December 16, 2015
Today’s final rule regarding margin requirements for uncleared swaps is far from perfect. The Commission had the unenviable task of harmonizing its rule with the prudential regulators’ rules and with standards issued by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (BCBS/IOSCO). While there are particular provisions of the final rule that I do not support, I think the final rule is far better balanced than the previous proposal.
Much of the discussion in finalizing this rule has been focused on margin requirements for inter-affiliate swaps. That discussion must begin with the recognition that inter-affiliate swaps transactions do not involve transactions between distinct financial institutions that was at issue in the 2008 financial crisis and do not pose the systemic risk that the Dodd-Frank Act1 was ostensibly designed to address. Congress expressed no particular intention to subject inter-affiliate transactions to clearing or inter-affiliate margin.
Accordingly, the CFTC adopted a rule in April 2013 to exempt certain inter-affiliate swaps from mandatory clearing.2 That rulemaking, supported by former Chairman Gensler and Commissioners Wetjen, Chilton and O’Malia, recognized that inter-affiliate swaps provide an important risk management role within corporate groups. They enable use of a single conduit on behalf of multiple affiliates to net affiliates’ trades, which reduces the overall risk of the corporate group and the number of outward-facing swaps into which the affiliates might otherwise enter. This, in turn, reduces operational, market, counterparty credit and settlement risk.3 Rather than increasing risk, inter-affiliate swaps allow entities within a corporate group to transfer risk to the group entity best positioned to manage it.
Moreover, in exercising its authority under Section 4(c) of the Commodity Exchange Act to exempt qualifying inter-affiliate swaps from the mandatory clearing requirement, the Commission found that the exemption promotes responsible financial innovation, fair competition and is consistent with the public interest.4 It further found that the exemption, which was conditioned on having certain risk mitigating measures in place,5 would not have a material effect on the Commission’s ability to discharge its regulatory responsibilities.6
When the CFTC issued its proposed rule in September 2014, I noted that subjecting inter-affiliate swaps to the higher costs of uncleared margin7 could not be logically or prudentially justified with the clearing exemption for inter-affiliate swaps that the Commission adopted in 2013.8 The Commission’s 2013 findings remain valid on this issue. I am aware of no facts that have come to light that would change the original assessment made by our predecessor Commission.
In fact, since issuing the proposed rule for notice and comment, an independent cost-benefit analysis of the rule recommended, among other things, exempting inter-affiliate swaps from initial margin requirements as a means to reduce the “excessively onerous” impact of the rule on competition, price discovery and overall market efficiency without allowing additional systemic risk.9 I concur with that recommendation.
Earlier this year, I testified before the U.S. House of Representatives Committee on Agriculture Subcommittee on Commodity Exchanges, Energy, and Credit. In response to a question, I explained that the cost of any requirement to impose initial margin in inter-affiliate transactions would have two likely impacts: first, it would raise the cost of commercial risk hedging for American end-users; and second, it would encapsulate risk in the U.S. marketplace and thus increase the risk of systemic hazard in American financial markets.10
The final rule before us today is not naïve or reckless concerning inter-affiliate swaps transactions. It recognizes that they are not without risk and sets appropriate safeguards. First, the rule requires operation of a centralized risk management program for such swaps. Second, variation margin will be required. Third, the rule requires covered swap entities to collect initial margin from non-U.S. affiliates that are not subject to comparable initial margin collection requirements for their own outward-facing swaps with financial entities. These measures appropriately address the risks associated with uncleared inter-affiliate swaps.11
In other regards, I am satisfied that the threshold for measuring material swaps exposure has been raised from $3 billion to $8 billion, which brings our requirement roughly in line with the BSBS/IOSCO standard of €8 billion.12 I am also pleased that the swaps of commercial end-users, agricultural and energy cooperatives that are classified as financial institutions and small banks will not be subject to the margin requirements if they qualify for an exclusion or exemption. That is one small assist to America’s remaining small banks to get their heads back above water in the toppling wake of the Dodd-Frank Act.
I disagree, however, with the definition of “financial end user,” which is overly broad. It includes entities that are unlikely to act as counterparties to swaps such as floor brokers, introducing brokers and futures commission merchants acting on behalf of customers, among others. These entities may not ultimately be captured by the rule because they are unlikely to have material swaps exposure triggering application of the rule, but I question the logic behind their inclusion. Good regulation means precisely crafted rules, not ones that are deliberately overly-broad.
I also continue to object to the ten-day liquidation horizon that must be incorporated into initial margin models for all types of uncleared swaps. The ten-day requirement is a made up number that is not tailored to the true liquidity profile of the underlying swap instruments. I call upon my fellow regulators to revisit this issue as we gain more experience with initial margin models.
Another item that requires further Commission action is to codify by rule the no-action letters providing clearing relief to certain Treasury affiliates acting as principal.13 The prudential regulators were unwilling to recognize the no-action relief in their final rules, but have indicated that if the Commission acts to exclude these entities by rule, they would also be excluded from the prudential regulators’ rules. The Commission should act to issue a rule without delay.
