[House Hearing, 114 Congress]
[From the U.S. Government Publishing Office]
DODD-FRANK TURNS FIVE: ASSESSING THE
PROGRESS OF GLOBAL DERIVATIVES
REFORMS
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED FOURTEENTH CONGRESS
FIRST SESSION
__________
JULY 29, 2015
__________
Serial No. 114-24
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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COMMITTEE ON AGRICULTURE
K. MICHAEL CONAWAY, Texas, Chairman
RANDY NEUGEBAUER, Texas, COLLIN C. PETERSON, Minnesota,
Vice Chairman Ranking Minority Member
BOB GOODLATTE, Virginia DAVID SCOTT, Georgia
FRANK D. LUCAS, Oklahoma JIM COSTA, California
STEVE KING, Iowa TIMOTHY J. WALZ, Minnesota
MIKE ROGERS, Alabama MARCIA L. FUDGE, Ohio
GLENN THOMPSON, Pennsylvania JAMES P. McGOVERN, Massachusetts
BOB GIBBS, Ohio SUZAN K. DelBENE, Washington
AUSTIN SCOTT, Georgia FILEMON VELA, Texas
ERIC A. ``RICK'' CRAWFORD, Arkansas MICHELLE LUJAN GRISHAM, New Mexico
SCOTT DesJARLAIS, Tennessee ANN M. KUSTER, New Hampshire
CHRISTOPHER P. GIBSON, New York RICHARD M. NOLAN, Minnesota
VICKY HARTZLER, Missouri CHERI BUSTOS, Illinois
DAN BENISHEK, Michigan SEAN PATRICK MALONEY, New York
JEFF DENHAM, California ANN KIRKPATRICK, Arizona
DOUG LaMALFA, California PETE AGUILAR, California
RODNEY DAVIS, Illinois STACEY E. PLASKETT, Virgin Islands
TED S. YOHO, Florida ALMA S. ADAMS, North Carolina
JACKIE WALORSKI, Indiana GWEN GRAHAM, Florida
RICK W. ALLEN, Georgia BRAD ASHFORD, Nebraska
MIKE BOST, Illinois
DAVID ROUZER, North Carolina
RALPH LEE ABRAHAM, Louisiana
JOHN R. MOOLENAAR, Michigan
DAN NEWHOUSE, Washington
TRENT KELLY, Mississippi
______
Scott C. Graves, Staff Director
Robert L. Larew, Minority Staff Director
(ii)
C O N T E N T S
----------
Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 1
Prepared statement........................................... 3
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 4
Witnesses
Duffy, Hon. Terrence A., Executive Chairman and President, CME
Group, Chicago, IL............................................. 5
Prepared statement........................................... 6
O'Malia, Hon. Scott D., Chief Executive Officer, International
Swaps and Derivatives Association, Inc., New York, NY.......... 9
Prepared statement........................................... 11
Edmonds, Christopher S., Senior Vice President, Financial
Markets, IntercontinentalExchange, Inc., Chicago, IL........... 22
Prepared statement........................................... 23
Supplementary material....................................... 67
Submitted reports............................................ 89
Thompson, Larry E., Vice Chairman and General Counsel, Depository
Trust and Clearing Corporation, New York, NY................... 25
Prepared statement........................................... 26
Parsons, Ph.D., John E., Senior Lecturer, Sloan School of
Management, Massachusetts Institute of Technology, Cambridge,
MA............................................................. 41
Prepared statement........................................... 42
DODD-FRANK TURNS FIVE: ASSESSING THE
PROGRESS OF GLOBAL DERIVATIVES
REFORMS
----------
WEDNESDAY, JULY 29, 2015
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:01 a.m., in Room
1300 of the Longworth House Office Building, Hon. K. Michael
Conaway [Chairman of the Committee] presiding.
Members present: Representatives Conaway, Rogers, Gibbs,
Austin Scott of Georgia, Davis, Yoho, Allen, Bost, Abraham,
Moolenaar, Newhouse, Kelly, Peterson, Walz, McGovern, DelBene,
Vela, Kuster, Nolan, Bustos, Kirkpatrick, Plaskett, Adams,
Graham, and Ashford.
Staff present: Caleb Crosswhite, Carly Reedholm, Haley
Graves, Jackie Barber, Kevin Webb, Mollie Wilken, Paul Balzano,
Scott C. Graves, Faisal Siddiqui, Liz Friedlander, Matthew
MacKenzie, and Nicole Scott.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
IN CONGRESS FROM TEXAS
The Chairman. Good morning. This hearing on the Committee
on Agriculture, Dodd-Frank Turns Five: Assessing the Progress
of Global Derivatives Reforms, will come to order. Please join
me in a brief prayer. Heavenly Father, we thank you, Lord, for
the privileges of being able to represent the folks we
represent for our districts. We ask, Lord, that we honor that
trust that they put in us as we consider things before the
Committee today. Give us wisdom, and knowledge, and discernment
that we might come to the right conclusions. Forgive us where
we fail, Lord. We ask these things in Jesus's name, amen.
