Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581
Seminar on Cross Asset Clearing
Can the clearing house model lend itself successfully to different asset classes?
Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
New York, September 27, 2005
It is a pleasure to be here to discuss innovation in clearing from the perspective of a regulator of futures and options markets. Before I get too far along into my comments, I must provide the disclosure that my comments this evening represent my own opinions and do not necessarily reflect those of the other Commissioners or the staff of the CFTC. I should also note that I am not an expert on the specifics of clearing or its regulation, past or present, but have enjoyed a rather rapid education in the area. I appreciate the opportunity to give you my observations and reflect upon what the future may hold in this area.
Some Historical Perspective
When Congress first developed a regulatory scheme for the futures markets in the 1920’s, the over-riding focus was on the operation of the market. During the 1920’s and for years before that, there was concern that prices in the futures markets were highly susceptible to manipulation, and that speculators were exerting undue influence over prices. Currently, Section 3 of the Act states that, “futures transactions are entered into regularly in interstate and international commerce and are affected with a national public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating price information through trading in liquid, fair and financially secure trading facilities.” It goes on to say that, “to foster these public interests, it is further the purpose of this Act to deter and prevent price manipulation or any other disruptions to market integrity.”
If you look at early versions of the Act, you will notice that protecting the price discovery process of the markets was the primary emphasis. There is no mention of the clearing process until the passage of the Commodity Futures Modernization Act (CFMA) in 2000. At that point, Section 3 of the Act adds that a purpose of the Act is, “to ensure the financial integrity of all transactions subject to this Act and the avoidance of systemic risk.” The CFMA also adds sections giving the Commission explicit authority to regulate clearinghouses. Thus, it is not until 2000 that Congress explicitly addresses the issue of clearing in the Act, but that is not to say that clearing has not always had the attention of the CFTC.
Prior to the CFMA, and for that matter the Futures Trading Practices Act of 1992, all futures trading, and in a broader context, derivatives contracts in general, were traded on-exchange, and typically the clearinghouse was part of the exchange. So to the extent that the clearing function was seen to be part of the exchange function, the regulation of clearing by the Commission was accomplished through the regulation of the exchange. The wisdom of the CFMA was to recognize explicitly that the clearing function was something that could be viewed separately from the exchange. And, the view that a clearinghouse can operate autonomously from a trading platform gives rise to the concept of clearing over-the-counter (OTC) derivatives, as well as other asset classes.
In 1999, the President’s Working Group on Financial Markets took a hard look at the over-the-counter derivatives markets and how they intersected, or clashed, with the Commodity Exchange Act. In its report on this these issues, one area on which they focused was the clearing systems for OTC products. The Working Group noted that clearing systems are quite effective at mitigating the loss that an individual party to a transaction suffers if its counterparty fails to settle an obligation, and can therefore reduce systemic risk by preventing the failure of a single market participant from having a disproportionate effect on the overall market. Moreover clearinghouses also facilitate the offset and netting of obligations, which is another way of saying that they support liquidity in the marketplace. However, the report also stresses that because clearinghouses may serve to concentrate diffuse credit risks in a single entity, clearing systems should be subject to regulatory oversight in order to help ensure that proper risk management procedures are established and implemented and that the clearing system is properly structured. The Working Group recommended that clearing organizations designed to clear OTC derivatives products be permitted to form under the authority of various regulators, including the CFTC. Ultimately, the CFMA was written to give just such authority to the Commission.
Clearing OTC Energy Contracts
As I noted earlier, in addition to clearing, the Commission’s main focus is on the proper functioning of the price discovery mechanism. It has long been my view that good price discovery comes from liquid markets. In the 1990’s, we saw very liquid markets in OTC energy markets. For the most part the trading in these markets was done through bilateral transactions where the credit risk that a party assumed in the transaction was simply a function of the creditworthiness of the counterparty with which it transacted. Thus, a party did whatever due diligence it could to determine how creditworthy its trading partner was. Following the collapse of Enron, however, participants in the energy markets had greater appreciation for the credit risk to which they were exposed in bilateral transactions. As a result, liquidity in the markets quickly dried up and the search was on for some way to manage counterparty credit risk. One solution that was quickly seized upon was the concept of clearing, which for many years has served as the mechanism for credit risk mitigation in the futures industry.
