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CFTC Market Risk Advisory Committee Meeting

Commodity Futures Trading Commission

Market Risk Advisory Committee Meeting

Tuesday, June 2, 2015    

Key Topics & Takeaways 

  • CBEST: Bank of England’s Evans gave a presentation on the CBEST program, noting that it was started one year ago to create a common framework for cybersecurity testing that would be repeatable, scalable, and allow line supervisors to take information from the testing and have conversations with the organizations they regulate. 
  • Liquidity is in the Eye of the Beholder: Deutsche Bank’s Murray noted the difficulty in defining liquidity simply, stating that it “is in the eye of the beholder,” as a market participant engaging in a block transaction will have a different perspective than those trading single-size transactions, or in different markets 
  • Increasing Cost of Capital: KCG Holdings’ Chang said that, from the perspective of a market maker, as the cost of capital goes up, it will impact the availability of liquidity, saying “banks are rational in the way they allocate capital to their customers,” and that there is no way the cost of funding is going to be anything but “a lot more expensive.” 
  • Regulation’s Liquidity Impact: Goldman Sachs’ Yared stated that liquidity is conditional and impacted by volatility, also noting that regulations, including capital requirements, the SLR and NSFR, are “causing substantial challenges on both the executing broker and the clearing broker side” 

Meeting Participants

Opening Statements

Sharon Bowen, Commissioner of the Commodity Futures Trading Commission (CFTC) and sponsor of the Market Risk Advisory Committee (MRAC), stressed in her opening statement that the importance of having cybersecurity measures in place “cannot be overstated.” She also expressed interest in hearing the panelists’ views on what liquidity means, what causes liquidity levels to change, and what actions the CFTC could take to address liquidity issues. 

CFTC Chairman Tim Massad and Commissioner Mark Wetjen thanked the panelists for their participation and echoed the statements of Commissioner Bowen.  Commissioner Giancarlo was not present at the meeting but submitted an opening statement online. 

Panel 1: Cybersecurity – Considering Bank of England’s CBEST Program

Presentation

David Evans, Senior Manager, Bank of England (BoE), gave a presentation on the CBEST program, noting that it was started one year ago to create a common framework for cybersecurity testing that would be repeatable and scalable. He noted that the BoE wanted to build a process that would allow line supervisors to take information from the testing and have conversations with the organizations they regulate. He noted that the steps of the program are the same for all institutions but the content of these steps is unique to each individual institution. 

Evans noted that the program consists of: 1) accreditation of the testing organizations; 2) threat intelligence testing, where the scope and goals of the test are agreed to by the institution along with regulators; and 3) post-test analysis, where remediation plans to address security gaps are agreed to by the institution and regulators and progress is monitored through routine engagement. He added that the testing process takes about six months, with the actual test lasting about four to six weeks. 

Question and Answer

Kristen Walters, Global Chief Operating Officer of Risk and Quantitative Analysis Group, BlackRock, asked what findings and performance metrics have resulted from the BoE’s testing thus far.  Evans said the results from tests are not shared outside of the individual institutions, but noted that the BoE has received positive feedback about the framework. 

When asked what types of institutions participate in the testing, Evans said all kinds of market participants have been involved, including buy and sell side firms and clearinghouses. 

Anat Admati, Professor of Finance and Economics at Stanford University Graduate School of Business and representing Better Markets, said this type of testing is primarily about safety and asked if it would eventually become mandatory for the industry. Evans said he did not know if CBEST would become mandatory, but highlighted that over 90 percent of institutions want to take part in the program. 

Andrew W. Lo, Director, Massachusetts Institute of Technology’s Laboratory for Financial Engineering, asked how many firms are accredited, if CBEST tests social engineering, if software firms are examined for weaknesses, how much the testing cots, and if the threats are looking to disrupt market activity or steal information. Evans replied: 1) that six penetration firms and four threat intelligence firms are accredited and three to five firms’ applications have been rejected; 2) that social engineering has been used in some tests, but only if these methods were used by identified threat actors; 3) that the BoE does not have data to show software firms are a weak link; 4) that costs are dependent on size and duration of the testing; and 5) that the BOE is looking for threats that undermine financial stability and compromise data. 

Jerry Perullo, ICE, noted that his institution engaged in a “CBEST-lite” and said there were questions and challenges that arose by having a regulator “at the table.” He highlighted that scope issues can arise if an organization has subsidiaries overseas, where the regulator does not have jurisdiction.  He also said the test results and lists of vulnerabilities are “high risk assets” and that he does not want regulators to have this kind of document due to security concerns. Evans agreed that these concerns are “valid challenges.” 

Massad noted that the U.S. has mechanisms for sharing information such as the FS-ISAC, but that this is not tied to a specific testing regime. He asked what the similarities and differences are between the U.S. system and CBEST.  Evans said both mechanisms are peer-to-peer sharing systems and noted that CBEST is not trying to undermine any other mechanisms out in the market. 