Thank you for being here today and joining us in this full
Committee hearing. The 2008 financial crisis prompted global
leaders to re-evaluate the regulatory regime for derivatives.
In Pittsburgh, and again in Cannes, global leaders set out five
categories of reforms--clearing, margining, electronic
execution, data reporting, and capital standards--they all
agreed would make derivatives markets much safer. Perhaps most
importantly, though, the G20 leaders recognized the global
nature of swaps markets, and sought to ensure that national
regulators coordinated these reform efforts.
In 2008, at the close of the first G20 summit in
Washington, the assembled heads of state declared: ``our
financial markets are global in scope, therefore intensified
international cooperation among regulators, and strengthening
of international standards were necessary, and their consistent
implementation is necessary to protect against adverse cross-
border, regional and global developments affecting
international financial stability. Regulators must ensure that
their actions support market discipline, avoid potentially
adverse impacts on other countries, including regulatory
arbitrage, and support competition, dynamism, and innovation in
the marketplace.''
G20 leaders continued to push for cooperation, and
cooperation between regulators, at every subsequent G20
meeting, including in the joint announcement following the 2013
St. Petersburg summit, where G20 leaders spoke about the
importance of deferring to national regulators. They said, ``We
agree that jurisdictions and regulators should be able to defer
to each other, when it is justified, by the quality of the
respective regulatory and enforcement regimes based on similar
outcomes, in a non-discriminatory way, paying due respect to
home country regulation regimes.''
As we mark the fifth anniversary of the Dodd-Frank Act, it
is important that we take stock of where we were and where we
are trying to get to by enacting this legislation. The G20 laid
out a road map that demanded international action to respond to
an international crisis, but left it to national regulators to
implement that vision. Over the past several years the
Agriculture Committee has heard from market participants, CFTC
Commissioners, and even foreign regulators about the struggles
national regulators are having living up to the proclamations
of the G20.
Today the Committee is concerned that the lack of
coordination and harmonization is jeopardizing the
implementation of these promised and widely sought reforms to
global swaps markets. If we get these reforms wrong, we will
permanently disrupt global financial markets, trapping
liquidity behind regulatory barriers, and preventing end-users
from seeking out their best risk management counterparts.
Splintering global financial markets through regulatory pride-
of-authorship is not reform, it is bureaucratic hubris. If that
is the ultimate outcome of the Dodd-Frank Act, regulators will
have squandered the responsibility to which they were
entrusted. Today we will begin to examine the progress global
regulators have made with derivatives reforms and what work
remains to be done, where the perils are for market
participants. And I look forward to the testimony of our
witnesses.
In the background of this debate looms the continued
inaction of the Congress on the expired authorization of the
CFTC. I consider it a failure of our institution to allow
Federal agencies to operate outside the traditional budget
process of authorization, appropriation, and oversight. That is
why I set an ambitious agenda this spring to re-authorize all
of our expired or expiring programs and agencies. Together we
got our work done, we moved the four bills through the
Committee and the House floor, re-authorizing everything within
our jurisdiction that needed to be done this year.
For the CFTC, this Committee has done its work twice over
the past 2 years, and moved two bipartisan re-authorization
packages through the House of Representatives, with no
corresponding action in the Senate. Despite the lack of
authorization, appropriations to the agencies have increased,
from $194 million at the end of Fiscal Year 2013 to $250
million this year, a 29 percent increase in 2 years.
To that end, I want to publicly state I am opposed to any
increase in funding for the Commission until it is re-
authorized. Both the House and the Senate Appropriations
Committee have proposed level funding for the agency, and I do
not believe it is appropriate to have any conversation that
moves that line, while so many end-users and good government
issues remain outstanding and unresolved. This is not a
position I take lightly, which I hope highlights the importance
in which I hold the re-authorization of every agency and
program under the jurisdiction of this Committee.
[The prepared statement of Mr. Conaway follows:]
Prepared Statement of Hon. K. Michael Conaway, a Representative in
Congress from Texas
Thank you all for joining us today and welcome to today's full
Committee hearing, Dodd-Frank Turns Five: Assessing the Progress of
Global Derivatives Reforms.
The 2008 financial crisis prompted global leaders to reevaluate the
regulatory regime for derivatives. In Pittsburgh and again in Cannes,
global leaders set out five categories of reforms--clearing, margining,
electronic execution, data reporting, and capital standards--they all
agreed would make derivatives markets safer.