While it has taken a few years to develop, OTC energy clearing has really begun to take off. Today, Nymex, through their ClearPort facility, and the InterContinental Exchange (ICE), through their partner LCH.Clearnet, are significant sources of clearing for OTC natural gas contracts. And recently the North American Energy Credit and Clearing Corp (NECC), the ICE and The Clearing Corp (CCorp) combined their efforts to establish an accessible mechanism to clear physical power transactions. The first transaction cleared under this cooperative effort took place on June 3rd and resulted in the physical delivery of power into the ERCOT power transmission hub in Texas on June 7th.
As a result of these industry initiatives, the OTC energy markets are once again becoming vibrant markets that can offer vital risk management services to the industry. As a regulator of derivatives markets I see this as an important success, because I view my job as not only ensuring the safety of markets, but ensuring that they exist.
Clearing OTC Derivatives
We all know counterparty credit risk is not unique to energy markets. As a result we have seen various clearing solutions in financial markets. Again the London Clearing House has been a leader in this area, launching its SwapClear facility in 1999. Through SwapClear, users can, among other things, reduce their credit risk through multilateral netting and the margining of exposures, offset margins between swaps and futures and options positions traded on LIFFE, and simplify the processing of trades.
Another company, called TriOptima, while not offering outright clearing services, has developed a process that enables derivatives dealers to reduce their derivatives inventories through the mass multilateral termination of contracts. The early termination of these contracts allows dealers to eliminate the risk of holding open positions and cuts operational and capital costs in the OTC derivative markets. So while not actually providing a clearing platform, TriOptima is able to provide an important aspect of clearing to the derivatives markets, which is the early offset of contracts.
Regulatory interest in credit and settlement issues was highlighted by the recent meeting hosted by the Federal Reserve Bank of New York to address market practices with regard to assignments of trades and operational issues associated with confirmation backlogs in the credit derivatives market. As we have seen, the recent growth of the credit derivatives markets has created backlogs in parties receiving confirmations of trades or a lack of timely communication when trades have been transferred to third parties. Again, while solutions to these problems may be resolved through a mechanism other than clearing, clearinghouses nonetheless have been quite effective at solving these issues by providing a central repository for contracts and contract risk.
Regulatory Interest in the Clearing Function
As I alluded to earlier, the Commission, as affirmed by the President’s Working Group, has an interest in clearing systems because they concentrate diffuse credit risks in a single entity. If that entity fails, not only do customers lose money, but, as was the case in the energy markets, liquidity collapses and potentially sets off a whole string of unfortunate events related to the unavailability of risk management contracts.
When the CFMA was passed, Congress effectively decoupled the execution function of an exchange from the clearing function, while also allowing the newly recognized entity, the Derivatives Clearing Organization, or DCO, to clear both exchange-traded contracts and OTC products. To become a DCO, a clearinghouse must submit an application that includes the applicant’s rules and demonstrates how the applicant is able to satisfy each of thirteen core principles specified in the Act. The Act specifies that if the clearinghouse is clearing futures contracts traded on a DCM, it must register with the Commission as a DCO in order to clear the contracts. Incidentally, this is the provision that comes into play in consideration of the Eurex clearing linkage and whether Eurex clearing should be required to register as a DCO (regardless of whether they only clear for their non-US customers). For contracts that are excluded or exempted from the Act, a clearinghouse need not register with the Commission, but may voluntarily do so with the understanding that it is required to comply with the core principles of the Act.
For an entity wanting to be registered as a clearinghouse, the core principles that they must demonstrate that they can comply with relate to: financial resources; participant and product eligibility; risk management; settlement procedures; treatment of funds; default rules and procedures; rule enforcement; system safeguards; reporting; recordkeeping; public information; information sharing; and antitrust considerations.
Not to diminish the importance of all 13 core principles, I would like to highlight those that I believe are the most important with respect to maintaining financial integrity in the OTC markets.
Regulatory Interest: Financial Resources
Probably the most fundamental core principle is that which requires that the clearinghouse has adequate financial, operational, and managerial resources to discharge the responsibilities of a clearing organization. If an organization is unable to adequately fund its operation and employ the necessary talent to effectively manage its operation, it will be able to do little to provide financial integrity to the markets. The level of managerial sophistication and financial resources that it would need to supply will certainly differ depending on the markets it is clearing. For example, in February 2004, the Commission designated HedgeStreet as a DCO. As a clearinghouse, HedgeStreet is a very simple operation requiring little financing or management expertise. The contracts it clears expose HedgeStreet to very little risk since the contracts are fully paid-up, cash-settled, binary options. For each contract that two counterparties enter into, HedgeStreet will collect $10 from each party and in the end pay all $20 of what was collected to one of the parties. In other words, HedgeStreet at all times holds all of the money that will need to be paid to customers. Compare that to an operation such as the CME Clearinghouse which operates at a level of complexity magnitudes beyond HedgeStreet.
