Joint Statement from Chairmen Giancarlo and Clayton on the IDI Exception to the Swap Dealer Definition 

December 13, 2018

Washington, DC – U.S. Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo and U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton issued the following joint statement on the IDI exception to the swap dealer definition in the Dodd-Frank Act:

“We are committed to continuing to engage and take action to better harmonize our agencies’ swap dealer and security-based swap dealer regulations under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  As part of this commitment, we wish to provide market participants with additional clarity regarding the treatment of swaps that insured depository institutions (“IDIs”) enter into with customers in connection with originating loans. 

“The Dodd-Frank Act included an “IDI exception” in the definition of swap dealer to encourage banks – particularly small and regional institutions – to enter into swaps with loan customers to minimize risks to lenders and borrowers. The CFTC’s June 2018 notice of proposed rulemaking regarding the swap dealer de minimis exception raised a number of issues related to the swap dealer definition and corresponding exemptions.  We look forward to working together to consider these issues.  As we stated in our joint 2012 adopting release, our Commissions have not interpreted the joint rulemaking provisions of the Dodd-Frank Act to require joint rulemaking with respect to the de minimis exception to the swap dealer definition, including an exception for a de minimis quantity of swaps entered into by IDIs in connection with loans.

“More generally, we recognize that it is important for both Commissions to provide market participants with consistent and comparable regulations to the extent practicable.  Our Commissions will continue to work together toward this harmonization goal, which will remain an important part of our 2019 policy agendas.”

The views expressed in this statement are our own and do not necessarily reflect those of our fellow Commissioners or the staff of the CFTC or SEC.

Statement of Chairman J. Christopher Giancarlo on the Passing of Robert Cox

December 12, 2018

Washington, DC - Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo issued the following statement on the passing of Robert T. Cox, vice president in the financial markets group at the Federal Reserve Bank of Chicago:

"We are deeply saddened at the loss of Bob Cox, a tremendous figure in the derivatives community," said Giancarlo. "Throughout his career, Bob found meaningful ways to contribute to the CFTC's mission to oversee American derivatives clearinghouses - from serving on advisory committees to participating in agency discussions and consultations. His absence will be deeply felt here at the agency, as it will no doubt be throughout the financial markets."

Statement of Chairman J. Christopher Giancarlo  on the White House Intent to Nominate Heath Tarbert as CFTC Chairman

December 11, 2018

Washington, DC – Commodity Futures Trading Commission (CFTC) Chairman J. Christopher Giancarlo issued the following statement regarding the White House announcement of President Donald J. Trump's intent to nominate Heath P. Tarbert as the next Chairman of the CFTC:

“The White House has made a superb choice in Heath Tarbert as the intended nominee to be the next Chairman for the Commission,” said Giancarlo. “If confirmed by the US Senate, he will be an effective Chairman and will be well suited to continue the work of transitioning the CFTC into a Twenty-First Century digital regulator that balances concerns over systemic stability with market vibrancy to support strong economic growth and American prosperity.”

Opening Statement of Commissioner Dan M. Berkovitz before the Market Risk Advisory Committee

December 4, 2018

Good morning everyone.  I want to briefly mention my interest in two topics to be discussed today:  clearinghouse risk management and the treatment of derivatives exposures and margin under prudential regulator rules.

First, on clearinghouse risk generally:  clearinghouse risk management is a critical issue for the CFTC.  After the adoption of the Dodd-Frank Act, substantially more activity—both in swaps and futures—is now centrally cleared.  I believe wholeheartedly that encouraging central clearing is good for our markets and market participants.  Central clearing mitigates systemic risk.

However, with the expansion of the volume of trades cleared, we need to be ever more vigilant at monitoring and overseeing clearinghouse risk management.  A big part of that effort is having opportunities like this meeting to discuss with market participants the clearing risk management and governance issues on today’s agenda.

Next, a few words about the capital treatment of derivatives exposure: During the Commission’s last public meeting, I expressed concern that market concentration in fewer entities can have negative effects on competition and systemic risk.  It is well known that FCM services are becoming more and more concentrated.  A large majority of futures and swaps are now cleared by a handful of FCMs affiliated with large banks.  