Robert Wasserman, CFTC Chief Counsel, Division of Clearing and Risk, said CBEST is tailored to individual organizations while the FS-ISAC is meant for a more broad distribution of information. He also noted that just because an organization has affiliated entities does not mean that regulators have scope over them, but added that regulators’ concerns do not change if functions are outsourced. He added that the CFTC is well aware of the security concerns of sensitive testing documentation and the importance of keeping it secure.  David Taylor, CFTC Associate Director, Division of Market Oversight, said the two types of involvement would be mutually beneficial. 

Panel 2: Liquidity in the Derivatives Market

Guest Panelists

Susan McLaughlin, Senior Vice President, Federal Reserve Bank of New York and moderator, asked the panelists to define “liquidity.” 

Piers Murray, Managing Director, Global Head of OTC Derivatives Clearing & Prime Brokerage, Deutsche Bank, noted the difficulty in defining liquidity simply, stating that it “is in the eye of the beholder,” as a market participant engaging in a block transaction will have a different perspective than those trading single-size transactions, or in different markets (i.e., foreign exchange and equity markets vs. interest rate markets). He noted that liquidity generally means having the ability to transact an asset without affecting its price. 

Isaac Chang, Global Head of Fixed Income, KCG Holdings, stressed the challenges in measuring and monitoring market liquidity in a manner which looks to the linkages between products, as opposed to an isolated view, and specifically highlighted differences between the Treasury futures and OTC cash Treasury market as one example.  He noted that, while linked, each asset class has different market and information structures, making it extremely challenging to measure or monitor liquidity. Chang added that measuring liquidity might be impossible due to the lack of information about the entire market and stressed the challenge faced by regulators in trying to monitor liquidity as a whole. 

Thomas Wipf, Managing Director, Global Head of Bank Resource Management, Morgan Stanley, next stressed the impact infrastructure, central clearing, and settlement issues have on market liquidity.  

Chang added that, from the perspective of a market maker, as the cost of capital goes up, it will impact the availability of liquidity, saying “banks are rational in the way they allocate capital to their customers,” and that there is no way the cost of funding is going to be anything but “a lot more expensive.” 

Panelists also raised the impact of current differential pricing at LCH and CME.  Wipf noted that such basis differential highlights that imbalances exist, and said there is a cost factor in determining where to clear that will likely impact pricing.  

Impact of Regulations

Rana Yared, Managing Director at Goldman Sachs, stated that liquidity is conditional and impacted by volatility, further noting that regulations, including capital requirements, the supplementary leverage ratio (SLR) and net stable funding ratio (NSFR), are “causing substantial challenges on both the executing broker and the clearing broker side,” as both must determine the most “economically efficient” way to deploy capital. Yared stated that clearing trades has served to contravene G20 clearing goals, as capital and liquidity regimes have imposed punitive treatment on cleared trades. As a result, she said, there would be risk that “significant hedging, that should happen, remains undone in the market” and “a significant bifurcation in pricing between cleared and uncleared trades which could also potentially impact liquidity in the market.” 

Luke Zubrod, Director of Risk and Regulatory Advisory Services at Chatham Financial, next described the difficulties that small and mid-sized companies seeking to establish trading relationships with banks may encounter due to the increased cost of doing business for banks in light of capital regulations, “know your counterparty” (KYC), legal entity identifier (LEI), and pre-trade documentation rules.  Zubrod noted that in light of these regulations, the cost burdens associated with establishing such relationships may be too great for banks to justify.  

John Nixon, Group Executive Director, Americas, ICAP, further stressed that the implementation of new regulatory requirements has increased the cost of capital, and banks are thus less apt to take on risks.  He noted that “the market is less liquid than before because there is an absence of a major player that was there was previously,” and that while there are some market makers stepping in, “they’re not going to fill the void of what has been probably taken out of the marketplace.” He added that, in the future, when markets move it will be more difficult to hedge and transact because there will be fewer counterparties to take the other side of a trade.  

Lo noted that the characteristics of liquidity have changed, part of which may be intentional, and that “the fact that capital requirements are higher, many would argue is a feature, it’s not a bug.”  He further stated that it is “important for us to study the entire ecosystem, to try to understand not only how to measure liquidity, but who the participants are in a marketplace, and what their incentives are for providing liquidity.” He also said regulators should study how quickly liquidity can be withdrawn before figuring out if it can be managed and if there are appropriate remedies are for dealing with it through regulatory oversight. 

McLaughlin next asked participants to provide insight on their experiences with decreases in liquidity.  

Access to Markets

Sunil Cutinho, President of CME Clearing, noted that some clients are losing access to markets as rules have increased costs, and that regulators should “make sure that we don’t put in rules or structures in place that limit participation.” He stressed the need for a diverse set of market participants and for regulators to ensure their rules do not limit access. 

