October 18, 2011
Today, the Commission approved a final rulemaking on the operation of derivatives clearing organizations (each, a “DCO”).1 Of the Dodd-Frank rulemakings that the Commission has so far undertaken, this rulemaking is among the most important. I have been a strong proponent of clearing. In the aftermath of the Enron crisis, I witnessed first-hand how the creation of ClearPort ameliorated counterparty credit fears in the energy merchant markets and restored liquidity to those markets. I am certain that clearing will similarly benefit the swaps market,2 particularly by significantly expanding execution on electronic platforms, thereby increasing price transparency and discovery. Moreover, as we have seen in the 2008 financial crisis, clearing has the potential to mitigate systemic risk, by ensuring that swap counterparties – not hardworking American taxpayers – post collateral to support their exposures.
The main goal of this final rulemaking is to ensure that clearing contributes to the integrity of the United States financial system by, among other things, allowing entities other than the largest dealer banks to offer clearing services to commercial and financial end-users. I fully support this goal. However, in an attempt to achieve this goal, this rulemaking abandons the principles-based regulatory regime which permitted DCOs to perform so admirably in the 2008 financial crisis. Instead, the final rulemaking sets forth a series of prescriptive requirements. I disagree with this approach. DCO risk management poses complex and multidimensional challenges. One DCO may have a significantly different risk profile than another. Consequently, each DCO must have sufficient discretion to match requirements to risks. The role of the Commission is to oversee the exercise of such discretion, not to prevent such exercise.3
Additionally, I am mindful of the cost of clearing and want to ensure that such cost does not constitute a barrier to entry. Certain provisions in this final rulemaking may impose substantial costs without corresponding benefits. Such provisions may discourage market participants from executing transactions subject to mandatory clearing, even if they need such transactions to prudently hedge risks, or from clearing on a voluntary basis. By creating perverse incentives to keep risk outside of the regulatory framework, and to leave it within our commercial and financial enterprises, the DCO rules undermine a fundamental purpose of the Dodd-Frank Act – namely, the expansion of clearing.
I will elaborate on each concern in turn.
Participant Eligibility: One-Size Does Not Fit All
This final rulemaking prohibits a DCO from requiring more than $50 million in capital from any entity seeking to become a swaps clearing member. This number makes a great headline, mainly because it is so low. It also sends an unequivocal message to DCOs that have clearing members that are primarily dealer banks. However, in adopting and interpreting this requirement, the Commission may unwisely limit the range of legitimate actions that DCOs can take to manage their counterparty risks. By imposing such limitations, the Commission is introducing costs to clearing that it fails to detail and explore.
Let me be plain. I oppose anticompetitive behavior. However, an entity with $50 million in capitalization may not be an appropriate clearing member for every DCO. The $50 million threshold prevents DCOs from engaging in anticompetitive behavior but also prohibits DCOs from taking legitimate, risk-reducing actions. Instead of adopting this prescriptive requirement, the Commission should have provided principles-based guidance to DCOs on the other components of fair and open access, such as the standard for less restrictive participation requirements.4 By taking a more principles-based approach, the Commission could have been in greater accord with international regulators, one of which explicitly cautioned against the $50 million threshold.5
Basis for the $50 Million?
How did the Commission determine that the $50 million threshold is appropriate? It is not really evident from the notice of proposed rulemaking.6 In the final rulemaking, the Commission states that the $50 million threshold was derived from the fact that most registered futures commission merchants (“FCMs”) that are currently DCO clearing members have at least $50 million in capital.7
The final rulemaking, however, does not answer a number of questions that are crucial to determining whether the $50 million threshold is appropriate for all swap transactions. These questions include, without limitation: What types of products do the referenced FCMs currently clear? Are there differences between the capital distributions of FCMs that clear different products? If so, what are such differences?
The answers to these questions are important because FCMs may need different amounts of capital to support their exposures to different products. Assume, for example, that the average capitalization of FCMs clearing agricultural futures is $50 million. Further assume that an FCM has $50 million in capital, and is seeking to become a clearing member. The Commission may reasonably conclude that such FCM would have the resources to clear agricultural futures. It may also reasonably conclude that such FCM would have the resources to clear agricultural swaps that have the same terms and conditions as agricultural futures. The Commission cannot reasonably conclude, however, that such FCM would have the resources to clear credit default swaps.
By not setting forth the answers to questions such as these, the final rulemaking creates the impression that the $50 million threshold is arbitrary, and renders vulnerable its conclusion that the threshold “captures firms that the Commission believes have the financial, operational, and staffing resources to participate in clearing swaps without posing an unacceptable level of risk to a DCO.”8
Anticompetitive Behavior? Or Legitimate, Risk-Reducing Action?