Perhaps most importantly though, the G20 Leaders recognized the
global nature of swaps markets and sought to ensure that national
regulators coordinated these reform efforts. In 2008, at the close of
the first G20 Summit in Washington, the assembled Heads of State
declared:
. . . our financial markets are global in scope, therefore,
intensified international cooperation among regulators and
strengthening of international standards, where necessary, and
their consistent implementation is necessary to protect against
adverse cross-border, regional and global developments
affecting international financial stability. Regulators must
ensure that their actions support market discipline, avoid
potentially adverse impacts on other countries, including
regulatory arbitrage, and support competition, dynamism and
innovation in the marketplace.
G20 leaders continued to push for cooperation and coordination
between regulators at every subsequent G20 meeting, including in the
joint announcement following the 2013 St. Petersburg Summit, where the
G20 Leaders spoke about the importance of deferring to national
regulators:
``We agree that jurisdictions and regulators should be able
to defer to each other when it is justified by the quality of
their respective regulatory and enforcement regimes, based on
similar outcomes, in a non-discriminatory way, paying due
respect to home country regulation regimes.''
As we mark the fifth anniversary of the Dodd-Frank Act, it is
important that we take stock of where we were and where we were trying
to get to by enacting this legislation. The G20 laid out a roadmap that
demanded international action to respond to an international crisis,
but left it to national regulators to implement that vision.
Over the past several years, the Agriculture Committee has heard
from market participants, CFTC Commissioners, and even foreign
regulators about the struggles national regulators are having living up
to the proclamations of the G20. Today, the Committee is concerned that
the lack of coordination and harmonization is jeopardizing the
implementation of these promised and widely supported reforms to global
swaps markets.
If we get these reforms wrong, we will permanently disrupt global
financial markets, trapping liquidity behind regulatory barriers and
preventing end-users from seeking out their best risk management
counterparts. Splintering global financial markets through regulatory
pride-of-authorship is not reform, it is bureaucratic hubris. If that
is the ultimate outcome of the Dodd-Frank Act, regulators will have
squandered the responsibility with which they have been entrusted.
Today, we'll begin to examine what progress global regulators have
made with derivatives reforms, what work remains to be done, and where
the pitfalls are for market participants. I look forward to the
testimony of our witnesses.
In the background of this debate looms the continued inaction of
Congress on the expired authorization the CFTC. I consider it a failure
of our institution to allow Federal agencies to operate outside of the
traditional budget process of authorization, appropriation, and
oversight. That is why I set an ambitious agenda this spring to
reauthorize all of our expired or expiring programs and agencies.
Together, we got our work done and we've moved four bills through this
Committee and the House floor reauthorizing everything within our
jurisdiction that we need to this year.
For the CFTC, this Committee has done its work twice over the past
2 years and moved two bipartisan reauthorization packages through the
House of Representatives, with no corresponding action in the Senate.
Despite the lack of authorization, appropriations to the agency have
increased from $194 million at the end of FY 2013 to $250 million this
year, an increase of 29% in 2 years.
To that end, I want to publicly state I am opposed to any increase
in funding for the Commission until it is reauthorized. Both the House
and Senate Appropriations Committees have proposed level funding for
the agency, and I do not believe it is appropriate to have any
conversation that moves that line while so many end-user and good-
government issues remain outstanding and unresolved. This is not a
position I take lightly, which I hope highlights the importance in
which I hold the reauthorization of every agency or program under the
jurisdiction of this Committee.
The Chairman.With that, I yield to the Ranking Member for
any opening statement he has.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
Mr. Peterson. Well, thank you, Mr. Chairman, and I thank
the panel for being here to visit with us today. It has, as you
said, been about 7 years since the financial crisis, and 5
years since this Committee finished our work on Title VII of
Dodd-Frank. In that time the CFTC has finished 50 of the 60
rules required by Title VII. Central clearing, margin, price
transparency are now the rule, rather than the exception, in
the swaps market. And as a result of Title VII the derivatives
market, as a whole, is now much safer for end-users, consumers,
market participants and taxpayers than they were 7 years ago.
Still, there is much work to be done. I look forward to
hearing our witnesses' views on the areas that need more work,
particularly what they feel would be the most appropriate role
for Congress to support Chairman Massad in his efforts to
coordinate the CFTC's rules with those of foreign regulators. I
think he has done a good job. He has been a good leader in that
effort, and I do want to make sure that whatever action we take
enhances that effort, and the progress that he has made.
I also want to hear the witnesses' views on how we can help
to improve the Dodd-Frank's trade data reporting regime.
Reporting is very important, and it is non-controversial, but
it is no secret that it isn't working as well as it should,
that something needs to be done in that area. So, again, Mr.
Chairman, thank you for the hearing, and I yield back.
