Category Archives: Bank Capital & Liquidity Rules

Bank Capital & Liquidity Rules

Agencies Propose Orderly Liquidation Rule for Covered Broker-Dealers

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Pursuant to Dodd-Frank Act Section 205(h), the FDIC and the SEC proposed a rule to govern the orderly liquidation of “covered brokers-dealers,” or large broker-dealers that are subject to liquidation under Title II of the Dodd-Frank Act and not dissolution under the Securities Investor Protection Act (“SIPA”).

According to the proposal, the rule would clarify (i) how the customer protections of SIPA will be integrated with the orderly liquidation provisions of Dodd-Frank, (ii) the role of the FDIC as receiver and that of the Securities Investor Protection Corporation (“SIPC”) as trustee of a failed broker-dealer, and (iii) the administration of claims in an orderly liquidation process. In addition, the proposal would address (a) the priorities for unsecured claims against a covered broker-dealer, (b) the administrative expenses of SIPC and (c) the treatment of Qualified Financial Contracts (e.g., repurchase agreements and security-based swaps).

Much of the proposal consists of procedural details on how the liquidation of a covered broker-dealer would proceed, and how the process and distribution of assets through orderly liquidation would differ from those aspects of the ordinary SIPA process. The proposal specifies that although a “Title II orderly liquidation is under a different statutory authority, the process for determining and satisfying customer claims would follow a substantially similar process to a SIPA proceeding.” Additionally, the calculations of the amount due and the actual amount paid to customers are not intended to be affected by the existence of the proceeding.

The most important aspect of the new liquidation process is the ability it gives regulators to create a new legal entity, which the proposal defines as a “bridge broker-dealer,” to which contracts of the insolvent broker-dealer may be transferred. This bridge broker-dealer is deemed to be registered as a broker-dealer with the SEC and a member of any self-regulatory organization of which the insolvent firm was a member.

The right of a counterparty to declare a default under a Qualified Financial Contract would be (i) delayed until the close of business on the business day following the appointment of the FDIC as receiver for the insolvent broker-dealer or (ii) lost if the counterparty is notified that the relevant contract has been transferred to a bridge broker-dealer.

The proposal requests comments on a number of questions relating to the orderly liquidation process for a covered broker-dealer.

For large broker-dealers that may be “covered broker-dealers” and so would be subject to orderly liquidation, the key question is this: whether any aspect of the proposed process could make them appear unattractive as parties to Qualified Financial Contracts, or raise the cost for them of entering into such contracts.

CFTC Commissioner Giancarlo Discusses 6 Mega-Trends Facing Financial Markets

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CFTC Commissioner J. Christopher Giancarlo identified 6 mega-trends facing 21st century financial markets. His comments were drawn from a guest lecture delivered on December 1, 2015 at Harvard Law School and recently released in a podcast.

Commissioner Giancarlo identified the following “overarching challenges”:

Cyber threats. “Unfortunately, cyber-hostilities will not end any time soon. They will be relentless for . . . years to come. As mega-trends go, cyber-risk is the number one threat to 21st century financial markets. . . . As market leaders and regulators, we must make it our first priority in time and attention. We must leave no step untaken or precaution unavailed to thwart cyber-destruction of the world’s financial markets.”

Disruptive technology. “[E]xponential digital technologies are rapidly changing the very nature of human identity, work, leisure and society. . . . The only effective way for a regulatory agency to stay abreast of the rapid advances of trading automation is to be informed through an ongoing, bottom-up process.”

Giancarlo voiced the following concerns regarding proposed rules for the registration and regulation of automated trading: “First, the apparent window-dressing of requiring risk controls and testing that are already widely adopted by industry. Second, the high cost and burdens the rule places on small market participants. And third, the rule’s inconsistencies regarding what firms must comply with it.”

Central bank (government) intervention. “[The Federal Reserve] has become the multi-trillion dollar ‘Washington Whale’. . . . The Fed is having an increasingly direct and immediate impact on [all] markets, from corporate bonds to equities and foreign exchange rates, to developing nations’ sovereign debt.  It has reduced the heterogeneity of the investor base, herding it into one-way bets on anticipated changes in Fed policy rather than traditional fundamental credit or value analysis.

