[House Hearing, 115 Congress]
[From the U.S. Government Publishing Office]

                      RECOVERY, AND RESOLUTION OF
                       DERIVATIVE CLEARINGHOUSES



                               BEFORE THE

                        COMMITTEE ON AGRICULTURE
                        HOUSE OF REPRESENTATIVES


                             FIRST SESSION


                             JUNE 27, 2017


                            Serial No. 115-8
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]                          

          Printed for the use of the Committee on Agriculture

                    U.S. GOVERNMENT PUBLISHING OFFICE                    
26-115 PDF                  WASHINGTON : 2017                     
For sale by the Superintendent of Documents, U.S. Government Publishing Office, 
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, 
U.S. Government Publishing Office. Phone 202-512-1800, or 866-512-1800 (toll-free). 
E-mail, [email protected]                          

                        COMMITTEE ON AGRICULTURE

                  K. MICHAEL CONAWAY, Texas, Chairman

GLENN THOMPSON, Pennsylvania         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
BOB GIBBS, Ohio                      JAMES P. McGOVERN, Massachusetts
AUSTIN SCOTT, Georgia                FILEMON VELA, Texas, Vice Ranking 
ERIC A. ``RICK'' CRAWFORD, Arkansas  Minority Member
VICKY HARTZLER, Missouri             ANN M. KUSTER, New Hampshire
JEFF DENHAM, California              RICHARD M. NOLAN, Minnesota
DOUG LaMALFA, California             CHERI BUSTOS, Illinois
RODNEY DAVIS, Illinois               SEAN PATRICK MALONEY, New York
TED S. YOHO, Florida                 STACEY E. PLASKETT, Virgin Islands
RICK W. ALLEN, Georgia               ALMA S. ADAMS, North Carolina
MIKE BOST, Illinois                  DWIGHT EVANS, Pennsylvania
DAVID ROUZER, North Carolina         AL LAWSON, Jr., Florida
RALPH LEE ABRAHAM, Louisiana         TOM O'HALLERAN, Arizona
TRENT KELLY, Mississippi             JIMMY PANETTA, California
JAMES COMER, Kentucky                DARREN SOTO, Florida
DON BACON, Nebraska
JOHN J. FASO, New York
NEAL P. DUNN, Florida


                   Matthew S. Schertz, Staff Director

                 Anne Simmons, Minority Staff Director

                             C O N T E N T S

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


Steigerwald, J.D., Robert S., Senior Policy Advisor, Financial 
  Markets Group, Economic Research Department, Federal Reserve 
  Bank of Chicago, Chicago, IL...................................     4
    Prepared statement...........................................     6
Hill, Scott A., Chief Financial Officer, Intercontinental 
  Exchange, Inc., Atlanta, GA....................................    25
    Prepared statement...........................................    26
Salzman, LL.B., Jerrold E., Of Counsel, Derivatives; Litigation, 
  Skadden, Arps, Slate, Meagher & Flom LLP, Chicago, IL; on 
  behalf of CME Group............................................    30
    Prepared statement...........................................    31
Dabbs, John, Global Head of Prime Derivatives Services, Credit 
  Suisse, Washington, D.C........................................    36
    Prepared statement...........................................    39
Gerety, Amias Moore, Special Advisor, QED Investors; former 
  Acting Assistant Secretary for Financial Institutions, U.S. 
  Department of the Treasury, Washington, D.C....................    44
    Prepared statement...........................................    46

                      RECOVERY, AND RESOLUTION OF
                       DERIVATIVE CLEARINGHOUSES


                         TUESDAY, JUNE 27, 2017

                          House of Representatives,
                                  Committee on Agriculture,
                                                   Washington, D.C.
    The Committee met, pursuant to call, at 10:00 a.m., in Room 
1300 of the Longworth House Office Building, Hon. K. Michael 
Conaway [Chairman of the Committee] presiding.
    Members present: Representatives Conaway, Thompson, 
Goodlatte, Lucas, King, Austin Scott of Georgia, Hartzler, 
Allen, Rouzer, Abraham, Kelly, Comer, Marshall, Bacon, Dunn, 
Arrington, Peterson, David Scott of Georgia, Costa, Fudge, 
McGovern, Vela, Lujan Grisham, Kuster, Bustos, Plaskett, Adams, 
Evans, Lawson, O'Halleran, Soto, and Blunt Rochester.
    Staff present: Darryl Blakey, Jackie Barber, Paul Balzano, 
Rachel Millard, Stephanie Addison, Liz Friedlander, Matthew 
MacKenzie, Troy Phillips, Nicole Scott, and Carly Reedholm.

                     IN CONGRESS FROM TEXAS

    The Chairman. Well, good morning. Before we call this 
hearing to order, I have asked Ralph Abraham to open us with a 
prayer. Ralph.
    Mr. Abraham. Let's pray. Our Father, we certainly 
appreciate your presence in this Committee meeting. We pray for 
your wisdom, your discernment, your understanding, your 
knowledge, everything that we lack. Go with us through this 
day, guide us, direct us, lead us, have us do the best thing 
for you. We pray these things in your name. Amen.
    The Chairman. Thank you, Ralph.
    This hearing of the Committee on Agriculture entitled, 
Clearing the Next Crisis: Resilience, Recovery, and Resolution 
of Derivative Clearinghouses, will come to order.
    I thank everyone for being here this morning. Before I get 
to my statement, I would like to acknowledge that Commissioner 
Sharon Bowen has announced her intent to resign from the CFTC 
last week. I personally want to thank her for the great work 
she did chairing the Market Risk Advisory Committee, she did 
some eight hearings over the last couple of years, and she, as 
a part of her announcement, called for a full Commission, all 
five, and I certainly second her call for that issue. Ms. Bowen 
has been a consistent voice, reminding the Commission that 
markets exist to serve people, and I want to thank her for her 
service and wish her well in whatever her next challenge is.
    We would have also had a panel today with somebody from the 
CFTC on the panel; Chris Giancarlo is over at the Senate today, 
so just physically, mechanically we couldn't make that welcome. 
And probably the most important thing we will announce the 
entire day, is that today is David Scott's birthday. Happy 
birthday, David Scott.
    Mr. David Scott of Georgia. Well, thank you, my friend. I 
appreciate it. Thank you.
    The Chairman. He is sweet 16 and never been kissed. All 
    Well, good morning, and thank you for being here today. 
Today's hearing builds on the important work done by the CEEC 
Subcommittee, chaired by Austin Scott, and Ranking Member David 
Scott. And I want to thank them for their work in examining how 
well our regulators responded to the financial crisis. While 
those hearings were focused on past performance, today's 
hearing examines the possibility, and again, just the 
possibility, for a future financial crisis and how our cleared 
markets may respond.
    Failure of a major clearinghouse would be an unprecedented 
event. Such an event would mean that there would be a 
cataclysmic breakdown of the interlocking risk management 
schemes, despite their highly regulated system to prevent its 
collapse. While this probability is remote, and I repeat, 
remote, recent history demonstrates that the words improbable 
and implausible do not necessarily mean impossible.
    To be clear, I don't know if or when another financial 
crisis might hit. What I do know is that markets are comprised 
of millions of people interacting and responding to incentives; 
regulated by thousands of able civil servants applying the best 
knowledge they can; overseen by hundreds of lawmakers trying to 
recognize and prioritize the tradeoffs in regulatory goals. 
There are many smart but fallible people involved in our 
markets, offering numerous opportunities for mistakes. That is 
why we have gathered here today to discuss what happens when 
the best-laid plans of men go awry.
    Today's hearing is important for two reasons. First, to 
provide this Committee with an understanding of the work that 
has been done to prepare for and prevent a crisis; and second, 
to consider how we want regulators to respond in the unlikely, 
implausible event of a failure.
    Recovery from a default is not an automatic process. While 
substantial planning has gone into preparing for a crisis, 
there are wider factors outside a clearinghouse's control that 
might impact the recovery process. Things like the availability 
of liquidity, the impact of regulations like the Supplemental 
Leverage Ratio, and even the stability of the broader economy 
will all impact the implementation of recovery plans.
    Finally, if a clearinghouse cannot be recovered, Congress 
needs to identify the ultimate goal of any government 
intervention. Today, the Dodd-Frank Act generally assigns the 
FDIC the power to resolve failed, systemically important 
institutions, but it is largely silent on clearinghouses. We 
must fully consider what the resolution process might look like 
and understand its impact on broader financial markets before 
putting it to use.
    We should consider as clearly as we can the expectations of 
our regulators and the potential consequences of the limits of 
their actions. Absent a plan, I fear regulators will respond to 
a crisis with the only tool in their arsenal, and that would be 
a bazooka of money.
    Thank you to our witnesses for coming in today. We have a 
panel with deep knowledge of the derivatives industry who have 
spent a career wrestling with these challenging issues, and we 
certainly appreciate your willingness to share your views with 
us today.
    [The prepared statement of Mr. Conaway follows:]

  Prepared Statement of Hon. K. Michael Conaway, a Representative in 
                          Congress from Texas
    Good morning. Thank you for being here today. Today's hearing 
builds on the important work done by the CEEC Subcommittee last year, 
under the helm of Chairman Austin Scott and Ranking Member David Scott. 
I want to thank them for their work examining how well our regulators 
responded to the financial crisis. While those hearings were focused on 
past performance, today's hearing examines the possibility for a future 
financial crisis and how our cleared markets may respond.
    Failure of a major clearinghouse would be an unprecedented event. 
Such an event would mean there was a cataclysmic breakdown of 
interlocking risk management schemes, despite our highly-regulated 
system to prevent its collapse. While this probability is remote, 
recent history demonstrates that words like ``improbable'' and 
``implausible'' do not necessarily mean ``impossible.''
    To be clear, I don't know if or when another financial crisis might 
hit. What I do know is that markets are comprised of millions of people 
interacting and responding to incentives; regulated by thousands of 
able civil servants applying the best knowledge they can; overseen by 
hundreds of lawmakers trying to recognize and prioritize the tradeoffs 
in regulatory goals. There are many smart but fallible people involved 
in our markets, offering numerous opportunities for mistakes. That is 
what we've gathered today to discuss--what happens when the best laid 
plans of men go awry.
    Today's hearing is important for two reasons--first to provide this 
Committee with an understanding of the work that has been done to 
prepare for a crisis, and second to consider how we want regulators to 
respond in the event our planning has failed.
    Recovery from a default is not an automatic process. While 
substantial planning has gone into preparing for a crisis, there are 
wider factors outside a clearinghouse's control that may impact the 
recovery process. Things like the availability of liquidity, the impact 
of regulations like the Supplemental Leverage Ratio, and even the 
stability of the broader economy will all impact the implementation of 
recovery plans.
    Finally, if a clearinghouse cannot be recovered, Congress needs to 
identify the ultimate goal of any government intervention. Today, Dodd-
Frank generally assigns the FDIC the power to resolve failed, 
systemically-important institutions, but it is largely silent on the 
clearinghouses. We must fully consider what the resolution process 
might look like and understand its impact on broader financial markets 
before putting it to use.
    We should consider--as clearly as we can--the expectations of our 
regulators and the potential consequences of the limits on their 
actions. Absent a plan, I fear regulators will respond to a crisis with 
the only tool in their arsenal--a bazooka of money.
    Thank you to our witnesses for coming in today. We have a panel 
with deep knowledge of the derivatives industry who have spent time 
wrestling with these challenging issues and we appreciate your 
willingness to share your views with us today.
    With that, I'll turn to Mr. Peterson, for his opening remarks.

    The Chairman. With that, I will turn to Mr. Peterson, for 
his opening remarks.


    Mr. Peterson. Thank you, Mr. Chairman. I am pleased to 
welcome today's witnesses to the Agriculture Committee. It has 
been a while since we have reviewed these issues, and I look 
forward to hearing your testimony.
    Central clearing is the backbone of the futures industry, 
and when we wrote title VII of the Dodd-Frank Act, we 
anticipated that clearing could also become a central component 
of the swaps industry. Now, nearly 10 years after the financial 
crisis, that change is taking place. We can all agree that 
making our market safer is a good thing.
    Today we will discuss current policies that are in place to 
manage a future crisis, and how the clearinghouses are prepared 
if we find ourselves in a crisis situation again.
    It is important to note that the issues we will discuss 
today would only happen under extreme circumstances, and this 
is why reviewing these issues now, rather than in the midst of 
a financial collapse, is important.
    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 their testimony, and to ensure there is ample time for 
    And I would like to welcome our witnesses today. We have 
Mr. Robert Steigerwald, who is the Senior Policy Advisor, 
Financial Markets Group, Federal Reserve Bank in Chicago. 
Robert, was I close on your last name?
    Mr. Steigerwald. Very good.
    The Chairman. All right. Scott Hill is the Chief Financial 
Officer, Intercontinental Exchange, in Atlanta. Mr. Jerrold 
Salzman, Of Counsel, Skadden, Arps, Slate, Meagher, and Flom, 
Chicago, Illinois, on behalf of CME. And please pass on our 
best wishes to Terry's quick recovery, otherwise he would have 
been in that seat. Mr. John Dabbs, the Global Head of Prime 
Derivatives, Credit Suisse, here in Washington, D.C. And Mr. 
Amias Gerety, Special Advisor to QED Investors, former Acting 
Assistant Secretary of Financial Institutions, U.S. Treasury 
Department, Washington, D.C.
    With that, Robert, you are recognized for 5 minutes.

                      CHICAGO, CHICAGO, IL

    Mr. Steigerwald. Chairman Conaway, Ranking Member Peterson, 
and Members of the Committee, I very much appreciate the 
opportunity to testify today concerning some important public 
policy issues relating to central counterparty clearing. 
Specifically, I will explain why I support the provision of 
central bank account services, and if necessary, emergency 
liquidity support, not solvency support, to clearinghouses.
    Before I go further, it is incumbent upon me to tell you 
that my remarks today are solely my own, and not those of the 
Federal Reserve Bank of Chicago, the Board of Governors, or any 
other person.
    I will briefly discuss the role that central banks have 
traditionally played, both as depositories and as liquidity 
providers, and make some observations regarding what I and my 
colleagues at the Chicago Fed have come to call time-critical 
liquidity. I will explain that in just a moment.
    Since I believe the clearinghouses are uniquely dependent 
on the immediate availability of liquidity in circumstances 
where private-sector liquidity arrangements may prove to be 
inadequate, I believe that it is crucial for central banks to 
be prepared to provide emergency liquidity assistance in such 
    Central banks have long provided accounts used to settle 
bank-to-bank obligations, and in this respect they play a 
prominent role in large value payment systems around the world. 
Central banks also play a critical role in the modern financial 
system as providers of liquidity. In particular, central banks 
commonly play the role known as lender of last resort. This 
function involves the provision of emergency liquidity 
assistance to solvent but illiquid institutions. These 
functions are not new, but the environment in which central 
banks provide both account services and liquidity has change 
profoundly in the past several decades. Modern financial 
systems are critically dependent on large-scale flows of 
intraday liquidity in payment, clearing, and settlement 
systems; this is the concept of time-critical liquidity that I 
    Time-critical liquidity reflects the transformation of 
credit risk to liquidity risk. This is a positive trade-off. We 
compress credit risk, we manage it appropriately, but because 
of the tight interdependence associated with transfers of 
collateral, settlement payments, variation margin payments, 
which the other speakers will also address, this conversion of 
credit risk to liquidity risk means that we must have 
appropriate institutions available to provide liquidity as 
needed on an immediate basis. This is, in effect, a reflection 
of the increasing interconnectedness of our financial system, 
which the Chairman made reference to in his opening remarks.
    Central counterparty clearinghouses, or CCPs, are 
particularly vulnerable to liquidity risk in connection with 
the daily and sometimes intraday exchange of settlements on a 
mark-to-market basis. This process may be impaired in unusual, 
extreme market conditions, such as the failure of one or more 
large clearing members of the CCP. The liquidity stresses that 
the CCP may experience in connection with these transfers do 
not necessarily imply that the CCP is insolvent or is likely to 
become insolvent. CCPs, unlike banks, have extraordinary 
recovery powers to deal with such circumstances. However, 
private-sector liquidity arrangements on which the CCPs rely 
may become unreliable precisely in those circumstances where 
immediate provision of liquidity is necessary. As a result, I 
believe that central banks can provide a useful and effective 
backstop to the private-sector system.
    If the financial resources on which the CCPs rely are also 
held in custody at the central bank, in central bank accounts, 
as I believe should be allowed, I believe that will facilitate 
the immediate provision of liquidity under those circumstances 
where it may be necessary.
    With that, I will end my remarks.
    [The prepared statement of Mr. Steigerwald follows:]

   Prepared Statement of Robert S. Steigerwald, J.D., Senior Policy 
Advisor, Financial Markets Group, Economic Research Department, Federal
                Reserve Bank of Chicago, Chicago, IL \1\
    \1\ The views expressed in this statement are solely those of the 
author and do not necessarily reflect the views of the Federal Reserve 
Bank of Chicago, the Board of Governors of the Federal Reserve System 
or any other person. This statement draws in significant part upon 
previous work with Robert T. Cox, Christian A. Johnson, and David A. 
Marshall. The author is solely responsible for the current form of the 
statement and any errors that may be present therein.
    Chairman Conaway, Ranking Member Peterson, and Members of the 
Committee, I appreciate the opportunity to testify today concerning 
some important public policy issues relating to central counterparty 
clearing. Specifically, my testimony will explain why I support the 
provision of central bank account services and, if necessary, emergency 
liquidity support--not solvency support--to clearinghouses.
    I will briefly discuss the role that central banks have 
traditionally played both as depositories and liquidity providers and 
make some observations regarding ``time-critical'' liquidity in the 
modern financial system. Since I believe that clearinghouses are 
uniquely dependent on the immediate availability of liquidity in 
situations where private-sector resources may prove to be inadequate, I 
believe that it is crucial for central banks to be prepared to provide 
emergency liquidity assistance in such circumstances.
Central Bank Account Services and Lender of Last Resort Function
    Central banks have long played a critical role in the financial 
system as depositories and payment intermediaries.\2\ Green and Todd 
(2001), for example, note that central banks historically were 
chartered to perform two primary functions:
    \2\ See, e.g., Johnson & Steigerwald (2008); Millard & Saporta 
(2005); Green & Todd (2001); McAndrews & Roberds (1999) (examining the 
important role banks have historically played as payments 

          One is to be an intermediary between the government and its 
        lenders, enabling the government to obtain credit by ensuring 
        that implicit default through inflation will occur only in 
        genuine national emergencies. The other is to serve broad 
        public interests as the trustworthy and neutral apex of a 
        hierarchy of banks that, in turn, provide the nonbank public 
        with accounts used to settle financial, business, and personal 
        payments by transfer of balances. [Green & Todd (2001), p. 5 
        (emphasis added)]

    They conclude that ``[t]he role as the apex of the banking 
hierarchy puts the central bank in a unique and distinguished position 
in the payments business.'' [Green & Todd (2001), p. 5 (emphasis 
added)] Reflecting that special position, central banks today play a 
prominent role in large-value payment systems--including the provision 
of accounts and related services necessary for those systems to 
function properly.
    Central banks also play a critical role in the modern financial 
system as providers of liquidity to the banking system. In particular, 
central banks today commonly play the role of ``lender of last 
resort.'' This function involves the provision of emergency liquidity 
assistance necessary to solvent, but illiquid, institutions that might 
fail without immediate central bank assistance.\3\
    \3\ There is an extensive literature on the lender of last resort 
function, which we do not attempt to summarize herein. See, e.g., 
Freixas, Parigi & Rochet (2003); Freixas, Giannini, Hoggarth and Soussa 
(2000); Oganesyan (2013).
The Development of ``Time-Critical'' Liquidity Dependence
    These functions are not new--but the environment in which central 
banks provide both account services and emergency liquidity assistance 
has changed profoundly over the past several decades. As Marshall & 
Steigerwald (2013) note, ``modern financial markets are critically 
dependent on large-scale flows of intraday (within 1 day) liquidity in 
payment, clearing, and settlement systems.'' They call this phenomenon 
``time-critical'' liquidity:

          [T]he processes for settling financial contracts, and related 
        settlement-risk-management operations, increasingly make use of 
        time-critical liquidity to address the problem of counterparty 
        credit risk. Under conditions of time-critical liquidity, a 
        settlement payment, delivery of securities, or transfer of 
        collateral must be made at a particular location, in a 
        particular currency (or securities issue), and in a precise 
        time frame measured not in days, but in hours or even minutes. 
        [Marshall & Steigerwald (2013), p. 30]

    The authors conclude that this phenomenon is the cumulative result 
of public and private-sector efforts to mitigate credit risk in 
financial markets over the past several decades, including;

   the proliferation of real-time gross settlement (RTGS) (such 
        as Fedwire', which is operated by the Federal 
        Reserve Banks);

   the implementation of delivery-versus-payment (DvP) systems 
        for securities and analogous payment-versus-payment (PvP) 
        systems for foreign exchange to mitigate settlement risks; and

   the increasing use of collateral to mitigate counterparty 
        credit risk in its various forms, both in payment systems and 
        financial market clearing arrangements, such as central 
        counterparties. [Marshall & Steigerwald (2013), p. 31)]

    Central counterparty clearinghouses are particularly vulnerable to 
liquidity risk in connection with the daily (and sometimes intraday) 
process of receiving and making mark-to-market settlements (or 
variation margin) with clearing members on a timely basis. [Peirce 
(2016), p. 622] These settlements are necessary in order to mitigate 
credit risk and are essential to the operation of a CCP. Peirce (2016) 
notes, for example, that ``CCPs function by making and receiving 
payments according to a strict timeline'' and that, above all else, 
``[a]dherence to a strict timeline of payments is important to keep the 
system working.'' In addition, ``during a crisis, CCPs likely would 
face significant liquidity strains'' in connection with the daily 
exchange of variation settlements. [Peirce (2016), p. 622] While these 
strains maybe severe under such conditions, there is no reason why they 
must lead to disaster.
Support for Liquidity, Not Solvency
    The liquidity stresses that a CCP may experience in connection with 
the time-critical exchange of settlement payments do not necessarily 
imply that the CCP is insolvent or likely to become insolvent. CCPs, 
unlike banks, have extraordinary default management and recovery powers 
to manage the consequences of a member default. [Cox & Steigerwald 
(2017), p. 13] The solvency of a CCP is not automatically called into 
question as a result of its default management and recovery efforts.
    However, the CCP's private-sector liquidity arrangements may become 
unreliable as a result of severe market stress precisely when the 
immediate provision of immediate liquidity is essential. Accordingly, 
Marshall & Steigerwald (2013) conclude that ``[i]f private liquidity 
provision may be inadequate in certain extreme conditions, it may be 
useful to create a framework in which central bank liquidity can act as 
a backstop.'' [p. 32].
    If the financial resources that clearinghouses depend on for 
default management and recovery purposes are held at the central bank, 
as I believe should be allowed, those resources will be immediately 
available when needed, without impairment as a result of the crisis. 
This, in turn, may facilitate the provision of emergency liquidity 
support by the central bank.
    This is only a brief description of the consequences of time 
critical liquidity for the financial system. Nevertheless, for the 
reasons suggested herein, I believe that the provision of central bank 
account services and emergency liquidity support--not solvency 
support--to financial market infrastructures such as CCPs is warranted.

    Cox, Robert T., & Robert S. Steigerwald, 2017, ``A CCP Is a CCP Is a
 CCP,'' Federal Reserve Bank of Chicago Working Paper, Vol. PDP, No.
 2017-01 (April), available at: https://www.chicagofed.org//media/
    Freixas, Xavier, Curzio Giannini, Glen Hoggarth, & Farouk Soussa,
 2000, ``Lender of Last Resort: What Have We Learned Since Bagehot?,''
 Journal of Financial Services Research, Vol. 18, No. 1, pp. 63-84,
 available at: http://download.springer.com/static/pdf/45/
    Freixas, Xavier, Bruno M. Parigi, & Jean-Charles Rochet, 2003, ``The
 Lender of Last Resort: A 21st Century Approach,'' European Central
 Bank, Working Paper No. 298 (December), available at: https://
    Green, Edward J., & Richard M. Todd, 2001, ``Thoughts on the Fed's
 Role in the Payments System,'' Federal Reserve Bank of Minneapolis,
 Quarterly Review, Vol. 25, No. 1 (Winter), available at:\4\ https://
\4\ This article originally appeared as an essay in the Federal Reserve
 Bank of Minneapolis 2000 Annual Report issue of The Region (April 2001,
 vol. 15, no. 1, pp. 5-27), available at: https://minneapolisfed.org/
    Johnson, Christian A., & Robert S. Steigerwald, 2008, ``The Central
 Bank's Role in the Payment System,'' in International Monetary Fund,
 Current Developments in Monetary and Financial Law, Vol. 5 (Washington,
 D.C.: IMF).
    Marshall, David A., & Robert S. Steigerwald, 2013, ``The Role of
 Time-Critical Liquidity in Financial Markets,'' Federal Reserve Bank of
 Chicago, Economic Perspectives, Vol. 37 (2nd Qtr.), available at:
    McAndrews, James, & William Roberds, 1999, ``Payment Intermediation
 and the Origins of Banking,'' Federal Reserve Bank of New York, Staff
 Report No. 95 (September), available online at: http://ssrn.com/
    Millard, Stephen, & Victoria Saporta, 2005, ``Central banks and
 payment systems: Past, present and future,'' Background Paper, Bank of
 England Conference on ``The Future of Payments,'' London (May),
 available online at: www.bankofengland.co.uk/financialstability/
    Oganesyan, Gayane, 2013, ``The Changed Role of the Lender of Last
 Resort: Crisis Responses of the Federal Reserve, European Central Bank
 and Bank of England,'' Institute for International Political Economy
 Berlin, Working Paper No. 19/2013, available at: http://www.ipe-
    Peirce, Hester, 2016, ``Derivatives Clearinghouses: Clearing the Way
 to Failure,'' Cleveland State Law Review, Vol. 64, pp. 589 et seq.,
 available at: http://engagedscholarship.csuohio.edu/clevstlrev/vol64/

Economic Perspectives, 2Q/2013
The Role of Time-Critical Liquidity in Financial Markets
David Marshall and Robert Steigerwald
    David Marshall is a senior vice president, associate director of 
research, and director of the financial markets group in the Economic 
Research Department at the Federal Reserve Bank of Chicago. Robert 
Steigerwald is a senior policy advisor in the financial markets group 
of the Economic Research Department at the Federal Reserve Bank of 
Chicago. The authors would like to thank Caroline Echols, Tom Ferlazzo, 
Richard Heckinger, Bill Johnson, John McPartland, Ann Miner, and Jeff 
Stehm for helpful comments. All errors remain the responsibility of the 
     2013 Federal Reserve Bank of Chicago.
    Economic Perspectives is published by the Economic Research 
Department of the Federal Reserve Bank of Chicago. The views expressed 
are the authors' and do not necessarily reflect the views of the 
Federal Reserve Bank of Chicago or the Federal Reserve System.
    Charles L. Evans, President; Daniel G. Sullivan, Executive Vice 
President and Director of Research; Spencer Krane, Senior Vice 
President and Economic Advisor; David Marshall, Senior Vice President, 
financial markets group; Daniel Aaronson, Vice President, microeconomic 
policy research; Jonas D.M. Fisher, Vice President, macroeconomic 
policy research; Richard Heckinger, Vice President, markets team; Anna 
L. Paulson, Vice President, finance team; William A. Testa, Vice 
President, regional programs; Richard D. Porter, Vice President and 
Economics Editor; Helen Koshy and Han Y. Choi, Editors; Rita Molloy and 
Julia Baker, Production Editors; Sheila A. Mangler, Editorial 
    Economic Perspectives articles may be reproduced in whole or in 
part, provided the articles are not reproduced or distributed for 
commercial gain and provided the source is appropriately credited. 
Prior written permission must be obtained for any other reproduction, 
distribution, republication, or creation of derivative works of 
Economic Perspectives articles. To request permission, please contact 
Helen Koshy, senior editor, at 312-322-5830 or e-mail 
[email protected]
    ISSN 0164-0682.
Introduction and Summary
    Modern financial markets are critically dependent on large-scale 
flows of intraday (within 1 day) liquidity in payment, clearing, and 
settlement systems. As noted by the Payments Risk Committee, ``On a 
routine day, over $14 trillion worth of payments to and from 
individuals, institutions, corporations, governments and other 
enterprises are settled in U.S. dollars worldwide. To complete these 
transactions, more than $9 trillion flows throughout the financial 
system.'' \1\
    \1\ See Federal Reserve Bank of New York, Payments Risk Committee 
(2012, p. 9). The Payments Risk Committee is a private-sector group of 
senior managers from U.S. banks that is sponsored by the Federal 
Reserve Bank of New York. The Committee's primary goal is to foster 
enhancements to the safety and resiliency of financial market 
infrastructure, including steps to strengthen the clearing and 
settlement of financial transactions, and to inform the Federal Reserve 
Bank of New York about developments, conditions, and practices in 
payments, clearing, and settlement systems (see www.newyorkfed.org/prc/
    Table 1 provides a more detailed breakdown of these payment flows. 
As can be seen, the largest funding flows by dollar value are 
associated with large-value funds transfer systems and government 
security clearing, but there are also large flows associated with 
central securities depositories and retail payments systems. Flows 
associated with foreign exchange (FX) settlements and central 
counterparty clearinghouses (CCPs) are somewhat smaller in magnitude, 
but these flows are critical to financial stability--a fact recognized 
by the Financial Stability Oversight Council in July 2012, when it 
designated the main FX settlement engine (CLS Bank), the two major 
securities CCPs (Fixed Income Clearing Corporation [FICC] and National 
Securities Clearing Corporation [NSCC]), and the three largest 
derivatives CCPs (CME Group, Options Clearing Corporation [OCC], and 
ICE Clear Credit) as systemically important financial market utilities.
    This article discusses an important feature of this intraday 
liquidity usage in payment, clearing, and settlement systems. 
Specifically, we examine how the processes for settling financial 
contracts, and related settlement-risk-management operations, 
increasingly make use of time-critical liquidity to address the problem 
of counterparty credit risk. Under conditions of time-critical 
liquidity, a settlement payment, delivery of securities, or transfer of 
collateral must be made at a particular location, in a particular 
currency (or securities issue), and in a precise time frame measured 
not in days, but in hours or even minutes.\2\ Examples of time-critical 
liquidity requirements (which we discuss below) include the settlement 
process at the Depository Trust Company (DTC), the funding time frame 
for CLS Bank, and the tight restrictions on the timing of required 
variation settlements in derivatives clearinghouses.
    \2\ See Heckinger, Marshall, and Steigerwald (2009). For purposes 
of a payment through a funds transfer system, ``location'' refers to an 
account specified by the recipient into which a payment or securities 
transfer must be made. Thus, a payment made in the right currency at or 
before the time settlement is due would not meet the requirements of 
time-critical liquidity if it is not placed at the disposal of the 
intended recipient in the account specified by the recipient.
    We use the term ``time critical'' to denote more than merely the 
existence of a temporal framework for payment obligations. All 
contracts calling for future performance, and all payment obligations 
arising from such contracts, specify some temporal framework within 
which performance of the payment obligation is due. For the purposes of 
this article, however, a time-critical payment has a number of specific 
characteristics. First, the payment must be made by a specific point in 
time, rather than merely by a certain date. Second, failure to make a 
time-critical payment within the predetermined time-certain deadline 
typically carries immediate consequences for the defaulting party. For 
example, a CCP member who fails to make a required variation margin 
payment by the time-certain deadline is subject to being declared in 
default to the CCP, with immediate suspension of membership privileges 
and consequent liquidation of the member's positions. This treatment of 
default is markedly different from non-time-critical obligations, such 
as routine accounts payable, where failure to discharge a payment 
obligation when due merely puts the defaulting party in breach of 
    \3\ The remedy for such a breach of contract typically involves the 
payment of damages intended to compensate the nondefaulting party for 
loss. Consequential damages are generally disallowed.

                                 Table 1
     Gross Daily Activity Value Versus Amount Needed for Settlement
                Estimated gross
   Sector      value of  payment        Funding         Funding flows b
                 transactions       transactions a
                                     ($ billions)
Large value              3,953.0             2,426.1           c 2,378.2
Foreign                  2,067.9                11.6                23.5
Central                      5.8                 7.4                12.5
 ies (CCPs)
Central                  1,101.7              e 55.8               129.5
 s (CSDs) d
Government               7,646.0             6,408.4             6,408.4
 clearing f
Retail                     159.8               159.8               159.8
  Total for             14,934.2             9,069.1             9,111.8
a Funding may occur through a Fedwire transaction or on the books of a
  commercial bank.
b Includes funding and defunding flows.
c Excludes known double counts of funding transactions for other
  financial market utility sectors.
d Information on gross value of payments settled was not collected for
  some CCPs and some CSDs.
e One CSD provided net values of flows.
f Includes settlements on the books of the clearing banks, including tri-
  party repo and internal Fixed Income Clearing Corporation settlements.
Source: Federal Reserve Bank of New York, Payments Risk Committee (2012,
  p. 17).

