Dissenting Statement of Commissioner Sharon Y. Bowen Regarding Final Rule on Margin for Uncleared Swaps
December 16, 2015
Thank you, Mr. Chairman.
I commend the staff, the Chairman, and Commissioner Giancarlo for their work on this final rule. This rule has many benefits for the American public and is an important step towards further girding the financial system. Unfortunately, as compared to our September, 2014 proposal and the rule passed by the prudential regulators, this final rule fails to meet statutory intent and it puts swap dealers we regulate at greater risk in times of financial stress because of its treatment of interaffiliate margin.
In 2008, our financial system was brought to its knees as a tidal wave of financial risk washed away the savings of many, destroyed confidence in the financial system, and swept away platitudes about large, sophisticated, financial players’ ability to manage their own credit risks. This crisis was considerably compounded by derivatives transactions that were unregulated and woefully under-collateralized.
While these large players were bailed out by taxpayers, today they have returned to record profits. Many of those same taxpayers had no similar help. No recourse to the financial institutions that harmed them. No help to pick up the pieces and rebuild a financial future.
In the aftermath, the international regulatory community recognized that margin requirements for uncleared swaps are a critical safeguard against repeating these mistakes. They provide covered entities with protections against counterparty default. Crucially, initial margin is a protection paid by the “defaulter.” These defaulter-paid protections help entities recognize the risk they take and impose on others. Variation margin, on the other hand, force entities to recognize losses they have already incurred. Together, variation margin and initial margin reduce systemic risk and excess leverage. They help ensure the parties have the capacity to perform on the swap over time.
In 2010, the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) recognized the higher risk swap dealers faced from using uncleared swaps. Dodd Frank mandated margin requirements to protect the safety and soundness of swap dealers using uncleared swaps.
In 2011, the Group of Twenty (G20) added margin requirements on uncleared derivatives to the global financial reform agenda.
In September, 2013, following the G20 agenda, the Basel Committee on Banking Supervision (“BCBS”) and International Organization for Securities Commissions (“IOSCO”) released a framework for margin requirements for uncleared derivatives (the “BCBS/IOSCO Framework”)1. This framework highlighted the increased risk posed by uncleared derivatives as the “same type of systemic contagion and spillover risks”2 involved in the 2008 financial crisis. The Framework also found that margin requirements for uncleared derivatives would promote central clearing.3
In September, 2014, the Commission re-proposed its 2011 rule on uncleared margin, updating it to reflect the Framework and working with the prudential regulators to develop a proposal that was consistent with theirs.
Unfortunately, the rule before us is a considerable retreat from the September proposal. This final rule provides an exemption for swap dealers, excusing them from collecting initial margin when entering into transactions with most affiliated parties including prudentially regulated swap dealers, i.e., swap dealers that are also banks. It also includes, in most cases, under-capitalized affiliates, foreign affiliates, and even unregulated affiliates.
As the prudential regulators noted in their recently released final rule, these swaps “may be significant in number and notional amount.”4 As I understand from our staff, interaffiliate transactions likely make up nearly half of all uncleared transactions by notional volume.
Initial margin functions a performance bond. Collected from your counterparty, it helps ensure that even as one party defaults on you, you will be able to perform on your obligations to others. Posted and collected across the financial system, it is a critical shock absorber for the bumps and potholes of our financial markets and for the risk of contagion and spillovers.
The large financial institutions that benefit from this exemption have tremendously complicated organizational structures, webs of hundreds, sometimes thousands, of affiliates spread across the globe. These complicated structures allow these banks to shift risk across the globe through different legal entities in their quest to earn higher returns on capital.
The difference in political, financial, and legal systems across these interconnected, international affiliate webs makes it difficult, likely impossible, to fully predict how risk unfolds across the global entity in a period of severe financial stress.
Think of immunizations. We have them to protect our population against the risk of infectious disease, not just for us as individuals, but to keep disease from spreading across our communities. Immunizations are not always enough, people still get sick, but they are a vital protective measure. People do forgo them, perhaps hoping that they either are not going to get sick, or if they do, that they can be treated. But, we know, hope is not enough. The whole point of immunizations is protecting against dangerous, but preventable, risks.
