Keynote Remarks of Chairman Timothy Massad before the Risk USA Conference
October 22, 2015
As Prepared for Delivery
Thank you, Duncan for that kind introduction. And thank you for inviting me to speak here today.
It’s been seven years since the dark days of the financial crisis. And a little over five years ago, Congress enacted Dodd-Frank. Since that time, we have implemented many changes to the regulation of our financial markets and financial institutions. In particular, this has included the regulation of the over-the-counter swaps markets. In light of these anniversaries, today I’d like to speak about where we are in that process – where we’ve made significant progress, and what we’ll be doing in the months ahead.
As many of you know, there were four key components of reform for the swaps market that were agreed to by the G-20 leaders and later adopted by the United States in Dodd-Frank. They included: central clearing of standardized swaps, oversight of the largest market participants, transparent trading on regulated platforms, and regular reporting.
Today, this framework is largely in place. The vast majority of transactions are centrally cleared. Trading on regulated platforms is a reality. Transaction data is being reported and is publicly available. And we have developed a program for the oversight of major market participants.
But there’s more work to be done. So let me review where we are in each area.
One of the most important reforms we’ve undertaken is requiring more derivatives transactions to be cleared through clearinghouses.
Central clearing is one of the great innovations of the financial system. It enables market participants to reduce exposures through netting, mitigate counterparty credit risk, and mutualize tail risk.
We have now implemented it for the swaps market. Clearing is now mandated for most interest rate and credit default swaps. Today, approximately 75 percent of swap transactions are being cleared, as compared to only about 15 percent in 2007.
But as you well know, central clearing is not a panacea. It allows us to monitor and mitigate risk, but it does not eliminate it. So as we increase our use of central clearing, it becomes even more important to focus on making sure clearinghouses are strong and resilient.
Clearinghouse Resiliency. Now I know that yesterday you had some discussions about clearinghouse risk. Over the last few years, we have done a major overhaul of our clearinghouse oversight. We have substantially strengthened risk management and increased transparency. We have incorporated international standards that we helped develop into our regulations, strengthened customer protection measures, and enhanced our examination, compliance, and risk surveillance programs.
And we have more to do. We are very focused on recovery and resolution planning for clearinghouses. I know those are important topics for many of you. They raise important issues not only about the structure of the waterfall of resources available in the event of a problem. They also raise issues of governance— that is, if a clearinghouse faces significant losses, how should decisions about what to do be made?
The Commission is also working on clearinghouse strength and stability with other regulators internationally. CFTC staff is helping to lead much of this important work. It includes taking a close look at margin methodologies and the resources available to a clearinghouse in the event of a default, including “skin in the game.” It includes looking at standards for stress tests so that clearinghouse risk can be compared across borders. It includes assessments of the implementation of the Principles for Financial Market Infrastructures, or PFMIs.
This international work also includes recovery and resolution planning for clearinghouses – and an examination of interdependencies among global clearinghouses.
Let me just add that while we must engage in recovery and resolution planning, our goal is never to get to a situation where either of those is necessary. And that is why risk management is so important. Sometimes in the current discussions about clearinghouse resiliency, the activities that comprise ongoing risk management don’t get much attention. But given that I’m speaking at a Risk USA conference, perhaps it is worth spending a moment highlighting some of the things we do or that we require at both the clearinghouse and clearing member level – because these are the everyday activities that fundamentally matter to clearinghouse safety.
We look at risk at the clearinghouse, clearing member and trader level. We look at market risk, liquidity risk, credit risk and concentration risk. We have extensive daily margin and position reporting requirements that enable us to engage in daily risk surveillance. Our program includes daily review of the positions of clearing members and large traders. We engage in analysis of margin models, stress testing of positions, back testing of margin coverage, and in-depth compliance examinations. We seek to identify who is at risk, the magnitude of that risk, and how that risk compares to available financial resources. We also require clearinghouses to oversee the risk management policies and practices of their members.
There is more that we do – this is just a quick list. But I welcome your input on what else should be done in terms of ongoing risk surveillance—whether by us, the clearinghouses or the clearing members. In this regard, I am a strong supporter of transparency when it comes to clearinghouse risk management. Because clearinghouses mutualize risk, it’s important that clearing members have sufficient knowledge of the risk management practices of a clearinghouse – and sufficient input into decisions that may affect overall risk of the clearinghouse.