The final rulemaking recognizes that DCOs may increase capital requirements for legitimate, risk-reducing reasons. In fact, the final rulemaking requires a DCO to “set forth capital requirements that…appropriately match capital to risk.”9 Further, the final rulemaking mandates DCOs to “require clearing members to have access to sufficient financial resources to meet obligations arising from participation in the [DCO] in extreme but plausible market conditions.”10 The final rulemaking states that a DCO “may permit such financial resources to include, without limitation, a clearing member’s capital.”11
The final rulemaking, however, provides little insight on how the Commission intends to differentiate between (i) a required risk-based increase in capital requirements and (ii) an illegitimate attempt to circumvent the $50 million threshold to squash competition. To use an example grounded in reality – ICE Clear Credit recently lowered its minimum capital requirement for clearing members to $100 million. However, it added a requirement that clearing members hold excess net capital equal to 5 percent of their segregated customer funds. Upon learning about the additional requirement, at least two existing FCMs complained that it violates fair and open access.12 The final rulemaking gives very little guidance on the criteria that the Commission will apply in adjudicating a dispute such as this. The preamble to the final rulemaking simply states: “a DCO may not… [enact] some additional financial requirement that effectively renders the $50 million threshold meaningless for some potential clearing members.” It further states that such a requirement would violate the other components of fair and open access, such as “§ 39.12(a)(1)(i)(less restrictive alternatives), or § 39.12(a)(1)(iii)(exclusion of certain types of firms).”13 This vague statement provides no legal certainty or bright lines for DCOs and potential clearing members to follow.
If I were running a DCO, I would be extremely confused. On the one hand, the final rulemaking requires me to match capital requirements to risk. On the other hand, the preamble suggests that I cannot increase capital requirements (or any other financial requirement), if that would prohibit some entities with $50 million in capitalization from becoming clearing members. How should I resolve this conundrum?
If a DCO took a narrow interpretation of the reference to financial requirements in the preamble, then it has only one alternative: (i) admit any entity with $50 million in capital as a clearing member and (ii) impose strict risk limits.14 How strict could such limits be? To lend some context to this $50 million threshold, a recent report from the staff of the Federal Reserve Bank of New York observed that $50 million tended to be the notional value of one single transaction in a credit default swap index with relatively high liquidity.15
Assuming that the Commission does not require the DCO to increase its risk limits,16 where does this situation leave the DCO? The DCO would need to incur the cost of (i) evaluating applications from all entities with $50 million in capital, (ii) operationally connecting to such entities, and (iii) potentially defending itself against claims from such entities that the risk limits or financial requirements are too stringent. The DCO may pass on such costs to clearing members, which may pass on such costs to commercial and financial end-users. In the meantime, such entities, when admitted, may be unable to clear any significant volume of transactions, for themselves or for customers, especially in asset classes such as credit default swaps. Under this scenario, rather than leading to fair and open access, the $50 million threshold may actually impede access to clearing by commercial and financial end-users, because the threshold would increase their costs without introducing meaningful competition among FCMs offering clearing services.
If, on the other hand, a DCO took a more aggressive interpretation of the reference to financial requirements in the preamble, then it may have other alternatives to mitigate risks that admitting an entity with $50 million in capital may introduce. For example, it may increase margin requirements. It may also increase guaranty fund contributions for all clearing members, in proportion to their clearing activity. In other words, a DCO may increase the overall cost of clearing in order to compensate for the risks of having lesser capitalized new clearing members.
What are the potential effects of such increases? It is difficult to determine from our cost-benefit analysis. The analysis does not identify increases in margin or guaranty fund contributions as potential costs, much less attempt to quantify such costs.17 However, if the increases in costs are significant, and if such increases apply to a wide-range of clearing members (because the DCO fears being accused of unjustified discrimination),18 then such increases would most definitely influence whether commercial and financial entities voluntarily clear or even enter into hedges in the first place.
Principles-Based Regulation is a Better Solution
I propose a simple solution that would have addressed the confusion and hidden costs resulting from the $50 million threshold. The Commission should have eliminated the threshold. The threshold adds no value to the other components of fair and open access.19 Given that the final rulemaking rightfully requires a DCO to properly manage its risks, one or more DCOs would inevitably impose some sort of financial requirement that would prevent entities with $50 million (or more) in capital from directly participating in clearing. At that point, the Commission would not be able to opine on such a requirement without looking to the other components of fair and open access. As a result, it would have served the Commission well to have focused in the first instance on setting forth principles-based guidance on such components.20 Moreover, principles-based guidance would have brought the Commission into greater accord with certain international regulators,21 current international standards on CCP regulation,22 as well as the proposed revisions to such standards.23
Costs without Benefits: Minimum Liquidation Time Requirements
I have consistently highlighted that our rulemakings are interconnected and that the Commission has an obligation to analyze the cost impact across rulemakings. In this instance, I am concerned about the relationship between this final rulemaking and our proposal interpreting core principle 9 for designated contract markets (DCMs), which may be finalized in the future.24 Although this relationship may result in significant costs for the market, this final rulemaking fails to disclose such costs.