    Third, time-critical payments have a systemic aspect not present 
for most other payment obligations. In particular, what makes a 
settlement time critical is that all the participants in a payment, 
clearing, or settlement system agree to meet their obligations 
according to protocols (including cutoff times) that are calculated to 
mitigate settlement risk and result in final intraday settlement. For 
this reason, the deadlines governing time-critical payments typically 
are ``hard,'' with little room for flexibility and with no possibility 
of renegotiating the settlement obligation. In one way or another--ways 
that differ depending upon the nature of the system involved--the 
participants are interdependent. Time-critical liquidity obligations 
reflect this interdependence among system participants who must meet 
strict risk-management protocols in order to benefit from the reduction 
of settlement risk and the certainty associated with final, intraday 
payment or settlement. This systemic interdependence is unlike anything 
that exists in simple bilateral contracts calling for future 
    Dependence on time-critical liquidity has developed in response to 
the adoption over the past 30 years of innovative risk-management 
practices designed to manage settlement risk--the risk that one or more 
parties to a financial transaction may fail to satisfy the terms of the 
transaction in a timely fashion. Noteworthy innovations to address 
settlement risk include:

   The proliferation of real-time gross settlement (RTGS) (such 
        as Fedwire', which is operated by the Federal 
        Reserve Banks), or equivalent payment mechanisms, to achieve 
        intraday finality of settlement;

   The implementation of delivery-versus-payment (DvP) systems 
        for securities and analogous payment-versus-payment (PvP) 
        systems for foreign exchange to mitigate settlement risks in 
        those markets; and

   The increasing use of collateral to mitigate counterparty 
        credit risk in its various forms, both in payment systems and 
        financial market clearing arrangements, such as CCP mechanisms.

    These institutional and risk-management innovations have become 
standard practice throughout the world. By establishing a framework 
within which financial market participants can more closely manage 
settlement and related risks arising from trading in financial markets, 
these practices have made an important contribution to financial 
    However, the dependence of these institutional and risk-management 
practices on time-critical liquidity also increases the risk and cost 
of illiquidity in financial markets. Financial market participants must 
be able to make payments, deliver securities, or arrange for the 
transfer of collateral with a high degree of precision if they are to 
meet the settlement requirements of the systems in which they 
participate. Moreover, a failure of timely liquidity provision in one 
system can hold up settlement completion in other systems. Hence, the 
growing dependence on time-critical liquidity has important 
implications for the stability of the financial system.
    Financial market participants are well aware of the increasing 
importance of time-critical liquidity. For example, the Payments Risk 
Committee highlights the growing importance of time-critical, large-
value payments and concludes that

          payment liquidity (also known as intraday liquidity) is 
        critical . . . because it is at the core of a bank's capacity 
        to make payments. The recent transformation of the global 
        financial environment has created a heightened reliance upon 
        such liquidity, which in a financial, operational or political 
        crisis, is the first to be affected in the financial 
    \4\ See Federal Reserve Bank of New York, Payments Risk Committee, 
Cross-border Collateral Pool Task Force (2003, p. 7). There is an 
important and growing literature discussing the many aspects of 
liquidity more generally. See, for example, Brunnermeier and Pedersen 
(2009); Nikolaou (2009); and Garleanu and Pedersen (2007).

    In this article, we analyze the benefits and drawbacks of this 
increased reliance on time-critical liquidity to manage settlement 
risk. As we explain in the next section, settlement risk comprises both 
credit risk and liquidity risk. Time-critical liquidity is designed to 
mitigate credit risk, but in doing so it might inadvertently exacerbate 
liquidity risk. Thus, the notable success of modern payments, clearing, 
and settlement arrangements at reducing the credit component of 
settlement risk can have the unintended consequence of increasing the 
vulnerability of such arrangements to systemic liquidity disruptions.
    The potential trade-offs between credit risk and liquidity risk in 
the settlement process have important consequences for public policy. 
They raise the question of whether certain arrangements to mitigate 
credit risk work, in part, by transforming one type of risk (credit 
risk) into another (liquidity risk). They focus renewed attention on 
developing processes that reduce liquidity risk without exacerbating 
credit risk. Examples of such processes could include further 
exploitation of netting opportunities (e.g., through portfolio 
margining) or liquidity-saving mechanisms in payment systems (such as 
so-called hybrid RTGS systems). They motivate an inquiry into potential 
adverse consequences should liquidity shortages in a future financial 
crisis interact adversely with time-critical liquidity constraints. And 
they lead to an inquiry into the appropriate role of central bank 
liquidity provision in times of unusual liquidity stress.
    In the remainder of this article, we explore these questions in 
detail. In the next section, we characterize more fully the problem of 
settlement risk. Then we provide an overview of the procedures that are 
typically used to manage the credit component of settlement risk and 
the implications of those practices for the management of liquidity. We 
apply these insights to the management of settlement risk in payments 
systems, securities and foreign exchange markets, and central clearing 
arrangements, respectively. Finally, we discuss some related public 
policy issues.
The Problem of Settlement Risk
    Settlement is the process whereby all elements of a trade are 
completed as expected. Cash-settled financial contracts, such as 
certain derivatives transactions, typically are settled by means of 
funds transfers, usually through the interbank payment system. 
Transactions involving delivery of a financial asset typically are 
settled through a two-part process involving both a funds transfer and 
a transfer of the asset itself, a process that may involve other 
systems and institutions, such as securities depositories, CCPs, and 
other clearing and settlement arrangements.
    A fundamental risk of such financial contracts is that settlement--
either by means of a funds transfer or the transfer of a financial 
asset--may not occur. In most theoretical models, such as the standard 
Arrow-Debreu framework used by many economists, there is no need to 
distinguish between trade execution and trade settlement, since these 
models typically assume full commitment. In reality, however, it has 
long been recognized that agreeing to a trade (the execution phase) 
does not ensure that settlement will occur.\5\ Hence, there is a need 
to adopt risk-management practices to mitigate this settlement risk.
    \5\ See, for example, Nosal and Steigerwald (2010).
    Settlement risk comprises both credit risk and liquidity risk.\6\ 
According to the Bank for International Settlements' Committee on 
Payment and Settlement Systems (CPSS), credit risk is ``the risk that a 
counterparty will not settle an obligation for full value, either when 
due or at any time thereafter'' (CPSS, 2003b, p. 17); and liquidity 
risk is ``the risk that a counterparty (or participant in a settlement 
system) will not settle an obligation for full value when due. 
Liquidity risk does not imply that a counterparty or participant is 
insolvent since it may be able to settle the required debit obligations 
at some unspecified time thereafter'' (CPSS, 2003b, p. 29).
    \6\ For a comprehensive discussion of credit and associated risk 
associated with financial transactions, see Duffie and Singleton 
(2003). For the purposes of this article, we focus on credit and 
liquidity risks associated with settlement and rely principally upon 
risk definitions drawn from the payment, clearing, and settlement 
    An alternative characterization of credit risk versus liquidity 
risk describes counterparty credit risk as the risk that a party 
involved in a transaction might not have assets of sufficient value to 
meet their obligations (or may be unwilling to make this value 
available). In contrast, liquidity risk is the risk that the party 
cannot access assets of the particular form required to settle the 
transaction at the time settlement is due. In most cases, the form 
needed is cash of a particular denomination. However, there are cases 
in which a particular security must be delivered to settle the 
transaction. In such a case, the notion of liquidity risk can be 
extended to include the risk that the needed security cannot be 
Managing Credit Risk Associated with Financial Settlements
    In this article, we argue that dependence on time-critical 
liquidity follows logically from the basic needs of risk management. It 
is a fundamental principle of modern risk management that risks should 
be identified, quantified, and controlled or mitigated.\7\ Such methods 
are critical if counterparties are to take on only those risks they 
choose to take on and appropriately manage those risks. Of course, such 
quantification and mitigation can never be perfect, since risk 
management is not an exact science. But the conditions of 
identifiability, quantifiability, and controllability of risk should be 
met within reasonable tolerances.
    \7\ This principle is stated both explicitly and implicitly in the 
risk-management literature, including in a standard recently 
promulgated by the International Organization for Standardization 
    While this principle is intuitive, it is often violated in simple 
counterparty exposures. Consider, for example, a simple loan to a 
counterparty whose solvency is not well known to the creditor and where 
collateral or other measures to mitigate credit risk are not 
implemented. The creditor is exposed not only to the direct risk of the 
counterparty, but also to the indirect risk of defaults by second-order 
counterparties (the counterparty's counterparties), third-order 
counterparties, and so forth. The distribution of these higher-order 
risks, taken together, may be irredeemably opaque. There may be no 
meaningful way in which such risks can be identified, much less 
If-and-Only-If Conditionality
    The solution to this problem of risk management for financial 
transactions is to develop robust risk-management protocols that do not 
rely on precise identification of these higher-order risks. In 
practice, this is done by structuring transactions with some form of 
if-and-only-if conditionality.\8\ Specifically, once a transaction is 
initiated, there is a sequence of steps leading to its completion via 
final settlement. If-and-only-if conditionality arises because certain 
of these steps will be executed if and only if certain conditions are 
met. These conditions are designed to ensure that any additional 
counterparty credit risks associated with that step can be identified, 
quantified, and mitigated to the extent consistent with the system 
design. In particular, these conditions would typically move exposures 
from more opaque risks (difficult to quantify) toward more transparent 
risks that are easier to quantify and at least partially mitigate.
    \8\ Our use of the term ``if-and-only-if conditionality'' is 
consistent with the way some of the risk-management practices described 
in this article have been described by policymakers. See CPSS (1992, 
1995) and Group of Thirty (2003).
    The specific conditions incorporated into this if-and-only-if 
conditionality can be one of two types (Garner, 1995, p. 197):

   Condition precedent--a required payment or asset transfer is 
        required before or at the same time that some related 
        performance by a counterparty is expected. An example is the 
        requirement in many RTGS payments systems that funding be 
        available at the time a payment is to be transferred.

   Condition subsequent--a required payment or asset transfer 
        is required to maintain an existing position. An example is the 
        daily variation margin that must be paid to maintain an open 
        derivatives position that is centrally cleared through a CCP.

    Later in the article, we give specific examples of if-and-only-if 
conditions that are used in payments systems, DvP and PvP settlement 
systems, and CCPs.
    A payment or security transfer is said to be final if the sender 
cannot unilaterally retrieve or revoke the transfer without additional 
legal processes. The concept of finality is critical for settlement 
risk management: If a payment associated with a given transaction is 
settled without finality, the payment can be unilaterally reversed, and 
the possibility of such a reversal is itself another form of settlement 
risk. Therefore, the types of if-and-only-if conditionality implemented 
to mitigate settlement risk generally require transfers to be made with 
    Finality is a composite concept involving both legal rules--a 
payment or asset transfer cannot unilaterally be reversed by the sender 
(subject to special rules where fraud, mistake, or duress is involved); 
and economic consequences--a ``final'' payment or asset transfer may be 
relied upon by the recipient to support other transactions (for 
example, funds received may be paid out in settlement of the 
recipient's other payment obligations).
    As we will discuss later, payment systems that guarantee finality 
(preferably intraday finality) are fundamental to more-complex forms of 
risk management (for example, securities settlement).
Implications for Time-Critical Liquidity
    There is an intimate connection between if-and-only-if 
conditionality for mitigating settlement risk, finality, and the use of 
time-critical liquidity. This connection arises because the risk-
management conditions typically require delivery of liquid assets. 
There are examples of conditionalities that require the counterparty 
merely to promise performance by some future date. An example would be 
a Fedwire payment by a bank eligible for daylight overdraft credit. 
However, possession of a low-risk, highly liquid asset provides a 
higher degree of risk mitigation than any such promise, even by a 
highly creditworthy agent. As a result, we should not be surprised that 
the gold standard for risk management is to require counterparties to 
actually deliver funds and/or securities before the given transaction 
settles with finality.
    Furthermore, risk-management practices in payments, clearing, and 
settlement systems that incorporate if-and-only-if conditionality 
generally require that this delivery of liquid assets be made on a 
time-critical basis. The reason is that finality has a temporal 
component: It is determined as of a particular time. It would be 
inherently contradictory to ``guarantee finality'' without specifying 
the date and time by which the finality becomes effective. Timing is 
critical because deferral of finality to the future expands the 
temporal window within which credit risk remains a problem.
    The term ``liquidity'' is often reserved for cash and near-cash 
instruments. For our purposes, however, it is useful to expand our 
notion of liquidity to include, in addition, access to specific 
securities that may be needed to complete a transaction. Such 
securities may be needed to collateralize a position, or may be 
required to complete the delivery leg in a DvP settlement.
    Risk management under if-and-only-if conditionality thus implies 
the need to closely manage time-critical liquidity, both in terms of 
available funding and access to particular securities. This scrutiny is 
particularly important where funding is dependent upon credit 
arrangements (as in most intermediated payment arrangements) or when 
access to particular securities is dependent upon market dynamics (for 
example, the willingness of a seller to sell the needed security at the 
time it is needed). In a crisis, credit provision can contract and 
markets can hoard the sorts of securities needed to satisfy if-and-
only-if conditions. For example, during the fall 2008 financial crisis, 
there were reports of shortages of Treasury securities that were the 
most commonly used forms of collateral. This insight has broad 
ramifications, because if-and-only-if conditionality only addresses 
credit risk. Liquidity risk (and the corresponding need to manage 
liquidity) remains an inherent feature of settlement in payments, 
clearing, and settlement systems.
    The dependence of financial markets on time-critical liquidity goes 
beyond the individual risk-mitigation processes described here. In 
practice, these processes are combined to allow for highly 
sophisticated risk-management strategies. For example, one can start 
with an RTGS payment system as the foundation for immediate, intraday 
finality of payment. An RTGS system can be combined with central 
securities depository (CSD) functionality to make possible DvP 
securities settlement. That is, the ability to make final intraday 
transfers of both funds and securities is a necessary condition to the 
establishment of effective DvP arrangements. Similarly, a domestic RTGS 
system combined with a foreign RTGS system makes possible PvP in 
foreign exchange settlements.
    The upshot of these interdependencies is that the failure to meet 
time-critical liquidity constraints within one system can propagate 
rapidly to other systems. Thus, the dependence of multiple 
interconnected systems on time-critical liquidity can increase the 
fragility of the system as a whole.
Settlement Risk in Payments Systems
    Our discussion thus far of settlement risk management and the role 
of time-critical liquidity has been rather abstract. Next, we provide 
an extended example of how the logic works in the context of payments 
Failure of Bankhaus Herstatt
    The risk considerations associated with financial settlements were 
dramatically illustrated by the market disruption that followed the 
failure of a German bank, Bankhaus Herstatt, in June 1974. 
Specifically, the Herstatt incident illustrates how structures that 
allow participants broad latitude with respect to the timing of 
liquidity provision can actually exacerbate credit risk.
    The facts are as follows. Bankhaus I.D. Herstatt KGaA, a small 
commercial bank based in Cologne, was closed by the German banking 
supervisory authorities at about 3:30 p.m. central European time on 
Wednesday, June 26, 1974,\9\ after the interbank system for making 
deutsche mark payments had closed and Herstatt had received irrevocable 
payments in deutsche marks and other currencies for settlement of 
foreign exchange trades. Herstatt's correspondent bank in New York, 
Chase Manhattan, responded to the news by withholding $620 million in 
dollar payments that were to be made on behalf of Herstatt. At the 
time, most interbank payments were made through the Clearing House 
Interbank Payment System (CHIPS), which was operated as a deferred net 
settlement payment system. As such, interbank payments made through 
CHIPS were only provisional, not final, at the time instructions were 
processed.\10\ Banks exploited this lack of finality in CHIPS by 
reversing their U.S. dollar payments through CHIPS. The result of these 
actions was gridlock in the U.S. dollar payment system, triggering 
systemic ``dislocations in the international interbank sector of the 
Eurocurrency market'' (Herring and Litan, 1995, p. 96).
    \9\ See Koleva (2011).
    \10\ For example, according to Bech and Hobijn (2007, p. 4), 
``until 1981, final settlement occurred on the morning of the next 
business day through the transfer of balances across the books of the 
Federal Reserve.'' See also Federal Reserve Bank of New York, Payments 
Risk Committee, Intraday Liquidity Management Task Force (2000).
    The Herstatt incident demonstrated that any system attempting to 
control the credit component of settlement risk requires intraday 
finality of settlement (IFS). IFS guarantees that no party can 
unilaterally unwind a given transaction. Without IFS or some similar 
finality guarantee, the risk is always present that such an unwinding 
could lead to an unexpected failure of settlement. In the aftermath of 
the Herstatt incident, central banks recognized that IFS could not be 
achieved with the deferred net settlement payment systems that existed 
at that time. Given the available technology, the only practical method 
for achieving IFS was to implement an RTGS system. In a gross 
settlement system, transfers are settled individually without netting 
debits against credits. In a real-time settlement system, final 
settlement occurs continuously rather than periodically at prespecified 
times, provided that a sending bank has sufficient covering balances or 
credit.\11\ As a result, final settlement in an RTGS system is both 
immediate and continuous.
    \11\ See, for example, CPSS (1997, 2005); Mills and Nesmith (2008); 
and Bech and Hobijn (2007).
If-and-Only-If Conditionality in RTGS Payment Systems
    Simply adopting an RTGS system does not completely fix the problem 
of providing IFS. While an RTGS system does ensure finality, many such 
systems do so by having the RTGS system take on credit risk. This 
credit risk must then be controlled by implementing risk-management 
practices incorporating if-and-only-if conditionality.
    Let us consider how this is done. A payment is settled with 
finality in a simple RTGS system if and only if sufficient funds are in 
the payer's account or sufficient overdraft credit is available. 
Without such conditions, the payment system might guarantee finality to 
a payment that the payer cannot cover, exposing the system to a degree 
of payer credit risk that may be extremely difficult to quantify. (That 
is, it may be difficult to assign a probability to the event that the 
payer cannot discharge its obligations.) Under the RTGS conditions, 
this risk can be at least partially controlled by specifying overdraft 
credit limits. This if-and-only-if conditionality for an RTGS system 
could be expressed as follows:

    Conditionality 1: Payment will be made (funds will be transferred) 
with finality if and only if the sender has adequate funds on account 
or immediately available credit in the amount needed to complete the 
payment transfer.

    Conditionality 1 implies a dependence on time-critical liquidity, 
because any payments beyond those financed by immediately available 
credit will only be completed if the requisite liquidity is on deposit 
on or before the time of the transaction. Note that conditionality 1 
would not generally result in complete elimination of risk, or even in 
perfect quantification of risk. Nevertheless, the conditionality that 
we see so frequently in payment and settlement systems goes a long way 
to reducing the uncertainty associated with these risks. For example, 
the risk associated with uncollateralized daylight overdraft credit in 
the Fedwire RTGS system is mitigated by the supervisory process, since 
typically such credit is only provided to regulated institutions known 
to be creditworthy within the tolerances of the overdraft credit 
    There are other ways of implementing RTGS. Some payment systems 
that allow for intraday extensions of credit require all such credit to 
be fully collateralized. The if-and-only-if conditionality for real-
time gross settlement payments incorporating collateralized credit 
would modify conditionality 1 as follows:

    Conditionality 2: Payment will be made (funds will be transferred) 
with finality if and only if conditionality 1 is satisfied and the 
amount of collateral necessary to fully collateralize the required 
credit has been posted at the time the payment is to be made.

    This arrangement contributes to a time-critical liquidity 
environment because the payment will not be made if the collateral 
requirement has not been satisfied. As mentioned earlier, we regard 
securities used as collateral as a form of liquidity, so a requirement 
that collateral be positioned in a particular location before a payment 
is executed represents a time-critical liquidity constraint. This is an 
example of a condition precedent, as discussed previously.
    The introduction of collateral presents additional systemic 
considerations. Collateral is generally thought of as a means of 
mitigating credit risk. But the need to move collateral dynamically, 
according to precise rules, makes collateral a liquidity phenomenon as 
well. In particular, the types of securities that are generally 
eligible for use as collateral are traded in markets like other 
securities, and because trading in those securities may be liquid or 
illiquid depending upon the circumstances, the collateralization of 
financial transactions introduces another dimension of liquidity 
management into the system. (Box 1 provides a further discussion of how 
time-critical liquidity is used in Fedwire and other RTGS payments 

                                  Box 1
   Time-Critical Liquidity in Fedwire and Other RTGS Payments Systems
    The Fedwire Funds Service, which is owned and operated by the
 Federal Reserve System, is a classic RTGS system, generally used to
 make large-value, time-critical, U.S. dollar payments in central bank
 money.\1\ Fedwire payment instructions are processed immediately upon
 receipt if and only if the account holder issuing the instructions has
 ``sufficient funds, either in the form of account balances held at the
 Federal Reserve or overdraft capacity'' (CPSS, 2003a, p. 443). Unless
 that condition is satisfied, the payment instruction will be rejected.
 In accordance with applicable law, a Fedwire payment ``is final and
 irrevocable when the amount of the payment . . . is credited to the
 receiving participant's account or when notice is sent to the receiving
 participant, whichever is earlier'' (Board of Governors of the Federal
 Reserve System, 2009, p. 7). The Federal Reserve also provides intraday
 credit, in the form of ``daylight overdrafts,'' to most Fedwire
 participants. The extension of central bank credit facilitates the
 smooth and efficient operation of the funds transfer service, but also
 ``converts the liquidity risk otherwise borne by participating
 institutions to credit risk borne by the Reserve Banks'' (Board of
 Governors of the Federal Reserve System, 2009, pp. 15-16). Any daylight
 overdrafts must be repaid by the end of the Fedwire operating day, in
 accordance with the Federal Reserve's payment system risk policy.
    The RTGS design has been adopted in many other jurisdictions. A
 recent World Bank survey documented that 112 systems also employ the
 individual, payment-by-payment processing logic of the Fedwire system
 (World Bank, Payment Systems Development Group, 2008). According to the
 CPSS (2005), this prevalence of RTGS payment structures is due in part
 to an increasing demand for time-critical payments linked to foreign
 exchange settlement systems, securities settlement systems, and other
 financial market utilities. As the CPSS (2005, p. 2) states, ``More
 linkages imply short time frames to make time-critical payments from
 one system to another, hence the need to achieve finality within that
 time frame.''
\1\ For more details, see www.federalreserve.gov/paymentsystems/
  fedfunds_about.htm; also, Board of Governors of the Federal Reserve
  System (2009).

Settlement Risk in Securities and Foreign Exchange Markets
    The introduction of RTGS systems and improved net settlement 
arrangements made it possible to make large-value payments with greater 
assurance of intraday finality, but it did not by itself eliminate 
Herstatt risk--the principal risk that arises from unsynchronized 
transfers of financial assets.\12\ As Hills and Rule (1999, p. 101) 
observe: ``Where financial transactions involve an exchange of 
financial assets, any party to the transaction can be exposed to 
principal risk if the two legs do not settle at the same time.'' To 
eliminate that risk, some means must exist to synchronize the 
settlements--a process that has become known as DvP (which stands for 
delivery-versus-payment) for securities settlements and PvP (which 
stands for payment-versus-payment) for foreign currency settlements.
    \12\ CPSS (1992) defines principal risk as ``the risk of loss of 
the full value of securities or funds that [a nondefaulting party] has 
transferred to the defaulting counterparty'' (p. 13). See also CPSS 
    In the United States, securities settlement typically occurs 1 or 
more days after trade execution. For example, equities settle on the 
third day after the trade date. On the date when settlement is 
scheduled to occur, the seller or its agent must deliver a security to 
the buyer, and the buyer must deliver payment to the seller. If these 
two operations are not closely coordinated, one or both parties will 
incur settlement risk. For example, if the seller delivers the security 
before receiving funds from the buyer, the seller could lose the full 
principal value of the transaction if the buyer were to default after 
delivery of the security was completed.
    To mitigate that risk, central securities depositories (CSDs) 
typically settle securities using delivery-versus-payment or DvP. While 
the details of this process can be somewhat intricate, the key point is 
that delivery of securities to the purchaser and payment of funds to 
the seller occur if and only if the CSD is satisfied that each party 
has met its obligations. Once the CSD is satisfied that payment has 
been received and that the securities are available for transfer, title 
to the securities passes to the buyer on the books of the CSD \13\ and 
cash is released to the seller.
    \13\ Our description of this process is, of course, highly 
simplified. In practice, further interfaces exist between CSDs and 
registrars, transfer agents, custodial institutions, and the like.
    The if-and-only-if conditionality characterizing a DvP system can 
be expressed as follows:

    Conditionality 3: A securities transfer will take place if and only 
if the buyer has immediately available funds to pay for the delivery of 
securities and the seller has immediately available securities to be 
delivered to the buyer, and both the funds transfer and delivery of 
securities can take place with finality.

    Conditionality 3 implies a dependence on time-critical liquidity 
because the buyer must have the full amount of liquid funds available 
within the time frame mandated by the DvP settlement schedule. 
Similarly, the seller must make the securities available within the 
relevant time frame. If such funds are not made available by the 
relevant deadline, the buyer is in default and the transaction will not 
go through. (Box 2 provides more details about the use of time-critical 
liquidity in DvP securities settlement systems.)

                                  Box 2
          Time-critical liquidity in DvP securities settlement
    The most liquidity-intensive implementation of DvP is a so-called
 Model 1 system, in which both securities and funds settle on a gross
 basis, trade by trade, with funds transfer and securities transfer
 occurring simultaneously (CPSS, 1992). As noted in Payments Risk
 Committee (2003, pp. 21-22), ``Participation in such systems requires
 participants to maintain substantial money balances during the business
 day.'' Examples of Model 1 DvP systems include the Federal Reserve's
 system for settling transfers of U.S. government and agency securities
 (the Fedwire Securities Transfer System) and the TARGET2-Securities
 service currently under development by the European Central Bank (ECB).
    An alternative, less liquidity-intensive implementation of DvP is
 the so-called Model 2 system, in which securities settle on a gross
 basis throughout the day, but funds are settled on a net basis at the
 end of the processing cycle. An example of a Model 2 system is the
 Depository Trust Company (DTC), which is the primary securities
 settlement system for U.S. corporate equities and fixed-income
    The netting feature of Model 2 systems makes them somewhat less
 reliant on time-critical intraday liquidity provision than Model 1
 systems. Even so, Model 2 systems typically rely on if-and-only-if
 conditionality to appropriately control settlement risk. This is clear
 in the following description of the DTC's settlement system from the
 International Monetary Fund's financial sector assessment report for
 the United States:
        During the day, participants [in DTC] receive incoming
     securities to the extent their payment settlement account has
     sufficient net payment credits or sufficient net payment debit
     capacity and subject to DTC's net debit cap and collateral
     controls. (International Monetary Fund, Financial Sector Assessment
     Program, 2010, pp. 12-13, italics added).

    Foreign currency settlements use a payment versus payment, or PvP, 
process. Like DvP, the PvP process requires both legs of a transaction 
to be settled either simultaneously or with equivalent assurances that 
one leg will be settled if and only if the other leg is settled with 
finality. The conditionality for such a PvP arrangement can be 
expressed as follows:

    Conditionality 4: Payment in one currency will take place if-and-
only-if immediate payment in the other currency (or possibly 
currencies) can take place with finality.

    The key institution implementing PvP in foreign exchange markets is 
CLS Bank, a special-purpose institution designed to handle the 
settlement of foreign currency transactions. CLS Bank began operations 
in September 2002 and currently provides services for 17 actively 
traded currencies (CPSS, 2003a). (Box 3 discusses how time-critical 
liquidity is used in CLS Bank's PvP settlement system.) In addition, 
the large-value payment system in Hong Kong (known as the Clearing 
House Automated Transfer System, or CHATS) has been linked to other 
payment systems to facilitate settlements on a PvP basis between the 
Hong Kong dollar and the U.S. dollar, euro, renminbi, and ringgit 
(CPSS, 2003a, and Hong Kong Monetary Authority, 2013).

                                  Box 3
          Time-critical liquidity in DvP securities settlement
    The PvP system for foreign currency settlement operated by CLS Bank
 depends on precise coordination of foreign currency settlements to
 eliminate settlement risk. Specifically, each CLS member has an account
 with CLS Bank that is divided into subaccounts, one for each currency
 being traded. Settlement instructions must be submitted by 12 midnight
 central European time (CET).\1\ Settlement starts at 7:00 a.m. CET of
 the settlement date (continuing throughout the settlement period until
 9:00 a.m. CET) by debiting the subaccounts of currencies being sold and
 simultaneously crediting accounts of currencies being bought.
    Settlement occurs when CLS Bank simultaneously debits and credits
 the accounts of two settlement members in accordance with eligible
 instructions that were submitted, and is final, irrevocable, and
 binding upon (1) the submitting members of such instructions; (2) the
 settlement members through whose accounts such instructions are
 settled; and (3) CLS Bank. However, the settlement for a matched pair
 of instructions may only occur if the settlement of such instruction
 would not cause the settlement member's account to fail any of three
 risk management tests--positive adjusted account balance, short
 position limit (per currency), and aggregate short position limit. To
 ensure that there are sufficient balances in the settlement member
 accounts to meet these risk tests, members must provide funding in the
 needed currencies. This funding must be provided according to a tight
 time schedule. In this way, CLS Bank relies on time-critical liquidity
 provision. As described in CPSS (2003a, p. 462):
        Members must submit payments to CLS Bank to provide funds in the
     correct currencies to cover projected net debit positions. They can
     do so by making a single payment for the full amount at 8 a.m. CET
     or a series of payments in hourly installments. CLS Bank makes
     payouts throughout the settlement day to members in currencies in
     which they have a net credit position, subject to the constraint
     that the sum of all currency balances (positive and negative) in a
     member's account, converted into U.S. dollars, is not negative. . .
     . In normal circumstances, settlement members will have zero
     balances in their CLS Bank accounts at the end of each day, and CLS
     Bank will have zero balances in its central bank accounts at the
     end of each day.\2\
    As with DvP, policymakers and industry participants clearly
 recognize the liquidity implications of CLS Bank's system for PvP
 settlement of foreign currency transactions. As the Payments Risk
 Committee (2003, p. 26) has noted: ``The key liquidity issue the market
 faces is the requirement to make large timed payments, in non-domestic
 currencies, during a small time window and in some cases outside normal
 domestic banking hours.''
\1\ Instructions can also be submitted for same-day settlement between
  midnight and 6:30 a.m. before the revised pay-in schedule is issued.
\2\ Actually, payouts are made only during the settlement and funding
  period from 7:00 a.m. to 12:00 p.m. CET.

    Since both legs of a DvP or PvP transaction must be made with 
finality, it follows that the associated payments must also be made 
with finality. More generally, these types of FX or securities 
settlement systems depend critically on a payments infrastructure that 
can reliably transmit funds subject to tight deadlines, which, in 
practice, means an RTGS system. For example, this is why neither DTC 
nor CLS accepts payments through CHIPS, which is not an RTGS 
    \14\ Special considerations apply where CLS Bank is not a direct 
member of the payment system for making final payments in a currency 
settled through CLS Bank on a PvP basis. For example, CLS Bank is not a 
member of the Canadian Payment Association and, therefore, is not a 
direct participant in the Large Value Transfer System (LVTS) for 
Canadian dollar payments. Furthermore, LVTS has aspects of both an RTGS 
system and a so-called continuous net settlement system. As a 
consequence, the Bank of Canada, which is a direct participant in LVTS, 
provides CLS Bank with an account and processes payments through LVTS 
on CLS Bank's behalf. (See Bank of Canada, www.bankofcanada.ca/wp-
content/uploads/2012/02/fsr-1202-miller.pdf.) All Canadian dollar 
payments made or received by CLS Bank are final when posted to its 
account by the Bank of Canada.
    Finally, it should be noted that settlement systems incorporating 
DvP or PvP may allow for a form of settlement failure when the if-and-
only-if conditionality is not met. To give an example, if the seller of 
a security fails to deliver the security into a DvP settlement system, 
the buyer simply retains funds equal to the purchase price of the 
security. This principal is not at risk, since it will be paid if and 
only if the security is available for delivery. The only risk is that 
the security price may have changed before the transaction is 
eventually completed or a substitute transaction is undertaken to 
replace the failed transaction.
Settlement Risk in CCPs
    Central clearing via CCPs is a standard feature of exchange-traded 
securities and derivatives markets and is increasingly used to settle 
and guarantee contracts that are traded over the counter (OTC). For 
both securities and derivatives contracts, the CCP mitigates credit 
risk by becoming the legal buyer to every seller and the legal seller 
to every buyer, a process known as novation. Thus, the need to manage 
counterparty credit risk associated with bilateral trades is replaced 
by the CCP's need to manage the creditworthiness of its clearing 
members. Of course, all participants in the market now depend on the 
CCP's own creditworthiness.
    CCPs typically mitigate the credit risk they incur under novation 
by requiring all of their counterparties to post initial margin (or 
performance bond). That is, CCP members and their customers can open 
new positions only under the condition that the necessary margin is 
posted to the CCP within a prespecified time. Such arrangements 
illustrate a type of if-and-only-if conditionality that incorporates a 
condition subsequent (as defined earlier). That is, the condition 
becomes binding only after the trade to which it applies has been 
initiated. The CCP retains the power to terminate the open position if 
the trader fails to post the required margin or bond at the future time 
    As a (simplified) example, we can look at the case of a trader 
taking a long position on a futures contract traded on an organized 
exchange. An if-and-only-if conditionality relevant to this trade may 
be expressed as follows:

    Conditionality 5: The clearinghouse will novate the trade (that is, 
agree to act as the substituted legal counterparty to the trade) if and 
only if the clearing member posts initial margin within the time frame 
specified by the CCP's rules.\15\
    \15\ This stylized example simplifies the actual conditions. In 
reality, additional conditions would typically be imposed, such as that 
the trade is within the applicable position limits, that the clearing 
member has sufficient capital, and so on.