In addition, I remain concerned about the cross-border implications for this rule, which remain unfinished because they were proposed separately from the rule finalized today.14 As I stated at the time of the cross-border rule proposal, I have many concerns and questions surrounding that rulemaking, including: (1) the shift away from the transaction-level approach set forth in the July 2013 Cross-Border Interpretive Guidance and Policy Statement; (2) the revised definitions of “U.S. person” (defined for the first time in an actual Commission rule) and “guarantee” and how these new terms will be interpreted and applied by market participants across their entire global operations; (3) the scope of when substituted compliance is allowed; and (4) the practical implications of permitting substituted compliance, but disallowing the exclusion from CFTC margin requirements for certain non-U.S. covered swap entities.15
An appropriate framework for the cross-border application of margin requirements for uncleared swaps is essential if we are to preserve the global nature of the swaps market. I reiterate a few of my concerns with the yet-to-be-finished cross-border element of the margin for uncleared swaps regime because that proposal and this final rule must work in harmony. We must avoid further fragmenting the global swaps markets by imposing another regulatory framework that is inconsistent, confusing or burdensome. Doing so will only result in yet another competitive disadvantage between American institutions and their international counterparts.
I am disappointed that the Commission decided to treat the results of portfolio compression of legacy swaps as new swaps subject to the margin rule at this time. In 2013 the Division of Clearing and Risk (DCR) determined that it would not recommend enforcement action for the failure of market participants to submit to clearing amended or replacement swaps that are generated as part of a multilateral portfolio compression exercise and are subject to required clearing, provided that certain conditions are met.16 Staff recognized in issuing the no-action relief that “multilateral portfolio compression allows swap market participants to net down the size and/or number of outstanding swaps, and decrease the number of outstanding swaps or the aggregate notional value of such swaps, thereby reducing operational risk and, in some instances, reducing counterparty credit risk.”17
Portfolio compression is of great benefit to the safety and soundness of the market. It should be incentivized, not penalized. Treating swaps created by compressing legacy swaps as new swaps subject to margin requirements may well discourage portfolio compression. Moreover, it is inconsistent with the DCR staff no-action relief. This is a missed opportunity. I urge the Commission to revisit this issue prior to implementation of the margin requirements.
From my perspective, the most objectionable aspect of today’s rule is its foundation in the superficial logic that, if the cost of margining uncleared swaps is forced high enough, then market participants will use more cleared instruments.18 That foundation is not supported by either reason or experience. If no clearinghouse is willing to clear a particular swap, then no amount of punitive cost will enable it to be cleared.
I know this because I was involved before the financial crisis in one of the first independent efforts by non-Wall Street banks to develop a central clearing house for credit default swaps.19 For years, I have expressed my support for increased central counterparty clearing of swaps20 and continue to support it where appropriate. Yet, I also recognize that central counterparty clearing is not a panacea for counterparty credit risk.21 As regulators, we must be intellectually honest and acknowledge that there are legitimate and vital needs for both cleared and uncleared swaps markets in a modern, complex economy.
As I have previously said,22 uncleared swaps allow businesses to avoid basis risk and obtain hedge accounting treatment for more complex, non-standardized exposures. Uncleared swaps are an unmatched tool for customized risk management by businesses, governments, asset managers and other institutions whose operations are essential to American economic growth. Their precise risk transfer utility generally cannot be replicated with standardized cleared derivatives without resulting in improper or imperfect hedges or hedges that fail hedge accounting treatment under U.S. GAAP.
Today’s rule also reflects a disingenuous reading of the Dodd-Frank Act to favor cleared derivatives over uncleared swaps. In fact, there is no provision in the law directing regulators to set punitive levels of margin to drive hedging market participants toward cleared products. Imposing punitive margin levels will hazard a range of adverse consequences from raising the commercial cost of risk hedging to reducing trading liquidity in uncleared swaps markets and incentivizing movement of products otherwise unsuitable for clearing into clearinghouses into which counterparty risk is already increasingly concentrated. More critically, punitive margin on uncleared swaps will increase the amount of inadequately hedged risk exposure on America’s corporate balance sheets exacerbating volatility in earnings and share prices.
Yet, I know that my voice alone cannot reverse the course of the present prevalence of “macro-prudential” regulation that prioritizes systemic stability over investment opportunity, market vibrancy and economic growth. Only time will show that systemic risk cannot be managed through centralized economic planning. In fact, rather than being managed, systemic risk is being transformed today from counterparty credit exposure to jarring volatility spikes and liquidity risk across the breadth of financial markets, with ramifications that will be even harder to manage in the future.
Unfortunately, today’s rule will not reverse these trends. I will vote for the rule, not because it is the right prescription for uncertain markets, but because it is much better than originally proposed and less harmful than likely alternatives.
I commend the CFTC staff for their hard work, thoughtfulness and, ultimately, the generally improved rulemaking that is before us today.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).