Specifically, this final rulemaking requires a DCO to calculate margin using different minimum liquidation times for different products. A DCO must calculate margin for (i) futures based on a one-day minimum liquidation time, (ii) agricultural, energy, and metals swaps based on a one-day minimum liquidation time, and (iii) all other swaps based on a five-day minimum liquidation time.25
No Policy Basis for Minimum Liquidation Times
As a preliminary matter, this final rulemaking creates the impression that these requirements are arbitrary, like the $50 million threshold. Although the final rulemaking characterizes these requirements as “prudent,” it sets forth no justification for this characterization.26 According to the final rulemaking, DCOs should consider at least five factors in establishing minimum liquidation times for its products, including trading volume, open interest, and predictable relationships with highly liquid products.27 In setting forth such factors, the Commission is holding DCOs to a higher standard than it holds itself. The final rulemaking presents no evidence that the Commission considered any of the five factors in determining minimum liquidation times.28
Negative Implications for Competition
More importantly, when these requirements are juxtaposed against our proposal interpreting DCM core principle 9, the potential of these requirements to disrupt already established futures markets becomes apparent. In the proposal, which is entitled Core Principles and Other Requirements for Designated Contract Markets, the Commission proposed, in a departure from previous interpretations of DCM core principle 9, to prohibit a DCM from listing any contract for trading unless an average of 85 percent or greater of the total volume of such contract is traded on the centralized market, as calculated over a twelve (12) month period.29 If the Commission finalizes such proposal, then DCMs may need to delist hundreds of futures contracts.30 Financial contracts may be affected, along with contracts in agricultural commodities, energy commodities, and metals.
According to the proposal, DCMs may convert delisted futures contracts to swap contracts.31 However, if the futures contracts reference financial commodities, then this final rulemaking would require that a DCO margin such swap contracts using a minimum liquidation time of five days instead of one day for futures. If nothing substantive about the contracts change other than their characterization (i.e., futures to swaps), then how can the Commission justify such a substantial increase in minimum liquidation time and margin? An increase of this magnitude may well result in a chilling of activity in the affected contracts. Such chilling would be an example of the type of market disruption that the CEA was intended to avoid.
I believe this has severe implications for competition. As commenters to the DCM proposal noted, market participants generally execute new futures contracts outside the DCM centralized market until the contracts attract sufficient liquidity. Attracting such liquidity may take years.32 Let us assume that an established DCM already lists a commercially viable futures contract on a financial commodity that meets the 85 percent threshold. Even without the DCM proposal and this final rulemaking, a DCM seeking to compete by listing a futures contract with the same terms and conditions already faces an uphill battle. Now with the DCM proposal, the competitor DCM would have to also face the constant threat of being required to convert the futures contract into a swap contract.
With this final rulemaking, the competitor DCM (or a competitor swap execution facility (SEF)) faces the additional threat that, by virtue of such conversion, the contract would be margined using a five-day minimum liquidation time. In contrast, the incumbent futures contract – which may have the same terms and conditions as the new “swap” contract – would still be margined using a one-day minimum liquidation time. It is difficult to imagine a DCM (or a competitor SEF) willing to compete given the twin Swords of Damocles that it would need to confront. By dissuading such competition, this final rulemaking and the DCM proposal undermine the “responsible innovation and fair competition among boards of trade” that the CEA was intended to promote.33
Some may argue that this final rulemaking would not have the negative effects that I articulated because it explicitly permits the Commission to establish, either sua sponte or upon DCO petition, longer or shorter liquidation times for particular products or portfolios.34 I would argue that requiring market participants, during the pendency of such a petition, to pay margin calculated using a five-day minimum liquidation time would likely cause a substantial number of market participants to withdraw from the market, thereby chilling activity– perhaps irrevocably – in the contract. I would further argue that the additional cost that (i) a DCM would incur to persuade a DCO to file a petition with the Commission and (ii) a DCM or DCO would incur to prepare such a petition, when coupled with the possibility that the Commission may deny such petition, would likely deter a DCM from seeking to compete with an incumbent futures contract. After all, the Commission may take a long time to consider any DCO petition. For example, the Commission took approximately two years to approve a petition to reduce the minimum liquidation time for certain contracts on the Dubai Mercantile Exchange from two days to one day.35 Thus, this power to petition the Commission for relief may be of little value to offset the likely stifling of competition.