The document recently released by the FSB on Incentives to Centrally Clear OTC Derivatives states that “[a]cross the United States, the United Kingdom and Japan, the amount of cleared client trading activity which passes through the top five clearing members exceeds 80% for IRS, as measured by notional value.”[1]   The FSB also reports that the current treatment of margin posted by clients in the leverage ratio may be a significant disincentive for FCMs to offer or expand client clearing.[2]

I am very much aware of the concerns around bank leverage and support efforts to restrict excessive risk taking by banks.  However, a reduction in the availability of clearing services offered by fewer firms could itself become a risk issue.  This would not be a good outcome. 

In considering measures to reduce risk in one area, we must ensure that we are not creating or exacerbating risks in other areas.   Accordingly, I look forward to the discussion today of current proposals by prudential regulators to revise the calculation of derivatives exposures for bank capital rules.

I thank in advance all of the participants in today’s meeting for contributing to this discussion and Commissioner Behnam and Alicia Lewis for sponsoring this meeting.

Statement of Chairman J. Christopher Giancarlo on Financial Stability Concerns regarding Brexit

December 6, 2018

The U.S. Commodity Futures Trading Commission (CFTC) continues to carefully monitor discussions between the United Kingdom (U.K.) and the other EU member states (EU27) regarding the U.K.’s exit from the European Union.  Uncertainty surrounding the effect of Brexit on the U.K. and EU27 financial markets is already having a substantial impact on entities and markets regulated by the CFTC.  If not dispelled, such uncertainty has the potential to create instability in the global derivatives market.  For this reason, we look forward to the U.K. and EU27 settling the terms of Brexit in a manner that provides sufficient legal and regulatory certainty to market participants so that European and international derivatives markets can continue to carry out their essential role in economic risk transfer essential to global economic growth.

I welcome recent statements from European authorities, including the European Commission (EC) and the European Securities and Market Authority (ESMA), that they will act to ensure EU market participants can continue to clear through U.K. central clearinghouses (CCPs) after March 29, 2019 in the case of a no-deal Brexit.  The EC’s decision to allow a “temporary and conditional” equivalence regime for U.K. CCPs, along with ESMA’s call for U.K. CCPs to apply for recognition, is a responsible first step in limiting the risk of market disruption.  These actions send an important message that European authorities do not wish the political discussions over Brexit to threaten the integrity and continued operation of markets for derivatives and other financial products.

More assurances, however, are still needed.  Derivatives market participants should have greater detail and clarity from European authorities on a full range of issues, including when the proposed equivalence decision for the U.K. and recognition decision for U.K. CCPs will be made, whether the equivalence and recognition decisions will apply to all cleared products or only to derivatives, and whether the equivalence and recognition decisions will apply to both new and existing cleared transactions.  Furthermore, the relevant legal and regulatory decisions made by European authorities should be for a reasonable duration and with limited conditions.  This additional clarity and certainty are necessary to limit substantial operational and market risks that will result from the sudden transfer of potentially trillions of euros in swap exposures in the remaining weeks before a possible no-deal Brexit.

Consistent with our regulatory mission, the CFTC stands ready to consider all necessary action including use of no action relief to provide certainty and clarity to participants in European derivatives markets.  We call on relevant U.K. and European authorities to take immediate and fully effective action to provide market participants with the necessary legal and regulatory certainty to manage their operations and activities after Brexit.

* * *

The U.S. Commodity Futures Trading Commission (CFTC) is the primary regulator of the U.S. derivatives market, which is the world’s largest derivatives market and is deeply interconnected with the markets in Europe, Asia and other regions.  U.S. market participants regulated by the CFTC are a major source of clearing capital and trading liquidity to European and other international markets.  The CFTC also regulates U.S. participation in the two largest derivatives clearinghouses in the United Kingdom.  The mission of the CFTC is to foster open, transparent, competitive, and financially sound markets.

Opening Statement of Commissioner Brian D. Quintenz before the CFTC Market Risk Advisory Committee

December 4, 2018

Due to a previously scheduled official overseas trip, I am unable to participate in today’s meeting of the Market Risk Advisory Committee (MRAC).  However, given the importance to me of the issues presented today, specifically around the leverage ratio and incentives to clearing, I would like to provide the following comments.

Incentives to Clearing

I have previously discussed the importance of regulators evaluating the effects of the post-crisis reforms on the global financial system.[1]  Regulators should carefully examine these reforms holistically to see if their cumulative effect is the desired one, if the reforms are calibrated appropriately vis-à-vis each other, and what incentives or disincentives they create.  This is one reason I am very pleased to see a panel devoted to the impact that various global standards—in particular, the leverage ratio—have had on market participants’ incentive to clear.

