several concrete steps that could be taken to improve Title VII
    of the Dodd-Frank Wall Street Reform and Consumer Protection Act of
    2010.

       Regulators should work to harmonize their rules on a global
            basis within specified time frames. Organizations such as IOSCO
            could play a role here. Existing industry definitions and
            standards should be used to the extent possible. Regulators
            should also set out clear, transparent guidelines for achieving
            equivalence determinations, consistent with the approach set
            out in a report by the Financial Stability Board Chairman to
            G20 leaders in 2013.\2\ This reflects an agreement that
            equivalency/substituted compliance assessments should be based
            on whether other regulatory regimes achieve broadly similar
            outcomes. ISDA has proposed specific fixes, which are outlined
            in more detail below.
    ---------------------------------------------------------------------------
        \2\ Report from the Financial Stability Board Chairman for the G20
    Leaders' Summit, September 2013: ``Instead, substituted compliance and
    equivalence assessments of others' regulatory regimes should be based
    on whether jurisdictions broadly achieve similar outcomes. At the same
    time, in applying such an overall broad approach, regulators will need
    to decide in different policy areas how much flexibility to apply in
    assessing the similarity of outcomes. For instance, there may be some
    particular policies (such as CCP margin rules) where differences in key
    requirements between jurisdictions could lead to regulatory arbitrage,
    and where further discussion between regulators is needed. Detailed
    work, and a timeline for action, is thus needed to address the
    challenges in translating the encouraging recent cross-border
    regulatory understandings into practice.'' http://
    www.financialstabilityboard.org/wp-content/uploads/
    r_130902a.pdf?page_moved=1.

       The CFTC and the Securities and Exchange Commission (SEC)
            should harmonize their cross-border rules and guidance. More
            effort is needed to turn the aspirational words on substituted
            compliance into action. In addition, where the Federal Reserve
            Board has jurisdiction over swap dealers and major swap
            participants, it should work with the CFTC and SEC to ensure
            the rules do not conflict or undermine the financial stability
    ---------------------------------------------------------------------------
            objectives of Title VII of the Dodd-Frank Act.

       Regulators should agree on common regulatory reporting
            requirements within and across jurisdictions and adopt common
            data standards such as unique legal entity identifiers (LEIs),
            unique trade identifiers (UTIs) and unique product identifiers
            (UPIs). ISDA has proposed a path forward, and has worked to
            develop common standards and reporting formats that could be
            used to ensure the reporting and analysis of transaction data
            is more effective.

       Divergences in national implementations of non-cleared
            margin rules should be reduced as far as possible to avoid an
            unlevel playing field and enable cross-border trading. Once
            national-level rules are finalized, adequate time must be
            provided for implementation and preparation, particularly as
            many market participants subject to the new requirements will
            be posting initial margin on their non-cleared trades for the
            first time. Implementation of global margining and segregation
            requirements will involve major changes to documentation,
            technology and business practices. ISDA has been leading
            efforts to prepare the industry for implementation, notably
            through the development of a common initial margin methodology.
            But work cannot be completed until final rules are released
            globally.

       Capital requirements should be globally consistent, coherent
            and appropriate to the risk of a given activity. The interplay
            of the various regulatory components should be comprehensively
            assessed to ensure the cumulative impact is fully understood to
            avoid excessively high financing costs for borrowers and
            increased hedging costs for end-users, and to encourage
            appropriate risk management incentives.

       Negotiations with the European Securities and Markets
            Authority (ESMA) over the recognition of U.S. clearing houses
            have stalled over technical differences in margin
            methodologies. Immediate recognition should be given to central
            counterparties (CCPs) that meet the Committee on Payment and
            Settlement Systems and IOSCO Principles for Financial Market
            Infrastructures.\3\ Further work is also needed by regulators,
            CCPs and market participants to develop and implement best
            practices. ISDA has been active in this regard, and recently
            circulated a letter that recommends best practices on stress
            testing.
    ---------------------------------------------------------------------------
        \3\ Principles for Financial Market Infrastructures, CPSS/IOSCO,
    April 2012: http://www.bis.org/cpmi/publ/d101a.pdf.

       Regulators must work to minimize the differences in trade
            execution rules to avoid the cross-border problems that have
            occurred in data reporting and clearing. An attempt by the CFTC
            in February 2014 to introduce a so-called qualifying
            multilateral trading facility (QMTF) regime \4\ for trading
            venues in Europe clearly showed that insisting on the adoption
            of U.S. rules will not work.
    ---------------------------------------------------------------------------
        \4\ CFTC Letter No. 14-16, February 12, 2014: http://www.cftc.gov/
    ucm/groups/public/@lrlettergeneral/documents/letter/14-16.pdf.

       The CFTC should take action on ISDA's petition \5\ to review
            and modify the SEF rules in order to increase use of U.S. SEFs
            and facilitate cross-border trading. This includes allowing for
            more flexibility in execution mechanisms in limited
            circumstances, which would bring the rules more in line with
            European proposals. ISDA also recommends changes to the `made-
            available-to-trade' process to give the CFTC the authority to
            make final determinations, following a short public
            consultation period.
    ---------------------------------------------------------------------------
        \5\ ISDA's petition to the CFTC: http://www2.isda.org/attachment/
    NzY2Mg==/ISDA%20CFTC%20Petition.pdf.

       Regulators should ensure the costs and compliance burdens
            for end-users are minimized to enable them to effectively hedge
            their risks. Regulators should consider the cumulative impact
    ---------------------------------------------------------------------------
            of the rules on end-users, including indirect effects.

       The CFTC must provide final registration to swap dealers,
            SDRs and SEFs, which have been in regulatory limbo for as long
            as 3 years.

        Congress also has role in reviewing and making the necessary
    adjustments to the Dodd-Frank Act. This includes:

       Examination of the misapplied cross-border authorities
            implemented by the CFTC and the SEC, which have expanded U.S.
            regulatory reach well beyond U.S. boundaries. This approach
            ignores the requirement of Section 2(i) of the Commodity
            Exchange Act (CEA), which states that the swaps provisions of
            the CEA shall not apply to activities outside the U.S. unless
            those activities have a direct and significant connection with
            activities in, or effect on, commerce of the U.S.

       Legislators should oversee the process of finalizing the new
            margin regime to ensure U.S. rules are aligned with those
            overseas, particularly on the issue of inter-affiliate trades,
            to ensure financial institutions operating in the U.S. are not
            put at a competitive disadvantage. Without the ability to
            efficiently centralize risk management activity, banks may stop
            providing products in certain markets or to certain customers
            via local affiliates because inter-affiliate margin would make
            these products less economically viable. The result would be a
            further fragmentation of markets and reduction in liquidity.

       Repeal of Section 21(d) of the CEA, which requires
            indemnification of SDRs. This has become a barrier to sharing
            data among regulators in the U.S. and internationally.

       Legislative action to make clear commercial end-users that
            hedge their risk through centralized Treasury units are not
            denied the end-user clearing exemption.

       Congress should continue to use its oversight role by asking
            regulators to conduct a quantitative assessment on new capital,
            liquidity and leverage rules to ensure the cumulative impact on
            the economy and market liquidity is fully understood.
              * * * * *
        I would like to address each of my points in more detail. Before I
    do, I would like to stress that ISDA supports the intent of Dodd-Frank
    to strengthen financial markets and reduce systemic risk. That includes
    the reporting of all derivatives trades and clearing of standardized
    derivatives products where appropriate. ISDA has worked constructively
    and collaboratively with policy-markers in the U.S. and across the
    globe to achieve these objectives. In fact, this work began even before
    the passage of Dodd-Frank, as part of the `voluntary commitment
    process' overseen by the Federal Reserve Bank of New York.
        This is very much in line with our mission statement: to foster
    safe and efficient derivatives markets for all users of derivatives.
    Since ISDA's inception 30 years ago, the Association has worked to
    reduce credit and legal risks in the derivatives market, and to promote
    sound risk management practices and processes. This includes the
    development of the ISDA Master Agreement, the standard legal agreement
    for derivatives, and related collateral documentation, as well as our
    work to ensure the enforceability of netting.
        Today, ISDA has over 800 member institutions from 67 countries.
    These members comprise a broad range of derivatives market
    participants, including corporations, investment managers, government
    and supranational entities, insurance companies, energy and commodities
    firms, and international and regional banks. In addition to market
    participants, members also include key components of the derivatives
    market infrastructure, such as exchanges, clearing houses and
    repositories.
        End-users of derivatives are the largest constituent, accounting
    for roughly \1/2\ of our membership. Approximately \1/3\ is located in
    North America.
              * * * * *
        Before I expand upon the challenges faced by derivatives market
    participants, I would like to briefly summarize the commitments made by
    the G20, which were reflected in Dodd-Frank. They were:

       Non-cleared derivatives should be subject to higher capital
            requirements;

       Standardized derivatives should be cleared through CCPs;

       Derivatives should be reported to a trade repository;

       Standardized contracts should be traded on exchanges or
            electronic trading platforms where appropriate.

        A requirement for non-cleared derivatives to be subject to margin
    requirements was also later agreed by G20 leaders.
        Underlying these commitments was a pledge that regulators ``are
    committed to take action at the national and international level to
    raise standards together so that our national authorities implement
    global standards consistently in a way that ensures a level playing
    field and avoids fragmentation of markets, protectionism, and
    regulatory arbitrage''.
        As noted earlier, significant progress has been made in meeting the
    clearing, trading and reporting requirements included in Dodd-Frank.
    This progress will continue as clearing houses expand their product
    offerings and new clearing and trading mandates come into force.
        Unfortunately, much less progress has been made on ensuring
    consistency and harmonization and in avoiding the fragmentation of
    markets.
    Cross-Border Harmonization
        The derivatives markets are, and always have been, global markets.
    European banks can trade with U.S. asset managers; Asian banks can
    trade with European hedge funds; U.S. banks can trade with Asian
    companies. That choice has benefited end-users. They can easily tap
    into a global liquidity pool with few barriers and choose who they want
    to trade with.
        That global liquidity pool is now at risk because of a lack of
    consistency in the timing and substance of national-level rules. This
    lack of harmonization is a particular concern because of the
    extraterritorial reach of some domestic rules, meaning counterparties
    are potentially subject to two or more possibly contradictory sets of
    requirements--those of their own jurisdiction and the extraterritorial
    rules of foreign jurisdictions.
        Section 2 of the CEA (7 U.S.C. 2) stipulates that Dodd-Frank should
    not apply to activities outside the U.S., unless those activities have
    a ``direct and significant connection with activities in, or effect on,
    commerce of the United States''. However, the CFTC's cross-border
    guidance \6\ takes a much broader approach to capture overseas
    activities. This has resulted in non-U.S. firms turning away from any
    trade or counterparty that would result in them being subject to U.S.
    rules and regulatory oversight, on top of their own jurisdiction's
    rules.
    ---------------------------------------------------------------------------
        \6\ Interpretive Guidance and Policy Statement Regarding Compliance
    with Certain Swap Regulations; Rule, Federal Register/Vol. 78, No. 144/
    July 26, 2013: http://www.cftc.gov/ucm/groups/public/
    @lrfederalregister/documents/file/2013-17958a.pdf.
    ---------------------------------------------------------------------------
        CFTC Staff Advisory 13-69 \7\ is an example of U.S. regulatory
    overreach. It clarifies that a non-U.S. swap dealer should comply with
    Dodd-Frank transaction-level requirements when trading with another
    non-U.S. person if the trade is arranged, negotiated or executed by
    personnel or agents of the non-U.S. swap dealer located in the U.S.
    ---------------------------------------------------------------------------
        \7\ CFTC Staff Advisory No. 13-69, November 14, 2013: http://
    www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-
    69.pdf.
    ---------------------------------------------------------------------------
        ISDA believes U.S. regulators should focus on practices that pose a
    risk to the U.S. It is difficult to see why a trade between two non-
    U.S. entities that is booked overseas should be subject to CFTC
    oversight and Dodd-Frank transaction-level rules, simply because a
    U.S.-based employee has provided input to the transaction. In these
    cases, the trade would be subject to U.S. clearing, trading and
    reporting rules, as well as potentially inconsistent requirements from
    the non-U.S. entity's home regulator. These kinds of personnel-based
    tests could result in firms excluding their U.S.-based personnel from
    certain trades, or relocating them elsewhere.
        The CFTC has issued four successive no-action letters since
    November 2013 to exempt market participants from compliance with Staff
    Advisory 13-69. But concerns about being subject to multiple sets of
    requirements are prompting market participants to change behavior in
    some cases. This is causing liquidity to fragment along geographic
    lines.
        The CFTC's recent proposed cross-border treatment for margin on
    non-cleared derivatives transactions \8\ is another example of
    regulators taking an expansive approach, as it captures non-guaranteed
    non-U.S. affiliates in certain cases. That's despite the fact the non-
    cleared margin rules were agreed at a global level, and will likely be
    applied in the U.S., Europe and Japan at the same time. This approach
    could further contribute to the fragmentation and regionalization of
    liquidity pools.
    ---------------------------------------------------------------------------
        \8\ Margin Requirements for Uncleared Swaps for Swap Dealers and
    Major Swap Participants--Cross-Border Application of the Margin
    Requirements; Proposed Rule, Federal Register/Vol. 80, No. 134/July 14,
    2015: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/
    documents/file/2015-16718a.pdf.
    ---------------------------------------------------------------------------
        ISDA research shows 87.7% of regional European interdealer volume
    in euro interest rate swaps was traded between European dealers in the
    fourth quarter of 2014, compared with 73.4% in the third quarter of
    2013.\9\ The change in trading behavior coincided with the introduction
    of U.S. SEF rules, which required all electronic venues that provide
    access to U.S. entities to register with the CFTC as SEFs. Many non-
    U.S. platforms chose not to register, meaning U.S. persons were no
    longer able to access liquidity on these platforms. Following the first
    SEF trading mandates in February 2014, non-U.S. participants opted to
    avoid trading mandated products with U.S. counterparties, so as not to
    be required to trade on CFTC-registered SEFs that offer restrictive
    methods of execution for these instruments. U.S. entities, conversely,
    are unable to access the most liquid pool for euro interest rate swaps,
    which is centered in Europe, away from SEFs.
    ---------------------------------------------------------------------------
        \9\ ISDA research on fragmentation of global derivatives markets,
    April 2015: http://www2.isda.org/attachment/NzUzMQ==/
    Market%20fragmentation%20FINAL.pdf.
    ---------------------------------------------------------------------------
        Many of the problems could be resolved through an effective process
    for granting equivalence/substituted compliance. A transparent
    substituted compliance mechanism based on broad outcomes, rather than a
    granular rule-by-rule comparison, would help minimize the compliance
    challenges and fragmentation of liquidity. The CFTC should clearly
    articulate how substituted compliance decisions will be made in order
    to shed light on this currently theoretical and opaque process.
        Regulators should also work to harmonize rules sets as far as
    possible, particularly in clearing, trading and reporting. The CFTC and
    the SEC must resolve the differences in their respective rules to
    foster greater consistency and clarity within the U.S. Greater
    harmonization with global regulations is also necessary. Differences in
    national-level rules have already led to protracted--and still
    unresolved--negotiations over whether U.S. clearing houses should be
    recognized by the ESMA. A restrictive interpretation of Dodd-Frank SEF
    rules by the CFTC means a similar outcome may emerge for trading rules,
    further exacerbating the fragmentation of markets, to the detriment of
    end-users.
        Congress should give careful consideration to legislative changes
    based on the following principles:

       Emphasize the results and outcomes of foreign regulatory
            requirements, rather than the design and construction of
            specific rules;

       Make clear that the location of personnel should not be a
            factor in determining whether activities have a direct and
            significant connection with activities in, or effect on,
            commerce of the U.S.;

       Establish separate criteria regarding the application to
            end-users and transactions involving end-users, and mitigate
            the direct and indirect costs or other burdens imposed on end-
            users.
    Reporting
        Cross-border issues have also hampered the effectiveness of
    derivatives reporting.
        A lack of standardization in reporting formats across different
    repositories, and inconsistencies in what is reported, mean accurate
    data aggregation is currently impossible. Differences in regulatory
    reporting requirements within and across jurisdictions also mean
    regulators are unable to gain an accurate picture of risk exposures on
    a global basis. These differences increase operational complexities for
    end-users and make aggregation across corporate groups difficult. It
    also increases the cost of reporting for firms that have reporting
    obligations in multiple jurisdictions.
        To resolve this, regulators across the globe should identify and
    agree on the trade data they need to fulfill their supervisory
    responsibilities, and then issue consistent reporting requirements
    across jurisdictions. Further work is also needed by the industry and
    regulators to develop and then adopt standardized product and
    transaction identifiers, as well as reporting formats. ISDA has played
    a leading role in this area through its taxonomies, FpML reporting
    standard and unique trade identifier prefix service (UTIPrefix.org),
    among other things.
        Even then, it will be difficult for regulators to obtain an
    accurate picture of global risk exposures because of the Dodd-Frank SDR
    indemnification requirement and privacy laws in some jurisdictions
    prohibiting the disclosure of certain counterparty information. Until
    these two issues are resolved, the ability of regulators to build a
    comprehensive picture of derivatives positions across the globe and to
    spot potential systemic risks will be stymied.
        Reporting mandates have been in place in the U.S. for over 2 years,
    while Europe has had similar rules in place for nearly 18 months.
    However, little tangible progress has been made over that time to
    resolve differences in their respective requirements and facilitate the
    sharing of information. As a first step to resolving this, global
    regulatory institutions such as IOSCO could play a greater role to
    agree common requirements. Regulators and market participants should
    also work to identify, develop and adopt common data standards where
    necessary.
        ISDA has recently joined with ten other international trade
    associations to send a letter \10\ to global regulators that calls for
    rule harmonization consistent with a set of principles developed by
    ISDA.\11\
    ---------------------------------------------------------------------------
        \10\ Industry trade association letter, June 2015: http://
    www2.isda.org/attachment/NzY1OA==/
    Joint%20Trade%20Association%20Data%20Harmonization%20letter.pdf.
        \11\ ISDA principles on improving regulatory transparency of global
    derivatives markets, February 2015: http://www2.isda.org/attachment/
    NzI4NQ==/Improving%20Regulatory%20
    Transparency%20FINAL.pdf.
    ---------------------------------------------------------------------------
        The principles are:

       Regulatory reporting requirements for derivatives
            transactions should be harmonized within and across borders.

       Policy-makers should embrace and adopt the use of open
            standards--such as LEIs, UTIs, UPIs and existing messaging
            standards (e.g., FpML, ISO, FIX)--to drive improved quality and
            consistency in meeting reporting requirements.

       Where global standards do not yet exist, market participants
            and regulators can collaborate and secure agreement on common
            solutions to improve consistency and cross-border
            harmonization.

       Laws or regulations that prevent policy-makers from
            appropriately accessing and sharing data across borders must be
            amended or repealed.

       Reporting progress should be benchmarked. The quality,
            completeness and consistency of data provided to repositories
            should be tracked, measured and shared with market participants
            and regulators in order to benchmark, monitor and incentivize
            progress in reporting.
    Margin Requirements for Non-cleared Derivatives
        Dodd-Frank recognizes there is a place for bespoke derivatives
    instruments that enable corporate and financial institution end-users
    to closely match and offset risks. It also acknowledges that less
    liquid derivatives instruments, currencies and/or maturities may not be
    suitable for clearing. This point was echoed in a recent speech by CFTC
    Chairman Timothy Massad, before the District of Columbia Bar
    Association.\12\
    ---------------------------------------------------------------------------
        \12\ Keynote address, Timothy G. Massad before the District of
    Columbia Bar (Washington, D.C.), July 23, 2015: http://www.cftc.gov/
    PressRoom/SpeechesTestimony/opamassad-26.
    ---------------------------------------------------------------------------
        These non-cleared instruments are not necessarily more complex than
    cleared transactions, nor do they pose significantly more risk.
    Clearing houses typically consider the depth of the market, liquidity
    and availability of prices, among other factors, when deciding whether
    to clear a derivatives instrument--criteria also considered by
    regulators when deciding whether to apply a clearing mandate. Those
    products with non-standard terms that are used to meet specific end-
    user hedging needs may not meet those requirements.
        Nonetheless, these instruments are vital elements in the risk
    management strategies of corporates, insurance companies, pension
    funds, sovereigns, smaller financial institutions and others. Without
    them, these entities may experience greater earnings volatility due to
    an inability to qualify for hedge accounting, or be unable to offset
    the interest rate, inflation and longevity risks posed by long-dated
    pension or insurance liabilities.
        To give an example: a U.S. exporter has issued a U.S. dollar bond
    to grow its domestic business, but earns most of its revenue from
    exports to Europe. If the dollar strengthens against the euro, the
    company will face financial statement and cashflow volatility. It will
    therefore need to allocate a larger amount of its euro cashflow to
    service its dollar-denominated debt. To hedge this risk, the firm could
    swap the loan into euros using a cross-currency swap, allowing it to
    match the currency in which revenues are received and interest expense
    is paid. Cross-currency swaps are currently not cleared.
        While clearly recognizing the need for a robust and competitive
    non-cleared derivatives market, the Dodd-Frank Act requires regulators
    to set margin requirements for non-cleared derivatives--in other words,
    requiring collateral to be posted against those trades to mitigate
    counterparty risk.
        These rules are now close to finalization. The Basel Committee and
    IOSCO published a final global margining framework in September 2013,
    which calls for eligible counterparties to post initial and variation
    margin on non-cleared derivatives trades. U.S. Prudential Regulators
    \13\ and the CFTC \14\ published separate national-level proposals
    building on this framework in September and October 2014, and final
    rules are expected to be released in the third quarter of this year.
    ---------------------------------------------------------------------------
        \13\ Margin and Capital Requirements for Covered Swap Entities;
    Proposed Rule, Federal Register/Vol. 79, No. 185/September 24, 2014:
    http://www.gpo.gov/fdsys/pkg/FR-2014-09-24/pdf/2014-22001.pdf.
        \14\ Margin Requirements for Uncleared Swaps for Swap Dealers and
    Major Swap Participants; Proposed Rule, Federal Register/Vol. 79, No.
    192/October 3, 2014, http://www.cftc.gov/ucm/groups/public/
    @lrfederalregister/documents/file/2014-22962a.pdf.
    ---------------------------------------------------------------------------
        The implementation of this regime on a global basis will require
    significant work, particularly as many derivatives users have not
    posted initial margin on their non-cleared swaps before. For some non-
    bank users, it will also be the first time they've had to post
    variation margin.
        ISDA has worked very hard to develop the infrastructure, processes
    and documentation necessary for the new margining regime. The
    Association is also working to develop the ISDA Standard Initial Margin
    Model (ISDA SIMM), a common calculation methodology for computing
    initial margin amounts, which will be available to all market
    participants.
        Use of a standard methodology provides a number of benefits. For
    one thing, it provides regulators with a consistent, transparent model
    to enhance market oversight. Second, by creating a model that everyone
    can use, it reduces the potential for disputes between counterparties
    over the initial margin amounts that need to be exchanged.
        In addition to the ISDA SIMM, ISDA is working on a number of other
    initiatives. Existing ISDA Credit Support Annexes (CSAs) and other
    collateral documentation will need to be replaced or revised in order
    to comply with the new non-cleared margin rules. A number of key terms
    in the CSA will need to be modified, including collateral eligibility,
    collateral haircuts, calculation and collection timing, dispute
    resolution, and the procedure for exchanging initial margin. In
    addition, derivatives users will need to set up new custodial
    agreements or make changes to existing arrangements to comply with
    initial margin segregation requirements. Given the changes, new or
    updated netting opinions may be needed for some jurisdictions.
        Given this workload, it is important that national-level margin
    rules are finalized as soon as possible. While significant progress has
    been made in ISDA's implementation efforts, certainty in the final
    rules in each jurisdiction is required in order to progress these
    initiatives. It is also important that enough time is given to
    development and testing between finalization of the national rules and
    implementation, to ensure these rules can be introduced safely with
    minimum disruption to markets.
        Achieving global consistency in the rule sets is also imperative.
    The initial proposals from U.S. regulators contained a number of
    divergences from the Basel Committee and IOSCO framework.\15\ There
    were also discrepancies between the national rules proposed by Europe
    and Japan.
    ---------------------------------------------------------------------------
        \15\ ISDA's response to U.S. Prudential Regulators' proposal for
    the margining of non-cleared derivatives, November 2014: http://
    www2.isda.org/attachment/NzExOA==/ISDA_-
    _PR_Proposed_Margin_Rules_Letter%20112414.pdf.
    ---------------------------------------------------------------------------
        Proposals from U.S. Prudential Regulators, for example, would
    subject transactions between affiliates of the same financial group to
    margin requirements. This does not appear in European and Japanese
    proposals, potentially putting financial institutions operating in the
    U.S. at a competitive disadvantage internationally and reducing choice
    for U.S. end-users domestically.
        Analysis conducted by ISDA members shows that the inter-affiliate
    margining requirement would result in double the amount of initial
    margin being posted, relative to rules that only require initial margin
    to be posted to external parties. We welcome the recent bipartisan
    letter from Chairman Conaway and Ranking Member Peterson that
    highlighted this issue, and agree with their concerns that the cost of
    funding this initial margin would likely be passed on to end-users.
        It would also run counter to the objective of reducing systemic
    risk. These internal risk management trades enable firms to consolidate
    their swaps within a single entity, resulting in substantial risk
    management and operational benefits. Inter-affiliate margin
    requirements could discourage this behavior. This could deter firms
    from offering products in certain markets that can only be accessed
    through an affiliate, as the cost of posting inter-affiliate margin
    would make these products uneconomic.
        Attention also needs to be paid to how these rules will be applied
    on a cross-border basis. Under recent proposals from the CFTC, U.S.
    covered swap entities would be able to rely on substituted compliance
    when trading with a non-U.S. entity (assuming the home rules of the
    non-U.S. entity are deemed equivalent), but this would only apply to
    initial margin posted. Initial margin collected would have to meet U.S.
    rules.
        In addition, non-U.S. entities whose obligations are not guaranteed
    by a U.S. person but whose financial statements are included in those
    of a U.S. ultimate parent entity would be subject to the U.S. regime.
    This goes further in extraterritorial reach than other U.S. rules.
    Unless U.S. rules are harmonized with those in Europe and Japan, it is
    conceivable that a trade between a U.S. and overseas counterparty will
    be required to comply with two sets of rules simultaneously.
        Finally, regulators need to make some accommodation for non-cleared
    derivatives conducted with counterparties in jurisdictions that haven't
    applied the margin rules. For example, regulators should consider
    making a transitional equivalency determination, valid for 2 years, for
    jurisdictions that have yet to implement the Basel Committee/IOSCO
    framework for margin rules.
        ISDA recommends that:

       Regulators harmonize the margin rule sets to avoid an
            unlevel playing field and the potential for fragmentation.

       Final U.S. rules should be published as soon as possible so
            implementation efforts can be progressed.

       These rules should provide sufficient time (at least 12
            months between publication of the final rules and the
            implementation date) in order to give to market participants
            adequate time to develop and test the necessary models,
            documentation and infrastructure, and ensure all parties sign
            legal documentation compliant with the final rules.
    Capital Requirements
        Dodd-Frank also requires swap dealers to be subject to strict
    capital requirements to mitigate risk. A key driver has been a desire
    to incentivize clearing through higher capital requirements for non-
    cleared trades. Changes to the capital rules have been agreed at a
    global level through the Basel Committee, and are then implemented in
    each jurisdiction by national authorities.
        The capital reforms include increased bank capital requirements,
    higher quality capital, enhanced market risk rules, greater focus on
    counterparty credit risk, new liquidity requirements, a leverage ratio,
    a capital surcharge for systemically important banks and total loss-
    absorbing capital requirements. The Basel Committee has set a phase-in
    schedule from 2013 through to 2019.\16\
    ---------------------------------------------------------------------------
        \16\ Basel III: A Global Regulatory Framework for More Resilient
    Banks and Banking Systems, Basel Committee on Banking Supervision,
    December 2010, http://www.bis.org/publ/bcbs189.pdf.
    ---------------------------------------------------------------------------
        The full impact is unlikely to be known after 2019, when the full
    array of requirements is fully phased in. Following the finalization of
    Basel III in December 2010, banks have had to prepare for a succession
    of follow-up consultations and implementations, at the same time as
    complying with numerous other regulations relating to trading,
    reporting and clearing. The Basel Committee phase-in period for higher
    and better quality capital requirements began from January 2013, with
    the minimum common equity capital ratio and tier-one capital
    requirement rising to 4.5% and 6%, respectively, from this year. Other
    changes to capital--the introduction of new capital conservation and
    countercyclical buffers, along with a surcharge for systemically
    important banks--will be phased in from January 2016.
        The first stages of the new liquidity risk management regime have
    also been implemented. The liquidity coverage ratio is being
    incrementally rolled out from this year until 2019. The net stable
    funding ratio, meanwhile, is meant to ensure banks fund their
    activities with sufficiently stable sources of funding to avoid
    liquidity mismatches. Following an observation period, the requirements
    are scheduled to come into force from January 2018. ISDA's own industry
    analysis suggests this will further significantly increase costs for
    the derivatives users.
        Other changes, such as for bank exposures to central counterparty
    default funds, have also been introduced.
        But plenty of other components have yet to emerge--and, in some
    cases, even to be finalized. The Fundamental Review of the Trading Book
    (FRTB) is a case in point.\17\ This initiative is meant to replace the
    current framework implemented through Basel 2.5 with a more coherent
    and consistent set of requirements and to reduce the variability in the
    capital numbers generated by banks.
    ---------------------------------------------------------------------------
        \17\ Consultative Document: Fundamental Review of the Trading Book:
    Outstanding Issues, Basel Committee on Banking Supervision, December
    2014: http://www.bis.org/bcbs/publ/d305.pdf.
    ---------------------------------------------------------------------------
        The rules are scheduled to be finalized at the end of this year,
    with implementation by 2018. But market participants say it's too early
    to determine what the impact of these rules will be. That's largely
    because the analysis conducted so far has been hampered by data-quality
    issues, which has made it difficult to assess the impact on individual
    business lines. Nonetheless, the rules as they stand are likely to lead
    to punitive capital increases in certain business lines, and will
    potentially cause some key markets, such as securitization and small-
    and medium-sized entity credit, to become uneconomic. This could lead
    to lower liquidity and increased financing costs for borrowers. End-
    users could also experience higher hedging costs and a reduction in the
    ability to hedge effectively as capital, liquidity and leverage charges
    are passed on by banks.
        On top of this, the Basel Committee recently issued a new
    consultation on credit valuation adjustment \18\ to bring it into line
    with FRTB and address other perceived weaknesses, which is likely to
    further increase charges for counterparty risk.
    ---------------------------------------------------------------------------
        \18\ Consultative Document: Review of the Credit Valuation
    Adjustment Risk Framework, Basel Committee on Banking Supervision, July
    2015: http://www.bis.org/bcbs/publ/d325.pdf.
    ---------------------------------------------------------------------------
        Other issues still to be finalized include the possible
    introduction of capital floors--essentially, a backstop to internal
    models, likely to be set at a percentage of the standard model output.
    A consultation paper was published last December,\19\ and final rules
    are likely sometime this year--although it is not clear when the
    requirements will be implemented.
    ---------------------------------------------------------------------------
        \19\ Capital Floors: The Design of a Framework Based on
    Standardised Approaches, Basel Committee on Banking Supervision,
    December 2014: http://www.bis.org/bcbs/publ/d306.pdf.
    ---------------------------------------------------------------------------
        Other components of the Basel III package are finalized but not yet
    implemented, including the leverage ratio. Under the Basel III
    implementation schedule, banks had to begin public disclosure of their
    leverage ratio numbers from this year, with the rules subject to final
    calibration in 2017 and full implementation in 2018.
        However, these various rules may interact in countervailing ways.
    For instance, regulators globally have been working to ensure
    incentives are in place for the central clearing of standardized
    derivatives, but those incentives are being undermined by the leverage
    ratio.
        For the purposes of calculating derivatives exposures as part of
    the leverage ratio, segregated margin received from clients is not
    allowed to offset the potential future exposure associated with such
    off-balance sheet exposures. The policy rationale is that margin can
    increase the economic resources at the disposal of the bank, as the
    bank could use the collateral to increase leverage. However, margin
    that is segregated cannot be leveraged by a bank to fund its
    operations--it solely functions as a risk mitigant to reduce exposures
    with respect to a bank's cleared derivatives. Failure to recognize the
    exposure-reducing effect of margin acts as a significant disincentive
    to central clearing, as margin will substantially increase a clearing
    firm's total leverage exposure, leading to an increase in the amount of
    capital required to support client clearing activities. This will:

       Lead to more clearing firms exiting the business, therefore
            concentrating risk among a smaller set of providers;

       Result in a reduction of clearing-member capacity to clear
            for end-users, potentially forcing some participants to abandon
            use of derivatives;

       Increase counterparty risk for clearing members, as many
            will be discouraged from collecting excess margin; and

       Increase costs to end-users that use non-cleared
            derivatives, as their counterparties face increase costs to
            hedge their risks in the cleared swap markets.