2 Clearing Exemption for Swaps Between Certain Affiliated Entities, 78 FR 21750 (Apr. 11, 2013); 17 CFR 50.52.
3 Id. at 21753.
4 Id. at 21754.
5 For example, the clearing exemption may be elected only if the affiliates’ financial statements are consolidated, which increases the likelihood that the affiliates will be mutually obligated to meet the group’s swap obligations; the affiliates must be subject to a centralized risk management program; and outward-facing swaps must be cleared or subject to an exemption or exception from clearing. Id. at 21753.
6 Id. at 21754.
7 The costs of posting margin for uncleared swaps will likely be substantially higher than the costs associated with clearing. For example, the minimum liquidation time for cleared agricultural, energy and metals swaps is one-day for purposes of calculating initial margin, and five days for cleared interest rate and credit default swaps. Commission Regulation 39.13(g)(2). Under the final rule, initial margin for uncleared swaps may be calculated under either a standardized table-based method or a model-based method. Under the table-based method, initial margin for commodity swaps must equal 15 percent of gross notional exposure. The model-based method requires a ten-day close out period for all swaps regardless of the underlying liquidity characteristics.
8 Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants; Proposed Rule, 79 FR 59898, 59936 (Oct. 3, 2014) (Statement of Commissioner J. Christopher Giancarlo), available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2014-22962a.pdf.
9 Cost-Benefit Analysis of the CFTC’s Proposed Margin Requirements for Uncleared Swaps, NERA Economic Consulting (Dec. 2, 2014), available at http://www.nera.com/content/dam/nera/publications/2014/NERA_Margin_Requirements_Uncleared_Swaps.pdf.
10 Hearing before the Subcommittee on Commodity Exchanges, Energy, and Credit of the Committee on Agriculture, House of Representatives, 114th Congress, First Session, Serial No. 114-7, Transcript at 193-194 (Apr. 14, 2015), available at http://agriculture.house.gov/uploadedfiles/114-07_-_93966.pdf.
11 AIG often did not post initial margin or pay variation margin on its outward facing swaps. See Opening Statement of Commissioner Michael V. Dunn, Public Meeting on Proposed Rules Under Dodd-Frank Act (Apr. 12, 2011). Both are required under today’s rule.
12 I note an inconsistency between the $8 billion de minimis threshold for purposes of determining who must register as a swap dealer or major swap participant and the $8 billion threshold for measuring material swaps exposure. Foreign exchange swaps, foreign exchange forwards and hedging swaps must be included in the calculation of material swaps exposure; they are not included in calculating the de minimis threshold.
13 See CFTC No-Action Letter No. 13-22 (Jun. 4, 2013); CFTC No-Action Letter No. 14-144 (Nov. 26, 2014).
14 See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements; Proposed Rule, 80 FR 41376 (Jul. 14, 2015), available at http://www.cftc.gov/idc/groups/public/@lrfederalregister/documents/file/2015-16718a.pdf.
15 Id. at 41407.
16 CFTC Letter No. 13-01.
17 Id. at 2.
18 See Chair Janet L. Yellen, Opening Statement on the Long-Term Debt and Total Loss-Absorbing Capacity Proposal and the Final Rule for Margin and Capital Requirements for Uncleared Swaps, Board of Governors of the Federal Reserve System, Oct. 30, 2015, available at http://www.federalreserve.gov/newsevents/press/bcreg/yellen-statement-20151030a.htm; see also Madigan, Peter, US Margin Rules Threaten Clearing Bottleneck, Risk.net, Dec. 14, 2015.
19 See, e.g., GFI Group Inc. and ICAP plc To Acquire Ownership Stakes In The Clearing Corporation, PRNewswire, Dec. 21, 2006, available at http://www.prnewswire.com/news-releases/gfi-group-inc-and-icap-plc-to-acquire-ownership-stakes-in-the-clearing-corporation-57223742.html; see also, Testimony Before the H. Committee on Financial Services on Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 112th Cong. 8 (2011) (statement of J. Christopher Giancarlo) (“In 2005, GFI Group and ICAP Plc, a wholesale broker and fellow member of the WMBAA, took minority stakes in the Clearing Corp and worked together to develop a clearing facility for credit default swaps. That initiative ultimately led to greater dealer participation and the sale of the Clearing Corp to the Intercontinental Exchange and the creation of ICE Trust, a leading clearer of credit derivative products.”).
20 See Testimony Before the H. Committee on Financial Services on Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 112th Cong. 8 (Feb. 21, 2011), available at http://financialservices.house.gov/media/pdf/021511giancarlo.pdf; see also WMBAA Press Release, WMBAA Commends Historic US Financial Legislation, Jul. 21, 2010, available at http://www.wmbaa.com/wp-content/uploads/2012/01/WMBAA-Dodd-Frank-Law-press-release-final123.pdf.
21 See CFTC Commissioner J. Christopher Giancarlo, Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank (Jan. 29, 2015), available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/sefwhitepaper012915.pdf.
22 See Opening Statement of Commissioner J. Christopher Giancarlo, Open Meeting on Proposed Rule on Margin Requirements for Uncleared Swaps and Final Rule on Utility Special Entities, Sept. 17, 2014, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/giancarlostatement091714.
Last Updated: December 16, 2015