The Basel Committee on Banking Supervision adopted the leverage ratio as a non-risk based “backstop” to prevent the build-up of excessive leverage in the banking sector and to complement its risk-based capital framework.[2]  Under this approach, banks must hold a certain minimum amount of capital against their aggregate on- and off-balance sheet exposures, regardless of the actual risk profile of their assets.

As a true and remote backstop metric, a blunt regulatory instrument like the leverage ratio can work.  However, as a binding capital constraint, especially on conditional or probabilistic off-balance sheet exposures, a leverage ratio creates many perverse outcomes and is a poor regulatory construct.  When a risk-neutral capital regime becomes a binding constraint, banks are encouraged to divest themselves of lower risk assets with lower returns in favor of riskier assets with higher rates of return.  This is exactly what we are currently seeing with the leverage ratio’s outsized negative impact on clearing and custody services that are the heart of the futures and swaps markets.

The leverage ratio requires a clearing member futures commission merchant (FCM) to include in its leverage calculation the full exposure resulting from its guarantee of a client’s trade, without reducing this exposure by the amount of segregated margin posted by the client, and then counts this margin as a source of leverage against which additional capital should be held.  This thinking ignores the fact that segregated margin will always be used to absorb client losses before the central counterparty (CCP) looks to the clearing member to absorb any residual losses. When margin is segregated, it remains an asset of the customer.  It is only at the disposal of the clearing member FCM under a client default scenario and then can only be used to reduce the resulting exposure to the clearinghouse.[3]  The clearing member cannot use the margin to leverage itself under any circumstance.  As a result, segregated margin is not just risk-free.  It is actually more than risk-free—it is always risk-reducing.  If the goal of the leverage ratio is to calculate the clearing member’s most accurate exposure for a cleared trade, then it should always use the amount of segregated client margin as an offset.

The impact of this is no small matter.  By one estimate, the average leverage exposure of the 14 largest clearing members was 80 percent higher when they were prohibited from using margin as an offset as compared to when offset was permitted.[4]  In a recent study, 72% of client clearing service providers stated that the leverage ratio, as currently implemented, disincentivizes providing client clearing services.[5]  Additionally, over 2/3 of clients responding to the study stated that they faced challenges in obtaining and maintaining access to clearing.[6]  Moreover, 70% of clients who were able to maintain their clearing services agreements stated restrictions have been placed on their cleared derivatives activity[7]

Unless the treatment of client margin changes, I fear we will see FCMs continue to exit the clearing business and the worrisome trend of FCM consolidation will continue.  As of 2017, the top five swaps clearing members controlled up to 75% of the business.[8]  I am pleased that the Basel Committee on Banking Supervision recently requested input regarding whether a revision to the leverage ratio exposure measure for the treatment of client cleared derivatives would be appropriate.[9]  In addition, I applaud the Federal Reserve Board’s recent proposed rule regarding the Standardized Approach for Calculating the Exposure Amount of Derivatives which includes a question regarding the recognition of collateral for cleared transactions for purposes of the supplementary leverage ratio, including how recognition of collateral may affect the cost of clearing services.[10]  I hope that through these consultative processes, the risk-reducing nature of segregated margin can be recognized by domestic and international regulators.

Again, I would like to thank, in absentia, all of today’s participants and the MRAC membership, as well as Commissioner Behnam for organizing this meeting.

Opening Statement of Commissioner Rostin Behnam before the Market Risk Advisory Committee

December 4, 2018

Introduction

Good morning and welcome to the CFTC’s Market Risk Advisory Committee’s (“MRAC” or “Committee”) third and final meeting of 2018.  As we edge closer to a new year, I have begun to reflect on the work of this Committee that started twelve months ago, and I am both proud of the accomplishments, and equally optimistic and excited for 2019.  As our markets continue to grow, evolve, and innovate in an atmosphere of increasing geopolitical tensions, there will be new questions and issues to address.  This Committee continually demonstrates a deft ability to adapt itself by addressing the most pressing and challenging market risk issues of the day.

I want to thank Chairman Giancarlo and Commissioners Stump and Berkovitz for being here today and for their contributions to this discussion.  We have a full day ahead, including the introduction of the newly formed Interest Rate Benchmark Reform Subcommittee.  I want to thank and acknowledge the MRAC members who volunteered to moderate panels today.  I also want to thank each of the speakers for their willingness to travel to Washington during the holiday season and contribute to this important conversation.