        The leverage ratio should therefore be amended to recognize the
    exposure-reducing effect of segregated margin.
        How each of these elements will interact is not entirely clear.
    While each rule may make sense in isolation, the cumulative impact is
    unknown, and individual requirements may duplicate or even contradict
    the intention of other rules.
        ISDA and its members are trying to understand the interplay between
    the capital, leverage and liquidity rules as a result. This could lead
    to lower liquidity and increased financing costs for borrowers. End-
    users could also experience higher hedging costs as capital, liquidity
    and leverage charges are passed on by banks.
        ISDA recommends that:

       The impact of the capital rules, and how each component
            interacts with other regulatory requirements, is
            comprehensively assessed before progressing further.

       Congress should engage with global regulatory bodies to
            better understand the overall goals and objectives, as well as
            the potential impact on liquidity, borrowing costs and economic
            activity as a whole.
    Clearing
        ISDA and its members have been in the vanguard of clearing even
    before the financial crisis and the enactment of the Dodd-Frank Act.
    ISDA documentation and industry implementation groups were crucial to
    transforming mandatory clearing from an idea into reality in the U.S.
    and Japan. ISDA is playing the same role in Europe ahead of the first
    clearing mandates in Europe in 2016.
        ISDA believes clearing mitigates risk. However, as a proponent of
    safe, efficient markets, ISDA has observed the ever increasing volume
    of trades passing through CCPs due to mandatory clearing, and believes
    these entities have become a systemically important part of the
    derivatives market infrastructure.
        Supervisors and regulators are conscious of this fact, and have
    collectively taken action. International standard-setting bodies have
    established CCP risk management principles, as well as provided
    guidance on CCP recovery and resolution plans. In many respects, CCPs
    are held to higher standards now than ever before.
        But further work is required. It has been 3 years since supervisors
    and regulators issued CCP risk management principles. Now is the time
    to re-examine these principles, as well as ascertain whether and to
    what extent the G20 jurisdictions have implemented them.
        Given the increasing systemic importance of CCPs, all supervisors,
    regulators and market participants have an interest in CCP resiliency.
    ISDA has actively supported supervisory and regulatory initiatives in
    this area. Most recently, ISDA circulated a letter on CCP stress
    testing, which sets out specific best practices. In the letter, ISDA
    notes that consistent application of these best practices across G20
    jurisdictions would minimize the risk of CCP failure, and may form a
    path forward for the U.S., the European Union and other G20
    jurisdictions towards CCP equivalence. ISDA looks forward to further
    coordinating and cooperating with supervisors and regulators on other
    aspects of CCP resiliency.
        More regulatory input and detail is also needed on acceptable CCP
    recovery mechanisms, as well as on the circumstances and processes for
    CCP resolution to ensure that the failure of any clearing service can
    be managed in an orderly way with the least possible disruption to
    financial stability. No recovery and resolution action should involve
    the use of public money. Given the large clearing houses have global
    operations, close cooperation and coordination between national
    authorities across borders is paramount.
        In addition, legislative action is needed to make clear that end-
    users that hedge through centralized Treasury units (CTUs) in order to
    net and consolidate their hedging activities are eligible for the
    clearing exemption. Many CTUs classify as financial entities under
    Dodd-Frank, subjecting them to clearing requirements. While the CFTC
    has issued no-action relief, legislation clarifying that end-users
    using these efficient structures are exempt would provide much-needed
    certainty.
    Trade Execution
        ISDA has proposed a series of targeted fixes to U.S. SEF rules to
    encourage more trading on these venues and facilitate cross-border
    harmonization.
        Specifically, ISDA believes allowing for greater flexibility in
    execution mechanisms will foster further growth of centralized trading
    venues. While the Dodd-Frank Act allows derivatives to be traded by
    ``any means of interstate commerce'', the CFTC's SEF rules restrict the
    execution of mandated products to order-book or request-for-quote-to-
    three mechanisms. These execution methods may not be appropriate for
    certain, less liquid instruments, discouraging trading on SEFs. The
    CFTC's restrictive interpretation of Dodd-Frank also differs from the
    more flexible approach taken by European regulators in their trade
    execution proposals, which could impede future attempts to obtain
    equivalence or substituted compliance determinations.
        The CFTC attempted to find a solution to the fracturing of
    liquidity last year, issuing two conditional no-action letters on
    February 12, 2014 (CFTC No-Action Letter 14-15 \20\ and 14-16) that
    allowed U.S. entities to continue trading on European multilateral
    trading facilities (MTFs), without the need for those platforms to
    register with the CFTC as SEFs. However, those European venues were
    required to report all swap transactions to a CFTC-registered SDR as if
    they were SEFs, submit monthly reports to the CFTC summarizing levels
    of participation and volume by U.S. persons, and meet other SEF
    requirements as well as their own home regulations. Not surprisingly,
    no MTF applied within the time frame for this so-called QMTF status.
    ---------------------------------------------------------------------------
        \20\ CFTC Letter No. 14-15, February 12, 2014, http://www.cftc.gov/
    ucm/groups/public/@lrlettergeneral/documents/letter/14-15.pdf.
    ---------------------------------------------------------------------------
        This validates my belief that it is better for the CFTC to conduct
    a review of its rules now, rather than reach a point where divergent
    trading rules are in place elsewhere, forcing cross-border
    counterparties to try and comply with two different sets of
    requirements.
        ISDA has published a set of principles \21\ aimed at promoting
    consistency in the development and application of centralized trading
    rules for derivatives. They include:
    ---------------------------------------------------------------------------
        \21\ ISDA's Path Forward for Centralized Execution of Swaps, April
    2015: http://www2.isda.org/attachment/NzM1Ng==/
    Path%20Forward%20for%20Centralized%20Execution
    %20of%20Swaps%20FINAL.pdf.

       The trading liquidity of a derivatives contract (and
            consequently the regulatory obligations to which the contract
            is subject) should be determined by reference to specific
            objective criteria. The process should be based on concrete,
            transparent and objective standards so that market participants
            have a clear understanding of when swaps will be required to
    ---------------------------------------------------------------------------
            move from the bilateral market to centralized trading venues.

       Derivatives contracts that are subject to the trading
            obligation should be able to trade on a number of different
            types of centralized venues. It is important for regulators to
            achieve a flexible trade execution regime that would allow
            contracts to be traded across jurisdictions, and not be subject
            to costly duplicative compliance obligations and regulatory
            arbitrage.

       Trading venues must offer flexible execution mechanisms that
            take into account the trading liquidity and unique
            characteristics of a particular category of swap. We believe
            that regulators will encourage centralized trading by
            permitting parties to communicate and execute trades freely, so
            long as the parties comply with the requirement to execute
            trades on a centralized venue.
              * * * * *
    Conclusion
        US legislators moved quickly to draw up and finalize the Dodd-Frank
    Act in response to the financial crisis. Five years on from its
    enactment, the vast majority of the key requirements on derivatives
    have been implemented. The first U.S. clearing mandates, for example,
    were introduced in 2013. All swaps transactions involving a U.S. person
    are now required by the CFTC to be reported to SDRs, and SEF trading
    volumes increased rapidly following the first trade mandates in 2014.
        But this first-mover status has also created problems. The speed
    with which the legislation was drawn up meant little time was given to
    coordination and cooperation with non-U.S. legislators. Differences in
    implementation schedules and in the substance of the regulation in
    different jurisdictions have emerged as a result.
        With other jurisdictions now developing or implementing comparable
    rules, there is now an opportunity to harmonize the various regulations
    to facilitate cross-border trading. Critical to this initiative is an
    effective and transparent substituted compliance framework. Efforts to
    achieve equivalence between jurisdictions have floundered on several
    occasions because regulators have conducted a granular, rule-by-rule
    comparison of the requirements. Substituted compliance determinations
    based on broad outcomes would maximize the potential for cross-border
    harmonization, and would align the regulatory framework more closely
    with the G20 commitments.

        The Chairman. Thank you, Mr. O'Malia. Mr. Edmonds.

              STATEMENT OF CHRISTOPHER S. EDMONDS, SENIOR
     VICE PRESIDENT, FINANCIAL MARKETS, IntercontinentalExchange,
                            INC. CHICAGO, IL

        Mr. Edmonds. Chairman Conaway, Ranking Member Peterson,
    Members of the Committee, thank you for the opportunity to
    appear before you today. Since launching an electronic over-
    the-counter energy marketplace in 2000, ICE has expanded both
    in the U.S. and internationally. Over the past 15 years we have
    acquired or founded derivatives exchanges in clearing houses in
    the U.S., Europe, Singapore, and Canada. As such, we are
    uniquely impacted by global financial reform efforts.
        Looking at the derivatives markets now, 5 years into
    financial reform, it is more transparent, and risk management
    is more robust. Many more products are centrally cleared today,
    including the important interest rate and credit default swap
    markets. Also importantly, market participants have invested
    greatly in compliance systems and staff, which in turn have
    resulted in safer and more resilient derivatives markets.
    However, while we are in the later stages of Dodd-Frank
    implementation, other jurisdictions have chosen to develop at a
    much slower schedule, which has caused uncertainty. The goal of
    global regulatory cooperation and protection from regulatory
    arbitrage must be paramount, going forward.
        With this in mind, I have two recommendations for what we
    could have done better in financial reform, which I hope are
    helpful for policymakers, going forward. At the time of
    passage, regulators and Congress were very concerned about the
    ability of market participants to exploit loopholes. Therefore,
    Dodd-Frank was very prescriptive, and in turn the regulators
    have implemented very prescriptive rules. In some ways a
    prescriptive rule is helpful to market participants, as it
    provides clarity. However, prescriptive rules can also have a
    negative impact on a dynamic market, like the derivatives
    markets.
        We should review financial reforms put in place and
    eliminate the ones that do not account for technological
    advances, or which constrain competition. We should then
    replace those rules with a more flexible regulatory principle
    that are able to best meet the evolving nature of markets and
    technology, while making certain all of the rules in place are
    making markets safer.
        In the early days of financial reform efforts the G20
    nations agreed to harmonize financial reform legislation. In
    derivatives, this is vitally important, as the markets are
    global, and the U.S. economy has benefited greatly as the home
    to the international derivative markets. Unfortunately, the
    past 5 years have demonstrated that harmonization has yet to be
    achieved. Going forward, I believe that future financial reform
    efforts should take great care to harmonize major rules both
    domestically and internationally before the rules are issued.
    While this would inevitably slow down the process, coordination
    would save considerable time and unnecessary expense for both
    regulators and market participants.
        ICE has always been, and continues to be, a strong
    proponent of open and competitive markets, and supports robust
    regulatory oversight of these markets. We look forward to
    working with Congress and regulators in the U.S. and abroad to
    address the evolving regulatory changes. Mr. Chairman, thank
    you for the opportunity to share our views with you. I would be
    happy to answer any questions you or the Committee may have.
        [The prepared statement of Mr. Edmonds follows:]

     Prepared Statement of Christopher S. Edmonds, Senior Vice President,
         Financial Markets, IntercontinentalExchange, Inc. Chicago, IL
        Chairman Conaway, Ranking Member Peterson, I am Chris Edmonds,
    Senior Vice President of Intercontinental Exchange (ICE). I appreciate
    the opportunity to appear before you today to testify on the fifth
    anniversary of the Dodd-Frank Wall Street Reform and Consumer
    Protection Act.
    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 fifteen 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 or clearing
    houses are directly regulated by the UK Financial Conduct Authority
    (FCA), the U.S. Commodity Futures Trading Commission (CFTC), the
    Securities and Exchange Commission (SEC) and the Manitoba Securities
    Commission, among others. As such, ICE is uniquely impacted by
    financial reform efforts in the U.S. and abroad.
    Five Years of Financial Reform
        ICE continues to support global financial reform efforts. When
    Dodd-Frank was passed, ICE already had been leading in the development
    of electronic trading and clearing of OTC derivatives, two primary
    goals of global financial reform efforts. As such, ICE believes that
    increased transparency of electronic trading and proper risk and
    capital management of clearing are central to efficient and transparent
    markets. However, as we stated at the time, we believe derivatives
    clearing and trading would ideally evolve naturally as opposed to top
    down mandates.
        Looking at the derivatives market now, 5 years into financial
    reform, it is more transparent and risk management is more robust. Many
    more products are centrally cleared today, including the important
    interest rate and credit default swap markets. Also importantly, market
    participants have invested greatly in compliance systems and staff,
    which in turn have resulted in safer and more resilient derivatives
    markets. However, now that we have come to the later stages of Dodd-
    Frank implementation our larger questions are related to global
    regulation and harmonization. Other jurisdictions have chosen to
    develop on a much slower schedule, which has caused uncertainty in the
    market. Frankly, we are not globally harmonized as the market demands.
    The goal of global regulatory cooperation and protection from
    regulatory arbitrage was the original goal of the G20 and must be
    paramount going forward. It is only through such efforts that we can
    prevent fragmented liquidity pools and divergent regulatory structures.
    Both outcomes would be detrimental to market participants and
    ultimately, the public. With this in mind, I have two recommendations
    for what we could have done better in financial reform, which I hope
    are helpful for policy makers, going forward.
    Reliance on Prescriptive Rules
        At the time of passage, regulators and Congress were very concerned
    about the ability of market participants to exploit loopholes.
    Therefore, Dodd-Frank was very prescriptive, and in turn, the
    regulators have implemented very prescriptive rules. In some ways, a
    prescriptive rule is helpful to market participants as it provides
    clarity. However, prescriptive rules can also have a negative impact on
    a dynamic market like the derivatives market and in some cases make the
    market less safe.
        As an example of how prescriptive rules can go awry, in the late
    1800s, the British Government passed rules mandating that passenger
    liners over 10,000 metric tons have 16 lifeboats. The Titanic's
    shipbuilders over-complied with the regulations--they had 20 lifeboats.
    What the rule did not contemplate is that the technology of
    shipbuilding would change dramatically over the next few years. Thus
    complying with that prescriptive rule in part lead to the tragedy in
    1912. In retrospect, a better rule would have been a flexible one that
    required enough lifeboats for all passengers--whether that was 10, 16,
    or 30.
        We should review the financial reforms put in place for these types
    of prescriptive rules and eliminate the ones that do not account for
    technological advances or which constrain competition. We should then
    replace those rules with more flexible regulatory principles that are
    able to best meet the evolving nature of markets and technology, while
    making certain all of the rules in place are making markets safer.
    Conflicts in Financial Reform Efforts
        In the early days of financial reform efforts, the G20 nations
    agreed in Pittsburgh to harmonize financial reform legislation. In
    derivatives, this is vitally important as the markets are global and
    the U.S. economy has benefited greatly as the home to international
    derivatives markets. Unfortunately, the past 5 years have demonstrated
    the clearly stated goal of harmonization has not been achieved
    internationally or domestically.
        At the outset, the broad mandate of Dodd-Frank created great
    uncertainty for international transactions. The sole recognition of
    applicability of Dodd-Frank to international transactions is in Section
    722 of the Act which states ``[t]he provisions of this Act relating to
    swaps that were enacted by the Wall Street Transparency and
    Accountability Act of 2010 . . . shall not apply to activities outside
    the United States unless those activities:

      (1)  have a direct and significant connection with activities in, or
                effect on, commerce of the United States, or

      (2)  contravene such rules or regulations as the Commission may
                prescribe . . . or to prevent the evasion of any provision
                of this Act . . .''

        This broad provision led the United States to export many of its
    regulations globally. The impulse to regulate global markets is
    understandable as the United States issued its financial reform rules
    faster than most other jurisdictions. However now, as other
    jurisdictions, particularly Europe, finalize their financial reform
    laws, we are seeing major differences across borders. These differences
    are compounded as each jurisdiction's rules are prescriptive and thus
    harder to harmonize. This continued development of compounding
    regulatory standards is leading to fragmented derivatives markets, in
    turn impairing the ability of end-users to access efficient and liquid
    markets to manage their risk.
        Domestically, we have also seen regulations working at cross
    purposes. For example, the prudential banking regulators, through the
    Basel III process, have instituted a Supplemental Leverage Ratio (SLR)
    on cleared transactions. The SLR, in effect, penalizes banks for
    collecting margin from customers, even though the bank acts only as an
    agent between the customer and clearing house. The rule directly
    conflicts with the clearing goals of Dodd-Frank as the SLR will make
    access to clearing more difficult and expensive for customers. In
    addition, the rule could add to systemic risk as clearing firms leave
    the market, leaving risk concentrated in the remaining firms.
        Going forward, I believe that future financial reform efforts
    should take great care to harmonize major rules, both domestically and
    internationally, before the rules are issued. While this would
    inevitably slow down the process, coordination would save considerable
    time and expense for both regulators and market participants in the
    overall.
    Conclusion
        ICE has always been and continues to be a strong proponent of open
    and competitive markets and supports robust regulatory oversight of
    those markets. As an operator of global futures and OTC markets, and as
    a publicly-held company, ICE understands the importance of ensuring the
    utmost confidence in its markets. We look forward to working with
    Congress and regulators in the U.S. and abroad to address the evolving
    regulatory challenges presented by derivatives markets.
        Mr. Chairman, thank you for the opportunity to share our views with
    you. I would be happy to answer any questions you may have.

        The Chairman. Thank you, Mr. Edmonds. Mr. Thompson.

       STATEMENT OF LARRY E. THOMPSON, VICE CHAIRMAN AND GENERAL
     COUNSEL, DEPOSITORY TRUST AND CLEARING CORPORATION, NEW YORK,
                                   NY

        Mr. Thompson. Thank you, Mr. Chairman, and Ranking Member
    Peterson. I am Larry Thompson, Vice Chairman and General
    Counsel of the Depository Trust and Clearing Corporation, or
    DTCC, the primary financial market infrastructure for U.S. and
    global markets. The G20 reform initiatives pushed financial
    market regulation into the 21st century. As a result, over the
    last several years, the global OTC derivatives marketplace has
    undergone a dramatic transformation. Progress has been steady,
    but slow. Just last Friday the Financial Stability Board issued
    its ninth progress report, indicating that there remained a
    range of implementation issues. To date the G20 goal of
    enhanced transparency remains only partially addressed. While
    regulators and market participants have made significant
    progress, identifying cross-border risks remains a challenge.
    The goal of global data transparency has not been achieved.
        I would like to focus on three points today. First, legal
    barriers to global trade reporting among regulators. Second,
    challenges to global coordination, and third, the need for
    consistent global data standards. Today there are significant
    legal barriers that are preventing cross-border data sharing.
    These issues, such as Dodd-Frank's indemnification provisions,
    need to be removed before data can be aggregated and used for
    systemic risk oversight. They block regulators, both in the
    U.S. and globally, from utilizing the transparency offered by
    swap data repositories, and may hinder access to and sharing of
    data among U.S. authorities. Thanks to the leadership of this
    Committee, the House recently passed H.R. 1847, a bill
    introduced by Mr. Crawford and Mr. Maloney, which would resolve
    this issue. DTCC urges the Senate to quickly pass this
    technical, non-controversial fix.
        Second, there is a lack of global coordination among
    jurisdictions. While trade repositories are recognized as
    essential tools for systemic risk management, the emergence of
    reporting regimes with regional, rather than global, focus has
    limited their effectiveness to date. Although this has
    significantly improved market transparency at the local level,
    it has fragmented the global reporting landscape. This approach
    impacts U.S. regulators, who, due to the data fragmentation,
    will not see the full picture of risk developing across the
    system. Achieving the G20 goals of transparency requires
    harmonized reporting across jurisdictions.
        And that leads me to my third and final point, about the
    critical need to adapt global data standards. Jurisdictions
    have made significant progress in implementing derivatives
    reporting rules, and data is now being reported to trade
    repositories on an unprecedented scale. However, data
    collection alone is not sufficient. Common standards must be
    adopted to improve the quality of the data. Policymakers need
    to focus on two priorities. First, trade reporting must be
    conducted using globally adopted data standards, and, second,
    the aggregated data sets that combine information from multiple
    jurisdictions must be available. Standardized formats are
    necessary to transform reported data into usable information,
    which can be more efficiently aggregated to monitor market
    risks.
        Efforts to identify systemic risk, including by U.S.
    regulators, will be frustrated if they can only obtain a
    partial picture of the global activity. Collaboration between
    the industry and regulators is critical, and an increased sense
    of urgency is needed. But market infrastructure, such as DTCC,
    stand ready to address these challenges. The best place for the
    dialogue to be advanced is among the global regulator bodies,
    such as CPMI/IOSCO. These organizations must move quickly to
    enact global data standards and develop appropriate governance
    frameworks to enable cross-border access to timely, accurate
    data. The U.S., along with its partners in Europe and in Asia,
    should continue to play a leadership role in these efforts.
        Mr. Chairman, tremendous progress has been made since the
    2009 G20 summit, but as you have heard today, there remains
    significant work to ensure our markets remain competitive,
    transparent, and resilient. Thank you for the opportunity to
    participate in today's hearing. I look forward to your
    questions.
        [The prepared statement of Mr. Thompson follows:]

      Prepared Statement of Larry E. Thompson, Vice Chairman and General
        Counsel, Depository Trust and Clearing Corporation, New York, NY
    Introduction
        Chairman Conaway, Ranking Member Peterson, and Members of the
    Committee, thank you for holding today's hearing.
        I am Larry Thompson, Vice Chairman and General Counsel of The
    Depository Trust & Clearing Corporation (``DTCC''). DTCC has more than
    40 years of experience serving as the primary financial market
    infrastructure serving the global markets, enabling thousands of
    institutions worldwide to issue securities and raise capital to build
    businesses and support the global economy.
        Through our subsidiaries and affiliates, DTCC provides clearing,
    settlement and information services for virtually all U.S. transactions
    in equities, corporate and municipal bonds, U.S. Government securities,
    mortgage-backed securities and money market instruments, and mutual
    funds and annuities. In 2014, our subsidiaries processed securities
    transactions valued at approximately U.S.$1.6 quadrillion. DTCC
    processes the equivalent of the U.S. annual gross domestic product
    every 2 days. Underscoring the critical role market infrastructures
    play in protecting the capital markets, DTCC's U.S. clearing and
    depository subsidiaries were designated as Systemically Important
    Financial Market Utilities (``SIFMUs'') by the Financial Stability
    Oversight Council (``FSOC'') in 2012 pursuant to Title VIII of the
    Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd-
    Frank'').
        As a critical infrastructure provider, DTCC is not only focused on
    reducing systemic risk in derivatives markets, but we are hard at work
    on a number of initiatives designed to make markets safer, more
    transparent, and more resilient. These include operating a CFTC
    provisionally registered swap data repository (``SDR'') and through
    DTCC's Global Trade Repository, supporting regulatory regimes around
    the world. DTCC is also actively involved in efforts to: shorten the
    U.S. settlement cycle for equities, corporate and municipal bonds and
    unit investment trust trades; \1\ facilitate compliance with new margin
    regulations for non-cleared derivatives; \2\ create and assign
    globally-accepted legal entity identifiers (``LEIs''); \3\ standardize
    and automate cyber threat intelligence distribution; \4\ and work
    carefully towards addressing issues related to central counterparty
    resiliency.\5\
    ---------------------------------------------------------------------------
        \1\ See DTCC White Paper, ``Shortening the Settlement Cycle: The
    Move to T+2'' (June 18, 2015), available at http://www.dtcc.com/news/
    2015/june/18/the-move-to-t2.aspx.
        \2\ See Press Release, Leading Global Banks, Service Providers and
    Market Infrastructures Create New Hub for End-to-End Margin Processing
    (July 7, 2015), available at http://www.dtcc.com/news/2015/july/07/
    service-providers-and-market-infrastructures-create-new-hub.aspx.
        \3\ See DTCC Global Markets Entity Identifier Utility Overview,
    http://www.dtcc.com/data-and-repository-services/reference-data/
    gmei.aspx.
        \4\ See Press Release, Soltra Launches Soltra Edge, The First
    Industry-Driven Threat Intelligence Sharing Platform Designed to Enable
    Community-Driven Cyber Defenses (Nov. 4, 2014), available at https://
    soltra.com/pdf/FINAL%20Soltra%20Edge%20press%20release
    _11.4.14FINALWEB%20(1).pdf.
        \5\ See DTCC White Paper, ``CCP Resiliency and Resources'' (June
    2015), available at http://www.dtcc.com/news/2015/june/01/ccp-
    resiliency-and-resources.aspx.
    ---------------------------------------------------------------------------
        My testimony today, however, will focus on the progress of global
    financial reform, particularly with regard to new regulatory
    requirements for the over-the-counter (``OTC'') derivatives markets.
    DTCC provides services for a significant portion of the global OTC
    derivatives market and has extensive experience operating repositories
    to support derivatives trade reporting and enhance market transparency.
    Through regulated subsidiaries, DTCC supports regulatory reporting
    regimes in the U.S., Europe, Japan, Australia, Singapore, Hong Kong and
    Canada.
        As described below, the 2009 Group of 20 (``G20'') initiatives for
    global financial markets pushed financial market regulation into the
    21st century. The G20 Pittsburgh Summit introduced new trade reporting
    rules and spurred the advent of centralized clearing and new capital
    requirements. As a result, the OTC derivatives market has undergone a
    dramatic transformation over the past several years and continues to
    evolve rapidly as market participants meet new mandates, including new
    regulatory requirements stemming from Dodd-Frank.
        Today, I would like to identify several key obstacles that
    frustrate global regulatory efforts to achieve the goals set forth by
    policymakers in the aftermath of the 2008 financial crisis. I will also
    highlight several solutions that policymakers should consider as
    implementation of the G20 commitments move forward, such as continued
    efforts to aggregate and standardize data, as well as ensure it can be
    freely and appropriately shared across jurisdictions.
        Progress on global derivatives reform is at a critical juncture as
    the G20 goal of enhanced transparency remains only partly addressed.
    While regulators and the industry have made significant strides in
    addressing the data gap that existed in 2008, cross-border
    identification of risk remains difficult for macro-prudential
    authorities. I applaud you for holding this hearing at such a critical
    time for global financial market reform.\6\
    ---------------------------------------------------------------------------
        \6\ DTCC has also discussed the G20's global derivatives
    transparency mandate. See DTCC White Paper, ``G20's Global Derivatives
    Transparency Mandate'' (Feb. 2, 2015), available at http://
    www.dtcc.com/news/2015/february/02/gtr-white-paper.aspx.
    ---------------------------------------------------------------------------
    Importance of G20 Commitments for Global Financial Markets
        The global financial crisis of 2008 shook the foundations of the
    financial system to the core. This period was followed by a commitment,
    at a global level, led by the G20 to take a number of measures to
    enhance transparency in the derivatives market and improve the global
    response to systemic risk stemming from cross-border derivatives
    trading activities.
        More specifically:

       The G20 agreed that ``all standardized OTC derivative
            contracts should be traded on exchanges or electronic trading
            platforms, where appropriate, and cleared through central
            counterparties. OTC derivative contracts should be reported to
            trade repositories. Non-centrally cleared contracts should be
            subject to higher capital requirements.'' \7\
    ---------------------------------------------------------------------------
        \7\ See G20 Leaders' Statement at the Pittsburgh Summit (Sept.
    2009), available at http://www.treasury.gov/resource-center/
    international/g7-g20/Documents/pittsburgh_summit_
    leaders_statement_250909.pdf.

       The G20 leaders further called on the Financial Stability
            Board (``FSB'') and its relevant members to ``assess regularly
            implementation and whether it is sufficient to improve
            transparency in the derivatives markets, mitigate systemic
            risk, and protect against market abuse.'' \8\
    ---------------------------------------------------------------------------
        \8\ See id.

        This commitment was followed by the adoption, in November 2009, of
    the 20 recommendations put forward by the FSB in their report, ``The
    Financial Crisis and Information Gaps.'' The report identified four
    areas in which data gaps would need to be addressed, namely to better
    capture the build-up of risk in the financial sector, to improve data
    on international financial network connection, to monitor the
    vulnerability of domestic economies to shocks, and to enable
    communications of official statistics.
        According to FSB's Eighth Progress Report on Implementation of OTC
    Derivatives Market Reforms:

              As of November 2014 the majority (16) of FSB member
            jurisdictions have trade reporting requirements in effect for
            one or more product and participant types, though specific
            reporting requirements currently vary across jurisdictions. By
            end-2015, all but one jurisdiction are expected to have trade
            reporting requirements in effect for at least some product
            classes. As of end-October 2014, 13 FSB member jurisdictions
            have [trade repositories (``TRs'')] that are permitted to
            receive transaction reports for at least some asset classes.
            Globally, there are 23 TRs currently operational, spanning all
            asset classes.

