[House Hearing, 115 Congress]
[From the U.S. Government Publishing Office]
CLEARING THE NEXT CRISIS: RESILIENCE,
RECOVERY, AND RESOLUTION OF
DERIVATIVE CLEARINGHOUSES
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTEENTH CONGRESS
FIRST SESSION
__________
JUNE 27, 2017
__________
Serial No. 115-8
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]
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agriculture.house.gov
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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
SCOTT DesJARLAIS, Tennessee MICHELLE LUJAN GRISHAM, New Mexico
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
ROGER W. MARSHALL, Kansas LISA BLUNT ROCHESTER, Delaware
DON BACON, Nebraska
JOHN J. FASO, New York
NEAL P. DUNN, Florida
JODEY C. ARRINGTON, Texas
______
Matthew S. Schertz, Staff Director
Anne Simmons, Minority Staff Director
(ii)
C O N T E N T S
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Page
Conaway, Hon. K. Michael, a Representative in Congress from
Texas, opening statement....................................... 1
Prepared statement........................................... 3
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 4
Witnesses
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
CLEARING THE NEXT CRISIS: RESILIENCE,
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.
OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE
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
right.
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.
STATEMENT OF HON. COLLIN PETERSON, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF MINNESOTA
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
questions.
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.
STATEMENT OF ROBERT S. STEIGERWALD, J.D., SENIOR
POLICY ADVISOR, FINANCIAL MARKETS GROUP, ECONOMIC RESEARCH
DEPARTMENT, FEDERAL RESERVE BANK OF
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
circumstances.
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
referenced.
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
intermediaries).
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.
Conclusion
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.
References
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/
publications/policy-discussion-papers/2017/pdp-2017-01-pdf.pdf.
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/
art%253A10.1023%252FA%253A1026527607455.pdf?auth66=1414692400_456528ae7
9e2853af58f2969790553e2&ext=.pdf.
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://
www.ecb.europa.eu/pub/pdf/scpwps/ecbwp298.pdf.
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://
www.minneapolisfed.org/research/qr/qr2512.pdf.
\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/
publications/the-region/thoughts-on-the-feds-role-in-the-payments-
system.
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:
https://www.chicagofed.org/ /media/publications/economic-perspectives/
2013/2q2013-part1-marshall-steigerwald-pdf.pdf.
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/
abstract=935335.
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/
futureofpayments/background.pdf.
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-
berlin.org/fileadmin/downloads/working_paper/ipe_working_paper_19.pdf.
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/
iss3/8.
Attachment
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
authors.
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
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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
contract.\3\
---------------------------------------------------------------------------
\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
transfer
systems
Foreign 2,067.9 11.6 23.5
exchange
settlements
Central 5.8 7.4 12.5
counterpart
ies (CCPs)
d
Central 1,101.7 e 55.8 129.5
securities
depositorie
s (CSDs) d
Government 7,646.0 6,408.4 6,408.4
securities
clearing f
Retail 159.8 159.8 159.8
systems
-----------------------------------------------------------
Total for 14,934.2 9,069.1 9,111.8
participa
ting
firms
------------------------------------------------------------------------
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
performance.
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
stability.
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
markets.\4\
---------------------------------------------------------------------------
\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
context.
---------------------------------------------------------------------------
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
obtained.
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
(2009).
---------------------------------------------------------------------------
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
quantified.
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.
Finality
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.
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.
Interconnectedness
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
systems.
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
limits.
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
systems.)
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
(1995).
---------------------------------------------------------------------------
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
securities.
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
system.\14\
---------------------------------------------------------------------------
\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
specified.
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
losses.
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
markets.\1\
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
methodologies.
---------------------------------------------------------------------------
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
crisis.
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/
wiki/Black_Monday_(1987).
---------------------------------------------------------------------------
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.
Sentinel
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.
Discussion
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
years.
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
itself.
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.
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payment-systems-survey-2008.html.
The Chairman. Thank you, sir.
Mr. Hill.
STATEMENT OF SCOTT A. HILL, CHIEF FINANCIAL OFFICER,
INTERCONTINENTAL EXCHANGE, INC., ATLANTA, GA
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
products.
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
Introduction
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
clearing.
Background
Since launching an electronic over-the-counter (OTC) energy
marketplace in 2000 in Atlanta, Georgia, ICE has expanded both in the
U.S. and internationally. Over the past 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/
cpss101a.pdf.
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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
approval.\4\
---------------------------------------------------------------------------
\3\ Supra, nt. 1.
\4\ For an overview of ICE central clearing operation and
governance see: https://www.theice.com/publicdocs/
Central_Clearing_Reducing_Systemic_Risk.pdf.
---------------------------------------------------------------------------
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
funds.
---------------------------------------------------------------------------
\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
on-boarding.
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
situation.
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
two).
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.
Conclusion
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.
STATEMENT OF JERROLD E. SALZMAN, LL.B., OF COUNSEL,
DERIVATIVES; LITIGATION, SKADDEN, ARPS, SLATE, MEAGHER & FLOM
LLP, CHICAGO, IL; ON BEHALF OF CME GROUP
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
matchbook.
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.
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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
clearing.
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/
cpmi/publ/d101a.pdf.
\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
http://www.bis.org/cpmi/publ/d121.pdf.
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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
processes.
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
funds.
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
available.
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
customers.
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
involved.
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
recovery.
Thank you for your consideration of CME Group's views on these
significant issues.
The Chairman. Thank you, sir.
Mr. Dabbs.
STATEMENT OF JOHN DABBS, GLOBAL HEAD OF PRIME DERIVATIVES
SERVICES, CREDIT SUISSE, WASHINGTON, D.C.
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
clearing.
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
business.
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
CCP.
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
resolution.
[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.
Introduction
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
affiliates.
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.
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\1\ Clearing members do not guarantee the financial obligations of
the CCP to their clearing clients.
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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
regulations.
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
withdrawn;
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
member[;]
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
assessments.
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
jurisdiction.
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.
Conclusion
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
resolution.
The Chairman. Thank you.
Mr. Gerety.
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.
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-
Frank.
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
power.
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
country.
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\
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\1\ http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/
stresstestpresentation11
1616.pdf.
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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
recovery.
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.
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\2\ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD508.pdf.
\3\ http://www.iosco.org/library/pubdocs/pdf/IOSCOPD509.pdf.
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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
resolution.
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
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'
understanding.
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
account.
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?
Jerry?
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
cease.
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
table.
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
proved.
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
soon.
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
process.
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
scenario.
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
matters.
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
expertise.
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
minutes.
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
member.
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
areas.
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
may.
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
matter----
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
time.
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
interesting----
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
transactions.
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
efforts.
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
established.''
That has been the solution. I think it is the right
solution.
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
Committee.
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
standards.
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
Dodd-Frank.
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
statement?
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
banks?
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.
treasuries.
Mr. Allen. Yes.
Mr. Gerety. And those are obviously at this point
guaranteed.
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
difference?
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.]
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