I want to thank the Commission staff who will be speaking today—some of whom also traveled to be here.  I would also like to thank Margie Yates, her team, and all of the Commission staff who work behind the scenes to make these meetings come alive and run smoothly.

Finally, I would like to thank Alicia Lewis, the Committee's Designated Federal Officer.  Three meetings deep in a short twelve months, Alicia keeps core logistics running smoothly and helps formulate and shape the topics, issues, and discussions that make all of the MRAC meetings so valuable and insightful.

The Agenda

The Interest Rate Benchmark Reform Subcommittee

Today’s agenda begins with Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley and our newly appointed Chairman of the Interest Rate Benchmark Reform Subcommittee.  Tom has more than forty years of experience as an industry leader, and has served in multiple capacities at Morgan Stanley in New York, London, and Tokyo.  Over the years, he has held several key roles at the U.S. Treasury, the Federal Reserve Bank of New York, and currently serves as a member of the Alternative Reference Rates Committee (“ARRC”) of the Board of Governors of the Federal Reserve System (“Federal Reserve Board”), which will be particularly relevant to his role as the Subcommittee Chairman.

The last meeting of the MRAC in July introduced benchmark reform as a key topic of interest not only to MRAC members, but also to anyone who has a car or small business loan, student loan, mortgage, or credit card. [1]  As highlighted by Chairman Giancarlo in remarks last week at the 2018 Financial Stability Conference,[2] despite huge improvements in the governance process to produce LIBOR, the market for unsecured inter-bank term lending that underlies LIBOR has dried up, and the regulatory mandate compelling LIBOR submissions has an expiration date.[3]  Fortunately, there are coordinated initiatives underway specifically targeted at addressing the myriad of impending issues specifically related to the derivatives market.  Chief among these initiatives is the ARRC, which is tasked with leading and directing the transition away from LIBOR to SOFR, the Secured Overnight Financing Rate.

At the MRAC’s July meeting, three panels focused on:  (1) the role of interest rate benchmarks in the economy, the impetus for LIBOR reform, and the current status of global reform initiatives; (2) the development of SOFR and SOFR derivatives; and (3) the impact of LIBOR reform on legacy derivatives contracts, the development of fallback language, and key risk management and governance considerations for market participants.  Following the meeting, the Commission voted to establish the Interest Rate Benchmark Reform Subcommittee to provide reports and recommendations to the MRAC regarding efforts to transition U.S. dollar derivatives and related contracts to SOFR and the impact of such transition on the derivatives markets.[4]

I was overwhelmed by the number of highly qualified nominations to the Subcommittee, and it was difficult to make selections.  I strived to ensure that the membership represents a diversity of viewpoints.  I believe the twenty-one (21) individuals chosen to serve will participate actively and engage one another as they develop and work towards the Subcommittee’s goals and objectives.  Tom will kick off today by reporting on the Subcommittee’s first initiatives.

My goal is to use the Subcommittee to complement the work of the ARRC by providing additional insight into the potential challenges leading up to the 2021 end of compelled LIBOR, identifying the risks for financial markets and individual consumers, and, above all else providing solutions within the derivatives space. My expectation is that the Subcommittee’s work—and that of the Commission itself—will recognize the critical importance of benchmarks while demanding integrity and reliability.

I have spoken publicly on this issue several times since July, in various forums.  I intend to continue to engage as wide an audience as possible to ensure that market participants, both business and legal; the global regulatory community, lawmakers, and the general public are aware of the impending issues and timeline, and know that I am available as needed on any matters that will serve to navigate a smooth transition.

With that said, I want to recognize and thank Tom for his willingness to serve in this important leadership role as Subcommittee Chairman.  Finally, I want to thank Chairman Giancarlo for his continued support of this endeavor.  The Chairman and I are in lockstep, and I am confident the Subcommittee’s work will produce deliverables that will be extremely valuable to the Commission, and ultimately global financial markets.

Central Counterparties (CCPs), Clearing, and Current Events

Turning to the primary issue of today’s MRAC, one of the core reforms outlined in the 2009 G-20 Pittsburgh Accord involved mandatory clearing of standardized swaps.  The Congress embraced this reform in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act,[5] and the CFTC subsequently finalized a series of rules defining the clearing mandate.  Since March 2013,[6] the clearing mandate has led to a tectonic shift in the swaps market place.  According to data collected by the CFTC on U.S. reporting entities, by 2017, about 85% both of new interest rate swaps and credit default swaps were being cleared.[7]

The numbers speak for themselves.  I certainly believe—and I know I am not alone in this—there will always be room for improvement, and that we can all strive to set policy and market practices to further incentivize clearing, where appropriate.  As the financial crisis taught us, central clearing works.  While the unregulated OTC swaps market played a role in the credit crisis, the exchanged traded futures books of major financial institutions proved resilient, in part because of central clearing.