        Since then, significant steps within jurisdictions have been taken
    towards developing a framework to address the goals outlined in the FSB
    report. Trade reporting regimes are now in place in major derivatives
    jurisdictions around the world and regulators have access to more
    derivatives data than ever before.
        Despite these steps, the G20 goals remain only partly addressed.
    Data is being collected as prescribed by each jurisdiction's
    legislation and local regulators are able to review data. However, more
    work remains to fully achieve the FSB goals outlined in the 20
    recommendations. Of most importance, the goal of global data
    transparency--one of the major factors that led to the 2008 financial
    crisis and a critical element in understanding systemic risks and
    interconnectedness--has not yet been achieved. In my testimony, I will
    address the following points as to what work remains to fully achieve
    this important goal:

      1.  Lack of global coordination resulting from the localized or
                jurisdictional approach to trade reporting regimes;

      2.  Lack of global data standards; and

      3.  Legal barriers to global data sharing among regulators.
    DTCC's Trade Repository and Global Markets Entity Identifier Help
            Regulators Identify and Mitigate Global Financial Market Risk
        DTCC has extensive experience collaborating with regulatory bodies
    and market participants to support new regulatory reporting mandates
    globally, including Dodd-Frank in the U.S., the European Market
    Infrastructure Regulation (``EMIR'') and the Markets in Financial
    Instruments Directive (``MiFID'') in Europe, as well as new reporting
    requirements for trade repositories throughout the Asia-Pacific region.
    Global Trade Repository
        DTCC's Global Trade Repository (``GTR'') supports reporting across
    all five major derivatives asset classes--credit, interest rate,
    equity, foreign exchange and commodity--in nine jurisdictions across 33
    countries. Despite differences in local reporting requirements across
    regions, DTCC has built a robust and flexible infrastructure with a
    global trio of fully replicated GTR data centers.
        GTR has more than 5,000 clients in all regions of the world,
    including the top 30 global banks. In fact, GTR reports data for more
    than 100,000 entities globally and holds up to 40 million open
    derivatives trades. We also process more than one billion customer
    messages each month.
        DTCC is a strong proponent of efforts to increase transparency in
    the OTC derivatives markets. In line with global reporting commitments,
    Dodd-Frank requires that all derivatives transactions, whether cleared
    or uncleared, must be reported to newly created SDRs. Based on our
    experience providing regulated trade repository services globally, DTCC
    is pleased significant progress has been made in implementing this
    mandate.
        To support Dodd-Frank reporting requirements, the DTCC Data
    Repository (U.S.) LLC (``DDR'') applied for and received provisional
    registration from the Commodity Futures Trading Commission (``CFTC'')
    to operate a multi-asset class SDR for OTC credit, equity, interest
    rate, foreign exchange and commodity derivatives in the U.S. DDR is the
    only repository to offer reporting across all asset classes, a major
    milestone in meeting regulatory calls for robust trade reporting and
    risk mitigation in the global OTC derivatives market. Currently, DDR
    holds approximately ten million CFTC-reported open derivatives trades.
        DDR began accepting trade data from its clients on October 12,
    2012--the first day that financial institutions began trade reporting
    under Dodd-Frank. Furthermore, on December 31, 2012, DDR was the first
    and only registered SDR to publish real-time price information. DTCC--
    through its Trade Information Warehouse--has provided public aggregate
    information for the credit default swap market on a weekly basis,
    including both open positions and turnover data, since January 2009.
    This information is available, free of charge, on www.dtcc.com.
    1. Global Coordination
        While financial market infrastructures like DTCC have become
    fundamental in enabling G20 reforms, challenges remain regarding the
    introduction of new regulatory mandates, and the potential unintended
    consequences of various regulations. There remain significant concerns
    regarding the harmonization of new regulatory requirements and the
    cross-border impact of new rules throughout the marketplace.
        While trade repositories are heralded as an essential pillar of
    systemic risk management, the global derivatives reporting regime that
    emerged following the 2008 crisis was developed along national or
    regional lines. Due to this fragmented regulatory landscape, trade
    repositories have not been able to reach their full potential as tools
    for systemic risk oversight.
        Since the 2008 crisis, major derivatives jurisdictions around the
    world have developed frameworks to mandate reporting of derivative
    trades to trade repositories. Regulators have also devised local rules
    and designated authorized trade repositories to operate within their
    domains. Although transparency has been created through national
    reporting regimes, this localized approach has resulted in divergences
    among jurisdictions.
        While local authorities were developing the mandated reporting
    frameworks, in 2010 DTCC implemented a voluntary reporting framework
    under OTC Derivatives Regulators Forum (``ODRF'') guidelines to data
    access. This framework leveraged DTCC's Trade Information Warehouse
    post-trade processing service, which contains virtually all credit
    derivative trades transacted globally. A portal was established that
    made this data available to more than 40 regulators globally. The
    portal allows for regulators to access data within their jurisdiction
    and data provided is consistent with ODRF data-sharing guidelines. The
    portal assists regulators in their supervisory capacities in scenarios
    such as sovereign debt crises, corporate failures, credit downgrades
    and significant losses by financial institutions.
        Despite these voluntary efforts, the mandated regulations that
    emerged throughout each jurisdiction have created a fragmented and
    inconsistent set of reporting requirements. This frustrates the ability
    to perform aggregation and data access provisions such as those
    previously established via this portal.
        In 2013, DTCC stated that achieving the G20 goals of transparency
    required an optimal trade reporting framework which consisted of
    harmonized reporting requirements across jurisdictions and advocated
    for one repository to collect data as a public good.\9\ However, the
    current trade reporting reality is quite different and reporting is now
    fragmented across jurisdictions as well as across multiple
    repositories. Given this current state, it is imperative that we focus
    on creating the necessary conditions for the reporting function to
    fulfill the G20 mandate.
    ---------------------------------------------------------------------------
        \9\ Michael C. Bodson, CEO, DTCC, ``New Infrastructures for a
    Sounder Financial System,'' Financial Stability Review, Banque de
    France (April 2013).
    ---------------------------------------------------------------------------
    2. Global Standards as Means to Improve Data Quality
        While progress has been made to improve standards globally,
    additional work remains before the G20 transparency mandate can be
    achieved. Standards are necessary as they provide a means to
    transforming data into information that can be used to help identify
    and mitigate systemic risk. Through the global adoption and use of
    identifiers and consistent standards, the quality of data will improve
    and data can be effectively aggregated.
    Legal Entity Identifier
        DTCC is actively engaged in the global effort regarding LEIs, which
    allow for the unique identification of legally distinct entities that
    are counterparties on financial transactions. Global use of LEIs would
    serve as a valuable building block to increasing transparency and risk
    mitigation in the financial markets.
        Following the 2008 financial crisis, the importance and benefit of
    a universal LEI became clear. The inability of regulators to quickly
    and consistently identify parties to transactions across markets,
    products, and regions hindered their ability to evaluate systemic risk,
    identify trends and emerging risks, and take appropriate corrective
    steps. Recognizing the critical data gap in regulatory oversight as a
    result of the lack of an international standard for an LEI, authorities
    around the world have taken incremental steps to develop a global LEI
    system.
        Through a competitive process, DTCC was chosen to build and operate
    an LEI utility for the industry and was designated by the CFTC to
    provide LEIs to swap market participants as required by CFTC record-
    keeping and reporting rules. This utility, which was developed and
    operates in conjunction with SWIFT, is the Global Markets Entity
    Identifier (``GMEI''). To date, the GMEI utility has assigned LEIs to
    and maintains reference data corresponding to more than 185,000 legal
    entities across more than 140 jurisdictions, representing approximately
    50 percent of all global LEIs that have been assigned. I am pleased to
    announce that last week the CFTC extended the GMEI utility's
    designation as the provider of LEIs in support of the CFTC's swap data
    record-keeping and reporting rules.
        To ensure adoption of LEI both domestically and globally, it is
    essential that new registration, record-keeping and reporting rules
    include an LEI mandate. DTCC is pleased there is widespread regulatory
    support for the LEI to serve as the international standard. Among U.S.
    regulators, the CFTC \10\ was the first to mandate use of the LEI and
    the Securities and Exchange Commission (``SEC'') \11\ is advancing
    rules with LEI mandates. Additionally, several authorities--including
    the European Securities and Markets Authority, the Monetary Authority
    of Singapore, the Hong Kong Monetary Authority, the Australian
    Securities and Investment Committee, and the Ontario Securities
    Commission--have promulgated record-keeping and reporting rules for OTC
    derivatives transactions that require counterparties to be identified
    by LEIs. Given the progress by the public and private sectors working
    together to implement the Global LEI System, DTCC anticipates LEI
    mandates in rulemaking in the U.S. to greatly accelerate, thus enabling
    a significant improvement in systemic risk management.
    ---------------------------------------------------------------------------
        \10\ See Swap Data record-keeping and Reporting Requirements, 77
    Fed. Reg. 2136 (Jan. 13, 2012).
        \11\ Regulation SBSR--Reporting and Dissemination of Security-Based
    Swap Information, 80 Fed. Reg. 14564 (Mar. 19, 2015).
    ---------------------------------------------------------------------------
        Global LEI adoption would serve as a significant step in the
    process to increase transparency and mitigate risk. However, additional
    standards need to be addressed at a global level to support the trade
    reporting regime. For example, currently there is a lack of global
    agreement regarding the appropriate standard for a trade identifier or
    product identifier. In addition, more client information must be
    standardized such as the branch locations for each Global LEI and the
    hierarchy structure for company (referred to as parent LEIs to enable
    aggregation by grouping all legal entities to one parent). These
    standards are necessary requirements in creating an effective
    regulatory reporting framework.
    Making Data Useful: Aggregation and Standardization
        Notwithstanding divergent reporting requirements, jurisdictions
    have made significant progress in implementing derivatives reporting
    rules and a massive amount of data is being reported to trade
    repositories. However, data collection alone is not sufficient to
    address the G20 transparency goal. The ability to aggregate this data,
    convert it into information, and use it to monitor the build-up of risk
    in the system is absolutely essential.
        Understanding the challenges associated with data aggregation
    requires distinguishing between the requirements of micro-prudential
    regulators, who are responsible for local market surveillance, and
    macro-prudential regulators, who are focused on monitoring risk in the
    financial system. While national reporting regimes have been mostly
    effective at providing transparency into local markets, the same is not
    true at the macro-prudential level due to the fragmented nature of
    jurisdictional reporting rules, which has led to the absence of
    harmonized global data standards across jurisdictions and trade
    repository providers. By lacking a common vocabulary with which to
    communicate, trade repositories are unable to share and aggregate data
    on a global scale.
        To address this situation, regulators must come to agreement on the
    specific data set required for systemic risk identification and adopt
    consistent reporting standards across jurisdictions in order to fully
    capitalize on the benefits of the data being collected.
        Data standardization requires a collaborative effort by the
    industry, trade repositories and regulators globally. As operator of
    the largest global trade repository, DTCC strongly supports efforts to
    create a common data vocabulary, such as those spearheaded by the
    Committee on Payments and Market Infrastructures (``CPMI'') and
    International Organization of Securities Commissions (``IOSCO'')
    Harmonization Working Group. Active dialogue between the industry and
    its supervisors is vital to resolving this fundamental issue.
        In June 2015, DTCC provided recommendations to CPMI/IOSCO,
    detailing a proposed path towards global data harmonization with credit
    derivatives identified as the first step.\12\ The approach involves
    harmonizing approximately 30 data fields across global trade repository
    providers, essentially creating a global data dictionary. These fields
    are viewed as critical to financial stability and systemic risk
    analysis.
    ---------------------------------------------------------------------------
        \12\ See Press Release, DTCC Proposal to CPMI IOSCO on Global Data
    Harmonization (June 18, 2015), available at http://www.dtcc.com/news/
    2015/june/18/dtcc-proposal-to-harmonization-working-group.aspx.
    ---------------------------------------------------------------------------
    3. Remove Barriers to Global Data Sharing
        While data standardization is essential, it will have limited
    impact if barriers that hinder cross-border data sharing are not also
    concurrently addressed. Significant legal barriers need to be removed
    before data can be aggregated at a cross-border level and used by
    relevant supervisory authorities.
        For example, the Dodd-Frank Act requires swap data repositories to
    obtain indemnification agreements before sharing information with
    regulatory authorities.\13\ The indemnification requirements in Section
    21(d) of the Commodity Exchange Act and Section 13(n)(5)(H) of the
    Securities Exchange Act of 1934, as amended by Dodd-Frank, require--
    prior to sharing information with various regulatory authorities--that
    (i) registered SDRs receive a written agreement from each entity
    stating that the entity shall abide by certain confidentiality
    requirements relating to the information on swap transactions that is
    provided, and (ii) each entity must agree to indemnify the SDR and the
    CFTC or SEC, respectively, for any expenses arising from litigation
    relating to the information provided.
    ---------------------------------------------------------------------------
        \13\ Such regulatory authorities include U.S. Prudential
    Regulators, the Financial Stability Oversight Council, the Department
    of Justice, foreign financial supervisors (including foreign futures
    authorities), foreign central banks, and foreign ministries.
    ---------------------------------------------------------------------------
        In practice, these provisions have proven to be unworkable and run
    counter to policies and procedures adopted by regulatory bodies
    globally to safeguard and share information. In addition, these
    provisions pose a significant barrier to the ability of regulators
    globally and within the U.S. to effectively utilize the transparency
    offered by SDRs, and may have the effect of precluding U.S. regulators
    from seeing data housed at non-U.S. repositories. These provisions also
    limit access to and sharing of data among U.S. authorities such as the
    CFTC, SEC, the Federal Reserve Board, and the Office of Financial
    Research.
        Concerns regarding global information sharing have been echoed by
    regulatory officials and policymakers globally. In an August 2013
    report, the Committee on Payment and Settlement Systems and the Board
    of IOSCO highlighted that legal obstacles may preclude trade
    repositories from providing critical market data and encouraged the
    removal of legal obstacles or restrictions to enable effective and
    practical access to data.\14\
    ---------------------------------------------------------------------------
        \14\ See CPSS-IOSCO Report, ``Authorities' Access to Trade
    Repository Data'' (Aug. 2013).
    ---------------------------------------------------------------------------
        During a February hearing this year before this Committee, CFTC
    Chairman Timothy Massad stated that removal of the indemnification
    provisions would facilitate the sharing of information and
    collaboration among regulators to monitor risk.\15\ CFTC Commissioner
    J. Christopher Giancarlo and Commissioner Mark Wetjen also identified
    indemnification as a priority issue and expressed support for a
    legislative fix during an April hearing before the Subcommittee on
    Commodity Exchanges, Energy, and Credit.\16\ In addition, SEC
    Commissioner Michael Piwowar has voiced concern and called for removal
    of the indemnification provisions.\17\
    ---------------------------------------------------------------------------
        \15\ For example, Chairman Massad stated that if legislation ``did
    remove [the indemnification] provision, then it would facilitate . . .
    the sharing of information.'' See 2015 Agenda for CFTC: Hearing Before
    the H. Comm. On Agric., 114th Cong. (2015) (colloquy between Chairman
    Massad and Congressman Eric Crawford).
        \16\ See Testimony of CFTC Commissioner J. Christopher Giancarlo
    Before the H. Comm. on Agric., Subcomm. on Commodity Exchanges, Energy,
    and Credit (April 14, 2015), available at http://agriculture.house.gov/
    sites/republicans.agriculture.house.gov/files/images/
    Giancarlo%20Testimony.pdf; see also Testimony of Mark Wetjen,
    Commissioner, CFTC, Before the H. Comm. on Agric., Subcomm. on
    Commodity Exchanges, Energy, and Credit (April 14, 2015), available at
    http://agriculture.house.gov/sites/republicans.agriculture.house.gov/
    files/images/Wetjen%20Testimony.pdf.
        \17\ Commissioner Michael Piwowar, Secs. and Exch. Comm'n, Remarks
    at the Int'l Swaps and Derivatives Ass'n 30th Annual General Meeting
    (Apr. 22, 2015).
    ---------------------------------------------------------------------------
        DTCC strongly supports legislation that would resolve issues
    surrounding the indemnification provisions. DTCC is pleased that
    removing the indemnification provisions from Dodd-Frank remains a
    bipartisan, bicameral priority for the current Congress.
    Indemnification correction amendments have recently been considered by
    the House Financial Services, House Agriculture, House Appropriations,
    Senate Banking and Senate Agriculture Committees.
        On July 14, the House passed the Swap Data Repository and
    Clearinghouse Indemnification Correction Act of 2015 (H.R. 1847). DTCC
    applauds House passage of H.R. 1847, which would help ensure regulators
    obtain a consolidated and accurate view of the global OTC derivatives
    marketplace. We urge the Senate to move swiftly to support this non-
    controversial, technical fix.
        There is precedent for global information sharing. As mentioned
    previously, DTCC's Trade Information Warehouse, established in 2006,
    provided authorities access to data pursuant to guidance issued by the
    ODRF, a group of regulators from across the globe that were able to
    define the parameters of what information could be disclosed based on
    parties to the transaction and the underlying reference entity to whom
    credit protection was being bought or sold. The credit derivatives data
    provided was standardized, aggregated and shared across jurisdictions.
    The ODRF serves as an example of a well-functioning governance model,
    demonstrating the potential of what can be achieved with consistent
    data standards, data aggregation and clear access rules.
    Looking Forward: Global Regulatory Coordination and Market Guidance
        Following the removal of legal barriers, market infrastructures
    such as DTCC will be able to play an important role in supporting data
    quality efforts to ensure that data can be turned into useful
    information. A key step is the establishment of a governance framework
    to set the conditions upon which regulators could access each other's
    data once legislative hurdles such as Dodd-Frank's indemnification
    provisions are removed.
        A global college of regulators--for example, CPMI IOSCO--is best
    positioned to provide the industry with specific guidelines outlining
    clear data access rules based on the individual regulator's authority.
    Such an undertaking requires defined cross-border guidance that each
    jurisdiction adopts and adheres to. While removing legal barriers and
    establishing a governance model for data sharing will take time, these
    are necessary elements to achieve the G20 goal of increased
    transparency and systemic risk mitigation.
        To continue progress on global derivatives reform, a critical next
    step is the analysis of data and use of tools to transform data into
    information which can be used to identify systemic risk. That is the
    value provided by reporting data--to provide regulators with
    transparency into the marketplace to assist with potential risk
    identification and mitigation.
        DTCC encourages CPMI, U.S. policymakers and regulatory bodies
    globally to take a leadership role in the governance process and
    address global standards. Collaboration among the industry and
    regulators is paramount and an increased sense of urgency is needed to
    address current challenges.
    Conclusion
        Mr. Chairman, Ranking Member, thank you for inviting me to speak
    today on this important topic. As you can see, a great deal of progress
    has been made in modernizing the global derivatives market, but there
    is much work yet to be done. I will be happy to answer any questions
    you may have and look forward to a continued dialogue on these issues
    with you and your staffs.
                                   Attachment
    G20's Global Derivatives Transparency Mandate
    January 2015
        About DTCC

        With over 40 years of experience, DTCC is the premier post-trade
    market infrastructure for the global financial services industry. From
    operating facilities, data centers and offices in 15 countries, DTCC,
    through its subsidiaries, automates, centralizes, and standardizes the
    post-trade processing of financial transactions, mitigating risk,
    increasing transparency and driving efficiency for thousands of broker/
    dealers, custodian banks and asset managers worldwide. User owned and
    industry governed, the firm simplifies the complexities of clearing,
    settlement, asset servicing, data management and information services
    across asset classes, bringing increased security and soundness to the
    financial markets. In 2013, DTCC's subsidiaries processed securities
    transactions valued at approximately U.S.$1.6 quadrillion. Its
    depository provides custody and asset servicing for securities issues
    from 139 countries and territories valued at U.S.$43 trillion. DTCC's
    global trade repository processes tens of millions of submissions per
    week.
        To learn more, please visit www.dtcc.com or follow us on Twitter
    @The--DTCC.
    Table of Contents
      Abstract
      Executive Summary
      Introduction

        1. Has the G20 policy response brought about the required
        transparency?
        2. Can existing data collection satisfy the G20 mandate?
        3. What legislative hurdles need to be overcome to ensure that data
        can be shared globally?
        4. What are the practical challenges to improving data quality and
        converting data into information?
        5. What are the possible governance models for cross-border data
        sharing?

      Conclusion
    Abstract
        Progress on global derivatives reform is at a critical juncture.
    The lack of transparency, identified during the 2008 crisis as critical
    to the supervision of the financial system, remains only partly
    addressed.
        As a result, the cross-border identification of systemic risk
    remains beyond the reach of macro-prudential authorities. Trade
    repositories, heralded as essential to achieving greater transparency
    in the global derivatives markets, have not been able to reach their
    full potential as tools for systemic risk oversight.
        It is imperative that a plan of action, together with a concrete
    timetable, is agreed upon to remove the remaining barriers, practical
    and legal, that would turn the aspiration of global derivatives market
    transparency, and the identification and management of global systemic
    risk, into a reality.
    Executive Summary
        The global financial crisis of 2008 shook the foundations of the
    financial system to the core. This period was followed by a commitment,
    at a global level, led by the Group of 20 (G20) to take a number of
    measures which would enhance the transparency in the derivatives market
    and improve the global response to systemic risk stemming from cross-
    border derivatives trading activities.
        The policy response which followed the G20 commitments was,
    however, developed along national or regional lines, thus focusing on
    the identification of risk originating at a local level and posing risk
    to the stability of the respective local jurisdictions. This approach,
    which was driven by micro-prudential regulatory requirements, has
    resulted in a fragmented regulatory landscape that is unable to respond
    to the original G20 goal of preserving the integrity of the global
    financial system as a whole.
        The fact that this policy response has not been tested to date does
    not mean that the risks that the financial system faced in 2008 are
    less real. Derivatives markets remain as global and as interconnected
    as ever. Whilst achieving transparency, albeit at a local level, has
    been a significant accomplishment for both the regulatory community and
    the industry, we should not confuse this level of transparency with the
    ability to monitor and identify systemic risk and thereby protect and
    preserve global financial stability.
        As the dust settles on the first phase of the reforms which
    immediately followed the financial crisis, it is imperative that we
    take a step back to assess the progress made to date against the G20
    commitments and agree a plan of action to enable macro-prudential
    regulators to address the original G20 mandate.
        This paper provides an analysis of current status against the G20
    goal of increasing global derivatives market transparency, and
    identifies what is still required to ensure that the G20 aspirations
    are turned into a reality.

        We call on the global regulatory community for a harmonised global
    plan of action with an appropriate timetable to:

       Reach agreement on the global data set required to identify
            systemic risk.

       Revise existing laws which prevent cross-border data
            sharing.

       Agree consistent data standards to be adopted across
            jurisdictions, leveraging existing standards where possible.

       Agree a governance model enabling cross-border data sharing.
            This could leverage proven governance models such as that
            defined by the OTC Derivatives Regulators' Forum (ODRF) around
            the credit derivatives Trade Information Warehouse (TIW), the
            forerunner of the modern trade repository.
    Introduction
        Over 5 years ago, G20 finance ministers and central bankers, in
    response to the most severe financial crisis since the Great
    Depression, made a commitment to ``adopt a set of policies, regulations
    and reforms to meet the needs of the 21st century global economy.'' \1\
    ---------------------------------------------------------------------------
        \1\ G20 Leaders statement: The Pittsburgh Summit, 24-25 September
    2009 http://www.g20.utoronto.ca/2009/2009communique0925.html.
    ---------------------------------------------------------------------------
        Among these was the commitment to make the global over-the-counter
    (OTC) derivatives markets safer and more transparent, and to create
    powerful tools for the supervision of global participants.

        More specifically:

       The G20 agreed that ``all standardized OTC derivative
            contracts should be traded on exchanges or electronic trading
            platforms, where appropriate, and cleared through central
            counterparties. OTC derivative contracts should be reported to
            trade repositories. Non-centrally cleared contracts should be
            subject to higher capital requirements.''

       The G20 leaders further called on the Financial Stability
            Board (FSB) and its relevant members to ``assess regularly
            implementation and whether it is sufficient to improve
            transparency in the derivatives markets, mitigate systemic
            risk, and protect against market abuse.''

        That the G20 aim was to promote global financial stability was
    already evident at its earlier London summit, in April 2009, where it
    committed to:

       Strengthening financial supervision and regulation by
            ``establishing much greater consistency and systematic
            cooperation between countries, and the framework of
            internationally agreed high standards that a global financial
            system requires.''

       ``Amend our regulatory systems to ensure authorities are
            able to identify and take account of macro-prudential risks
            across the financial system . . . to limit the build-up of
            systemic risk.''

        It further added that:

       ``We will ensure that our national regulators possess the
            powers for gathering relevant information on all material
            financial institutions, markets, and instruments in order to
            assess the potential for their failure or severe stress to
            contribute to systemic risk. This will be done in close
            coordination at international level in order to achieve as much
            consistency as possible across jurisdictions.'' \2\
    ---------------------------------------------------------------------------
        \2\ Declaration on strengthening the financial system--London
    Summit, 2 April 2009 http://www.g20.utoronto.ca/2009/2009ifi.html.

        This commitment was followed by the adoption, in November 2009, of
    the 20 recommendations put forward by the International Monetary Fund
    (IMF) and the FSB in their report ``The Financial Crisis and
    Information Gaps''. The report identified four areas in which data gaps
    would need to be addressed, namely to better capture the build-up of
    risk in the financial sector, to improve data on international
    financial network connection, to monitor the vulnerability of domestic
    economies to shocks, and to enable communications of official
    statistics.\3\
    ---------------------------------------------------------------------------
        \3\ The Financial Crisis and Information Gaps: Report to the G20
    Finance Ministers and Central Bank Governors http://
    www.financialstabilityboard.org/publications/r_091029.pdf.
    ---------------------------------------------------------------------------
        Since then, important steps have been taken towards developing a
    framework to address these goals for the global derivatives market.
    Trade reporting regimes are now in place in major derivatives
    jurisdictions around the world and national regulators have access to
    more derivatives trading data than ever before.
        In its 2009 Pittsburgh statement, the G20 said that a ``sense of
    normalcy should not lead to complacency''. This statement is more
    relevant today than ever before as we put increasing time and distance
    between the current signs of global recovery and the almost
    catastrophic crisis of 2008.

        It is against this backdrop that this paper aims to address five
    fundamental questions:

       Has the G20 policy response brought about the required
            transparency?

       Can existing data collection satisfy the G20 mandate?

       What are the practical challenges to improving data quality
            and converting data into information?

       What legislative hurdles need to be overcome to ensure that
            data can be shared globally?

       What are the possible governance models for cross-border
            data sharing?
    1. Has the G20 policy response brought about the required transparency?
        Although much transparency has been created through national
    reporting regimes, the answer must be a resounding `no' if we measure
    success against the original G20 goal of creating the transparency
    which would help identify and mitigate global systemic risk.
        Major derivatives jurisdictions around the world have developed
    legislative frameworks to mandate reporting of derivative trades to
    trade repositories and have devised detailed local rules and designated
    authorised trade repositories to operate within their domains. But far
    from achieving the global consistency implicitly aspired to by the G20,
    this localised approach has resulted in divergences between reporting
    regimes which can be grouped into three categories:

       Scope of Regulations: For example, jurisdictions across
            Asia-Pacific, the U.S. and Canada mandate reporting of OTC
            derivatives trades only, while in the EU reporting of exchange-
            traded derivatives also forms part of the scope;

       Reporting Obligations: Single versus dual sided reporting is
            mandated inconsistently between EU, U.S., and Asia-Pacific; and

       Reportable Data: Regional variations exist in the data
            fields that are reportable, although there is some consistency
            in a core set of data fields.

        In a paper published in April 2013,\4\ DTCC argued that to achieve
    the G20 goals of transparency required an optimal trade reporting
    framework which consisted of harmonised reporting requirements across
    jurisdictions and one single repository collecting data as a public
    good.
    ---------------------------------------------------------------------------
        \4\ ``New infrastructures for a sounder financial system'', Michael
    C. Bodson, CEO, DTCC, Financial Stability Review, Banque de France,
    April 2013.
    ---------------------------------------------------------------------------
    Fig. 1. DTCC's Original Vision for the Global Trade Repository Model

        However, what we have today is exactly the opposite, a derivatives
    reporting environment, fragmented across jurisdictions as well as
    across multiple repositories. It is clearly impractical to wind back
    the clock on these developments, it is imperative that we focus on
    creating the necessary conditions for the reporting function to fulfil
    the G20 mandate.
    Fig. 2. The Current Trade Reporting Reality

    2. Can existing data collection satisfy the G20 mandate?
        Notwithstanding divergent reporting requirements which exist across
    major derivatives jurisdictions, data is being collected and on the
    whole compliance has been good. However, data collection itself is not
    sufficient to address the transparency goal. What is needed is the
    ability to aggregate this data, convert it into information and then
    use it to monitor the build-up of risk in the system.
        To understand the challenge of aggregating the data and converting
    it into information requires a distinction between the requirements of
    micro-prudential regulators for the purposes of local market
    surveillance, and the requirements of macro-prudential regulators for
    the purposes of monitoring the build-up of risk.
        To ensure that both regulatory functions can be performed, any
    efforts to address the derivatives aggregation challenge should
    therefore be preceded by a clear distinction between two tier data
    sets--both a national or regional data set for the purposes of market
    surveillance together with a smaller global data subset for systemic
    risk oversight.

       The first dimension of the data set required for micro-
            prudential supervision is well served by the current national
            reporting regimes. This data set includes numerous data fields
            which national regulators require to be able to perform their
            own analysis on a number of issues related to local market
            surveillance. In jurisdictions with multiple trade
            repositories, given that all relevant local market data is
            housed in locally authorised trade repositories, the challenge
            of aggregating that data and converting it into useable
            information is predominantly an issue of having common local
            standards and appropriate analytical tools--an important
            challenge, but certainly not insurmountable.

       The second dimension of a derivatives data set--the global
            data set required for systemic risk surveillance--is more
            challenging to implement. Namely, it requires:

         Cross-border agreement on a specific set of data
                needed for systemic risk identification;

         Adoption of consistent reporting standards across
                jurisdictions for those specific data fields;

         Definition of the population required to report;

         Removal of legal barriers to data sharing;

         Agreement on a governance model for data sharing.

        In the following chapters, we explore the actions required to
    overcome these practical and legal hurdles.
    3. What legislative hurdles need to be overcome to ensure that data can
            be shared globally?
        Before data can be aggregated at a cross-border level and used by
    the relevant supervisory authorities, significant legal barriers need
    to be removed. Failure to address these legal barriers would make all
    other efforts to address derivatives transparency futile. Removing
    legal barriers to data sharing--some of which predate derivatives
    reform such as data protection laws, blocking statutes, state secrecy
    laws and bank secrecy laws--requires international regulatory
    cooperation for the greater public good.
        Today, regulatory cooperation happens on many levels. Currently
    unique among them is the bilateral Memorandum of Understanding signed
    between the Australian Securities and Investments Commission (ASIC) and
    the Monetary Authority of Singapore (MAS) allowing trade repositories
    licensed in one jurisdiction to provide relevant data to the authority
    in the other jurisdiction. This agreement, together with ASIC's
    alternative trade reporting arrangements which allow firms already
    reporting to a recognised trade repository in another jurisdiction, to
    discharge their reporting obligation in the ASIC jurisdiction, is a
    step towards fostering greater cooperation between international
    regulators which will be essential for successful cross-border
    oversight. We applaud the initiative of these two authorities and hope
    it sets an important global precedent.
        Bilateral agreements are useful steps towards building the case for
    greater cooperation as they make eventual data sharing easier at a
    multi-lateral level. However, multi-lateral agreements are a quicker
    way to achieving the ultimate goal of global transparency mandated by
    the G20.
        For agreements at a multi-lateral level to work, revision of some
    legislative provisions which prohibit data from being shared need to be
    undertaken. For example, the Dodd-Frank Act in the U.S. incorporates an
    `indemnification clause' requiring non-U.S. regulators to indemnify
    U.S. regulators and trade repositories from possible data misuse before
    access is granted. This creates a financial cost as well as a legal
    impediment for non-U.S. regulators, and effectively prevents them from
    viewing data relevant to their jurisdictions collected and held by
    trade repositories located in the U.S. and operating under the Dodd-
    Frank Act. Revision of legislation is the only way to ensure privacy
    laws and other legislative hurdles do not compromise the efforts
    towards data aggregation which are needed to ensure the regulators have
    a complete and timely picture of risk in the system. However, bringing
    legislative change remains extremely challenging.
        The need for such change was further stressed in a recent letter
    from the OTC Derivatives Regulators' Group (ODRG) to the FSB Chairman,
    Mark Carney.\5\ The ODRG called for urgent changes, including
    legislative changes where required, to remove provisions that prevent
    the identification of counterparties under reporting obligations to
    trade repositories. The ODRG further makes the case for setting a
    deadline for the unmasking of counterparty information, and recommends
    the FSB seek the G20 leaders' agreement to ensure the removal of those
    barriers.
    ---------------------------------------------------------------------------
        \5\ OTC Derivatives Regulators' Group--Barriers to Reporting to
    Trade Repositories, August 2014, http://www.esma.europa.eu/system/
    files/letter_to_fsb_08122014.pdf.
    ---------------------------------------------------------------------------
        The agreement on the global data set that is required for systemic
    risk oversight should make regulatory cooperation and removal of
    legislative hurdles easier as it will focus attention on a specific
    data set needed for systemic risk oversight, rather than numerous
    fields which are required for market surveillance. The information
    should be sufficiently high level (e.g., LEI counterparty level
    information) to allow the relevant authority to address any legislative
    limitations on sharing those specific fields.
    4. What are the practical challenges to improving data quality and
            converting data into information?
        Following the removal of legal barriers, market infrastructures can
    play an important role in supporting data quality efforts to ensure
    that data can be turned into globally useful information. We believe
    these efforts should focus on the following areas:

        Global Data Set

        Global regulators must agree on the set of data fields which, at a
    global level, can be used to identify the impact of market activity
    outside their jurisdiction on their jurisdiction, and vice versa.
        To understand why this data set would differ from the current
    national reporting requirements, consider this scenario. During the
    collapse of Lehman Brothers, if two parties outside the U.S. were
    trading on an underlying Lehman Brothers asset, data collected under
    U.S. rules, which allow for the supervision of U.S. persons only, would
    have misrepresented the scale of the problem.
        Advancing systemic risk oversight, therefore, requires an agreement
    on the global data set to be aggregated which mitigates the
    interconnectedness of the financial system.
        And before you say `not possible!', the credit derivatives markets
    provide an important precedent of how such a global data set can
    deliver the transparency that global regulators require to monitor risk
    in the system.\6\
    ---------------------------------------------------------------------------
        \6\ See boxout on ODRF.
    ---------------------------------------------------------------------------
        Once an agreement on this global data set has been reached, the
    focus on improving data quality by advancing consistent standards can
    begin.
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Much has been said about the importance of adopting
            consistent data standards across jurisdictions, and the focus
            of the debate has often centred around three particular
            standards which relate to information on the product, taxonomy,
            and the counterparties to a trade. While these standards are
            important, our view is that their use, whilst helpful, does not
            address the lack of standards across a number of other fields.
            For aggregation at a global level to work, data standards for
            all fields required for aggregation must be agreed upon.
              The Legal Entity Identifier (LEI) is the standard that is
            most evolved in that regard. We have a situation where a global
            standard is being adopted, but more work is required to enforce
            its usage.
              The Unique Product Identifier (UPI) does not exist in any
            meaningful way; different regulations allow for products to be
            expressed in different ways and the product taxonomy is not
            granular enough. For UPIs to work, a global standard must be
            adopted and enforced.
              The case of the Unique Trade Identifier (UTI) is slightly
            different from the above in that the difficulty is not in
            adopting a consistent standard for generating a unique code,
            but in establishing an infrastructure which is needed to
            exchange the identifier between trading counterparties in time
            for reporting cycles.