    The initial margin requirement induces a need for time-critical 
liquidity, because failure to post margin by the time it is due would 
constitute a default to the clearinghouse. Notice how conditionality 5 
converts the CCP's exposure to an opaque set of risks (risk that the 
trader might default, or one of the trader's higher-order 
counterparties might default) into a more transparent set of risks 
associated with the clearing member's solvency and ability to post 
acceptable initial margin. Monitoring the clearing members rather than 
monitoring the entire body of traders is advantageous, because 
clearinghouses intensively vet potential members and impose financial, 
credit, and other standards for membership. In addition, clearing 
members' financial resources (including capital and liquidity), 
activities, and creditworthiness are audited by the CCP on an ongoing 
basis, with the clearinghouse often empowered to impose restrictions on 
member activities if warranted.
    In practice, clearinghouses typically impose multiple mechanisms to 
control financial risks. The cumulative effect of this multiplicity can 
create a chain of if-and-only-if conditionalities. Often, this chain is 
the key factor in generating time-critical liquidity constraints. To 
illustrate, let us return to the futures contract example. Posting 
initial margin in and of itself would eliminate risk to the CCP only if 
the margin requirement were sufficiently high to cover (with high 
probability) the cumulative exposure of the CCP to clearing member 
default risk over the entire life of the contract--from the trade date 
to the delivery date. To economize on performance-bond collateral, the 
CCP typically marks participants' positions to market on a daily 
basis,\16\ and requires participants to settle the day's accumulated 
gains and losses via exchange of variation margin.\17\ Thus, the CCP 
compounds conditionality 5 with another if-and-only-if conditionality, 
as follows:
    \16\ In this stylized example, variation margin is posted daily. In 
fact, many CCPs require variation margin to be posted two or even three 
times each day.
    \17\ We follow common practice in using the term ``variation 
margin'' to denote the exchange of funds for mark-to-market 
settlements. However, these daily settlements serve a role rather 
different from that served by initial margin (performance bond). In 
particular, the latter constitutes collateral whose function is to 
mitigate risk, while the former constitutes payment of market gains and 

    Conditionality 6: The clearinghouse will novate the trade if and 
only if conditionality 5 holds and the clearing member agrees to post 
daily variation margin, incorporating marking to market, as demanded by 
the CCP within the precise time frame specified.

    This compounded if-and-only-if conditionality dramatically reduces 
the needed initial margin. By introducing payment of daily variation 
margin as a condition subsequent, the initial margin need only be 
sufficient to cover a possible clearing member default over a single 
day forward. Clearly, conditionality 6 induces a requirement for 
additional time-critical liquidity, since a position at the 
clearinghouse will be kept open only if daily variation margin is paid 
promptly, according to the deadlines specified by the clearinghouse.
    This requirement of timely variation margin is an integral 
component of the CCP's risk-management structure. That means that the 
receipt of variation margin when due is compulsory (not simply 
desirable or beneficial). The reason is that initial margin 
requirements are set in relation to expected receipt of variation 
margin within a precise time frame, day in and day out, as variation 
margin falls due. Therefore, the CCP's default rules mandate 
consequences for a failure to comply with variation margin requirements 
when due (that is, forfeiture of initial margin and recourse to other 
CCP financial safeguards).
    Moreover, variation margin payments must be made with finality. In 
particular, if a clearing member were to default, the CCP must have 
certainty that any margin payments previously made by the defaulting 
entity can be used to satisfy any liquidity shortfalls resulting from 
the default. For this reason, variation margin payments must be made 
using a system that supports intraday or even real-time finality. 
Typically, this would require use of an RTGS payments system.\18\ (Box 
4 gives a further discussion of time-critical liquidity requirements in 
two important derivative CCPs, the Chicago Mercantile Exchange and the 
Options Clearing Corporation.)
    \18\ In the Principles for Financial Market Infrastructures, 
released in April 2012, the Bank for International Settlements' 
Committee on Payment and Settlement Systems and the Technical Committee 
of the International Organization of Securities Commissions (CPSS-
IOSCO) do not rule out net settlement systems, but note that any system 
relying on batch settlement ``may expose participants to credit and 
liquidity risks for the period during which settlement is deferred'' 
(CPSS-IOSCO, 2012, p. 66).

                                  Box 4
               Time-critical liquidity in derivatives CCPs
    Two major derivatives CCPs in the United States are the CME Clearing
 House (CME Clearing) and the Options Clearing Corporation (OCC). CME
 Clearing is an unincorporated division of the Chicago Mercantile
 Exchange Inc. that provides central counterparty clearing and
 settlement services for exchange-traded futures contracts, as well as
 certain options and OTC derivatives contracts. The OCC is a
 clearinghouse for exchange-traded equity options as well as certain
 futures contracts. It currently provides central counterparty clearing
 and settlement services to nine options exchanges and five futures
    CME Clearing marks open contracts to market twice daily and settles
 payment obligations once in the morning and once in the afternoon of
 each business day. The OCC normally marks open contracts to market once
 daily and settles payment obligations incurred in the morning of each
 business day. (They have the authority to conduct additional intraday
 marking-to-market if warranted.) For both of these CCPs, settlement
 occurs through designated settlement banks that act as settlement
 intermediaries between the CCP and its clearing members. Each CCP and
 its clearing members grant settlement banks the authority to credit or
 debit their respective accounts for daily market activity based on
 clearing instructions sent by the CCP.
    Both CCPs rely on time-critical payments that must be completed
 according to tight deadlines. Specifically, CME Clearing sends
 settlement information for CME clearing members to the settlement banks
 before 7:30 a.m. CT and again at approximately 12:30 p.m. CT. Clearing
 members must complete the settlement amounts (or have their settlement
 bank irrevocably commit to making the required payment on the clearing
 member's behalf) before the 7:30 a.m. deadline for the morning
 settlement cycle and within about 1 hour from receiving settlement
 information for the afternoon cycle. For the OCC, settlement
 information for each clearing member is sent to the settlement banks
 before 9:00 a.m. CT. Payment of the settlement amounts must be made (or
 irrevocable commitment from the clearing member's settlement bank must
 be obtained) before the 9:00 a.m. deadline. Failure to meet these
 deadlines constitutes default under the OCC's rules. The OCC also
 commits to initiate payments to its clearing members by 10:00 a.m. CT.
\1\ Currently, these exchanges and markets include: BATS; Boston Options
  Exchange; C2 Options Exchange Inc.; Chicago Board Options Exchange
  Inc.; International Securities Exchange LLC; NASDAQ OMX PHLX; NASDAQ
  Options Market; NYSE Amex Options; NYSE Arca Options; CBOE Futures
  Exchange LLC; ELX Futures LP; NASDAQ OMX Futures Exchange; NYSE Liffe
  U.S.; and OneChicago Exchange.

Public Policy Implications
    We have argued that the imperative to mitigate credit risk 
associated with financial market settlements leads logically to 
increased use of time-critical liquidity. The benefits of credit risk 
mitigation are sufficiently great that we are likely to see continued 
movement in this direction. Recent developments pointing toward 
increased use of time-critical liquidity include the following:

   The commitment of the Group of Twenty (G20) leaders in 
        October 2009 that all standardized OTC derivatives be centrally 
        cleared clearly goes in this direction, as does the mandate in 
        title VII of the Dodd-Frank Act for increased use of 
        centralized clearing and the expanded development of CCPs in 
        emerging markets (G20, 2009; Financial Stability Board, 2010).

   Title VII of the Dodd-Frank Act mandates increased use of 
        collateral for swaps not centrally cleared. As we have 
        discussed, collateral requirements typically carry with them 
        time-critical deadlines for delivery of collateral. In 
        addition, proposed regulations to implement this provision of 
        Dodd-Frank would forbid or attenuate the practice of 
        rehypothecation, whereby the recipient of collateral can sell 
        or otherwise use the collateral as if it were the recipient's 
        property. Such restrictions could, in effect, decrease the 
        supply of acceptable collateral precisely when requirements for 
        collateral are increasing.

   Finally, recent proposed revisions to the international 
        standards for financial market infrastructures include a 
        proposal to increase financial resources dedicated to 
        mitigating counterparty credit risk. In particular, the 
        international standards in effect prior to April 2012 recommend 
        financial resources sufficient ``to withstand, at a minimum, a 
        default by the participant to which it has the largest exposure 
        in extreme but plausible market conditions.'' \19\ These 
        standards were replaced by the Bank for International 
        Settlements' Committee on Payment and Settlement Systems and 
        the Technical Committee of the International Organization of 
        Securities Commissions (CPSS-IOSCO), which recommend 
        strengthening these standards to enable institutions ``involved 
        in activities with a more-complex risk profile'' or 
        ``systemically important in multiple jurisdictions'' to 
        withstand the default of the two participants generating the 
        largest credit exposure (CPSS-IOSCO, 2012, p. 37).
    \19\ See CPSS-IOSCO (2004, p. 23). Similar wording is found in CPSS 
(2001) and CPSS-IOSCO (2001).

    All of these efforts to mitigate credit risk have clear value. 
However, the trend toward increased dependence on time-critical 
liquidity raises an important question, in our view: To what extent 
does this settlement risk mitigation merely transform credit risk into 
liquidity risk? In other words, once the more straightforward steps to 
reduce credit risk have been taken (for example, through netting), 
might further actions to mitigate credit risk have the unintended 
consequence of increasing liquidity risk?
    The main concern with this increased dependence on time-critical 
liquidity, from a public policy standpoint, is that it may exacerbate 
the effect of periodic liquidity crises. More specifically, as payment, 
clearing, and settlement (PCS) systems create increased demand for 
time-critical liquidity, participant institutions need to take steps to 
ensure the flow of funding needed to meet these time-critical liquidity 
constraints. These efforts may drive increasingly tight and 
interdependent payment flows as system participants attempt to meet 
time-critical liquidity demands across PCS systems. This process can 
make the PCS infrastructure more sensitive to systemic perturbations 
during a crisis episode.
    An alternative way to think about this increased sensitivity to 
systemic perturbations is in terms of demand and supply dynamics. The 
demand for time-critical liquidity is unlikely to decrease during such 
a crisis.\20\ Indeed, the need for time-critical liquidity may tend to 
increase during a crisis, as collateral haircuts expand and margin 
requirements adjust upward in light of increased market volatility and 
declining asset valuations. But the sources of time-critical liquidity 
may well attenuate in a crisis environment, as pervasive uncertainty 
induces institutions and individuals to hoard liquid assets.
    \20\ As a practical matter, operators of payment, clearing, and 
settlement systems have little discretion to forbear on time deadlines 
for liquidity provision, because forbearance fundamentally undermines 
the if-and-only-if conditionalities that underlie their risk-management 
    Let us consider in detail three examples that illustrate how time-
critical liquidity requirements can interact adversely with the 
diminished willingness of intermediaries to provide liquidity during a 
1987 Market Break
    On Monday, October 19, 1987 (Black Monday), stock markets around 
the world crashed, shedding a huge value in a very short time.\21\ As a 
result of the market price declines and increased volatility on Black 
Monday, intraday and end-of-day margin requirements at derivatives 
clearinghouses rose to record levels. For example, clearing members of 
the CME faced margin calls (reflecting both mark-to-market variations 
and increased initial margin requirements) around ten times the 
previous average margins (Carlson, 2006). At the same time, banks 
became less willing to advance credit to clearing members. Bernanke 
(1990) and Carlson (2006) argue that aggregate liquidity provision 
could have been insufficient without Federal Reserve action. As 
Bernanke (1990, p. 148) states, ``The Fed `persuaded' the banks, 
particularly the big New York banks, to lend freely, promising whatever 
support was necessary.''
    \21\ For more details of this event, see http://en.wikipedia.org/
    Just as serious was the problem of gridlock in the flow of mark-to-
market variation settlements and initial margin requirements. This 
disruption was manifested in various ways. Payments on behalf of 
clearing members that had received margin calls from a clearinghouse 
were significantly delayed.\22\ In addition, clearing members that were 
expecting margin payments from a clearinghouse found it necessary to 
meet the payment expectations of significant customers before receiving 
payment from the clearinghouse. Notably, two major clearing members, 
Kidder Peabody and Goldman Sachs, advanced funds for customer margin 
calls only to find themselves short by over $1.5 billion when payments 
due to them were delayed.\23\
    \22\ See U.S. General Accounting Office (1990, p. 41), which 
summarizes the evidence of persistent delays in the completion of 
settlement payments:

      According to the SEC February 1988 Report, between October 19 and 
October 30, 1987,
  clearing members made late payments to stock clearing organizations 
approximately 60
  times. . . . On October 19, 20, and 21, CME received late payments 
from several of its mem-
  bers. According to CME, clearing banks were late in confirming member 
payment for 26 of
  CME's 90 clearing members. Thirteen of those payment confirmations 
were between \1/2\
  hour and an hour late on October 20. These late payment confirmations 
violated clearing orga
  nization rules and increased clearing organization risk. CFTC 
officials said that although
  some payment confirmations from clearing banks to the CME House 
Division were late, by
  the time of the opening of the S&P 600 contract for trading, all 
payment confirmations were
  received by CME.

    \23\ Bernanke (1990); see also, Brimmer (1989). There has been some 
confusion in the literature regarding the liquidity problems Goldman 
Sachs and Kidder Peabody faced in connection with this incident. See 
Tamarkin (1993).
    The situation was exacerbated by an operational failure that shut 
down the Fedwire system for 2\1/2\ hours on the morning of October 20, 
1987. This service interruption occurred just when large funds 
transfers needed to be made to complete margin settlements on Chicago's 
futures and options clearinghouses.
    A second example of how markets that depend on time-critical 
liquidity can be disrupted during a financial crisis is the case of 
Sentinel Management Group Inc. Sentinel was a registered futures 
commission merchant (FCM) that specialized in investing funds of 
futures market participants (including some clearing members of the 
CME) in the money markets. In effect, it functioned analogously to a 
money market mutual fund for other FCMs. Sentinel had experienced heavy 
customer demand for redemptions during the onset of market volatility 
in mid-August 2007, causing a ``run'' on the firm and impairing its 
ability to meet its customer obligations. As a result, Sentinel 
announced on Monday, August 13, 2007, that it would not allow further 
redemptions from at least one of the portfolios it managed. Four days 
later, Sentinel filed for bankruptcy (see Lamson and Allen, 2011). The 
effect of these actions was to impede disbursement of customer funds to 
a number of CCP clearing members that were relying on these funds to 
meet their obligations to the clearinghouse. In a court appearance 
involving Sentinel on August 20, counsel for the U.S. Commodity Futures 
Trading Commission (CFTC) argued that ``eleven FCMs will fail if the 
money is not distributed . . . and there will be reverberations 
throughout the economy'' (Lamson and Allen, 2011, pp. 7-8). Presumably, 
the CFTC's concern was that these FCMs may have had payments owing to 
the clearinghouses and had no source of readily available funds other 
than their Sentinel investments. As it turned out, the bankruptcy court 
did permit sufficient disbursements to avoid any FCM defaults.
Tri-Party Repo Market
    A third example of how sources of time-critical liquidity can 
attenuate during a crisis is the potential instability of the tri-party 
repurchase (or repo) market under certain conditions (Gorton, 2009). 
The tri-party repo market is a short-term credit market that is used as 
an important source of time-critical liquidity in payments, clearing, 
and settlement mechanisms. In this market, users of short-term credit 
borrow from providers of short-term credit (typically money market 
mutual funds) by selling securities to the lender with a simultaneous 
agreement to repurchase the securities on a specified future date at a 
prespecified price. The ``third party'' is a clearing bank that 
facilitates funds transfer and acts as collateral custodian.
    Under the operating procedures that prevailed during the financial 
crisis of 2007-09, the clearing banks at the heart of the tri-party 
repo market would each day provide large amounts of intraday credit, in 
effect providing bridge financing between the time when funds are 
returned to the lenders (typically between 8:00 and 8:30 a.m. eastern 
standard time, or EST) and when new loans are executed (typically 
between 3:00 and 6:00 p.m. EST) (see Copeland, et al., 2011). This 
practice could lead to greater instability during a crisis. As 
explained in Federal Reserve Bank of New York (2010, p. 13):

          The daily hand-off of credit extensions between overnight 
        cash lenders and clearing banks creates an incentive for each 
        to reduce its exposure quickly by pulling away from a 
        potentially troubled dealer before the other one does. Indeed, 
        as dealers came under severe stress, clearing banks 
        reconsidered their longstanding practice of routinely extending 
        intraday credit, as they recognized the potential risk it posed 
        to them.

    During the recent financial crisis, there was a risk that, 
recognizing this inherent vulnerability of the tri-party repo market, 
lenders would withdraw liquidity, with damaging consequences both for 
the market as a whole and for weakened market participants that were 
critically dependent upon funding ordinarily available through short-
term funding markets.
    All of these examples illustrate how dependence on time-critical 
liquidity can exacerbate financial market turmoil during a financial 
crisis. This is a problem that clearly needs to be addressed, but the 
solution is not obvious.
    One way of addressing this problem would be to reduce the use of 
time-critical liquidity. But, as we have stressed in this article, 
time-critical liquidity is a key component of mechanisms to reduce 
settlement risk in financial transactions. In practice, efforts to 
reduce use of time-critical liquidity would weaken financial markets' 
commitment to ensuring same-day settlement, a goal that has been 
enshrined in 39 years of post-Herstatt practice.
    Furthermore, the goal of guaranteeing same-day (or even intraday) 
settlement is explicitly incorporated in the current international 
standards, the Principles for Financial Market Infrastructure (PFMI), 
adopted in April 2012 under the auspices of the CPSS-IOSCO.\24\ 
Specifically, a major focus of the PFMI is the problem of liquidity 
risk, and in particular the need to carefully manage intraday liquidity 
to achieve prompt settlement of financial transactions. For example, 
principle 7 of the PFMI states explicitly that
    \24\ See CPSS-IOSCO (2012). As used in the PFMI, the term 
``financial market infrastructure'' (FMI) refers to any of a number of 
institutions that support financial transactions, including payments 
systems, CSDs, securities settlement systems, and CCPs.

          an FMI should maintain sufficient liquid resources in all 
        relevant currencies to effect same-day and, where appropriate, 
        intraday . . . settlement of payment obligations with a high 
        degree of confidence under a wide range of potential stress 
        scenarios . . . in extreme but plausible market conditions. 
        (CPSS-IOSCO, 2012, p. 57, italics added)

    Recent developments in FMI design and academic thinking about the 
liquidity demands associated with settlements in FMIs might be 
interpreted as reflecting a reduced commitment to same-day assured 
settlement under certain conditions, such as the default of one or more 
FMI participants (see, for example, Hull, 2012). These developments are 
worth following as the PFMI are implemented in the coming months and 
    A consequence of PFMI principle 7 is that the liquidity risks 
undertaken to mitigate credit risk should be well contained by 
mandating robust minimum liquidity resources for payments, clearing, 
and settlement institutions. These resources would typically take the 
form of cash on hand, dedicated same-day liquidity facilities provided 
by a consortium of banks, and arrangements in advance to facilitate 
repurchase agreements. Such regulatory mandates are clearly warranted. 
An implication of the arguments in this article is that robust 
liquidity risk management is of crucial importance to modern PCS 
systems, and this importance is likely to increase over time.
    Ensuring that liquidity resources are adequate to withstand a 
crisis requires constant vigilance. Financial crises are times when 
market participants tend to hoard liquidity. For example, in the midst 
of a crisis, a party that had committed to provide time-critical 
liquidity may be incapable or unwilling to fulfill on that contractual 
obligation. In addition, same-day liquidity facilities typically must 
be renewed every 364 days. If the renewal date occurs during a 
financial crisis, it may be difficult to renew the facility to obtain 
the desired capacity. Furthermore, for some financial market utilities 
(such as large, global swaps CCPs), the only institutions with 
sufficient financial capacity to participate in these liquidity 
facilities may be the utilities' own members. This state of affairs 
would raise the uncomfortable problem of wrong-way risk, wherein part 
of the resources used to protect a utility against the default of one 
of its members is the capital of that very member.
    In addition, repo markets could become less reliable sources of 
liquidity during a crisis if money market mutual funds and other 
providers of liquidity to the repo markets move their resources into 
Treasury securities and other ultra-safe vehicles. Even cash can be a 
less reliable source of liquidity in a crisis if the cash is in the 
form of commercial bank deposits, since commercial banks themselves are 
more likely to fail in a crisis situation. Finally, there may be a 
level of liquidity risk beyond which a financial market utility cannot 
self-insure and remain viable as an economic entity. That is, the costs 
of such self-insurance may exceed the economic value of the utility 
    If private liquidity provision may be inadequate in certain extreme 
conditions, it may be useful to create a framework in which central 
bank liquidity can act as a backstop. The principles in CPSS-IOSCO 
(2012) explicitly permit financial market utilities to count central 
bank credit toward their liquidity resources, provided the utility has 
routine access to such credit. Certain jurisdictions provide such 
routine access to central bank liquidity.\25\ However, CPSS-IOSCO 
(2012) also recognizes the obvious moral hazard problem of having a 
payments, clearing, or settlement utility count emergency (that is, 
nonroutine) central bank liquidity as part of its liquidity resources 
for the purposes of meeting the standards mandated by the PFMI.
    \25\ The availability to FMIs of routine access to central bank 
credit is dependent upon many factors, including whether the FMI is 
chartered as a banking institution (a requirement in some 
jurisdictions), the type of FMI (for example, whether it functions as a 
CSD, a CCP, or some other kind of market infrastructure), the type of 
credit (for example, intraday, overnight, or emergency), and the 
statutory authority of the relevant central banks to exercise 
discretion in extending such credit. Broad generalizations in this area 
are difficult to make and are subject to change as legislation and 
central bank credit policies are amended from time to time. Although a 
complete typology of credit policies for FMIs is outside the scope of 
this article, our research based on publicly available sources 
indicates that Belgium, France, Germany, Japan, and Switzerland are 
jurisdictions in which some form of routine access to central bank 
credit may be afforded certain FMIs. U.S. law and Federal Reserve 
policy do not currently permit nondepository institutions (including 
certain FMIs) routine access to central bank credit.
    In conclusion, we note that the trade-offs we have discussed 
between credit risk management and liquidity requirements appear to be 
fundamental to modern financial markets. It is likely that future 
policy developments will continue to grapple with optimal institutional 
design in light of these concerns.

    Bank for International Settlements, Committee on Payment and
 Settlement Systems, 2005, New Developments in Large-Value Payment
 Systems, Basel, Switzerland, May, available at www.bis.org/publ/
    _______, 2003a, Payment and Settlement Systems in Selected
 Countries, Basel, Switzerland, April, available at www.bis.org/publ/
    _______, 2003b, A Glossary of Terms Used in Payment and Settlement
 Systems, Basel, Switzerland, March, available at www.bis.org/publ/
    _______, 2001, Core Principles for Systemically Important Payment
 Systems, Basel, Switzerland, January, available at www.bis.org/publ/
    _______, 1997, Real-Time Gross Settlement Systems, Basel,
 Switzerland, March, available at www.bis.org/publ/cpss22.pdf.
    _______, 1995, Cross-Border Securities Settlements, Basel,
 Switzerland, March, available at www.bis.org/publ/cpss12.pdf.
    _______, 1992, Delivery versus Payment in Securities Settlement
 Systems, Basel, Switzerland, September, available at www.bis.org/publ/
    Bank for International Settlements, Committee on Payment and
 Settlement Systems, and Technical Committee of the International
 Organization of Securities Commissions, 2012, Principles for Financial
 Market Infrastructures, Basel, Switzerland, April, available at
    _______, 2004, Recommendations for Central Counterparties, Basel,
 Switzerland, November, available at www.bis.org/publ/cpss64.pdf.
    _______, 2001, Recommendations for Securities Settlement Systems,
 Basel, Switzerland, November, available at www.bis.org/publ/cpss46.pdf.
    Bech, Morten L., and Bart Hobijn, 2007, ``Technology diffusion
 within central banking: The case of real-time gross settlement,''
 International Journal of Central Banking, Vol. 3, No. 3, September, pp.
    Bernanke, Ben S., 1990, ``Clearing and settlement during the
 crash,'' Review of Financial Studies, Vol. 3, No. 1, January, pp. 133-
    Board of Governors of the Federal Reserve System, 2009, ``Fedwire
 Funds Transfer System: Assessment of compliance with the core
 principles for systemically important payment systems,'' report,
 Washington, D.C., revised March 2009, available at
    Brimmer, Andrew. F., 1989, ``Distinguished lecture on economics in
 government: Central banking and systemic risks in capital markets,''
 Journal of Economic Perspectives, Vol. 3, No. 2, Spring, pp. 3-16,
 available at www.jstor.org/stable/1942665.
    Brunnermeier, Markus K., and Lasse Heje Pedersen, 2009, ``Market
 liquidity and funding liquidity,'' The Review of Financial Studies,
 Vol. 22, No. 6, pp. 2201-2238.
    Carlson, Mark, 2006, ``A brief history of the 1987 stock market
 crash with a discussion of the Federal Reserve response,'' Finance and
 Economics Discussion Series, Board of Governors of the Federal Reserve
 System, working paper, No. 2007-13, November, available at
    Copeland, Adam, Darrell Duffie, Antoine Martin, and Susan
 McLaughlin, 2011, ``Policy issues in the design of tri-party repo
 markets,'' Federal Reserve Bank of New York and Stanford University,
 working paper (preliminary), July, available at www.darrellduffie.com/
    Duffie, Darrell, and Kenneth J. Singleton, 2003, Credit Risk:
 Pricing, Measurement, and Management, Princeton, NJ: Princeton
 University Press.
    Federal Reserve Bank of New York, 2010, ``Tri-party repo
 infrastructure reforms,'' white paper, May 17, available at
    Federal Reserve Bank of New York, Payments Risk Committee, 2012,
 ``Intraday liquidity flows,'' report, March 30.
    Federal Reserve Bank of New York, Payments Risk Committee, Cross-
 border Collateral Pool Task Force, 2003, Managing Payment Liquidity in
 Global Markets: Risk Issues and Solutions, report, March, available at
    Federal Reserve Bank of New York, Payments Risk Committee, Intraday
 Liquidity Management Task Force, 2000, Intraday Liquidity Management in
 the Evolving Payment System: A Study of the Impact of the Euro, CLS
 Bank, and CHIPS Finality, report, April, available at
    Financial Stability Board, 2010, Implementing OTC Derivatives Market
 Reforms, Basel, Switzerland, October 25, available at
    Garleanu, Nicolae, and Lasse Heje Pedersen, 2007, ``Liquidity and
 risk management,'' The American Economic Review, Vol. 97, No. 2, May,
 pp. 193-197.
    Garner, Bryan A., 1995, A Dictionary of Modern Legal Usage, 2nd ed.,
 New York: Oxford University Press.
    Gorton, Gary, and Andrew Metrick, 2009, The run on repo and the
 panic of 2007-2008, Yale University and National Bureau of Economic
 Research, working paper, March 9, available at http://economics.mit.edu/
    Group of Thirty, 2003, Global Clearing and Settlement: A Plan of
 Action, report, Washington, D.C.
    Group of Twenty, 2009, ``G20 leaders' statement,'' Pittsburgh
 Summit, Pittsburgh, PA, September 24-25.
    Heckinger, Richard, David Marshall, and Robert Steigerwald, 2009,
 ``Financial market utilities and the challenge of just-in-time
 liquidity,'' Chicago Fed Letter, Federal Reserve Bank of Chicago, No.
 268a, November.
    Herring, Richard J., and Robert E. Litan, 1995, Financial Regulation
 in the Global Economy, Washington, D.C.: The Brookings Institution.
    Hills, Bob, and David Rule, 1999, ``Counterparty credit risk in
 wholesale payment and settlement systems,'' Financial Stability Review,
 No. 7, November, pp. 98-114, available at www.bankofengland.co.uk/
    Hong Kong Monetary Authority, 2013, ``Payment systems,'' webpage of
 HKMA website, available at www.hkma.gov.hk/eng/key-functions/
    Hull, John, 2012, ``CCPs: Their risks, and how they can be
 reduced,'' Journal of Derivatives, Vol. 20, No. 1, Fall, pp. 26-29.
    International Monetary Fund, Financial Sector Assessment Program,
 2010, The Depository Trust Company's Observance of the CPSS-IOSCO
 Recommendations for Securities Settlement Systems: Detailed Assessments
 of Observance, country report, No. 10/128, Washington, D.C., May.
    International Organization for Standardization, 2009, ``Risk
 management-Principles and guidelines,'' report, No. ISO 31000:2009,
 Geneva, Switzerland, available for purchase at www.iso.org/iso/
    Koleva, Gergana, 2011, `` `Icon of system risk' haunts industry
 decades after demise,'' American Banker, June 23, available at
    Lamson, Donald N., and Hilary Allen, 2011, ``SEC and CFTC joint
 rulemakings under Dodd-Frank--A regulatory odd couple?,'' Securities
 Regulation & Law Report, March 7.
    Mills, David C., Jr., and Travis D. Nesmith, 2008, ``Risk and
 concentration in payment and securities settlement systems,'' Journal
 of Monetary Economics, Vol. 55, No. 3, April, pp. 542-553.
    Nikolaou, Kleopatra, 2009, ``Liquidity (risk) concepts: Definitions
 and interactions,'' European Central Bank, working paper, No. 1008,
 February, available at www.ecb.eu/pub/pdf/scpwps/ecbwp1008.pdf.
    Nosal, Ed, and Robert Steigerwald, 2010, ``What is clearing and why
 is it important?,'' Chicago Fed Letter, Federal Reserve Bank of
 Chicago, No. 278, September.
    Tamarkin, Bob, 1993, The Merc: The Emergence of a Global Financial
 Powerhouse, New York: Harper Business.
    U.S. General Accounting Office, 1990, Clearance and Settlement
 Reform: The Stock, Options, and Futures Markets Are Still at Risk,
 report, No. GAO/GGD-90-33, Washington, D.C., April, available at http://
    World Bank, Payment Systems Development Group, 2008, Payment Systems
 Worldwide: A Snapshot. Outcomes of the Global Payment Systems Survey
 2008, Washington, D.C., available at www.mfw4a.org/documents-details/
    The Chairman. Thank you, sir.
    Mr. Hill.