Regulatory Interest: Risk Management and Settlement Procedures
This brings us to the second set of core principles that I view as significant—risk management and settlement procedures. I have grouped these two together, because I believe that in the OTC context they are quite related and potentially are more difficult to control than in the exchange environment.
To invoke the example of HedgeStreet again, HedgeStreet really has very little risk that it must manage. Because customers pay up in full when they execute a contract, HedgeStreet as a clearinghouse faces no credit risk. Where a clearinghouse, such as that associated with exchanges or OTC markets, is clearing contracts on a margined basis, it is critical that it has in place the ability to manage the complex risks associated with clearing those contracts. When margining, it must have procedures and mechanisms in place to assure that margin can be collected in a timely fashion, and if cross margining, it must be assured that the models used to calculate margins provide adequate protection.
In the OTC markets these can be very tricky risks to manage. Consider that in marking contracts to market for the purpose of collecting variation margin, exchanges can usually rely on obtaining prices from the pit or electronic market. If a clearinghouse is clearing bilateral contracts, it may not be as clear at any point in time what the market clearing price is for purposes of margin collection. If the clearinghouse errs in setting that price, it risks overexposing itself to market losses and default risk.
Regulatory Interest: Treatment of Funds
The fourth core principle that deserves highlighting is the treatment of customer funds. In the case of exchange markets, the Act actually requires that customer funds be segregated from those of the FCM or clearinghouse. In addition, Commission rules limit how FCMs can invest customer funds they are holding. As with the requirement that clearinghouses are adequately financed, it is important to the financial integrity of the market that entities safeguard what funds they have collected. When such safeguards break down the potential then exists that customers cannot be made whole, in which case the market becomes exposed to a systemic event. For regulators, such an event represents a worst case scenario and most seek to avoid it at all costs.
Regulatory Interest: Default Rules and Procedures
Finally, and appropriately so, default rules and procedures are the necessarily evil of core principles that needs to be in place when everything goes wrong. Speaking from the perspective of a regulator or a clearinghouse, the use of default rules and procedures are the last thing that we want to employ since it means that somewhere else along the line something has gone drastically wrong. In the futures, industry we are proud to say that there has never been a default of a clearinghouse. But that is not to say that FCMs and their customers have not experienced default problems. In December 1998, Griffin Trading Company, an FCM, declared bankruptcy after one of its foreign-based customers traded on a foreign exchange in excess of his trading limits and then defaulted on his obligations. Griffin, in turn, defaulted on its obligations to its foreign clearing-brokers, which then seized all available customer money. Although no losses were sustained by customers trading on U.S. markets whose funds were in U.S. segregated accounts, non-defaulting customers whose funds were deposited in foreign accounts were not able to recover funds immediately. Such events highlight the need for procedures to quickly resolve default issues as they arise. Where such procedures are not in place, there is a great risk that defaults in one market can quickly escalate into other markets.
In the area of clearing, we have seen promising evolution across assets and borders. With ground breaking strides in asset pricing, risk modeling, and financial engineering, it is a logical progression for clearing entities to seek to span multiple asset classes and markets. As mentioned, numerous OTC markets have sought to expand the risk novation function of clearing to OTC products. With regard to energy, we saw that the availability of clearing for OTC products have helped to abate concerns about counterparty credit risk in the OTC markets and increase liquidity in those markets.
Because of the importance of the clearinghouse and the financial risks involved, the integrity of clearinghouses and the firms that use them are very important concerns for regulators like the CFTC. When you talk about systemic risk and the responsibility of regulators to be proactive, we must recognize that a sudden loss of liquidity can have as devastating an effect on the market and the firms involved as a default (witness Long Term Capital Management was largely a liquidity crisis). Because of the potential for risk reduction from the perspective of counterparty risk, market, and systemic risk, clearing is an important practice that regulators must both understand and encourage.
So I believe that the expansion of clearing to include multiple asset classes is a very good development from a regulatory perspective. Clearing of OTC contracts is still really in its early stages and as organizations such as Nymex, ICE, LCH and ICAP gain experience, we will ultimately see increased interest and innovation beyond what we see even now. I look forward to those developments since I believe that it will lead to not only more financially secure markets, but to larger and more liquid derivatives markets, in general.