        Data Standards

        At a local level, the issue of data standardisation stems from the
    fact that local rules in place today are frequently not granular enough
    to recommend specific data standards. Data standardisation remains a
    highly desirable outcome and must continue to be improved through a
    concerted effort by both the industry and the repositories, in
    collaboration with local market regulators. However, this will take
    time. To accelerate the development of appropriate systemic risk
    oversight and ensure that the quality of data is fit for purpose, we
    recommend that work to standardise fields within the global data set
    which are subject to the aggregation mandate must begin immediately.
        The principles for Financial Market Infrastructures (FMIs) which
    have been published by the International Organisation of Securities
    Commissions (IOSCO) and are being monitored by the Committee on
    Payments and Market Infrastructures (CPMI) provide a useful foundation
    upon which to further build towards agreeing common international
    standards for reporting of derivatives trades.
        The principles for FMIs could be extended in scope to include data
    requirements and standards which may have some commonality with
    existing requirements in jurisdictions which have mandated trade
    reporting, but resulting in an outcome which provides harmonisation of
    the requirements and standardisation of data at a global level.
        Ideally, a single standard setting authority should be responsible
    for monitoring the adoption of standards in national rulemaking,
    monitoring compliance with those rules as well as outcomes. This is a
    proven three level process which has been successfully adopted by the
    Basel Committee and the CPMI on monitoring the principles for FMIs, and
    could be extended in scope to create the necessary conditions for
    aggregating the derivatives data for the purposes of monitoring
    systemic risk.
    5. What are the possible governance models for cross-border data
            sharing?
        Once the global data set has been identified, it is natural to turn
    attention to the question of what governance framework is required for
    data sharing.
        A governance model would set the conditions upon which regulators
    could access each other's data, e.g., on the basis of entitlements,
    based upon a jurisdiction's market share in the global derivatives
    markets.
        Important precedents exist at a multi-lateral level which show that
    regulatory cooperation can make cross-border data sharing possible. It
    would be impossible to imagine the response to any global issue--from
    air traffic control, nuclear safety, global health, terrorism--without
    a framework for global data sharing. What these numerous examples tell
    us is that, while they may not be perfect, they are certainly
    achievable. The derivatives market is no exception.\7\
    ---------------------------------------------------------------------------
        \7\ See boxout on the OTC Derivatives Regulators' Forum (ODRF)
    which governs data sharing in the credit default swaps market, and Bank
    of International Settlements International Banking Hub which has been
    developed by the FSB to improve the collection and sharing of
    information linkages between global systemically important financial
    institutions and their exposure to different sectors and markets.
    ---------------------------------------------------------------------------
        The governance model can be founded upon an entitlement scheme,
    such as the one adopted by the ODRF for credit derivatives, based on
    the regulator type. What this means in practice is that the entity
    should be provided with a set of guidelines on how information needs to
    be presented in terms of aggregation, the underlying detail, and allow
    access based on the individual regulator's authority. Establishing the
    criteria for this will require agreeing what is the nature of the trade
    which leads that trade to be available to another regulator. At the
    high level, this can come down to either the domicile of the
    counterparty or the domicile of the underlying reference entity that
    was being traded in the credit derivatives world.
        What the ODRF example shows us in particular is that existing
    infrastructures can be leveraged to perform the aggregation of OTC
    derivatives data, provided the relevant supervisory authorities agree
    on a governance layer. For aggregation to work, as demonstrated in the
    credit derivatives markets, you need to have consistent data with very
    clear access rules.
      The OTC Derivatives Regulators' Forum
              The OTC Derivatives Regulators' Forum (ODRF) is comprised of
            international financial regulators including central banks,
            banking supervisors, and market regulators, and other
            governmental authorities that have direct authority over OTC
            derivatives market infrastructure providers or major OTC
            derivatives market participants, or consider OTC derivatives
            market matters more broadly. It was formed in 2009 to provide
            regulators with a means to cooperate, exchange views and share
            information related to OTC derivatives CCPs and trade
            repositories.\8\
    ---------------------------------------------------------------------------
        \8\ ODRF: Framework for information sharing and cooperation among
    OTC derivatives regulators, 22 September 2009 http://www.otcdrf.org/
    documents/framework_sept2009.pdf.
    ---------------------------------------------------------------------------
              ODRF began coordinating the voluntary sharing of credit
            derivatives data held by trade repositories, across
            jurisdictions and in accordance with governance and clear
            access guidelines. DTCC, having established its Trade
            Information Warehouse (TIW), a trade repository and post-trade
            processing infrastructure for OTC credit derivatives in 2006,
            used the guidelines provided by the ODRF to provide global
            regulators access to detailed transaction data on virtually all
            credit derivatives trades executed worldwide in which they have
            a material interest to monitor systemic risk.
              The success of this initiative was due to the fact that data
            was standardised and aggregated in the TIW, supported by a data
            sharing agreement which meant that data could be accessed and
            interpreted by regulators globally in accordance with the ODRF
            guidelines. While the ODRF did not facilitate an agreement on
            the adoption of consistent standards, it remains a useful
            example of a well-functioning governance model, demonstrating
            the potential of what can be achieved if you have:

           consistent data standards;

           data aggregated in one place;

           clear access rules.
      Financial Stability Board Data Gaps Project
              As part of the G20 initiatives aimed at promoting financial
            stability, the Financial Stability Board (FSB) has developed an
            ``international framework that supports improved collection and
            sharing of information on linkages between global systemically
            important financial institutions and their exposures to
            different sectors and markets. The objective is to provide
            authorities with a clearer view of global financial networks
            and assist them in their supervisory and macro-prudential
            responsibilities.''
              The governance of this initiative includes harmonised
            collection of data, which consists of common data templates for
            global systemically important banks to ensure consistency in
            the information collected. The data is then hosted in a central
            international data hub hosted by the Bank of International
            Settlements (BIS).
              Data collection and sharing through the hub is made possible
            through a multilateral Memorandum of Understanding which
            establishes the arrangements for the collection and sharing of
            information through the BIS hub.
              A governance group consisting of participating authorities
            oversees the pooling and sharing of information and monitors
            compliance with the multi-lateral framework. Data is collected
            by home authorities and then passed on to the data hub. Reports
            are then prepared and distributed to participating authorities,
            who can require additional information from the data hub, which
            fulfils the request after obtaining written consent from data
            providers.
    Conclusion
        Trade repositories have the potential to become powerful tools in
    identifying systemic risk, but they are currently unable to perform
    this role because there are practical and legal impediments which make
    transparency unattainable.
        Urgent action is required to remove these barriers and any efforts
    should focus on five key areas:

       First, there needs to be an agreement on the global data set
            required to identify systemic risk.

       Second, existing laws which prevent cross-border data
            sharing must be reviewed.

       Third, consistent standards which apply to this data set
            must be adopted across jurisdictions, leveraging existing
            standards where possible. This will require appointing a
            standards authority which would monitor and enforce their
            adoption.

       Fourth, a governance model which enables data sharing among
            regulators must be agreed upon. This should leverage where
            possible proven governance models such as the one adopted by
            the ODRF.

       Fifth, a timetable for action should be agreed upon,
            supported by the G20, providing a framework for the completion
            of the work which began in 2009.

        Only when these steps have been taken, we can finally put real
    distance between us and the 2008 financial crisis, confident that the
    lack of transparency which nearly brought the financial system to
    collapse has truly been addressed.
        For Further Information about your derivatives reporting
    requirements, please visit www.dtcc.com/gtr.

        This document is for information purposes only, and does not
    constitute legal advice.
        Readers should consult their legal advisors for legal advice in
    connection with the matters covered in this document. The services
    described are governed by applicable rules, procedures, and service
    guides for relevant DTCC subsidiaries, which contain the full terms,
    conditions, and limitations applicable to the services.
        If at any time you wish to be removed from our distribution list,
    please send an e-mail to PrivacyOffice@dtcc.com.
        To learn about career opportunities at DTCC, please go to dtcc.com/
    careers.
        10882_PS122014

        The Chairman. Thank you, Mr. Thompson. Dr. Parsons.

      STATEMENT OF JOHN E. PARSONS, Ph.D., SENIOR LECTURER, SLOAN
                  SCHOOL OF MANAGEMENT, MASSACHUSETTS
                 INSTITUTE OF TECHNOLOGY, CAMBRIDGE, MA

        Dr. Parsons. Good morning, Chairman Conaway, Ranking Member
    Peterson, and Members of the Committee. Thank you for the
    opportunity to be here. A healthy, well regulated derivatives
    market can be a valuable contributor to a vibrant and
    productive economy. The U.S. futures and options markets
    demonstrated that throughout the 20th century. Unfortunately,
    late in the 20th century, the U.S. and other countries took a
    gamble on an unregulated swaps market, with lax risk management
    practices, high leverage on transactions, organized in the
    shadows, outside of supervision, sunlight, and competition.
        The result was a disaster for the U.S. economy. More than
    ten million Americans lost their jobs. Countless others
    suffered economic hardships of many kinds. Businesses suffered.
    The Dodd-Frank Act was written to return us to healthy
    financial markets that are a source of stability and economic
    progress. In resolutely implementing this financial reform, the
    U.S. is once again showing leadership. The U.S. has a long
    tradition of healthy financial regulation that has made our
    financial markets among the best in the world. The Dodd-Frank
    Act is another example of that leadership.
        The U.S. has made significant progress in implementing the
    derivative reforms of Title VII. The prepared testimony I
    submitted discusses that in more detail, and other witnesses
    have spoken about it here. In the short time that I have now, I
    want to focus your attention on one specific problem discussed
    in my testimony, which I hope I can communicate to the
    Committee about that will give you a richer sense of the work
    that is still undone, and the obstacles that remain.
        One of the key goals of the reform is transparency. Swap
    trades should be reported somewhere so that regulators and the
    larger public will know important facts about the size and
    structure of the market. This is one of the least contentious
    goals of the reform, and one of the most critical if we are to
    avoid or manage a future crisis. So I want to ask the question
    how are we doing, and I want to answer that with a little
    personal experience of my own with the data that I think is
    easy for everybody here to grasp.
        In November 2013 the CFTC released its first weekly swaps
    report, which is a compendium of some of the information from
    that trade reporting made available to the public. Since I am a
    follower of the market, this first report was something I was
    keen to take a look at. It contains information on many things,
    but since my work with businesses revolves largely around
    commodity derivatives, I turned to that table first.
        The table shows the gross notional outstanding, it is a
    common index of size of the market, and the figure it showed
    was $1.7 trillion. I want you to keep that figure in mind. It
    is going to be key here. That is a start at the kind of
    information we badly need. It is just a summary figure compiled
    out of the more detailed information in the new databases where
    trades are reported. The table also contains a list of
    categories of specific commodity derivatives, like those for
    agriculture, energy, and metals, but there were no figures in
    those individual line items, just the notation N/A, which the
    footnote explains is not available. I was a little
    disappointed, but not entirely surprised. This was just the
    first report, and just the beginning. It takes great time and
    effort to put these things together.
        Each week the CFTC releases a new report, and each week I
    take a look. Each week I notice that the size of the commodity
    swaps market is exactly $1.7 trillion. It is never $1.6
    trillion or $1.8 trillion, it is always $1.7 trillion. That
    seems odd. Then I noticed the footnote that explains this
    figure is not really a total based directly on reported trades,
    but actually just an estimate. It didn't explain how the
    estimate was made. I followed the CFTC's weekly reports for
    more than 90 weeks over a year and a half. In my prepared
    testimony I gave you a screenshot of this table from the
    website of the CFTC. The size of the commodity swaps market is
    still being reported at exactly $1.7 trillion, the same number
    week after week for 90+ weeks, a year and a half.
        Now, I have colleagues who are very sophisticated with
    statistics, and can analyze complicated data sets that are
    beyond me, that look like a blur to me. This is the first time
    that I can say I can analyze a data set and tell you something
    is wrong here. That is not an estimate. That is a plug. It
    would be more honest to report N/A, not available. I don't
    really understand why we are still putting out data that
    doesn't tell you anything, but we are, and it is an indication
    of the deep problems. It is an indication that everybody on
    this Committee can see. You can go to the website and look at
    it yourself. And it is an indication that, while we have made
    great progress, there is still a long way to go. Thank you very
    much.
        [The prepared statement of Dr. Parsons follows:]

     Prepared Statement of John E. Parsons, Ph.D., Senior Lecturer, Sloan
          School of Management, Massachusetts Institute of Technology,
                                 Cambridge, MA
    Progress and Problems in Reforming the Swaps Marketplace
        My name is John E. Parsons. I am a Senior Lecturer in the Finance
    Group at the MIT Sloan School of Management and the Head of the MBA
    Finance Track. I a Research Affiliate of the MIT Center for Energy and
    Environmental Policy Research where I was previously the Executive
    Director. I have a Ph.D. in Economics from Northwestern University. At
    MIT I teach a course on risk management for non-financial companies,
    the so-called end-users or commercial hedgers. I have published
    research on theoretical and applied problems in hedging and risk
    management, and I have been a consultant to many non-financial
    companies on hedging problems of various kinds, as well as on other
    financial issues. I have participated in a number of Roundtables at the
    CFTC regarding the reform of the derivatives markets, and I represent
    BetterMarkets on the CFTC's Global Markets Advisory Committee. I have
    testified several times to the House Financial Services Committee and
    its subcommittees on derivatives market reform. I recently completed a
    term as a Visiting Scholar at the Federal Energy Regulatory Committee
    studying financial trading in electricity markets.
    Introduction
        Unregulated derivatives played a major role in the 2008 financial
    crisis. All the devils at play elsewhere in the financial system were
    also at play in the derivatives markets, but two points deserve
    highlighting. Derivatives served as a trigger for key events in the
    crisis and as a vector for contagion, helping to spread the crisis
    throughout the system. Both points were manifested in the collapse of
    insurance giant American International Group (AIG), among the most
    notorious episodes of the crisis. The company's London subsidiary, AIG
    Financial Products, had long profited on the sale of credit default
    swaps. The deregulation of the OTC derivatives market allowed these to
    be sold without any up-front capital or margin. The state insurance
    commissioners who supervised AIG's other insurance businesses had no
    authority vis-a-vis these derivatives, despite the fact that these
    swaps were marketed to serve a role comparable to insurance. AIG's
    financial regulator, the Office of Thrift Supervision, was ill equipped
    and completely ineffective at supervising the company's derivative
    operation. As losses on these credit default swaps accumulated and
    AIG's financial position deteriorated, the firm suffered the effects of
    a classic bank run, losing access to short-term financing such as
    commercial paper and repo. The U.S. Government stepped in and committed
    more than $180 billion to AIG's rescue, including a loan from the
    Federal Reserve as well as Treasury funding under the Troubled Asset
    Relief Program (TARP).
        More than any other single event, it is the case of AIG that
    provided the political clarity behind the need to regulate the
    derivatives market. In Senate testimony in 2009, Federal Reserve
    Chairman Ben Bernanke said, ``If there is a single episode in this
    entire 18 months that has made me more angry, I can't think of one,
    other than AIG. . . . AIG exploited a huge gap in the regulatory
    system. There was no oversight of the Financial Products division. This
    was a hedge fund, basically, that was attached to a large and stable
    insurance company, made huge numbers of irresponsible bets--took huge
    losses.'' For the public and for President Obama, the case of AIG is
    especially notorious because even after the company had taken taxpayer
    bailout funds, its Financial Products division proceeded to pay top
    managers enormous bonuses.
        The case also provides intellectual clarity on the necessary shape
    of reform. In the midst of the crisis, regulators found themselves ill
    equipped to respond. U.S. law had exempted AIG's derivative
    transactions from oversight, and so no government authority had
    knowledge about the company's trades, nor did any authority have
    substantive knowledge about the larger market in which those trades
    took place. Lacking this information, no government authority could
    have acted in advance of the crisis. Moreover, once we found ourselves
    in the midst of the crisis, the authorities stumbled about without
    critical information. This case made clear that reform must provide
    regulators with information about any and all corners of the
    derivatives market and the authority to act on that information.
        A second lesson was that risk management deficiencies involving
    derivatives at one institution like AIG could threaten other central
    parts of the system. As the news of AIG's financial woes became known,
    concern immediately arose about major banks, both American and
    European, with large exposure to AIG through the web of derivative
    contracts between the banks and AIG. Any reform of the derivatives
    market should help reduce the transmission of problems between
    institutions. This should be integrated with the larger reform of the
    financial system.
        The other crisis events in which derivatives played a role are less
    widely known, but equally important in guiding the design of reform. In
    particular, derivatives played a supporting role in the troubles at
    several other financial institutions in 2008, increasing the fragility
    of the system. For example, both Bear Stearns and Lehman Brothers were
    large investment banks with major businesses dealing derivatives. In
    both cases, losses on mortgage-related investments began to cast doubts
    on the solvency of the banks. These suspicions led various sources of
    short-term financing to dry up, creating liquidity crises. Both banks'
    positions as derivatives dealers played vital roles in their liquidity
    crises, when derivative counterparties began to reassign contracts away
    from them and refused new transactions, which drained cash from the
    firms.
        Before 2008, economists discussed bank runs using the archetypal
    example of the traditional commercial bank that takes deposits. The
    crisis forced economists to incorporate into their discussion other
    components of the financial system that are also susceptible to runs--
    notably money market funds, but extending as well to investment bank
    lines of business such as prime brokerage and derivative dealerships.
    Any reform of the derivatives market should here, too, be integrated
    with the larger reform of the financial system designed to protect
    against bank runs.
        At the September 2009 Summit of the G20 Leaders in Pittsburgh, it
    was agreed that the OTC derivatives market should be reformed:

              All standardized OTC derivative contracts should be traded on
            exchanges or electronic trading platforms, where appropriate,
            and cleared through central counterparties by end-2012 at the
            latest. OTC derivative contracts should be reported to trade
            repositories. Non-centrally cleared contracts should be subject
            to higher capital requirements.

        The reform has four main elements:

       Universal supervision. There can be no carve out for OTC
            derivatives that makes them exempt from supervision. Universal
            supervision represents a reversal of the explicitly
            deregulatory mandate of the United States' Commodity Futures
            Modernization Act of 2000.

       Transparency. All transactions must be reported to public
            data repositories.

       Exchange trading. Where possible, trading should move onto
            exchanges or comparable electronic platforms. Together with
            trade reporting this helps shine light onto the markets, for
            the benefit of the regulator as well as for competition and the
            wider public advantages that stem from transparency. Meanwhile,
            price transparency makes the market work better for all
            participates, while also giving regulators a crucial tool in
            examining systemic risk.

       Clearing. The mandate to clearing through central
            counterparties is designed to reduce the amount of credit risk
            accumulating in the system overall and also to locate credit
            risk where it is best supervised by regulatory authorities.
            Requiring capital for non-centrally cleared contracts is both a
            tool to encourage central clearing and a component of sound
            banking practice.

        The principles defining the G20 Pittsburgh consensus on derivatives
    reform already governed the regulation of the U.S. futures markets. All
    trade in the futures and options markets had long been subject to
    regulatory oversight. Indeed, the existence of the unregulated OTC
    derivatives market is due to an exemption from the pre-established
    principle of universal supervision of all futures and options trading.
    The futures and options markets are mostly transparent, dominated by
    exchange trading, with data feeds easily accessed by the regulatory
    authorities and important data available to the public. As well, all
    contracts are cleared by a central counterparty. As a specific example,
    look at the oil futures market, which is the largest among the
    commodity derivative markets. It is registered with the U.S. Commodity
    Futures Trading Commission (CFTC), largely exchange traded, with
    rigorous reporting and publicly accessible data feeds, and entirely
    cleared.
        So, the principles behind the reform are tried and true. Indeed,
    the customs and regulations embodying those principles evolved over
    more than a century. For example, the clearing mandate in the futures
    industry arose out of a debate that took place at the end of the 1800s
    and the first 3 decades of the 1900s. Central counterparty clearing was
    introduced to the U.S. in 1896 by the Minneapolis Grain Exchange, home
    to futures trading in grains. This innovation helped to reduce the
    aggregate amount of risk in the system and therefore lowered the amount
    of capital required to manage futures markets. This in turn lowered the
    cost charged to non-financial companies hedging with futures. Central
    counterparty clearing also improved access to the futures market,
    keeping the market competitive and growing. Established futures
    exchanges in other cities gradually recognized these advantages of
    central counterparty clearing and copied the innovation. As new futures
    exchanges were established, central counterparty clearing was often the
    chosen structure right from the start. This was the case at the Chicago
    Mercantile Exchange, established in 1919 for trade in butter, eggs, and
    other products. In 1925, the Chicago Board of Trade, which was the
    largest futures exchange at the time, switched to central counterparty
    clearing. From that date forward, central counterparty clearing reigned
    as the standard practice for futures trading in the U.S., and remained
    so for the next 50 years. Looking back, it is clear that the innovation
    of central counterparty clearing was a boon to the growth of U.S.
    futures markets throughout the 20th century.
    The Progress of Reform
        The United States has shown tremendous leadership in the reform of
    its derivative markets. Title VII of the Dodd-Frank Act provided the
    legislative authority to implement all of the Pittsburgh principles.
    The main responsibility for the implementing Dodd-Frank in this area
    falls to the Commodity Futures Trading Commission (CFTC), which is
    responsible for more than 90% of the U.S. derivatives marketplace. The
    Securities and Exchanges Commission (SEC) is responsible for the
    remainder, and some important elements of the reform also involve the
    banking supervisors as well as the Financial Stability Oversight
    Council.
        The CFTC moved swiftly to write the regulations Congress tasked it
    with. The SEC has moved more slowly, but is also making progress. While
    the CFTC still has a few rules yet to complete, its focus is shifting
    to implementation of its rules, which includes consideration of
    revisions needed. Attention is shifting to see how change is showing
    itself in the marketplace, and to fine-tuning the regulations in
    response.
        Swap dealers and major swap participants now register with the
    CFTC.\1\ The agency's rules establish standards for business practices
    covering a wide range of issues. Not all of the work in this area is
    complete: some governance rules remain. But the principle of
    supervision is being implemented.
    ---------------------------------------------------------------------------
        \1\ The CFTC's list of registered dealers is here: http://
    www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer. It's list
    of registered major swap participants is here: http://www.cftc.gov/
    LawRegulation/DoddFrankAct/registermajorswappart.
    ---------------------------------------------------------------------------
        A large fraction of U.S. swaps are now centrally cleared. For
    interest rate swaps, which is the largest category, it is estimated
    that over 80% of the market is now cleared. Another large category is
    credit derivatives which have also begun central clearing. However,
    progress is limited in the remainder of the market. In aggregate, the
    portion of swaps that are cleared is about 75% according to CFTC
    Chairman Massad's recent testimony to the Senate Agriculture
    Committee.\2\ This is a major accomplishment, and hopefully the CFTC
    will follow through on the other sectors of the market where clearing
    is appropriate.
    ---------------------------------------------------------------------------
        \2\ Testimony of Chairman Timothy G. Massad before the U.S. Senate
    Committee on Agriculture, Nutrition, and Forestry, Washington, D.C.,
    May 14, 2015. http://www.cftc.gov/PressRoom/SpeechesTestimony/
    opamassad-22.
    ---------------------------------------------------------------------------
        Trading of swaps has also begun to be moved onto exchanges and
    electronic platforms--the so-called Swap Execution Facilities or SEFs.
    Some of this shift looks like little more than moving the old bilateral
    brokering from telephones onto new electronic communications systems.
    However, even that shift entails important improvements in
    transparency, oversight and competition. Still, the development of
    fully competitive exchange trading is only in its infancy in the swaps
    market.
        Trade reporting is the area where progress looks the greatest on
    paper, but is most problematic in practice. In the U.S., all swap
    trades must be reported to a swap data repository or SDR. This is
    supposed to be a main tool for giving the regulators the insight about
    the market that was sorely missing in 2008. Although the statement that
    all trades must be reported is accurate, it disguises important
    deficiencies that should trouble this Committee and to which I will
    turn shortly.
        Beyond the implementation of the G20 principles and the specific
    provisions of Title VII of Dodd-Frank, other changes are also required.
    Commissioner Sharon Bowen has spoken about the need for improving the
    culture in finance, and we are well served by the prominence she has
    given the issue.\3\ While the country as a whole made a clear decision
    to reform the OTC derivatives market and to change the bad practices
    that had accumulated over so many years, many in the industry have not
    yet made that change.
    ---------------------------------------------------------------------------
        \3\ Commissioner Bowen Speech before the Managed Funds Association,
    2015 Compliance Conference, May 5, 2015. http://www.cftc.gov/PressRoom/
    SpeechesTestimony/opabowen-4.
    ---------------------------------------------------------------------------
    Problems in Trade Reporting
        The principle that all trades be reported is, on its face, the
    simplest reform. There was virtually no objection to writing this into
    the Dodd-Frank Act, and no disputes in principle in writing the
    regulations. Nevertheless, implementation has proven more difficult. It
    is equally difficult to assess progress in this area. One obstacle is
    that a simple reading of regulator reports on trade reporting does not
    give an accurate picture of the situation. For example, the Financial
    Stability Board (FSB)--an international body responsible for monitoring
    progress in implementing the derivatives reform--issued last week its
    Ninth Progress Report and wrote that \4\
    ---------------------------------------------------------------------------
        \4\ Financial Stability Board, OTC Derivatives Market Reforms,
    Ninth Progress Report on Implementation, 24 July 2015. http://
    www.financialstabilityboard.org/2014/11/fsb-publishes-progress-report-
    on-implementation-of-otc-derivatives-market-reforms/.

              At end-June 2015, the majority of FSB member jurisdictions
            (14) have trade reporting requirements in force covering over
    ---------------------------------------------------------------------------
            90% of OTC derivatives transactions in their jurisdictions.

    That sounds good. Later, the same report turns to the problems in trade
    reporting and writes that:

              Several authorities continue to note challenges in ensuring
            the efficacy of trade reporting.16 These have been discussed in
            some detail in prior progress reports, and include:

           difficulties with TR data quality, such as the accuracy
                of information being
                  received and processed by TRs, particularly associated
                with the absence of
                  Unique Transaction Identifiers (UTI) and Unique Product
                Identifiers (UPI);

           challenges in aggregating data across TRs (both
                domestically and cross-bor-
                  der);

           the existence in some circumstances of legal barriers to
                reporting complete
                  data into a TR (``input barriers'') (e.g., counterparty
                identity or other identi-
                  fying data); and

           legal barriers to authorities' access to TR-held data
                (``output barriers'').

    This language is far too anodyne to convey to outsiders the true state
    of the problem. What, for example, is really meant by ``difficulties
    with TR data quality'' and ``the accuracy of information being
    received''?
        What they mean is that a lot of the data is simply gobbledygook.
    Former CFTC Commissioner Scott O'Malia called attention to this a
    couple of years ago when he recounted the difficulty regulators had in
    making use of the data feeds coming from the U.S. trade repository, the
    Depository Trust & Clearing Corporation (DTCC). He said, ``The problem
    is so bad that staff have indicated that they currently cannot find [JP
    Morgan's now famous] London Whale in the current data files.''
        Unfortunately, not all assessments are as blunt about the problems.
    In his recent testimony to the Senate Agriculture Committee, Chairman
    Massad proudly cited the Weekly Swaps Report as evidence of the good
    progress being made, saying: \5\
    ---------------------------------------------------------------------------
        \5\ Testimony of Chairman Timothy G. Massad before the U.S. Senate
    Committee on Agriculture, Nutrition, and Forestry, Washington, D.C.,
    May 14, 2015. http://www.cftc.gov/PressRoom/SpeechesTestimony/
    opamassad-22.

              You can now go to public websites and see the price and
            volume for individual swap transactions. And the CFTC publishes
            the Weekly Swaps Report that gives the public a snapshot of the
    ---------------------------------------------------------------------------
            swaps market.

    I found that an odd citation because my experience with that report is
    that it is evidence for the problems as much as for the progress.
        What quality of information do you really get from the CFTC's
    Weekly Swaps Report? Printed below is a screenshot I took earlier this
    week of some of the data in that Report.\6\
    ---------------------------------------------------------------------------
        \6\ http://www.cftc.gov/MarketReports/SwapsReports/L2CommGrossExp.

    The table shows the Gross Notional Outstanding of swaps on Commodities
    measured in Millions of U.S. Dollars. Gross Notional Outstanding is a
    common measure of the total size of segments of the swaps market. The
    table shows a Total amount for each of the most recent weeks, June 12
    through July 10. The total shown is 1,700,000, which is $1.7 trillion.
    Below that total, there is a breakdown by category of commodity swaps,
    including Agriculture, Index, Energy, Metals and Other, but each of
    there is no number for any items in this breakdown. Instead, the entry
    is ``N/A'' which the footnote says ``indicates that data are not
    currently available.''
        The footnote above that explains that the total figures ``are
    estimates.'' Notice that the total value recorded in each week is the
    same $1.7 trillion. Actually, if we go back to the very first of these
    weekly reports which was posted in November 2013, we see that the total
    value of commodity derivatives reported even then was also exactly $1.7
    trillion. It has been the exact same figure for 92 weeks in a row. No
    matter how the volume of other derivatives goes up and down, the
    estimate for the commodity derivatives outstanding remains constant.
        That's not an estimate. It's a plug. It would be more honest to
    report ``N/A'', not available. Back in November 2013, when I first read
    the $1.7 trillion figure and the accompanying footnote, I imagined that
    the estimate had a foundation. Now, after having seen it stay constant
    for so long, I know that it can't have any reasonable foundation. Why
    pretend? Let's be honest with the American people and say that we still
    don't know, and we're working on it. Claiming to have a number when we
    don't provides an illusion that we are farther along on the reform than
    we really are.
        Not all of the data being reported is as worthless as this item.
    There is real information in those reports that regulators now have
    that they did not have before the reform. The problem is that there is
    so much junk mixed in with the good stuff.
        Why are there so many data problems? There are a number of reasons
    and excuses. It was always going to be difficult to take an industry
    that had evolved over decades without any oversight and reshape it to
    provide meaningful reports accessible to regulators and the public.
    Broad mandates like the call for transparency issued at the G20
    Pittsburgh meeting are simply stated, but implementation is a
    challenge. The staff at the CFTC have been working hard to write and
    rewrite their regulations to fit the particular structures of the swaps
    market. The CFTC is cooperating with the Office of Financial Research
    on an important project to improve data definitions and data structures
    to make the reporting meaningful and useful.
        But the problem is not just a technical and rulemaking challenge.
    It is also an enforcement challenge. Sometimes what companies report is
    just a Swiss cheese of information, riddled with missing data fields.
    And often the missing information is clearly standard stuff that no
    trader has an excuse to leave out. I wrote last year about a problem
    with reporting in electricity swaps on ICE's data repository, Trade
    Vault, quoting from a critique provided to the CFTC.\7\ As a rule, we
    have been very indulgent of this poor behavior, and the implementation
    of quality reporting has therefore lagged.
    ---------------------------------------------------------------------------
        \7\ http://bettingthebusiness.com/2014/02/11/never-give-
    information-to-the-enemy/.
    ---------------------------------------------------------------------------
        It is worthwhile to note that the U.S. futures and options markets
    do not have any of the same problems with trade reporting. The swaps
    industry is fond of making a distinction between swaps and futures--
    every swap is its own special snowflake, and this is what makes
    implementing the trade reporting and other mandates so difficult. While
    there is some truth to this distinction for a small volume of swaps,
    for the vast majority it is nonsense. For example, large portions of
    the interest rate swap market are economically the same as futures, and
    trade reporting should be no more difficult for these than for futures.
    The industry, therefore, needs to share responsibility for organizing
    itself to structure its trades and trading in a fashion that is
    transparent and monitorable. Otherwise, it represents and ongoing
    threat to the financial stability of the country.
    Conclusion
        In the 5 years that have passed since passage of the Dodd-Frank
    Act, much progress has been made. Regulators have begun to gain
    oversight of the market, credit risk has declined substantially and the
    framework for transparent and competitive trading is in place.
    Implementation has only recently begun, and progress has been uneven
    and marked with important problems. Therefore, much work remains. Some
    of this is work for the regulators, but much of it is work for the
    swaps industry. Leadership from the industry is required to shape the
    swaps market so that it is a vital and vibrant source of financial
    strength and stability to the U.S. economy.