    Mr. Hill. Chairman Conaway and Ranking Member Peterson, I 
am Scott Hill, Chief Financial Officer of Intercontinental 
Exchange, and I appreciate the opportunity to appear before the 
Committee today to discuss the important role of clearing.
    Since launching an electronic over-the-counter energy 
marketplace in 2000 in Atlanta, Georgia, ICE has expended both 
in the U.S. and internationally. Over the past 17 years we have 
acquired or built derivative exchanges and clearinghouses in 
the U.S., Europe, Singapore, and Canada. ICE has a successful 
and innovative history clearing exchange traded and over-the-
counter, or OTC, derivatives across a spectrum of asset 
classes, including many energy, agricultural, and financial 
    We began operating our first clearinghouse a decade ago, 
and today we are the third largest global clearing operator, 
with six clearinghouses in operation around the world. The 
risk-reducing benefits of central clearing have long been 
recognized by users of exchange-traded derivatives. The 
efficacy of the clearing model throughout even the most 
challenging financial situations made it the natural foundation 
of the global financial reforms put forward over the past 
decade for OTC derivatives. Clearing has consistently proven to 
be a fundamentally safe and sound process for managing systemic 
risk. Global regulators recognize that a clearinghouse, by 
acting as a central counterparty to transactions, minimizes 
bilateral risk. As a result of increased clearing, market 
participants are realizing that moving uncleared positions into 
clearing creates both operational and capital efficiencies.
    Over the past decade, ICE has invested heavily in our 
clearinghouse technology and risk-management practices. ICE has 
kept pace with, and often preceded, regulatory reforms, new 
global rules, and international standards that have been 
established with respect to risk controls, levels of 
protection, and proper functioning of clearinghouses. We have 
worked closely with regulators, clearing members, and end-users 
to implement clearing models that meet or exceed modern 
regulatory reforms and international standards.
    Our clearinghouses are subject to extensive regulatory 
oversight and strong corporate governance requirements, 
exercised largely through risk and advisory committees, and 
independent boards of directors. The committees include 
representatives from our clearing member firms, and in some 
cases clients. ICE clearinghouses regularly conduct margin 
back-testing, default fund stress testing, and liquidity stress 
testing, the results of which are publicly available and 
reviewed by clearing members and regulators. The rules, 
practices, and procedures of ICE's clearinghouses are fully 
transparent and publicly disclosed in a consistent manner.
    ICE clearinghouses have also established robust recovery 
plans that are clear and transparent, and provide sufficient 
detail for members and regulators to anticipate the likely 
actions and tools that may be used during a default. ICE has 
been working with regulators and clearing members to implement 
changes to its recovery rules to further enhance the recovery 
process, and incentivize clearing members, clearinghouses, and 
market participants to work together during a crisis situation 
to maintain the viability of a market.
    ICE's clearinghouses manage a significant amount of 
collateral, largely in the form of cash and U.S. Government 
securities. The management of these large collateral balances, 
and the need to facilitate daily variation margining requires 
the mitigation of custodial and depository risk and collateral 
liquidity risk.
    While clearinghouses have successfully managed these risks 
in the past through commercial arrangements, such arrangements 
are frequently with institutions that are also large clearing 
members. Central banks, including the Federal Reserve, can 
eliminate custodial and depository risk by allowing 
clearinghouses to access to deposit U.S. dollars in a Federal 
Reserve system account, and eliminate any liquidity risk by 
granting clearinghouses access to the discount window for the 
limited purpose of transforming U.S. treasuries into U.S. 
dollars. It is important to note that such access creates no 
additional risk to the taxpayer.
    Ironically, despite the growth in the volume of cleared 
contracts, the number of futures commission merchants, or FCMs, 
available to provide clearing services for end-users has 
dropped from nearly 200, to fewer than 60 in recent years. 
Unfortunately, the term off-boarding of end-users has become 
more prevalent in the industry than on-boarding.
    One of the biggest contributors to this troubling trend is 
the proposed requirements under Basel III. Basel III requires a 
bank to hold regulatory capital against clearing customer 
margin on its balance sheet, notwithstanding the fact that the 
customer margin is posted to a clearinghouse and segregated at 
that clearinghouse. Said differently, risk-reducing margins 
collected from customers and segregated on banks' balance 
sheets are considered risk-increasing for capital requirement 
purposes. In addition, these increased capital costs may impede 
customer porting from a failing clearing firm to a healthy 
clearing firm in a time of stress. Under current rules, FCMs 
accepting new customer positions from a defaulted FCM must 
immediately be willing and able to sustain large capital 
charges to absorb these new positions. These rules introduce a 
substantial impediment and disincentive for FCMs to take 
positions from a defaulting clearing member's books.
    Thank you for the opportunity to share our views with you. 
I would be happy to answer any questions from the Members of 
the Subcommittee.
    [The prepared statement of Mr. Hill follows:]

     Prepared Statement of Scott A. Hill, Chief Financial Officer, 
              Intercontinental Exchange, Inc., Atlanta, GA
    Chairman Scott, Ranking Member Scott, I am Scott Hill, Chief 
Financial Officer for Intercontinental Exchange, or ICE. I appreciate 
the opportunity to appear before you today to discuss the role of 
    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 seventeen years, we have 
acquired or founded derivatives exchanges and clearing houses in the 
U.S., Europe, Singapore and Canada. In 2013, ICE acquired the New York 
Stock Exchange, which added equity and equity options exchanges to our 
business. Through our global operations, ICE's exchanges and clearing 
houses are directly regulated by the U.S. Commodity Futures Trading 
Commission (CFTC), the Securities and Exchange Commission (SEC), the 
Bank of England, the UK Financial Conduct Authority (FCA), the European 
Securities and Markets Au[th]ority (ESMA) and the Monetary Authority of 
Singapore, among others.
    ICE has a successful and innovative history clearing exchange 
traded and over-the-counter (OTC) derivatives across a spectrum of 
asset classes including many energy, agriculture and financial 
products. ICE acquired its first clearing house, ICE Clear U.S. (ICUS), 
as a part of the 2007 purchase of the New York Board of Trade. ICUS 
clears a variety of agricultural and financial derivatives. In 2008, 
ICE launched ICE Clear Europe (ICEU), the first new clearing house in 
the UK in over a century. ICEU clears derivatives in several asset 
classes including energy, interest rates and equity derivatives. ICE 
Clear Credit (ICC) was established as a trust company in 2009 under the 
supervision of the Federal Reserve Board and the New York State Banking 
Department and converted to a derivatives clearing organization (DCO) 
following implementation of the Dodd-Frank Wall Street Reform and 
Consumer Protection Act (DFA). Today, ICE owns and operates six 
clearinghouses that serve global markets across North America, Europe 
and Asia.
CCPs Facilitate Market Participation by Mitigating Default Risk
    The risk reducing benefits of central clearing have long been 
recognized by users of exchange-traded derivatives (futures) and the 
efficacy of the clearing model throughout even the most challenging 
financial situations made it the natural foundation of the financial 
reforms put forward over the past decade for OTC derivatives around the 
world. Clearing has consistently proven to be a fundamentally safe and 
sound process for managing systemic risk throughout history. Observers 
frequently point to non-cleared derivative contracts as a significant 
factor in the broad reach and complexity of the 2008 financial crisis 
while noting the relative stability of cleared markets.
    The disciplined and transparent risk management practices 
(including: initial and ongoing counterparty credit monitoring; 
uniform, risk-based, collateral requirements; and, the daily marking-
to-market of losses) associated with regulated cleared contracts serves 
to reduce systemic risk. A clearing house, by acting as a central 
counterparty (or CCP), to transactions, minimizes bilateral risk by 
compressing derivative exposures. For example, since 2009, ICE Clear 
Credit and ICE Clear Europe have cleared more than $89.5 trillion in 
CDS notional, but, in part, through compression (also known as 
multilateral netting) the amount of bilateral credit exposure among 
market participants has been significantly reduced. ICE Clear Credit 
and ICE Clear Europe currently maintain a combined open interest of 
$1.6 trillion.
    Over the past 100 years, clearing house risk management practices 
have been repeatedly tested and proven in resolving clearing member 
defaults including large bankruptcy proceedings such as Lehman Brothers 
and MF Global. The recent introduction of mandated clearing obligations 
for certain swaps has prudently extended the significant benefits of 
clearing to a broader array of vitally important capital markets.
    Over the past decade, ICE has invested heavily in our clearing 
house technology and risk management practices. ICE has kept pace with 
and often preceded regulatory reforms, new global rules, and 
international standards \1\ that have been established with respect to 
risk controls, levels of protection and proper functioning of clearing 
houses. We have worked closely with regulators, clearing members and 
end-users to implement clearing models that meet or exceed modern 
regulatory reforms and international standards. The result is an even 
more robust clearing model that includes many ICE-led initiatives, such 
as the introduction of ``skin-in-the-game,'' or the contribution by the 
clearing houses of a designated, fully funded amount of its own capital 
to the default waterfall.
    \1\ Committee on Payment and Settlement Systems, International 
Organization of Securities Commissioners (CPSS-IOSCO), Principles of 
Financial Market Infrastructures (April 2012). http://www.bis.org/publ/
    ICE clearing houses are subject to extensive regulatory oversight 
and strong corporate governance requirements, exercised largely through 
customer-constituted risk and advisory committees and independent 
boards of directors.\2\ Risk committees include representatives from 
our clearing member firms and, in some cases, end clients. ICE clearing 
houses regularly conduct margin back-testing, default fund stress 
testing, and liquidity stress testing--the results of which are 
publicly available and reviewed by clearing members and regulators. In 
addition, the clearing houses' margin, guaranty fund and liquidity 
methodologies are independently validated on a routine basis and are 
subject to the review and approval of the relevant risk committee, 
board and prudential regulator(s).
    \2\ An overview of the risk governance at ICE clearing houses can 
be found online: ICE Clear Europe--www.theice.com/clear-europe/risk-
management; ICE Clear U.S.--www.theice.com/clear-us/regulation; ICE 
Clear Credit:--www.theice.com/clear-credit/regulation.
    The rules, practices and procedures of ICE's clearing houses are 
fully transparent and are publicly disclosed in a consistent manner, as 
set out within the CPMI-IOSCO Principles for Financial Market 
Infrastructures (PFMIs) \3\ and various regulatory requirements. Any 
material changes to ICE's clearing processes are subject to rigorous 
internal governance review as well as applicable regulatory review and 
    \3\ Supra, nt. 1.
    \4\ For an overview of ICE central clearing operation and 
governance see: https://www.theice.com/publicdocs/
CCPs Facilitate Market Participation by Managing Liquidity Risk
    ICE's clearing houses collect a significant amount of collateral 
largely in the conservative form of cash and U.S. Government 
securities. The management of these large collateral balances and the 
need to facilitate daily variation margining requires the mitigation of 
custodial/depository risk and collateral liquidity risk.\5\ While CCPs 
have successfully managed these risks in the past through commercial 
arrangements, such arrangements are frequently with institutions that 
are also clearing members. Central banks, including the Federal 
Reserve, can (1) eliminate custodial/depository risk by allowing CCPs 
to deposit cash collateral in a Federal Reserve System account and (2) 
eliminate any liquidity risk by granting CCPs access to the discount 
window for the limited purpose of transforming U.S. treasuries into 
cash. Fed account access benefits the market, reduces depository and 
investment risk and has proven to be a useful tool, allowing designated 
CCPs to more safely and soundly manage collateral, including client 
    \5\ The liquidity of U.S. Government securities is a topic of 
industry debate. ICE believes that U.S. Government securities are one 
of the more liquid forms of collateral and that historically, during 
times of stress, there has been a flight to the quality of U.S. 
Government securities.
    Fed account access provides the maximum level of protection for 
customer collateral, a central goal of regulators and policymakers, and 
such access should be made available to all CCPs. By providing 
selective access to designated clearing houses, the current policy 
unintentionally drains more liquid assets from non-designated CCPs, 
exacerbating their liquidity challenges. In addition, customers of 
designated CCPs are provided enhanced protections from commercial and 
depository risk while customers of non-designated CCPs are not. Why 
should a wheat farmer enjoy a greater level of protection than a cotton 
farmer? The government should promote a policy that expands and 
equalizes access to Fed accounts to level the playing field for all 
market participants. It is important to note that such access creates 
exactly zero additional risk to the taxpayer.
    In addition, as noted above, CCPs should have access to the 
discount window for the limited purpose of transforming U.S. treasuries 
into cash. Such access simply provides a facility to turn U.S. 
Government securities, at a hair-cut appropriate to the market 
environment at the time of access, into U.S. dollars to facilitate the 
vital variation margin process during a time of unprecedented stress. 
Again, such access in no way creates any additional risk to taxpayers.
Basel Impact on Clearing
    Despite the growth in the volume of cleared contracts, the number 
of futures commission merchants (``FCM'') available to provide clearing 
services for end-users has dropped considerably in recent years. There 
were around 190 firms providing clearing services in 2004 but only 
approximately 56 today, according to the Futures Industry Association. 
Exacerbating the decline, the majority of these FCMs focus only on 
futures execution services with only a subset providing both futures 
and over-the-counter swaps post trade clearing services. Consequently, 
the bulk of derivatives clearing is now concentrated amongst a few bank 
owned global FCMs and some customers find themselves excluded from 
markets because they cannot access clearing services. The term ``off-
boarding'' of clients has become more prevalent in the industry than 
    One of the biggest constraints on clearing service providers is the 
proposed Basel Committee on Banking Supervision's leverage ratio 
framework (``Basel III''). Basel III requires a bank to hold regulatory 
capital against clearing customer margin on its balance sheet 
notwithstanding the fact that the customer margin is posted to a 
clearing house and held at the clearing house on a segregated basis. 
Said differently, risk reducing margins collected from customers and 
segregated on a bank's balance sheet are considered risk enhancing for 
capital requirement purposes. For example, Basel III treats the capital 
requirements for a client cleared transaction with initial margin 
(``IM'') the same as a formerly bilateral trade without any IM posted. 
Without allowing IM Offsets, the clearing member is penalized for 
having a position that is actually more collateralized which makes the 
provision of clearing services far less attractive. As a direct result, 
and as reflected in the aforementioned statistics, the unintended 
consequence is that many FCMs are shrinking or ceasing their clearing 
services business at exactly the same time regulations are encouraging 
the increased use of clearing.
    In addition, these increased capital costs may also impede customer 
porting from a failing clearing firm to a healthy clearing firm in a 
time of stress. Under current rules, FCMs accepting new customer 
positions from a defaulted FCM must immediately be willing and able to 
sustain large capital charges to absorb the new positions. While the 
global CCPs and their members successfully managed through the large 
bankruptcy proceedings involving Lehman Brothers and MF Global, Basel 
III capital rules did not apply and mandatory client clearing rules for 
OTC swaps had not gone into effect. In the current construct, FCMs are 
likely to be far more reluctant to accept ported positions which will 
exacerbate the instability in markets already present in a default 
CCP Recovery and Resolution
    To accommodate extreme and unlikely circumstances that result in 
losses in excess of a defaulting clearing members' margin and guaranty 
fund resources, ICE clearing houses have established robust recovery 
plans that are clear and transparent and provide sufficient detail for 
members and regulators to anticipate the likely actions and tools that 
may be used during a default. ICE has been working with regulators and 
clearing members to implement changes to its recovery rules to further 
enhance the recovery process and incentivize clearing members, CCPs and 
market participants to work together during a crisis situation to 
maintain the viability of the market by returning to a matched book. 
The recovery rule amendments have been approved by regulators and 
clearing members for certain ICE clearing houses and we are actively 
working to harmonize changes across all ICE clearing houses.
    Further, ICE believes that, to the fullest extent possible, 
resolution authorities should not interfere with a CCP's implementation 
of its existing recovery process. If it does become necessary for a 
resolution authority to intervene before a CCP has exhausted its 
available tools, the resolution authority should continue to act 
consistently with the CCP's existing rules and arrangements. ICE 
additionally believes that resolution should be invoked only in a 
situation where all efforts at recovery have been unsuccessful (whether 
taken by CCP itself, the resolution authority, or a combination of the 
    Finally, an appropriate resolution authority should possess a deep 
understanding of the markets and role of CCPs. The Commodities and 
Futures Trading Commission (``CFTC'') possesses this requisite 
knowledge and experience given its direct regulatory oversight over 
CCPs and is well positioned to be the resolution authority for the CCPs 
it oversees.
    ICE has always been, and remains, a strong proponent of open and 
competitive markets with appropriate regulatory oversight. As an 
operator of global futures and derivatives markets, ICE understands the 
importance of ensuring the utmost confidence in its markets and we take 
seriously our obligations to mitigate systemic risk. To that end, we 
have worked closely with regulatory authorities in the U.S. and abroad 
in order to ensure they have access to all relevant information 
available to ICE regarding trade execution and clearing activity on our 
markets. ICE looks forward to continuing to work closely with 
governments and regulators at home and abroad to address the evolving 
regulatory challenges presented by derivatives markets and to expand 
the use of demonstrably beneficial clearing services that underpin the 
best and safest marketplaces possible.
    Mr. Chairman, thank you for the opportunity to share our views with 
you. I would be happy to answer any questions you and Members of the 
Subcommittee may have.

    The Chairman. Mr. Salzman, 5 minutes.


    Mr. Salzman. Chairman Conaway, Ranking Member Peterson, 
Members of the Committee, I am Jerry Salzman. I am testifying 
on behalf of the Chicago Mercantile Exchange. Mr. Duffy has 
been unable to get here today. He can't fly.
    Most of what I was going to say has already been said by 
Mr. Hill and Mr. Steigerwald, and I agree with them, so I am 
going to try and sort of change up on the fly and get a little 
more basic than what has been said here, which is pretty high-
level, especially if you are not really into how clearing 
works, what it is, and why it protects the country.
    A clearinghouse actually isn't a risk-taking enterprise. 
People bring contracts to the clearinghouse, and the 
clearinghouse steps between the buyer and the seller. It 
collects from those who lose, and it pays to those who win. It 
manages a matchbook, what we call it, because so long as the 
people are losing pay, the winners get paid, and the system 
works and the country works, and the markets work. We ensure 
that even if somebody fails, there still isn't going to be risk 
to the system. We apply the following types of devices. If you 
are going to be a member of a clearinghouse; a clearing member, 
we make you contribute to a guarantee fund, and your 
contribution to the guarantee fund is based on how much risk 
you bring to the clearinghouse. In addition to your 
contribution to the guarantee fund, we say not only that, but 
if you are going to put on a position, we are going to figure 
out how much can be lost on that position during the time it 
takes us to liquidate that position, or recreate the matchbook. 
We say in addition to what you pay to the guarantee fund, we 
want you to put up that money for your position and your 
customers' positions. We collect that money and we hold it at 
the clearinghouse. One of the things Mr. Steigerwald was saying 
is the safest place to hold that money is not at a bank, where 
we usually keep it, but at the Federal Reserves, because we 
know the Federal Reserve isn't going to fail, and that takes 
one piece of risk out of the system.
    In addition to those things, the clearinghouse next says, 
every day, sometimes twice a day, we are going to watch how the 
market moves. As the market moves, we are going to ask you if 
you are losing money that day on your positions, pay the money 
in immediately or the next morning, if you are gaining money, 
we are going to pay you, so that there is no debt built up in 
the system. This is how clearinghouses work. This is how the 
safety of the system is preserved.
    Now, in addition to the money flows, which are tremendously 
important, obviously, to keep debt out of the system, the 
clearinghouse does compliance reviews of all of its members on 
a regular basis. First of all, we have electronic systems to 
make sure that all the customer money is exactly where it is 
supposed to be, and we can get that on a daily basis. In 
addition, we do risk-based compliance reviews to make sure the 
finances of the clearing members continue to be solid, because 
one of the things we make sure is you don't get to be a 
clearing member unless you have the resources to make good on 
your obligations to the clearinghouse. We are doing this on a 
regular basis, and the CFTC is overseeing all of our work in 
these areas.
    Essentially, we are running a system where we have 
matchbooks and we have money to back anything up. If somebody 
fails to make a deposit when they are supposed to, or if 
somebody's financial condition is known to be too weak to 
continue as a member of the clearinghouse, we can declare them 
in default, even though there has been no loss. When we declare 
them in default, now we have all these resources we were 
talking about to cover their positions, to make it possible for 
us to liquidate their positions and to re-establish the 
    The disaster you are concerned with is the situation where 
at least two major U.S. or international banks that are members 
of our clearinghouse fail simultaneously, where the whole world 
is more or less falling apart. We have set up our money flows 
to cover exactly that situation. In fact, we are good for four 
banks failing simultaneously: big banks. This means that the 
protections not only include what we have collected, what we 
are managing every day, but what the banking system is doing to 
protect the banks from failing, and to make sure that if they 
do fail, they fail in an orderly fashion.
    As I have said, my actual testimony didn't involve anything 
I have just said to you now; it involved what has been said by 
the others. I hope this has been useful to you, and I will be 
here to answer any questions.
    Thank you.
    [The prepared statement of Mr. Salzman follows:]

     Prepared Statement of Jerrold E. Salzman, LL.B., Of Counsel, 
  Derivatives; Litigation, Skadden, Arps, Slate, Meagher & Flom LLP, 
                            Chicago, IL; on
                          Behalf of CME Group
    Good morning, Chairman Conaway, Ranking Member Peterson and Members 
of the Committee. I am Jerry Salzman appearing today on behalf of CME 
Group and its Chairman and Chief Executive Officer Terry Duffy. Thank 
you for the opportunity to testify today regarding Central Counterparty 
Recovery and Resolution.
    CME Clearing is a central counterparty or ``CCP.'' CCPs are risk 
neutral organizations. When a contract is submitted for clearing, a CCP 
becomes the buyer to the seller and the seller to the buyer. This is 
what CCPs call a matched book. By maintaining a matched book, a CCP 
does not take on any market risk and remains risk neutral. Furthermore, 
the substitution of the CCP eliminates the original counterparty risk 
and permits a party to exit its contract without dealing with the 
original party to the trade. Clearing members and their customers can 
trade without regard to the identity or credit of their counterparty 
and thereby achieve operational and financial efficiency.
    Both CCPs and banks can be systemically important to the 
functioning of financial markets, but it is a mistake to assume that 
recovery and resolution planning for banks and CCPs should follow the 
same path. Unlike CCPs, banks have depositors whose assets are employed 
in the risk-taking activities of banks. Banks engage in lending, 
investment banking, asset management, and other similar services that 
pose risks to their depositors and the financial system. Banks engage 
in and offer bespoke, illiquid derivative and other financial products. 
CCPs participate in none of these risk-taking activities. As a result 
of the different services and products offered by banks and the 
consequence to depositors of bank failure, the regulations governing 
banks and CCPs--including plans to address impending failure, capital 
requirements, and liquidity requirements--must be quite different.
    While some banks faced considerable challenges during the 2008 
financial crisis, CCPs performed well. This strong performance led to 
the Congressionally-mandated expanded use of central clearing. The 
expansion of clearing in response to the 2008 financial crisis has 
increased the number of contracts cleared and, correspondingly, the 
amount of performance bond \1\ collected by CCPs to minimize the risk 
that a clearing member fails to meet its obligations when due (or 
defaults) and the risk of contagion resulting from that failure.
    \1\ Performance bond is also called initial margin.
    While CCPs have become intermediaries for more open positions, this 
increase in transaction clearing reduces the risk of a systemic 
failure. The critical point is that clearing lessens systemic risk by 
(1) netting down positions, (2) interposing a neutral party to set 
performance bond and pay and collect daily gains and losses, (3) 
netting pays and collects, (4) providing a properly scaled guaranty 
fund, and (5) isolating the impact of the failure of a clearing member 
by acting as the sole counterparty. In formal terms, increased clearing 
of positions significantly reduces the likelihood that a member default 
would impact other clearing market participants. Because of the 
protections that a CCP provides, a CCP interposed between its member 
firms is far less likely to fail and create system wide losses and 
systemic risk than a member firm or firms without the benefit of 
    As clearing has expanded, so has the focus on the safety and 
soundness of CCPs. The Congress, U.S. and foreign regulators, clearing 
members, customers, and banks, which provide services and liquidity 
facilities, have all been engaged in the efforts to build on the safety 
and stability demonstrated by CCPs during the 2008 financial crisis.
    For example, the Commodity Futures Trading Commission (``CFTC'') 
enhanced its CCP rules, making a strong regime of oversight even 
stronger. The CFTC also implemented rules requiring CME Clearing to 
maintain plans to recover should an extreme, but plausible, event occur 
and to permanently cease, sell, or transfer one or more clearing 
services should a CCP's recovery plan fail--all without using any 
taxpayer funds. The CFTC exercises diligent oversight of these plans.
    In addition to these recent CFTC regulatory enhancements, the 
Committee on Payments and Market Infrastructures (``CPMI'') and the 
International Organization of Securities Commissions (``IOSCO'') 
published international guidance known as the Principles for Market 
Infrastructures or the ``PFMIs'' that calls for CCPs like CME Clearing 
to prepare and maintain a recovery plan.\2\ The PFMIs provides that the 
CCP recovery tools that impact clearing members and their customers 
should be transparent to help clearing members and their customers 
measure, manage, and control their potential losses and liquidity 
shortfalls when electing to clear with the CCP. CPMI and IOSCO also 
published recovery guidance providing that CCP recovery tools should 
create appropriate incentives for participants of the CCP to ``(i) 
control the amount of risk that they bring to or incur in the system, 
(ii) monitor the [CCP's] risk-taking and risk management activities, 
and (iii) assist in the [CCP's] default management process.'' \3\
    \2\ CPMI-IOSCO, Technical Committee of the International 
Organization of Securities Commissions, Principles For Financial Market 
Infrastructures  3.3.8 (Apr. 2012), available at http://www.bis.org/
    \3\ CPMI-IOSCO, Board of the International Organization of 
Securities Commissions, Recovery of Financial Market Infrastructures  
3.3.7 (Oct. 2014) (``CPMI-IOSCO Recovery Guidance''), available at 
CME Clearing Initiated Protections for Financial Integrity
    CME preserves the financial integrity of its CCP by mitigating the 
risk that a clearing member will default and by minimizing the impact 
of that default on the customers of the defaulting clearing member and 
other clearing members and their customers. CCPs maintain multiple 
layers of pre-funded financial resources as protection. In addition to 
the financial protections discussed below, CME Clearing regularly 
performs risk management and regulatory surveillance reviews to 
evaluate the quality of the risk management of its clearing members and 
to determine that clearing members are in full compliance with CFTC and 
CME Clearing financial and operational requirements and that customer 
funds are properly segregated.
    The first layer of the pool of pre-funded financial resources is 
based on our valuation of the portfolio of a firm's open positions. We 
require deposit of performance bond in an amount that has a high 
probability of covering the loss caused by a potential default. 
Performance bonds are posted in the form of high-quality, liquid assets 
and are isolated from CME Clearing's assets.
    Next, at least once or twice each business day, the portfolio is 
marked-to-market. If a position has lost value, we require the clearing 
member to make payments to CME Clearing to settle that loss. If a 
position has gained value, the clearing member receives a payment from 
CME Clearing to reflect that gain. This process--which we call 
settlement--avoids the build-up of exposures.
    If a clearing member defaults,\4\ CME Clearing will use as the 
first resource to cover that loss the defaulted clearing member's 
posted performance bonds and any other assets of the defaulted clearing 
member that are available to CME Clearing, including the defaulter's 
contributions to the guaranty funds (described below). Performance 
bonds posted by the defaulted clearing member to secure its customers' 
positions may only be used to cover unpaid losses for customer 
positions that were cleared through the defaulted clearing member.
    \4\ References to ``default'' are not limited to instances of a 
failure to meet an obligation to CME Clearing. As used herein, 
``default'' includes instances where: ``financial or operational 
condition of a clearing member or one of its affiliates is such that to 
allow that clearing member to continue its operation would jeopardize 
the integrity of [CME Inc.], or negatively impacts the financial 
markets by introducing an unacceptable level of uncertainty, volatility 
or risk . . . .'' CME Rule 975.
    In our 100+ year history, CME Clearing has resolved every clearing 
member default it has experienced by using only the defaulter's 
performance bonds.
    Third, the Chicago Mercantile Exchange, Inc. (``CME Inc.'') has 
committed $300 million of its own funds to the three separate guaranty 
funds it maintains for its different asset classes--one to support 
futures and options on futures (which are called ``Base'' products), 
one to support credit default swaps and one to support interest rate 
swaps. Each of these is called a ``CME Contribution.'' If losses remain 
after CME Clearing exhausts the performance bonds and other assets of 
the defaulter that are available to CME Clearing, CME Clearing would 
use the CME Contribution to the relevant guaranty fund to cover or 
reduce the remaining losses. The CME Contribution to the guaranty funds 
for Base products, credit default swaps, and interest rate swaps is 
$100 million, $50 million, and $150 million, respectively.
    Fourth, if losses still remain after the CME Contributions to the 
relevant guaranty funds are exhausted, CME Clearing would use 
contributions from CME Clearing's non-defaulting clearing members to 
the relevant guaranty funds to address the remaining losses. These 
contributions may only be used for this purpose and are pre-funded by 
clearing members. The amount of a clearing member's contributions to 
each guaranty fund is proportionate to the risk of the positions in the 
relevant asset class that are held by the clearing member for itself 
and its customers. The proportionality of this requirement is designed 
to incentivize clearing members to control the risk they bring to the 
CCP. The requirement to contribute to the relevant guaranty funds also 
incentivizes clearing members to support strong CCP risk management 
programs. Clearing members' guaranty fund contributions are held in the 
form of high-quality, liquid assets and are isolated from CME 
Clearing's assets.
    CME Clearing's pre-funded protections are robust and are based on 
resources that are substantial. CFTC regulations require CME Clearing 
to maintain financial resources sufficient to withstand the 
simultaneous default of its two largest clearing members. Stress tests 
performed by the CFTC as recently as November 16, 2016, have confirmed 
that CME meets this requirement. As of March 31, 2017, CME Clearing's 
guaranty funds and the CME Contributions exceeded $8.5 billion.
    Despite the robustness of our financial safeguards, some have 
suggested that a CCP maintain an additional tranche of pre-funded 
resources or ``skin in the game'' to cover losses resulting from a 
clearing member default. If the intent of the proponents of more skin 
in the game is to substitute the contribution of the CCP for 
obligations now borne by the clearing firms that are responsible for 
creating the risk, this adds an element of moral hazard that is 
inimical to sound risk management practices. Each clearing member 
should be responsible proportionately for the risk it adds to the 
clearing process.
    We made a business decision to put the CME Contributions ahead of 
any call on the default fund as a means of assuring our clearing 
members that we were protecting them and doing an appropriate job of 
risk management. We sized our first line contribution to meet this 
purpose. We do not agree that our contribution should be a function of 
the size of the largest clearing member's obligation to the default 
fund. That amount is a function of the risk that the clearing member 
has determined is appropriate to its business and its risk assessment. 
If the biggest clearing member has a $1 billion contribution level 
because of the risk it undertakes, there is no relationship between 
that amount and the purpose of our being first in line to cover losses. 
In fact, scaling the CCP's contribution in this manner would 
effectively reduce the mutualization of risk among clearing members, 
creating moral hazard.
    The reasons to avoid excess skin in the game are apparent. Trapping 
additional resources of the CCP in a commitment to the guaranty fund is 
detrimental. Devoting substantial assets to a totally unproductive use 
impinges on the efficient management of the business and adds to the 
costs of clearing that must be passed on. Adding costs to clearing 
could, in effect, exclude smaller clearing members from the markets 
resulting in concentration of risk in fewer clearing members and will 
restrict access to the markets for certain classes of smaller customers 
including farmers and ranchers. Access to clearing and a diversity of 
clearing members and market participants is critical to the stability 
of the broader financial markets.
    During the three major market crises since 1987, no U.S. CCP has 
failed. In the few instances where a clearing member was on the verge 
of failure, CME Clearing took action in advance of failure to close out 
or transfer positions and protect the defaulting clearing firm's 
customers. And even when a clearing member has defaulted, there were no 
losses to non-defaulted clearing members or their customers. At no time 
in CME Clearing's history have the losses arising from a clearing 
member failure come close to exceeding the failing firm's performance 
bonds. As a result, CME Clearing has never even approached utilizing 
the relevant CME Contributions or non-defaulted clearing members' 
contributions to the relevant guaranty funds.
    Nonetheless, CME Clearing has planned for the possibility that CME 
Clearing would access and exhaust the CME Clearing contributions and 
non-defaulted clearing member contributions to the relevant guaranty 
funds and that losses could remain. Under CME Clearing's rulebook, if 
losses from multiple clearing member defaults exceed our pre-funded 
financial resources, CME Clearing would assess additional funds from 
clearing members to satisfy remaining losses. The rulebook provides for 
a maximum amount of funds that CME Clearing may collect as assessments 
from its clearing members that participate in the relevant products. 
The amount of assessments collected from a particular clearing member 
is proportionate to the risk of positions held by the clearing member 
in the relevant asset class. CME Clearing monthly informs each clearing 
member of the maximum amount they could be assessed under these powers, 
enabling clearing members to measure, manage, and control their 
exposure to the CCP. This requirement is designed to incentivize 
clearing members to control the risk they bring to the CCP and to 
participate actively and bid aggressively in CCP default management 
    CME Clearing believes that these assessments, combined with the 
guaranty fund and the CME Contribution, would cover at least the 
simultaneous default of the four largest clearing members (which would 
equate to the simultaneous default of the four largest global banks).
    In addition to the aforementioned financial safeguards, CME 
Clearing would utilize its default management processes to address a 
clearing member default. If a clearing member defaults, CME Clearing 
would step quickly into the positions of the defaulted clearing member 
to liquidate the clearing member's own positions and/or work to 
transfer positions to another clearing member that elects to take them.
    CME Clearing would attempt to transfer or ``port'' the defaulted 
clearing member's customer positions to willing and able non-defaulted 
clearing members. To date, CME Clearing has always been successful in 
porting 100% of such positions where a clearing member has failed. Any 
customer positions that cannot be ported to a non-defaulted clearing 
member would be liquidated. CME Clearing requires that the required 
performance bond of each customer of a clearing member be held at CME 
Clearing--so-called ``gross margining.'' This facilitates our ability 
to transfer the customer positions held by a defaulted clearing member 
promptly upon the clearing member's default.
    Once all positions of the defaulted clearing member and its 
customers are (i) transferred by CME Clearing from the defaulted 
clearing member (for whom CME Clearing has stepped in) to solvent 
clearing members and/or (ii) liquidated, CME Clearing will have 
restored a matched book.
    CME Clearing maintains credit facilities with third parties to 
further its ability to meet the potential liquidity issues that could 
result from a clearing member default. In a default situation, CME 
Clearing's liquidity resources would allow it to meet the settlement 
obligations of the defaulted clearing member in all relevant currencies 
while CME Clearing works to transfer and/or liquidate the positions.
Regulatory Enhancements: Recovery, Wind-Down, and Resolution
    In 2013, the CFTC adopted regulations designed to further 
strengthen CCPs' risk management practices. These regulations require 
us to develop and maintain two types of plans in case we experience an 
extreme, but plausible, stress event that could threaten our 
viability--a recovery plan that sets forth how CME Clearing intends to 
recover and a wind-down plan that sets forth how CME Clearing would 
permanently cease, sell, or transfer one or more of its clearing 
services if its recovery plan fails. CME Clearing has developed these 
plans in consultation with the CFTC. Neither plan relies on taxpayer 
    Our recovery plan divides the extreme stress events that could 
threaten CME Clearing's viability into two categories--one for clearing 
member defaults and a second for any other extreme stress event that 
could threaten our viability (which we call ``non-default loss''). 
Recovery tools that could impact clearing members and their customers 
are set forth in the CME Clearing Rulebook, which is publicly 
    The extreme stress event most likely to trigger CME Clearing's 
recovery plan would be the simultaneous failure of four or more global, 
systemically important banks that are clearing members of CME Clearing 
as well as the failure of the bank resolution regime. In our recovery 
plan, we identify assessments as our first recovery tool to solve for 
losses arising from clearing member defaults that exceed CME Clearing's 
robust, pre-funded financial safeguards.
    Domestic and international regulators believe that they can ease 
the process of recovering from clearing member defaults by requiring 
CCPs to have tools in place to allocate fully all losses that arise 
from clearing member defaults and to restore a matched book after a 
clearing member default.
    Under current law, before adding new recovery tools to the CME 
Clearing Rulebook to address these regulatory requirements, CME 
Clearing published its proposed rules and submitted them for review by 
the CFTC who consults with the Board of Governors of the Federal 
Reserve System, along with analysis regarding the potential impact of 
the proposed tools on CME Clearing's clearing members and their 
    To satisfy the regulatory requirement to fully allocate losses, CME 
Clearing adopted rules providing for net portfolio gains haircuts 
(``haircuts'', which are also known as ``Variation Margin Gains 
Haircuts'' or ``VMGH'') for Base products should losses remain after 
CME Clearing exhausts its assessments. VMGH is designed to extinguish 
or ``haircut'' a portion of amounts due to clearing members and their 
customers with a net portfolio gain for a settlement cycle while 
collecting the full amount from clearing members and their customers 
with a net portfolio loss for the settlement cycle. CME Clearing 
determines the amount of the haircut based on the amount received from 
clearing members and their customers with net portfolio losses applied 
on a pro rata basis across the clearing members and their customers 
with net portfolio gains for the relevant account class for the 
settlement cycle. CME Clearing's rules provide for up to 5 days of 
haircuts for Base products and require that the legitimate interests of 
clearing members and customers of clearing members be considered before 
CME Clearing may change the duration of haircuts.
    Also to satisfy the regulatory requirement to fully allocate 
losses, CME Clearing added rules providing for voluntary contributions 
in Base products. If losses from a clearing member default remain after 
CME Clearing has exhausted the financial safeguards package for Base, 
CME Clearing may offer clearing members and their customers an 
opportunity to make voluntary contributions to assist in curing 
remaining losses. Clearing members and their customers may elect to 
make voluntary contributions in order to avoid haircuts. It is expected 
that voluntary contributions would only occur if the amount of 
contributions received are in the aggregate sufficient to fully 
mitigate all losses and thus avoid haircuts.
    In response to the regulatory requirement to restore a matched 
book, CME Clearing adopted rules to govern the use of voluntary or 
mandatory tear-ups for Base products. After identifying clearing 
members and customers whose positions are on the opposite side of 
defaulter positions that remain open, CME Clearing would provide those 
clearing members and customers an opportunity to agree voluntarily to 
have their positions extinguished to restore CME Clearing's matched 
book. It is expected that voluntary partial tear-ups would only occur 
if the universe of positions marked for voluntary partial tear-up are 
in the aggregate sufficient to fully mitigate all losses and would 
restore a fully matched book. If needed, CME Clearing would turn to 
mandatory tear-ups. CME Clearing designed the mandatory tear-up process 
to reestablish a matched book in a manner that, to the extent possible, 
localizes the impact of a failure to the markets in which defaulters' 
positions have not been fully transferred or liquidated and avoids 
impacting other markets. CME Clearing's rules for Base products 
explicitly require that the legitimate interests of clearing members 
and customers of clearing members be considered when determining the 
appropriate scope of tear-ups.
    By fully allocating losses and restoring a matched book after 
clearing member defaults, CME Clearing could continue to offer clearing 
services and promote the stability of the broader financial markets.
    By design, a CCP's recovery tools incentivize clearing members to 
participate in managing the default of fellow clearing members, without 
impact to taxpayers. This participation is critical in order for the 
CCP to recover. Any ability or expectation that the government could 
intervene to resolve the CCP before these tools are exhausted would 
undermine these incentives, weaken the CCP's ability to recover, and 
subsidize clearing member risk taking.
    CME Clearing's recovery plan addresses separately the extreme and 
remote scenarios that could threaten CME Clearing's viability as a 
going concern other than clearing member defaults as ``non-default 
loss''. These events include a disorderly failure by a settlement bank 
while it is holding money for CME Clearing; the failure of a custodian 
bank that is holding assets for CME Clearing at the same time as a 
clearing member defaults; a fraud or crime event; and a cyberattack.
    CME Clearing believes that any non-default losses that could be 
allocated to clearing members and/or market participants should be set 
forth clearly in a CCP's rulebook. Under CME Clearing's rulebook, none 
of the pre-funded financial safeguards (neither performance bonds nor 
CME Contributions or clearing member contributions to the guaranty 
funds) or assessment powers could be used to solve for a non-default 
loss. CME Clearing maintains insurance coverage to address non-default 
losses arising from a number of insurable risks, including employee 
fraud, a crime event, and cyber risks.
    CME Clearing maintains credit facilities with third parties to 
address liquidity issues resulting from temporary disruptions of the 
settlement and payment system upon which clearing relies.
    Our wind-down plan would be activated only if recovery fails. 
Pursuant to CFTC regulations, CME Clearing's wind-down plan contains 
actions CME Clearing could take to permanently cease, sell, or transfer 
one or more of its clearing services. No taxpayer funds would be 
    CME Clearing maintains financial resources to effect an orderly 
wind-down of its clearing house as required by CFTC Regulations.
    If Title II of Dodd-Frank applies to derivatives clearing 
organizations like CME Clearing, a government-ordered resolution of our 
clearing house would only be permitted after the failure of multiple 
layers of protection--namely, the failure of: (1) banking regulations 
designed to prevent the collapse of the largest global banks; (2) the 
bank resolution regime which is designed to ensure a failed bank can 
continue to meet its systemic obligations; (3) our prefunded financial 
resources; (4) our recovery plan; and (5) our wind-down plan. Thus, 
government-ordered resolution would and should remain an extremely 
remote possibility. If this sequence prescribed by Title II of Dodd-
Frank is followed, market participants will be responsible for their 
actions and both the financial markets and U.S. taxpayers will be 
better protected against future financial stress.
    We are concerned by a trend we have observed of some market 
participants and groups of regulators across the globe looking to bank 
resolution structures and processes as precedent when considering how 
CCPs should be resolved if the need arises. Regulations or standards 
that treat CCPs like banks would weaken--rather than strengthen--CCPs 
and would be a mistake. To the extent that CME Clearing could be 
expected to comply with international standards in order to maintain 
international business, it is important that the international 
standards not require actions that would weaken CCPs.
    The objective of CCP recovery is to promote the continuity of 
critical clearing operations and services and the stability of the 
broader financial markets. In order for recovery to achieve this 
objective, it is essential that resolution frameworks and strategies 
not undermine recovery or promote resolution over recovery. Government 
should not require CCPs to change their operations in order to become 
successful failures; instead, government should promote successful CCP 
    Thank you for your consideration of CME Group's views on these 
significant issues.

