The Over-the-Counter (“OTC”) Derivatives Regulators Group (“ODRG”) issued a report that provides an update to the G20 Leaders regarding the ODRG’s continuing effort to identify and resolve cross-border issues associated with the implementation of the G20 OTC derivatives reform agenda.
The ODRG is made up of authorities with responsibility for the regulation of OTC derivatives markets in Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, Switzerland, and the United States.
The report reflects how the ODRG has addressed, or intends to address, cross-border issues identified since the publication of the report published in 2013.
Picking up on Zsolt Darvas’ euro-area Divisia aggregates, two economists from around the world have already picked up on the Divisia aggregates and used them in their analyses:
Marcus Nunes compares European and U.S. money supply in “Money, Money, Money” to make sense of different economic behavior.
Bruegel Senior Fellow Zsolt Darvas created and made available euro-area Divisia aggregates. The new dataset includes monthly data from January 2001 onwards on euro-area simple-sum and Divisia money aggregates corresponding to the ECB’s M1, M2 and M3 aggregates for:
Euro area (changing composition);
The first 12 members of the euro area;
Break-adjusted euro area (changing composition) “notional outstanding stock” calculated by cumulating transactions.
The dataset can be downloaded from http://www.bruegel.org/datasets/divisia-dataset/. Darvas plans on updating the dataset in the future so bookmark this page.
Mr. Darvas has also released a working paper, “Does Money Matter in the Euro Area? Evidence from a New Divisia Index” where he examines the possible role of money shocks on output and prices in the euro area. Highlights from his paper are:
Standard simple-sum monetary aggregates, like M3, sum up monetary assets that are imperfect substitutes and provide different transaction and investment services. Divisia monetary aggregates, originated from Barnett (1980), are derived from economic aggregation and index number theory and aim to aggregate the money components by considering their transaction service.
No Divisia monetary aggregates are published for the euro area, in contrast to the United Kingdom and United States. We derive and make available a dataset on euro-area Divisia money aggregates for January 2001 – September 2014 using monthly data.
Using structural vector-auto regressions (SVAR), we find that Divisia aggregates have a significant impact on output about 1.5 years after a shock and tend also to have an impact on prices and interest rates. The latter result suggests that the European Central Bank reacted to developments in monetary aggregates. Divisia aggregates reacted negatively to unexpected increases in the interest rates. None of these results are significant when we use simple-sum measures of money.
Our findings complement the evidence from US data that Divisia monetary aggregates are useful in assessing the impacts of monetary policy and that they work better in SVAR models than simple-sum measures of money.
And finally, read Zsolt Darvas’ blog post “Money Matters in the Euro Area: A New Dataset on Euro Area Divisia Money Suggests that Money Shocks Have an Impact on the Economy.”
At the Annual International Banking Conference, Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome Powell discussed the global initiative to expand central clearing of over-the-counter (“OTC”) derivatives and how to ensure the successful operation of central clearing counterparties (“CCPs”).
According to Governor Powell, roughly 20 percent of all credit derivatives and 45 percent of all interest rate derivatives are now centrally cleared. To accommodate the move toward central clearing, achieve risk reduction and avoid CCP failure, Governor Powell said, a number of issues with CCPs must be addressed by domestic and international regulators:
- Liquidity – Governor Powell explained that the adoption of the Principles for Financial Market Infrastructures around the world is driving improvements in CCP liquidity; however, he stated, CCPs and their supervisors must be vigilant to ensure that liquid resources are sufficient to withstand the kinds of liquidity shocks that would likely accompany a member’s default. Additionally, he noted, it is crucial for liquidity scenario analysis to be a regular part of a CCP’s stress-testing program.
- Transparency and Disclosure – Governor Powell stressed that CCPs must provide greater transparency to their clearing members and to the public. He stated that clearing members must understand fully their risk exposure to CCPs, meaning that CCPs must disclose stress-test results. Additionally, he said, CCPs should provide clearing members with appropriate information about the specifications and application of margin models and the sizing of default funds to cover losses.
- Stress Testing – Governor Powell called for domestic and international regulators to consider taking steps to strengthen credit and liquidity stress testing conducted by CCPs, stating that clearing members and regulators should have “a more systematic view of what stress tests are performed, at what frequency, with what assumptions and with what results.” He also suggested that regulators work collaboratively and consider some sort of standardized approach to supervisory stress testing in order to ensure that the stress tests of different CCPs are comparable.
- “Skin in the Game” – Governor Powell mentioned that U.S. authorities should consider requiring that CCPs place significant amounts of their own loss-absorbing resources in front of a mutualized clearing fund, or other financial resources provided by clearing members, to create incentives for the owners of CCPs to consider new products and the modeling of risks carefully and conservatively.
Should a CCP fail, Governor Powell said, CCPs and regulators must develop clear and detailed recovery and resolution strategies that are designed to minimize the transmission of the CCP’s distress to its clearing members and beyond. In order to ensure that CCPs do not themselves become too-big-to-fail entities, he explained, the industry needs transparent, actionable and effective plans for dealing with financial shocks that do not rely on an explicit or implicit role played by the government.
Governor Powell’s speech recognizes a number of the major risks of CCPs to the financial system. As he points out, the incentive system that might motivate CCPs to keep themselves safe is so uncertain that CCPs would still require “careful consideration,” and a “number of [unidentified] factors would need to be considered in implementing [a skin-in-the-game] requirement” for the owners of CCPs. Although Governor Powell asserts that it is important for no institution to be too big to fail, it seems inconceivable that the government could actually allow a major clearinghouse to fail, given (i) the near-infinite notional value of contracts that must be run through the clearinghouse and (ii) the government’s responsibility for forcing everyone to use the clearinghouse in the first place. To the list of financial problems that could befall a clearinghouse, we must add the possibility of operational failures.