Return to Principles-Based Regulation
What should the Commission have done to avoid market disruption and a curtailment in competition? Again, the Commission should have retained a principles-based regime, and should have permitted each DCO to determine the appropriate minimum liquidation time for its products, using the five factors articulated above. Determining appropriate margin requirements involves quantitative and qualitative expertise. Such expertise resides in the DCOs and not in the Commission. In its cost-benefit analysis, the final rulemaking admits as much.36 Returning to a principles-based regime would have also better aligned with current international standards on CCP regulation,37 as well as the revisions to such standards.38
The “Race to the Bottom” Argument Simply Cannot Withstand Scrutiny
Some may argue that, by not imposing minimum liquidation times, the Commission may enable a “race to the bottom,” where DCOs would compete by offering the lowest margin. As a conceptual matter, given that the Commission has not demonstrated that the minimum liquidation times that it has decided to mandate are “prudent,” it cannot demonstrate that the one-day or five-day period would prevent a “race to the bottom.”39 As an empirical matter, the Commission must have decided that DCOs currently competing to clear interest rate swaps and credit default swaps have not entered into a “race to the bottom,” because the final rulemaking codifies the existing five-day minimum liquidation time that such competing DCOs voluntarily adopted.40
Finally, the Commission has more effective tools to prevent any “race to the bottom.” First, this final rulemaking requires a DCO to determine the adequacy of its initial margin requirements on a daily basis.41 Second, this final rulemaking requires a DCO to conduct back testing of its initial margin requirements on a daily or monthly basis.42 Third, this final rulemaking requires a DCO to stress test its default resources at least once a month, and to report to the Commission the results of such stress testing at least once every fiscal quarter.43 Fourth, the Commission has the ability to independently back test and stress test DCO initial margin requirements.44 Consequently, the Commission would be able to detect any “race to the bottom” that would cause any DCO to have insufficient initial margin to cover its risks.
Cost-Benefit Analysis: We Can Do Better
I have always emphasized that the Commission must engage in more rigorous cost-benefit analyses of its rulemakings. At various points in my speeches and writings, I have urged the Commission to (i) focus on the economic effects of its rulemakings, both cumulative and incremental, (ii) quantify the costs and benefits of its rulemakings, both cumulative and incremental, and (iii) better justify the choice of a prescriptive requirement when a less-costly and equally effective principles-based alternative is available. Only by engaging in more rigorous cost-benefit analyses would the Commission fulfill the mandates of two Executive Orders45 and render our rulemakings less vulnerable to legal challenge.46
I have read the cost-benefit analysis in this final rulemaking with great interest. I can confirm that such analysis is longer than previous analyses. Unfortunately, increased length does not ensure an improvement in analysis and content.
Although I have numerous concerns with the cost-benefit analysis, my primary concern relates to its failure to attempt meaningful quantification. In multiple places in the cost-benefit analysis, the Commission concludes that the costs of a particular requirement are difficult or impossible to estimate. In certain instances, the statement may be accurate. If the Commission truly cannot quantify the costs in those instances, then that fact alone should cause the Commission to proceed with caution if it is going to abandon the existing principles-based regime. In other instances, however, I find the statement to be puzzling, given the capabilities and expertise of the Risk Surveillance Group (“RSG”) and the DCO Review Group (“DRG”) in our Division of Clearing and Risk (formerly known as the Division of Clearing and Intermediary Oversight).
I would like to highlight two such instances where the Commission has not utilized its own data to quantify the costs associated with its policy decisions. First, with respect to the minimum liquidation time requirements, the Commission states that “it is not feasible to estimate or quantify these costs reliably.” The Commission justifies such conclusion by stating that (i) “reliable data is not available for many swaps that prior to the Dodd-Frank Act were executed in unregulated markets,” and (ii) it would be too difficult for the Commission to estimate margin using either a one-day or five-day minimum liquidation time for any particular product.47 Whereas these statements may be accurate for certain swaps, they are not accurate for futures contracts currently listed on a DCM that will be converted to swap contracts under the pending DCM proposal. However potentially incomplete, the Off-Market Volume Study (May 2010 through July 2010) accompanying the DCM proposal entitled Core Principles and Other Requirements for Designated Contract Markets48 demonstrates that the Commission has the ability to identify at least a sample of the futures contracts that may be potentially converted to swap contracts. It is true that the DCO usually impounds the minimum liquidation time in the risk arrays that it uses to calculate margin, and the RSG cannot change such risk arrays easily. However, the RSG can ask the DCO to provide the assumptions underlying the risk arrays, including the minimum liquidation time (usually one day). Then the RSG can modify such assumptions to estimate margin calculations using a five-day minimum liquidation time.49 Would these calculations be imperfect? Yes. However, any attempt, even an imperfect one, undertaken by the Commission to understand the cost of our rulemakings or to justify our policy decisions is better than no attempt at all.