    The Chairman. Thank you, sir.
    Mr. Dabbs.


    Mr. Dabbs. Chairman Conaway, Ranking Member Peterson, and 
Members of the Committee, thank you for holding this important 
hearing today, and for the opportunity to present our views.
    My name is John Dabbs, and I am the Global Head of Prime 
Derivatives Services, which includes listed derivatives and 
cleared swaps at Credit Suisse. We appreciate the Committee's 
leadership in holding this hearing to examine the role that 
various market participants play in facilitating swaps 
    Today, I will focus my comments on two key areas: improving 
resiliency of CCPs, and improving end-user access.
    Credit Suisse believes that the initiative to increase 
clearing has been successful, and that it has met many of the 
goals set out by the G20 in 2009, including improved 
transparency in financial markets, mitigation of systemic risk, 
and protection against certain market abuses.
    Since 2009, market participants have moved from being 
skeptical of clearing to embracing clearing, as evidenced by 
the pipeline of new products moving away from bilateral markets 
and into CCPs. It is worth noting that many of these products 
are not mandated for clearing, but rather are being cleared on 
a voluntary basis. For our part, Credit Suisse is an industry 
leader in providing clearing access to clients, including many 
U.S. pensions, energy, agricultural producers, and insurers, 
who look to the cleared swaps market to hedge a wide variety of 
risks that they encounter in their normal course of day-to-day 
    I lead a team that, amongst other things, serves as the 
intermediary between the client and clearinghouse. Credit 
Suisse's ability to serve as the intermediary, aka, the 
clearing member, is a vital part of the clearing ecosystem as 
it not only is cost-prohibitive to clients, but simply, many 
clients can't meet membership requirements.
    In addition to providing important access for clients to 
clear at CCPs, clearing members like Credit Suisse also 
significantly contribute to the safety and soundness of CCPs. 
For each cleared swap that we facilitate on behalf of a client, 
we guarantee the client's financial obligation to the CCP; 
i.e., we make the CCP whole in the event that the client might 
fail to meet its obligations under a swap transaction. We also 
provide default fund contributions to the CCP in an amount that 
is proportionate to the risk our client's portfolio adds to the 
    Last, clearing members also provide an array of services to 
clients, such as setting margin levels, monitoring risk, and 
providing operational efficiencies. Given our experience as one 
of the market's largest clearing members, we have seen 
firsthand the benefits of the evolution of cleared swaps 
markets. Conversely, we have also seen where cleared swaps 
markets can be enhanced. We believe that small tweaks to the 
current regime could allow for broader access and even greater 
resiliency to cleared markets.
    We believe that regulations should create a safeguard 
package that requires all CCPs, not just significant ones, to 
have enough resources to meet the coverage use standard; i.e., 
maintain a safety net large enough to absorb losses in the 
event that a CCP's largest two members were to default. 
Further, all CCPs, not just systemically important ones, should 
have access to the Fed for deposits. SIDCOs, or systemically 
important DCOs, should also have access to the Fed to borrow on 
a secured basis for converting U.S. sovereign debt into cash 
during a time of stress. Together, these measures would greatly 
reduce the interconnectedness of CCPs, and reduce the 
additional pressures placed upon banks during a time of stress.
    We also believe that CCPs should have skin in the game. 
They should contribute capital; either equity, debt, or 
insurance, that would act as a line of defense for the losses 
incurred in a clearing member default. There should be minimum 
standards that scale as clearinghouses and its risk profile 
grows or shrinks. We believe scaling this skin in the game to 
the largest clearing members' default contribution creates the 
right incentive for the CCP to diversity risk.
    Additionally, there should be incentives to ensure that 
clearing members stay in the CCP during a recovery or 
resolution scenario. I would argue that the current incentive 
is to exit as quickly as possible if members believe resolution 
is imminent. In times of stress, clearing members, like Credit 
Suisse, have little to no upside to stay at the CCP. There is 
only significant downside risk as default fund payments, 
assessments, and variation margin gains haircutting don't have 
to be paid back to the clearing members who stick around to aid 
in the default waterfall. We believe clearing members should be 
repaid for saving the clearinghouse, either by compensation 
from future earnings or by equity.
    And one last point on resiliency. Resiliency would improve 
if CCPs had mechanisms for clients to continue to perform on 
their positions carried by a defaulting clearing member. 
Allowing clients to directly guarantee their trades for a short 
period of time would greatly reduce the risk in the system, and 
allow regulators and bankruptcy trustees to quickly identify 
the good, paying clients from the bad, defaulting clients. 
Currently, all clients look the same at the time of an FCM 
insolvency because all clients stop paying variation margin.
    In addition to increasing resiliency, we also focus on how 
to ensure broad access to cleared derivatives markets, 
especially for hedgers. To this point, I would like to 
highlight for the Committee two adverse consequences of Basel 
III and Dodd-Frank. First, under Dodd-Frank we have CCAR 
stresses. Current CCAR regulations require banks to run stress 
tests on client portfolios, which we did well before CCAR 
required us to. However, current standards don't take into 
account the creditworthiness of a client. In fact, CCAR has the 
adverse effect of making our most creditworthy clients like 
money managers, corporates, insurance companies, and public 
pensions, look as if they are the most risky clients. The 
reality of this is that the clearing intermediary, like Credit 
Suisse, either have to hold significant capital or reduce our 
business with these institutions. Unfortunately, we have had to 
do both. Second, the Supplemental Leverage Ratio, or SLR, 
applies an overly burdensome capital charge on client clearing 
members. SLR treats the risk of client transactions guaranteed 
by clearing members where margin is collected, segregated, and 
posted to the CCP, the same as that of a bilateral swap where a 
bank acts as principle and doesn't segregate or post any 
collected margin to a CCP. To this point, we endorse the 
Treasury's recommendation to allow margin to reduce the 
clearing member's exposure of client cleared transactions. 
Without changes to the SLR, clearing intermediaries will 
continue to have a group of low-capital, returning clients who 
are typically hedgers, such as pensions. The return on capital 
is unsustainable at the current levels.
    In closing, we reiterate that the current clearing model is 
not broken. In fact, it has functioned quite well during the 
financial crisis and it has continued to grow. As clearing 
continues to expand and evolve, all market participants and 
regulators should continue to collaborate to achieve the 
objective of improving end-user access and CCP resilience, and, 
therefore, decreasing the probability of recovery and 
    [The prepared statement of Mr. Dabbs follows:]

  Prepared Statement of John Dabbs, Global Head of Prime Derivatives 
               Services, Credit Suisse, Washington, D.C.
    Chairman Conaway, Ranking Member Peterson, and Member of the 
Committee thank you for holding this important hearing and for the 
opportunity to present our views.
    My name is John Dabbs and I am the global head of Credit Suisse' 
cleared derivatives business. Credit Suisse Securities (USA) LLC 
(``CSSU'' or ``Credit Suisse'') is a U.S. futures commission merchant 
(``FCM'') registered with the Commodity Futures Trading Commission 
(``CFTC'') and the National Futures Association (``NFA''). CSSU clears 
derivative contracts-traded on exchanges, swap execution facilities 
(``SEFs'') and in the over-the-counter (``OTC'') derivatives markets 
directly through clearing house memberships and indirectly through 
    Credit Suisse is a direct member of the following central 
counterparties (``CCPs''): the Chicago Mercantile Exchange Inc.'s 
clearing division (``CME''), Intercontinental Exchange's ICE Clear 
U.S., ICE Clear Credit and ICE Clear Europe and the London Clearing 
House's LCH.Clearnet, each of which is registered with the CFTC as a 
derivatives clearing organization ``DCO'').
    Credit Suisse fully supports the clearing model and the efforts of 
regulators, clearing houses, clearing clients and clearing firms. 
Clearing has existed for decades and while it functioned extremely well 
during the financial crisis, it has grown considerably as a result of 
mandatory clearing under Dodd Frank. As the cleared derivatives markets 
and CCPs continue to expand and evolve, it is worth reviewing the model 
now with an eye towards promoting CCP resilience and reducing the risk 
of CCP recovery and resolution. We discuss aspects of the clearing 
model below, particularly the role of the clearing member, benefits and 
challenges of clearing, CCP resilience, recovery and resolution and 
finally the recent EU CCP supervisory proposal.
Clearing Member Role
    Clearing members are the cornerstone of the cleared derivatives 
process. They act as intermediaries between clearing clients and CCPs. 
Clearing members provide clients with a portal through which they may 
access clearing by acting as their agent and guaranteeing their 
financial obligations to the CCP.\1\ In addition, clearing members 
provide guaranty fund contributions to the CCP in an amount that is 
proportionate to the amount of risk carried in the clearing members' 
client portfolio. Clearing members are heavily regulated and provide an 
array of services to clients such as collecting margin, sending client 
statements and providing various operational efficiencies.
    \1\ Clearing members do not guarantee the financial obligations of 
the CCP to their clearing clients.
Client Clearing Benefits--General
    Clearing provides many benefits to clients. Clearing reduces 
counterparty risk, since CCPs act as the buyer to every seller and 
seller to every buyer to ensure financial security in the marketplace. 
CCPs pay to one party to a derivative contract what they receive from 
the other party. Clients face a CCP as their counterparty to a 
derivative transaction as the CCP takes the other side of the client's 
trade. In an uncleared derivative, clients face various swap dealers, 
who are mostly banks or bank affiliates, and, as a result, face the 
risk of a default of each such counterparty.
    Clearing reduces default risk through a performance bond system 
with daily mark-to-market payments. Clearing clients post initial 
margin to the CCP through their clearing members on each cleared 
contract and pay or receive daily variation margin payments based on 
market movements.
Client Clearing Benefits--Clearing Members
    Clients access CCPs through clearing members and, as discussed 
below, CCPs impose numerous financial, capital, regulatory, operational 
and other requirements on clearing members that clearing clients either 
cannot or prefer not to undertake.
    One of the basic tenets of client clearing is client fund 
protection. Clients of clearing firms who are registered as FCMs 
benefit from a robust regulatory client protection regime under the 
U.S. Commodity Exchange Act, U.S. Bankruptcy Code, CFTC, NFA and CCP 
    Clearing member FCMs are regulated by the CFTC, NFA, exchanges, 
CCPs and SEFs. They undergo periodic external and internal audits as to 
their compliance with applicable rules and regulations. Clearing firms:

   segregate client funds from house funds;

   are subject to restrictions on their use of client funds;

   establish client margin levels;

   establish and monitor risk based limits for each client;

   monitor client positions throughout the trading day;

   conduct stress tests of client portfolios;

   establish and monitor a robust risk management program;

   establish processes and procedures for client on-boarding, 
        including reviewing and monitoring client financial condition;

   provide early warning notifications to regulators including 
        immediate notice if:

     the FCM clearing member is undercapitalized, or

     the client segregation pool does not hold a sufficient 
            amount of funds;

   comply with financial requirements, including contributions 
        of a certain amount of their own funds to the client 
        segregation pool and restrictions on amounts that can be 

   comply with disclosure requirements to clearing clients at 
        the inception of the relationship and provide public disclosure 
        of certain clearing member information; and

   are subject to regulatory capital requirements, including 
        CFTC requirements and, if: (a) a joint FCM-broker dealer, SEC 
        requirements, and (b) if a bank or bank affiliate, prudential 
        regulatory requirements.
Client Clearing Benefits--CCPs
    CCPs are also regulated by the CFTC and are subject to DCO core 
principles set forth in the Commodity Exchange Act and CFTC 
Regulations. CCPs impose strict membership criteria such as adequate 
financial assurances, contributions to the guaranty fund, assessment 
rights, capital requirements, operational and technological 
requirements and demonstration of market and product knowledge and 
experience. Additional CCP requirements include robust CCP risk 
management, financial safeguards, such as performance bond and daily 
mark-to-market payments, surveillance and audit functions of clearing 
members and imposition and monitoring of position limits. CCPs:

   segregate client clearing funds from clearing member and CCP 
        house funds;

   are subject to restrictions on CCP use of client funds;

   establish clearing member margin levels;

   establish and monitor risk based limits for each clearing 

   monitor clearing member positions (house and client) 
        throughout the trading day;

   conduct stress tests of clearing member portfolios;

   establish risk management program; and

   review and monitor clearing member financial condition.

    In the event of a clearing member default, CCPs typically work to 
identify non-defaulting clearing members for purposes of transferring 
client positions and related margin.
    Each CCP is required to establish financial safeguards that 
typically contain a ``waterfall'' setting forth the sequence in which 
various risk management and loss mutualization mechanisms would be 
employed in the event of a clearing member default.
Clearing Member Perspective
    Clearing members view their role as similar to that of CCPs. CCPs 
run matched books and do not introduce market risk into derivatives 
markets. Clearing members are also market neutral. They perform agency 
and market intermediary services for clearing clients and are not 
principal counterparties to the underlying derivatives contracts. As 
clearing members guarantee the financial performance of their clients 
to the CCP, they are exposed to client credit and default risk. CCPs 
are exposed directly to the credit and default risk of their clearing 
members and indirectly to credit and default risk of the clearing 
member's underlying clients. Although, while clearing members are 
subject to regulatory capital rules of the CFTC and bank clearing 
members are also subject to regulatory capital requirements of 
prudential regulators, CCPs are not subject to capital requirements.
    In the event of a clearing member default, non-defaulting clearing 
members are at risk of mutualized default losses, i.e., covering losses 
from the non-defaulting clearing members' guaranty contributions and 
Clearing Challenges
Prudential Regulators Capital Requirements--Basel III, IHC, CCAR
    One of the major challenges to the clearing objectives of the G20 
Pittsburgh Summit and Dodd Frank is the impact of the regulatory 
capital regime.
    Basel III imposed numerous capital requirements on banks and bank 
affiliates. Two major components relate to risk weighted assets (RWA) 
and the leverage ratio. As currently implemented by prudential 
regulators Basel III disincentives client clearing and threatens the 
model for clients of the highest credit quality. Issues include 
reducing client access to clearing and challenges associated with 
transferring a defaulting member's client portfolios. The number of 
clearing firms is decreasing while client clearing is increasing, 
creating concentration and systemic risk.
Risk Weighted Assets (``RWA'')
    Basel III for the first time requires clearing member firms to 
obtain legal certainty, (e.g., legal opinions from external counsel) 
that speak to the issues of collateral enforceability and ``netting'', 
i.e., net exposure in the event that a clearing client were to default 
and or become insolvent. Such legal opinions must be obtained by law 
firms who are experts in the governing insolvency laws relevant for the 
form of organization of the clearing client in the client's 
jurisdiction (i.e., a pension plan organized under the laws of 
particular state or a clearing clients organized under the laws of a 
non-U.S. jurisdiction).
    There are certain jurisdictions and/or forms of organization of 
clearing clients that pose major challenges in obtaining a netting 
opinion. The result is that the clearing member's RWA capital 
requirement is calculated on a gross and not net basis, resulting in 
some clearing clients not being able to find a clearing member that can 
clear for them.
Supplemental Leverage Ratio (``SLR'')
    The Basel III Supplemental Leverage Ratio (``SLR'') raises several 
issues. First, a clearing member bank may not reduce its SLR exposure 
by the amount of initial margin that it collects from its clearing 
clients and posts to the CCP and/or holds in a client segregated 
account, as required by CFTC regulations.
    Second, the SLR includes a punitive add-on factor to the measure of 
a bank's exposure for certain types of clients (i.e., high credit 
quality clients such as pension plans and insurance companies) who tend 
to trade directional, longer term portfolios. The add-on factors are 
based on the types of cleared products and time to maturity. For 
example, the add-on factor for an interest rate product with a maturity 
over 5 years is 1.5% and that of ``other commodities'' with the same 
tenor is 15.0%. The add-on factors provide a perverse incentive for an 
FCM bank clearing member to clear for high turnover speculators rather 
than low turnover hedgers.
    Clearing clients have less access to clearing as the SLR provides 
barriers to entry for new clearing members and results in clearing 
members exiting the business or terminating client relationships with a 
non-SLR friendly portfolio.
    In a clearing member default, porting will be difficult as CCPs and 
regulators may not able to find another clearing member willing and/or 
able to take on the defaulting clearing member's client portfolios.
Comprehensive Capital Analysis Review (``CCAR'')
    CCAR and the Dodd-Frank Act Stress testing are part of the 
evolution of U.S. bank capital requirements in the wake of the 
financial crisis. Both of these exercises are administered by the 
Federal Reserve and require, among many other things, banks and certain 
affiliates to perform stress tests on their client's cleared derivative 
portfolios that do not take into account the creditworthiness or the 
probability of default of a clearing client under the stress scenarios. 
As a result, the most challenging clients under these tests prove to be 
real money investment vehicles, corporate, insurance companies and 
public pension plans as they clear required hedging positions in 
derivatives. When, as CCAR and the cleared derivatives are viewed in 
isolation from the commercial positions being hedged and ignoring the 
financial wherewithal of the client, the positions are likely to be 
identified as inconsistent with the CCAR limitations. The practical 
result is that clearing firms who are bank affiliates are required to 
hold significantly more capital, collect higher margin or reduce their 
clearing business with such clients--often some of the most highly 
regulated, well-funded and moderately positioned of the universe of 
market participants.
Risk Mitigation Versus Exacerbating Liquidity Risk
    Mandatory clearing, as implemented by the Prudential Regulators in 
the U.S., has more often than not contributed to deeper, broader and 
more resilient liquidity. This is because clearing allows for 
additional market participants who can take and provide liquidity 
without transacting exclusively with bank dealers. However, capital 
standards pursuant to Basel III, particularly the measures and ratios 
for leverage and risk exposures, and the requirements to post and 
otherwise administer substantial collateral balances for uncleared 
derivatives have reduced liquidity when there is no available, or 
mandated cleared alternative. The simultaneous decisions made to 
require clearing, constrain clearing and constrain trading in non-
clearable instruments reflect an effort to solve several perceived 
problems at once, instead of perhaps promoting clearing as a primary 
objective for a transitional period of years before adopting disruptive 
constraints on clearing and non-clearable instruments.
CCPs--Resilience, Recovery and Resolution
Clearing Ecosystem and Interconnectedness
    The clearing ecosystem has grown significantly with the 
introduction of mandatory clearing and other policy prescriptions 
implemented in the aftermath of the financial crisis. As previously 
discussed, clearing offers many benefits to help control and mitigate 
risk at the systemic level. While central clearing would not have 
addressed all the issues associated with the financial crisis, it would 
have mitigated certain aspects. Viewed in hindsight, clearing houses 
and their members had continued to provide clearing services during the 
crisis even as the bilateral markets suffered a domino collapse. By 
reconfiguring the otherwise random and often duplicative 
interconnections among market participants and introducing a layered 
package of financial backstop, clearing provides a level of systemic 
safeguards and resilience that was not present in the pre-crisis 
derivatives markets.
    However, we note that certain trends may have worked to reinforce a 
linier consolidation of interdependencies that may lead to perverse 
outcomes in distress scenarios.
    The first of these is a misalignment in financial package 
priorities that incentivizes a ``bank run'' on the clearing house. The 
current package was designed for a mutualized structure where clearing 
members and clearing house owners were one and the same. As membership 
and ownership diverged, members have become the primary bearer of 
clearing house risks while all profits are captured by owners, at 
little or no cost of capital. In an extreme but plausible scenario, 
members could be forced to contribute enormous amounts of funds in 
guaranty fund contributions, assessments, etc., while the clearing 
house could pay a substantial dividend to its investors. Moreover, the 
design of the clearing house financial package provides no legal 
certainty to clearing members for a full recovery of their default 
management contributions, even after the clearing house has been 
``bailed out'' by clearing members and has returned to profitability.
    Inevitably, this structure creates a tremendous disincentive to 
remain as clearing members, in any distress scenario and certainly 
during a clearinghouse recovery or resolution. The disincentive is 
further amplified by a fundamental shift in any rational expectation 
for clearing house risk management practices.
    In addition, the clearing houses continue to become more 
interconnected to the banking system as some of the largest client 
clearing members are also the largest market makers, liquidity facility 
providers and custodians. There are inadequate incentives for clearing 
houses to diversify the risks beyond the silo'ed measure of ``Cover 
Two'', i.e., safeguards that are intended to cover only the largest two 
of the clearing house's members.
Fed Access
    ALL CCP's (not just SIDCO) should have access to the fed for 
deposits and SIDCO's should have access to the Fed to borrow on a 
secured basis for converting U.S. Sovereign Debt into cash during a 
time of stress. Together, these greatly reduce the interconnectedness 
of the CCPs and banks and additional stress placed on banks during a 
time of stress.
Skin in the Game
    Skin in the game is an important element of the CCP financial 
safeguards package and should have a minimum standard that scales as a 
clearinghouse grows (or shrinks). We also think scaling it to the 
largest clearing member's default fund contribution creates the right 
incentive to diversify risk.
CCP Recovery
CCPs in Time of Crisis and Severe Stress
    One issue that CCPs and regulators will face in the event of a 
double default, i.e., a clearing default that results in a clearing 
member default, is that porting, an essential element of an orderly 
default management, may not be an available option due to the impact of 
regulatory capital requirements. The RWA and leverage ratio issues 
impede a clearing member's clearing capacity. A clearing member may not 
be able to accept a non-leverage ratio friendly portfolio even though 
such portfolio would be fully margined and otherwise pose no additional 
exposure if measured under conventional risks metrics.
    Recovery and resolution will always be most successful when the 
process is well-articulated and understood beforehand by the entire 
ecosystem. Key stakeholders must maintain a regular dialogue throughout 
the process and providing decisive and consistent guidance to end-users 
and infrastructure providers. The primary prudential regulator of the 
applicable CCP should be responsible for approving and administering 
the resolution structure. The applicable Federal Reserve banks should 
coordinate with and support the primary regulator in preserving 
necessary clearing member engagement and addressing any funding or 
liquidity challenges.
    Clearing participants should be given a meaningful level of input 
with respect to a CCP's assumption of risk, post-default risk 
management decisions and other corporate governance decisions that 
materially affect the allocation of risks and potential losses that 
non-defaulting clearing participants may incur in connection with a 
clearing participant default. In particular, CCP rules and applicable 
regulations should provide legal certainty as to how impacted 
participants will be compensated for losses that participants may incur 
where the CCP avails itself of loss mutualization measures such as 
default fund assessments and variation margin gains haircutting.
Clearing Client Guaranty
    When re-establishing a matched book, CCP's need a mechanism for 
clients to continue to perform on their positions (i.e., continue to 
pay margin) that are cleared through a defaulted clearing member. 
Allowing clients to directly guarantee their trades, at least for a 
short period of time, would greatly reduce the risk to the system and 
allow regulators and a bankruptcy trustee to quickly identify the good 
(paying) clients from the bad (defaulting) clients. Currently, as 
clients are understandably reluctant to pay margin to a distressed 
clearing member, all clients look the same on such clearing member's 
the books and records.
CCP Resolution
    In a CCP resolution proceeding, clearing participants should retain 
claims for the full amount of clearing participant losses associated 
with a CCP's use of such measures. Such claims should (i) be senior to 
existing CCP equity in the creditor hierarchy, (ii) not be 
extinguishable in resolution or post-resolution prior to full 
satisfaction or conversion into an instrument of equivalent value, and 
(iii) entitle claimants to future CCP accumulated earnings or returns 
in excess of regulatory capital requirements until they are paid in 
full (and during such time, both the CCP and its parent should be 
prohibited from paying dividends).
    Non-default losses should be covered entirely by the CCP and should 
not be covered by member resources.
    In the event of CCP resolution, cleared contracts should be 
transferred to another CCP; however, this may not be possible for all 
contracts. For example, equity Index futures clearing continues to grow 
at CCPs. During a severe CCP stress situation, there may not be 
alternative CCP's because of licensing agreements. Liquidity of many 
bond, interest rate and commodity contracts could conceivably move or 
be setup at alternative CCP's, however things like the S&P 500 futures 
are exclusively listened by a single exchange/CCP.
EU Proposal on CCP Supervision (June 13, 2017)
    We welcome the European proposal for mandatory joint supervision of 
non-EU CCPs that are deemed ``systemically important'' to the EU. The 
newly announce approach is a preferable alternative to any mandatory 
general CCP location policy. The proposed model seems to address 
regulatory concerns in a less disruptive manner than ideas that have 
previously been considered. The new proposal is largely consistent with 
that which is already implemented by the U.S. CFTC. The CFTC approach 
requires foreign-based CCPs clearing U.S. markets or serving U.S. 
persons to be registered with the CFTC and be subject to dual 
supervision by the CFTC and their home country regulator.
    By and large, systemically important non-EU CCPs should be able to 
continue to provide services in the EU subject to new, albeit strict, 
EU requirements. However, in its current form, the EC proposal also 
raises a number of questions:

  (1)  The proposal gives new discretionary powers to the EC to decide 
            that a non-EU CCPs is of `substantial systemic importance' 
            and therefore should be established and authorised in the 
            EU to provide services in the EU. Use of this discretionary 
            ability is permitted as a last resort measure. At this 
            stage it is unclear when and in which cases a non-EU CCPs 
            might be deemed of `substantial systemic importance' for 
            the EU and, as a result, required to get established and 
            authorised in the EU to offer clearing services in the EU. 
            The detailed criteria to determine the `substantial 
            systemic importance' of non-EU CCPs will only be defined at 
            a later stage via implementing rules.

  (2)  It is also unclear whether this obligation for non-EU CCPs of 
            `substantial systemic importance' for the EU to get 
            established and authorised in the EU to offer clearing 
            services in the EU would be a blanket obligation covering 
            all clearing services provided to EU clients or whether 
            this obligation could be more granular and targeted 
            covering a particular service, activity or class of 
            financial instruments.

  (3)  Where a non-EU CCPs of `substantial systemic importance' for the 
            EU would have to get established and authorised in the EU 
            to offer clearing services in the EU, query whether such 
            CCPs would still be allowed to provide euro-clearing 
            services to non-EU clients from its third country home 

    Finally, it remains to be seen whether the existing recognition 
decisions (including for U.S. CCPs), which will have to be reviewed 
under the new EU regime, will be re-opened and put at risk in view of 
the new enhanced EU requirements or whether the introduction of the new 
concept of `comparable compliance'--which would allow ESMA to determine 
whether the application of the relevant third country rules is 
comparable to compliance with EMIR--will be sufficient to maintain the 
validity of those existing recognition decisions.
    The clearing model is not broken; however, as clearing continues to 
expand and evolve, all market participants and regulators should 
continue to collaborate and achieve the objective of improving CCP 
resilience and therefore decreasing the probability of CCP recovery and 

    The Chairman. Thank you.
    Mr. Gerety.