As to liquidity risk, most troubling is the ability of a major CCP to survive by dragging down everyone else. That is, in times of extreme volatility and limited liquidity, a major CCP has the authority to demand unlimited cash margin from its participants, thereby draining liquidity from the economic system at the time when it is needed most. Global regulators appear to treat the idea that CCPs make the markets safer as axiomatic, but their assumptions are not well supported.
Speaking at the George Washington University Law School, Federal Deposit Insurance Corporation (“FDIC”) Vice Chair Thomas Hoenig offered recommendations as to how systemically important financial institutions (“SIFIs”) should structure living wills in order to satisfy their obligations under Dodd-Frank. Title II of Dodd-Frank requires all SIFIs to submit plans, which are called “living wills,” to the FDIC and the Board of Governors of the Federal Reserve System to demonstrate how they could be successfully unwound and enter bankruptcy in the event of failure.
The speech was given in response to the FDIC’s rejection of living wills submitted by 11 U.S. SIFIs as legally insufficient. Common deficiencies cited by the FDIC include what the FDIC describes as unrealistic assumptions about the availability of capital and funding, and about the actions of government regulators.
To remedy the insufficiencies found in living wills, Hoenig suggested, SIFIs must pay careful attention to the following issues:
- Capital – A SIFI’s balance sheet risk may be inadequately captured by its risk-weighted assets capital ratio. The Global Capital Index developed by Hoenig demonstrates that the lack of adequate tangible capital remains among the greatest impediments to successful bankruptcy and resolution.
- Liquidity – SIFIs should assume that, in bankruptcy, their liquidity shock will be severe: banking entities may be sold or taken into FDIC receivership, and broker-dealer affiliates may also enter bankruptcy. In their living wills, SIFIs should outline how their broker-dealers and other affiliates will access unencumbered assets to provide debtor-in-possession financing in bankruptcy.
- Corporate Structure – SIFIs should be realistic about the legal and operational demands of selling or unwinding branch and corporate affiliates, and should outline procedures in their living wills for disentangling banking entities from parent and broker-dealer affiliates.
- Cross-Border – International SIFIs should anticipate the sovereign ring fencing of local funds, and should demonstrate in their living wills how they plan to support operations and maintain links to the payment systems in bankruptcy across international borders.
The Board of Governors of the Federal Reserve System (“FRB”) issued a final rule to implement Dodd-Frank Section 622, which prohibits a financial company from acquiring, consolidating or merging with another company if the ratio of the resulting company’s liabilities exceeds 10 percent of the aggregate consolidated liabilities of all the financial companies.
The final rule, which is substantially similar to the proposal issued in May, adds an exemption to clarify that financial companies which have reached the 10 percent threshold may continue to engage in securitization activities. Under the final rule, such companies are barred from acquiring control of another company under merchant banking authority.
The final rule will be effective on January 1, 2015.
The SEC issued and requested public comment on a tick test pilot program, as proposed by FINRA and the exchanges.
The details of the pilot program include:
- a one-year pilot period;
- three test groups and one control group, with 400 pilot securities in each group (for a total of 1600 pilot securities):
- control group pilot securities will be quoted and traded at any price increment that is permitted;
- Test Group One pilot securities will be quoted in $0.05 minimum increments but may continue to trade at any permitted price increment;
- Test Group Two pilot securities will be quoted and may only be traded in $0.05 minimum increments; and
- Test Group Three pilot securities will have the same quoting and trading requirements as Test Group Two, but also will be subject to a trade-at prohibition; and
- pilot securities will be divided into 27 categories, including price, market capitalization and trading volume, and each category will be subdivided further into low, medium and high subcategories.
The SEC seeks comments on a number of questions about the pilot program, including its structure, potential harm to investors and risks, as well as the proposed selection process for pilot securities. Comments will be due 45 days after the publication of the proposed pilot program in the Federal Register, which is expected shortly.
The SEC should be applauded for testing what works in the equity markets and for seeking comments on these tests. Of the proposed tests – the minimum increment and the trade-at test seems more significant by far; however, conducting it in conjunction with the expanded minimum increment test may dilute its value.
The Alternative Investment Management Association, American Council of Life Insurers, Association of Institutional INVESTORS, Commodity Markets Council, Customer Commodity Coalition and MFA (collectively, “Trade Associations”) sent a letter to the Financial Stability Board (“FSB”) regarding a proposal to suspend counterparties’ early termination rights during U.S. bankruptcy proceedings.
In the letter, the Trade Associations expressed concern that using prudential regulations to amend the U.S. Bankruptcy Code will harm the financial system by “compelling customers and investors to waive important rights that protect them during U.S. bankruptcy proceedings.”
Furthermore, the Trade Associations explained, the FSB “reversed” the normal rulemaking process by conferring with a small group of participants and finalizing the ISDA Protocol before proposing prudential regulations. This reversal, according to the Trade Associations, is “contrary to public policy” and circumvents the legislative process by avoiding the petitioning of the Congress to amend the U.S. Bankruptcy Code.
The Federal Financial Institutions Examination Council (“FFIEC”) released observations culled from its recent cybersecurity assessment, and recommended that regulated financial institutions participate in the Financial Services Information Sharing and Analysis Center.
FFIEC members piloted the assessment in the summer of 2014 to evaluate the degree to which institutions were prepared to mitigate cybersecurity risks. The “FFIEC Cybersecurity Assessment General Observations” sets forth a number of general themes from the assessment, and offers questions that CEOs and boards of directors should consider when assessing their institutions’ cybersecurity preparedness.