        The Chairman. I thank the gentleman. The chair would remind
    Members that they will recognized for questioning in the order
    of seniority for Members who were here at the start of the
    hearing. After that, Members will be recognized in the order of
    arrival. I appreciate Members's understanding of that, and I
    will recognize myself for 5 minutes. And, again, I want to
    thank our witnesses for being here today.
        Mr. O'Malia, February 2015 the G20 finance managers and the
    central bank governors reaffirmed the importance of cross-
    border cooperation in overcoming global regulatory
    fragmentation. In your opinion, does CFTC's current cross-
    border guidance help or hinder efforts to reach that goal, and
    how?
        Mr. O'Malia. Thank you, Mr. Chairman. Obviously, as all the
    witnesses have indicated, a lot of work has been done and
    achieved by the CFTC to implement these rules. All the rules
    are--we have reporting, exchange trading, and clearing, and we
    are quickly moving on to the OTC margining. With regard to the
    international harmonization, Europe and some jurisdictions in
    Asia are following along, and they are making headway, but we
    have significant progress, as all the witnesses here have
    testified, in terms of the cross-border application.
        The CFTC, in my opinion, has overreached in their
    application of the cross-border rule and taken the statute well
    beyond its logical meaning. The statute, in 2(i), provides for
    a limitation on the CFTC's authority to extend its territorial
    reach to those activities that have a direct and significant
    impact on the U.S. economy. That test has never been validated
    or used, and the CFTC has instead applied a location test to
    these things.
        One of the best ways to figure out if it is having an
    impact or not, and if we have harmonization, is if you look at
    the trading activity. And since the implementation of the trade
    execution requirements of the United States, and the
    combination of the cross-border application, you have seen a
    bifurcated market between the U.S. rates market and the
    European markets in Sterling and Euros. And it is an indication
    that people are avoiding trading with U.S. participants, and we
    are beginning to develop fractured markets.
        If we don't recognize CCPs, for example, we will have
    fractured markets. If we do not harmonize our OTC margin
    requirements, we will see fractured markets. This makes it much
    more difficult to manage risk on a global basis, as these are
    global markets, and it frustrates end-users who try to access
    liquidity in the various markets as well.
        So, to your specific question, have they done enough, have
    they overreached? Yes, they have overreached. No, they have not
    done enough to embody the words they put in the cross-border
    guidance to say that there is a a compliance regime, because it
    has not yet occurred.
        The Chairman. Thank you. Mr. Edmonds, you call for
    replacing overly prescriptive Dodd-Frank rules that do not
    account for technological advances or constrain competition
    with flexible regulatory principles. Could you give us some
    specific examples of that?
        Mr. Edmonds. Well, Mr. O'Malia just made reference to some.
    We have the principles that were laid out by the G20. Those
    principles, and the goals that we were attempting to achieve
    with the legislation that was passed, all go in the right
    direction. And in Mr. Duffy's testimony, he laid out the idea
    that when you look at these rules, and how they are applied, it
    is the application of that prescription, and there is no way to
    achieve a harmony between those two.
        Put the regulators in a box, and when you have one group
    that is so far ahead, or one regulator that is so far ahead in
    the implementation phase, and you have others who are trying to
    catch up, if you look at the totality of those rules, and you
    look at those who followed us, if you will, and the
    implementation of financial reform, everyone has to have their
    little stamp. When you start with a very prescriptive rule
    base, and that next stamp comes along, the totality of all of
    those rules put together put us in the position that we are
    today, where people are looking for certainty around that.
        If you look at the history of the CFTC, it was a
    principles-based organization, and you had a lot of control
    around adhering to those principles. Now those principles
    aren't the rule, it is step and rule that you are going to
    follow, and it gives you very little opportunity to span across
    multiple jurisdictions, even in this country, between things
    that are in Title VII, between the SEC and the CFTC. You can't
    co-exist because as soon as you turn right in one, you are
    upsetting a regulator on the other side, and it puts you in a
    very compromised position.
        The Chairman. In the time left, did any of the other
    witnesses care to comment on CFTC's guidance? Dr. Parsons?
        Dr. Parsons. Well, I would just say that Chairman Massad
    has outlined a pretty clear set of principles for how to do
    this, and part of what he is looking to do is look back to the
    past. We have had derivatives exchanges operating, and clearing
    houses operating, for many years where we have been able to
    have business operate across boundaries, even under the older
    regime for futures and options markets. And that, in principle,
    should not be an obstacle, going forward. I think that is a
    kind of policy that will be viable in negotiations, going
    forward.
        Mr. O'Malia. Mr. Chairman, if I may, what Dr. Parsons could
    be referring to is the very workable solutions we have had in
    the CFTC rules under Part 30, recognizing foreign regulatory
    regimes. That has worked, and it has worked for years. What we
    are finding ourselves in is an inability to go back to that
    workable regime, and to recognize foreign jurisdictions, and
    that is a real frustration. So we have the template, as you
    have correctly pointed out. It is the Part 30 rules,
    recognizing foreign DCOs. But that is not what is happening
    today.
        The Chairman. I thank the gentleman. The Ranking Member, 5
    minutes.
        Mr. Peterson. Thank you, Mr. Chairman. Mr. Duffy, this end-
    user thing, you say that they are paying up to five times as
    much to clear trades, and the ag products are two times more
    expensive than credit default swaps. Can you explain to me why
    the ag products are more expensive than credit default swaps?
    Because, the credit default swaps are much more risky than ag
    products. How is that possible?
        Mr. Duffy. Well, they are much more risky, but, because of
    the way some of the rules are written, they fall outside of the
    scope of the law, so----
        Mr. Peterson. Now, who wrote those rules?
        Mr. Duffy. The CFTC wrote those rules.
        Mr. Peterson. But in Title VII we told them that they were
    not to put this on end-users. What is going on?
        Mr. Duffy. Well, again, we are saying that, potentially,
    credit default swaps can be cheaper, with a higher risk profile
    than agricultural futures, just the way the margin is
    structured today. And we don't believe it makes any sense
    whatsoever because of some of the loopholes that are
    potentially in this rule.
        Mr. Peterson. But, as I understand it, these requirements
    are being put on by the banks, by the FDIC, not by CFTC, and
    I----
        Mr. Duffy. Yes.
        Mr. Peterson.--as I understand it, CFTC doesn't necessarily
    agree with this.
        Mr. Duffy. When I mentioned earlier about the leverage
    ratio issue, where the banks have to account for so much
    margin, where they can't even have access to that margin, so in
    return the credit default swaps would be cheaper because they
    have to account for the ag products, not for the credit default
    swaps.
        Mr. Peterson. Right. But that is being done by the
    Prudential Regulators. It is not being done by the CFTC, right?
        Mr. Duffy. Right. I am sorry, you are correct.
        Mr. Peterson. Yes. So my question is, what I have been
    asking for the last 6 months, is why doesn't this get fixed?
    This is not our jurisdiction. This is another Committee's
    jurisdiction. We have known about this for some time. Why
    doesn't anybody fix this, other than just complain about it?
        Mr. Duffy. We have worked with the Administration, the
    Federal Reserve, and others, and the Basel Committee, to make
    certain that this leverage ratio issue gets resolved so we
    don't put ourselves into a situation where higher risk products
    are actually cheaper than agricultural commodities.
        Mr. Peterson. So how is this getting resolved? Can somebody
    explain this to me?
        Mr. Duffy. Well, as we start to walk through it with the
    regulators, and show them that the margin on deposit should not
    count against the balance sheet, people are starting to realize
    that this is not, but it is also multiple countries that have
    this. The United States has agreed with the Basel Committee on
    this. So we are not only dealing with the U.S., we are dealing
    with multiple other jurisdictions.
        Mr. Peterson. So does this require legislation, or can this
    be fixed with----
        Mr. Duffy. This can be fixed at the Basel Committee and the
    Federal Reserve.
        Mr. Peterson. Yes. So they are working on it?
        Mr. Duffy. We are very hopeful that they will give the
    relief on the margin issue not to be counted----
        Mr. Peterson. I hope so too, because it has been dragging
    on too long.
        Mr. Duffy. I agree.
        Mr. Peterson. On the issue of the EU holding up an
    equivalence determination over initial margin, can you describe
    the difference between the EU and the U.S. on initial margin?
        Mr. Duffy. Sure. On the client side in the United States it
    is 1 day gross margin, and on the house side it is 1 day net
    margin. In the EU it is 2 day net for both house and client.
    The difference is that Chairman Massad has shown that 1 day
    gross has about $38 billion when collecting in the clearing
    house. So our margin regime, even though it is 1 day gross
    versus 2 day net, is much higher. So we had to convince them
    and show them of that.
        They have still not deemed us equivalent in the European
    Union yet because it has become a competitive issue, where
    people are trying to race to the lowest bottom of margin. It is
    critically important, from a risk management standpoint, to
    have the appropriate margin in place. That is why our
    government, our regulators, saw 1 day gross as an appropriate
    weight for the client business. The client business is about 60
    percent, the house business is about 30 to 40 percent,
    somewhere in that neighborhood. So this is a big issue.
        So what they want us to do is to go to 2 days on our house
    business, and what they will do is say, ``We will give our
    clients in the EU the optionality to elect either 1 day gross
    or 2 day net.'' Well, we all know what they are going to elect,
    which is 2 day net, because it is $38 billion cheaper than 1
    day gross.
        Mr. Peterson. So----
        Mr. Duffy. There are imbalances right there.
        Mr. Peterson. Is this a legitimate issue, or is this a----
        Mr. Duffy. This is----
        Mr. Peterson. Or is this something that they are doing to
    get business.
        Mr. Duffy. This is an issue----
        Mr. Peterson. The European Union.
        Mr. Duffy. There is no question about it, this is a
    competitive issue.
        Mr. Peterson. So does blaming the European Parliament,
    which never can get anything done. That is not necessarily the
    real problem here.
        Mr. Duffy. Well, the problem is we need to be recognized in
    the European Union. You cannot recognize countries such as
    Singapore, Honk Kong, India like that, and not recognize the
    United States of America. I have said to this Committee many
    times before, this is the biggest slap in the face to the
    United States of America by not being recognized in the
    European Union. In my testimony I also said how business is
    being taken out of the United States and brought over to Europe
    because of these rules.
        Mr. Peterson. So how does Chairman Massad--hasn't he been
    on the ball on this, and----
        Mr. Duffy. Chairman Massad has done an outstanding job. He
    is dealing with a very difficult, to your point earlier,
    Parliament over in Europe right now. I think we are getting
    closer, but Mr. O'Malia said something very important about
    Part 30. Chairman Massad also has something he can use, which
    he could start pulling the foreign border trade designations
    for other clearing houses that want to do business in the
    United States if they will not deem us equivalent, which is
    exactly what should happen.
        Mr. Peterson. All right. Thank you. Thank you, Mr.
    Chairman.
        The Chairman. The gentleman yields back. Mr. Gibbs, 5
    minutes.
        Mr. Gibbs. Thank you, Mr. Chairman. The first two witnesses
    especially, I have heard a lot about lack of coordination,
    global framework hasn't been implemented, fragmentation. And I
    guess my question is: I am an end-user, I have been. For the
    end-user, it is price discovery, price transparency, has it
    been enhanced, or has it been reduced because of the
    implementation of Dodd-Frank? And then part of that question is
    too, have U.S. firms been put at a competitive disadvantage
    with the implementation of Dodd-Frank?
        So I guess the overall theme I am hearing is that this
    hasn't come together like it should. I know that Mr. O'Malia's
    testimony talks about the Basel Committee on Banking
    Supervision, and International Organization of Securities
    Commission September 2013 final national rules still haven't
    been published. That is almost 2 years. So is it because the
    Dodd-Frank is too restrictive, and have we put ourselves at a
    disadvantage compared to our foreign counterparts? And then,
    second, how has this had an impact on our end-users for price
    discovery, price transparency? Anybody to the right--first two,
    probably.
        Mr. O'Malia. Thank you for the question. Without a doubt
    Dodd-Frank has increased transparency, right? Talking about the
    basic data collection and oversight of the U.S., the work is
    improving. It is still a long way to go, as Dr. Parsons pointed
    out. Trade execution is coming online. It too could be better,
    and right now it is overly restrictive, and ISDA has suggested
    ways to improve the flexibility for end-users and participants
    in the market to access trading a much easier fashion, with
    more flexibility.
        I fear that as we merge and move towards clearing and
    trading with the Europeans, we are going to see the same
    results in trading as we have in clearing because of the points
    made here, that they are overly prescriptive, and we are not
    going to be able to find a broad----
        Mr. Gibbs. You mean that Dodd-Frank is overly----
        Mr. O'Malia. Dodd-Frank is overly----
        Mr. Gibbs. Okay.
        Mr. O'Malia.--prescriptive in trading. Have the costs
    increased, or have end-users been put at a disadvantage? I
    think the point that was made on the leverage ratio is
    precisely the point. A lot of these capital rules are beginning
    to come into play. We do not have a clear picture as to the
    individual costs of these rules, and the cumulative cost of the
    rules. And they are beginning to fall into place over the next
    3 to 5 years, and they are going to have massive increases on
    the banks which will make a difference on how they provide risk
    and liquidity to these markets.
        It is a changing factor, without a doubt. It is part of the
    outcome of the financial reform, but end-users are going to
    have a different price to pay to access these markets, and to
    access liquidity. Congress can really play a role in doing some
    oversight over the capital rules. This is not something that
    CFTC directly has responsibility of, but it is an outcome of
    the comprehensive Dodd-Frank reform. And you should ask for the
    individual and quantitative costs of these capital rules. The
    leverage ratio is a final rule, and we need to go back and fix
    it. Inquiring with the Basel Committee and the Prudential
    Regulators here about the status of that would be an
    appropriate oversight role for Congress.
        Mr. Gibbs. Mr. Duffy, would you care to comment on how you
    see it affecting the CME?
        Mr. Duffy. Well, I stated it earlier, but Mr. O'Malia said
    it correctly, this whole leverage ratio rule is an extremely
    burdensome rule that is going to hurt the end-users. As I said
    earlier, and I maybe didn't answer the Ranking Member's
    question as well as I should have, but because of the
    historical nature of agricultural products, that is one of the
    reasons why they are deemed to be higher risk than credit
    default swaps. It makes no sense whatsoever for that to happen.
        And that is the reason why what Mr. O'Malia said is true,
    we need to go back and re-visit this rule, especially on the
    leverage rule, because this money that is placed in the margin
    cannot be touched by a matter of law, so it should not count
    against the balance sheet and make other products more
    expensive for people that are using the markets.
        Mr. Gibbs. So this is a legislative fix, or can CFTC, in
    the rule----
        Mr. Duffy. This is a Basel/Federal Reserve fix, in my
    opinion.
        Mr. Gibbs. Federal Reserve?
        Mr. Duffy. I believe they have the ability to do so.
        Mr. Gibbs. Okay. All right. Thank you. I yield back.
        The Chairman. The gentleman yields back. Ms. Kuster, 5
    minutes.
        Ms. Kuster. Thank you, Mr. Chairman. Thank you to our panel
    for being with us. So my takeaway is that, 5 years in with
    Dodd-Frank, we are more transparent, more resilient, and we
    have minimized systemic risk caused by speculative derivative
    activity, but I also understand that we have further to go. The
    job is not complete, and you have talked today about some
    issues with regard to the international markets.
        My question is a little bit different. I have a concern,
    based upon a decision that was made by the majority in the
    Congress, about the CFTC re-authorization that recently passed,
    and my understanding is that this is going to woefully under-
    fund the CFTC, going forward, with the task that you have laid
    out. The funding level will limit the agency's ability to
    effectively implement the requirements of the law, and,
    including this cross-border derivatives that you have talked
    about today.
        So I would like to ask if the panel could speak to the
    effect that the current CFTC funding levels will have on the
    agency, and in particular the ability to collect and implement
    data that will be needed to effectively regulate the market.
    And if we could start with Dr. Parsons?
        Dr. Parsons. Yes. Well, the most important thing is just to
    appreciate how big the task is. So they have been tasked with a
    much, much larger market than they had ever had before, and it
    is a market that is only newly being regulated. So all of these
    issues in data reporting are issues where people are trying to
    grapple for the first time with how to organize this swapped
    data in a sensible fashion. That is an enormous task.
        I would emphasize that on top of the data reporting and the
    swaps exchanges, you have ongoing developments in technology.
    Now that we have electronic trading, we have seen the
    difficulties in electronic trading in a number of realms, and
    it certainly is impacting the futures and options market, and
    will impact the swap execution facilities. It is an enormous
    task for a regulator to have the technical capability to cope
    with the volume of data at hand. And then cybersecurity is
    another new challenge on top of trying to cope with and bring
    the swaps market into regulation. So I just think the burdens
    are very, very big, and need to be appreciated.
        Ms. Kuster. Do you have a concern about the level of
    funding, given this fragmentation, and what we need to try to
    accomplish to make this work better at an international level?
        Dr. Parsons. I do. I am not personally that involved in the
    details of the budget, but I know, for example, the $1.7
    trillion figure that I was quoting to you, which is commodity
    markets, everybody likes to say at the beginning of their
    speeches, it is the municipal utility, it is the farmer, the
    rancher, it is the airline company. Those are the $1.7 trillion
    that we don't have any good data on.
        Ms. Kuster. Yes.
        Dr. Parsons. But it is the interest rate swaps, and the
    credit default swaps which have been reported to you here are
    the ones where significant progress is being made, despite the
    preamble in the speeches. People think of those markets as
    small, and they know that their resources are very limited, so
    those commodity derivative markets are being overlooked because
    of limited resources.
        Ms. Kuster. So I just have 1 minute left. Anyone else on
    the panel have any comment on the funding? Sure, Mr. O'Malia.
        Mr. O'Malia. It is a great question, thank you, and the
    4\1/2\ years I spent as a Commissioner at the CFTC, we always
    focused on the budget and the needs. Right here you have three
    technology companies, and technology is where these markets are
    heading, and the ability to oversee these markets are based in
    technology. And I couldn't agree more with Dr. Parsons's
    analysis, that we really ought to focus and solve the data
    issues immediately.
        The technology budget, however, has always come second to
    every other priority at the Commission, and it has suffered
    from a lack of kind of long term planning----
        Ms. Kuster. Yes.
        Mr. O'Malia.--because it just hasn't articulated a very
    consistent direction for the Commission, and it could be done
    in a much more cohesive fashion and specific fashion. Each year
    Congress presents a budget. Each year it is slightly different,
    or the Administration presents a budget to the Congress, and
    the priorities kind of bang around with new things. Sometimes
    it has been DSIO, sometimes it has been enforcement, and it has
    really lacked kind of a cohesion and vision that is necessary
    to really implement a strategic planning around technology,
    which is the only way that the Commission is going to be able
    to keep up with automated markets and these broad global
    markets.
        Ms. Kuster. Mr. Duffy, I am sorry, you will have to ask the
    chair for his indulgence. My time is up. Thank you.
        Mr. Duffy. Real quick, what is important to note here,
    Congresswoman, is that when people are asking for additional
    funding because of the Dodd-Frank Act, or are they under-
    funded, they use the notional figure of swaps that they are
    going to have to now regulate. The number back in 2000 and
    2001, $761 trillion. That is on top of the $1.7 trillion that
    the Professor referred to as agriculture. The rest is about
    $700 trillion. Of those $700 trillion, there are 2,000 to 3,000
    transactions a day.
        In the world of listed derivative futures, between the
    Intercontinental Exchange and CME Group, we are talking about
    20 million transactions a day, with a notional value of over a
    quadrillion dollars a year. And we functioned flawlessly for
    years under the same amount of budget. So you cannot measure
    your budget of an agency by the notional value of the trades
    that you are doing. So I appreciate that the CFTC is probably
    under-funded to some extent, but also you can't base it on a
    notional value of trade. You have to base it on the amount of
    transactions, because there is no difference, and they are
    notional.
        The Chairman. The gentlelady's time has expired. Mr. Scott,
    for 5 minutes.
        Mr. Austin Scott of Georgia. Thank you, Mr. Chairman, and
    forgive me, I am having a few flashbacks to when I was a small
    business owner, and had licenses in multiple states, and the
    Federal Government, and sometimes the rules were in direct
    conflict with each other, and it made it absolutely impossible
    to comply with all of them. As we go through the next several
    months on this, and try to resolve these issues, I am looking
    forward to creating not only the transparency, but the
    consistency that we need to move forward. I have a couple of
    questions.
        Mr. Edmonds, in recent months the market events, the new
    research, the studies, and the current and former regulators
    have raised concerns about a deterioration in market liquidity,
    and the cumulative impact of the various new prudential and
    market regulations, and whether or not that is a contributing
    factor. Do you share these concerns, and the cumulative impact
    of the prudential and market regulations, is this causing the
    reduction in liquidity, and what is the price of the impact of
    that on people who are trying to hedge their risk?
        Mr. Edmonds. I think in a lot of ways--and thank you for
    the question. I think in a lot of ways it is the uncertainty
    that the activity around those items are introducing into the
    market. Let us talk about liquidity in the form of what it
    takes. And my friend, Mr. Thompson, will know a lot about this
    in his role. We think about how collateral works within the
    system. One of the goals of Dodd-Frank at the end of the day
    was we were going to better collateralize the risk that the
    economy faced.
        And that was all criticism when we came out of 2008. Yet we
    now have rules in place, a lot of because of what is going on
    in Basel that Mr. Duffy and Mr. O'Malia has spoken to today,
    that don't seem to be consistent with that. In a time of
    stress, a U.S. Treasury instrument, historically, goes up in
    value, because it is a flight to quality. Our international
    regulators have deemed U.S. Treasuries as a liquid instrument,
    but we haven't.
        So what is that cost at the of the end of the day
    introducing into the system, where a small business person,
    like yourself in your previous life, would sit here, and you
    would walk in, and you would say, ``I am going to do something
    to protect my business. I am going to take a very safe
    instrument, the U.S. Treasury, and I am going to introduce that
    as collateral into a clearing house, run by any one of us who
    are under the CFTC rule.'' And someone says, ``Yes, but that is
    not good enough.'' That is a problem.
        That is an uncertainty that we have in the system today
    that, because of what I defined in my testimony as prescriptive
    rules, we are trying to work our way through. It has a massive
    impact on the constituents of Mr. O'Malia in his role.
        Mr. Austin Scott of Georgia. Yes.
        Mr. Edmonds. So let us take that another place that--there
    is a call for an expanded list of collateral. The Europeans, in
    some cases, in the most recent legislation, they have
    eliminated the uses of letters of credit. There has been some
    thought here in the United States that we should not use
    letters of credit as acceptable forms of collateral. Whether we
    do or we don't, we just can't have a difference in rules, or we
    have to at least know what we are taking in the form of
    collateral.
        So as a small business user at that moment in time, you
    have to think very quickly if you are going to use these
    markets to protect the risk that you have on your books, and to
    make your ability to earn a living safer. How do you answer
    that question? I don't know that any of us can give you a
    declarative answer on that. We are stunned by some of it in the
    same way.
        Mr. Duffy. What is really fascinating, and what he is
    bringing up right now, is other clearing houses around the
    world will take U.S. Treasuries as good collateral, where our
    own government won't take them as good collateral.
        Mr. Austin Scott of Georgia. Dr. Parsons, how dire do you
    believe that the need for standardization of the form and
    format of swap data being collected is?
        Dr. Parsons. Well, it will be better if it gets
    standardized. We do want information to be crossing boundaries,
    but we need to understand that we don't even have good
    information inside our own island, let alone cross-border
    comparisons.
        Mr. Austin Scott of Georgia. Mr. Thompson, I have 30
    seconds left, but could you provide an example of just how
    different the various reporting requirements can be in
    different jurisdictions?
        Mr. Thompson. Sure, Representative Scott. In Europe you
    have two-sided reporting, and here in the U.S. you have one-
    sided reporting. That is just one. You also have different
    definitions as to what needs to be reported. Now, I used a very
    simple example. You have a definition now of what is a date.
    And, of course, you can write a date in Europe a number of
    different ways. You can start with the date, you can start with
    the month. There is no clear definition there.
        If you are just using those as simple examples, you will
    get very different data information, and you will get breaks in
    the data, depending on which way the reporting party enters
    that data into it from the two-sided view that you are going to
    have.
        Mr. Austin Scott of Georgia. Thank you. And, gentlemen,
    thank you for being here.
        The Chairman. The gentleman's time has expired. Ms. Adams,
    for 5 minutes.
        Ms. Adams. Thank you, Mr. Chairman. Thank you, Ranking
    Member Peterson, and thank you gentlemen for your testimony. My
    district has more than 37,000 financial service employees,
    along with a host of end-users, many of which are directly
    impacted by Dodd-Frank. This law was a much needed conduit in
    bringing our nation's financial markets under greater, more
    supervised regulations. And while banks and non-banking firms
    play an important and necessary role in our economy, it is
    imperative that we have mechanisms to provide the checks and
    balances.
        And having said that, Dr. Parsons, if Dodd-Frank had been
    passed prior to the financial crisis of 2008, what do you think
    might have played out differently?
        Dr. Parsons. Well, Dodd-Frank is a big law. Let me focus
    just on the derivatives piece. One of the most shocking
    experiences in the crisis was the experience with the insurance
    company AIG, and the credit default swaps it had sold. That
    accumulation of non-margined risk was a huge problem, which
    Dodd-Frank no longer makes possible.
        But it was also a problem because the regulators were
    suddenly confronted with this big issue, and did not have
    information about the larger market, and AIG's place in it, to
    give them the ability to respond sensibly. So, like in other
    situations during the crisis, the regulators and the government
    authorities were presented with a disaster that needed
    resolution now, and foreclosed sensible solutions.
        So the Dodd-Frank Act, in providing information and
    supervision, gives regulators and committees such as yours more
    ability to take control and respond to the situations in a
    sensible fashion.
        Ms. Adams. Thank you, sir. Moving more specifically to the
    expanded role of CFTC oversight, particularly with regards to
    the swaps derivative market, Mr. O'Malia, what is your
    assessment of the handling of the swaps market, and what
    resources can Congress provide to help CFTC provide better
    oversight of this market?
        Mr. O'Malia. Thank you. We have recommended in our
    testimony, and my testimony, that the regulators engage with
    the industry to quickly adopt industry convention standards
    around data reporting. I think many of the firms at the table
    can provide solutions around specific data sets, and use, and
    symbology and terminology, and taxonomy is probably the
    appropriate term, but to utilize those that are already in the
    market today to get a globally consistent standard for data
    reporting. This could help move the needle quite fast, in terms
    of global standards.
        We need endorsement from the regulators. Right now we don't
    know what the pathway is. We are ready to respond as called,
    but we think that, by having a seat at the table and engaging
    with the regulators, we can provide a very useful data set very
    quickly that have rapid uptake, because we will be more
    familiar with an industry standard that a separately developed
    standard. And, working through IOSCO and CPMI would be the
    appropriate venue further. These are the international
    coordinating bodies.
        Ms. Adams. Thank you. Mr. O'Malia, how have costs for end-
    users of swaps, including small banks that use swaps to hedge
    interest rate risk changed as new requirements for swap
    transactions have come into effect?
        Mr. O'Malia. Well, the adjustments are subtle, but
    beginning to manifest themselves, and we are beginning to see
    some real significant changes. Many of the capital rules have
    not yet been put in place, and we are just now discovering kind
    of the cumulative impact these capital rules have. As Mr. Duffy
    talked about, the leverage ratio rule is very problematic, as
    it poorly characterizes the protection that SEC provides, and
    treats it as leverage, and that is inappropriate.
        We are ready to talk and do the analysis around data to
    support the review that regulators can do, and to get into the
    data, and try to understand the ramifications of the increase
    in cost associated with the capital charges.
        Ms. Adams. Thank you very much.
        The Chairman. The gentlelady's yields back. Mr. Davis, 5
    minutes.
        Mr. Davis. Mr. Chairman, thank you, and thank you to the
    witnesses. The problem with going so late in the hearing is
    that the questions I initially had on clearing, and reporting,
    and others have really been asked. And I don't like to be
    redundant, and I do want to comment on my friend Mr. Duffy. I
    am glad you are here again, Terry. I joked with you earlier we
    are going to name that end of the witness table the Terry Duffy
    wing.
        But it does show your willingness to talk about issues that
    are very important, and very intricate issues for many of us,
    as policymakers, to have to try and address. So all of your
    willingness to be here, even on a regular basis, is very
    helpful, and it shows the desire for more transparency within
    the swaps markets, within the issues, the derivatives that all
    of you are addressing today.
        So let me focus instead today on some coordination issues.
    And I want to ask Mr. Duffy, Commissioner Giancarlo recently
    criticized the FSOC as an unmitigated disaster at its role at
    implementing hundreds of new rules and regulations mandated
    under Dodd-Frank. Do you share Commissioner Giancarlo's views
    on the work of FSOC, and if FSOC's not prepared to coordinate
    U.S. financial rulemakings, is there another body that should
    do so?
        Mr. Duffy. I don't know if I will say it is an unmitigated
    disaster. I will say that there are always issues when it comes
    to these type of things, Congressman. I am not quite sure that
    when the Commissioner's referring to all the different rules,
    if he has problems with certain ones, or he is just
    characterizing the whole thing as a disaster, is there another
    body that could be more helpful in doing this? I am not so
    certain that is true or not true. You would have to see what
    that body is, and I would not be the expert to say where it
    should go. So maybe somebody else on the panel could better
    answer that question for you.
        Mr. Davis. Mr. O'Malia?
        Mr. O'Malia. FSOC could serve the public better if it was
    more transparent, and it had a more diversified participant
    base. As you may know, it is only the Chairmen of the various
    Commissions. It could probably be broadened. The CFTC, the SEC
    are a balanced Commission of three to two in favor of the
    President's party, and those work very well. They bring
    bipartisan solutions. I think the FSOC could benefit by that,
    and additional transparency.
        We are obviously coordinating important rules that have
    gone through some APA reviews, and those are the appropriate
    steps, cost-benefit analysis, APA, notice and comment are
    essential to making good rules, and FSOC could benefit by
    pulling that page out of the playbook.
        Mr. Davis. I see. Anybody else on the panel want to address
    this issues?
        Mr. Edmonds. I am going to echo Mr. O'Malia's comments
    about the transparency. Mr. Thompson, myself, Mr. Duffy, we all
    have organizations that have been deemed systemically important
    until Title VIII of Dodd-Frank. That designation in and of
    itself puts you right square in the FSOC world. I don't know
    that any of us can tell you exactly what that means at any
    moment in time on any given issue.
        For us to better educate, impact that process for the
    betterment of the community as a whole is very difficult at the
    end of the day. That is not saying they are not doing very
    important, very hard work, but I couldn't tell you that the
    level of communication is something that you would find
    consistently acceptable.
        Mr. Davis. Thank you. Mr. Thompson?
        Mr. Thompson. Yes. I would say FSOC is a relatively young
    organization, and like other parts of Dodd-Frank that we have
    spoken about, it is probably a work in progress that can only
    get better. We at DTCC, well before we were designated as
    systemically important, knew our importance to the U.S.
    economy, and to the global economy. So we always viewed
    ourselves as systemically important, took that very seriously,
    as I am sure the other organizations did too, in terms of our
    risk management and resiliency efforts.
        So we try to work very hard with the FSOC. Again, as I
    said, I think very much so it is a work in progress that needs
    to be continued.
        Mr. Davis. Great. Dr. Parsons, I have about 30 seconds.
        Dr. Parsons. Yes. I would just like to give you one quick
    example. Securities and Exchange Commission found it very
    difficult to confront the systemic risk in mutual funds--money
    market funds, excuse me, and the FSOC gave them a kick in the
    pants, and that was very helpful, and we should appreciate that
    kind of thing.
        Mr. Davis. Great. You did it in 20. Thank you. Thanks to
    the witnesses. I yield back.
        The Chairman. The gentleman yields back. Mr. Abraham, for 5
    minutes.
        Mr. Abraham. Thank you, Mr. Chairman, and thanks for the
    witnesses for being here. It has been, for me, very
    informative. I will address my first question to Mr. Duffy, and
    any of the panel can surely weigh in. I have heard that certain
    countries allow U.S. Treasuries for collateral, we don't. I
    have learned that some countries base security on 1 day's net
    compared to 2 days' gross. It seems like the rules are just all
    over the place. I don't see how anybody plays in this arena.
        So take me back up to the 30,000 view, so to speak. Why
    haven't countries in the G20 conformed to a common data
    standard? Is it a money issue? Some people have an advantage if
    they don't conform? Is it a technology issue, or is it just an
    attitude issue that, ``Hey, we are not going to play because we
    don't have to play.'' Why doesn't everybody conform to these
    rules?
        Mr. Duffy. You would think in a global market that people
    would conform.
        Mr. Abraham. I do. I would.
        Mr. Duffy. And when we are talking about margin
    collections, there should never be a race to the bottom for
    margin. If you want to introduce more risk into the system,
    just have a race to the bottom on margin.
        Mr. Abraham. Right.
        Mr. Duffy. So when we show that 1 day gross is $38 billion
    higher in our clearing house than any clearing house in the EU
    under 2 day net, they should say, ``Okay, from a risk
    standpoint, we think that is a better proposal, even though
    they tried to say that 2 day net was more.'' So you cannot draw
    any other conclusion, sir, other than there are competitive
    issues, there are lobbying issues going on through European
    clients to bring business to their different institutions that
    have a lower margin, because cost of capital is very intense.
        Mr. Abraham. So, as a lot of answers in life, it is all
    about the money, then?
        Mr. Duffy. It is all about the money. And as I said earlier
    in my testimony, sir, when I was sitting in front of this
    Committee testifying about Dodd-Frank, I did say multiple
    times, we are going to be the country that institutes a 2,300
    page document before the rest of the world even decides what
    they are going to do. There is nothing wrong with being a good
    leader, but, at the same time, if you don't have coordination
    in a global market regulatory framework, you are going to have
    the problems that we have all outlined in our testimonies
    today.
        Mr. Abraham. Yes, well, our job in Congress is to herd the
    cats for you guys, and try to bring them in line. Go ahead.
    Yes, sir.
        Mr. Edmonds. I was taken back up to the 30,000 level that
    you were talking about. The ultimate outcome, and Mr. Duffy and
    I are not going to argue on the math of it, we have all seen
    the same stuff, but it can't be different.
        Mr. Abraham. I agree.
        Mr. Edmonds. That is the issue. If you want to give someone
    advice and counsel, in order to increase the certainty in the
    market, it has to be the same. Otherwise, the goal from
    Pittsburgh about not creating regulatory arbitrage is no longer
    a goal.
        Mr. Abraham. Mr. O'Malia?
        Mr. Duffy. Can I jump in there?
        Mr. Abraham. Sure.
        Mr. Duffy. Because, what is important here is we have
    offered to the European Union, of which, Mr. Edmonds, is
    regulated in London, parts of it, we said, ``We will tell you
    what we will do, we will take the higher of. Whatever you guys
    want to do, we will do the higher of, but it has to be the same
    for everybody.'' They absolutely threw that out the window. It
    goes to show you it is a competitive issue, sir.
        Mr. Abraham. Right.
        Mr. O'Malia. I would urge Congress to pay attention to the
    development of the OTC margin rules coming forward. The good
    news is this has been done from a global perspective. I first
    voted on these rules back in 2011. Since then there has been a
    global effort to harmonize the OTC margin rules, which are
    expected out this summer.
        There are some differences between jurisdictions. One of
    them deals with inter-affiliate trades. The U.S. would have to
    apply initial margin on inter-affiliate trades. In Japan and in
    Europe, that is not the case. This puts U.S. firms at--it is a
    difference, right? It is a significant difference. There are
    other differences. European rules have hair cutting on
    collateral and foreign exchange.
        This is a globally developed rule, right? This has been
    harmonized at the international level. If they can't come to
    agreement on this rule, where can they come to agreement on.
        Mr. Abraham. All right. Thank you. Dr. Parsons, real quick,
    I don't have a degree in quantitative analysis, but if I saw
    the $1.7 trillion figure 90 weeks in a row, I too would be
    suspect of its accuracy. You said something in your testimony
    about a swap trade, a central area to report it. Where, in your
    opinion, would be best to centrify this type of data so that
    everybody could access it at the same time, and it would be
    equalized?
        Dr. Parsons. So the data is being reported to data
    repositories that everybody can access. The problem is a lot of
    the data is true. It is not reported correctly.
        Mr. Abraham. How do you get rid of that difference?
        Dr. Parsons. Well, there are two ways. The regulators are
    making an effort to be more prescriptive, but it is also true
    that businesses are sometimes not being sensible in the way
    they report, and sometimes businesses choose to purposefully
    game the system, and not share all the information that they
    want.
        They are asking for prescriptive direction as an excuse,
    when we should be holding them to a standard to be reporting
    the normal way, and the normal degree of refinement.
        Mr. Abraham. Thank you. I am out of time, Mr. Thompson. I
    will yield back, Mr. Chairman.
        The Chairman. The gentleman's time has expired. Mr. Kelly,
    for 5 minutes.
        Mr. Kelly. Thank you, Mr. Chairman, and thank you to the
    witnesses for being here. Mr. Thompson, and I will try to
    phrase this question in a way that you can understand, speaking
    to the cross-border application and risk, what practices can
    we, as Congress, do either to emplace or remove things to
    facilitate the reduction or mitigation of cross-border risk, or
    to increase transparency?
        Mr. Thompson. I am glad you asked that question. First, as
    we have said in our testimony, both written and oral, we think
    having very clear standards and data sets would be
    extraordinarily helpful. The key thing there would be to
    encourage the regulator not to be prescriptive in that fashion,
    but to work with the industry. We have been working with ISDA
    and with CPMI/IOSCO coming up with a common data set, for
    instance, for systemic risks across all of it. And we have
    actually done that for credit default swaps. We are not looking
    forward to doing that with interest rate swaps, and we will go
    through each one of the asset classes. And we have been working
    with Scott's organization to do that very effectively.
        The other thing that we need to do, though, is to make
    certain that we don't get that far head of all of the other
    regulators. One of the issues with Dodd-Frank was we, in fact,
    were trying to lead the rest of the world. Well, the rest of
    the world didn't want our leadership. What they wanted was our
    cooperation. And so what we want to try to do is make certain
    that we are cooperating with the rest of the world in a group
    that you can actually sit down and have discussions with. We
    think that is CPMI/IOSCO. We think that is the right place
    where you can have a discussion about what these issues are,
    come up with common standards, and then drive that process
    forward on the local levels as you go back to each
    jurisdiction. Thank you.
        Mr. Kelly. Thank you for your response. And if any other
    member at the table would like to respond to that, I would also
    be interested to hear your views.
        Mr. O'Malia. On the data question, I have kind of an
    interesting anecdote, the Europeans are developing their method
    to review. This is their Dodd-Frank implementation, and they
    were developing a liquidity test, and they were using European
    data. And the data they put forward was completely different
    than the data we have seen about U.S. markets in the U.S. data.
        And we had to develop our comment letter on the European
    data rules--or on the trading rules--liquidity rules using U.S.
    data because we don't have access to European data. And they
    mischaracterized the differences between the U.S. dollar market
    significantly, two to three times larger than what it actually
    was.
        Without having solid data, and accurate data, you are going
    to continue to find and develop rules based on misinformation,
    and that is kind of what we are facing right now. And you are
    going to come up with some radically different rules between
    the U.S. and Europe if you can't reconcile that data.
        Mr. Kelly. And just very briefly, Dr. Parsons, how
    significant is the reporting of the $1.7 trillion commodity
    markets being the same over that period of time, and who or
    what body, or can this body, as the United States Congress, who
    can fix that?
        Dr. Parsons. Well, I purposefully chose it--first of all,
    that it is, as I said, something that I stumbled upon, so it is
    just very directly how I felt the problem. But I also thought
    it was just something that is so transparently clear that there
    is a problem. I think this whole conversation about data can be
    very confusing to many people. The fact that we are--I don't
    even understand why we are trying to report a number that we
    know is not right. That just seems really wrong. It really
    tells us the state of the situation, and helps to draw people
    in to what is not being done.
        You have heard from many of us here. There is a common
    appreciation that the data has a lot of problems, and needs
    some attention.
        Mr. Kelly. And this is more--I am about out of time, but
    this is more in comment, as opposed to a question. But data is
    very important, but what is important is turning data into
    information that this body can use. So just in the future,
    maybe in writing, you can tell us how can the CFTC turn data
    into information that both you and this body, this Congress,
    this nation can use. And with that I yield back, Mr. Chairman.
        The Chairman. The gentleman yields back. Thank you. Mr.
    Allen, for 5 minutes.
        Mr. Allen. Yes, sir. Thank you, Mr. Chairman, and I have
    been very interested in what we are talking about today. And
    just to clear up just a few things, of course, as a small
    business owner, It has been quite a disconnect between the
    business community and the government on how to regulate.
        Is that a problem here in what we are trying to accomplish
    with this? Are we getting feedback from our business community
    on, okay, this is the way to do that, and are the regulatory
    people listening to you about how to fix these issues?
        Mr. Edmonds. I will take a shot at that. The way I would
    want to answer that question is what has happened is that
    conversation has created uncertainty, because there are so many
    different moving parts around the globe that impact what the
    final outcome of any one of these implementations might be. For
    anyone to give a declarative answer that is going to be held as
    sacrosanct, that you have the certainty of how to operate your
    small business, it is a bit dangerous. Because we may be coming
    back to you in a few months, and we know we told you it was
    ``X'' 3 months ago----
        Mr. Allen. Yes.
        Mr. Edmonds.--but now, because of the implementation of
    this next phase of this global regulatory reform, it is really
    going to be ``X'' plus some variable that we don't know. That
    uncertainty does find its way into the business community. They
    want to come ask questions. They ask questions of all of our
    different respective groups represented here. They ask
    questions of the regulators. Sometimes they get different
    answers, sometime we get different answers.
        I said in my oral testimony we spend a lot of time around
    unnecessary cost, both the time of the regulators of the
    business community, and those of us who operate infrastructure
    within that marketplace. So it is never going to be perfect. We
    live in a world where there is always going to be some level of
    missed information, but we have a stated goal. And if we are
    all talking about the stated goal, let us figure out a way to--
    --
        Mr. Allen. But it is good if we understand each other. Mr.
    Duffy?
        Mr. Duffy. Can I just give you a quick example, sir----
        Mr. Allen. Yes, sir.
        Mr. Duffy.--of how the government is bumping heads with
    some of the business community? This is the Agriculture
    Committee. This is a critically important marketplace to this
    country because of the food that we supply to not only our
    country, but to the rest of world.
        There is a rule at the CFTC where, on the hedge exemptions
    for bona fide users, such as the biggest producers of food in
    this country, whether it is Cargill, ADM, Bungie, any one of
    the big producers that you want to talk about, they could--they
    need to get anticipatory hedge exemptions. They should get
    anticipatory hedge exemptions so they can do the needs of the
    risk management so we can all afford the food that they are
    producing, with the ebbs and flows of it.
        These are little rules that agribusinesses are bumping
    against, and every Member of Congress has some agribusiness in
    their district. They should be very focused on this particular
    hedge exemption role for the users. This is not a speculator
    issue. This is a bona fide agribusiness issue.
        Mr. Allen. Yes?
        Mr. O'Malia. Mr. Allen, the testimony we have submitted is
    the cumulative work of the industry and users, banks and buy
    side, working together, trying to articulate specific solutions
    and recommendations, going forward. We appreciate the
    opportunity to come here and testify today to present kind of
    the compendium of recommendations. It is imperative, and our
    frustration is we are making good headway. We are clearing
    trades, we are on exchanges, we are supplying data. We are
    moving towards a harmonized OTC rule. We are working very hard
    to implement all of these, and quite successfully we have done
    so.
        But there is some uncertainly, both have pointed out, that
    the Commission won't give us answers. The no action relief that
    is uncertain. What is the status of the cross-border rule? When
    does it end? When we have staffs that have been temporarily
    registered for almost 2 years. Trade data repositories 3 years.
    When do they get their final registration? We are tired of
    waiting.
        Mr. Allen. Yes.
        Mr. O'Malia. We know that reforms need to be made. And we
    brought this to you, and hopefully you can, through your
    oversight responsibilities, ask the same questions of the
    regulators, and ask for specific results, time tables, and
    action.
        Mr. Allen. Good. Well, as I learned in business, just let
    us know what the rules are, and give us certainty, and we will
    figure out how to get it done. And I hear what you are saying,
    and agree with you wholeheartedly.
        I do want to ask one--I am about out of time, but, during
    the crisis we had an intense focus on market liquidity. Do you
    believe that those liquidity concerns still pose a real risk
    for our economy today?
        Mr. Duffy. I will take a shot at it. Liquidity has been a
    big issue, especially as it relates to the U.S. Treasury debt.
    As you know, one of the biggest participants in the marketplace
    is now at Janus, Bill Gross, and he has said that the liquidity
    has been at its all-time worst in the Treasury fixed income
    market today. So that is not a good sign, but that is a
    function of the macro events that we are looking at today. We
    have basically rates sitting at zero. Nobody is playing into
    the game. Nobody believes they need to hedge that up anymore.
        So those are different types of issues where the liquidity
    has become a problem. I am concerned that this could affect our
    government and our country dramatically if those rates rise
    from zero to three or four percent overnight. And I am not
    saying they will, but that is where you can really affect this
    country. And then we will have too much liquidity, and a big
    problem.
        Mr. Edmonds. And just to add on that, the one place you
    could look at it from your seat and see where if you look at
    their repo market that is there. And I am sure Mr. O'Malia has
    some thoughts on that, given his constituency and things of
    that nature, Mr. Duffy, and I am certain we do. I won't take
    any more time. You can look at that----
        Mr. Allen. Yes, well----
        Mr. Edmonds.--and see that impact----
        Mr. Allen.--please get that information to us, so we can
    deal with it. Thank you. Mr. Chairman, sorry about the time.
        [The information referred to is located on p. 67.]
        The Chairman. The gentleman's time has expired. I want to
    thank our witnesses for coming today, and thank the Members for
    being a part of this hearing. Mr. Duffy, I appreciate you
    pointing out that it is not really notion of value that is the
    issue, it is trades, and the number of trades, as we all try to
    properly resource the CFTC. They have gotten some pretty good
    increases recently, and one of the things we would like to be
    able to do is try to understand what they have done with those
    increases that they have gotten, and how that has been
    implemented, where the technology is or isn't. We have some
    language in our bill that would help address the understanding
    on the technology side.
        Dodd-Frank is a law. It is not a covenant. It is not a
    relationship between us and God. It is a law, and it was
    written by people, many of whom had biases and agendas. Some of
    which could get worked out. Others had biases in the
    implementation of it, and we are struggling to make it better.
    I didn't hear one witness, I didn't hear one Member today talk
    about throwing it out, or repealing, or anything like that.
    Those days are behind us. We are now in the coping phase, and
    trying to make it work phase. And to hold it sacrosanct, and to
    argue that any change at all somehow threatens the world is
    misplaced. Because there has never been a law, in my view, that
    has been written perfectly. Every one of them should be looked
    at periodically to see what is working and what is not working.
        Unfortunately, with this one, we are not all the way to
    what is working yet, because there are additional rules that
    have to get implemented, and proposed, and written, and I am
    hopeful that the CFTC, as they have learned with respect to the
    cross-border things that are going on with the rules that have
    been put in place, that, as we look at those new rules moving
    forward, that there is some accommodation given, or some
    appreciation given to the fact that these are global markets,
    and we intend them to be global markets.
        I am an American, and I am unapologetically American, but
    that doesn't make us perfect, and that doesn't make us the best
    at every single thing. There are some other folks in the world
    who might have good ideas from time to time, and we ought to
    have the strength of self-confidence to be able to look at
    other people's ideas to say, what one might be just a little
    better than ours, or, at a minimum say, that is close enough to
    ours that we can live with it, and they can live with it moving
    forward.
        I appreciate our panel for helping point out some of those
    today. There are others that we couldn't get in the testimony
    that--looking forward to working with you. But the things we
    can agree on is that we ought be to be trying to make it
    better, make it work better, protect the public the way it
    needs to get protected. But that transaction cost didn't make
    sense, and continue to provide the services that are out there.
        One of the unintended consequences that we came across was
    that the Amish can no longer trade, because we have moved the
    swaps to the electronic market, and they can't trade in
    electronic markets. So every time we do something we really
    think is good, there is always another side to the story as we
    move along. So I want to appreciate the panel. I suspect we
    will see some of you again in the future as we, again, have a
    common purpose of trying to create a functioning regulatory
    scheme that does, in fact, work for as many people as possible.
        The Ranking Member had something else he had to go do, he
    couldn't stay until the end. 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 question posed by a Member.
    This hearing on the Committee of Agriculture is adjourned.
        [Whereupon, at 11:29 a.m., the Committee was adjourned.]
        [Material submitted for inclusion in the record follows:]
    Supplementary Material Submitted by Christopher S. Edmonds, Senior Vice
          President, Financial Markets, IntercontinentalExchange, Inc.
    Insert
              Mr. Allen. Good. Well, as I learned in business, just let us
            know what the rules are, and give us certainty, and we will
            figure out how to get it done. And I hear what you are saying,
            and agree with you wholeheartedly.
              I do want to ask one--I am about out of time, but, during the
            crisis we had an intense focus on market liquidity. Do you
            believe that those liquidity concerns still pose a real risk
            for our economy today?
              Mr. Duffy. I will take a shot at it. Liquidity has been a big
            issue, especially as it relates to the U.S. Treasury debt. As
            you know, one of the biggest participants in the marketplace is
            now at Janus, Bill Gross, and he has said that the liquidity
            has been at its all-time worst in the Treasury fixed income
            market today. So that is not a good sign, but that is a
            function of the macro events that we are looking at today. We
            have basically rates sitting at zero. Nobody is playing into
            the game. Nobody believes they need to hedge that up anymore.
              So those are different types of issues where the liquidity
            has become a problem. I am concerned that this could affect our
            government and our country dramatically if those rates rise
            from zero to three or four percent overnight. And I am not
            saying they will, but that is where you can really affect this
            country. And then we will have too much liquidity, and a big
            problem.
              Mr. Edmonds. And just to add on that, the one place you could
            look at it from your seat and see where if you look at their
            repo market that is there. And I am sure Mr. O'Malia has some
            thoughts on that, given his constituency and things of that
            nature, Mr. Duffy, and I am certain we do. I won't take any
            more time. You can look at that----
              Mr. Allen. Yes, well----
              Mr. Edmonds.--and see that impact----
              Mr. Allen.--please get that information to us, so we can deal
            with it. Thank you. Mr. Chairman, sorry about the time.
    Barclays
    The Decline in Financial Market Liquidity
      Jeffrey Meli, +1 212 412 2127, jeff.meli@barclays.com
      Brian Monteleone, +1 212 412 5184, brian.monteleone@barclays.com
      Eric Gross, +1 212 412 7997, eric.gross@barclays.com
      Conor Pigott, +1 212 412 3441, conor.pigott@barclays.com
      Joseph Abate, +1 212 412 7459, joseph.abate@barclays.com