Walters stated that while she has not noticed a significant change to the ability to access markets, “the way we do it has changed.”  Walters stated that capacity is more of an issue than liquidity, noting that while liquidity measurements are useful, “they don’t work very well when the market is highly illiquid, and at those times, capacity becomes a very major, and from my perspective, difficult thing to monitor.”  Walters further stated that capacity is a major issue in regards to centralized clearing party (CCP) risk, noting that there has been an impact on clearing members and futures commission merchants (FCMs) “from a capacity perspective of increased regulatory limits” on liquidity, leverage, and risk weighted assets (RWA), saying the “impact is very real.” 

Admati said she is “not a big fan” of liquidity requirements because they can distort market activity, but said that “liquidity it not a birthright” and that it will change as the situation in the market changes. 

Gerald Beeson, Chief Operating Officer and Chief Financial Officer, Citadel, said changes in business models and new technology have allowed new entrants to quote tighter bid/ask spreads and said the markets are more transparent now. He then expressed concern that liquidity is fragmented into different pools, noting that dealer-to-dealer markets are split from other liquidity pools.

Susan O’Flynn, Managing Director and Global Head of CCP Strategy, Governance and Optimization, Morgan Stanley, next noted that emergence of CME-LCH basis is a way for a dealer to create more capacity to continue to trade with clients.  

Capacity

Yared followed up, stating that capacity and liquidity are closely tied together and that banks must make important decisions regarding how they allocate these “scarce” resources.  She further stated that, “ultimately a lot of small risks equal big risk, and we need people in the markets who are willing to take on the large risk of particularly structured end users who need to hedge.”  

Wetjen then asked if there is anything negative or disadvantageous about splitting large orders into smaller ones. 

Yared said conducting smaller orders is not “prima facie” a positive development because execution costs are sometimes based on the number of transactions rather than size and that some market participants would prefer to transact a large order with a professional risk manager who can deal with it more effectively.  

Market Response

McLaughlin then asked how market participants are responding to these conditions. 

Chang said the CFTC should focus on increasing pre- and post-trade data to measure impacts on liquidity, and noted that liquidity provision is “a service that needs to earn an economic rate of return.” 

Wipf said the liquidity coverage ratio (LCR) and the NSFR, while they could be more granular, are “absolutely fundamental” to making sure there is limited reliance on short-term wholesale funding. He also said that there is not yet active participation from the buy-side in the securities financing transaction (SFT) markets, but that capacity could be created here under the current framework. He added “the fact is that at the current price levels the intermediation of high quality collateral, doesn’t meet anyone’s cost of capital.” 

Emily Portney, Global Head of Agency Clearing, Collateral Management and Execution, JP Morgan, highlighted that the number of clearing firms has been drastically reduced and questioned whether, once regulations are fully implemented, markets might reach a point where they are no longer healthy and end users question whether they can hedge at all.  

Jerry Jeske, Commodity Markets Council, noted that because of Basel III requirements, market participants may seek to self clear, taking themselves out of the “bank model,” which would result in an increase of operational risk for end users. 

Nixon stressed that having more participants in the market would provide more liquidity “shock absorbers.” 

Lo noted that the buy-side is being more proactive in measuring liquidity and trading around periods of illiquidity. He added that liquidity is essential to financial stability. 

Marcus Stanley, Policy Director, Americans for Financial Reform, said liquidity failure is a result of crises or instability but stated that higher levels of liquidity during good times do not promote financial stability. 

Closing Comments

Wetjen noted that the CFTC has no control over accessibility as it relates to capital requirements, but said that the Commissions has spoken publically and has been engaged with prudential regulators about these issues.  He noted the following themes from the discussion that the CFTC could focus on: 1) increased transparency; 2) accessibility to trading venues; 3) diversity of liquidity providers; and 4) changes to swap execution facilities (SEFs), including the floor trader exemption. 

Massad said he supports what the bank regulators are trying to accomplish with the SLR, in creating a “backstop” to risk-weighting, but said these goals need to be balanced with the objectives of clearing and end user concerns. He added that he is trying to get to equivalence with Europe on CCP recognition “without increasing costs” and that he supports “all these things being explored in a data-driven way.” 

On FCM concentration, Massad said that the trend of decline “has been happening for many, many years” and noted that many of the firms that disappeared did not hold customer money. He explained that concentration among the top 20 firms “has remained essentially the same” over 10 years, while noting that customer funds have increased and the top 10 firms have increased their holdings. Massad said that this situation is a “more complicated picture” than discussion has described and that other impacting factors include change in business models, low interest rates, and customer preferences. 

When asked for suggestions to improve the market situation, Murary expressed a need for longer implementation periods to create more certainty. Chang said there is a need for a coherent regulatory approach “across all the markets.” Wipf suggested finding ways to create new capacity in the current framework, particularly in SFT markets. 

For more information on this meeting and to view an archived webcast, please click here.