Another instance that I would like to highlight pertains to letters of credit. This final rulemaking prohibits DCOs from accepting letters of credit as (i) initial margin for swaps contracts (but not futures contracts) or (ii) as guarantee fund contributions. In the cost-benefit analysis, the Commission states that, “it is not possible to estimate or quantify [the] cost” of the prohibition.50 In response to questions from me and certain of my colleagues, however, the DRG prepared a memorandum on the use of letters of credit as initial margin. Although this memorandum is non-public, it is part of the administrative record for this final rulemaking. This memorandum details, among other things: (i) the number and identity of certain DCOs accepting and/or holding letters of credit as initial margin; (ii) the percentage of total initial margin on deposit across all DCOs that letters of credit constitute; and (iii) the potential disproportionate impact on energy and agricultural end-users of disallowing letters of credit. Whereas the memorandum may focus on the use of letters of credit as initial margin for futures contracts, the Commission proposal for DCM core principle 9 may force conversion of numerous energy and agricultural futures contracts into swaps contracts. Yet, the cost-benefit analysis contains none of the information in the memorandum, even in aggregate and anonymous form. In the interests of transparency, the Commission should have found a way to share this information with the public.
The Commission (or its predecessor) has regulated the futures markets since the 1930s. The Commission has overseen DCOs clearing swaps since at least 2001. We can do better than this. If the Commission needs to re-propose a rulemaking to provide quantitative estimates of its costs and benefits, so be it. Given the foundational nature of this rulemaking, as well as other rulemakings that are forthcoming, it is more important for the Commission to achieve the most reasonable balance between costs and benefits, rather than to finish the rulemaking fast.
International Coordination: We Must Do Better.
In closing, I would mention my strong desire for the Commission to ensure that its policies do not create disadvantages for United States businesses and that our rules comport with international standards. It is becoming increasingly clear that the schedule for financial reform is converging among the G-20 nations. It is less clear that the substantive policies underlying financial reform are experiencing the same convergence. We must be more cognizant of the effects of such lack of convergence on dually-registered entities, and the incentives created by such divergence for regulatory arbitrage.
This final rulemaking illustrates the inconsistent approach that the Commission has taken towards international coordination to date. First, although the final rulemaking notes that the CPSS-IOSCO Recommendations embody the current international standards on CCP regulation, the final rulemaking does not attempt to comport with the CPSS-IOSCO Recommendations.51 Instead, the final rulemaking attempts to comport with the CPSS-IOSCO Consultation, which has not been finalized.52 In general, both the CPSS-IOSCO Recommendations and the CPSS-IOSCO Consultation are less prescriptive than the final rulemaking.
Second, while the final rulemaking does note the rare instance where its prescriptive requirements comport with the CPSS-IOSCO Consultation,53it does not reveal where its prescriptive requirements depart from the CPSS-IOSCO Consultation. For example, as I stated above, the CPSS-IOSCO Consultation actually sets forth principles-based considerations for participant eligibility and margin calculation.
Finally, the final rulemaking states that the Commission will review a number of its provisions after CPSS and IOSCO finish their work, which is likely to occur in 2012. Whereas I support such a review, the statement begs the following questions: What legal certainty are these regulations offering DCOs, clearing members, and market participants if the Commission changes such regulations in 2012? Also, what are the implications of requiring DCOs to incur costs to comport with prescriptive requirements now when the Commission might change such requirements next year? If changes are foreseeable, shouldn’t the Commission adopt a phasing or delayed implementation plan to allow the international coordination process to reach completion before our rules and their costs become effective? If, in the alternative, the Commission will not be influenced by international standards, what are the costs of such non-convergence?
As we are finalizing foundational rulemakings, we can no longer rely on an inconsistent approach. We need to produce a more coherent plan for international coordination.
Due to the above concerns, I respectfully dissent from the decision of the Commission to approve this final rulemaking for publication in the Federal Register.
1 Derivatives Clearing Organizations, 76 Fed. Reg. [___] ([__________]) (to be codified at 17 C.F.R. pts. 1, 21, 39, and 140).
2 See Kathryn Chen et al., An Analysis of CDS Transactions: Implications for Public Reporting, Federal Reserve Bank of New York Staff Report no. 517 (September 2011), available at: www.newyorkfed.org/research/staff_reports/sr517.pdf (stating that “[c]learing-eligible products within our sample traded on more days and had more intraday transactions than non-clearing eligible products”).
3 See section 3(b) of the Commodity Exchange Act (CEA), 7 U.S.C. § 5(b) (stating that “[i]t is the purpose of this Act to serve the public interests…through a system of effective self-regulation of trading facilities, clearing systems, market participants and market professionals under the oversight of the Commission.”).
4 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.12(a)(1)).
5 See letter, dated March 21, 2011, from the United Kingdom Financial Services Authority (“FSA”), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=957 (stating that “whilst capital thresholds or other participation eligibility threshold limitations may be a potential tool to help ensure fair and open access to [central counterparties (“CCPs”)], to impose them on clearing arrangements for products that have complex or unique characteristics could lead to increased risk to the system in the short to medium term.”)
