CFTC Global Markets Advisory Committee Meeting Regarding Non-Deliverable FX Forwards and Bitcoins

The CFTC held a Global Markets Advisory Committee meeting that focused on issues relating to the mandatory clearing of FX non-deliverable forwards (“NDFs”) and the digital currency bitcoin.

In his opening statement, CFTC Chairman Timothy Massad stated that these topics of discussion are “both timely and important.” Chairman Massad discussed the importance of working out cross-border issues on clearinghouse regulation and supervision, commenting that Europe should recognize CFTC-registered clearinghouses (“CCP”) as equivalent, since they meet international standards. Regarding the CFTC’s interest in bitcoin, he stated, while the development of digital payment systems raises many issues outside the CFTC’s jurisdiction, one area within the CFTC’s responsibility is derivative contracts traded on SEFs or DCMs that are based on bitcoin.

CFTC Commissioner Mark Wetjen also spoke at the meeting. First commenting on discussions between the European Commission and the CFTC on equivalency determinations for CCPs, he highlighted the need for the CFTC and the European Commission to come to an agreement about which specific CFTC requirements will be satisfied when a CCP is following an EMIR-specific rule. Once equivalency determinations are settled, he explained, the CFTC and its global counterparts will be able to continue harmonization efforts in a number of other areas, including trading platforms.

Regarding a clearing mandate for NDF contracts, Commissioner Wetjen requested that the CFTC FX subcommittee prepare a written recommendation to address the settlement characteristics and standardization of NDF contracts and related market-structure issues involving clearinghouse, futures commission merchant (“FCM”) and service-provider risk management. He also stated that the implementation of any NDF mandate should be aligned with comparable mandates overseas.

Following Chairman Massad and Commissioner Wetjen’s remarks, the discussion about a potential mandatory clearing requirement for NDFs focused on the following issues:

  • The contracts (i.e., currency pairs and tenors) that would be appropriate for mandatory clearing.
  • The importance for the United States to have a mandate that is parallel with comparable (particularly European) foreign mandates given ESMA’s recent consultation release.
  • The effect, following mandatory clearing, that a “made available to trade” determination in the U.S. would have on the global NDF market.

Lofchie Comment: It would be prudent for the regulators to examine the risks of central clearing before forcing more types of transactions into a central clearing system. Regulators should be particularly cautious about forcing NDFs into central clearing, given that such transactions have an inherent international element, and the U.S. and EU have not resolved their differences as to how central clearing should be regulated. Clearly, there is no consensus that such a mandate would make the world economy safer. Given the obvious risks of the proposed mandate, what’s the rush ?

See: CFTC Event Notice; Chair Massad’s Opening Statement; Commissioner Wetjen’s Statement.

 

CFTC Global Markets Advisory Committee Announces Agenda for Upcoming Meeting

The CFTC released its agenda for the upcoming Global Markets Advisory Committee (“GMAC”) public meeting scheduled for October 9, 2014. The GMAC meeting will focus on issues related to clearing non-deliverable forwards (“NDFs”) and the digital currency, bitcoin.

The first panel will discuss whether a clearing mandate is appropriate for NDFs, with a particular focus on how such a mandate would impact foreign exchange contracts. The second panel will discuss the CFTC’s jurisdiction with respect to derivatives contracts that reference bitcoins.

See CFTC Press Release.

Streetwise Professor Craig Pirrong on Cross-Border Issues at the CFTC

University of Houston finance professor Craig Pirrong discussed the ongoing tension between the CFTC and its European counterparts with respect to cross-border issues in his blog post titled “Damage Control at the CFTC.”

According to Professor Pirrong, the failure on both sides to recognize cross-jurisdictional central counterparty clearinghouses (“CCPs”) could make clearing swaps “prohibitively expensive” and increase the “already worrisome fragmentation of swaps markets.” Professor Pirrong asserted that European regulators are “dismayed” at U.S. Regulators’ “rather imperialistic attitude” on derivatives regulation, especially under the leadership of Chair Gensler. He referenced CFTC Commissioner Christopher Giancarlo’s scathing speech,” in which Commissioner Giancarlo pointed out a number of CFTC rules that fail to serve their intended purpose of reducing risk, including:

  • trading only on order books and request-for-quote systems to two, then three, counterparties;
  • exchange-certified “made available to trade” determinations;
  • swap execution facility position-limit maintenance and enforcement;
  • limitations on counterparty transparency; and
  • CFTC Staff Advisory No. 13-69 (November 14, 2013).

