House Agriculture Subcommittee on Commodity Exchanges, Energy and Credit
“To review the impact of G-20 clearing and trade execution requirements”
Tuesday, June 14, 2016
Key Topics & Takeaways
- Basel’s Leverage Ratio: Several witnesses criticized the Basel Committee’s leverage ratio rule, explaining that it makes clearing more expensive and less accessible, failing to recognize how customer collateral reduces exposure. ICE’s Edmonds noted that Basel has indicated that they may rethink their position and has requested additional comments on their proposal.
- De Minimis Exception: Chatham Financial’s Zubrod expressed that Congress should exempt low-volume users from clearing and margin requirements through a de minimis exception, adding that Japan, Singapore, Australia and Canada have either made such an exemption or are proposing one, and concluded that a similar exemption would provide relief to such low-volume users without increasing systemic risk.
- Global Disadvantage: Multiple Members of Congress noted their concern over the competitive disadvantage the U.S. would have due to the E.U. delaying the margin for uncleared swaps rules, to which several witnesses agreed.
- Terrence A. Duffy, Executive Chairman & President, CME Group
- Christopher S. Edmonds, Senior Vice President, Financial Markets, Intercontinental Exchange
- Marnie J. Rosenberg, Global Head, Clearinghouse Risk and Strategy, J.P. Morgan Chase & Co.
- Stephen M. Merkel, Executive Vice President, General Counsel and Secretary, BGC Partners, Inc., on behalf of the Wholesale Markets Brokers’ Association, Americas
- Stephen John Berger, Director, Government & Regulatory Policy, Citadel, LLC, on behalf of the Managed Funds Association
- Luke D. Zubrod, Director, Risk & Regulatory Advisory Services, Chatham Financial
In his opening statement, Subcommittee Chairman Austin Scott (R-Ga.) said that a “vibrant and resilient derivatives marketplace is crucial,” and that the nature of the derivatives marketplace “cannot be taken for granted.” He stressed that while there have been steps towards harmonization between the U.S. and E.U. when it comes to regulations for clearing houses, European Securities and Markets Authority (ESMA) applications for clearing houses in the U.S. remain outstanding. Chairman Scott concluded that G20 leaders have been clear that collaboration and coordination among global regulators is needed when developing market reform frameworks.
In his opening statement, Subcommittee Ranking Member David Scott (D-Ga.) stated that the derivatives market is complex, and Title VII of the Dodd-Frank Act tasked the Commodities Futures Trading Commission (CFTC) and Securities Exchange Commission (SEC) with regulating it, adding that it is essential for the two regulatory agencies to harmonize with each other. Ranking Member Scott noted his concern over equivalency problems between U.S and E.U. implementation rules, as the “mismatch” in timing “has created a slew of problems.”
Terrence A. Duffy, Executive Chairman & President, CME Group
In his testimony, Duffy stressed that the lack of implementing core elements of the G20 regulatory reforms could cause inconsistency, potential harm and uncertainty to the global derivatives markets. He applauded steps towards equivalency taken by the U.S. and E.U., and noted that ESMA is ensuring CME Clearing is recognized as equivalent prior to the June 21 European clearing mandate.
Duffy continued that central clearing increases transparency, reduces systemic risk and strengthens the financial system, and that a clearing house’s core function is to manage risk, not create it. He concluded by criticizing the Basel Committee’s leverage ratio rule, explaining that it makes clearing more expensive and less accessible, failing to recognize how customer collateral reduces exposure.
Christopher S. Edmonds, Senior Vice President, Financial Markets, Intercontinental Exchange
In his testimony, Edmonds explained that global regulators have recognized that clearing houses minimize bilateral risk and that the increase in clearing creates operational and capital efficiencies. He noted that ICE has joined a group of market participants in asking the Basel Committee to reconsider and refine aspects of the leverage ratio rule, adding that Basel has indicated that they may rethink their position and requested additional comments on their proposal. Edmonds stated his encouragement that the U.S. and E.U. regulators reached agreements on margin equivalence standards for central counterparty clearing houses (CCPs) and his hope that global regulators will agree on equivalence between trade execution platforms.
