Fundamental to the Dodd-Frank Act was heightened risk management requirements for swap counterparties. Market participants have moved to central clearing of standardized swaps prior to CFTC mandatory clearing determinations (the first of which go into effect imminently), reducing transaction risk to counterparties. Under Dodd-Frank Act, cleared swaps customers are required to post initial and variation margin (collateral) through their FCM (or Clearing Member) to avoid the accumulation of large gain and/or loss obligations. Complementary margin requirements are under consideration for uncleared swaps, In addition to posting collateral, non-bank swap dealers and MSPs are also required to hold minimum levels of capital under Section 731 of the Dodd-Frank Act. These capital and margin requirements (along with those regulators) are intended to reduce swaps-related systemic risk in the global financial system. CFTC has new responsibilities in this new environment, primarily in risk and financial surveillance and examinations.
Surveillance (Risk and Financial)
- The CFTC faces a number of challenges with its new jurisdiction related to swaps. Foremost, the notional value of cleared swaps is estimated to be on the order of a factor of seven times that of futures and options. This fact alone demonstrates the need to apply significant resources to financial and risk surveillance of swaps market participants, in addition to maintaining (if not increasing) surveillance of futures and options market participants.
- In addition, unlike futures margin setting, where each CFTC-registered DCO uses the same methodology to margin positions, each DCO margining swaps positions will be using a unique margin methodology and a unique way to stress test positions. The Commission will need to developing expertise and automated tools to analyze margin requirements; determine price impact on portfolios; conduct margin trend analyses and back testing; and stress test swaps positions—including interest rate, energy and credit default swaps. Evaluating DCO models in a quantitative and systematic manner is critical based upon the value of the cleared swaps themselves and the commensurately higher risk now transferred to the clearing houses. The CFTC has had limited requirement for such capabilities and will be in competition for the requisite talent with its regulated entities.
- Ensuring that swap dealers and MSPs have sufficient capital to appropriately meet credit risk and market risk requirements will require similar capabilities within the CFTC to make informed decisions on the internal models used by swap dealers and MSPs to compute credit risk and market risk capital requirements.
- The Commission is also seeking to enhance its software and automated tools to accommodate its enhanced surveillance responsibilities.
- The technology (data and processes) required for surveillance of swaps markets differ from those required for futures and options markets, and differ across asset classes. In addition, the ability to view risk across asset classes and in combination with futures is an overarching requirement that must also be automated.
- DCOs that are determined to be systemically important under Title VIII of the Dodd-Frank Act must comply with heightened risk management and prudential standards concerning payment, clearing, and settlement supervision. Title VII requires mandatory annual examinations of systemically important DCOs to review the entities' adherence to these heightened standards. Title VIII also requires ongoing consultation between the CFTC, the SEC, and the Board of Governors of the Federal Reserve System, including the scope and methodology of planning examinations of systemically important entities. The Commission is the Supervisory Agency (primary regulator) for two DCOs that have been determined to be systemically important1. The Commission currently does not have adequate resources to perform this responsibility and maintain adequate oversight of the other significant entities within its jurisdiction.
- Direct examinations of swap dealers and MSPs to assess their compliance with financial requirements will also require additional resources and expertise.