CFTC Chair Timothy Massad announced in a recent interview that the CFTC is planning to bolster its examinations of clearinghouses (“CCPs”) to ensure their health. He noted that the CFTC will work with the Board of Governors of the Federal Reserve System on the effort.
Chair Massad cited new rules, which require banks and other firms to use CCPs owned by LCH.Clearnet Group Ltd, CME Group and ICE, as examples of how intensifying the oversight of CCPs can help “monitor and mitigate risks” without eliminating them.
Separately, in an online commentary, University of Houston Finance Professor Craig Pirrong discussed Chair Massad’s statement, explaining that “making CCPs less likely to default does not necessarily increase the safety of the financial system.” While former CFTC Chair Gary Gensler repeatedly discussed reducing the interconnectedness of the financial system through the clearing mandate, Mr. Pirrong stated that the mandate “just reconfigures interconnections” and redirects stresses to other vulnerable parts of the financial system.
After years of assurances that clearinghouses never fail, it is a breath of fresh air to have the new Chair admit openly the risks created by clearinghouses and acknowledge the need to be mindful of these risks. This welcome openness should make it possible for regulators, academics and market participants to engage in realistic discussion of both the benefits and the risks provided by clearinghouses. As the blog post by Professor Pirrong points out, making clearinghouses safer does not necessarily do the same for the financial system. In fact, it could make the system more vulnerable. The fact that clearinghouses have the unlimited power to demand cash collateral from clearing members makes the clearinghouses safer at the expense of their clearing firms, which is arguably a net loss to the safety of the financial system as a whole.
In a closed meeting, the Financial Stability Oversight Council (“FSOC”) voted to propose a preliminary determination of MetLife as a non-bank Systemically Important Financial Institution (“SIFI”).
According to the FSOC press release, the Council’s vote was unanimous with one member voting present. FSOC did not specifically name MetLife as the company it designated, explaining that it will not publicly announce the name of any non-bank financial company until the final determination is made. FSOC stated that it provided the company with a written explanation of the proposed determination, and the company has 30 days to request a hearing to contest the determination.
MetLife President and CEO Steven A. Kandarian stated that MetLife “strongly disagrees” with the preliminary designation. He explained that MetLife served as a “source of financial strength and stability during times of economic distress, including the 2008 financial crisis.” Furthermore, Mr. Kandarian said that MetLife is not “ruling out any of the available remedies under Dodd-Frank to contest a SIFI designation.”
Although there are many parts of Dodd-Frank that seem questionable as a matter of economic regulatory policy, the legal authority the government granted itself with respect to the designation of “systemically important financial institutions” is the most troublesome. The exercise of such discretionary and subjective power violates fundamental principles that rules of law should be established in advance of government actions, and should be reasonably objective, so that persons (both natural and corporate) can adjust their behavior in advance to conform to, or possibly to avoid acting in a manner inconsistent with those laws. The power to designate entities as SIFIs is inconsistent with the notion that persons (both natural and corporate) should be treated in an even-handed and objective manner, since the designation of SIFIs is done on an inherently subjective and one-off basis, without the establishment of any objective measures.
The objection made in this comment to the SIFI designation “rule” is not an objection to the government exercising authority over large, financial entities; it is to the manner in which the government exercises that authority. There is nothing to prevent the federal government from exercising power over insurance companies or from exercising greater powers over large insurance companies than it does over small. By way of example, the government imposes rules over banks that vary with respect to their size. The same could be done for insurance companies. Or they could be regulated based on some other objective measure, such as the number of individuals that they insure or the size of the premiums that they collect or the claims that they pay. Instead, the government has given itself the authority to regulate based on a variety of wholly subjective measures (such as “interconnectedness”) that are to be weighted by a wholly unknown formula. Section 113(a) of Dodd-Frank. This arbitrary power to designate entities as SIFIs is amplified because it appears that the requirements that will be imposed on any entity so designated will be equally arbitrary (or perhaps sui generis might be a fairer term) given the complete diversity of the types of entities subject to such designation.
To quote Friedrich Hayek: “Nothing distinguishes more clearly a free country from a country under arbitrary government than the observance in the former of the great principles known as the Rule of Law. Stripped of technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand.”
The Basel Committee on Banking Supervision and the International Organization of Securities Commissions (“IOSCO”) released the final framework for margin requirements for non-centrally cleared derivatives. Under these global standards, all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives will have to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions.
Below are key principles set out in the framework.
- Appropriate margining practices should be in place with respect to all derivatives transactions that are not cleared by CCPs.
- All financial firms and systemically important non-financial entities (“covered entities”) that engage in non-centrally cleared derivatives must exchange initial and variation margin as appropriate to the counterparty risks posed by such transactions.
- The methodologies for calculating initial and variation margin that serve as the baseline for margin collected from a counterparty should (i) be consistent across entities covered by the requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally cleared derivatives in question and (ii) ensure that all counterparty risk exposures are fully covered with a high degree of confidence.
- To ensure that assets collected as collateral for initial and variation margin purposes can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on non-centrally cleared derivatives in the event of a counterparty default, these assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress.
- Initial margin should be exchanged by both parties without netting of amounts collected by each party (i.e., on a gross basis) and held in such a way as to ensure that (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party to the extent possible under applicable law in the event that the collecting party enters bankruptcy.
- Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework.
- Regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory margin requirements for non-centrally cleared derivatives across jurisdictions.
- Margin requirements should be phased in over an appropriate period of time to ensure that the transition costs associated with the new framework can be appropriately managed. Regulators should undertake a coordinated review of the margin standards once the requirements are in place and functioning to assess the overall efficacy of the standards and to ensure harmonization across national jurisdictions as well as across related regulatory initiatives.
Compared with the near-final framework proposed earlier this year, the final framework includes the following modifications:
- Exempts physically settled foreign exchange (“FX”) forwards and swaps from initial margin requirements;
- Exempts the fixed, physically settled FX transactions that are associated with the exchange of principal of cross-currency swaps from initial margin requirements; and
- Permits limited rehypothecation of initial margin collateral, subject to a number of conditions.