Marnie J. Rosenberg, Global Head, Clearinghouse Risk and Strategy, J.P. Morgan Chase & Co.
In her testimony, Rosenberg explained observations that should be considered by Congress and the CFTC when ensuring markets meet the needs of market participants. These points included: 1) CCPs should be subject to enhanced resiliency standards; 2) robust recovery tools should avoid pro-cyclicality and market destabilization; and 3) resolution plans should ensure continuity of clearing services while minimizing risks to financial stability and to taxpayers.
She continued that more needs to be done by policymakers and market participants in the derivatives clearing market related to the following questions: 1) Whether CCPs are resilient enough that they can handle the default or major loss of a clearing member using defense measures; 2) If CCPs have plans to recover from such a loss and continue offering services; and 3) Whether the CCP has plans to continue to provide their services and ensure it does not cause further market instability or require taxpayer assistance should they be unable to recover.
Stephen M. Merkel, Executive Vice President, General Counsel and Secretary, BGC Partners, Inc., on behalf of the Wholesale Markets Brokers’ Association, Americas
In his testimony, Merkel focused on the following concepts: 1) transitioning to over-the-counter (OTC) trading on regulated platforms is an ongoing process, with its share of challenges; and 2) the global swaps trading landscape requires global coordination, and without it the financial markets will be harmed. He commended the CFTC for helping with the registration process in becoming a swap execution facility (SEF), as well as accommodating numerous no-action letters (NALs), but that it is necessary to codify certain existing NALs. Merkel concluded that the CFTC should regularly analyze market data to study the impact of its rules on the derivatives markets, with results published for market feedback.
Stephen John Berger, Director, Government & Regulatory Policy, Citadel, LLC, on behalf of the Managed Funds Association
In his testimony, Berger stressed that financial reforms have reduced systemic risk, increased protections for investors, promoted competition, and strengthened the financial markets. He noted that clearing has been successful in the U.S., which currently has approximately 75 percent of swaps transactions cleared compared to 2007 when only 16 percent were cleared. However, Berger said, further progress can be made so that customer clearing in the U.S. is affordable and robust, and that the Basel leverage ratio should be modified because it will increase the cost of clearing to customers. He concluded that the CFTC should engage in rulemaking to ensure anonymous access to SEFs so there is an “open, competitive, and level playing field,” and that by promoting central clearing and trade execution in the OTC derivatives market, the goal of reducing systemic risk will be further advanced.
Luke D. Zubrod, Director, Risk & Regulatory Advisory Services, Chatham Financial
In his testimony, Zubrod focused on two barriers affecting financial end users that use low volumes of derivatives: 1) the cost of clearing for low-volume users, with average fees amounting to $100,000 annually or more; and 2) risk imposed by margin requirements expose companies to liquidity risks that many firms are not willing to take on, which could cause the firm to default on their obligation. He continued that while the benefits of clearing were widely understood when Congress created the clearing mandate, the costs were not and do not accommodate low-volume users. Zubrod explained that Congress should exempt low-volume users from clearing and margin requirements through a de minimis exception, adding that Japan, Singapore, Australia and Canada have either made such an exemption or are proposing one, and concluded that a similar exemption would provide relief to such low-volume users without increasing systemic risk.
Question & Answer
Chairman Scott asked what would have to happen to exhaust the resources of a major clearing house. Edmonds explained that more than two of their largest members would have to default on exactly the same day and time, and that it would take a “very stressed market situation, one that is likely unprecedented.” He continued that ICE knows they can sustain two members and possible more, but that if it were more like five or six members, he is “unsure if you’ll be worried about a clearing house at that time…there would be a bigger problem.”
Chairman Scott then asked how the increase in capital has changed concerns about the risk of clearing houses. Rosenberg replied that due to the leverage ratio, they are facing a situation where cash received from their customers is risk reducing because it offsets exposure to the clearing house. She added that it has been impactful from their standpoint in terms of capital that needs to be held.