In addition, we’re stepping up efforts to protect against cyber threats – as well as technological and operational risk generally. That’s because clearinghouse risk does not come only from credit or market risk. This is a priority for us this fall.
I think you are all well aware of the importance of strengthening the security and resilience of our financial markets against cyber-attacks and technological failures. While we have been addressing this issue through our regulations and examinations, we are also considering some additional proposals. These would focus on making sure clearinghouses as well as other core infrastructure such as the major exchanges and swap data repositories – are doing adequate evaluation of these risks and testing of their own cybersecurity and operational risk protections.
I expect these will be principles-based standards. For example, our proposals will describe the general types of testing that are needed—including controls testing, vulnerability testing and penetration testing – but we will leave the detail of how to do the testing to the responsible firms.
Now I’d like to address two other topics related to clearing that you have asked me to discuss. The first is the dialogue we are having with European regulators over their recognition of U.S. clearinghouses, or the issue of “equivalence.”
First, let me say that we have had a very constructive dialogue with the European Commission and ESMA and I have a very good relationship with Commissioner Jonathan Hill. But, as you may know, the European Commission has not yet granted equivalence to our clearinghouses.
I believe there is an ample basis for the European Commission to declare us equivalent, and I think this should have been done some time ago. We have worked out a framework for substituted compliance with respect to the application of our rules to European clearinghouses. But we are continuing to discuss some concerns that the European Commission has pertaining to differences in our regulatory systems and, in particular, differences related to margin methodologies. These do not pertain to the clearing of swaps but rather to exchange-traded futures.
Margin methodologies are complex and have many parameters. In addition, they are only one part of overall risk mitigation. And that is why I think the European Commission should not focus on one or two particular aspects of margining in this process – such as one-day versus two-day minimum liquidation periods. Instead, we should look at overall outcomes. I believe that is especially appropriate because our rules are consistent with existing international standards—the PFMIs—and when measured through back testing or in other ways, our margining is just as robust.
I am open to considering whether we need international standards on margining that are more granular than the PFMIs. Both Europe and the U.S. already actively participate in the international review of clearinghouse resiliency issues led by CPMI and IOSCO, which I mentioned earlier. This is looking at a number of issues pertaining to clearinghouse resiliency, including margin methodologies.
I also note that the European Commission has recognized as equivalent other jurisdictions that follow many of the same margining practices as the CFTC. These include Australia, Hong Kong, Japan and Singapore. And recently, the Commission recommended that five additional jurisdictions be deemed equivalent, some of which follow similar policies, including Canada.
So let me just conclude by saying that all of us at the CFTC today want to reach an agreement, but we are concerned about increasing the costs of clearing in our markets when there may be no commensurate benefit in terms of risk reduction. And we are all concerned about the European Commission imposing a different equivalence standard on the U.S. than on other countries. So I am hopeful that we can resolve this matter soon.
Supplementary Leverage Ratio
You have also asked me to discuss another subject that is relevant to the costs of clearing and clearinghouse resiliency, and that is the supplementary leverage ratio, or “SLR.” So I will say a brief word on this.
I support having strong capital requirements on banks, including the SLR. I am concerned, however, about how the SLR may measure a clearing member’s exposure arising from cleared derivatives. The measurement methodology uses a schedule based on the notional amount of the trade. It does not take into account the collateral collected from a customer that is posted to – and held by – the clearinghouse. That collateral and the underlying positions are marked to market daily, as you know. If the clearinghouse rules state that it must use the collateral first – before seeking recourse against the clearing member –then the collateral in the hands of the clearinghouse clearly mitigates the risk faced by the bank, and I believe it should be taken into account.
We have made a national decision to expand the use of central clearing. Accomplishing this requires strong clearinghouses and a robust clearing member industry.
Many are concerned about the decline in the number of clearing firms. Many are concerned about portability of customers. That is, if one firm should default, will other firms be willing and able to take on additional customers? The ability to transfer positions quickly is critical to clearinghouse resiliency. So I hope we can continue to examine these issues and make sure we achieve both objectives: well-capitalized banks, and a resilient clearing industry.