    Mr. Gerety. Thank you, Chairman Conaway, Ranking Member 
Peterson, and the Members of this Committee. It is a great 
opportunity for me to be here today, and to share my 
perspective on the critical issue of central counterparties' 
resilience and resolution.
    Before I begin, I would like to emphasize that the views I 
express today are my own, and are not those of QED investors or 
its partners.
    Let me start with a clear statement. Dodd-Frank made 
derivatives markets safer and more stable. These reforms made 
our economy stronger, not only because they will help prevent 
future financial crises, but also because the stability and 
safety of the U.S. financial markets is a significant 
competitive advantage for the U.S. as a global economic power.
    In the lead-up to the crisis, the derivatives markets were 
characterized by complex webs of transactions, with limited or 
no credit protection against billions of dollars of daily 
market movement, woefully inadequate documentation and back-
office systems. There was simply no way to make sense of who 
owed what to whom in extreme market scenarios.
    In the course of the crisis then it should be no surprise 
that not only were derivatives transactions central to the 
failure of AIG and Bear Stearns, but they were the very 
instruments marbled through some of the most toxic securities, 
such as CDOs, CDO-Squareds, and synthetic CDOs that unraveled 
in the mortgage meltdown.
    In the height of the crisis, as Lehman Brothers failed, 
uncertainty about the value and holders of their risk 
transacted in derivatives markets acted as the single strongest 
accelerant of financial uncertainty, panic, and contagion.
    So what then did the Dodd-Frank reforms accomplish? Most 
importantly and most directly, Dodd-Frank gave the CFTC and the 
SEC explicit comprehensive authority to oversee their 
respective derivatives markets, according to the same standards 
that we uphold for other financial markets. Next, Dodd-Frank 
required pre- and post-trade transparency for all derivatives 
transactions, capital and margin rules for all dealers in 
derivatives, and mandated that standardized derivatives be 
centrally cleared. Dodd-Frank has changed the way derivatives 
markets operate for the better; making for deeper, more liquid 
markets, with simpler products and lower risk. And in doing so, 
reduced food, energy, and other costs for farms, businesses, 
and families across the country.
    Last, and the topic of today's hearing, Dodd-Frank extended 
existing frameworks for the oversight of central 
counterparties. Central counterparties are designed to 
centralize documentation, reconciliation, risk management, and 
margin for all their members. This means that well-managed and 
well-regulated central counterparties do not just centralize 
the risk of derivative markets and increase transparency to 
regulators, they actually transform and reduce that risk.
    Therefore, policymakers focus on resilience and resolution 
of central counterparties, and in today's hearing, should be 
understood as part of a responsible approach to risk 
management. First, diagnose the risks, then put in place 
controls to mitigate, then reassess the remaining risk. The 
regulators' current focus on the potential failure of central 
counterparties is part of an iterative process of assessing the 
risk after effective reforms.
    When considering the policy priorities ahead, the first 
obligation must be to preserve the gains to stability and 
safety that we have made since the financial crisis. And most 
importantly for this context, this means preserving Title II of 
Dodd-Frank and the orderly liquidation authority. Removing this 
authority would be deeply irresponsible for taxpayers; 
explicitly returning to the policy framework that gave birth to 
the TARP program. It would suggest that policymakers had 
forgotten the immense pain and suffering of families all across 
this country faced in the crisis and its aftermath. And most 
importantly, the stated rationale, which is to achieve budget 
savings, are a mirage. Those savings appear simply as an 
accounting quirk. By law, taxpayers cannot bear losses for any 
entity liquidated by the FDIC as part of the orderly 
liquidation authority.
    In today's hearing, I look forward to discussing both 
potential scenarios for the failure of a central counterparty, 
and it is worth emphasizing both member-default-related and 
non-member-default-related operational failures. I also look 
forward to offering my perspective on three continuing 
challenges for policymakers. First, coordination across 
multiple central counterparties; second, cross-border 
cooperation, where the U.S. Government has quietly had 
significant successes since the crisis; and the need to develop 
strategies that create ex ante incentives for positive risk 
management and for recovery before we get to resolution. There, 
much work remains to be done. But while we do not yet have 
complete strategies and tools to handle the resolution of a 
critically important central counterparty, the only way to 
avoid catastrophic outcomes in that event will be to build 
those tools on the foundational authorities created by Dodd-
    Thank you, and I look forward to answering questions today.
    [The prepared statement of Mr. Gerety follows:]

     Prepared Statement of Amias Moore Gerety, Special Advisor, QED
      Investors; Former Acting Assistant Secretary for Financial 
    Institutions, U.S. Department of the Treasury, Washington, D.C.
Successes of Derivatives Reforms and Continuing Risk Mitigation in 
        Central Counterparty Recovery and Resolution
    Thank you, Chairman Conaway, Ranking Member Peterson, and Members 
of the Committee for the opportunity to be here today and to share my 
perspective on the critical issue of central counterparties' resilience 
and resolution.
    Before I begin, I would like to emphasize that the views I express 
today are my own and not those of QED Investors or its partners.
    My testimony today will focus on three main areas:
    First, the importance of the post-crisis reforms to derivatives 
markets and the central role that clearing mandates and central 
counterparties play in the effectiveness of those reforms. Second, I 
will offer the Committee a d[es]cription of the potential mechanisms 
that could result in the failure of a central counterparty. Third, I 
will discuss key challenges for policy makers to continue to build the 
resilience and positive role that clearing will play in the stability 
of U.S. and global financial markets.
    Let me start with a clear statement. Dodd-Frank made derivatives 
markets safer and more stable. These reforms have made our economy 
stronger, not only because they will help prevent financial crises, but 
also because the stability and safety of U.S. financial markets is a 
significant competitive advantage for the U.S. as a global economic 
    In the lead up to the crisis, derivatives markets grew 
exceptionally rapidly and volume increases were driven significantly by 
trades made between global banks. The opacity of the market meant that 
this interconnected web of exposures were neither clear to regulators 
nor to the firms themselves. The complexity of these markets developed 
because of the structure of the transactions, the credit relationships 
between the players, and the weakness of risk management and backend 
processing capacity. As we saw in the crisis, all three of these 
weaknesses played major roles in the uncertainty and destruction that 
the financial crisis brought to towns and cities all across the 
    It is important to understand each of these weaknesses in some 
detail before discussing the reforms in Dodd-Frank.
    The complexity of the market was driven by the structure of 
bilateral derivatives transactions. Derivatives, or swaps, are mostly 
long-dated arrangements to exchange one type of risk for another. 
Unlike a stock or a bond, market participants do not exchange the cash 
for the security. In a bilateral context, this means that the notional 
value of a contract was constantly layered on top of previous contracts 
rather than simply changing hands. To illustrate, if Dealer A buys a 
bond from Dealer B and later sells that bond to Customer C--only 
customer C owns the bond at the end of that process. In the bilateral 
derivatives context, if Dealer A agrees to take interest rate risk from 
Dealer B in exchange for a series of payments, and then customer C buys 
that interest rate risk in exchange for a series of payments from 
Dealer A--both contracts will remain in force for the life of the 
agreements. Dealer A maintains its interest rate swap with Dealer B, 
and maintains a separate interest rate swap with Customer C. Played out 
over thousands of transactions and multiple years prior to the crisis, 
the complexity of the bilateral arrangements quickly grew to 
impenetrable density--with very little clarity within dealer systems 
and essentially no understanding of where risk existed in the system as 
a whole.
    The credit relationships that underlay bilateral derivatives 
transactions in the pre-crisis period added another significant layer 
of risk. Because large banks traded largely with important clients or 
with each other--the terms of these transactions included large 
quantities of counterparty credit risk, over and above the risk in the 
transaction itself. Let's take the example of the interest rate swap 
above. Dealer A and Dealer B would each have longstanding financial 
relationships with each other, they each had processes to understand 
the credit risk of the other (e.g., periodic underwriting, credit 
ratings, etc.), so even when the market value of a long-term swap would 
move up or down (that is, in favor of A or in favor of B) the dealers 
would treat that market move as part of a credit relationship--they 
would treat it as a loan to each other. This meant that billions of 
dollars of market value could be contractually obligated between 
dealers on a daily basis, with no margin (in the form of cash or other 
assets) changing hands. The value of the relationships and the generic 
trust between counterparties substituted for the rigor of assuring that 
dealers would be protected from market moves over time. This meant that 
in the crisis, when market prices moved rapidly and additional margin 
was sought, dealers were requesting huge sums from one another and from 
clients. And in the crisis, these sums were significant enough to 
materially affect the capital and liquidity positions of the largest 
and most complex financial institutions in the United States.
    Moreover, documentation of transactions and reconciliations of 
errors lagged the transactions themselves by months or more. Putting 
these three dynamics together, the pre-crisis regime was characterized 
by complex webs of transactions, with limited to no credit protection 
against billions of dollars of daily market movement, and woefully 
inadequate documentation and back office systems to make sense of who 
owed what to whom and where losses would be registered in extreme 
market movements.
    To make matters worse, there was an explicit statutory bar against 
the CFTC or SEC taking actions to set standards for this market which, 
in 2008, was measured at $673 trillion globally.
    In the course of the crisis then, not only were derivatives 
transactions central to the failure of AIG and Bear Stearns, they were 
also the very instruments marbled through some of the most toxic 
securities such as CDOs, CDO squareds, and synthetic CDOs that 
unraveled in the mortgage meltdown. And in the height of the crisis, as 
Lehman Brothers failed, uncertainty about the value and the holders of 
risk transacted in derivatives markets acted as the strongest 
accelerant of financial uncertainty, panic and contagion.
What then did the Dodd-Frank reforms accomplish?
    Most importantly and most directly, Dodd-Frank gave the CFTC and 
the SEC explicit, comprehensive authority to oversee their respective 
derivatives markets according to the same standards that we uphold for 
other financial markets. Strong standards and oversight have made the 
U.S. a global destination for financial investment and helped support 
our position as a global economic power.
    Next Dodd-Frank required pre- and post-trade transparency for all 
derivatives transactions, attacking the risk of uncertainty and lack of 
documentation that featured prominently in the pre-crisis derivatives 
markets. Dodd-Frank required capital and margin rules for all dealers 
in derivatives, so that large players could not simply ignore the real 
financial risks of daily market moves, but had to collect margin from 
each other and also fund their derivatives positions with shareholder 
equity and retained earnings--known as capital.
    Dodd-Frank also mandated that standardized derivatives be centrally 
cleared. A centrally cleared transaction allows for the complex web of 
transactions that I described above to be compressed into transferable 
units of risk--much more like the transfer of a stock or bond. In doing 
so, Dodd-Frank created incentives towards standardization both by 
requiring the CFTC to mandate which standardized contracts must be 
cleared and with the simple concept that bespoke contracts that remain 
uncleared require higher margins. Dodd-Frank has changed the way 
derivatives markets operate for the better, making for deeper, more 
liquid markets with simpler products and lower risk. This move towards 
standardization allows for netting on a massive scale, reducing 
outstanding exposures and risk while increasing liquidity and lowering 
transaction costs for end-users. This also reduces food, energy, and 
other costs for farms, businesses, and families across the country.
    Last, Title VIII of Dodd-Frank extended existing frameworks for the 
oversight of central counterparties. The benefits of central 
counterparties extend beyond their role in reducing the complexity of 
the market. Central counterparties are designed to centralize 
documentation, reconciliation, risk management, and margin for all 
their members. This means that well-managed and well-regulated central 
counterparties do not just centralize the risk of derivatives markets 
and increase transparency to regulators--they actually transform and 
reduce that risk.
    Perhaps the clearest example of this transformation is in the 
collection and management of margin. As I described above, market 
movements in derivatives in the bilateral market, especially in the 
pre-crisis period, were managed as extensions of credit. But central 
counterparties are not in the business of extending credit. When a 
trade is initiated, the participants place cash or securities as 
collateral at the clearinghouse as initial margin. Then, as swaps 
contracts change value, at the end of each day, they require each of 
their members to deposit additional funds equal to their new exposure. 
In some cases, central counterparties can and do require intraday 
payments of margin to limit the buildup of risk. While central 
counterparties follow these procedures to protect their own viability 
and to follow the standards of their regulators, these procedures mean 
that the maximum exposure of a dealer to a central counterparty will be 
the value of 1 day's market movements. The rigor of this margin 
procedure has benefits throughout the system as a whole. It means that 
for all standardized trades, the question of who owes what to whom is 
both answerable and limited.
    Much of the policy debate about central clearing has suggested that 
central counterparties themselves now hold and manage significant 
amounts of risk. This is true. Central counterparties play a more 
important role in the financial system today than they did before the 
crisis. But it is clearly also the case that the net risk for the 
system is reduced by the role of central counterparties. They are 
entities designed and overseen to manage that risk in a rigorous way--
they do not manage derivatives counterparty risk as an ancillary 
function of their trading businesses. It is also worth emphasizing that 
within a central counterparty, all trades are matched, therefore the 
central counterparty itself has no exposure to market risk.
    Carefully designed regulatory oversight is critical to the risk-
mitigating role of central-counterparties. While the CFTC has vastly 
greater responsibilities in the wake of Dodd-Frank, its funding and 
resources have not kept up. In particular, its ability to oversee the 
swaps markets and its participants and ensure that the benefits of 
these reforms flow to businesses, farms, and families is severely 
hamstrung by their current lack of resources. Like other Federal 
financial regulators, the CFTC should be self-funded based on fees from 
the industry it regulates.
    I will also focus briefly on the role of the Financial Stability 
Oversight Council (FSOC) in designating systemically important 
financial market utilities. FSOC designation has led to the 
codification of higher standards for the most critical central 
counterparties and enabled greater oversight and cooperation between 
the Federal Reserve, SEC, and CFTC. The policy goal behind designation 
of central counterparties recognizes that while the CFTC regulates many 
small commodities/futures exchanges, only those whose failure could 
threaten the financial stability of the United States should be subject 
to heightened standards and oversight. When the FSOC designated eight 
financial market utilities, we did so in a process that relied deeply 
on the expertise of the primary regulators, minimized data collection 
burdens on the companies themselves, gave significant access for 
companies to understand the process and review the Council's draft 
designation materials.
    In addition to higher standards, designation also provides security 
to the broader system in other ways. For example, by giving designated 
central counterparties access to accounts at the Federal Reserve, Title 
VIII allows central counterparties to manage billions of dollars in 
customer margin without reintroducing the credit risk that would result 
from placing that customer margin at a commercial bank or investing it 
in the money markets. Importantly, being able to place cash in a 
Federal Reserve account does not give central counterparties the 
ability to borrow from the discount window the way that banks can; it 
simply removes a potential source of risk for customers that rely on 
central counterparties to mitigate risk in derivatives markets.
    It is also important to note, as you will hear today from other 
witnesses, that the largest financial firms are deeply supportive of 
the increased role of central counterparties and clearing in 
derivatives markets. They recognize the risk management and risk 
mitigation benefits and share the same goals as this Committee--for 
central counterparties to be well-managed, transparent entities that 
mitigate risk and facilitate market functioning.
Mechanisms for Failure of Central Counterparties
    Policy makers' focus on resilience and resolution of central 
counterparties reflects a well-founded desire to evaluate and mitigate 
any well-understood and potentially important risks in our financial 
system. The focus on central counterparty risk should be understood as 
part of a responsible approach to risk management--first diagnose the 
risks, then put controls in place to mitigate, then reassess the 
remaining risk--and repeat that process. Dodd-Frank examined the risks 
posed by derivatives markets, put in place mechanisms to mitigate that 
risk, and now we are left with the residual risk. The regulators' 
current focus on the potential failure of central counterparties is 
part of an iterative process of assessing the risk after effective 
reforms have been implemented and seeking to prepare and mitigate any 
remaining risk.
    In addition to the policy benefits of central clearing enumerated 
above, the economic benefits of functioning central counterparties are 
important to understand when considering the possibility of central 
counterparty failure. In the normal course of business, central 
counterparties underpin both the value of existing derivatives 
contracts and the ability of market participants to transact in new, 
standardized derivatives contracts. Remember that since derivative 
contracts often last for multiple years, they are integral to long term 
economic arrangements both for financial institutions acting as dealers 
and for end-user clients seeking to hedge risk. To take an example, 
many large corporate loans have floating rate terms but corporate 
treasurers often pair those loans with interest rate swaps that allow 
the business to transform that floating rate loan into a fixed rate 
loan. Therefore, businesses across the country rely on the resilience 
of central counterparties just as they rely on the smooth functioning 
of our banking system.
    There are three main mechanisms for the failure of a central 
counterparty. They can be thought of as: a failure caused by cascading 
defaults of central counterparty members which overwhelm the resources 
of the central counterparty; operational failure that is unrelated to 
economic and market conditions; or some combination whereby 
operational, risk management or modeling problems within a central 
counterparty lead the resources of a central counterparty to be 
insufficient in scenarios far less severe than cascading defaults.
    The first mechanism for failure has been the primary focus of both 
central counterparty risk management and policy makers' discussions, in 
part because it most closely resembles the events in the financial 
crisis of 2008 and because it is most closely connected to broader 
policy discussions about how to handle the failure of a large, complex 
financial company. Under this scenario, central counterparties, which 
are required to hold financial resources large enough to survive the 
default of their two largest clearing members, could find those 
resources overwhelmed by the failure of three or more large members to 
make timely payments into the central counterparty. Although there are 
many layers of protection against even this scenario, such a cascade 
could imperil the central counterparty's ability to make payments to 
its solvent clearing members. In turn, solvent clearing members may 
refuse to participate in the ongoing operation of the central 
counterparty. Importantly, [because] of the resolution planning efforts 
that the FDIC and the Federal Reserve have undertaken, along with the 
critical authorities granted the U.S. Government in the Orderly 
Liquidation Authority--even if a large clearing member becomes 
insolvent, the subsidiaries of that entity which directly engage with 
central counterparties should be able to meet their daily obligations 
to each central counterparty they are members of. Therefore, while it 
is important to prepare for and understand these risks, this scenario 
requires not only the failure of multiple large, complex financial 
institutions; but also the failure of existing strategies to handle to 
orderly liquidation of those large, complex financial institutions.
    The second mechanism for failure would be a scenario in which the 
central counterparty is unable to complete its obligations to its 
members based on internal problems. Importantly, because the risk of 
central counterparties is absorbed primarily in margin accounts and 
default funds, this second mechanism of default could happen without 
any financial stress occurring in clearing members themselves. Given 
the current threat landscape, the most important potential risk in this 
area is probably the threat from a malicious cyber attack. While at 
Treasury, we designed and executed a number of cybersecurity exercises 
that examined ways that malicious cyber attacks could affect financial 
stability either by directly or indirectly affecting large money-center 
banking organizations or central counterparties. One positive takeaway 
from these exercises is that the spirit of cooperation that firms 
demonstrated in working to provide assistance to an institution 
affected by cyber attacks bodes well for our ability to avoid self-
destructive financial reactions to a cyber event. One negative takeaway 
is that our collective ability to identify and respond to cyber attacks 
that affect critical functions in our financial system needs 
significant and continuing development.
    The third mechanism for failure of a central counterparty would be 
a scenario in which a central counterparty suffers an economic or 
market based shock that should be within the economic resources, but 
due to operational, risk management, or model weaknesses--the liquid 
financial resources of a central counterparty are insufficient to meet 
its obligations.
    I am not the only person to recognize these potential scenarios. 
Central counterparties and their regulators have in place mitigating 
procedures to address different types of distress. I will leave it to 
my fellow witnesses to elaborate, but each central counterparty has a 
recovery plan to manage the default of a clearing member and provide ex 
ante certainty about loss allocation. And market regulators are working 
at an international level through CPMI-IOSCO to establish best 
practices for the stress testing of central counterparties' resources. 
The CFTC conducted their first stress tests of how central 
counterparties under their supervision would fare under extreme but 
plausible market stress in the fall of last year.\1\
    \1\ http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/
    However, if any of these scenarios were to come to pass, it would 
put distinct pressures on the U.S. financial system and on U.S. 
regulators. And it is important to note that derivatives are a global 
business; so it is unlikely that the U.S. would be the only market 
affected. Significantly more work will need to be done to understand 
what authorities would be brought to bear and what strategies would be 
used to maintain the critical functions of the central counterparty and 
to maintain market confidence in the flow of payments through 
derivatives markets.
Policy Priorities and Policy Challenges
    When considering the policy priorities ahead, the first obligation 
must be to preserve the gains to stability and safety that we have made 
since the financial crisis. Above, I described the significant 
achievements of the Dodd-Frank Act in reducing risk and transforming 
transparency of global derivatives markets. Equally important is 
maintaining the tool of the Orderly Liquidation Authority. This is the 
central answer to the horrible dilemma that faced U.S. policy makers in 
the fall of 2008--should they allow another disorderly bankruptcy like 
Lehman Brothers or a deeply unfair bailout like AIG. The practical 
effects on small businesses and farms from those events should be 
motivation enough to maintain and support these reforms. Estimates of 
lost output due to the crisis, and due to the lack of tools to contain 
the damage are $10 trillion or more. And those estimates do not include 
the incalculable pain and suffering of families who lost jobs, houses, 
farms and lives because of their economic suffering.
    Many Members of this Committee have already voted to eliminate this 
authority, but it must be stressed that removing this authority from 
the U.S. toolkit would be misguided, shortsighted, and deeply 
irresponsible to the taxpayers that Members of this Committee 
represent. Removing the orderly liquidation authority would be 
misguided because the purported savings that the CBO has scored with 
this proposal are a mirage. They appear simply because of an accounting 
quirk in the budget window. By law, taxpayers cannot bear losses for 
any entity liquidated by the FDIC as part of the orderly liquidation 
authority. It would be short-sighted because it would suggest that 
policy makers had forgotten the immense pain and suffering families all 
across this country faced when the crisis-induced panic ripped through 
global financial markets and hurt families and small businesses most of 
all. It would be deeply irresponsible for taxpayers, because in the 
absence of this authority--we would be explicitly returning to the 
policy framework that gave birth to the TARP program of bank bailouts 
and taxpayer bailout risk. Orderly liquidation authority is the best 
tool the government has to provide predictability, fairness, and 
financial stability even as it allows any large, complex financial firm 
to fail because of their own mistakes.
    It may also be helpful to note that there is no serious debate 
about whether orderly liquidation authority can be used to resolve a 
central counterparty. While the Dodd-Frank Act does not explicitly 
reference financial market utilities when discussing orderly 
liquidation authority, the authority is written deliberately to allow 
for its use with any nonbank financial company whose failure could 
threaten financial stability. Financial market utilities are very 
clearly nonbank financial companies and therefore fit squarely within 
that authority. Importantly, while the resolution approach for a 
central counterparty will likely not mirror the approach that has been 
developed for bank holding companies, the core authorities that are 
needed to facilitate any successful resolution are included in orderly 
liquidation authority. These authorities include the ability to 
allocate losses--by utilizing pre-funded resources, assessing members 
or tearing up contracts--and to provide liquidity. If a central 
counterparty were to need to be resolved, the resolution authority 
would `step into the shoes' of the central counterparty, assuming 
responsibilities (principally operation of the central counterparty and 
the payment of variation margin) and rights. The rights of the central 
counterparty are laid out in an extensive rulebook that serves as a 
contract between the central counterparty and its clearing members. 
U.S. central counterparties have expansive powers in extenuating 
circumstances, if necessary, the FDIC would assume these powers and 
have at its disposal tools to affect recovery or orderly wind down of 
the central counterparty's operations.
    Going forward, I would like to highlight three key challenges for 
policy makers: coordination across multiple central counterparties; 
cross-border cooperation; and the need to develop resolution strategies 
that create ex ante incentives for positive risk management and for 
    The first challenge is coordination across multiple central 
counterparties in the event of default or multiple defaults. As 
discussed above, one mechanism for central counterparty failure would 
be cascading defaults among clearing members. Because derivatives 
trading is a highly concentrated industry, each of the major 
derivatives dealers is a member of virtually all the major central 
counterparties; and may be a member of dozens of central counterparties 
worldwide. Even in a scenario with just a single dealer default--a 
scenario that is very unlikely to threaten the viability of a central 
counterparty--the need for coordination among U.S. and European central 
counterparties to avoid confusion or uncertainty about market 
functioning will be necessary. Here U.S. regulators have taken to heart 
the lessons of central counterparties own fire drills (semi-annual 
events where they simulate distress scenarios with clearing members) 
and our experience working with industry on cybersecurity exercises, to 
begin both coordinated and cross-border exercises to understand and 
iron out potential points of friction and misunderstanding. As I 
learned in my experience in government, often simple arrangements for 
collaboration and communication are enough to avoid market confusion 
and destabilizing market movements.
    Second, efforts on cross-border regulatory cooperation are 
essential, and have quietly had a number of important successes in the 
years since the crisis. Even before the crisis, market regulators like 
the CFTC and SEC regularly worked with international counterparts 
through Committee on Payments and Market Infrastructures and the 
International Organization of Securities Commissions (CPMI-IOSCO). In 
April 2012, these standard setting bodies published Principles for 
Financial Market Infrastructures (PFMI), which are a set of 24 
principles that apply to FMIs including central counterparties on areas 
including credit and liquidity risk management and default management. 
It has been the responsibility of local authorities to codify rules and 
regulations customized for their jurisdiction that are broadly in line 
with these principles. This means that U.S. firms operating globally 
will have confidence in the risk management procedures and the rights 
that they will have when they participate in global clearing houses.
    Since 2013, CPMI-IOSCO has performed a series of jurisdictional 
assessments to mark progress on compliance. In August 2016, their first 
report on financial risk management and recovery practices in place at 
a selected set of derivatives central counterparties, found that 
central counterparties have made important and meaningful progress in 
implementing arrangements, but identified some gaps and shortcoming in 
certain jurisdictions. A follow-up assessing the further progress is 
expected this year. These mechanisms for accountability are a critical 
support for the agreement to global principles that U.S. Companies 
need. By providing ground for assessment, we can increase our 
confidence that other countries do not seek unfair advantage by 
lowering their standards and our confidence that our companies will be 
protected when they pursue global business opportunities.
    Regulators have also recognized that analysis of central 
counterparties cannot be done in isolation by market regulators; since 
clearing members and their clients are financial institutions, it is 
also important to coordinate with the Financial Stability Board (FSB) 
on issues related to resolution and the Basel Committee on Bank 
Supervision (BCBS) on bank exposures to central counterparties. In 
2015, a joint workplan \2\ was published and the committees are 
continuing to coordinate among themselves and provide public updates 
\3\ on progress. This international, principles-based coordination does 
not supersede the ability and, indeed the necessity, of U.S. regulators 
to create granular standards and supervisory rules for central 
counterparty resilience, recovery and resolution. U.S. regulators have 
also successfully worked bilaterally with jurisdictions like the EU as 
they seek to create authorities to handle the potential failure of a 
central counterparty in their jurisdiction. Our close engagement has 
allowed us to seek alignment based on an understanding of the tools 
local jurisdictions will need to address the failure of a central 
counterparty and enable cross-border coordination in the event of 
broader market distress.
    \2\ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD508.pdf.
    \3\ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD509.pdf.
    The successes of international coordination have also included 
private-sector partnerships, such as an agreement to change the 
standard global derivative contract (known as the ISDA protocol) to 
avoid damaging withdrawals from a firm that is undergoing resolution. 
This agreement was led by industry in cooperation with regulators and 
will significantly increase our ability to limit the damage to the 
economy if a large, complex financial institution fails.
    The third challenge is to develop and clarify the specific 
strategies and parameters around tools that will be used by central 
counterparties, the CFTC, and the FDIC to handle the unpredictable 
losses that will attend an unsuccessful recovery and move a central 
counterparty into resolution. This was an important element of my own 
efforts within government last year, and it was a deeply collaborative 
effort--both between U.S. regulators and with other stakeholders. While 
I look forward to engaging with the Committee about some of the 
specific tradeoffs in developing those strategies and parameters, I 
want to first lay out the basic problem. There is a necessary tradeoff 
between giving ex ante certainty to stakeholders and giving regulators 
the flexibility to manage a situation that we have never before faced. 
Making this more complicated, the incentives of central counterparty 
management, clearing members and other market participants need to be 
compatible whether we are talking about resilience, recovery or 
    Necessarily, the interests of these parties cannot be perfectly 
aligned. In the normal course of business, private-sector entities want 
to optimize the amount of capital they commit to the safe operation of 
central counterparties; this is why regulators have imposed rules about 
initial margin and collateral quality. The same must be done for more 
extreme cases where both central counterparty management and market 
participants will be focused on minimizing their own exposure to 
losses. There are creative solutions already in place to align 
incentives in recovery; for example, some central counterparties 
`juniorize' the pre-funded resources of clearing members who submit 
poor bids in auctions.
    For resolution, regulators must work with other stakeholders to 
both strike a balance between flexibility and certainty, ensure that 
solutions follow laws that prevent taxpayer risk, and endeavor to make 
incentives for orderly wind down, liquidation or complete 
recapitalization as compatible as possible among market participants. 
There is not yet agreement on how best to do this. To highlight just 
one example, central counterparties argue that their members, who bring 
market risk to the central counterparty, should be subject to broad, 
but not unlimited, capital assessments to recapitalize the central 
counterparty. Clearing members and their trade groups have suggested 
that central counterparties be required to issue long term debt that 
could be converted to equity if the central counterparty needed to be 
recapitalized. As stakeholders continue to explore these questions, 
keeping our focus on creating incentives for each group that are 
compatible with market stability and resilience is an important and 
achievable aim.
    The work of financial stability monitoring is never finished, but 
we must remain mindful of the progress we have made since 2008. Safe, 
stable markets are a U.S. competitive advantage and are good for 
business; markets thrive where rules are clear and integrity is valued. 
Central clearing of standardized products has materially improved the 
resilience of our financial markets. It has increased transparency, 
efficiency and raised the bar on risk management standards. Progress 
has been made on strengthening the recovery tools at central 
counterparties; there are more assets available for loss allocation and 
market participants have worked and continue to work with regulators to 
stress test the adequacy of those assets and increase clarity about 
what would happen in the event of a large counterparty default. With 
these measures in place and regulatory and cross-border coordination 
continuing, it is important that we continue to explore solutions for 
resolution. Most importantly, there is no viable approach to these 
challenges without existing orderly liquidation authority. While we do 
not yet have complete strategies and tools to handle the resolution of 
a critically important central counterparty, the only way to avoid 
catastrophic outcomes in that event, will be to build those tools on 