6 See Risk Management Requirements for Derivatives Clearing Organizations, 76 Fed. Reg. 3698, 3791 (Jan. 20, 2011).
7 See 76 Fed. Reg. at [___] (further stating that “of 126 FCMs, 63 currently have capital above $50 million and most FCMs with capital below that amount are not clearing members.”).
8 Id. at [___].
9 Id. at [___] (to be codified at 17 C.F.R. § 39.12(a)(2)(ii)) (further stating that “[c]apital requirements shall be scalable to risks posed by clearing members”.).
10 Id. at [___] (to be codified at 17 C.F.R. § 39.12(a)(2)(i)).
11 Id. Additionally, the notice of proposed rulemaking states: “Proposed §§ 39.12(a)(2)(ii) and 39.12(a)(2)(iii),
considered together, would require a DCO to admit any person to clearing membership for the purpose of clearing
swaps, if the person had $50 million in capital, but would permit a DCO to require each clearing member to hold
capital proportional to its risk exposure. Thus, if a clearing member’s risk exposure were to increase in a non-
linear manner, the DCO could increase the clearing member’s corresponding scalable capital requirement in a non- linear manner.” 76 Fed. Reg. at 3701.
12 See Matthew Leising, “ICE Clear Credit’s Member Rules Too Exclusive, Small Firms Say,” Bloomberg, Aug. 9, 2011, available at: http://www.bloomberg.com/news/2011-08-09/ice-clear-credit-s-member-rules-too-exclusive-small-firms-say.html.
13 76 Fed. Reg. at [___].
14 The final rulemaking requires DCOs to impose risk limits on clearing members. See id. at [___] (to be codified at 17 C.F.R. § 39.13(h)(1)).
16 See 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.13(h)(1)(i)(C)) (stating that “[t]he Commission may review such methods, thresholds, and financial resources and require the application of different methods, thresholds, or financial resources, as appropriate.”).
17 Interestingly, the preamble notes that at least two commenters agreed that a DCO may legitimately use such increases to moderate the risk of a member with only $50 million in capital. Specifically, the preamble states: “Newedge commented that the proposed rule should not increase risk to a DCO because a DCO can mitigate risk by, among other things, imposing position limits, stricter margin requirements, or stricter default deposit requirements on lesser capitalized clearing members.” The preamble also states: “J.P. Morgan, however, commented that a cap on a member’s minimum capital requirement would not impact the systemic stability of a DCO as long as…DCOs hold a sufficient amount of margin and funded default guarantee funds.” Id. at [___]. It is therefore unclear why the cost-benefit analysis did not address the potential for such increases.
18 See 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.12(a)(1)(iii)) (stating that “[a] derivatives clearing organization shall not exclude or limit clearing membership of certain types of market participants unless the derivatives clearing organization can demonstrate that the restriction is necessary to address credit risk or deficiencies in the participants’ operational capabilities that would prevent them from fulfilling their obligations as clearing members.” The regulation contains no further detail regarding what type of demonstration would be sufficient.).
19 In legal parlance, the $50 million threshold is neither necessary nor sufficient to determining whether a DCO has violated fair and open access. The threshold is not necessary because a DCO can set an even lower minimum capital requirement and still violate fair and open access if another requirement “excludes or limits clearing membership of certain types of market participants.” 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.12(a)(1)(iii)). The threshold is not sufficient because, even if the DCO accepts all entities with $50 million in capital as clearing members, the Commission may still hold that DCO violated fair and open access if it imposes “some additional financial requirement that effectively renders the $50 million threshold meaningless.” 76 Fed. Reg. at [___].
20 In such guidance, the Commission could have detailed the information that a DCO would need to provide in order to demonstrate that it could not adopt a less restrictive participation requirement without materially increasing its own risk. The Commission could have also discussed the weight that DCOs should accord to a particular level of capitalization, depending on whether the relevant clearing member (i) engages in businesses other than the intermediation of futures or swaps, or (ii) participates at multiple DCOs rather than one DCO.
21 See supra note 5. I note that the Commission and FSA share jurisdiction over three DCOs clearing swaps – namely, LCH.Clearnet Limited, ICE Clear Europe Limited, and CME Clearing Europe. How the Commission and FSA will resolve conflicting regulation remains to be seen.
22 See Bank for International Settlements’ Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions (“CPSS-IOSCO”), “Recommendations for Central Counterparties,” CPSS Publ’n No. 64 (November 2004), available at: http://www.bis.org/publ/cpss64.pdf (the “CPSS-IOSCO Recommendations”). Section 4.2.2 of the CPSS-IOSCO Recommendations state: “To reduce the likelihood of a participant’s default and to ensure timely performance by the participant, a CCP should establish rigorous financial requirements for participation. Participants are typically required to meet minimum capital standards. Some CCPs impose more stringent capital requirements if exposures of or carried by a participant are large or if the participant is a clearing participant. Capital requirements for participation may also take account of the types of products cleared by a CCP. In addition to capital requirements, some CCPs impose standards such as a minimum credit rating or parental guarantees.”