       Banking regulation has intensified since the financial and
            sovereign crises in a global effort to improve the safety and
            stability of the financial system. Regulators have forced banks
            to change their capital structures and their business models to
            enhance the safety of the banking system and make future
            financial crises less likely.

       These new regulations have materially improved the stability
            of the financial system. However, in an effort to reduce the
            risk of future fire-sales financed by short-term debt, they
            have also reduced the supply of safe, short-term, liquid assets
            such as repurchase agreements, causing them to trade at lower
            yields (and, by extension, higher prices).

       The reduction in the supply of short-dated safe assets and
            associated fall in the liquidity of fixed income markets has
            created incentives for investors to look to non-traditional
            sources of liquidity, such as ETFs and mutual funds. In turn,
            this may result in a transfer of fire-sale risk into assets
            such as leveraged loans and investment grade and high yield
            bonds, as liquidity in the underlying investments of these
            funds deteriorates, exposing end-investors to run risk.
    A Changing Landscape
        Before the crisis that erupted in 2007, many banks operated with
    too little equity and were overly reliant on short-term wholesale
    financing, such as ``repo'', or repurchase agreements, to fund illiquid
    investments. When the crisis began, these banks did not have the
    capacity to absorb losses, given their limited capital base. Regulators
    have addressed this by forcing all banks to significantly increase
    their capital ratios, which are now higher than at any time since World
    War II. Excessive reliance on short-term financing exposed some banks
    to destabilizing runs when investors pulled their financing as the
    crisis began to mount, contributing to failures. More important from a
    systemic point of view, this precipitated the fire-sale of assets
    financed by short-term debt, driving down the prices of specific
    assets. This contributed to system-wide funding issues, even for banks
    with relatively strong balance sheets. To reduce the risk of future
    fire-sales, several of the new initiatives have targeted repo and other
    short-term liabilities, resulting in a more than 50% reduction in repo
    balances relative to their peak. In particular, the Volcker Rule was
    introduced to address illiquid and riskier investments that had
    burgeoned in the banking sector before the crisis.

              The best evidence of the effect of new regulations probably
            comes from the credit market, where the spreads of bonds issued
            by the largest banks have narrowed significantly . . .

        Whether these steps will be sufficient to curb future crises
    remains an open question. But it is clear that the new regulatory
    environment has materially improved the stability of the system. The
    best evidence of the effect of new regulations on banks probably comes
    from the credit market, where the spreads of bonds issued by the
    largest banks have narrowed significantly and, in many cases, are now
    tighter than industrial spreads. In other words, bond investors believe
    bank safety has improved so much that they are once again willing to
    accept low spreads for bank risk.\1\
    ---------------------------------------------------------------------------
        \1\ This argument is bolstered by the fact that banks arguably
    benefited from implicit government support (i.e., bail-outs in the
    event of a disruption) pre-crisis, causing their credit spreads to be
    artificially low. Subsequent changes to regulation have likely reduced
    or eliminated the extent to which banks will benefit from bail-outs in
    any future crisis, which would bias bank spreads wider absent the
    improvements in credit quality that we cite.
    ---------------------------------------------------------------------------
        Less well understood are the broader effects of improved stability
    on investors and the economy. Last year, we wrote that decreased bank
    lending was one potential implication (see The cost of evolving bank
    regulation, (https://live.barcap.com/go/publications/
    content?contentPubID=FC2008788) 13 February 2014). This year, we focus
    on the implications of two separate, but related, changes in financial
    markets.

       The reduced size of the repo market. This large, but
            relatively esoteric, part of the financial market is used by
            hedge funds and banks to finance securities and by money market
            funds to invest cash.

       The fall in liquidity in fixed income markets, demonstrated
            by a decrease in turnover and an increase in bid-offer spreads.
            This is related to the changes in repo, which is an important
            financing tool for banks' market-making operations, but is also
            driven by other changes that have made banks less willing to
            warehouse risk on behalf of investors.

        These changes have important consequences for financial market
    participants, including hedge funds and insurance companies, which are
    having a harder time financing securities and positioning their
    portfolios and are paying higher transaction costs. Retail investors
    are also paying higher transaction costs in their mutual funds, and
    there is evidence that poor liquidity is affecting the behavior of
    active managers. However, these seem like relatively small prices to
    pay for a material decrease in the likelihood and magnitude of future
    financial crises.

              The decline in repo has reduced the supply of safe, short-
            term assets . . .

        We believe there are two broader implications that are more likely
    to be disruptive, particularly once (if) interest rates begin rising.
    First, the decline in repo has reduced the supply of safe, short-term
    assets. Relatively few assets fit this description: Treasury bills,
    bank deposits, and repo. The reduction in repo is happening as Treasury
    bill supply is shrinking and banks are less willing recipients of
    deposits, given lackluster loan demand. As overall supply of such
    assets declines, we believe investor demand for them is relatively
    inelastic and a function of financial wealth, which has been rising. We
    expect excess demand for short-dated safe assets to cause them to trade
    at lower yields (i.e., higher prices), even as and when interest rates
    begin to normalize. This applies to deposit rates, which we believe
    will lag any rate hikes, such as we expect in the U.S. later this year,
    as investors remain willing to accept low interest rates to maintain a
    base of liquid assets. Similarly, money market funds may need to accept
    lower rates to remain invested.

              . . . creating incentives for investors to look to
            nontraditional sources of liquidity . . .

        Second, reducing the supply of these safe, short-dated assets
    creates incentives for investors to look to non-traditional sources of
    liquidity. Migration to seemingly liquid alternatives has happened
    before: in the pre-crisis period, safe short-dated assets were in
    limited supply (relative to financial wealth) because of the tremendous
    run-up in equity prices. The result was a massive spike in CP, repo on
    structured assets such as ABS and CDOs, and auction rate securities,
    all of which purported to offer the daily liquidity investors were
    seeking. But this liquidity dried up once the crisis began.
        For various reasons, the same alternatives will not be chosen this
    time around: the changes in regulations, investors' collective
    experiences with those investments, and the simple fact that many of
    them no longer exist. However, there have been increased flows in other
    vehicles that offer daily liquidity, such as ETFs and mutual funds. The
    desire for liquidity may also be limiting demand for closed-end fixed
    income funds, which would seem a natural response to the decline in
    fixed income liquidity.
        The inflows into ETFs and mutual funds are happening just as
    liquidity in the underlying investments that these funds purchase is
    deteriorating. This has raised new concerns about ``retail runs'' and
    fire-sale risks in such assets as leveraged loans and investment grade
    and high yield bonds, where either liquidity has dropped most severely
    and/or where the funds offering daily liquidity have grown the most.
    Ironically, these new fire-sale risks have arisen in part because the
    risks of a repo-driven fire-sale have fallen. The well intentioned and
    arguably successful efforts to make the banking system more robust and
    less susceptible to runs have transferred fire-sale risk out of the
    banking system and into the hands of end-investors.
    Repo 101
        A repurchase transaction (repo) is effectively a collateralized
    short-term (often overnight) loan. For example, an investor looking to
    borrow money pledges a security (e.g., a Treasury) as collateral, and
    receives cash. The next day, the investor pays back the cash plus
    interest, and receives his or her collateral back in return. A
    ``reverse repo'' is the same transaction but viewed through the lens of
    the lender.
        Repurchase transactions have several important aspects. First,
    although much of the repo market is overnight, ``term'' repo, which can
    be measured in weeks or even months, is also possible. The structure is
    the same, but the collateral is not returned (and the loan paid off)
    until the end of the term. The second aspect is the interest rate of
    the transaction, which depends on the term and the specific collateral
    involved. For various reasons, some collateral may be specifically
    desirable to lenders and thus command lower interest rates. The final
    key dimension is the ``haircut''--which defines just how much cash the
    borrower gets for the collateral. This is quoted in terms of a
    percentage of market value. Higher-quality collateral, such as
    Treasuries or agency debt, typically requires the lowest haircuts,
    e.g., 2%. This means that it is possible to borrow $98 for every $100
    of Treasuries that the borrower pledges as collateral. Lower-quality
    collateral (e.g., corporate bonds) typically requires higher haircuts.
        Banks engage in repo transactions for two related reasons. First,
    repos match cash-rich investors (such as money market funds) with
    investors (such as hedge funds) who own securities but need financing.
    This is done via a ``matched book''--banks engage in reverse repo
    transactions with hedge funds, lending them money collateralized by
    securities. Banks then borrow from money market funds via repo
    transactions, collateralized by the same securities. The banks
    effectively act as middlemen, with the cash flowing from the money
    funds to the hedge funds, and the collateral moving in the opposite
    direction. The second reason banks engage in repo is to finance their
    own portfolio of securities, essentially playing the role of the hedge
    funds in the matched book example above.
    Anatomy of a Repo Run
        Although the repo market is large (measured in trillions of
    dollars; more on this below), it also seems, at first, fairly
    innocuous. Short-dated, collateralized loans sound safe, particularly
    relative to equities or the highly structured assets that featured so
    prominently in the credit crisis. In fact, these are safe investments
    for lenders. The short-term nature of the transaction means that if any
    concerns arise, the lender need not sell or unwind the transaction--it
    is closed out the next day, in the case of overnight repo. In case of
    default, the lender can sell the collateral and recoup his or her
    money. It is precisely the safety of repo that makes it an attractive
    investment for money market funds. They invest in safe, highly liquid
    short-term assets because their end-investors use these funds as cash
    substitutes.

              The same features that make reverse repo a safe asset for
            money funds make repo a risky liability for leveraged investors
            and banks . . .

        However, the same features that make reverse repo a safe asset for
    money funds make repo a risky liability for leveraged investors and
    banks. At the slightest hint of trouble with either the collateral or
    the borrower, the funding can be withdrawn, which is as simple as not
    renewing an expiring contract. For example, if the collateral is
    downgraded, it may become harder to borrow against. Similarly, if the
    borrower (e.g., hedge fund or bank) deteriorates in some way such that
    money funds or other lenders question its credit quality, borrowers may
    have a harder time securing funds regardless of the quality of their
    collateral. Essentially, borrowers reliant on repo need to continually
    roll over their financing, and are exposed to the risk of a run as a
    result, similar in concept to a deposit run.
        This presents two concerns for regulators. First, banks finance
    significant securities portfolios via repo, and thus there is risk that
    an individual bank would need to liquidate assets in response to being
    locked out of the repo market--a pre-default fire-sale. This is
    problematic because the highest-quality assets are the easiest to
    sell--Treasuries, agencies, etc. A bank that was overly reliant on repo
    financing of lower quality securities and faced a repo run could be
    forced to sell assets quickly to raise liquidity, potentially driving
    down their market valuations and leading to asset write-downs that
    would impair capital, and increase the bank's risk of default or
    downgrade. It might also need to sell assets or draw down on its cash
    holdings to meet increases in haircuts on the collateral it is
    pledging.
        Such a run could affect multiple (or even all) banks at once if
    bank credit quality deteriorated across the board, or if the entire
    repo market experienced a disruption. This could be caused by a
    systemic shock leading to a crisis of confidence in the broader
    financial system. In this scenario, with multiple borrowers trying to
    liquidate assets, the market could experience a fire-sale--the prices
    of certain assets could plummet because of a large number of forced
    sellers trying to liquidate at once. This could be exacerbated by money
    market funds, which are often legally prohibited from owning the types
    of collateral underpinning their repo trades and would be forced to
    sell quickly if their counterparty defaulted and the fund took
    possession of the collateral. The solvency of an individual bank could
    deteriorate much faster in this scenario because it would be forced to
    sell assets at a loss, thereby eroding its capital. In fact, solvency
    concerns could spread through the financial system.
        Academic studies have described this phenomenon as a ``funding and
    liquidity spiral''.\2\ Asset price shocks in a particular market create
    funding problems for cash borrowers who pledged the same or similar
    collateral. Borrowers reduce their positions by selling some of their
    holdings, while their ability to borrow against their remaining assets
    shrinks as haircuts increase and the value of these holdings falls in
    response to selling pressure. This exacerbates the funding problems and
    forces more de-leveraging and asset fire-sales--the process becomes
    self-reinforcing.
    ---------------------------------------------------------------------------
        \2\ See ``Market Liquidity and Funding Liquidity'', M. Brunnermeier
    and L. Pedersen, National Bureau of Economic Research working paper,
    December 2008.
    ---------------------------------------------------------------------------
    Lessons from the Credit Crisis
              Concerns about repo runs are not theoretical. The failure of
            Lehman Brothers serves as a real world case study . . .