Today’s discussions will largely focus on topics and issues raised by MRAC members related to clearing and the roles and responsibilities of central counterparties (CCPs) in monitoring and managing the variety of risks arising from stresses including, but not limited to, a clearing member default.  The CFTC, along with its international counterparts, is continually confronting the challenge of building and maintaining the appropriate regulatory framework for clearing in and among a population of CCPs with unique risk profiles that will withstand routine shocks and demonstrate resiliency in a crisis.  As the financial crisis also taught us, we must cooperate, and provide predictability while remaining flexible in our approach to ensure the response is appropriate when addressing an actual crisis.[8]  As well, we must constantly examine and evaluate whether our rules effectively and appropriately allocate duties and burdens in and among CCPs, exchanges, intermediaries, and market participants.  Today’s panels aim to highlight how CCPs currently approach their duty to engage in strong risk management amidst our current regulatory landscape and how global and domestic standard setting bodies are analyzing our current structures in support of making any necessary changes.

Our first panel, facilitated by Robert Steigerwald from the Federal Reserve Bank of Chicago, will set the stage by providing an overview of current risk management and governance issues with a focus on the appropriate balancing of interests and incentives between the clearinghouse and its members, as well as the consideration of clearing member and customer viewpoints.

In our second panel, we will examine management approaches to non-default losses generally, as well as in recovery and resolution, and some of the scenarios in which they may arise.  One such scenario could involve a cybersecurity breach that creates non-default losses.  Cybersecurity, as an operational risk issue, is a concern that has been voiced by many on this Committee, and as newer, faster, and more pervasive technology permeates our market infrastructure, the chance of a successful cyberattack will likely increase.  If such an event occurred and caused losses at the CCP, should those losses be met from available CCP capital and other CCP assets?  Or should they be socialized amongst the clearing members?  Or partially covered by both?

The answers to these questions will likely depend on the CCP, but by having the conversation about how these losses can be dealt with, we will be in a position to better understand how to react when an operational, investment, or custodial risk becomes a reality, particularly where non-default losses occur in tandem with default losses.

In our third panel, we will discuss some of the most recent relevant reports from global standard setting bodies on the costs and incentives of clearing and the resilience, recovery, and resolution of CCPs.  Eight years after the first reforms were implemented, the accumulated data can be used to evaluate the effectiveness of the G-20 clearing mandate and related reform-based incentives.  Many of these reforms have proven effective by moving risk from over-the counter-derivatives away from the unobserved fringes of our financial markets and toward monitored institutions that conduct central clearing and data reporting.  This move has facilitated greater transparency into market risks and provided increased netting efficiencies.  As the reports have shown, however, these benefits have not come without costs, and there remain concerns regarding whether the regulatory structure properly accounts for risk in terms of capital, margin, and leverage. 

Oversight of Third-Party Service Providers and Vendor Risk Management

Our last panel of the day will introduce a new topic for MRAC and cover the oversight of third-party service providers and vendor risk management.  Exchanges, clearinghouses, intermediaries, Commission registrants and their customers employ a wide-array of vendors that provide a multitude of different services, and each relationship carries its own risks.  As all of these entities continue to increase the number and complexity of relationships with vendors through the outsourcing of business and regulatory compliance functions, registrants must ensure that they have appropriate management and control functions to address the associated risks.  At the heart of those relationships is the ability of market participants to know with whom they are doing business, both directly and indirectly, and what risks may arise from third-party service providers.  

During this panel, we will hear from the Office of the Comptroller of the Currency whose bulletin on the risk management of third-party relationships[9] is considered among many to be the eminent guidance on sound risk management across a variety of relationships.  We will also hear from a principal provider of services in our market and from our own supervisory staff as we explore the current regulatory guidance and tools at our disposal to evaluate, monitor and manage these risks, and consider whether the Commission’s current regulatory scheme works to mitigate risks posed to market participants by third-party service providers.

It is my intention that this afternoon’s panel discussion on risks related to vendor relationships will be the start of a longer conversation by this Committee and potentially a subcommittee, with the ultimate goal of providing the Commission with surgical recommendations – as needed – to ensure market safety, transparency, and resiliency.