23 See CPSS-IOSCO, “Principles for financial market infrastructures: Consultative report,” CPSS Publ’n No. 94 (March 2011), available at: http://www.bis.org/publ/cpss94.pdf (the “CPSS-IOSCO Consultation”). The CPSS-IOSCO Consultation, which CPSS-IOSCO has not adopted as final, does not set forth any requirement or suggestion that resembles the $50 million threshold. Instead, the Consultation, like the Recommendations, emphasizes the importance of “risk-based” CCP participation criteria that are not unduly discriminatory. Specifically, Section 3.16.6 of the CPSS-IOSCO Consultation states: “participation requirements based solely on a participant’s size are typically insufficiently related to risk and deserve careful scrutiny.” Whereas the Consultation may have intended to comment on restrictively high CCP participation requirements, the same logic applies to restrictively low CCP participation requirements. Neither are risk-based.
24 See Core Principles and Other Requirements for Designated Contract Markets, 75 Fed. Reg. 80572 (Dec. 22, 2010).
25 See 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.13(g)(2)(ii)).
26 See Id. at [___].
27 According to the final rulemaking, such factors are: “(i) average daily trading volume in a product; (ii) average daily open interest in a product; (iii) concentration of open interest; (iv) availability of a predictable basis relationship with a highly liquid product; and (v) availability of multiple market participants in related markets to take on positions in the market in question.” Id. at [___].
28 Instead of considering the five factors, the Commission appears to have simply codified the minimum liquidations times that certain DCOs currently use for swaps. For example, the Commission justifies setting a minimum liquidation time of five days for swaps referencing non-physical commodities as follows: “The longer liquidation time, currently five days for credit default swaps at ICE Clear Credit LLC and CME, and for interest rate swaps at LCH and CME, is based on their assessment of the higher risk associated with these products.” Id. at [___]. Given that this justification appears to focus on credit default swaps and interest rate swaps, it is unclear how the Commission concluded that a five-day minimum liquidation time is appropriate for swaps that reference financial commodities but are neither credit default swaps nor interest rate swaps.
29 75 Fed. Reg. at 80616.
30 According to information that I have received from one DCM, the proposal would force conversion of 628 futures and options contracts to swap contracts. Moreover, according to the Off-Market Volume Study (May-2010 through July-2010) prepared by Commission staff, the proposal would force conversion of approximately 493 futures and options contracts. See Off-Market Volume Study, available at: http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_12_DCMRules/index.htm.
31 See 75 Fed. Reg. at 80589-90.
32 See letter, dated February 22, 2011, from NYSE Liffe U.S., available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27910&SearchText=. See also letter, dated February 22, 2011, from ELX Futures, L.P., available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27873&SearchText=. See further letter, dated February 22, 2011, from Eris Exchange, LLC, available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27853&SearchText=.
33 See section 3(b) of the CEA, 7 U.S.C. § 5(b).
34 See 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.13(g)(2)(ii)(D)).
35 The petition is available at: http://www.cftc.gov/PressRoom/PressReleases/pr5724-09. The petition was filed on July 28, 2009. The Commission issued an order granting the petition on September 16, 2011. The order does not appear on the Commission website.
36 See 76 Fed. Reg. at [___] (stating that “[i]n addition to the liquidation time frame, the margin requirements for a particular instrument depend upon a variety of characteristics of the instrument and the markets in which it is traded, including the risk characteristics of the instrument, its historical price volatility, and liquidity in the relevant market. Determining such margin requirements does not solely depend upon such quantitative factors, but also requires expert judgment as to the extent to which such characteristics and data may be an accurate predictor of future market behavior with respect to such instruments, and applying such judgment to the quantitative results…Determining the risk characteristics, price volatility, and market liquidity of even a sample for purposes of determining a liquidation time specifically for such instrument would be a formidable task for the Commission to undertake and any results would be subject to a range of uncertainty.”).
37 See supra note 22. With respect to minimum liquidation times, Section 4.4.3 of the CPSS-IOSCO Recommendations simply state: “Margin requirements impose opportunity costs on CCP participants. So, a CCP needs to strike a balance between greater protection for itself and higher opportunity costs for its participants. For this reason, margin requirements are not designed to cover price risk in all market conditions. Nonetheless, a CCP should estimate the interval between the last margin collection before default and the liquidation of positions in a particular product, and hold sufficient margin to cover potential losses over that interval in normal market conditions.”