        Concerns about repo runs are not merely theoretical. Lehman
    Brothers' failure in September 2008 serves as a real world case study.
    Lehman's repo book accounted for 34% of total liabilities at 2Q08, a
    cursory measure of the firm's dependence on short-term funding. During
    normal times, this was an effective strategy for leveraging returns,
    but as the firm's crisis reached a climax, repo funding providers
    suddenly fled. Between September 9, 2008, and September 15, 2008 (the
    day of its bankruptcy filing), the number of tri-party counterparties
    providing Lehman Brothers with cash in exchange for securities fell
    from 63 to 16. Given that Lehman Brothers had used repo to fund a
    material volume of lower-quality, non-governmental securities--the
    prices of which had fallen sharply--the firm was left with assets it
    could no longer fund in overnight markets or sell without destroying
    capital, eventually contributing to the firm's bankruptcy filing.
        Although the Lehman experience is an important, cautionary tale, it
    also delineates where the true ``run risk'' lies within the repo
    market. Interestingly, the financial crisis did not cause a waterfall
    of repo runs across the rest of the system. Instead, the deterioration
    in repo markets was more focused.

       Higher-quality assets were still funded at modest haircuts:
            Repo haircuts did rise during the crisis across many asset
            classes; however, this was generally concentrated in funding
            for lower-quality ABS structures.\3\ Treasuries, agencies, and
            even investment grade corporate bonds showed modest--if any--
            increases in margin requirements over this period. For example,
            a Federal Reserve staff report indicated that U.S. Treasuries
            and agencies continued to be funded in the repo market
            throughout this period at haircuts of only 3% or less (i.e.,
            97% loan to value).
    ---------------------------------------------------------------------------
        \3\ See ``Repo Runs: Evidence from the Tri-Party Market'', A.
    Copeland, A. Martin, and M. Walker, Federal Reserve Bank of New York,
    July 2011.

       Evaporation of repo funding was concentrated in lower-
            quality issuers: Evidence from the same Federal Reserve study
            suggests that the repo funding flight was highly idiosyncratic
            to Lehman Brothers. Certain investors chose to cease providing
            Lehman with repo funding but nonetheless continued to fund
    ---------------------------------------------------------------------------
            other financial market participants.

        Overall, this suggests to us that repo is less flight-prone than
    might be imagined. Funding terms were not markedly increased and were
    not in themselves the transmission mechanism for forced sales.
    Furthermore, the markets for higher-quality assets that typically serve
    as repo collateral were able to absorb the liquidation of Lehman's
    large Treasury and agencies books, which had been funded by repo. This
    can be naturally linked to the strong performance of these safe haven
    assets during times of turbulence, minimizing the risk of needing to
    take a loss as positions are closed.
        However, we must be careful not to draw too much comfort from the
    experience of the crisis, given the unprecedented intervention in
    markets by the Federal Reserve and other central banks, which may have
    helped stem further contagion. The core issues around funding long-
    term, price-sensitive assets remain--entities using short-term funding
    (such as repo) need to mark their assets to market and obtain new
    funding every day. A temporary price decline has the potential to wipe
    out a firm's margin and force it to sell its assets. This could in turn
    push asset prices lower, forcing other participants to sell and
    perpetuating the cycle. We believe that it is this risk--of a waterfall
    of forced sellers destabilizing the broader system--that regulators are
    attempting to address via repo-targeted reform.
    Regulators Have Responded With Significant Changes
        Global standards for bank balance sheet size were fairly lax prior
    to the financial crisis. Basel I and II capital standards were largely
    based on risk-weighted assets, as opposed to total assets. This
    facilitated inflated balance sheets and more active proprietary risk
    taking in trading businesses. Regulators have made a series of changes
    to the bank regulatory framework to address perceived balance sheet
    structure and business model risks. These include:

       Volcker Rule.

       The introduction of leverage ratios.

       SIFI buffers.

       Haircuts.
    Volcker Rule
        Banks' trading operations historically served two main purposes:
    (1) providing liquidity to market participants wanting to buy or sell
    securities in exchange for a bid-ask spread; and (2) using the bank's
    balance sheet to generate profit from price movements. Bank regulators
    grew concerned that proprietary trading positions created undue risks
    on banks' balance sheets. In response, the Dodd-Frank Act created the
    Volcker Rule, which prohibits proprietary trading. Among other things,
    the rule limits banks' ability to take trading positions--capped at
    demonstrated market demand. In a market where demand from clients,
    customers or counterparties is expected to diminish, this limits a
    bank's ability to intermediate the market. Notably, regulators chose to
    exempt Treasury and municipal securities from these restrictions.
    Leverage Ratios
        Pre-crisis, the most important (and binding) regulatory capital
    ratios banks needed to meet were based on risk-weighted assets. Safe
    assets, such as repo, were assigned low risk weights, and thus banks
    were required to allocate very limited capital to those types of
    positions. As a result, there were few practical limitations on the
    size of bank balance sheets, which expand as banks increase the size of
    their matched-book repo positions.
        This has changed in both the U.S. and Europe. Regulators in the
    U.S. have adopted a 5% supplementary leverage ratio for the holding
    companies of the systemically important U.S. banks.\4\ This represents
    a materially stricter requirement than the old U.S. standard, as it
    raises the hurdle from 4% and expands the scope to capture some off-
    balance sheet assets. This rule complements existing risk-weighted
    capital measures by ensuring that even low-risk assets and certain off-
    balance-sheet exposures are backed by material equity capital if
    exposures are large enough (see Leverage ratio: An attack on repo?
    (https://live.barcap.com/go/publications/
    content?contentPubID=FC1953464)).
    ---------------------------------------------------------------------------
        \4\ Technically, the proposed higher supplementary leverage ratio
    requirement would apply to all banks in the U.S. with at least $700bn
    in assets and/or $10trn in assets under custody, which at present
    captures the eight U.S. G-SIBs: Bank of America, Bank of New York,
    Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street, and
    Wells Fargo.

              Before the crisis, European banks were not subject to any
            restrictions on balance sheet; thus, they naturally gravitated
    ---------------------------------------------------------------------------
            toward lower risk-weighted assets--this has now changed . . .

        Prior to the crisis, European banks were not subject to any
    restrictions on balance sheet. Thus, they naturally gravitated toward
    lower risk-weighted assets (e.g., repo). This has now changed for two
    reasons. First, European regulators have adopted a 3% leverage ratio
    and several are moving toward an even higher standard. Second, new
    regulations on U.S. subsidiaries of foreign banks will push these banks
    to manage the balance sheets of their U.S. operations more
    conservatively. Previously, foreign banks' U.S. intermediate holding
    companies were not required to meet U.S. capital standards
    independently. However, beginning in July 2015, Section 165 of the
    Dodd-Frank Act will require foreign-domiciled banks to roll up all
    their U.S. broker/dealers and bank branches into a single intermediate
    holding company (IHC). The IHC will then need to meet risk-based
    capital requirements, maintain minimum liquidity buffers, and meet the
    minimum leverage ratio. The challenge of establishing an IHC is
    particularly acute for foreign banks that mainly conduct broker-dealer
    business in the U.S., with limited lending capabilities, because their
    balance sheets would be naturally skewed toward lower risk-weight
    business (Figure 1). Based on recent data, these institutions will be
    under similar pressure as their U.S. peers to reduce size and/or
    increase equity.
    Figure 1
    Foreign banks account for a significant share of U.S. broker-dealer
            activity
    Assets of U.S. broker-dealers ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: Data as of YE 2013. Source: Company reports, Barclays
            Research.
    SIFI Buffer for Short-Term Wholesale Funding Reliance
        In December 2014, the Federal Reserve released its notice of
    proposed rulemaking (NPR) outlining the U.S. implementation of
    additional capital buffers at systemically important banks. This highly
    anticipated release outlined the rules for determining how much more
    Tier 1 common capital the largest banks will hold above the Basel III
    minimums.
        Most elements of the rule were taken directly from the Basel/
    Financial Stability Board guidelines; however, the Fed also shifted
    critical elements. In one key change, the Federal Reserve decided to
    vary capital requirements based on the amount of short-term wholesale
    funding used by a given bank. Although we do not believe this change in
    itself generates higher capital requirements versus the FSB rules
    (based on current balance sheets), it does establish a link, for the
    first time, between capital requirements and wholesale funding
    structure. For a more detailed discussion of the proposal, see We're
    Gonna Need a Bigger Buffer: Fed Proposes SIFI Capital Surcharge,
    (https://live.barcap.com/go/publications/content?contentPubID=FC209
    5719) 11 December 2014.
    Haircuts Up Next
        Though somewhat less certain, we expect further rulemaking to
    address haircuts for repo transactions. These would likely be designed
    to cap leverage within the repo market to levels appropriate for the
    quality of the underlying collateral, see Squeezing the leverage out,
    (https://live.barcap.com/go/publications/
    content?contentPubID=FC2080857) October 24, 2014. Federal Reserve
    Governor Daniel Tarullo has repeatedly expressed a desire to add
    regulation along these lines over the past year. Most recently, in a
    speech at an Office of Financial Research conference (excerpted below),
    he highlighted his intention that such rules also apply outside the
    traditional banking sector to mitigate the risk of non-banks building
    up repo leverage as banks pull back.

    ------------------------------------------------------------------------

    -------------------------------------------------------------------------
            Federal Reserve Governor Daniel Tarullo, January 30, 2015

        ``I have on past occasions described at some length my concerns with
     short-term wholesale funding--especially, though not exclusively,
     funding associated with assets thought to be cash equivalents . . . .
     One policy response that the Federal Reserve has advocated and that has
     now been proposed by the Financial Stability Board (FSB), is for
     minimum margins to be required for certain forms of securities
     financing transactions (SFTs) that involve extensions of credit to
     parties that are not prudentially regulated financial institutions.
     This system of margins is intended to serve the macro-prudential aim of
     moderating the build-up of leverage in the use of these securities in
     less regulated parts of the financial system and to mitigate the risk
     of pro-cyclical margin calls by preventing their decline to
     unsustainable levels during credit booms.''
    ------------------------------------------------------------------------

    These Changes Have Reduced Repo Volumes and Liquidity
    The Repo Market Has Shrunk
        Repo balances have fallen from a peak of more than $5trn pre-crisis
    to about $2.5trn currently. We believe this market will decline by an
    additional 20%, or roughly $500bn. The total amount of outstanding
    repo has contracted twice since 2008 (Figure 2). During the first
    episode (March 2008-December 2009), total repo outstanding shrank by
    almost 47%, driven by asset price fears and bank and investor de-
    leveraging. Although repo against corporate bonds accounted for less
    than 10% of overall collateral pledged in March 2008, this market had
    the biggest reduction in activity, with volumes plunging by more than
    63% during the financial crisis. We interpret this decline as a
    response to the use of non-traditional collateral.
        The second repo contraction, which occurred between November 2012
    and February 2014, has been focused on higher quality collateral, and
    in our view has been a result of new regulations. In this episode,
    overall repo volume fell by 22%, led by agency MBS collateral, which
    plunged by 43%--more than it fell during the financial crisis.
        This is clearly visible in the repo balances of the large U.S.
    banks, which have declined by 28% over the past 4 years (Figure 3).
    Notably, the only U.S. global systemically important bank (G-SIB) to
    grow its repo balances over the past few years has been Wells Fargo,
    which we estimate has a significant surplus to its required
    supplementary leverage ratio requirement. That is because Wells Fargo
    predominantly focuses on traditional banking businesses of taking
    deposits and making loans (higher RWA), with lower exposure to repo and
    trading (lower RWA).
    Figure 2
    Aggregate Repo Volumes Have Contracted Sharply From Pre-Crisis Levels
    Repo outstanding ($trn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve, Barclays Research.
    Figure 3
    Most Large U.S. Banks Have Responded to SLR Requirements by Reducing
            Repo Balances
    Repo borrowings ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Company reports, Barclays Research.

        Although the pace of the reaction to new rules has varied, all bank
    management teams that face balance sheet size pressure have taken steps
    to reduce their low RWA exposures. Most recently, Goldman Sachs CFO
    Harvey Schwartz highlighted the company's focus on reducing its balance
    sheet in response to increased regulatory clarity.

    ------------------------------------------------------------------------

    -------------------------------------------------------------------------
                Goldman Sachs CFO Harvey Schwartz, July 15, 2014

        ``Over the past few months, we have received greater clarity on the
     role of the balance sheet across a variety of regulatory requirements,
     most notably the Comprehensive Capital Analysis and Review (CCAR) and
     the supplementary leverage ratio. During the quarter, we undertook a
     comprehensive analysis of our balance sheet. We began the process by
     examining the return on asset characteristics associated with different
     businesses. Through that analysis, we identified opportunities to
     reduce balance sheet with a de minimis impact to our client franchise
     and earnings potential. As you would expect, the quarterly reduction
     largely impacted lower return asset activities within our matchbook and
     other secured financing transactions.''
    ------------------------------------------------------------------------

    Liquidity in Fixed Income Markets Has Contracted
        The decline in liquidity in fixed income markets is another
    consequence of the changes in bank regulation for financial markets.
    For illustrative purposes, we focus on the U.S. credit market, for
    which we have accurate volume and transaction cost data, but we believe
    the results shown below are indicative of how trading patterns have
    evolved generally.
        Beginning with volume data (from the TRACE reporting system, which
    captures all corporate bond trades in the U.S.), we compute turnover
    metrics for both the U.S. investment grade and high yield bond markets.
    Turnover has clearly been on a declining trend--in both markets, it is
    at or close to the lowest levels on record (high yield experienced a
    small bounce in late 2014 as a result of the volatility of energy
    credits). In high yield, turnover has steadily made its way down from
    177% in 2005 to 98% in 2014 (Figure 5). Notwithstanding a genuine spike
    in investment grade corporate turnover in 2009, as the market recovered
    from the credit crisis, volumes in that market have also failed to keep
    pace with growth in par outstanding, and turnover is down from 101% to
    66% over the same period (Figure 4).
    Figure 4
    Volume, Market Size, and Turnover in High Grade Credit
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: MarketAxess, Barclays Research.
    Figure 5
    Volume, Market Size, and Turnover in High Yield Credit
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: MarketAxess, Barclays Research.

        Transaction costs have risen at the same time. Figure 6 contains
    pre- and post-crisis transaction costs in the IG and HY markets,
    estimated using our Liquidity Cost Score (LCS) methodology.\5\
    Transaction costs have increased in both markets. Although the change
    in HY is notable, at more than 20%, the change in IG is more marked. We
    think this is the result of the substantial strength of pre-crisis
    liquidity in that market. Note that the change in LCS is more severe
    than that in bid-offer--this is driven by an increase in the average
    duration of the IG market over the past several years. The same average
    bid-offer spread corresponds to a higher transaction cost for a longer-
    duration bond.
    ---------------------------------------------------------------------------
        \5\ Liquidity Cost Scores for U.S. Credit Bonds, (https://
    live.barcap.com/go/publications/content?contentPubID=FC1484108) October
    2009.
    ---------------------------------------------------------------------------
    Figure 6
    Transaction Costs, Today Versus the Pre-Crisis Period

    ----------------------------------------------------------------------------------------------------------------
                                                1/31/2007                 1/31/2015                  Change
                                       -----------------------------------------------------------------------------
                                          LCS (%)     Bid-Offer       LCS       Bid-Offer       LCS       Bid-Offer
    ----------------------------------------------------------------------------------------------------------------
    U.S. Credit Corporate                     0.531       8.5 bp        0.951      13.2 bp         +79%         +55%
    U.S. High Yield Corporate                 1.276     1.28 pts        1.550     1.56 pts         +21%         +21%
    ----------------------------------------------------------------------------------------------------------------
    Source: Barclays Research.

              Changes in the drivers of volumes and turnover at the
            individual bond level provide further evidence of the decline
            in liquidity . . .

        The changes in the drivers of volumes and turnover at the
    individual bond level provide further evidence of the decline in
    liquidity. In Figure 7, we present regressions of turnover in high
    yield bonds against size, age, and volatility in 2006 and 2014. In
    2006, the two main determinants of turnover were the age of a bond and
    its volatility. We interpret the relevance of age as a halo effect
    around new issue--bonds tend to trade in meaningful size in the months
    immediately after issuance. Turnover increases with volatility because
    price changes force investors to re-evaluate their holdings in a
    particular bond. Corporate actions, earnings, upgrades and downgrades
    are all possible sources of volatility that could lead credit investors
    to reposition their portfolios.
        By 2014, a few things had changed. First, the coefficients on age
    and volatility were both sharply lower. The ``new issue effect'' was
    much reduced, and it took much more volatility to drive the same level
    of turnover. More interesting, size became a much more important
    determinant of turnover. This suggests to us that investors ``pooled''
    liquidity in the largest bonds, which became proxy trading vehicles for
    the market. This is exactly the type of reaction we would expect from
    investors struggling to position portfolios in a lower-liquidity
    environment--the little liquidity that does exist is concentrated in a
    smaller number of issues, rather than dispersed across the market.
    Figure 7
    Cross-Sectional Regressions of Annual Turnover on Size ($bn), Age
            (yrs), and Volatility (%)

    ----------------------------------------------------------------------------------------------------------------
                                                       2014 (R2 18%)                        2006 (R2 20%)
                                           -------------------------------------------------------------------------
                                              Size     Age      Vol      Alpha     Size      Age      Vol     Alpha
    ----------------------------------------------------------------------------------------------------------------
    Beta                                       0.15    ^0.06     3.80     0.89      0.08     ^0.17  11.40 1      .20
    Standard Error                             0.03     0.01     0.11     0.02      0.04      0.01     0.34     0.04
                                           -------------------------------------------------------------------------
      t-statistic                              6.10    ^9.13    35.62    38.36      1.82    ^14.82    33.16    32.30
    ----------------------------------------------------------------------------------------------------------------
    Source: Barclays Research

    The Short-Term Safe Asset Conundrum
        Much repo funding is intra-sector--i.e., financial intermediaries
    lending to one another--but ultimately, a portion of this funding is
    indirectly provided by households and non-financial corporates through
    investments in money market funds. From the perspective of non-
    financial entities, repo is an asset and just one of a number of short-
    term, safe--even ``cash-like''--investment alternatives. Households and
    corporates have a natural need for these types of funds as a cash
    management vehicle and store of liquidity.
        This natural need for liquidity grows as financial wealth grows,
    which results in the share of safe, short-term assets remaining in a
    relatively tight range for households and corporates. To demonstrate,
    we create a measure of short-term assets, which includes currency,
    deposits, and money market fund shares. For corporates, we also include
    a de minimis amount of direct repo lending and commercial paper owned.
    Although the direct repo holdings of households and corporates are not
    significant, the funding that households and corporates provide to
    money market funds is then reinvested by these funds in repo.
    Similarly--but on a smaller scale--a proportion of individual and
    corporate deposits is also reinvested by the bank in repo.
        Households have consistently allocated 12-18% of financial assets
    into cash and short-term securities in every quarter since the early
    1990s (Figure 8). Likewise, non-financial corporates' allocation has
    remained at 10-14% (Figure 9).
        We think demand for short-term safe assets is even more stable than
    these ranges imply. Short-term assets as a percentage of total
    financial assets troughed three times: in 2000, 2007, and today--each
    period one of strong equity market performance inflating exposure to
    stocks (Figure 10). Similarly, relative exposure to short-term assets
    peaked in 2001 and 2008, when sharp equity market declines reduced the
    value of stocks. In fact, absolute holdings of short-term assets have
    increased in 19 of the past 20 years, by an average of 6.2%. In other
    words, the pace of growth in short-term assets has steadily tracked the
    long-term growth rate of household and corporate accounts. Indeed,
    Gorton, et al., report that their ``safe asset'' share of all U.S.
    assets has remained steady at around 33% since 1952.\6\
    ---------------------------------------------------------------------------
        \6\ See ``The Safe-Asset Share'', G. Gorton, S. Lewellen, A.
    Metrick, NBER working paper, January 2012.
    ---------------------------------------------------------------------------
    Figure 8
    Short-Term Assets Have Accounted for a Stable Proportion of Household
            Financial Assets
    Household Financial Assets
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve Flow-of-Funds data, Barclays
            Research.
    Figure 9
    Non-Financial Corporates Have Also Maintained a Steady Proportion of
            Assets in Short-Term Funds
    Non-Financial Corporate Financial Assets
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve Flow-of-Funds data, Barclays
            Research.
    Figure 10
    Following Periods of Strong Equities Performance, Household Exposure to
            Equities Peaks and Short-Term Assets Reach a Local Low As a
            Percentage of Total Assets
    U.S. Household Exposure to Equities and Short-term Assets
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve, Bloomberg.

        How will the demand for safe, short-term assets be met?

              Treasury bills, bank deposits, and the Federal Reserve's new
            reverse repo program (RRP) all have their limitations as short-
            duration liquid as-
            sets . . .

        Faced with the prospect of shrinking bank-provided repo, what
    alternatives are available to investors seeking short-duration liquid
    assets? A survey of similar low-risk, short-term options suggests
    investors may struggle to deploy their growing allocation to this
    category. The main low-risk alternatives--Treasury bills, bank
    deposits, and the Federal Reserve's new reverse repo program (RRP)--all
    have their limitations.
    Bills Insufficient and Declining
        Short-dated Treasury debt is probably the closest substitute for
    repo--and probably the most plentiful alternative--with $1.5trn in
    bills and $1.5trn in coupon Treasuries under 400 days to maturity
    outstanding. Moreover, given the limitations on what some investors can
    own, short-dated Treasury debt is one of the easiest substitutes. In
    fact, when repo balances contracted during the financial crisis, there
    was a marked increase in money market funds' Treasury bill holdings,
    supported by the increased bill supply in 2008 (Figure 11).
        However, as the budget deficit shrinks and the Treasury moves to
    lengthen the average maturity of the outstanding debt, it has steadily
    trimmed bill issuance. Since peaking in 2009, the outstanding bill
    supply has contracted by more than 20% (>$500bn) (Figure 12). Demand is
    so strong that at bill auctions--of any maturity--bids exceed the
    offering amount four-fold. And given the buy-and-hold nature of the
    investor base, once the paper is purchased into a portfolio it almost
    never returns to the market. Thus, even though $1.5trn in absolute
    terms is larger than the aggregate debt outstanding of some G7
    countries, the Treasury bill market--even supplementing the supply with
    coupons out to 13 months--is probably too small to absorb demand
    diverted from the private sector repo market.
    Figure 11
    Upon the Contraction of the Repo Market in 2008, MMFs Redeployed
            Capital into Treasury Bills
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve, SIFMA, Barclays Research.
    Figure 12
    However, Bill Volume Has Since Declined and Is Unlikely To Be Able To
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve Flow-of-Funds, Barclays Research.
    Deposits Are a Natural Alternative, But Rates Could Lag if Demand
            Increases Out of Step With Lending Opportunities
        Deposits are clearly a safe, liquid asset and are one of the main
    areas where households and corporates deploy short-term funds.
    Uninsured bank deposits (above the $250k insurance maximum) do
    represent incremental credit risk versus government obligations;
    however, money market funds already deploy roughly 20% of their
    holdings into wholesale bank deposits, suggesting that deposits form a
    reasonable investment avenue for these entities.
        However, we do not see much demand from banks for this incremental
    funding. Banks are already awash in deposits, as demonstrated by an
    average loan-to-deposit ratio of roughly 70%. Although banks will
    continue to take deposits, away from pockets of demand for retail
    deposits driven by the new Liquidity Coverage Rule (LCR), we believe
    banks' interest in further inflating their balance sheets is limited.
    Their appetite is constrained both by the new SLR rule and limited
    lending opportunities. Thus, if money market funds boost the supply of
    deposits to banks, banks in turn may be less inclined to raise the
    interest paid on deposits.
    Figure 13
    Deposits Already Form the Core of Households' Safe, Short-Term Assets
            and a Material Share of Money Market Holdings, Suggesting They
            Are a Likely Alternative Investment Avenue
    Mix of Household Financial Assets (% of Total)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve, Barclays Research.
    Federal Reserve's RRP Capped, Limiting Capacity To Absorb Incremental
            Demand
              The RRP is a close substitute for shrinking private sector
            repo . . .

        The Fed's reverse repo program (RRP) is a close substitute for
    shrinking private sector repo and is available to a wider range of
    counterparties, including large money market funds and the GSEs. For
    these investors, Treasury repo from the Fed supplements what is
    available to them from the private sector. Since program testing began
    in September 2013, average daily balances in the RRP have been roughly
    $125bn (and considerably higher at quarter-ends, when bank and dealer
    balance sheet scarcity increases and few private sector repo assets are
    available for money market funds to invest in). This has largely offset
    the decline in private sector repo volume in recent years (Figure 14).
    In turn, mutual fund repo holdings have remained relatively stable in
    aggregate (actually increasing as a % of total holdings) as they have
    redeployed funds into the RRP.
    Figure 14
    Fed RRP Has Offset Much of the Fall in Private-Sector Repo Volume,
            Helping MMFs Keep Total Repo Holdings Fairly Constant
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve Flow-of-Funds, Barclays Research.

        However, the Fed's stated concerns about the program have led it to
    put a hard cap of $300bn on the RRP; thus, we expect its capacity to
    replace shrinking private sector collateral supply to be limited. The
    Fed's concern stems from its discomfort with directly funding money
    market funds and the fact that even with the $300bn cap, its market
    presence in the repo market is nearly as large as the top three dealers
    combined. Moreover, it worries about the potential for the program to
    dis-intermediate bank funding during a financial crisis. Notably, in
    the January FOMC minutes, most participants accepted that the Fed might
    have to temporarily increase the cap on the overnight RRP program to
    strengthen its control over the fed funds rate. Officials are
    concerned, however, that the market might attach more significance and
    permanence to the RRP program if the size was increased so it is far
    from certain the Fed will provide money funds with extra repo.
    Limited Supply of Alternatives Could Inhibit Higher Short-Term Rates
              We expect deposits to exhibit a lower beta to short-term
            rates once the Fed begins hiking rates . . .

        In aggregate, we expect demand for safe, short-term assets to grow
    steadily. However, the supply of these assets from the avenues listed
    above will likely be constrained. When we factor in an expected decline
    in repo, we project an increased imbalance between supply and demand.
    This imbalance--more investors looking to deploy cash in the short end
    than safe borrowers needing that cash--should lower the relevant
    interest rates paid. For example, the available data suggest that bank
    deposits have historically had a 60-80% beta to short-term interest
    rate changes. We expect deposits to exhibit a lower beta once the
    Federal Reserve begins hiking rates, as funds that short-term investors
    previously allocated to repo assets flow into bank deposits. Through
    this indirect mechanism, forced declines in repo volumes could keep the
    interest earned by deposits or government-focused money market funds
    closer to the zero bound, even as other rates rise. In fact, it is
    exactly the concern about substantial demand for short-dated assets
    that is leading the Fed to question whether the RRP program may need to
    be increased. Otherwise, the actual front-end rates used in the economy
    may not track Fed funds as closely, limiting Fed's control of interest
    rates.

        Private-Sector Alternatives Add Incremental Risk

        Where investment avenues backed by the government, both directly
    (Federal Reserve RRP, Treasuries) and indirectly (government collateral
    repo, FDIC), are less available, we expect private sector alternatives
    to become more prominent. However, their degree of substitutability
    with repo is lower and could introduce new risks.
    Figure 15
    When Short-Term Assets Are Scarce, Non-Traditional Alternatives Step In
            To Fill the Void
    Y/Y Change in Deposits and Other Short-Term Assets (LHS) and Difference
            from Median Short-Term Asset Holdings % Total Assets (RHS)
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: Short-term assets and deposit assets for all entities.
            Median short-term asset rate represents aggregate of household
            and non-financial corporate data. Source: Federal Reserve Flow-
            of-Funds data, Barclays Research.
    History Suggests Less Standard Alternatives Are Likely To Rise
        The Federal Reserve's Flow of Funds data suggest that growth in
    less traditional cash-like products may be particularly responsive to a
    shortfall in traditional safe, short-term investment opportunities.
    Deposits have generally grown steadily over the past 2 decades, with
    relatively limited responsiveness to economic conditions. On the other
    hand, other short-term assets, such as CP vehicles and money market
    funds, have had a more volatile growth pattern, responding to the
    relative demand for incremental safe assets in any given period. Figure
    15 suggests that when households and corporates have a low percentage
    of total assets in short-term investments, the growth rate of short-
    term alternatives picks up sharply. In other words, when there is a
    shortage of traditional short-term safe assets, alternative assets have
    historically stepped in to fill the void.
        The last trough of short-term assets as a percentage of total
    financial assets coincided with a large rise in the use of what were
    deemed to be near-safe short-term asset substitutes. CP and ABCP
    balances surged as investors stretched to find additional safe assets
    and pick up incremental yield and banks sought cheaper sources of
    funding (Figure 16). When market sentiment turned in 2008, these non-
    traditional sources of liquidity proved to be less liquid and stable
    than expected. The decline in bank commercial paper has not reversed
    due to increased regulation and lower ratings at banks, while more
    esoteric products such as auction rate securities and asset backed--CP
    proved to bear much higher liquidity and credit risk than expected and
    are thus unlikely to return any time soon.
    Figure 16
    Holdings of Cash-Like Substitutes Grew Dramatically Pre-Crisis and Have
            Shrunk Since
    Commercial Paper and Bankers Acceptances Outstanding ($trn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve Flow-of-Funds, Barclays Research.
    Investors Now Appear To Be Seeking Liquidity in Mutual Funds and ETFs
        Evidence suggests that investors have settled on fixed income
    mutual funds and ETFs as stores of liquidity. These funds offer daily
    liquidity such that investors can, in principle, redeem their money as
    quickly as in a money market fund. The influx into these types of funds
    has been heavy. Since 2009, taxable bond funds have received a massive
    $1.2trn in inflows, excluding the effect of significant market
    appreciation. Investment grade corporate funds have been the biggest
    beneficiaries (+$588bn), followed by flexible funds that can typically
    roam freely across the credit spectrum (+$311bn) and high yield funds
    (+$70bn), according to Lipper data (Figure 17).
        Similarly, ETFs are growing rapidly in fixed income. For example,
    although virtually nonexistent before the crisis, credit ETFs have
    grown to account for c.2.5% of the investment grade corporate debt
    market and nearly 3% of the high yield corporate market (Figure 18).
        Despite their passive nature and management fees, ETFs appear to be
    gaining traction not only for retail end users and hedge funds, but
    also among institutional investors. In effect, ETFs are being used not
    only by end investors looking for instruments with daily liquidity, but
    also by mutual funds seeking to mitigate the differences between the
    liquidity their investors expect versus the (poor) liquidity available
    in the underlying bonds. ETFs function as a trading vehicle, aided by
    their increasing liquidity, such that portfolio managers can meet daily
    inflows and redemptions without actually needing to trade bonds.\7\
    ---------------------------------------------------------------------------
        \7\ Institutional Investors Turning to Fixed-Income ETFs in
    Evolving Bond Market, Greenwich Associates, 2014.
    ---------------------------------------------------------------------------
    Figure 17
    Cumulative Retail Flows By Fixed Income Asset Class ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Lipper.
    Figure 18
    ETFs Have Gained a Significant Foothold in the Management of Fixed
            Income Assets
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Lipper, Barclays Research.

              Investors are increasingly using the ultra-liquid CDX indices
            to satisfy their daily liquidity needs . . .