Market illiquidity. “In trying to stamp out risk, global regulators are instead harming trading liquidity. . . . The question that must be asked is whether the amount of capital bank regulators are causing financial institutions to take out of trading markets is at all calibrated to the amount of capital need to be kept in markets to support market health and durability. I understand how prudential regulators want banks to limit trading capital to limit their insolvency risk. But what is missing is any analysis of how much trading capital is appropriate to limit broad liquidity risk. Those of us with direct responsibility of overseeing financial markets need to ask that question and demand that analysis, even if bank prudential regulators will not. Once again, Dodd-Frank provides no answers.”

Market concentration. “[A] wave of market consolidation has taken place across the financial landscape, concentrating the provision of essential market services to fewer and fewer institutions. . . . Unfortunately, global financial markets are now undergoing a pronounced reduction in the bio-diversity of market service providers, with deleterious effect on market safety and soundness. Market regulators must find a way to reverse this trend, that threatens the systemic safety that Dodd-Frank was meant to preserve.”

Deglobalization. “[T]he 2008 financial crisis and the political and response . . . seems to have reversed the course of financial market globalization. . . . [T]here is a fundamental mismatch between [the CFTC’s swaps trading] regulatory framework and the distinct liquidity and trading dynamics of the global swaps markets. This mismatch, and the application of the framework worldwide, has caused numerous harms, foremost of which is driving away global market participants from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets.”

Commissioner Giancarlo concluded: “Regulators and others with responsibility for financial markets must take steps to address these challenges:  prioritize cyber-risk resiliency; foster best practices for new trading technologies; counter the distortions caused by central bank market intervention; acknowledge and address the diminishing liquidity in trading markets; and review and reduce the numerous poorly designed rules and regulations that are causing service-provider concentration and market fragmentation.”

Commissioner Giancarlo delivered his remarks as part of the Fidelity Guest Lecture Series on International Finance at Harvard Law School, which was previously covered in the Cabinet News.

House Passes Bill to Include Municipal Bonds under the Liquidity Coverage Ratio Rule

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The U.S. House of Representatives passed a bill requiring federal banking regulators to include municipal bonds under the “Liquidity Coverage Ratio: Liquidity Risk Measurement Standards; Final Rule” (79 Fed. Reg. 15 61439).

H.R. 2209 requires the appropriate federal banking agencies to treat certain municipal obligations as “level 2A liquid assets.” The bill was sponsored by Representatives Luke Messer (R-IN) and Carolyn Maloney (D-NY) and passed the House unanimously.

Specifically, the bill:

  • amends the treatment of certain municipal obligations under the Federal Deposit Insurance Act to direct federal banking agencies to treat any municipal obligation as a high-quality level 2A liquid asset if the obligation is liquid, readily marketable and investment-grade as of the calculation date;
  • calls on the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Comptroller of the Currency to amend the rule titled “Liquidity Coverage Ratio: Liquidity Risk Measurement Standards; Final Rule” in order to implement this Act.

According to Representative Maloney, the “decision to exclude investment grade municipal bonds from the liquidity buffer was senseless, and municipalities across the country were being hurt as a result. The Federal Reserve has concluded a fix is necessary and there is strong bipartisan consensus in support of correcting this problem.”

Lofchie Comment: Leaving aside the issue of whether the liquidity requirements are set at the right levels, the question is whether this is good public policy or a subsidization of lending to governmental entities that bypasses the private sector. Notably, Representative Maloney describes banking regulators as “senseless” when they take any action that may burden governmental entities. Apparently, when they impose burdens on the private sector, they become Solomonic.

Global Financial System Committee Provides Analysis of Liquidity in the Fixed Income Market

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The Committee on the Global Financial System (“CGFS”) provided a detailed analysis on the current state of liquidity in the fixed income market. Published by the Bank for International Settlements (“BIS”), the report acknowledges that liquidity has declined in some markets, but observed that this decline has been primarily reflected in the size of trades rather than in a widening of the bid-ask spread.

The report states that the demand for market-making liquidity (which the report refers to as “immediacy”) increased, while dealers continue to reduce their willingness to take on customer positions, either because they find it unprofitable to do so or because new regulatory capital requirements make it impossible for them to do so.