Additionally, Professor Pirrong and Commissioner Giancarlo criticized the recent ruling by the D.C. District Court on the CFTC’s issuance of its “Interpretive Guidance” and a “Staff Advisory,” rather than a formal rule regarding cross-border issues. According to Professor Pirrong, the CFTC is attempting through its recent guidance to “impose its dictates through such procedural legerdemain.” In his speech, Commissioner Giancarlo stated that he intends to do everything he can to encourage the CFTC to replace its cross-border guidance with a final rule. Commissioner Giancarlo also would like to see the CFTC withdraw the November 13 Advisory, which he believes “fails not only the letter and spirit of the ‘Path Forward,’ but also contradicts the conceptual underpinnings of the CFTC’s Interpretive Guidance.”

Professor Pirrong expressed the view that under the new CFTC Commissioner, Timothy Massad, the CFTC could implement a new “more reasonable” approach to derivatives regulation than under his predecessor.

Lofchie Comment: Professor Pirrong’s comments and, more importantly, CFTC Commissioner Giancarlo’s speech, raise two important procedural policy questions for the CFTC. First, is it good public policy for the CFTC to regulate cross-border transactions through the issuance of what it calls “guidance” rather than a formal rulemaking process? While a court affirmed the CFTC’s authority to rely on guidance, the fact that the CFTC has the “authority” to act without going through a rulemaking process does not mean that acting in this manner is good policy. The SEC’s rulemaking on cross-border issues is a better piece of work than the CFTC’s guidance, and that the difference is likely reflected in part by the additional time that the SEC gave to considering difficult issues and the discipline of going through a formal rulemaking process, including responding to public comments and conducting a cost-benefit analysis.

Second, the CFTC must decide this: what are the fundamental policies behind Dodd-Frank? There is no reason to believe that Dodd-Frank was primarily intended to address swap-trading procedures. Thus, there is no reason for the CFTC to seek to impose United States trading rules on European swaps markets (after all, we do not impose our trading rules on European securities markets or futures markets). Accordingly, it follows that the CFTC should scale back its attempts to impose trading procedures on the markets generally, perhaps leaving some room for knowledgeable market participants to decide how they wish to trade.

See: Streetwise Professor Craig Pirrong’s blog post, “Damage Control at the CFTC“.

 

JPMorgan Issues Paper on Resolution Plan for Central Clearing Parties

JPMorgan Chase & Co. Office of Regulatory Affairs issued a paper proposing steps required to establish a credible securities and derivatives clearinghouse (“CCP”) resolution framework to manage the event of a CCP failure.

According to the paper, the “issue of resolution” has become increasingly important given that the use of CCPs in the United States is now mandatory, and there is a larger volume of transactions going through these institutions. Additionally, many CCPs have migrated from being utilities owned by members to private for-profit institutions, introducing a possible conflict between a CCP’s role as a market utility and its commercial objectives to increase revenues and market share.

The paper listed two questions about CCP resolution that must be answered: (i) do CCPs have sufficient financial safeguards to minimize the threat of “too big to fail”? and (ii) if a CCP should fail, how can that failure be managed to limit market contagion, avoid pro-cyclicality and ensure the continuity of financial market functions?

The paper recommended solutions to consider regarding a CCP resolution framework:

  • a standard, disclosed stress test framework mandated by regulators and used to size “Total Loss Absorbing Resources;”
  • the CCP’s entire Total Loss Absorbing Resources should be fully pre-funded;
  • CCPs should be recapitalized rather than liquidated upon failure, to continue systemically important activities;
  • CCPs should have “Recapitalization Resources” to allow opening on the business day following failure with a fully funded Guarantee Fund;
  • CCPs should contribute to the Guarantee Fund and Recapitalization Resources the greater of 10% of the Guarantee Fund or the largest single clearing member contribution; and
  • beyond this minimum, CCPs should retain flexibility as to how such resources are tranched and allocated.

According to the paper, the proposed approach will “promote greater market confidence in CCPs, providing the last step to achieving the promise of the newly centrally-cleared market paradigm driven by global legislation and regulations.”

Lofchie Comment: The important questions, as framed in the JPMorgan paper, underscore the core problem with central clearing. Simply put, CCPs are not the great cure to systemic risk. CCPs are the ultimate too-big-to-fail SIFIs. By the government essentially mandating that tremendous volumes of transactions flow through CCPs, failure of a major CCP would not only have the potential to cause significant credit risks, it would also create major operational problems. Once all trading in a particular asset flows through a (failed) CCP, it is not clear that the market would be able to quickly develop a means to trade around the failed CCP in the relevant product (which would be a matter of some urgency as all market participants would have had their trades in the relevant product terminated or at least threatened).