    The Chairman. Well, thank you, gentleman, and I appreciate 
your testimony this morning.
    The chair would remind Members that they will be recognized 
for questioning in order of seniority for Members who were here 
at the start of the hearing. After that, Members will be 
recognized in order of arrival, and I appreciate Members' 
    And with that, I recognize myself for 5 minutes.
    Well, thank you for presenting this. I understand it is 
unsettling, perhaps, to talk about failure of a clearinghouse 
and all those kind of things, but if we don't talk about it, 
and have some reasonable understanding of it, then we as 
policymakers will have a difficult time making sure we have the 
policies in place.
    All of you have talked about the extensive protections and 
counterbalances, and all the things that are in place right now 
for the risks that we know about. This is what we are trying to 
explore this morning are the risks that we don't know about, or 
the ones we don't think could happen. I am old enough to have 
been around in 1987 when the stock market dropped 22 percent in 
1 day, which was a bit unsettling. All of us were around in 
2006, 2007, and 2008 when the housing market property values 
collapsed across the country. No one necessarily thought that 
was the case. Looking at the two sides to this question: one, 
what all those kind of things would cause monster liquidity 
risks in the system that where if two banks failed, or more 
than several banks failed; in that scenario what would we do 
and how we handle it, could the market take it? On the 
resolution side that, if you had that, what happens then to the 
clearinghouse, those customers, and everything else. Looking at 
the broader side of it from the liquidity standpoint, is there 
a plausible or just stunningly remote scenario that would 
create that kind of liquidity risk where the largest banks out 
there couldn't make their intraday transfers, and that we would 
have a circumstance that would cause the Secretary of the 
Treasury to be as white as my shirt in trying to explain to us 
in 2008 what was about to happen in his mind with respect to 
the credit markets at that point in time.
    Anybody want to jump in and just tell us are we 
unreasonably asking that question?
    Mr. Salzman. I can try. Jerry Salzman. Essentially, we are 
running tests on a regular basis, internationally and 
nationally, looking at scenarios that are far out but still 
plausible, given current market conditions, to create a risk or 
liquidity risk big enough to bring down a clearinghouse. So 
far, we have all been passing all of the tests, but obviously, 
it is possible that something could happen. For example, one of 
the things the CME does is to have a standby liquidity facility 
from the major banks. The problem in the world is there has 
been tremendous concentration among the banks that are still 
out there; the banks that are the major banks, where the money 
is held, who the clearing members are. And although we have a 
liquidity facility in place, and we have tons of treasuries to 
give to the banks to convert to immediate cash, the question is 
if the banks are failing at the same time we are going to the 
banks to get cash, now we just have treasuries.
    We have plans to settle in treasuries instead of cash if we 
had to, but that is not particularly a good way to do things. 
The best way to do things from our point of view is what Mr. 
Steigerwald has said and what Governor Powell has said, and to 
make the access to the Fed window to borrow on treasuries more 
expeditious than it currently is under law.
    The Chairman. Let's flesh that out because one of the 
criticisms of that is somehow the taxpayers would be on the 
hook for some sort of bailout, to use a horrible phrase. What 
is the credit risk to the Fed for a clearinghouse swapping 
treasuries for cash?
    Mr. Salzman. Is zero. They are ahead two percent the second 
we give them the treasuries, because they----
    The Chairman. That is assuming the Federal taxpayers 
continue to make good on their debt.
    Mr. Salzman. That is assuming that the Federal taxpayer and 
the Federal Government continues to make good on their debt, 
yes, sir.
    The Chairman. All right. One of you mentioned, Mr. Hill may 
have mentioned access to that window could be, in statute or 
policy, limited to that transaction only. In other words, the 
only thing the Fed could lend on the window would be against 
U.S. treasuries. Is that what you anticipated?
    Mr. Hill. That is exactly what I propose.
    It is for that very direct and limited purpose. I 
completely agree with Mr. Salzman, in that scenario, we would 
even suggest if the Fed felt it was necessary that they could 
put a larger haircut on those when we show up at the window.
    But it is only for the U.S. treasuries to turn them into 
U.S. dollars to facilitate liquidity.
    The Chairman. All right.
    And quickly, the risks to the taxpayer for allowing 
clearinghouses to park their excess collateral and assets at 
the Fed is what?
    Mr. Steigerwald. I see no additional risk that goes beyond 
the ordinary incidences of acting as the depository, performing 
account services and functions that the Fed performs each and 
every day, day in and day out.
    I would add very quickly that the sort of liquidity support 
that I have spoken to would be extremely short-term in nature. 
These institutions could not survive without immediate 
liquidity provision, and will not survive by being dependent on 
resources provided from outside of the clearing community.
    The Chairman. All right. My time has expired.
    Mr. Peterson, 5 minutes.
    Mr. Peterson. Thank you, Mr. Chairman.
    I have been saying for years that the Basel Committee's 
supplemental leverage ratio accounting treatment of initial and 
variation margins gets it wrong. Late last week, Federal 
Reserve Board Governor, Jerome Powell, suggested the SLR should 
be changed. In his last speech before he retired, Daniel 
Tarullo, another Fed Board Governor, suggested the same.
    Mr. Steigerwald, for those who don't know, could you please 
describe the problem and tell us how regulators could go about 
fixing this? And, Mr. Dabbs, how, as a clearing member, you see 
this issue. Mr. Steigerwald first.
    Mr. Steigerwald. Thank you, Ranking Member Peterson.
    This, as you undoubtedly are aware, is a very complicated 
topic, the application of the capital rules, I must say, causes 
my head to spin when I try to think about it and its 
comprehensive nature.
    Let me say that there are implications both to the ordinary 
ability of financial institutions that are subject to the 
supplementary leverage ratio in providing access to clearing. 
The mandate to centrally clear standardized derivatives, 
frankly, doesn't mean very much if the end-user can't get 
there. That has to be a concern.
    More importantly from my perspective, in an emergency 
circumstance where a clearing member has failed it is essential 
for customer accounts to be smoothly, swiftly, and safely 
transferred to a solvent operating clearing member. My 
understanding from the analyses I have seen suggests that that 
process could be, almost certainly would be, impaired by the 
existing form of the SLR.
    Mr. Peterson. How do we fix it?
    Mr. Dabbs. Well, I will grab that one.
    From an SLR perspective, just to real quickly describe what 
SLR does, on the derivatives side, it was intended to make 
visible the non-balance sheet items of a bank, because 
traditionally we would measure leverage just by looking at the 
balance sheet of a bank, and it added an ability to recognize 
derivatives that are not on the balance sheet. And we are okay 
with that as a concept. Where we think we got it wrong is in 
the case of derivatives that are cleared for clients. We 
recognize the risk of the instrument; however, we don't 
recognize the value of that deposit that the client has 
provided. If the risk of the instrument is $5 and you give me 
$3, then clearly, $5^$3=$2, and we have $2 of risk that we 
should cover and should be on our balance sheet, and we are 
okay with that. Currently, we take the $5, we ignore the fact 
that we have collected margin from that, and simply put $5 on 
our balance sheet.
    And if I step back and just look at where your capital 
regulations and your legislation have kind of divided is, when 
we made the mandate to centrally clear, we took one transaction 
that historically had been done between a bank and a client and 
we split that up into two transactions; each transaction facing 
a clearinghouse. We have two transactions: one where a bank 
faces the clearinghouse; and a second one where a clearing 
member, which is typically a bank, and a client. Now you have 
taken the universe and you have effectively doubled leverage as 
we measure it today.
    We didn't do anything. We, in fact, made the market safer, 
but as measured under our capital regime, we have actually 
taken one unit of leverage and made it into two units of 
leverage, so when we look at the system it actually appears 
that the leverage is doubled in the system.
    We think the effective policy would be to use the initial 
margin that a client has provided us as a deduction from the 
risk of the instrument that the client has put on in their 
    Mr. Peterson. Thank you.
    It appears from a review of the material that one of the 
weak spots in the system is the repo market. Could somebody 
describe the role of the repo market and what the concerns are 
out there in regards to how this might undermine the system? 
    Mr. Salzman. Well, I will try. The repo market is used by 
people who have securities who need cash, and generally it is 
an overnight market, and the liquidity in that market has been 
very high, so that if you had securities, generally, you could 
get cash often the next day. Frequently, for clearinghouses, 
they need the cash immediately because all their payments are 
made at set times.
    In the past, we have been able to make arrangements with 
people to get paid the same day, the same day we give up our 
securities, and so that functions wonderfully for us. But, one 
of the things we are worried about, one of the things everybody 
has to worry about, is that in a time of crisis the repo market 
will be one of the first things that breaks down, it did during 
the Lehman Brothers situation, they could not use their 
securities to get cash. And that would be a disaster because 
everybody is sitting there, everything is solvent, everything 
should work, but the system breaks for 1 second and then we are 
all in trouble that we shouldn't be in.
    Again, we fall back to the idea, we do have a central bank 
with essentially unlimited liquidity, and as long as we have 
really good securities to give it, we are not hurting the 
taxpayer, we are helping the taxpayer, because the cost of 
undoing a crisis is ten times the cost of the potential losses 
of the crisis.
    Mr. Hill. One thing I would add, and I agree with 
everything that was said is, we have established for our 
clearinghouses committed repo facilities, so that at a time of 
crisis we are able to access liquidity. I know the CME has done 
the same thing. We have committed FX facilities. We have taken 
steps in the commercial market to do what we can, similar to 
the default stress tests, we run liquidity stress tests that 
look at what happens if your two largest clearing members go 
down in the middle of a liquidity event, are you able to 
sufficiently provide the liquidity, Mr. Salzman notes that it 
is necessary to keep the system functioning. And I will give 
you an example. In our clearinghouses, that stress could be up 
to as much as $4 billion in the middle of the day. And so we 
have provided backstops against that, but it is important to 
realize that those backstops are with large financial 
institutions that in many cases are the large clearing members. 
And so you have effectively a potential wrong-way risk, in that 
your committed backstop may be from a firm that is also subject 
to the risk of default. And that is where the Fed can step in 
and provide the services that Mr. Steigerwald talked about, 
again, not as the primary defense, we at CCPs have primary 
defenses, but as a last step to ensure the liquidity continues 
to flow in the system.
    The Chairman. The gentleman's time has expired.
    Mr. Austin Scott, 5 minutes.
    Mr. Austin Scott of Georgia. Thank you, Mr. Chairman.
    Mr. Hill, sorry to keep coming back to you, but you 
represent ICE, and one ICE clearinghouse is designated as 
systemically important, and another one is not. Does it make 
sense that we treat systemically important clearinghouses 
differently from other clearinghouses, and how does this impact 
you representing both?
    Mr. Hill. Thank you for the question.
    It doesn't make sense, is the short answer, to treat one 
clearinghouse differently than another. And I will give you a 
specific example. ICE Clear Credit is our CDS clearinghouse. It 
has been deemed systemically important. It does have access to 
put its cash at the Federal Reserve. It is a similar position 
that the CME is in. Our agriculture clearinghouse, ICE Clear 
U.S., was not deemed to be systemically important and does not 
have the access to deposit its cash at the Fed.
    The Fed today provides returns on cash that are above what 
the market pays, and we have seen cash leave ICE Clear U.S. and 
go to other clearinghouses where that money will be put on 
deposit at the Fed and earn a higher return. And that is an 
unintended consequence where you have a wheat farmer whose cash 
is lodged at the Fed at the end of the day, and a cotton farmer 
whose cash is lodged at a commercial market earning a lower 
return. And to be clear, it is not about the return.
    Mr. Austin Scott of Georgia. Yes.
    Mr. Hill. The fact that the Fed pays an above-market return 
is not particular logical to me, as it is. It is really about 
the security of those deposits, not the return on them. What we 
are looking for is the ability for each of our customers to 
have the same access to the secure deposit services that are 
available to systemically important institutions.
    Mr. Austin Scott of Georgia. And so prior to Dodd-Frank, 
the clearing community was required to find its own solutions 
to the clearinghouse solvency question. All of you have 
testified, and this is unusual that all would testify that the 
same solution would work. Each of you endorsed the Federal 
Reserve account as an important place to hold the cash reserves 
of the clearinghouses. Those accounts are currently provided by 
Title VIII of the Dodd-Frank Act for systemically important 
clearinghouses, some of your clearinghouses are, some aren't. 
This discussion about repealing Title VIII without addressing 
all of the individual things in Title VIII that it covers, and 
whether or not repeal is appropriate in all cases.
    Just a few questions about the Federal Reserve account 
services. Mr. Hill, again, where will clearinghouses put their 
financial reserves if they lose access to those account 
services at the Federal Reserve?
    Mr. Hill. Thank you again for the question, Congressman 
Scott. To be clear, the clearinghouses have existed a long time 
and have been able to facilitate places to put their cash, and 
to generate the liquidity necessary, before the systemically 
important designation, and to the extent that that is removed, 
we will be able to continue to find those commercial services.
    The direct answer to your question, if ICE Clear Credit no 
longer was able to deposit its cash at the Fed, we would create 
relationships with other commercial institutions, other 
financial institutions, that would be able to take those 
deposits. And again, those are the same relationships we have 
today for ICE Clear U.S., they are the same relationships that 
we have for our large lending clearinghouse, ICE Clear Europe, 
so we know that those facilities are available and able to be 
implemented. I simply am suggesting that access to the Fed 
makes the system more secure. And, therefore, whether Dodd-
Frank and Title VIII are repealed or not, I think a rational 
policy decision would be to provide that access.
    Mr. Austin Scott of Georgia. Mr. Steigerwald, what problems 
are there with market-based solutions to managing clearinghouse 
cash collateral in a crisis?
    Mr. Steigerwald. Congressman, the answer to that question 
is that in the midst of the sort of crisis that would cause a 
central counterparty clearinghouse to turn to its resources, 
the financial system as a whole would be stressed. We would see 
a generalized phenomenon known as hoarding of liquidity, akin 
to a bank run. We saw this clearly during the crisis, and we 
can expect that private-sector transactions will slow, if not 
    We were pleased to have Governor Powell speak at an event 
at the Chicago Fed on Friday, where he went into some detail 
about the events relating to the 20th of October 1987, which 
showed, in fact, the kind of gridlock in the payments system 
and in the exchange of these critical settlement payments that 
we are concerned with. That is why I think the public-sector as 
a backstop and as a custodian of these critical resources makes 
a lot of sense.
    Mr. Austin Scott of Georgia. Right. Thank you.
    Mr. Chairman, my time has expired.
    The Chairman. The gentleman's time has expired.
    David Scott, 5 minutes.
    Mr. David Scott of Georgia. Thank you, Mr. Chairman.
    I want to ask several questions here. And let me just 
commend the panel on the expertise, that you all are dealing 
with, what is a very complex and complicated system.
    But I want to first of all, Mr. Hill, address this question 
to you. We recently saw that the EU proposed additional 
standards for clearinghouse regulation, and I believe that this 
will tie into the Brexit determination. I want to ask your 
opinion on whether or not these proposed standards threatened 
the equivalence determination that we negotiated for, we fought 
for, for so long, and how do you view this from the perspective 
of cross-border competition and cooperation?
    Mr. Hill. Thank you, Congressman Scott, it is a really 
important question. And happy birthday.
    I would tell you, and for the Committee's benefit, if you 
haven't seen it, what the European Commission has done is 
published a paper that has effectively looked at how they will 
regulate clearinghouses that aren't on the European Continent, 
but in their opinion may create some form of systemic risk, 
particularly around Euro-denominated products.
    And they define two tiers of clearinghouses. Tier 1 is 
effectively not material; we are not going to worry about it, 
we will defer to the home jurisdiction. Tier 2 is a very, very 
broad category that can range from anything to, we will work 
closely with the home regulator, to, we, Europe, will have 
direct oversight of a non-European CCP, to the very extreme of 
we will not allow our European companies to use that CCP if 
they remain located outside of Europe.
    Unfortunately, Congressman, that is a wide breadth of 
possibilities. It is difficult to say ultimately what it will 
mean because, effectively, they have left all the cards on the 
    They have complete optionality on what they will do.
    I don't know that it will be a threat to the equivalence 
that, I agree with you, we worked long and hard to establish. 
The CFTC, particularly, did a remarkable job working with our 
European colleagues to reach that agreement. I can't say for 
certain that it will impact it, but it has the possibility to 
impact it if, for example, the European regulators decide that 
a U.S.-based clearinghouse, or, in our case, a UK-based 
clearinghouse, clears Euro-denominator products in a sufficient 
amount that they deem to create risk.
    Mr. David Scott of Georgia. Yes.
    Mr. Hill. It creates uncertainty, without question.
    Mr. David Scott of Georgia. Well, thank you, Mr. Hill.
    I want to turn my attention to you, Mr. Salzman. In 
addition to my work here on the Agriculture Committee, I am 
also a Member of the Financial Services Committee. And we 
recently reported on a bill, controversial, that I thought had 
serious problems, and that is the Financial Choice Act, because 
it repeals both Title II, which provides for the orderly 
liquidation authority to wind down in a crisis, and then it 
also repeals Title VIII, which provides access to deposit in 
the Federal Reserve in the Dodd-Frank Act.
    How damaging is this, and could you share with us why it is 
important that if, and as we move forward, that we keep these 
two sections in place?
    Mr. Salzman. Well, I am going to be a bit more limited and 
less political, if I can.
    The part of Title VIII that is definitely important to us, 
as everybody here has testified, is access to the Fed accounts 
and access to the Fed window. And to the extent that is 
preserved, I don't want to jump in and talk about essentially 
getting rid of the rest of Title VIII.
    With respect to Title II, and the authority to wind down a 
clearinghouse, I am deeply concerned that the determinations 
made by the European regulators on equivalence depended on the 
notion that there was resolution authority in the government. 
And I am very concerned that getting rid of Title II will give 
somebody in Europe a further excuse to assert either more power 
or to deny us European clients. I want to be really careful 
about that.
    With respect to the Choice Act itself, there are actually 
some very interesting things in the Choice Act in other parts.
    As I say, I don't want to be political on those issues if I 
can avoid it.
    Mr. David Scott of Georgia. Thank you, sir.
    The Chairman. The gentleman's time has expired.
    Mr. Comer, 5 minutes.
    Mr. Comer. Thank you, Mr. Chairman.
    With respect to liquidity risk, during the Brexit vote we 
saw very significant margin costs from clearinghouses. What 
lessons should we draw from that experience in terms of 
liquidity management and risk management? Mr. Steigerwald. Yes.
    Mr. Steigerwald. I think you point to a very important 
illustration of exactly the principle that I was talking about.
    Mr. Comer. Yes.
    Mr. Steigerwald. These markets, the clearinghouses that 
serve them use time-critical settlement processes to contain 
credit risk, precisely because clearing members are called 
daily and sometimes intraday to make payments that extinguish 
obligations they have to the clearinghouse, that credit risk 
can be managed in an efficient and effective way.
    That means, however, that all participants in the system, 
and we have to think about clearing as a system, have to be 
ready, willing, and able to meet those time-critical 
obligations as they come due. On extraordinary days, the 
amounts involved can be quite exceptional. The Brexit vote and 
the aftermath demonstrates that. That is a part of the new 
world of interconnectedness.
    Mr. Salzman. I do want to say one thing about that. There 
wasn't a problem at every clearinghouse. There was no problem 
at CME's clearinghouse. And this is, in part, a matter of 
experience and a matter of judgment. And remember, 
clearinghouses have been in business for 100 years, and some of 
us have actually learned something during that period, 
including 1987 where our clearinghouse made a mistake and we 
made an extra call for intraday margin that actually caused a 
problem. This is not something you forget when you make a 
mistake, and I am sure that the clearinghouses that did call 
for extra margin this time have learned a significant lesson, 
and at least that will be out of the system, going forward.
    Mr. Dabbs. Yes, as a member that had to make a very large 
payment, I can tell you that each clearinghouse was unique in 
their response, and there was one clearinghouse that acted 
differently than what I would call the global standard. It has 
been remedied at this point, however, the challenge really was 
that it was a one-way collection. Instead of taking money from 
the loser and paying it to the winner, it was just a collection 
from all the losers, without any of the winners benefitting. 
You were effectively trapping liquidity at the very time that 
you wanted to provide liquidity back to the market.
    Mr. Comer. Right.
    Mr. Dabbs. They have since remedied it. It was a 
combination of rules and general structure of their technology 
systems, but I think that we have moved in the right direction.
    These are why those stress tests and things, and real-life 
examples, are always better than just a test that we do behind 
the scenes. It is always good that we have results that are 
    Mr. Comer. Right.
    Mr. Hill. The only thing that I would add is two important 
things. First, the Brexit scenario created a lot of volatility, 
and the outcome was, loosely saying, unexpected. It 
demonstrated the system does work because the money did move.
    Mr. Comer. Right.
    Mr. Hill. It is also important to note that the one 
clearinghouse that was the exception was outside the U.S., and 
that reinforces the importance of the cross-border 
communications and regulations, because even though the 
clearinghouse was outside the U.S., a number of members 
weren't. The system did work in this situation, and where the 
issue existed demonstrates why we have to have cross-border 
cooperation among regulators.
    Mr. Comer. Okay.
    Thank you, Mr. Chairman. I yield back.
    The Chairman. The gentleman yields back.
    Ms. Kuster, 5 minutes.
    Ms. Kuster. Thank you, Chairman Conaway and Ranking Member 
Peterson, for holding this hearing. And thank you to our panel.
    Nearly 10 years ago, the United States and the world 
experienced one of the most serious financial crises in our 
nation's history, which wiped away a generation of wealth for 
countless American families, and put millions of Americans out 
of work. While the 2007-2008 financial crisis was in large part 
caused by an unprecedented number of defaults on subprime 
mortgages that should never have been awarded in the first 
place, reckless trading on Wall Street and risky bets placed by 
hedge funds wreaked havoc on our economy. Dodd-Frank was put in 
place because the financial crisis made it clear that just a 
few bad actors can hurt the economic well-being of millions of 
Americans. And I refuse to let us go back to a time when Wall 
Street can wreak havoc on Main Street.
    Now, I appreciate the opportunity to evaluate the role that 
clearinghouses have in protecting market participants against 
systemic risks, and discussing how the recently passed 
Financial Choice Act would hurt the clearinghouses' ability to 
effectively manage risk.
    So my question is this, for the panel, I am talking about 
the repeal of Title II and Title VIII of Dodd-Frank, which was 
a provision of the Financial Choice Act, passed on a pure 
party-line vote on June 8, if this were to become law what 
effect would the repeal of these two titles have on 
clearinghouses in the overall health and safety for swaps 
markets? And anyone can respond.
    Mr. Gerety. Let me jump in. Thank you very much. It is a 
very important question, and already has been addressed to some 
extent. But it is important to note that the framework absent 
Title II is bankruptcy, and bankruptcy alone. I don't think 
there is anyone on this panel who would not hope that these 
entities or any financial entity can go through bankruptcy, but 
in the context of a severe financial crisis, when normal 
sources of commercially available liquidity are frozen, there 
is no other opportunity other than Title II.
    It is also worth noting that Title VIII is the key to 
allowing for account services from the Federal Reserve, and the 
reason for that is that the Federal Reserve generally has not 
ever felt comfortable giving account services to entities that 
it did not have some sort of regulatory relationship with.
    While it is theoretically possible to give account services 
to entities that are completely outside of the Federal 
Reserve's regulatory orbit, it would be completely 
unprecedented in the history of the United States.
    The reason we have banking relationships between the 
Federal Reserve and banks all across this country is because 
banks are regulated by the Federal Reserve. Similarly, what 
Title VIII did was an arrangement where, in exchange for more 
cooperation between SEC, CFTC, and the Federal Reserve, there 
is also an arrangement for more security for monies held by 
CCPs to be able to go to the Fed. That arrangement is 
consistent with the way we regulate our financial services, and 
it is an arrangement that would be broken if either of those 
titles were repealed.
    Ms. Kuster. As a follow-up, if the Choice Act were to 
become law, would the CFTC likely become responsible for the 
resolution of a failed clearinghouse? We have heard testimony 
for the last 10 years, including this year, that the CFTC is 
understaffed and under-funded, and it seems unlikely that the 
agency will see an increase in funding or staffing any time 
    My question is, does the market have confidence that they 
would be up to the task of resolving a failed clearinghouse?
    Mr. Salzman. Let me try that for a second. The problem is, 
as Mr. Gerety said, in the absence of the appointment of either 
the FDIC, or somebody else, the actual fallback is to 
bankruptcy under the Bankruptcy Code, and under the Bankruptcy 
Code the only option for clearinghouses is pure liquidation, 
not reorganization. The CFTC wouldn't step in.
    In the CFTC somehow were, by law or otherwise, made the 
party responsible for dealing with the resolution of a 
clearinghouse, even though its budget didn't go up, I believe 
that by appointing an appropriate person as trustee, and 
overseeing the process and getting the fees out of the process, 
that it could be done by the CFTC. But as I say, that isn't 
what the law is now, and it isn't the fallback position.
    Ms. Kuster. You are saying what would likely happen then is 
a total liquidation under bankruptcy?
    Mr. Salzman. Unfortunately, I believe that is what the 
fallback is if Title II goes away, but there are other options 
out there and legislation floating around, I know, people are 
talking about.
    Ms. Kuster. Okay, thank you very much.
    I yield back.
    The Chairman. The gentlelady's time has expired.
    Mr. Marshall, 5 minutes.
    Mr. Marshall. Yes, thank you, Mr. Chairman.
    I will direct my first question to Mr. Hill and Mr. Dabbs 
both. I serve on other committees, on the Science, Space, and 
Technology Committee we talk a lot about cybersecurity. And if 
I was to prioritize my concerns sitting on this side of it as a 
more pressing danger concerning cybersecurity, and maybe, Mr. 
Hill, you can talk a little bit about what ICE is doing to get 
a handle on some of those.
    Mr. Hill. Yes. I suspect what I will say will be very 
similar to the CME and others. Cybersecurity is at the top of 
our agenda. Effectively, we operate exchanges and 
clearinghouses, but we fundamentally run technology. And so our 
ability to have those markets run, our clearinghouses to 
operate, our exchanges to facilitate risk management, all 
depends on our technology being up and running.
    We have developed significant disaster recovery and 
business continuity plans that have been reviewed with our 
members, have been reviewed with our regulators, that are 
reviewed by our independent boards of regulators, and have made 
significant investments in our information security in terms of 
resources, and in terms of not just trying to keep the bad guys 
out, but more important, assume the bad guys are in, and can 
you find them and can you stop them. This is an area where I 
would suggest to you, over the last 3 years, there has not been 
a heavier place of investment for our company, or a topic that 
has had more senior management and, frankly, board-level 
attention at our company.
    Mr. Marshall. Mr. Dabbs, do you have anything to add?
    Mr. Dabbs. Yes, I would echo some of the things that Scott 
said. I would say that, first and foremost, I am not an expert 
on cybersecurity within my institution. As an institution of 
45,000 people, we have teams of people that do this as their 
day-to-day job. In terms of expertise, I can follow up and give 
you some greater detail of what we have been doing, but just 
from a user perspective and how I see it, we have BCP plans, we 
have employee training where we will go through not only video 
and instructional training; also, we'll send spoofing e-mails 
and things like that that will try to catch people that you 
shouldn't click this, and whoever clicks it gets an e-mail 
saying, ``Hey, you shouldn't have done that.'' We will do 
things like spoofing e-mails, we will do tire-kicking, we look 
at things like two-factor authentication.
    I engage in it and I am aware of it, but I am certainly not 
the expert on the subject for my institution.
    Mr. Marshall. Okay.
    Mr. Gerety. If I may.
    Mr. Marshall. Sure.
    Mr. Gerety. One of the responsibilities that I had when I 
was at the Treasury Department was to oversee the Treasury's 
relationships with the financial industry on cybersecurity. And 
as part of that, the centerpiece of our efforts were a series 
of tabletop exercises where we brought together law 
enforcement, Homeland Security, intelligence community, 
industry, and regulators to explore scenarios where a cyber 
incident would create business impact. And as part of that, we 
had members of the CME, ICE, and other clearinghouses 
participate fully.
    The bad news in those scenarios was that the uncertainty 
associated with cyber means it may well be our single most 
important risk in this or any other context. The scale of the 
resources, while very significant, still pales in comparison to 
the scale of the potential threats.
    Second, the good news in this is that when we went through 
these exercises, the reaction and the spirit of cooperation 
among all parties, the spirit of alignment was notable and 
notably different than what happens when people are in a 
creditor relationship.
    There is much to be learned, but also very significant 
cooperation that is undergoing even today across government and 
with industry.
    Mr. Marshall. Okay. My last question is, in 1987 I was in 
medical school, I didn't even know there was a crisis. Mr. 
Salzman and Mr. Steigerwald, lessons learned, what happened 
then so it doesn't happen today? I mean I have a minute left, 
so each of you get 30 seconds at it. Mr. Salzman.
    Mr. Salzman. Okay. Well, in 1987 when the crisis hit, 
fortunately, a bunch of CME people were actually at a meeting 
that night, and I almost would have needed the services of a 
doctor because I thought my heart was going to stop. We found 
that the interconnections between the Stock Exchange, the 
commodities exchanges, and the banks were nonexistent. It was 
the closest thing to essentially blowing up that event into a 
major disaster. The banks didn't know what their obligations 
should be to create liquidity. The Stock Exchange and the 
futures exchange were at the beginning of a fight as to who was 
to blame, with the Stock Exchange trying to blame the futures 
exchange. Finally, the Federal Reserve stepped in and told the 
banks to provide liquidity and they would backstop them. And 
the next morning the Chicago Mercantile Exchange, I forget at 
what time, but at some time in the morning, the Chicago Board 
of Trade, the Dow Jones contract started moving up and that put 
a stop to the crisis and we all healed, and then we had 3 years 
of reports afterwards, as you know, to look back and try and 
learn something from it. And the things we learned was, you had 
better have hotlines, you had better be prepared, you had 
better have everybody interconnected and stopping and starting 
at the right time.
    We did learn, and we are still learning.
    Mr. Marshall. Okay.
    My time has expired, sorry.
    The Chairman. The gentleman's time has expired.
    Mr. O'Halleran. Tom, I cannot get your last name right.
    Mr. O'Halleran. Well, we will get that there, Mr. Chairman.
    The Chairman. Keep working at it.
    Mr. O'Halleran. Thank you, Mr. Chairman.
    I guess 1987 is where it all began because I was on the 
Board of Directors at Chicago Board of Trade at the time, and 
the word liquidity was something that I will never forget. And 
when we are talking about these issues; the complexity of these 
issues, if we are talking about protecting the American public, 
we have to understand that if our economy goes awry, we are 
still, 10 years later, suffering as an economy from what 
occurred in 2007 and 2008.
    What occurred back in 1987 was exactly as was explained, 
but the concerns continued on and on. And, yes, communication 
was bad. It is better today. But it still gets down to this 
cascading impact that occurs within the marketplace. And one of 
the things that is not realized a lot, we talk a lot about the 
crisis and the cascading impact is how to stop it from 
occurring in the first place. And that is where clearinghouses 
come in, their ability to change margin requirements, their 
ability to liquidate positions, their ability to see markets 
that are cornered, their ability to understand the marketplace. 
But they require that type of liquidity that only, I believe, 
the Federal Reserve can produce. The guarantee fund, the 
position requirements, all of that can only get us to a certain 
point, but each and every one of those segments protects the 
economy of America.
    It is part of the whole process that without it, that is 
what we saw in 2007 and 2008. There was none of that available 
to us, for the most part, and we had that cascading impact that 
just tore us apart as an economy, and luckily, the decision was 
made for the Federal Reserve to step in, because if it hadn't 
those banks that we tried to get ahold of in 1987 in October, 
and other exchanges tried to get ahold of, there was limited 
ability. And now we are communicating more on an international 
basis, which adds another level of complexity. We had markets 
that were international at the time and trading 
internationally, but the complexity today is so different. I 
just can't envision a marketplace in which we have to identify 
that the Federal Reserve is not the backstop for this whole 
    With that, if we are really going to protect the taxpayers 
of our nation, the economy has to be the number one protection, 
not just worrying about the risk on the Federal Reserve side of 
the equation. We have really smart, competent people that will 
address that risk, but our overall objective needs to be how do 
we protect the American people.
    With that, I will ask for anybody to comment how much 
better off are we today than we were in 2007 and 2008 as far as 
creating that protection?
    Mr. Hill. I appreciate the question, and I will start and 
be quick, John, so you can jump in.
    A great example is the credit default swap, or CDS, market. 
Back in 2007 and 2008, I like Mr. Gerety's phrase, I wrote it 
down, a complex web of transactions. That is what you had. They 
were bilateral trades. It was undetermined who was exposed to 
whom, you didn't have the benefit of netting, you didn't know 
what margins had been required, if any, and based on what the 
individual firms knew, but collectively nobody had insight into 
exactly what the exposures are.
    Cycle ahead a decade later and more than 80 percent of the 
CDS index market is now cleared, around \1/2\ of the CDS 
single-name market is cleared, and on any given day we know 
what the net exposures are, we know exactly how much collateral 
is held against those positions, and that collateral is held 
based upon an ability to liquidate the positions over a 5 day 
period, representing the relative illiquidity of the CDS 
market. You have transparency in the market today, you have 
certainty of collateral in the market today, you have a----
    Mr. O'Halleran. I only have 4 seconds, so I am going to ask 
does anybody identify that lack of liquidity would help this 
process? No. Thank you.
    The Chairman. The gentleman's time yield back.
    Mr. Bacon. General Bacon.
    Mr. Bacon. Thank you, gentlemen. I appreciate it.
    As a 30 year Air Force guy, your testimony is informational 
for me, so I appreciate it.
    My first question is to Mr. Dabbs. How might a 
clearinghouse failure occur? We touched on this a little bit, 
maybe in the testimony, but is it more likely to be a gradual 
or just a shock or a surprise?
    Mr. Dabbs. It is going to be a relatively shocking event. 
It is not going to be a gradual demise, it is going to be a 
kind of cliff event. And to the point that we were just talking 
about: how is the system safer, how does this happen----
    Mr. Bacon. Right.
    Mr. Dabbs. Post-2008 we have ratcheted-up all of the 
reforms. We have had money market reform, we have increased 
bank capital, we have taken leverage out of the system. All of 
the components of the ecosystem have gotten safer.
    I don't think anybody can tell you how safe, because we 
haven't gone through the next crisis, right, but we all know 
that every component of the market infrastructure has gotten 