Closing

As Chairman Giancarlo noted last week, market reform is a continuous, iterative process that requires constant and consistent communication, coordination, engagement, and evaluation.  As I have noted before, we cannot observe the current strength of the financial markets and expansiveness of the regulatory landscape and conclude that our job is done, or worse, that we can dial back our efforts under the guise of excess.  We must all remain vigilant and not limit our focus on the looming shadow of systemic risk to the tools we have.  We must examine all of the components in our systems and go beyond assessing and assigning a metric of risk.  We must strive to understand and actively monitor and manage the risk of each component at every system level and in every connection. 

As the risk footprints change or lead in different directions, our goal must be to respond through adaptation in our management and regulatory responses.  In the international clearing space, we have an interconnected, highly concentrated system comprised of other interconnected, somewhat less concentrated systems.  This is all governed by regulations held together by consensus-based principles aimed at preserving and strengthening financial stability.  Within that structure the points of potential default and larger, catastrophic failure are too numerous—and many too remote—to account for.  Nevertheless, we must persist in our analyses, and participate in coordinated efforts to better understand, better inform, and better address risk in all its forms.  This Committee is among those efforts and its ongoing operation and input contributes to our ongoing progress.

I am very excited about our agenda for today and want to again recognize the tremendous amount of work that has gone into planning this meeting and thank everyone for being here.

Remarks by Chairman J. Christopher Giancarlo at the Fourth Annual Conference the Evolving Structure of the U.S. Treasury Market, New York, New York

“The Complex and Dynamic Liquidity Hierarchy of the US Treasury Market”

December 3, 2018

Thank you.  Good afternoon.

I want to thank John Williams, Nate Wuerfel, and the New York Fed for inviting me to speak to you today.

It is good to be here in New York City.

It is good to be downtown Manhattan, in the financial district, the heart of this great city, the first capital of the United States.

It is good to be on Maiden Lane, where in 1790, at a house just down the block, Number 57, Thomas Jefferson, Alexander Hamilton and James Madison produced the compromise of 1790.  Under that agreement the national capital would move out of New York (satisfying the two Virginians, Jefferson and Madison) and the new Federal government would undertake and settle the Revolutionary War indebtedness of the thirteen states (satisfying Hamilton).  This compromise assured that the new District of Columbia would be America’s political capital and New York City would be its financial center.

Maiden Lane is also where I began my career thirty four years ago as a municipal securities lawyer.  As I walked up from the East River Ferry terminal this morning past my first office at 180 Maiden Lane, I thought about how much has changed in government debt markets in three and a half decades.

Then, the provision of trading liquidity was entirely a human activity, analog and personal, conducted by market specialists who crowded into the financial district and its trading pits and dealing floors each day from ferries, buses and subways.  Today, liquidity is increasingly machine conducted, digital and anonymous, from all parts of the country and all corners of the globe.

But what of that change?  What difference, if any, does it make?  That is part of what this New York Fed conference and the three that proceeded it are designed to explore – the evolving structure of the market for US Treasury securities.  That evolving structure has direct parallels, not only in markets for other government debt, but also in those for corporate debt and, for us at the CFTC, in the range of exchange traded and over-the-counter derivatives.

I followed closely Governor Brainard’s review this morning of the changing nature and roles of liquidity providers in US Treasury markets, including the growing liquidity provision by proprietary trading firms, trading their own account, and the greater use of electronic execution for more active market segments.  I am pleased to hear her estimation that the Treasury market has adapted well to the post-crisis regulatory regime, the normalization of monetary policy, and wide technological changes in trading processes that have emerged.

In fact, we observe quite similar developments in US and global derivatives markets, where both broker-dealers and proprietary trading firms play important, often complementary, roles in liquidity provision.  In swaps, we also see the growing use of electronic trading, including batch auction-based systems.  Yet, those more automated trading systems continue to operate alongside more traditional, “squawk box” voice execution, just as Governor Brainard confirmed remain active in less liquid segments of cash Treasuries.

What makes all of those methods of swaps execution continually viable is the complex and dynamic hierarchy of swaps liquidity.  It is the reason why the CFTC recently put forward a proposal to sanction within our swaps trading mandate a wider scope of trading methodologies similar to what is available in US cash treasuries.  Our new proposal is designed to encourage greater flexibility, competition and innovation in methods of swaps trade execution without impacting larger financial stability goals.  The dynamic and complex liquidity hierarchy of financial swaps requires the same diversity and flexibility in execution methods that are widely used in cash markets for US Treasury securities.