        Similarly, portfolio managers have increased their trading in other
    related products. For example, investors are increasingly using the
    ultra-liquid CDX indices to satisfy their daily liquidity needs. In the
    high yield market, where the on-the-run CDX index trades nearly as much
    as all TRACE bonds combined, the correlation between large fund flow
    events and positioning data shows that portfolio managers use the
    derivatives index as a source of liquidity in periods of high fund flow
    volatility (Figure 19).
        However, these alternative sources of liquidity come at a cost,
    even if such cost is not immediately apparent in bid-offer prices. With
    CDX, the price of liquidity comes in the form of basis risk, which can
    be very significant in times of market stress (Figure 20). This risk
    comes as a result of mismatches in rates exposure (CDX has virtually
    none) and differing credit exposure, among other potential mismatches.
    With the ETFs, the costs include non-trivial management fees and a
    market that can dislocate significantly from its underlying asset
    value. Holding more cash to fund potential liquidity events is an
    alternative whose risks are better understood, but the consequent
    performance drag can make this the least appealing option to managers.
        The increased use of these tools to manage the disparity between
    the provision of daily liquidity to end-investors and poor liquidity in
    the underlying fixed income assets is itself evidence of the tension
    that the influx into mutual funds has caused. Fund managers have found
    that they need to use these tools already, in relatively calm markets.
    In the event of a market disruption, these tools may no longer be
    effective--if outflows exceed the extent to which fund managers have
    built in flexibility to meet them, they would have no choice but to
    turn to the underlying markets to meet their liquidity needs. This
    could become self-perpetuating if the corresponding price declines in
    the underlying led to further outflows.
        Thus, regulations aimed at bolstering stability at the core of the
    financial system, combined with a growing demand for liquidity, may
    eventually lead to increased instability and fire-sale risk in the
    periphery (e.g., the secondary markets for investment grade, high
    yield, leveraged loans, and emerging markets). The fragile new
    equilibrium comes not only from the reduced tradability of these asset
    classes, but also from deep liquidity mismatches between the assets
    themselves and the instruments being used to manage daily liquidity
    needs.
    Figure 19
    Changes in Investor Positioning in HYCDX (OTR) Are Consistent With
            Liquidity Needs ($mn)
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: DTCC, EPFR, Barclays Research.
    Figure 20
    Basis Between the HYCDX Index and the Barclays U.S. High Yield Very
            Liquid Index (bp)
            [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Barclays Research.

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                                     ______

      Submitted Reports by Christopher S. Edmonds, Senior Vice President,
               Financial Markets, IntercontinentalExchange, Inc.
    Barclays
    Repo Reform
      Joseph Abate, +1 212 412 7459, joseph.abate@barclays.com
    Interest Rates Research
    U.S. Money Markets
    12 March 2015

        This is an excerpt from Regulatory reform: Repo-cussions, (https://
    live.barcap.com/go/publications/content?contentPubID=FC2120226) March
    12, 2015.

        Following up on an article prepared for the Equity Gilt Study 2015,
    (https://live.barcap.com/go/publications/
    content?contentPubID=FC2115179) we take a closer look at how recent
    bank reforms have changed the size, scope, and nature of the $2.5trn
    repo market. We also explore how these challenges are likely to
    intensify in coming years.

       The effect of tougher bank regulation on the repo market
            extends beyond trading volumes.

       Capital requirements appear to have the most significant
            effect on repo volumes. Net stable funding requirements will
            amplify the effect.

       As regulatory deadlines approach, we expect these mix and
            volume effects to intensify. Non-Fed tri-party repo may
            contract 20% in the next year or so.

        While further volume reduction and collateral shifts will likely
    produce market ``winners'' and ``losers,'' they will also spur market
    changes and alter the way banks and dealers think about the business.
    Evidence of Regulatory Effects
        In regulators' minds, the behavior of the repo market during the
    financial crisis as it helped to spread contagion and amplified
    systemic risk makes it a prime target for reforming. Nearly every post-
    crisis financial industry reform has in some way zeroed in on repo
    activity. In The decline in financial market liquidity, (https://
    live.barcap.com/go/publications/content?contentPubID=FC2115196) we
    detail several of these new regulations.
        Among the ones with the most direct consequence for the market are
    leverage ratios (including supplemental capital buffers), net stable
    funding requirements, and the liquidity coverage ratio. And although QE
    and the RRP account for some of the post-crisis decline in repo trading
    volumes, we expect regulatory pressures to begin taking a more
    prominent role in the market this year. Below, we present some key
    regulations and how they have begun to influence behavior in the repo
    market.
    Leverage Ratio
              The leverage ratio has probably had the most significant
            regulatory effect on repo . . .

        Perhaps the most significant regulatory change affecting the repo
    market since the crisis has been the leverage ratio. Since leverage is
    calculated off of total assets rather than risk-weighted assets, low-
    risk (and consequently, low-return) activities that consume a large
    portion of bank balance sheets have become far less attractive. Repo--
    and, more generally, running a match book--is the poster child for a
    low return balance sheet-intensive business. As we detailed in Leverage
    Ratio--An Attack on Repo? (https://live.barcap.com/go/publications/
    content?contentPubID=FC19
    53529) (August 2, 2013), this has led banks to reconsider how they
    operate in the repo market. Although obscured by the Fed's programs,
    accounting rule changes, and efforts to strengthen their balance
    sheets, we suspect the tightening of balance sheet flexibility caused
    by the leverage ratio has led to three specific post-crisis changes.

              . . . producing sharp, recurrent plunges in volume . . .

        First, although banks and dealers have always shrunk their balance
    sheets on quarter-ends, ``window dressing'' seems to have intensified
    since 2012. The short-term nature of repo--on both the asset and
    liability sides of a bank's balance sheet--makes it an ideal candidate
    for end-of-period balance sheet adjustment. This makes it easy to
    switch on and off--curtailing balances as quarter-end approaches and
    then ramping them up again once the reporting period has passed.
    Indeed, this ``on/off'' propensity is most evidence in data on money
    fund repo holdings, as money funds provide about \1/3\ of the cash in
    the repo market. Not only has their overall level of non-Fed repo
    declined over time, but their repo holdings plunge an average of 13% in
    the final month of a quarter--and quickly recover (Figure 1). In 2014,
    the average quarter-end decline was 17%, compared with 10% in 2013.
    These declines and their clockwork repetitiveness point to intensifying
    bank and dealer balance sheet rationing.

              . . . and a reduced willingness to intermediate between
            smaller dealers and cash providers . . .

        Second, there is also evidence of balance sheet rationing in other
    areas of the repo market, such as the inter-dealer GCF market. Higher
    capital requirements have reduced the incentive for larger dealers to
    ``supplement'' their pool of repo collateral by reversing in Treasuries
    (lending cash) in the inter-dealer GCF market to then pass this
    collateral on to money funds. Volumes in the GCF market are falling
    (Figure 2). Larger dealers have traditionally been able to take
    advantage of an arb in the GCF market that reflects the fact that
    smaller or weaker institutions may be unable to raise cash directly
    from money funds and the GSEs. Instead, the larger dealer acts as an
    intermediary--effectively renting its balance sheet--exchanging cash
    and collateral between the smaller dealers and cash providers. Larger
    banks appear increasingly reluctant to expand their balance sheets
    through these types of trades and have begun demanding wider spreads.
        In addition to the volume effect, we look at the spread widening in
    GCF repo rates compared with the rates that money funds earn on their
    repo holdings (recall that their repo collateral is provided by
    stronger and generally larger banks).\1\ This spread has averaged 6bp
    since late 2011, although late last year, as balance sheet pressures
    intensified, the spread widened to 18bp.
    ---------------------------------------------------------------------------
        \1\ Since detailed industry-wide money fund rates are available
    only at month-end, we are comparing market rates at a time of month
    when dealer balance sheet is particularly scarce and, correspondingly,
    money market repo rates are low.
    ---------------------------------------------------------------------------
    Net Stable Funding
        Leverage ratios are not the only reason for banks to reduce their
    repo footprint or widen spreads. Recall that large institutions are
    subject to net stable funding requirements (NSFR) under Basel III. At
    its simplest, the NSFR compares the asset and liability sides of a bank
    balance sheet assuming normal, business-as-usual conditions, to judge
    the risk of the institution's funding model. The NSFR compares the
    amount of available stable funding (based on the bank's liability mix)
    with the amount of required funding that regulators judge the bank
    should have given the composition of its assets.
        Most repo and other forms of wholesale funding are not considered
    available stable funding sources because of their short tenors
    (generally under 1 year) and their behavior during the financial
    crisis. Moreover, who provides the funding is almost as important as
    its type. Generally, regardless of the type and tenor of the funding
    they provide to banks, most cash lent from money funds generally adds
    nothing to a bank's stock of available stable funding. This, along with
    the leverage ratio, may be contributing to the decline in (non-Fed)
    money fund repo holdings. While capital and leverage effects may
    already be pushing large banks and dealers to reduce and re-price their
    repo activity, the NSFR will add additional pressure as these
    institutions move to get compliant before 2018.
    Figure 1
    Money Fund Repo Holdings ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: Excludes repo from the Fed's RRP program.
              Source: Crane's Data, Barclays Research.
    Figure 2
    GCF Repo Volume ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: 20 day average. Source: DTCC.
    Shifting Collateral Mix
              The collateral mix is shifting toward non-government
            securities . . .

        Declining repo volumes and GCF repo spread widening, however, are
    not the only manifestations of regulatory pressure on the repo market.
    In addition, the mix of collateral in the tri-party market seems to be
    shifting away from government securities: Treasuries, agencies, and
    MBS. With RRP collateral netted out, government-only collateral has
    shrunk to 70% of tri-party repo outstanding, down from nearly 80% in
    December 2012. Moreover, the amount of non-government financed
    collateral has increased 10% since December 2012 and is roughly the
    same volume as in late 2010.
        Although there has been growth in other types of securities, such
    as structured products and corporate bonds, the primary driver of the
    non-government collateral share increase has been equities (Figure 3).
    Pledged equity collateral has risen 50% since December 2012 and has
    grown to 10% of the private sector (that is, non-RRP) tri-party repo
    market. The $160bn in pledged equities now accounts for about $1 of
    each $3 in non-government collateral.
        Our sense is that the liquidity coverage ratio (LCR) may be
    encouraging banks to swap equity collateral for Treasuries given the
    different haircuts regulators apply to holdings of high-quality liquid
    assets. Recall that Treasuries have no haircut or discount in the
    numerator of the LCR. By contrast, the haircut applied to equities used
    as HQLA is 50%. Given this differential, as well as the traditional
    role that repo markets play in collateral substitution, banks may be
    more willing to repo out their equity holdings while simultaneously
    reversing in Treasuries to be applied to the bank's HQLA.
    The Future of Repo
        In addition to increasing regulatory pressures, the repo market
    faces a number of other cross-currents. While it is difficult to
    identify and quantify all these forces, we outline some of the more
    important ones below.
    Figure 3
    Non-Government Collateral Mix ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Source: Federal Reserve.
    Figure 4
    Money Fund Repo Holdings by Region ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: Non-U.S. includes banks from France, Germany, UK and
            Japan.
              Source: Crane's Data, Barclays Research.

        Regulation--and more specifically, the tightening of dealer balance
    sheets--points to further reduction in repo volumes. But banks are at
    different stages in their adjustments to regulation. Generally, U.S.
    institutions are further along in adapting to a new world of leverage
    limits and net stable funding and liquidity requirements than their
    European colleagues. This is most apparent in the intra-quarterly
    pattern of repo activity, which largely reflects the fact that many
    (non-U.S.) institutions have yet to migrate to quarterly average
    balance sheet reporting (Figure 4). The Basel Committee on Bank
    Supervision, however, recommends that all banks move to calculating
    their leverage ratios based on quarterly averages within the next few
    years.

              Repo volumes could fall another 20% . . .

        Since the intra-quarterly pattern--and, most importantly, the size
    of these quarter-end declines in primary dealer repo activity--is a
    direct consequence of balance sheet reporting, we reckon that it can
    provide useful insight on the future size of the repo market once all
    banks are required to report leverage on a quarterly average basis. We
    expect this to flatten out the calendar peaks and troughs in repo. But
    it effectively means that every day will be a quarter-end, so while the
    provision of repo from large global banks may become more constant and
    predictable, there will be less of it. Based on the current peak-to-
    quarter-end declines, we see Treasury repo volumes falling another 20%
    from their current level. However, whether this decline will be
    concentrated in 2015 or spread out over the next few years as global
    banks move into Basel compliance is unclear.
    Smaller Is Better, But Less Speculative Is Best
        If asked, most regulators would probably feel more comfortable with
    a smaller repo market. But while an additional 20% reduction--on top of
    the 50% reduction since 2008--will likely further reduce systemic risk,
    it is not clear how much safer the market will become. More important,
    we doubt that regulators are targeting a specific size for the repo
    market--say, based on the volume of cash trading. Instead, our sense is
    that they are more interested in changing market behavior--reducing the
    propensity for investors to run, cause asset fire sales, or increase
    leverage in the shadow banking sector.

              More than reducing size, regulators probably seek to change
            behavior in repo . . .

        Along these lines, regulators probably have two goals in mind: to
    shift much of repo trading back to its former infrastructure role while
    moving more volume onto centrally cleared platforms. Prior to 2005,
    dealer repo businesses were structured primarily to finance firms'
    holdings of securities, along with a limited role in providing customer
    leverage. But, by 2006, repo trading became more speculative, with more
    emphasis on large trading volumes involving extensive maturity and
    collateral transformation. Returning repo to its former role, however,
    could entail significant externalities. For example, the reduction in
    repo volumes will change the capacity of banks and dealers to act as
    intermediaries between securities buyers and sellers. And, as we
    outline in the Equity Gilt Study 2015, (https://live.barcap.com/go/
    publications/content?contentPubID=FC2115179) this has implications for
    market liquidity.
    Revenge of the Plumbing
        Most people pay little attention to plumbing, provided it works
    properly. The repo market has long been considered a dull part of the
    financial market plumbing, largely overlooked by many until it stops
    working, as it did during the financial crisis. However, just as
    plumbing attracts considerable focus when the taps run dry (or
    otherwise), this mundane market is about to get significantly more
    attention. Regulatory reform is likely to shrink the market further and
    reduce the role of banks and dealers as intermediaries in the exchange
    of collateral and cash. Similarly, balance sheet scarcity is likely to
    lead to further spread widening with clear winners (banks) and losers
    (long-only investors who cannot net trades). At the same time, the
    Fed's efforts to put a floor under short-term interest rates is likely
    to increase the central bank's presence in the repo market despite its
    discomfort with the RRP program.
        Stay tuned.

    Analyst Certification:

        I, Joseph Abate, hereby certify (1) that the views expressed in this
     research report accurately reflect my personal views about any or all
     of the subject securities or issuers referred to in this research
     report and (2) no part of my compensation was, is or will be directly
     or indirectly related to the specific recommendations or views
     expressed in this research report.

    Important Disclosures:

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                                     ______

    Barclays
    Central Clearing and the Repo Market
      Joseph Abate, +1 212 412 7459, joseph.abate@barclays.com, BCI, U.S.
    Interest Rates Research
    U.S. Money Markets
    5 June 2015

        Balance sheet reporting pressures are intensifying and have reduced
    liquidity in the market for Treasury collateral. An expansion of the
    current GCF framework or the development of a new centrally cleared
    repo product might significantly improve liquidity.

       In a central counterparty (CCP), the central agent is the
            buyer to every seller and the seller for every buyer. In
            effect, the agent is counterparty to every repo transaction.

       In addition to balance sheet netting capacity, a repo CCP
            would set collateral eligibility requirements and determine
            minimum haircuts while increasing market transparency. The CCP
            structure also minimizes post-default asset fire sales.

       Although generally supportive, Fed officials have recently
            expressed concern about the ability of CCPs to withstand
            shocks.

        We think the current GCF framework will eventually be expanded to
    include limited ``buy side'' participation, but this is likely to take
    several years and much regulatory scrutiny.
    Signs of Repo Illiquidity
        Another month-end has come and gone. And although repo rates did
    not become as disjointed as at the end of March, the market is clearly
    showing signs of strain. In particular, rates on Treasury collateral
    are trading considerably above the Fed's overnight RRP rate while
    program usage is above its long-term average on the last day of the
    month. The strain also shows up as a widening of the spread between the
    rate money funds earn on their Treasury repo and what lower-rated or
    smaller banks pay to borrow cash against Treasuries (Figure 1).
        Moreover, based on foreign bank cash holdings, this tendency for
    banks to step away from the repo market at quarter-ends appears to have
    intensified since 2012. However, as all banks move to daily average
    balance sheet reporting, these seasonal dips in repo availability will
    eventually be smoothed out, with every day effectively a quarter-end.
    We expect this to lead to a permanent gap between where some large,
    highly rated banks raise cash and where their smaller, lower-rated
    counterparties are able to borrow against Treasury collateral.
    Moreover, we expect volume in the Treasury repo market to be at least
    20% smaller.\1\
    ---------------------------------------------------------------------------
        \1\ See, Regulatory reform: Repo-cussions, (https://
    live.barcap.com/go/publications/content?contentPubID=FC2120226) March
    12, 2015.
    ---------------------------------------------------------------------------
    Not All Repo Is Equal
              The balance sheet wedge reflects a shortage of collateral
            from the top-tier banks . . .

        Essentially, this balance sheet wedge at the largest banks, which
    is driving spreads wider and keeping RRP usage high, partly reflects
    the fact that even in the overnight market for borrowed cash
    collateralized with Treasuries there is still an element of
    counterparty risk. Counterparty risk is influenced by the cash lender's
    assessment of the borrower's default probability and the resulting
    likelihood that he/she will need to liquidate collateral to get his/her
    cash back.\2\ As a result, and also because of counterparty ratings
    restrictions, money funds and some other cash lenders are able to lend
    only to top-tier banks. Smaller institutions or those with lower credit
    ratings are able access cash from these lenders only through the
    intermediation of a larger, more highly rated bank. But since this
    intermediation boosts the larger bank's balance sheet and increases its
    leverage ratio, these institutions are reluctant to trade, creating the
    balance sheet wedge in the market. As a result, the larger banks step
    away from the repo market on key reporting dates, including quarter-
    ends.\3\
    ---------------------------------------------------------------------------
        \2\ Repo is bankruptcy remote--the collateral can be liquidated
    immediately without having to wait for a judge's decision. Some lenders
    are not legally able to own the underlying collateral or they don't
    have the expertise to sell it.
        \3\ See, Repo and fed funds inversion, April 9, 2015.
    ---------------------------------------------------------------------------
        In the absence of counterparty credit issues (or balance sheet
    limits), our sense is that the repo market would adjust: as collateral
    flows from the largest institutions retreat, those flows from the
    smaller institutions might rise to make up the difference. In effect,
    the current decline in repo volume and the widening in the spread
    between those banks with access to money fund cash and those without is
    a ``locational shortage''--the largest, capital-constrained banks are
    not providing enough repo to meet market demand from money funds who
    cannot find replacement supply since repo from smaller, lower rated
    banks is not a substitute.
        In an ideal world, this locational shortage would be arbed away if
    the smaller banks could borrow directly from the same lenders as the
    largest institutions without having to rely on the larger banks to act
    as intermediaries. Another solution would be to increase the balance
    sheet capacity of the largest banks--expanding their ability to act as
    repo market intermediaries--through the creation of a repo CCP.\4\
    ---------------------------------------------------------------------------
        \4\ Another solution, which we leave for a later date, would be a
    relaxation on counterparty credit requirements on rated money funds. It
    can reasonably be argued that counterparty credit restrictions applied
    to overnight Treasury repo transactions are extreme and all rated funds
    should be able to ``look through'' to the underlying collateral.
    ---------------------------------------------------------------------------
    CCP Basics
              The CCP is the counterparty to every transaction . . .

        At the most basic level, the CCP is a network in which the central
    agent is the buyer to every seller and the seller to every buyer. The
    central agent is thus the counterparty to every transaction--and,
    correspondingly, each member's credit exposure is to the CCP rather
    than to the party on the other side of the transaction. Members are
    required to contribute to the CCP's guarantee fund and the CCP is
    capitalized. Members must also post an initial margin on their trades.
    This is meant to protect the CCP from losses associated with having to
    find other members willing to take over a defaulting dealer's trades or
    to liquidate those trades outright. The size of the initial margin
    should, in theory, cover the potential risk to the CCP that it might
    not be able to immediately liquidate or transfer a defaulting dealer's
    trades.
        In the event that a member defaults, there is a mandated loss
    waterfall. Initially, losses are absorbed by the defaulting dealer's
    margin on the trade. If this is insufficient, losses move to the
    defaulting dealer's guarantee fund and, if this, too, is insufficient,
    the CCP's capital is charged. Beyond this point, the remaining members
    of the CCP face charges to their own guarantee funds (loss
    mutualization). The CCP's ability to absorb losses in this waterfall is
    based on a balanced mixture of pre-funded resources from participating
    members as well as pre-determined ``cash calls'' that are triggered
    under certain conditions.
    Figure 1
    TSY GC Less TSY Repo Rate Earned by MMFs (bp)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: Weighted average rate on money fund Treasury repo at
            month-end.
              Source: DTCC, Crane's Data.
    Figure 2
    Treasury GCF Repo Volume ($bn)
    [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

              Note: 20d average. Source: DTCC.
    General Benefits
        There are several generalized benefits to the CCP structure. First,
    members are insulated against another member's default.\5\ Second, the
    CCP establishes eligibility and other membership requirements which, in
    the case of repo, could include the type of collateral that can be
    traded on the platform as well as the corresponding haircuts. Moreover,
    since members are subject to loss mutualization, they all have a strong
    incentive to see that these standards are rigidly maintained.
    ---------------------------------------------------------------------------
        \5\ Assuming the CCP has collected sufficient initial margin and
    the defaulter has a sufficiently deep guarantee fund.
    ---------------------------------------------------------------------------
        Most important, in today's world of constrained balance sheets, the
    CCP increases market efficiency via netting. Since all transactions are
    with the same counterparty, longs and shorts can be netted. Recall
    that, under existing accounting rules, repo balance sheet netting
    outside the CCP requires that trades have the same counterparty, same
    maturity date and be of the same collateral type. Unsurprisingly, given
    these accounting limits, trade coordination across multiple customers
    is much more difficult outside the CCP.

              The CCP returns cash to the lender in the event of a member
            default . . .

        Additionally, in the event of a member default, lenders receive
    cash rather than the underlying collateral as they would in a standard
    (uncleared) repo trade. The CCP agent either transfers the defaulting
    dealer's transaction to another CCP member willing to take over the
    trade or the CCP liquidates it. In theory, and depending on the
    strength of the CCP, this should prevent post-default asset fire sales.
    Unsurprisingly given these benefits, and particularly given the intense
    balance sheet pressure in the repo market, there is strong support for
    a repo CCP.
    Magic Balance Sheet Bullet
        Of course, there already exists a repo CCP--the GCF interdealer
    market. The GCF repo market is a blind, brokered market, sponsored by
    DTCC, where Treasury, Agency, and MBS collateral is traded. In this
    market, roughly $115bn/day in Treasury collateral is traded. This
    market is made up of dealers as legal restrictions on money funds and
    their capacity to participate in loss mutualization schemes prohibits
    their participation.

              GCF could be expanded to include limited RIC participation

        However, last October, the DTCC submitted a proposal to the SEC to
    expand this market to include members from the buy-side (``registered
    investment companies or RICs'') in a limited capacity. Technically,
    they and the current GCF membership would participate in a new program
    called ``institutional tri-party.'' In this program, a member can be
    either a cash lender or a cash borrower; the RICs would always be cash
    lenders. Cash lenders in ``institutional tri-party'' would have
    different membership status than dealers who borrow cash. Their
    ``membership-lite'' status is justified by the fact that the RICs do
    not pose the same credit risk to the platform as, say, a dealer, who
    could default while owing money to the other members.
        Our understanding is that a typical trade between a RIC and a
    dealer would be similar to current bilateral arrangements. RIC A and
    dealer X would agree to exchange cash and collateral at a fixed rate
    for a set term. But both would agree to novate the trade to the GCF.
    Although RICs would not face loss mutualization in the event of a
    member default (and would receive cash instead of the underlying
    collateral), it is still possible for the RIC to experience a loss. For
    example, if dealer X defaults on a repo with RIC A, the latter might
    face a loss if the margin it collects on the transaction is
    insufficient.
        Although the repo is novated by the GCF, the RIC still faces
    counterparty risk--and, importantly, these risk-averse cash lenders are
    likely to limit their loans to the largest banks and dealers.
    Consequently, we do not expect that an expansion in GCF membership will
    necessarily increase smaller dealers' ability to raise repo funding at
    lower rates.

              GCF dealers could expand their balance sheet capacity by
            netting more transactions . . .

        However, expanding GCF membership could boost the balance sheet
    capacity of the larger banks and dealers. Bilateral trades with RICs
    that previously consumed balance sheet could now be moved (novated) to
    the GCF. And these transactions could be netted against the large bank/
    dealer's collateral borrowings on the platform. In effect, the more
    that dealers can net down via this shift, the more trading capacity
    they can create for themselves.

              and RICs could earn more from lending their cash in
            repo

        All else equal, we would expect this to boost the return that RICs
    earn from lending their cash. But, as noted above, RICs are likely to
    remain fairly risk averse, so they might continue to avoid lending to
    smaller dealers and lower-rated institutions on GCF. Thus, although the
    balance sheet premium illustrated in Figure 1 might narrow, smaller
    dealers' funding costs might not change at all. Of course, increasing
    the scope for netting could increase trading volume on the GCF market,
    which has been falling for several years (Figure 2).
        GCF expansion is not the only current repo market proposal. Others
    include the creation of cleared repo on an exchange. Clearinghouse
    operators CME and LCH.Clearnet Group are working on proposals, but no
    details have been released yet.\6\
    ---------------------------------------------------------------------------
        \6\ See, ``Large Banks Backing New Safeguards in Short-term Lending
    Markets'', K. Burne, October 9, 2014.
    ---------------------------------------------------------------------------
    CCP Conundrum
              The most efficient CCP structure is large, with many members
            across different assets . . .

        A CCP for repo, however, creates a conundrum for regulators. On the
    one hand, it reduces counterparty risk, increases market transparency
    and establishes strict trading and membership guidelines. On the other,
    some regulators worry that these platforms could themselves become
    ``too big to fail''.
        Recent academic work notes that the most efficient CCP structure is
    one that has many participating members, accounts for a large share of
    market volume, and, ideally, spans multiple asset classes.\7\ But a
    single, enormous multi-asset CCP that, for example, clears repo, as
    well as interest rate and credit derivatives might create a substantial
    concentration risk. Within the CCP, regulators worry about membership
    concentration and the risk that default by a single, large member could
    overwhelm the CCP and bring the whole platform down.\8\ Capponi, et
    al., illustrate the risks of membership concentration by examining a
    model where an increasingly concentrated banking industry uses CCPs to
    hedge loan book risks.
    ---------------------------------------------------------------------------
        \7\ See ``Does a Central Clearing Counterparty Reduce Counterparty
    Risk?'', D. Duffie and H. Zhu, Stanford University, July 2010.
        \8\ See, ``Systemic Risk: The Dynamics under Central Clearing'', A.
    Capponi, W.A. Cheng, S. Rajan, Office of Financial Research, U.S.
    Treasury May 7, 2015.

    ---------------------------------------------------------------------------
              CCPs need to collect sufficient initial margin . . .

        The alternative--of several loosely connected CCPs with largely the
    same membership--might also pose some risk. Glasserman, et al., focus
    on liquidity risks to the CCPs arising from uncoordinated initial
    margin requirements across multiple CCPs.\9\ Recall that the CCP
    collects initial margin to cover the cost of finding another member to
    take over a defaulting dealer's trades or for the CCP to liquidate
    them. Because the liquidity cost increases more than proportionally
    with the size of the transaction, it is possible for the CCP to under-
    collect initial margin. This under-collection risk is compounded by the
    fact that CCP members have an incentive to minimize their transaction
    costs by shopping around for the platform with the lowest margin costs
    and spreading their transactions over multiple platforms, where
    possible. Naturally, those platforms with the lowest margins will
    attract a bigger share of total trading volumes. Thus, at any point, a
    CCP could be under-collecting initial margin, leaving it and its
    participating members more exposed to a member default. In addition, a
    single member defaulting across multiple CCPs could trigger asset fire
    sales--similar to the post-default fire sales in the bilateral
    (uncleared) repo market.
    ---------------------------------------------------------------------------
        \9\ See, ``Hidden Illiquidity with Multiple Central
    Counterparties'', P. Glasserman, C. Moallemi, K. Yuan, Office of
    Financial Research, U.S. Treasury, May 7, 2015.
    ---------------------------------------------------------------------------
    Repo-Centric Risk
        Although this issue has not been studied academically, we wonder
    about risks specific to a repo-centric CCP. Ahead of each of the recent
    debt ceiling crises, activity in the Treasury GCF market dried up and
    rates shot up. Cash lenders stepped away from the market, fearful that
    they could receive ``payment-delayed'' collateral as they had no way to
    prevent this collateral from being pledged to them in the GCF market.
    Operationally, this might be solved by enabling lenders in the GCF
    market to exclude certain CUSIPs. But, given the similarity in risk
    tolerance and asset allocation across RICs, it is possible to imagine
    other, non-debt ceiling-scenarios where these members pull back en
    masse from providing cash to the repo market.

              Adding RICs to GCF might reduce repo volume and rate spikes
            at quarter-ends . . .

        More generally, as larger banks continue to step away from their
    role as principal cash providers in the GCF market, (GCF) repo market
    dynamics could change in unpredictable ways. First, since the RICs are
    not governed by the balance sheet reporting issues as the capital-
    constrained large banks, their lending of cash into this market should
    theoretically be more stable and not prone to the sharp--but
    predictable--quarter-end contractions that frequently shrink trading
    volume by more than 15% and push funding rates sharply higher. As a
    result, adding RICs to GCF could remove some of the spikiness in repo
    rates.
    Federal Reserve Reservations
              Regulators generally support the creation of repo CCPs . . .

        Financial regulators have long favored the creation of central
    clearing in the repo market--at least since the formation of the Tri-
    party Repo Reform Task Force in 2009. More recently, Fed Governor
    Powell observed that ``central clearing holds the promise of enhancing
    financial stability through the netting of counterparty risks, creating
    greater transparency, and applying stronger and more consistent risk-
    management practices.'' \10\ However, in the same speech, he expressed
    concern about designing CCPs to be strong enough to sustain a
    significant financial shock, including a simultaneous default by
    multiple members.
    ---------------------------------------------------------------------------
        \10\ See, ``Financial Institutions, Financial Markets, and
    Financial Stability'', J. Powell, NYU, February 18, 2015.
    ---------------------------------------------------------------------------
        Earlier this year, Fed Governor Daniel Tarullo was more explicit in
    voicing his concerns about CCPs, noting for example that ``more
    attention must be paid'' to some of the assumptions underlying the
    structure of CCPs.\11\ Although systemically important CCPs are
    required to hold sufficient funds to cover defaults by their two
    largest members, it is not clear if this ``coverage ratio'' would be
    adequate in a financial crisis. Of course, like other precautionary
    liquidity buffers it is unclear a priori what the optimal size is. More
    significantly, CCPs assume that they can draw liquidity from their
    members, but during a systemic shock, their members might also be
    suffering redemptions and liquidity withdrawals, reducing their
    capacity to support the CCP. Dodd-Frank gives systemically important
    financial market utilities access to the Fed's discount window, but it
    is not clear how the Fed might interpret this with respect to, say, an
    expanded GCF market.
    ---------------------------------------------------------------------------
        \11\ See, ``Advancing Macro-prudential Policy Objectives'', D.
    Tarullo, Office of Financial Research, January 30, 2015.
    ---------------------------------------------------------------------------
        The DTCC recently published a study on the mechanics of
    strengthening CCPs' loss absorption capacity.\12\ Although the DTCC
    supports regular stress-testing, it notes that given the various
    products traded on these platforms these stress tests may need to be
    customized for each platform. Similarly, they note that this loss
    absorption capacity should be sized (with pre-funded member
    contributions and future cash calls) to an ``extreme event''. We
    suspect, however, that defining an ``extreme event'' will be difficult.
    ---------------------------------------------------------------------------
        \12\ See, ``CCP Resiliency and Resources'', DTCC, June 1, 2015.
    ---------------------------------------------------------------------------
        We expect the structure and mechanics of stress testing a repo CCP
    will be debated for some time. And although we expect that the GCF
    market will ultimately be expanded, it will likely face tough
    regulatory scrutiny from the Fed.

    Analyst Certification:

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