safer. When I think about, how do we get to this point of a 
failure, the failure, again, has to happen where a major 
banking institution, at least one of them, again, I know that 
you are covered for four, and you are covered for two, but 
again, it depends on how bad the world is, a major banking 
institution has to default, and that is your start of the 
    Mr. Bacon. That will be a first indication?
    Mr. Dabbs. Yes, that is when you know. In our minds what we 
would call that is your stress event.
    Mr. Bacon. Yes.
    Mr. Dabbs. Right? And then, do we just stay in stress zone, 
or do we get to a recovery zone or do we get to a resolution 
zone, but our goal that all of us have kind of focused on is 
the resiliency, and that is how do we respond when we hit that 
stress moment how do we respond, and what tools and what 
infrastructure have we built for readiness for that stress 
moment, because that, to me, is the real time when all of this 
    Mr. Bacon. Okay, thank you.
    Mr. Salzman and Mr. Dabbs both for this next question. When 
should a regulator step in and trigger its resolution powers?
    Mr. Salzman. Well, I mean many people believe, and I know 
Mr. Gerety believes, that Title II is the authority to the 
FDIC, and I agree with that with respect to certain 
clearinghouses, but there are actually definitions in there 
that raise a question as to whether that applies to every 
clearinghouse under all circumstances.
    Right now, my guess is whatever the law is, the FDIC would 
be the one who would step in, and nobody would really have, 
despite my legal background in technicalities, I don't know 
that anybody could really stop them once they did step in.
    The real point here is the timing of when they should step 
in. Remember, we have all spent 2\1/2\ to 3 years creating 
plans to deal with how do we avoid getting to resolution. How 
do we have resilience so that when one bank fails, nothing 
really happens? We employ a bunch of the stuff, everybody opens 
the next day, everything is good. Two or three banks fail, we 
start using these pools of money, we can still open the next 
day, everything is still good.
    What happens past then? Well, we have been required by our 
regulators and by European regulators to have ways to 
distribute losses and still keep working. The question is, is a 
Federal regulator, the FDIC, going to step in and do something 
else that differs from the plan that everybody else has 
accepted and that has been worked through in the industry. We 
think that is a bad idea. We don't know what is going to 
happen. Nobody knows what is going to happen.
    Mr. Dabbs. Yes, my view on this would be there are a few 
things. First, from a resolution perspective, it is my opinion 
that whatever the resolution authority is, when they step in 
all they are going to be doing is distributing funds. There is 
no high-functioning moment at that point, it is who is at the 
table at stress and recovery that is the key. The actual 
resolution process is now the clearinghouse is defunct and now 
it is just distributing whatever funds are left over. And so in 
my opinion, the CFTC, for the two CCPs up here, or more broadly 
you could follow the designated regulator under Title VIII of 
all the relevant CCPs, but for up here I would say the two 
CCPs, that CFTC is the expert of their functioning domain. And 
then you want the Fed at the table, just because if you want to 
take any extraordinary actions, the Fed has the most 
credibility to take extraordinary actions, given we don't know 
what the problem is, where it is coming from. We can't predict 
what that is, you want the Fed there just to be able to take 
action if there are extraordinary measures that they could do 
at the time that were appropriate.
    Mr. Bacon. Thank you to all five for sharing your 
    And, Mr. Chairman, thanks for the time. I yield back.
    Mr. Lucas [presiding.] The gentleman yields back.
    The chair recognizes the gentlelady from Delaware for 5 
    Ms. Blunt Rochester. Thank you, Mr. Chairman. And thank you 
to the panel. I first want to also thank Mr. Salzman for going 
off-script. It was very helpful what you shared.
    And I heard so much today. I come from Delaware, the 
financial services industry is important to my state, but I 
heard a lot about mitigation and management of risk, about 
interconnectedness and resiliency, safety, and solvency. And my 
question initially was going to be really about the safety of 
the market, but Mr. Dabbs basically started to run through some 
of the answers there as well about the swaps market. I am going 
to ask more of a general question for the whole panel. Are 
there other big-picture changes to the regulation of 
clearinghouses post-Dodd-Frank that we in Congress should be 
watching out for?
    Mr. Dabbs. And like you, I applaud you for going off-script 
as well. I would point in, and in my testimony I also mentioned 
it, but one of the mechanisms that currently is unavailable 
that would enhance the system at a time of stress is for a 
client of a defaulted clearing member, so that is the time when 
we have described as a stress event where a clearing member has 
defaulted, their clients immediately stop paying because nobody 
is going to pay to a bankrupt entity or a defaulted entity. And 
so what that does is you then have a regulator come in and you 
also have a trustee come in, and they can't tell the difference 
between a good client, which is they have the finances 
available to pay, they just won't pay it because it is 
defaulted, and a bad client, who is actually insolvent as well. 
When a regulator comes in they can't tell the difference, and 
immediately you want to decipher between where are my problem 
areas within that defaulted clearing member, and where are my 
areas that are fine and just need to be ported out to a new 
    Establishing a mechanism that is a very temporary mechanism 
that allows an end-user to make payments to a clearinghouse 
during the default of their member would not only make the 
system easier for the regulators and the trustee to manage, but 
it would also increase the liquidity at which the clearinghouse 
requires during that time. Instead of the clearinghouse needing 
to go source that liquidity because those clients have stopped 
paying, those clients would be able to continue to pay and 
receive, and so you would decrease the size of the problem and 
provide more transparency.
    In my opinion, that would be a very simple, simple in the 
sense that nobody is going to argue with it in the ecosystem, 
but it still needs to find an avenue between Bankruptcy Code 
and the Commodity Exchange Act, where that could actually work 
and function.
    Ms. Blunt Rochester. All right.
    Mr. Salzman. We have been working with Mr. Dabbs for years 
to find this type of solution, and we are in the process, but 
unfortunately at this point it is only going to work for very 
large clients, not for smaller clients, I don't think, because 
you have to have everything prearranged, and it is expensive.
    Mr. Dabbs. Yes, this is slightly different, so this is a 
new one.
    Mr. Salzman. Well, again, but the fact is in order for 
there to be proper banking relationship so these cash flows can 
work the next day, you have to have a lot of stuff prearranged, 
including a prearranged place to go to another clearinghouse. 
And we do that for swaps to a certain extent. To futures, it 
has been more difficult, and there are problems with the 
Bankruptcy Code. And we are happy to have technical meetings 
with your staff, who, by the way, I want to compliment the 
staff. The preparation for this hearing is about as good as I 
have ever seen. It is really great.
    Ms. Blunt Rochester. And my second question, Mr. Gerety, 
last year the CFTC conducted stress tests of the 
clearinghouses. What were some of the key lessons of those 
tests, and how could those tests be improved?
    Mr. Gerety. Thank you for that question. It is very 
important, obviously, as I was not a staff member of the CFTC, 
I can't speak to all of the lessons learned, but as Mr. Hill 
mentioned earlier, the general set of stresses found that the 
existing resources across the CCP landscape were sufficient.
    The places where additional work probably should be done, 
and needs to be done, is on the interaction effects. Because of 
the concentration of derivatives markets, if a large clearing 
member fails at one, they are also very, very likely to be 
members of other CCPs. There is a coordination element to that, 
which is just the simple communication and collaboration of 
knowing who will communicate what to whom and at what time. 
That is a very important part that could be, and is already 
being worked into stress tests. And then there are also 
liquidity elements, and Governor Jay Powell talked about that 
earlier, to make sure that the liquidity flows in the system as 
a whole would be sufficient and prearranged, those are two 
    The stress tests themselves were successful, but the 
collaboration between multiple sets of CCPs and multiple 
clearing members is a place where more work can and is already 
being done.
    Ms. Blunt Rochester. My time has expired. Thank you.
    The Chairman [presiding.] Mr. Dunn, 5 minutes.
    Mr. Dunn. Thank you, Mr. Chairman.
    Let me start by saying I certainly have enjoyed the 
opportunity to listen to five such learned financial leaders. 
It is important for us to understand the mechanisms of the 
clearinghouses and the processes by which they might fail. It 
has been a great deal of fun for me.
    But I am going to ask you a question that Joe Citizen on 
the street might ask. I want something that is maybe a little 
more visceral and palpable to our constituents back home.
    Your clearinghouses are full of treasury bills, and those 
assets are central to mitigating the risks that you manage. In 
the past, we talked about here in Congress, and it is said 
about us that we are talking about raising the debt ceiling, 
and maybe we won't, maybe we will fail to pay all or part of 
the United States' obligations. No big deal, I don't think we 
are going to do this, by the way, but the argument is made that 
this will somehow affect, we actually will perhaps default on 
our interest. And what I want to know is how do the 
clearinghouses respond, how would you value U.S. debt, how 
would you respond to that? I will start with Mr. Salzman, if I 
    Mr. Salzman. Well, right now, clearinghouses that take 
treasuries and other kinds of collateral, we value them each 
night. If there were some fear that interest might not be paid 
and the value of treasuries went down, the clearinghouses would 
automatically revalue all the collateral they are holding. Some 
collateral might go up in value, some would go down.
    Mr. Dunn. You are chasing the market on the U.S. debts.
    Mr. Salzman. And we would require our clearing members to 
come up with additional collateral if the value of their 
collateral went down.
    In addition, at the same time the collateral is going down 
in value, obviously, the value of contracts is changing, and so 
to the extent that there are losses on these contracts, those 
people who have bigger losses than were expected would be 
required to pay, and, of course, we would then pay over the 
money to the people who can't----
    Mr. Dunn. Do you ever reprice intraday or just once a day?
    Mr. Salzman. For futures we price intraday, for swaps we 
price once daily. Futures we price about 1 o'clock.
    Mr. Dunn. How does that affect the value, or what does 
that--in your clearinghouse you are going to stay solvent, no 
    Mr. Salzman. We stay solvent----
    Mr. Dunn. I mean we do something terribly stupid up here, 
will you stay solvent?
    Mr. Salzman. We will stay solvent as long as you don't 
bring down the banking system, and bring down the bank, which I 
am sure you are not going to do that, please.
    Mr. Dunn. No, I know we are not.
    Mr. Salzman. Good.
    Mr. Dunn. We are not. But I mean these are the questions 
that you hear, and I really wanted something to come out of 
here that the citizenry could understand without creating a 
derivatives market.
    Mr. Salzman. From your point of view, we are prepared for 
changes wrought in the market by ordinary, even extraordinary 
uncertainty. That is all built into the system, 100 years of 
work, it all gets done automatically, and the next morning the 
books are clean.
    Mr. Dunn. Mr. Gerety, you seem to be the pessimist in the 
group here. Would you opine on that?
    Mr. Gerety. Yes. It is difficult to overstate the severity 
of the shock if the U.S. Government failed to pay its interest 
or its obligations of any sort. Can you imagine a scenario in 
which the U.S. Congress made the decision and asked the 
Treasury to pay foreign investors who held U.S. treasuries 
instead of Social Security beneficiaries? I simply cannot 
imagine that scenario. And because of that, the question of the 
debt ceiling it is impossible to overstate the severity of the 
shock both to U.S. citizens and the world financial system. The 
U.S. credit is the single safest asset that we understand in 
the globe. It would cause an immediate repricing of all 
financial securities worldwide, and I am not sure that anyone 
at this table or in the world is prepared for the severity of 
that shock.
    Mr. Dunn. That is an excellent answer.
    Would you answer that, Mr. Steigerwald? Same question about 
if Congress loses its mind and we default on some portion of 
the U.S. debt.
    Mr. Steigerwald. Well, I am mindful that it is an awfully 
delicate issue to address issues involving the operation of the 
U.S. Treasury as a staff member of the Federal Reserve, so I 
don't want to go beyond, say----
    Mr. Dunn. I can give you a hall pass, since we are short on 
    Mr. Steigerwald. Yes.
    Mr. Dunn. Let me ask Mr. Hill instead. You are up, Mr. 
Hill. Same question, we have defaulted up here.
    Mr. Hill. Okay, so I agree with what Mr. Salzman said. 
First, we do hold U.S. treasuries as collateral, but we also 
hold a significant amount of cash. And so assuming it was a 
temporary loss of mind and things resolved itself, I think it 
would be fine.
    I will tell you our experience in running up to, and I will 
be interested if CMEs was different in running up to the prior 
is, we actually saw the value of U.S. treasuries longer-dated 
go up, not down, as we approached the debt ceiling. And so 
though we stopped taking some of the very short-dated 
treasuries, the value of the treasuries we held longer out the 
curve actually went up.
    Mr. Dunn. Glass half full kind of guy. Thank you guys very 
much for those answers. And I thought they might be more 
    The Chairman. The gentleman's time has expired.
    Mr. Dunn. I yield.
    The Chairman. Ms. Plaskett, 5 minutes.
    Ms. Plaskett. Thank you so much, Mr. Chairman. And thank 
you, gentlemen, for being here this morning.
    This is all very fascinating, and, of course, my head is 
just now kind of full with numbers and processes, but it is 
important that we understand how this works, and it is really 
integral to how our money stays safe. I wanted to ask a couple 
of questions that were related to some of the testimony that 
you have given already.
    Mr. Salzman, in your testimony you went through the series 
of precautions to be taken in the case of a defaulting member, 
and that was the waterfall discussion that you gave us. First, 
the collection of initial margin, the default fund 
contributions, the clearinghouse would put it in its own 
capital, its own contribution to the waterfall. Then, if 
necessary, non-defaulting member contributions would be 
involved. And if that were still not sufficient, you would go 
to an assessment of your members.
    Now, have you ever gone to the place where you have to go 
beyond the defaulter's contribution?
    Mr. Salzman. No.
    Ms. Plaskett. That has never happened? And if not, what do 
you feel that says about the resilience of the clearinghouse? 
What does that mean?
    Mr. Salzman. Well, you don't want to make too much because, 
obviously, we are planning for worse.
    Ms. Plaskett. Yes.
    Mr. Salzman. We have seen a lot of things, but nobody can 
guarantee that 1987 is the worst we are ever going to see, or 
that there couldn't be some combination of things.
    We think we are very good, we think we have learned a lot, 
but we know we aren't all-knowing.
    Ms. Plaskett. Yes.
    Mr. Salzman. There is only one that is all-knowing, and so 
we need to prepare----
    Ms. Plaskett. That is your mother.
    Mr. Salzman. We need to prepare.
    Ms. Plaskett. The all-knowing is your mother. I know you 
were thinking God, but----
    Mr. Salzman. At my age, I no longer--yes. We are prepared 
for much worse than we have seen. Much worse than we have seen.
    Ms. Plaskett. Okay, thank you.
    And I know this was discussed in some measure by my 
colleague, Ms. Kuster, with you, Mr. Gerety, but I wanted to 
ask Mr. Steigerwald----
    Mr. Steigerwald. That is it.
    Ms. Plaskett. Yes. That same issue with regard to the 
sufficiency to cover losses that result from default. We know 
that you ultimately may have to step into a manager resolution 
under the orderly liquidation authority that is under Dodd-
Frank, however, just recently in the House the Financial Choice 
Act rolled back some of Dodd-Frank, and the Financial Choice 
Act would repeal some of that authority, in addition to the 
authority of the Financial Stability Oversight Council, the 
FSOC, to designate non-bank financial institutions for 
heightened supervision by the Fed. If that is adopted, what are 
your thoughts on the effects this would have on clearinghouse 
resiliency should a crisis occur?
    Mr. Steigerwald. Thank you. That is quite an important and 
complicated question. Let me----
    Ms. Plaskett. That is how I like to do it.
    Mr. Steigerwald. Let me address first the resolution 
aspects of the issue.
    Ms. Plaskett. Great.
    Mr. Steigerwald. I must say, as I indicated in my opening 
statement, that we should be mindful of the extraordinary 
default management and recovery authorities that central 
counterparties have. I would distinguish central counterparty 
clearinghouses from other kinds of financial companies that 
might be eligible for resolution under Title II.
    Ms. Plaskett. Okay.
    Mr. Steigerwald. Speaking strictly with respect to CCPs, I, 
frankly, see almost no need for resolution whatsoever. My view 
about resolution is that we need to have effective measures and 
the appropriate incentives to make recovery work. Bear in mind 
that the issue in a clearinghouse is not only the allocation of 
losses, as it is in an ordinary bankruptcy, but critically it 
is the effort to reestablish a matchbook to serve the ongoing 
interests, the continuity of those positions for clearing 
members. That is the whole raison d'etre of the clearinghouse; 
it serves as a commitment mechanism to preserve the value of 
open positions struck at market prices in voluntary 
    Ms. Plaskett. And you feel you have the mechanisms in place 
now to do that?
    Mr. Steigerwald. The clearinghouses, in my opinion, have 
various mechanisms that will ensure or best assure the 
coordination and cooperation with clearing members to preserve 
value. It is in their interest as well as the CCP's interest to 
preserve that value.
    We should not get so fixated on money losses. Though they 
may be large in an extreme market circumstance, we have to 
remember the value of the matchbook.
    Ms. Plaskett. Thank you.
    The Chairman. The gentlelady's----
    Ms. Plaskett. Thank you very much, Mr. Chairman.
    The Chairman. The gentlelady's time has expired.
    Mr. Thompson, 5 minutes.
    Mr. Thompson. Thank you, Mr. Chairman.
    Mr. Steigerwald, numerous scholars have written that Title 
VIII of Dodd-Frank creates moral hazards for clearing 
participants by promising government support to a failing 
clearinghouse. They generally argue that account services imply 
a possible bailout of insolvent clearinghouses by the Federal 
Reserve, which might cause clearinghouses and their members to 
be more risky. Despite your ultimate support for the Federal 
Reserve accounts, do you share these concerns? Why or why not?
    Mr. Steigerwald. I do not. In fact, it is incumbent upon us 
to understand the critical distinction between solvency and 
illiquidity. This is an age-old problem. Of course, it goes 
back to Walter Bagehot and his original prescriptions for the 
lender of last resort function. I would say, by comparison to 
banks, it is even simpler to determine that a CCP is solvent 
while it is undertaking default management and recovery 
    The extraordinary powers I referred to that CCPs have 
embedded in their rules to liquidate a defaulter's positions, 
or conduct an auction so that those positions can be assumed by 
other clearing members, or to tear up the positions if it turns 
out that it is impossible to reestablish a matchbook, those 
measures, I believe, are sufficient to restore the 
clearinghouse to a proper matched operating basis. And we 
should not regard that as a problem of solvency; we should 
merely assure that private-sector sources of liquidity are 
operating, or if not, that the Federal Reserve has the 
opportunity to provide temporary secured liquidity to sustain 
the recovery efforts of the clearinghouse.
    Mr. Thompson. Okay, thank you.
    Mr. Dabbs, if the market has lost confidence in a 
clearinghouse, swap participants may stop transacting simply to 
avoid being forced to make the clearinghouse their 
counterparty. How can the market continue to function while a 
clearinghouse is failing, and should the resolution authority 
be empowered to suspend the clearing mandate temporarily?
    Mr. Dabbs. It is a very problematic situation because: 
first, when you have concern about the safety of a 
clearinghouse, what you really have is you have concern about 
its clearing members. That is almost every example. There are 
non-defaulting losses, but your general concern that we are all 
playing towards is that a clearing member has a problem. Your 
willingness to transact on a bilateral basis with 
counterparties is also going to be decreased because in the 
stress situations, if we go back to Lehman, you have concerns 
about who is the good bank and who is the bad bank, who is the 
next guy to fail. And so that is problem number one. I don't 
see necessarily going back to the bilateral market as being a 
good liquidity function. Second, we have had such a large 
migration from uncleared markets to cleared markets that if I 
look out 10 years from now, the size of those uncleared markets 
are going to be significantly smaller. They are getting smaller 
by the day, and they are going to continue to get smaller.
    The ecosystem and the ability for those markets to actually 
function 10 years from now is greatly reduced. We simply will 
not have the infrastructure from a legal perspective, from a 
documentation perspective, and from a technology and 
operational equipment perspective to be able to fall back on a 
bilateral market in 10 years, 5 years.
    Mr. Thompson. Thank you.
    I am going to ask this just briefly to the panel, since we 
will have some different views. What power should regulators 
have when dealing with a failing clearinghouse?
    Mr. Salzman. The regulators currently have emergency power 
to step in and take wide range of actions, but what they have 
done, which is the good thing, is that they have acted in 
advance before there is any failure, and they have caused us to 
spend 2, 2\1/2\ years drafting plans which have preset steps 
that we will take under certain circumstances. Instead of 
trying to get a Commission together, make a determination that 
there is an emergency, and then decide how to act, we have it 
already on paper and the Commission can just say to us, 
``Fellas, this is your plan, you agreed to this, your clearing 
members know what it is, everybody knows what it is, it is in 
your rules, you had better carry it out as it has been 
    That has been the solution. I think it is the right 
    Mr. Thompson. Thank you.
    The Chairman. The gentleman's time has expired.
    Mr. Lawson, 5 minutes.
    Mr. Lawson. Thank you, Mr. Chairman. And welcome to the 
    Probably 2 weeks ago there was a considerable amount, and I 
understand you don't want to get into the political aspect of 
it, but a considerable amount of concern coming from the 
banking community about overturning Dodd-Frank. Mr. Gerety, I 
understood your comments earlier you said that Dodd-Frank was 
not implemented to prevent another financial crisis, but to 
mitigate the impact of another financial crisis that we might 
have on our economy. Please describe the role that a 
clearinghouse may have in helping to mitigate the impact of 
another financial crisis.
    Mr. Gerety. Thank you. I think that is a very important 
point that you make, Representative Lawson, that while it is 
all of our intentions and hopes that financial crises are 
prevented, if we look across the scope of history we know that 
we also need very strong tools to mitigate, because there is no 
possibility of no financial crisis as we look into the stretch 
of the future.
    At the same time, I think that central counterparties play 
a really critical role in the transformation from very large 
and poorly documented bilateral arrangements, with poor credit 
arrangements and worse liquidity arrangements, moving to a 
central counterparty world they can act as very significant 
buffers in terms of making sure that the losses from one are 
prefunded so that the defaulter pays, rather than immediately 
transmitting losses across to other parts of the financial 
system. And just as importantly, they can act as beacons of 
transparency and predictability, as Members of this Committee 
have said, because in the crisis, it is that panic and 
uncertainty even more than the losses that can generate such 
terrible outcomes.
    Mr. Lawson. Okay. And anyone can answer this, because I am 
trying to understand it. The big banks and the commercial banks 
all seem to be on the same page about the amount of paperwork 
and everything that is caused by Dodd-Frank. Is that a 
legitimate concern? Is it overburden, has Dodd-Frank 
overburdened these institutions? What is causing them to come 
together, because normally they are on different spectrums?
    Mr. Dabbs. If I understand the question correctly, the 
question is the burdensome nature of Dodd-Frank. And if I look 
at institutions; peer institutions, our institutions, everybody 
has a team, and I should actually call it an army of people 
over the last 8 years, 7 years, that have implemented the Dodd-
Frank standards, and now continue to operate under those 
    And whether it is measured in paperwork or process, I think 
that there is a level in here where we might have gone too far 
on certain things that are not necessarily beneficial to the 
actual ecosystem. As I mentioned earlier, we have kind of 
ratcheted everything up. Whether it be money market reform for 
asset managers, we have taken leverage out, we have done lots 
of things to the system in all different spheres of the 
ecosystem. And now that we are kind of starting to get to the 
completion of implementation, everybody looks back and says, 
``Okay, well, did we really need this in this, or are we 
solving the same problem twice, and, therefore, adding extra 
burden onto the system.''
    I think that the goal is to find things that are not 
necessarily going to harm the taxpayer or the economy, but yet 
make the system more efficient, because we have increased the 
inefficiencies in the systems by just simply complying with 
    Mr. Lawson. Okay. And this will probably be a quick one 
because I am running out of time. The concerns of the financial 
institutions about all of the issues that they have to go 
through is legitimate, if I understand the latter part of your 
    Mr. Dabbs. Yes.
    Mr. Lawson. Okay.
    And with that, Mr. Chairman, I yield back.
    The Chairman. The gentleman yields back.
    Mr. Allen, 5 minutes.
    Mr. Allen. Thank you, Mr. Chairman.
    And to expand on the banking situation a little bit, from 
your standpoint in the clearinghouse, Mr. Salzman, do you all 
exclusively, we have the large national, almost international, 
banks, and then we have our regional banks that maybe across 
one or two states, and then we have our community banks, which 
are all important to the, as stated, the ecosystem of our 
financial markets. The folks that are getting killed right now 
are the community banks, because the larger institutions are 
able to deal with the compliance issues because they have the 
expertise, and they have to keep that ongoing expertise because 
of their business model.
    Who does a clearinghouse typically do business with? Is it 
just large banks, or is it regional banks or even community 
    Mr. Salzman. It is the large banks.
    Mr. Allen. It is the large banks.
    Mr. Salzman. Yes. I mean the smaller banks come to us 
through the larger banks indirectly.
    Mr. Allen. In participations, or something?
    Mr. Salzman. No, not so much in participations, but doing 
their own business, their own hedging through the bigger banks, 
not directly. We do not face them.
    Mr. Allen. Okay. Largely under the Financial Choice Act 
that we passed, basically it deals with banks that are 
community banks, banks that have a fairly conservative business 
model, and did that Choice Act affect your relationship as far 
as the big banks were concerned?
    Mr. Salzman. No, not with the big banks. And what you are 
doing for the small banks, as I say, I am trying to stay out of 
politics, so----
    Mr. Allen. You can't stay out of politics.
    Would anybody want to take on that question?
    Mr. Gerety. It is worth highlighting, when I was the 
Assistant Secretary for Financial Institutions at the Treasury 
I spent dozens and dozens of hours a year with hundreds of 
community bankers. That was a significant part of my role. It 
is important to make distinctions even within the community 
banking space in terms of the resources and the size of the 
institution that we are talking about.
    If you take a community bank with $100 million in assets, 
the right way to think about that community bank is as a small 
business. They will often have $1 million, or less than $1 
million in net earnings over the course of a year. When you get 
to about the $10 billion frame, you are talking about quite 
large enterprises that might have, on average, about $100 
million in their profit earned each year. Even within the 
community bank space, it is important to keep our focus on what 
are the reforms doing and what can be done to simplify the 
world for the smallest of the community banks. Those community 
banks also tend to serve the areas that are more rural and 
lower income as a general matter.
    Mr. Allen. Exactly.
    Mr. Gerety. As it relates to clearinghouses more generally, 
any community bank of whatever size has interest rate risk. 
That interest rate risk ultimately finds its place in global 
financial markets. And so when community banks are managing 
that risk, they do rely on the strength and stability of the 
central counterparties.
    Mr. Allen. And that is why I was asking about your impact 
on those community banks because they loan to small business, 
and their risk model is totally different. It is built on 
relationships. And small businesses create 70 percent of all 
new job growth, and that is what we have to do is create jobs 
in the country. And I just wanted to see kind of how you played 
out in those risks.
    This is a question for anyone on the panel. The Federal 
Government is guaranteeing a lot of debt out there. You have 
the mortgage industry that depends on Fannie Mae and Freddie 
Mac, your industry, lots of people are depending on the Federal 
Government to back the debt. Any of you have any idea what 
percentage of all debt is backed by the Federal Government, and 
is that a danger to the whole system? I mean I have heard 
numbers as far as like 60 percent of all consumer, business, 
debt is backed by this Federal Government. Does anybody have 
the answer to that question?
    Mr. Gerety. While I don't have a precise answer to the 
question, one simple way to think about that question is think 
about the size of large debt markets. The global treasury 
market is about $10 trillion, the global mortgage market is 
about $10 trillion. If you just take in very rough numbers, 
those obviously are not precise numbers, you can take, if you 
look at the size of aggregate debt markets, the two largest 
debt markets in the world are U.S. mortgages and U.S. 
    Mr. Allen. Yes.
    Mr. Gerety. And those are obviously at this point 
    Mr. Allen. Right.
    Mr. Gerety. When you look into consumer credit, outside of 
mortgage you find very little, and similarly in the small 
business space, outside of the SBA, which is obviously a 
different arrangement.
    Mr. Allen. And the concern there, and I know I am out of 
time, is that when one goes out, it is not like a domino 
effect. And that is a very big concern, getting back to Mr. 
Dunn's question.
    I yield back.
    The Chairman. The gentleman's time has expired.
    Mr. Soto, 5 minutes.
    Mr. Soto. Thank you, Mr. Chairman.
    I had a different concern about our cybersecurity of our 
clearinghouses. It would be great to hear from Mr. Dabbs, Mr. 
Hill, or any other member of the panel who wants to comment on 
how well protected are these clearinghouses from cyber attacks?
    Mr. Hill. Thank you for the question. And I will 
acknowledge, as Mr. Dabbs did earlier, I am not a cybersecurity 
expert, but I noted earlier that the number one topic that we 
have spent time and resources on over the last 3 years has been 
cybersecurity. Fundamentally, we operate exchanges and 
clearinghouses that depend on technology, and our customers 
depend on that technology being up and available. We move 
billions of dollars every day across that technology. There 
couldn't be a more important topic. Examples that, again, Mr. 
Dabbs noted earlier, we do similar things where we do employee 
education, we do phishing tests on our employees. We invest a 
significant amount in ensuring that we can detect intrusions, 
prevent them, of course, is the first goal, but then to detect 
the intrusions. We run red and blue teams where we have one of 
our own teams that we have attack our exchange. We pay third-
party firms to attack our exchange, all in order to learn 
lessons and build better defenses. There is not a more 
important topic at our senior management and board level.
    I would be happy to introduce you to our head of 
information security who could give you far more details than I 
can, but I assure you it is topic number one on our agenda.
    Mr. Soto. Are there generally multiple locations that you 
all store data sort of as a redundancy network? I know they do 
that with the stock market currently.
    Mr. Salzman. Yes, it is not just storing data, we 
essentially have to have a second facility that is more than 
400 miles from our first facility, that can be brought up in 
under 2 hours now.
    Mr. Hill. Two hours.
    Mr. Salzman. And so we run that test regularly. Even in our 
first facility, the redundancies in terms of the different 
electrical systems coming in, plus they have a set of back-up 
generators, they have six of them that look like the biggest 
jet engines you have ever seen. I don't know if anybody has 
been there. But they test them once a month, I was there when 
they did, and when they test them, they blow the walls off the 
building, and they fire up these generators, and they have 
50,000 gallons of diesel to run in case two different 
electrical sources go down.
    Not only do they have strength at the original facility, 
but they have a separate facility, everything is tested. That 
is not the problem. The real problem are cyber intrusions, 
which is something that we are working on every day. And I must 
say, the CFTC has required our board, at the board level, not 
just the management level but the board level, to bring in 
outside experts and to have prepared remarks and discussions at 
board meetings all the time.
    Mr. Soto. Has there been any recent, over the last 5 to 10 
years, successful cyber attacks on any of our clearinghouses?
    Mr. Salzman. It just depends on what you mean by 
successful? There are literally hundreds of attempts to get 
into every financial system in this country, every day. 
Hundreds is an understatement.
    Mr. Soto. I guess successful, I would define as an 
interruption in the clearinghouse procedures.
    Mr. Salzman. No, not that I am aware of. Not for us, 
nothing like that.
    Mr. Hill. Or us.
    Mr. Soto. Thank you.
    I yield back.
    The Chairman. The gentleman yields back.
    Well, gentlemen, thank you very much for being here this 
morning and testifying for us. We certainly appreciate that.
    Just a couple of nits and nats. On a clearinghouse, is 
there, in fact, a bright line between illiquidity and 
insolvency? Mr. Steigerwald.
    Mr. Steigerwald. In the broader context, that is always a 
very tricky----
    The Chairman. Because at the heart of the fight, when it is 
at the speed of light happening, can regulators tell the 
    Mr. Steigerwald. In the context of central counterparty 
clearinghouse, it is simpler to make that distinction than in 
general banking organizations. The matchbook that the 
clearinghouse operates is crystal clear; it needs to 
intermediate all of the sellers and all of the buyers. That is 
very easy to see. When a default occurs, it destroys a part of 
that match, and the clearinghouse's immediate exercise is to 
restore that match.
    The regulators, the CCP itself, and its clearing members, 
frankly, don't have to engage in the kind of speculative 
valuation of capital assets in order to determine whether the 
clearinghouse is viable.
    The Chairman. While the clearinghouse is still functioning, 
even though it has a major clearing member who has defaulted, 
which, I assume, triggered this issue, they are able to keep 
matching that up.
    But getting back to Mr. Dabbs' comments about shifting your 
customers of that customer, being able to go directly to the 
clearinghouse or whatever, all that analysis everything, 
someone else stepping in to that point in time and deciding is 
this illiquid or is this insolvent, it can't be particularly 
crystal clear, can it?
    Mr. Steigerwald. Well, again, all of these issues are 
terribly complicated, no doubt about that, but again, it is 
relatively clear, the clearinghouse either liquidates in open 
markets the defaulter's position, or conducts an auction so 
that those positions can be assumed. There is a very regular 
process for making that happen. And if, for some reason, those 
processes do not restore a matchbook, the clearinghouse has 
tear-up authority which would, in effect restore the 
clearinghouse to a match.
    Mr. Dabbs. I----
    The Chairman. Okay. Real quick.
    Mr. Dabbs. And just to make a quick point, I think that one 
of the major differences between a CCP and a banking 
institution is it is much easier to identify the assets and 
liabilities of a CCP, relative to the banking organization. The 
banking organization just has so many tentacles----
    The Chairman. Right. But still even a CCP has assets 
related to customers, that you talked about.
    Mr. Dabbs. Exactly. They are segregated at all times so you 
know what your assets are here, what shape of liquidity, but 
you know how much they are worth here, and then you have your 
liabilities, which is what are the clearing members' 
obligations that aren't being paid. It is just the math is 
easier just because there aren't as many moving components of 
things that get revalued.
    The Chairman. Okay. Unrelated, Mr. Hill, you mentioned that 
the Fed pays above-market rates on their deposits. Banks in the 
dark ages, when I was in banking, we would only pay higher 
interest rates if we needed deposits. Does the Fed need 
deposits, is that why they are paying higher interest rates? Is 
there a stated reason why that is the case?
    Mr. Hill. I can't speak to Fed policy. I will revert to 
what I said thought, for us, it is not about the return, it is 
about the security.
    The Chairman. Right.
    Mr. Hill. I don't know the policy aspects of that decision.
    The Chairman. Okay. One of the things I hope is clear today 
is that we have established there is relatively limited risk to 
the taxpayers of the country to allow all clearinghouses access 
to Fed account services, and in very narrow, specific 
transactions, access to the Fed window. And so hopefully that 
came clear with the testimony.
    Again, thank you very much for being here this morning.
    Under the Rules of the Committee, the record of today's 
hearing will remain open for 10 calendar days to receive 
additional material and supplemental written responses from the 
witnesses to any question posed by a Member.
    This hearing of the Committee on Agriculture is adjourned. 
Thank you all.
    [Whereupon, at 12:01 p.m., the Committee was adjourned.]