Oversight of Major Market Players
Now I’d like to turn to the second pillar of reform: oversight of major market players. Here we also have made important progress. We have a framework in place for registration and regulation of swap dealers – more than 100 are now registered. This new framework requires swap dealers to comply with strong risk management practices. It requires them to follow good, basic business conduct practices, such as documentation and confirmation of transactions – as well as dispute resolution processes. Further, they must ensure their counterparties are eligible to enter into swaps. And they must make appropriate disclosures to those counterparties about risks and conflicts of interest.
Margin for Uncleared Swaps
One important issue related to the oversight of major market participants is the rule on margin for uncleared swaps.
This rule plays a key role in the new regulatory framework. We recognize that there will always be a large part of the swaps market that is not centrally cleared. There will always be some products that are not suitable for clearing mandates because of liquidity concerns or other risk characteristics. And clearinghouses will be stronger if we exercise care in what is centrally cleared.
That’s why margin for uncleared swaps is critical. Our proposed rule requires swap dealers to post and collect margin on uncleared swaps with one another – and with certain financial counterparties.
This helps reduce the risk of those trades, and thus reduce the risk to our financial system as a whole. I would also note that our proposed rule exempts commercial end-users from these requirements.
We have been working closely with the prudential regulators, who are also responsible for developing rules on margin for uncleared swaps. I congratulate them, as I understand they expect to finalize their rules this week. Though we have a different mission than those that oversee banks, we have been working to make the rules as similar as possible.
The CFTC also has been working with European and Japanese regulators, who are currently considering margin rules, to ensure similarity in many respects. For example, we originally wanted a lower threshold as to when a swap dealer must collect margin, which would result in more margin being collected. However, I expect that in our final rule we will agree to the European position, in order to achieve greater harmonization.
I expect our final rule to come out before the end of the year.
I also expect that once we finalize the margin rules, we will re-propose rules related to capital requirements for swap dealers and major swap participants. As with the margin rules, we’re working with our fellow regulators to harmonize these standards as much as possible.
Another important pillar of reform is the area of swaps trading. Over the past two years, we have implemented a new framework for trading on regulated platforms. This is bringing greater transparency, better price information and greater integrity to the process.
Currently, we have nearly two dozen swap execution facilities – or SEFs. According to the International Swaps and Derivatives Association, SEF trading accounted for about half of the total average daily volume of interest rate derivatives in 2014. And according to data by Clarus Financial Technology, over the first three quarters of 2015, 73 percent of credit default swaps – both cleared and uncleared – were executed on-SEF – as were 69 percent of all interest rate swaps. This was up from 65 and 62 percent, respectively, for the same period last year.
So the volume is growing. But there is more to do here also.
We continue to focus on fine tuning our rules to improve SEF trading. Over the past year, we have taken action to allow more flexibility regarding acceptable modes of execution, in particular where certain SEFs wanted to use auction –match protocols. We have simplified SEF confirmation practices and confirmation data reporting. We have clarified SEF capital requirements. We provided relief related to executing block trades and correcting erroneous trades. We addressed issues related to package trades by providing more time to develop appropriate procedures. And in August, we proposed a rule that would clarify certain reporting obligations for cleared swap transactions. I will discuss this in greater detail in a moment.
And there are a number of areas we’re still looking at, such as the “made available to trade” – or MAT – determination process.
The current MAT rule allows a SEF or designated contract market to submit a determination that a swap is “made available to trade” based on its analysis of several liquidity factors. The trade execution requirement currently applies to certain fixed-to-floating interest rate swaps in several currencies and tenors – and to certain credit default swaps based on a limited number of indices.
Some market participants have suggested that the Commission play a larger role in this process. In July, the Commission held a public roundtable to invite discussion on this process, and we will be continuing to consider these issues.
I would also like to discuss a subject outside of swaps reforms that is a priority for us, which is the increased use of automated or algorithmic trading. For the futures markets, almost all trading is electronic in some form, and automated trading accounts for more than 70 percent of all trading over the last few years.
Automated trading raises fundamental issues concerning market structure. On the one hand, some would say automated trading has created a more efficient marketplace. They would assert that speed has brought significant benefits in terms of reduced transaction costs, improved price discovery, greater liquidity and greater linkages across markets. But on the other hand, some would ask whether the speed is worth it? Can our markets manage it? How should we think about the impact of automated trading on market efficiency, fairness and systemic risk? And what if anything should we do about it?