In a report issued last week, IOSCO described the difficulty of CCPs maintaining appropriate levels of capital as a “fine balancing act” that would be made more difficult by the “competitive pressures” to which CCPs are subject. That description, issued by an association of global financial regulators, does not reflect confidence in CCPs. Indeed, it raises the very significant question of whether concentrating credit and operational risk through CCPs is superior to a system in which risk is more dispersed.

As the IOSCO report observes, it is the global financial regulators that have been behind the push for the use of central clearing. This puts them in a difficult position in assessing whether central clearing is a good idea, or, even if it might be a good idea in part (i.e. whether there are limits on the types of transactions or counterparties to which central clearing is appropriate.) Other risks of central clearing highlighted by the IOSCO report include: “the inherent pro-cyclicality of margin calls [that CCPs are going to drain liquidity from the financial markets at a time when such a drain will be most damaging]; and the widespread use of similar risk management models [the CCPs effectively force the entire market to adopt the same view of risk]; the varying levels of capitalization of CCPs to withstand the failure of clearing members [given that the market is forced to clear through CCPs, market participants can not choose to step away from a poorly capitalized CCP], risk related to the investment policies of CCPs, the acceptance of collateral of varying quality and the structure of default waterfalls.”

Perhaps a non-governmental body would be best positioned to lead a public discussion of these risks.

See: JPMorgan Paper, “What is the Resolution Plan for CCPs?
Related news: IOSCO Launches Securities Markets Risk Outlook (October 3, 2014).

 

IOSCO Launches Securities Markets Risk Outlook

IOSCO published its Securities Markets Risk Outlook 2014-2015, a report intended to identify future potential risks in securities markets. 

The Outlook is divided into two parts: Part I describes selected global trends and potential vulnerabilities in securities markets, and Part II identifies potential systemic risks in or related to securities markets.  Some of the potential systemic risks identified include:

  • the search for yield and the return of leverage in the financial system;
  • the search for yield and volatility affecting emerging markets;
  • risks in central clearing; 
  • the increased use of collateral and risk transfer; and
  • the governance and culture of financial firms. 

Lofchie Comment:  The report discusses a range of risks – from an overheated global housing market to the growth of credit default swaps on municipal debt. The risks associated with central clearing are a major focus. The report states that central clearing has been strongly supported by all of the various government regulators.  The conclusion of the report, however, suggests that the benefits of central clearing are less certain and subject to far more contingencies than commonly accepted.

The report states:

“The design of the default waterfall and the placement of the [Central Clearingparties’ (“CCPs'”)] contributions therein are likely to influence incentives. . . . [It is also important for central clearing corporations to] . . . do proper due diligence on credit risk of (potential) clearing members. Determining the amount of capital that is placed, however, is a fine balancing act. The default waterfall acts like insurance. The more CCP capital that is placed senior in the default fund, the more likely the clearing members are going to be indifferent to the counterparty, with the knowledge that any default will be internalised within the CCP and its resources. In other words, it undermines the incentives to do proper due diligence and source proper counterparties, so that in the end, overall default rates may increase. So from that point of view, a model where default fund resources are placed before that of the CCP aligns the practices of clearing members and their own risk management due diligence with that of their counterparties.  Looking forward as the nature of CCP business becomes more complex, through expansion into new markets, and more centralised through consolidation, the systemic importance of CCPs may grow, and it will be important for CCP risk management capabilities to evolve to reflect these developments. Regulators, additionally, will need to be cognisant of the changing business environment that CCPs operate under, and remain vigilant to any moves in operational standards due to competitive pressures” [emphasis supplied].

This reads as less than a ringing endorsement for central clearing; it portrays a system that massively centralizes credit risk in one place, yet “must conduct a fine balancing act” in order to be safe and is required to be subject to “vigilant” ongoing regulation in light of “competitive pressures.”  Judging by the above excerpt and other sections of the report, it is not entirely obvious that central clearing is superior to an economic model in which credit decisions are decentralized.

See: Securities Markets Risk Outlook 2014-2015; IOSCO Press Release

 

House Financial Services Committee Chair Hensarling Questions FRB and FDIC about Early Derivatives Termination Rights

House Financial Services Committee Chair Jeb Hensarling (R-TX) wrote a letter to Federal Reserve Board (“FRB”) Chair Janet Yellen and FDIC Chair Martin Gruenberg regarding the regulators’ approach toward changing derivatives termination rights. 

Chair Hensarling explained that, at a September 9, 2014 hearing, Chair Gruenberg and Governor Daniel Tarullo of the FRB testified that the FRB and FDIC are working with international counterparts to make changes to the ISDA Master Agreement, which is designed to limit the early termination rights of derivatives counterparties.  According to Chair Hensarling, the officials indicated their “intention to require that regulated banks use the new ISDA protocols in swap agreements.”

