Dissenting Statement of Commissioner Sharon Y. Bowen Regarding Comparability Determination for Japan: Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants
September 8, 2016
I thank the staff for all of its hard work on this margin comparability determination. However, I cannot support it. I will be voting no as I think it would introduce greater risk into the derivatives markets – the very thing that we were sent here by the American people to prevent.
There are just three questions I will answer in my remarks today:
1. What is a margin comparability determination and why does it matter?
2. What are the problems with this particular comparability determination?
3. How can we fix it?
First, what is a margin comparability determination and why does it matter? For many Americans, a margin comparability determination is truly a foreign concept. But it actually has great significance to our economy. Margin is collateral. The 2008 derivatives market was under-collateralized, and that is what caused it to explode and take our economy with it. The American people expected us, as regulators, to fix that by requiring sufficient collateral to address the risk. We have done that with our margin rule.1
In a margin comparability determination, we are defining when our US dealers that are operating in the other jurisdiction, can ignore our margin rule and follow the other jurisdiction’s margin rule. Allowing American companies to just follow one set of rules – that of the jurisdiction they are in – makes sense when the rules are basically accomplishing the same thing. I am in favor of that. International comity, harmonization across jurisdictions, and having an outcomes-based approach to comparability all make sense.
Unfortunately, that is not the scenario that we have here. While Japanese law has some strong similarities to our own, there are some areas of divergence that are significant and would allow American companies to do overseas what they would never be allowed to do here. And make no mistake; though these companies are physically located in Japan, their cash line runs right back to the United States. That risk could be borne again by American households. A comparability determination should not be the back door way of undoing or weakening our regulations and thereby incentivizing our companies to send their risky business to their affiliates located in Japan. That would not be good for our economy, Japan’s economy, or global financial stability overall.
This determination is doubly important because this is the first one and thus sets the stage for others. By adopting a weak standard today, we pave the way for even weaker determinations in the future. Moreover, we are not establishing this determination in conjunction with the Prudential Regulators, who oversee roughly half of US swap dealers and are our counterparts on these issues. We have worked effectively with our Prudential counterparts on the international Working Group on Margin Requirements (WGMR)2 thus far; making this determination without harmonization amongst US regulators is ill-advised. Differences in requirements would only open the door to regulatory arbitrage domestically.
Second, what is the problem with this particular comparability determination? The answer: bankruptcy. Bankruptcy is something that we do not like to think about, but in finance, it is something that we must always consider when designing deals. We know the old adage: Hope for the best, but plan for the worst. In my work as a law firm partner and Acting Chair of the Securities Investor Protection Corporation (SIPC), I have seen too many bankruptcies. And there are three key differences in our margin rule and the Japanese margin rule that would leave our American companies operating under Japanese law vulnerable. The key differences are:
1. Where the customer money is kept. Our rules require customer collateral to be held by a third party – not by either one of the counterparties. This is a safeguard for bankruptcy. If the money is held by one of the counterparties, then a bankruptcy court may use that money to meet the counterparty’s debts. Or in a stress event, the counterparty could potentially take the customer money to meet its obligation. If, however, the money is at a third party, it is far more likely that it will get back to the customers that provided it. Japanese law does not have a comparable rule. Thus, in a bankruptcy situation, US customers may be unable to receive back their customer funds. This discrepancy is noted in the determination,3 but the staff states that the fact that the funds are segregated sufficiently mitigates against the risk. I disagree. In my experience with bankruptcies, I have learned that access to customer funds largely depends on the location of those funds. Third-party custodianship is an important safeguard.
2. Transacting with counterparties in bankruptcy-risky jurisdictions. There are certain developing countries where there is little certainty that collateral will be there if there is a bankruptcy (non-netting jurisdictions), and/or where they do not adequately protect customer funds from that of the dealer (“non-segregation jurisdictions”). Under our rules, our US dealers have to limit the way they trade with counterparties in these bankruptcy-vulnerable jurisdictions because we are not confident that our American investors will get their money back in a bankruptcy scenario.4 These safeguards vary depending on the circumstances and include limiting the amount of business that our dealers can do with these counterparties, and limiting the type of acceptable collateral. Japan does not have these kinds of limits on their dealers who deal in these bankruptcy-vulnerable jurisdictions. Thus, the American companies operating in Japan could potentially have an unlimited number of deals with counterparties in these developing countries. This could put some of our major American financial firms, and thus our economy, at risk.