Initial margin fulfills a similar role. Legally, the affiliates we are talking about here are separate entities, even if they are part of a larger company structure. If their transactions across affiliates create risk, that risk should be addressed. For uncleared swaps, initial margin helps immunize individuals, institutions and ultimately the whole financial system from financial disease and contagion.
In November of this year, the prudential regulators decided to allow, subject to conditions, dealers to collect but not post initial margin with affiliates. The prudential regulators noted this accommodation would meet the twin goals of “protect[ing] the safety and soundness of covered swap entities in the event of an affiliated counterparty default” while not “permit[ting] such inter-affiliate swaps … to remain unmargined and thus to pose a risk to systemic stability.” According to the statute, our rules are to be comparable, “to the maximum practicable” to those of our fellow prudential regulators.5
While this rule today is, in many respects consistent with that of the prudential regulators, regarding interaffiliate initial margin it is neither comparable to that of the prudential regulators, nor does it protect safety and soundness of swap dealers we oversee. It places the swap dealers we regulate, and thus, their customers, at unnecessary risk in times of financial stress.
The situation of a CFTC-regulated swap dealer transacting with a prudentially regulated swap dealer is particularly problematic. Not only does the CFTC-regulated swap dealer not have the benefit of collecting initial margin, it has to post initial margin to the prudentially-regulated swap dealer. For entities with high volumes of affiliate transactions, this can leave these CFTC-regulated swap dealers in a huge hole in the case of default. By not collecting initial margin, this rule places the swap dealers we regulate at greater risk in times of severe financial stress. That cannot be consistent with the intent of a statute mandating us to protect the “safety and soundness” of our swap dealers.
By not requiring the collection of interaffiliate initial margin for this significant number of trades, we lose a vital financial shock absorber that is intended to help immunize institutions and the system against the risk of default.
We should not minimize the risk of this action. One could say that having our swap dealers collect initial margin is not necessary because a large financial institution is never going to let one of its affiliates go under. Do we want to risk the health of our economy on that bet? Especially since, relying on financial entities to properly risk manage, without regulatory limitations, did not work in 2008?
The rationale noted in this rule for allowing this loophole seems to be in order to reduce the margin amount collected by the overall enterprise. But, we are charged with protecting the “safety and soundness” of swap dealers.6 We need to address the risks that cause a particular swap dealer to fail. Especially, those risks that might cause a swap dealer to fail to meet its obligations to its customers or protect its customers’ funds.
I do not know, for a particular swap dealer, what circumstances might arise that would send it careening towards another financial crash. I cannot predict whether collecting interaffiliate initial margin will be enough to protect the swap dealer and ultimately its customers. I do know that having collateral in the form of initial margin makes it more likely the swap dealer will meet its obligations than not having it.
This decision seems to reflect a forgetfulness about how we, as a country, allowed the last financial crisis to happen. It is easy to believe that large, complex financial institutions can manage their risks. They are smart people. They make a lot of money. They have to know what they are doing.
However, the risks we are dealing with are hard to quantify. They are the kinds of risks that humans have shown, throughout history, they are quite poor at managing.
Most institutions for whom these transactions are relevant, failed in 2008 to manage the risk of these transactions. This action today seems to be a return to blindly trusting in large financial institutions’ ability and willpower to manage their risks adequately. Are we really willing to make that bet again?
I am not.
Our prudential colleagues have agreed that initial margin is the correct tool to manage the risks of transactions across affiliates. We should not be trying to guess whether a large, complex financial institution’s global risk controls will be sufficient to protect the swap dealers we regulate. Our failure to provide comparable protection for our swap dealers is inexplicable to me.
I have been responsible for dealing with customers who have lost their life savings when complex financial entities collapse. I cannot vote for a rule that places the swap dealers we regulate, and most importantly, their customers, at risk. Accordingly, I vote no.
1 BCBS/IOSCO, Margin requirements for non-centrally cleared derivatives (“BCBS/IOSCO Framework”) (September 2013).
2 Id. at 2.
4 80 FR 74840 (November 30, 2015) at 74889.
5 7 U.S.C. § 6s(e)(3)(D)(ii).
6 7 U.S.C. § 6s(e)(3)(A)(i).
Last Updated: December 16, 2015