Ranking Member Scott noted his concern that differing regulations between jurisdictions could put financial firms, clearing houses, and market participants in a competitive disadvantage in the global marketplace. Duffy agreed, adding that market participants are not certain what rules or regulations will be due to differing timelines, or what jurisdictions they can participate in.
Rep. Frank Lucas (R-Okla.) commented that no one wants the U.S. industry to be at a disadvantage and asked for a global status update. Rosenberg commented that the European Commission is drafting legislation on CCP recovery and resolution, which is expected closer to the end of the year or next year. She continued that it must be ensured that any legislation developed in Europe does not cause differences with U.S. rules and our legal environment. Rosenberg added that the Financial Stability Board (FSB) is in the process of developing global standards regarding resolution planning for clearing houses, and encouraged Europeans and CFTC Chairman Timothy Massad to ensure those standards developed are consistent across Europe and the U.S. Duffy added that “it would be nice” to have a uniformed approach regarding stress testing across the globe but until then it is important that they be overseen by U.S. regulators.
Rep. Pete Aguilar (D-Calif.) noted the global nature of the derivatives market and asked about how the financial regulatory structure in other countries will impact the swaps market. Rosenberg explained that enhancements could be made in the U.S. to curtail current market fragmentation seen between Europe and the U.S., and that she expects European regulators to develop specific rules around SEFs going into next year. Merkel agreed, adding that he has seen “good intentions” on part of the CFTC to try to lead and get other jurisdictions to harmonize forms of execution but “it didn’t work.” He continued that at some point, U.S. firms may not be able to do business in Europe easily and “it will be unfortunate.” Berger added that the European regime is “a few years behind [the U.S.],” as clearing is just being phased this year. Zubrod added that due to exemptions to clearing and margin in Singapore, Australia, Japan and Canada, those countries will not be unnecessarily burdened like the U.S. will be.
Chairman Scott asked Rosenberg how the E.U.’s shift in delaying the margin for uncleared swaps rules will impact her firm. Rosenberg replied that since the announcement was just made this past Friday, her firm is still considering implications for the bank.
House Agriculture Committee Chairman Mike Conaway (R-Texas) asked whether the U.S. should continue with their implementation date for the margin on uncleared swaps. Duffy answered that the delay puts U.S. banks at a huge disadvantage to European banks but that he is hopeful the implementation date can be postponed to coordinate with the European date.
Ranking Member Scott asked whether the clearing mandate has been a positive development, or if there is something else the CFTC should do. Rosenberg replied that the G20 global derivative reforms overall have made the financial system safer, more resilient, and have increased transparency in the markets, but that the global standards were set in 2012 so it is time to revisit them.
When Rep. Trent Kelly (R-Miss.) asked if the clearing mandate has been positive for the derivatives market, Rosenberg answered yes, that G20 reforms have made the system safer and more transparent.
Rep. Randy Neugebauer (R-Texas) asked how to determine what level of risk a clearing house takes on and what tools are used to manage such risk. Edmonds explained that decisions are made at the risk committee level, and that a recommendation is made to launch new products. He continued that it is ensured all risk and collateral they bring is the function of the clearing house, and continues to be their primary responsibility. Duffy added that Dodd-Frank gives them the ability to reject a swap at the clearing house level if the are not comfortable with the risk being brought into the institution.
Swap Execution Facilities
Kelly asked for insight on market participants of SEFs, to which Berger noted credit default swaps (CDS) and interest rate swaps have eight or nine SEFs with a “decent amount” of liquidity, but “only two SEFs are really open to customers” as the others have certain barriers, adding that it would be beneficial if investors could access all SEFs.
Conaway noted CFTC Commissioner J. Christopher Giancarlo’s 2015 White Paper, which was critical of required methods of execution, and asked what impact the limitations have on the way business is conducted. Merkel agreed with Giancarlo’s assessment, adding that proposed rules are constraining and that requests for relief are sometimes unanswered. He continued that the Markets in Financial Instruments Directive (MiFID) II has a more expansive approach to execution and that he is “optimistic it will all be harmonized.”
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