3. Types of collateral allowed. There are significant differences in the treatment of collateral between our margin rule and the Japanese rule. First, while our rules limit daily variation margin to cash for dealer-to-dealer swaps, under Japanese law, variation margin could be in a number of much less liquid instruments. And second, while we require a 25% haircut for certain equities not included in the S&P 500, under Japanese law, equities included in major equity indices of certain designated countries just have a 15% blanket haircut.5 That means that we require our companies to value equities much more conservatively than under Japanese law. That means that in a crisis, American companies in Japan could be exchanging instruments that are virtually worthless since they cannot be readily converted to cash, thereby putting them in jeopardy.
If these were insignificant differences, I would happily brush them aside and accept this comparability determination as is. But these issues could mean the difference between an orderly bankruptcy, and a disaster overseas that pulls down a significant American financial company, and potentially our economy.
And last, how could we have fixed it? Fixing this is actually rather simple. We could provide a partial comparability determination – our American businesses could follow the Japanese margin rule except in the areas above where they would have to follow our rule. We have already done this in the current draft in the area of inter-affiliate margin. We would simply extend the same treatment to these three areas as well.
Unfortunately, that common sense approach was not followed here. And that is why I am unable to vote for it. While our two jurisdictions are partly comparable, there are significant areas in which there are material divergences. A partial comparability determination, as described above, would be the best way to strike the balance between international harmonization and protection of American financial companies that are located elsewhere but still directly linked to our economy.
1 Though, as noted in my dissent, this rule was far weaker than it should have been due to how it dealt with inter-affiliate margin. See Dissenting Statement of Commissioner Sharon Y. Bowen Regarding Final Rule on Margin for Uncleared Swaps (Dec. 16, 2015), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement121615a.
2 Working Group on Margin Requirements of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.
3 See “Comparability Determination for Japan: Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,” pp. 63-65. (“The Commission notes that the JFSA’s [Japan Financial Services Agency] margin requirements with respect to custodial arrangements are less stringent than those of the Final Margin Rule in one material respect. Under the Final Margin Rule, all assets posted by or collected by CSEs as initial margin must be held by one or more custodians that are not the CSE, the counterparty, or margin affiliates of the CSE or the counterparty. The JFSA’s margin rules do not prohibit a FIBO/RFI from using an affiliated entity as custodian to hold initial margin collected from counterparties.”).
4 Id. at pp. 67-72. (“[W]ith respect to transactions subject to the laws of a non-netting jurisdiction JFSA’s margin regime exempts FIBOs/RFIs from the otherwise applicable requirements to collect and post margin…. [W]ith respect to non-cleared OTC Derivatives subject to the laws of a jurisdiction that has inherent limitations on the ability of a CSE/FIBO/RFI to post initial margin in compliance with the custodial arrangement requirements of the JFSA’s margin rules and the Final Margin Rule … [t]he JFSA margin rule does not have the cash-only requirement, nor does it limit transactions to 5% of a FIBO/RFI’s total notional of uncleared swaps.”).
5 Id. at pp. 59-61. (“[T]he JFSA’s requirements are less stringent where they permit the same haircut for all equities (15%) included in major equity indices of certain designated countries while the Final Margin Rule applies a 25% haircut for certain equities not included in the S&P 500. The JFSA’s requirements are also less stringent with respect to the eligible collateral for variation margin for non-cleared OTC Derivatives between FIBOs/RFIs that are CSEs and FIBOs/RFIs that are SDs and MSPs (including other CSEs). The Final Margin Rule only permits immediately available cash funds that are denominated in U.S. dollars, another major currency (as defined in § 23.151), or the currency of settlement of the uncleared swap, while the JFSA’s requirements would permit any form of eligible collateral (as described above). In addition, the JFSA’s margin rules allow eligible collateral in the form of securities issued by bank holding companies, savings and loan holding companies, certain intermediary holding companies, foreign banks, depository institutions, market intermediaries, and margin affiliates of the foregoing, all of which are prohibited by the Final Margin Rule. Finally, the JFSA’s margin rules also do not specifically address requirements to monitor the eligibility of posted collateral.”).
Last Updated: September 8, 2016