[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
                           
                           
                           
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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 [email protected].
    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, [email protected]
  Brian Monteleone, +1 212 412 5184, [email protected]
  Eric Gross, +1 212 412 7997, [email protected]
  Conor Pigott, +1 212 412 3441, [email protected]
  Joseph Abate, +1 212 412 7459, [email protected]

   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, [email protected]
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.

 
 
 
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Barclays
Central Clearing and the Repo Market
  Joseph Abate, +1 212 412 7459, [email protected], 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.

 
 
 
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