The report identifies a potential trade-off between increased capital requirements for market makers, which according to the report, makes them more resilient, and the expense of maintaining such capital, which makes market makers more reluctant to take on risk. Further, the report states that very high capital requirements may actually make the system less resilient; i.e., “fragile,” because any decline in market prices can very quickly force deleveraging, which, if it becomes widespread, results in market sell-off.

Lofchie Comment: This report is a significant step forward by the global regulators in at last acknowledging that very high and potentially punitive capital requirements may be counterproductive and a source of risk. This may seem counterintuitive. It may appear obvious that when a single institution has more capital than others, it is better placed to survive a downturn than are others. However, when all institutions carry more capital, because they are all subject to higher capital requirements, a new risk arises because there is no cushion between the amount of capital an institution must have and the amount it actually has. Further, the “punishment” (being forced to shut down) for a capital violation is severe. Accordingly, universally high capital requirements combined with severe sanctions for capital failure is likely to lead to the result that in a downturn, everyone is very fast to flee the market; i.e., the system then becomes more “fragile.”

SEC Proposes Restricting the Use of Derivatives for Regulated Funds

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In a 3-to-1 vote, the SEC proposed a new rule that would restrict the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds and closed-end funds as well as business development companies that are subject to Investment Company Act Section 18 (“Capital Structure of Investment Companies”).

In support of the proposal, SEC Chair Mary Jo White said that funds use derivatives extensively for a variety of purposes, which can raise risks relating to leverage and the fund’s ability to meet future obligations. She remarked on the current practice of mark-to-market segregation, raising concerns that a fund may not have sufficient liquid assets to cover potential future losses. Chair White highlighted three elements that addressed these concerns: 1) new requirements that funds segregate assets to cover their mark-to-market liability, plus an additional risk-based coverage amount designed to address potential future losses on derivatives; 2) portfolio limitations based either on a fund’s aggregate derivatives exposure or on a risk-based analysis; and 3) the requirement that certain funds establish formalized risk management programs.

In presenting the proposal, SEC staff highlighted the following requirements for derivatives:

  • Portfolio Limitations for Derivatives Transactions: A fund would be required to comply with one of two alternative portfolio limitations (“Exposure-Based Portfolio Limit” or “Risk-Based Portfolio Limit”) designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. Under the exposure-based limitation, a fund would be required to limit its aggregate notional derivatives exposure to 150% of the fund’s assets. As an alternative, the risk-based limitation permits a fund to have aggregate notional derivatives exposure of up to 300% of the fund’s assets but only if the fund’s portfolio is subject to less market risk determined by a value-at-risk test.
  • Asset Segregation for Derivatives Transactions: A fund would be required to manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of “market-to-market coverage amount” and a “risk-based coverage amount.”
    A fund would be required to segregate respectively:

    (i) assets equal to the amount that the fund would pay if the fund exited the transaction at the time of the determination; and

    (ii) an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the transaction under stressed conditions.

  • Derivatives Risk Management Program: Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.

  • Requirements for Financial Commitment Transactions: A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.

  • Disclosure and Reporting: Two forms the SEC proposed in May 2015, Form N-PORT and Form N-CEN, would be amended respectively: (i) require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives; and (ii) require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.

The majority of Commissioners relied on the white paper for evidence of the necessity for new regulation. They also referenced Section 1(b) of the Investment Company Act (which cites the Policy of the Investment Company Act) as evidence of the statutory need to eliminate undue leverage by registered funds.

Commissioner Aguilar supported the proposal but questioned whether the proposed rules place too large of a burden on fund boards. However, the Commissioner concluded that boards must be proactive in foreseeing the challenges in executing all of their fiduciary and regulatory responsibilities.

Commissioner Piwowar supported the asset segregation requirements but dissented from the portfolio limitations. He reasoned that asset segregation should be enough to address current derivative risks, therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. In addition, the Commission has recently adopted other proposed rules that will either have a direct impact on the risks of derivatives positions held by funds, or will provide us with data that could be used to better understand how we should regulate.