Today, I would like to tell you about a recent CFTC study on the relative liquidity of exchange traded futures contracts and cash securities in the US Treasury market.[1]  The study looks at the relatively new source of TRACE data on cash Treasury transactions with CBOT futures transaction data collected by the CFTC.  The study is the work of the CFTC’s Office of the Chief Economist and was authored by Lee Baker, LIhong McPhail and our Chief Economist, Professor Bruce Tuckman.

The study portrays a highly complex and dynamic “liquidity hierarchy” in the US Treasury Market.  It shows that, while overall risk volume is greater across all cash securities than across all futures contracts, the liquidity hierarchy is more complex, with certain futures contracts more liquid than certain cash securities, and vice versa.

The study also found that futures contracts play a special role in liquidity-challenged environments.  The relative amount of risk traded through futures contracts is higher on days with large price movements.  The amount of risk traded through futures is also larger at times after U.S. trading hours.

The study further found that average trade size, in risk terms, is much higher for cash securities that for future contracts.  This is likely due to the higher prevalence of automated trading in futures markets and execution on electronic exchanges.  This, in turn, results in futures trades being broken into smaller orders for execution.

There are, of course, many ways to measure trading liquidity in markets. To name some of the most common, there’s trading volume, turnover, bid/ask spreads, market depth, and the market impact of trades of various size.

The measure of trading liquidity used in this CFTC study is DV01 risk volume, which is a variant of trading volume.  To illustrate, using very round numbers, one could describe the trading liquidity of the 7-year on-the-run note by saying that its average daily trading volume is about $35 billion face amount.  Alternatively, however, one could express this trading volume in terms of how much interest risk changes hands.  Using the common risk metric of DV01, $35 billion of the 7-year note increases in value by about $22 million for a 1 basis point decline in rates.  Therefore, one can describe the trading liquidity of the 7-year by saying either that its trading volume is about $35 billion or that its DV01 risk volume is about $22 million.

One reason to use risk volumes is to account for the fact that trading $100 of the 7-year note represents a lot less risk transfer than trading $100 of the 30-year bond.  Again, using very round numbers to illustrate the point, say that the daily trading volumes of the 7-year and the 30-year on-the-runs are each $35 billion.  As we’ve just seen, this implies that the risk volume of the 7-year is $22 million.  The implication for the 30-year bond, however, is quite different. Using its DV01, its risk volume is $66 million, which is 3 times as large as that of the 7-year.

Another reason to use risk volumes is as a means of comparing trading liquidity in futures with liquidity in cash treasuries.  Futures volume is often measured as the number of contracts traded, while volume in cash treasuries, as we’ve been discussing, is often measured as the face amount traded.  Converting both to risk volumes is a straightforward and intuitive way to compare the liquidity of the two markets.

For further methodological details, please have a look at the paper, which is available on our website. For now, let’s look turn to the results.

Figure 1.

Average % DV01 Volume by Instrument.  The bars represent the average daily traded DV01 in each instrument bucket as a percent of the total DV01 traded.

Figure 1 shows the liquidity hierarchy of futures and cash instruments.  The volumes of futures contracts are depicted by red bars, of on-the-run bonds by blue bars with a black border, and of other cash securities by black bars.

The 10-year futures contract is the most liquid contract, at 19% of total DV01 volume.  The 10-and 5 year on-the-run bonds are next, with 15% and 10% respectively.  Then there are 30-year futures contract and the 30-year on-the-run bond with about 9.5 percent each.

In short, for reasons likely relating both to history and market factors, neither futures nor cash dominate the liquidity landscape.

We can also see that outside on-the-run bonds, cash securities are significantly less liquid.  We can see that futures contracts and on-the-run bonds comprise about 87% of total DV01 volume, with the rest of the 13% is divided across more than 300 remaining cash securities.

Let’s turn to Figure 2.

Figure 2.

Average % DV01 Volume by Instrument and Volatility Percentiles.  The bars represent the average daily traded DV01 as a percent of total DV01 traded in each instrument bucket and each volatility percentile. Daily volatility is measured as the intra-day price range of the 10-year futures contract.

Figure 2 shows the average percentage DV01 volume for various instruments buckets and groups of buckets for 4 sets of days.  The red bars show results for the high volatility days, with the dark red bars showing the 90^th percentile of volatility and the light red bars show the 75^th percentile of volatility.  The blue bars show results for low volatility days, with the light and dark blue bars showing the 25^th and 10 percentiles, respectively.