The Chairman. I thank the gentleman. The chair would
request that other Members submit their opening statements for
the record so that our witnesses may begin testimony to ensure
there is ample time for questions.
I would like to welcome to our witness table today Mr.
Terry Duffy, Executive Chairman and President of CME Group,
Chicago Illinois, Mr. Scott O'Malia, the Chief Executive
Officer, International Swaps and Derivatives Association, Inc.
of New York, Mr. Christopher Edmonds, Senior Vice President,
Financial Markets, IntercontinentalExchange in Chicago, Mr.
Larry Thompson, Vice Chairman and General Counsel, Depository
Trust and Cleaning Corporation of New York, and Dr. John
Parsons, Senior Lecturer, MIT Sloan School of Management,
Cambridge, Massachusetts.
Mr. Duffy, you may begin when you are ready.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN AND
PRESIDENT, CME GROUP, CHICAGO, IL
Mr. Duffy. Thank you, Chairman Conaway, Ranking Member
Peterson, Members of the Committee. I appreciate the
opportunity to offer CME Group's perspective on the G20
commitments, and whether the U.S. and global regulators are
meeting them.
Since Congress passed the Dodd-Frank Act, the U.S. has
imposed a clearing mandate for certain swaps. Today they are
traded transparently on futures exchanges and SEFs, which are
swaps execution facilities, cleared through central clearing
houses, and reported. These developments represent progress
towards the goals of the G20 to strengthen the financial system
through reforms that increase transparency and reduce systemic
risk.
But the point of the G20 commitments was also to create a
global framework. As of today, many G20 nations have not
implemented the core elements of the G20 regulatory reforms
that the U.S. has in our Dodd-Frank Act. This lack of
coordination has led to policies that have created
inconsistency, uncertainty, and the potential to harm efficient
functioning of the U.S. and global derivatives markets.
A few examples would be, first, in the European Union, the
current lack of recognition for U.S. clearing houses will
prevent EU participants from clearing EU mandated products in
the United States. This will prevent U.S. clearing houses from
competing for this global business. And it is clearly unfair,
given the way the European and other foreign clearing houses
have been able to compete for U.S. business arising from our
Dodd-Frank mandate.
Of equal concern, the lack of recognition of U.S. exchanges
by the European Union has begun to drive some trading out of
the United States. I suggested to this Committee many years
ago, when I was testifying, that this was exactly what was
going to happen, and we are seeing that happen today. I am
hopeful that the U.S. and European Union will achieve
resolution on the equivalence issue in the coming months. This
would give participants the regulatory certainty they need to
effectively manage their global risks.
Second, global coordination is also essential for an
effective position limits regime. If the CFTC adopts an overly
prescriptive position limits rule when other G20 nations have
not, price discovery and risk management for U.S. commodities
will likely move abroad. For end-users that stay in the United
States, their cost to hedge will be significantly higher due to
the potential lack of liquidity, and the spread is widening.
Before closing I want to raise one other issue that is
contrary to the objectives of the G20 commitments, and that is
the leverage ratio rule adopted by the Basel Committee and the
U.S. Federal Reserve. The rule mistakenly fails to recognize
the risk reducing effect of segregated margin. Instead, the
rule penalizes the use of central clearing houses by banks on
behalf of their clients. It forces banks to overstate their
leverage exposure, and hold more capital against their client
clearing activities. This is the case even when those
activities cannot, as a matter of law, increase the bank's
leverage exposure.
Under this rule, the current calculation of leverage ratio
results in better treatment for higher risk products, such as
credit default swaps, versus agriculture or other commodity
futures. This makes absolutely no practical sense whatsoever.
Making clearing more expensive, and less successful, for end-
users is directly contrary to the objectives of the G20
commitments. For the G20 commitments to work globally, each
member nation needs to have a workable cross-border regulatory
framework. CFTC Chairman Timothy Massad has been a leader in
working with his counterparts among the G20 member nations to
address that.
In closing, an effective cross-border regulatory framework
does not mean that regulators of G20 nations must be identical.
The key is to whether each nation's rules achieve the G20
commitments. In the global market, the goal should be for
nations to adopt frameworks that lead to consistent regulation,
and the results that allow for appropriate substitutable
compliance. I want to thank the Chairman and the Members of the
Committee for the time. I look forward to answering your
questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman and
President, CME Group, Chicago, IL
Good morning Chairman Conaway, Ranking Member Peterson. I am Terry
Duffy, Executive Chairman and President of CME Group.\1\ Thank you for
the opportunity to offer our perspective on the G20 commitments and
whether U.S. and global regulators are meeting them.
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\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.
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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.
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\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\
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\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.
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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\
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\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.
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\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.
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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\
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\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).
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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
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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\
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\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.
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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.
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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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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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