38 See also supra note 23. Like the CPSS-IOSCO Recommendations, the CPSS-IOSCO Consultation also advocates a principles-based model for estimating minimum liquidation times. Section 3.6.7 of the CPSS-IOSCO Consultation states: “A CCP should select an appropriate close-out period for each product cleared by the CCP, and document the close-out periods and related analysis for each product type. A CCP should base its close-out period upon historical price and liquidity data when developing its initial margin methodology. Historical data should include the worst events that occurred in the selected time period for the product cleared as well as simulated data projections that would capture potential events outside of the historical data. In certain instances, a CCP may need to determine margin levels using a shorter historical period to reflect better new or current volatility in the market. Conversely, a CCP may need to determine margin levels based on a longer period in order to reflect past volatility. The close-out period should be set based on anticipated close-out times in stressed market conditions. Close-out periods should be set on a product-specific basis, as less-liquid products might require significantly longer close-out periods. A CCP should also consider and address position concentrations, which can lengthen close-out timeframes and add to price volatility during close outs.”
39 The Commission acknowledged as much in its cost-benefit analysis. The analysis states: “The Commission anticipates that using only one criterion—i.e., the characteristic of the commodity underlying a swap—to determine liquidation time could result in less-than-optimal margin calculations. For some products, a five-day minimum may prove to be excessive and tie up more funds than are strictly necessary for risk management purposes. For other products, a one-day or even a five-day period may be insufficient and expose a DCO and market participants to additional risk.” 76 Fed. Reg. at [___].
40 Id. at [___] (stating “…the final rule provides that the minimum liquidation time for swaps based on certain physical commodities, i.e., agricultural commodities, energy, and metals, is one day. For all other swaps, the minimum liquidation time is five days. This distinction is based on the differing risk characteristics of these product groups and is consistent with existing requirements that reflect the risk assessments DCOs have made over the course of their experience clearing these types of swaps. The longer liquidation time, currently five days for credit default swaps at ICE Clear Credit, LLC, and CME, and for interest rate swaps at LCH and CME, is based on their assessment of the higher risk associated with these products.”).
41 Id. at [___] (to be codified at 17 C.F.R. § 39.13(g)(6)).
42 Id. at [___] (to be codified at 17 C.F.R. § 39.13(g)(7)).
43 Id. at [___] (to be codified at 17 C.F.R. § 39.11(c)(1) and (f)).
44 See United States Commodity Futures Trading Commission, International Monetary Fund – Financial Sector Assessment Program: Self-Assessment of IOSCO Objectives and Principles of Securities Regulation, August 2009, available at: http://www.treasury.gov/resource-center/international/standards-codes/Documents/Securities%20CFTC%20Self%20Assessment%208-28-09.pdf (the “FSAP Assessment”) (describing the capabilities of the Risk Surveillance Group within the Division of Clearing and Risk (formerly known as the Division of Clearing and Intermediary Oversight): “After identifying traders or FCMs at risk, the RSG estimates the magnitude of the risk. The SRM system enables RSG staff to calculate the current performance bond requirement for any trader or FCM. This amount is generally designed to cover approximately 99% of potential one-day moves…SRM also enables RSG staff to conduct stress tests. RSG staff can determine how much a position would lose in a variety of circumstances such as extreme market moves. This is a particularly important tool with respect to option positions. As noted, the non-linear nature of options means that the loss resulting from a given price change may be many multiples greater for an option position than for a futures position in the same market. Moreover, the complexity of option positions can result in situations where the greatest loss does not correspond to the most extreme price move.”).
The FSAP Assessment also describes the ability of the RSG to check DCO stress testing of its default resources: “The RSG compares the risk posed by the largest clearing member to a DCO’s financial resource package. The RSG analyzes not only the size of the DCO package but also its composition. In the event of a default, a DCO must have access to sufficient liquidity to meet its obligations as a central counterparty on very short notice.”
45 See Exec. Order No. 13,563, 76 Fed. Reg. 3821 (Jan. 21, 2011); Exec. Order No. 13,579, 76 Fed. Reg. 41,587 (July 14, 2011).
46 See, e.g., Business Roundtable and the United States Chamber of Commerce vs. SEC, No. 10-1305, 2011 U.S. App. LEXIS 14988 (July 22, 2011).
47 See 76 Fed. Reg. at [___].
48 See supra note 30. The Off-Market Volume Survey does not include contracts listed on new DCMs, such as NYSE Liffe U.S., ELX Futures, L.P., or Eris Exchange, LLC. However, the existence of such survey is proof that the Commission has the ability to identify contracts that DCM core principle 9 may affect.
50 76 Fed. Reg. at [___].
53 See, e.g., id. at [___] (stating that requiring DCOs to calibrate margin to cover price movements at a 99 percent confidence interval accords with Principle 6 of the CPSS-IOSCO Consultation).
Last Updated: October 18, 2011