Four futures contract groups are depicted on the left side.  For each of these groups, futures comprise a higher percentage of DV01 volume on higher volatility days than on lower volatility days.  The effect is particularly pronounced for the most liquid bucket, the 10-year futures contract.  For that contract, average percentage DV01 volume is 21% and 20% on high volatility days, compared with 18% and 17% on low volatility days.

Take a look at the right side of Figure 2.  The two most liquid groups, the 10-and 5-year on-the-run bonds, have an average percentage DV01 volume that is relatively flat across the volatility categories.  For the 30-year on-the-run bond, the percentage DV01 is a bit higher on low volatility days.  Most noticeable, however, is the group “All Other Cash” securities, which includes all bonds other than the 10-year, 5-year, and 30-year on-the-runs.  On high volatility days the risk volume share of this other cash group is around 18% or 19%, but 23% or 24% on low volatility days.

So, as volatility increases, liquidity migrates from less liquid cash securities to more liquid futures contracts.  Isn’t that interesting.

Now, let’s turn to Figure 3.

Figure 3.

Average % DV01 Volume by Instrument and Trading Hours.  The bars represent the average daily traded DV01 as a percent of total DV01 traded in each instrument bucket and each of U.S., Asian, and European trading hours.

Figure 3 breaks down the trading hours results by instrument.  In almost all cases, futures are a bigger fraction of risk transfer outside of U.S. trading hours.  The reverse is true for cash securities.

The trading hour effects are particularly pronounced for the super-liquid 10-year futures contract and for all but the most liquid cash securities.  The 10-year futures contract comprises 16% of risk volume during U.S. trading hours, but over 30% of volume outside those hours.

By contrast, during U.S. trading hours, “All Other Cash Securities” comprise 24% of risk volume, but only 13% during Asian trading hours and 8% during European trading hours.

These trading hours results are subject to the caveat that TRACE includes only trades reported by FINRA members, which could underrepresent cash trades outside of U.S. trading hours.

Figure 4.

Average and Median Trade Size, quoted in Dollar DV01 by Instrument.

Our last figure shows a large difference between risk trading in cash and futures.  Trade size is much greater for on-the-run bonds than for futures contracts.  Across all on-the-run bonds, the median and average trade size is over $1,300 and almost $5,000 of DV01.  The corresponding numbers across all futures are much lower, with the median less than $200 and the average just under $500.  As the figure makes clear, the greater median and average trades sizes for on-the-runs relative to futures holds across all individual instruments.

So, what have learned from this study of new TRACE data on cash Treasury transactions with CFTC futures transaction data?

First, while overall risk volume is greater across all cash securities than across all futures contracts, the liquidity hierarchy is more complex, with certain futures contracts trading in greater risk volume than certain cash securities and vice versa.

Second, futures contracts play a dynamic role in liquidity-challenged environments.  The relative amount of risk traded through futures contracts is higher on days with large price movements and at times outside of U.S. trading hours.

Third, average trade size, in risk terms, is much higher for cash securities than for futures contracts.  This is likely due to the higher prevalence of automated trading in futures markets and execution on electronic exchanges, which in turn results in futures trades being broken down into smaller orders for execution.

With this study, we have a much clearer picture of the complex and dynamic nature of trading liquidity in markets for US Treasury cash bonds and exchange-traded Treasury futures contracts.

The sophisticated liquidity hierarchy of the US Treasury market is well served by the diversity of new and traditional market makers and liquidity providers.  Trading cash treasuries in this complex hierarchy is also appropriately conducted by the varied methods of trade execution that Governor Brainard reviewed for us this morning, from electronic trading and batch auction-based systems to traditional voice execution.

This dynamic and complex liquidity hierarchy is also present in financial and other swaps markets overseen by the CFTC.  Regulated swaps markets require the same diversity and flexibility in execution methods that continue to provide a robust and resilient foundation for cash markets for US Treasury securities.

This combination of complex and dynamic trading liquidity, diversity of liquidity provision and multiple modes of trade execution is a hallmark of the continued vitality of the US Treasury market, a cornerstone of the global financial system.

Much has indeed changed in the past decades here in the Financial District.  The US Treasury market certainly continues to evolve. Yet, its sophistication, depth and diversity persist.

The more we understand our markets, the better we are able to enhance their resilience and dynamism for decades to come.

Thanks for letting me share this data with you.

Thank you.