Chair Hensarling stated that he expects “regulatory action of this magnitude” to occur by way of a deliberative and transparent process that includes publishing a notice in the Unified Agenda of Federal Regulatory and Deregulatory Actions and releasing the proposal for notice and comment, as required by the Administrative Procedures Act. 

Additionally, he expressed concern about “the threat to the rule of law” posed by the approach taken by the FRB and FDIC, stating that it will “evade both Congressional deliberation and agency notice and comment.” 

Chair Hensarling requested that the FRB and FDIC each provide a written response to his questions regarding their approach by October 7, 2014. 

See: Chair Hensarling’s Letter

 

UK HM Treasury Publishes Consultation Document Proposing Additional Benchmarks

The UK’s HM Treasury published a consultation document seeking views on which additional benchmarks should be brought into the regulatory framework originally implemented for LIBOR.

On June 12, 2014, a joint review of the ways in which wholesale financial markets operate was launched by HM Treasury, the Bank of England and the Financial Conduct Authority (“FCA”). The final report is expected in June 2015, but in the near-term, the Chancellor of the Exchequer will consider which additional major benchmarks – across the fixed income, currency and commodity markets – should be brought into the regulatory framework originally implemented in the wake of recent LIBOR misconduct.

The consultation document recommends bringing the following benchmarks into the scope of the regulation of benchmarks:

  • Sterling Overnight Index Average (“SONIA”);
  • Repurchase Overnight Index Average (“RONIA”);
  • WM/Reuters’ (“WMR”) 4 p.m. London Closing Spot Rate;
  • ISDAFIX;
  • ICE Brent Futures;
  • LBMA Silver Price; and
  • London Gold Fixing.

The consultation document’s summary of the Fair and Effective Markets Review (“Review”) reports that the Review advises that all benchmarks on the recommended list should be made “specified” benchmarks for the purposes of the Regulated Activities Order and be designated as “relevant” for the purposes of the criminal offence of making misleading statements in relation to benchmarks, so that these benchmarks are brought under the FCA’s regulatory regime and their manipulation is subject to criminal legislation.

The Review anticipates that the regulatory framework will apply to the seven benchmarks in somewhat different ways:

  • Generally speaking, under the framework, an administrator of a specified benchmark is responsible for collecting, analyzing or processing information or expressions of opinion used to determine a specified benchmark and must be authorized and subject to FCA rules. The Review expects that the administrators of all seven recommended benchmarks will be treated in this way.
  • Under the framework, anyone who acts as a benchmark submitter – i.e., someone who provides information or expressions of opinion to a benchmark administrator required for the purpose of determining a specified benchmark – also must be authorized and subject to FCA rules. However, those requirements are disapplied when, among other things, that information consists solely of factual data obtained from a publicly available source. On that basis, the Review anticipates that these requirements would be applied to the contributing brokers who submit brokered overnight transaction rates and volumes to the Wholesale Markets Brokers’ Association for the purpose of determining SONIA and RONIA, and the submitting banks that contribute mid-market swap rates to ICE Benchmark Administration Limited for the purpose of determining ISDAFIX.

Comments on the consultation document are due by October 23, 2014.

See: HM Treasury Consultation Document.

 

FSB Releases Report on FX Rate Benchmarks; IOSCO Reviews Implementation of Foreign Exchange Benchmark

The Financial Stability Board (“FSB”) released the final version of its report on foreign exchange (“FX”) rate benchmarks. In conjunction with this report, IOSCO published a report reviewing the implementation of its Principles for Financial Benchmarks with regard to the administrator of the rate, WM/Reuters 4 p.m. Closing Spot Rate (“WMR”).

The FSB report sets out a number of recommendations to reform the FX markets and benchmark rates that have been identified as preeminent by market participants, including the WMR. The recommendations fall into the following broad categories:

  • the calculation methodology of the WMR benchmark rates;
  • the publication of reference rates by central banks;
  • market infrastructure in relation to the execution of fix trades; and
  • the behavior of market participants around the time of the major FX benchmarks (primarily the WMR 4 p.m. London fix).

The IOSCO report explains the findings of IOSCO’s review of the WMR implementation of its Principles for Financial Benchmarks, and sets out:

  • the methodology used to conduct the review;
  • a discussion of the implementation of each of the principles by the World Markets Company PLC, with distinctions drawn between the currency pairs where relevant; and
  • where a principle has yet to be implemented fully, the reasons why, the plans for implementation and the recommended actions.

See: FSB Final Report on FX Benchmarks; IOSCO Report; FSB Press Release; IOSCO Press Release.