I think all these questions deserve consideration. Yesterday, the CFTC, SEC, Federal Reserve Board, New York Federal Reserve, and the Treasury Department jointly sponsored a conference to consider the evolution of the Treasury market, including the role that automated trading plays. I spoke about the rise in automated trading – and discussed some of the steps the CFTC is taking to mitigate any risks it may pose.
As many of you know, we have already adopted a number of measures to address concerns associated with automated trading, as have the exchanges in our markets. This includes certain risk-based limits, and requirements to automatically screen orders for compliance with such limits.
But we remain concerned about minimizing the potential for disruptions and other operational problems that may arise. These can come about due to malfunctioning algorithms, inadequate testing of algos, errors and similar problems.
I expect that we will make some additional proposals, which will include requirements for pre-trade risk controls and other measures with respect to automated trading. These will apply regardless of whether the automated trading is high- or low-frequency. We will not attempt to define high-frequency trading specifically. I expect that we will propose controls at the exchange level, and also at the clearing member and trading firm level.
I anticipate that our proposals for risk controls will be largely consistent with the best practices followed by many firms already, and they will build on what the exchanges have already done. While we would, in some cases, propose the types of controls necessary, we will not prescribe the parameters or limits of such controls.
For example, we will likely propose requiring pre-trade controls, such as message throttles and maximum order size limits. But we will not prescribe how those limits should be set. We are looking at proposing requirements pertaining to the design, testing and supervision of automated trading systems – as well as measures such as “kill switches,” which facilitate emergency intervention in the case of malfunctioning algorithms.
Further, we are looking at whether to require registration for proprietary firms not already registered with the CFTC who access the market directly and who are also using automated trading – to facilitate more effective oversight.
And we are also looking at whether to require measures to limit the practice of self-trading. I would also distinguish unintentional self-trading from wash trading, which is illegal. We are also looking at market maker and trading incentive programs, which have become more significant as automated trading has increased. I expect our focus here will be on increased transparency.
Harmonizing and Standardizing Reporting
Finally, I want to discuss some issues pertaining to data reporting. Though we have made a number of significant changes to the overall regulatory structure since the financial crisis, one of the most dramatic shifts from that time is in swap data reporting.
In the fall of 2008, there was virtually no reporting of swap positions or transactions. This meant regulators had little knowledge of what was going on in the market or the exposures of major institutions. And market participants lacked the transparency that fosters competition and efficiency.
But today, all swap transactions, whether cleared or uncleared, must be reported to swap data repositories. And the availability of data is putting the CFTC in a better position to monitor the market and understand potential risks. Market participants have better information as well, which contributes to competition and better pricing. You can now go to public websites and see the price and volume for individual swap transactions. You can go to our website for a Weekly Swaps Report that gives a snapshot of the market. And third parties are providing SEF trackers and other data on SEF trading that gives the public a much better picture of the swap market than ever before.
But creating the system to collect and effectively use data is a big project, and there is still much to do. I already noted one area where staff has taken steps—and that is the no-action relief with respect to SEF confirmation and data reporting.
Reporting of Cleared Swaps. Another important improvement we are proposing are changes to the reporting obligations for cleared swap transactions. This will create a simple, consistent process for the reporting of cleared swaps, and address the risk of having duplicate records at multiple SDRs for the same swap when a swap is cleared. This will thereby reduce reporting costs and burdens and improve the quality of swap data.
We are also working on standardizing and harmonizing data reporting in several other ways. This includes possible changes to our own rules for swap participants and SEFs, as well as working with our international colleagues on harmonization. I am proud to say that CFTC staff are helping to lead the current CPMI-IOSCO effort to develop international data harmonization standards.
Thank you for the opportunity to share my views and priorities with you today. In many of the areas I have discussed, such as automated trading, cybersecurity and margin for uncleared swaps, the Commission has not yet acted, so these are my own views.
Let me just conclude with one final thought.
The reforms we are putting in place for the swaps market are part of a broader response to the global financial crisis. We must never forget the costs of that crisis. Whenever people talk about the costs of these reforms, the effects on liquidity, new reporting burdens, and the like, we need to remember the costs of the crisis to American families – the millions of jobs lost, homes foreclosed, businesses shuttered, and savings for college and retirement wiped away. While we have made great progress in implementing this new regulatory framework, we have more work to do. And we will always strive to implement it in a way that avoids unnecessary costs and burdens. But let us always remember the history that brought us here.
Thank you again. I welcome your thoughts and questions.
Last Updated: October 22, 2015