Lofchie Comment: Commissioner Piwowar’s dissent from the proposal of the rule is well-reasoned. The SEC does not have adequate information needed for proper analysis of the proposal at the current time.

As the Commissioner argues, the SEC justifies the proposed derivatives framework as an “exemption” from Section 18 of the Investment Company Act (“Capital Structure of Investment Companies”), even though the SEC is in fact limiting behavior that it has previously sanctioned. It is not at all obvious that the conduct requires an exemption from Section 18; and the fact that the SEC had previously sanctioned the conduct would seem to indicate that no such exemption is required. If no exemption is required, it raises the question of the specific authority under which the SEC proposes to act.

The proposal also raises the question of whether the SEC acted appropriately in further restricting the activities of SEC-registered investment companies that have made appropriate disclosure of the risks involved in their investment strategies. The safety that SEC-registered investment companies provide to investors necessarily comes at a cost, whether it is the increased cost of managing the fund or the implicit cost to investors being denied investment opportunities. It is far from obvious that the subsequent costs that the SEC proposes here are justifiable.

As for the risk of derivatives, the idea that such risk may be judged based on a predetermined notional “size” measure is inherently inexact. Beyond that, the requirement of specified derivatives management procedures has the feel of more government-required formalities that have the potential to provide more benefits to consultants than to investors.

Federal Reserve Vice Chair Fischer Discusses Financial Stability and Shadow Banking

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Board of Governors of the Federal Reserve System Vice Chair Stanley Fischer: (i) offered an assessment of vulnerabilities in the financial system; and (ii) identified gaps in the current understanding of conditions inside and outside of the banking sector that should be addressed by regulators and researchers.

In discussing the current financial system’s cyclical developments, Mr. Fischer mentioned the following “five factors that contribute to financial fragility”: (i) high debt burdens at households and firms; (ii) elevated leverage and maturity transformation within the financial sector; (iii) complexity and interconnectedness in intermediation chains; (iv) low risk premiums on assets, especially assets funded with debt; and (v) complacency on the part of investors, supervisors and decision-makers in the private sector of the financial system.

Mr. Fischer made the following assertions regarding what needs to be understood to monitor financial stability:

  • A Closer Look at Shadow Banking: The reduction in leverage and maturity transformation associated with better regulations leaves the financial system “much more resilient – even if such regulations have modestly affected market liquidity.”
  • What We Know and What We Do Not: Data on a range of activities – including securities lending, bilateral repos, and derivatives trading – that create funding and leverage risks “remain inadequate and hence could prove destabilizing if sufficiently large or widespread.”
  • Data Are Not Enough: We Need Theory Too: An “important area in need of development” is economic modeling on interconnectedness, particularly on the interaction of shadow banking, banks and the broader financial system. Further, research that distinguishes between banks and nonbanks, or highlights how their interactions are driven by economic incentives, could guide regulator efforts to collect data and set policies to limit possible instabilities associated with interconnectedness.

“An essential element of [the federal regulatory] infrastructure is learning the lessons of history – both the lessons of what happened, and the fact that supervisors and regulators will on occasion be surprised,” he stated.

Mr. Fischer delivered his remarks at the “Financial Stability: Policy Analysis and Data Needs” 2015 Stability Conference sponsored by the Federal Reserve Bank of Cleveland and the Office of Financial Research.

Lofchie Comment: In his remarks, the Vice Chair of the Federal Reserve announced that “the Federal Reserve will be developing regulations that would establish minimum margins for securities financing transactions on a marketwide basis. The margins would apply to all market participants, thereby mitigating the risks associated with regulation along institutional lines.”

It is not clear under what process, or under what authority, the Federal Reserve will propose and implement these regulations governing all market participants. Whatever the process is, the proposed rulemaking would seem to be of a type that goes materially beyond the Federal Reserve Board’s historical discretionary authority to regulate the money supply. If the Federal Reserve Board believes that such broad rulemaking should not be subject to Congressional oversight, it would at least be useful for the Federal Reserve Board to indicate what it believes are the furthest reaches of its discretionary authority.

Further deference to the Federal Reserve Board might be all to the good if one were really convinced that the Federal Reserve is consistently correct in its actions. The strength of that argument is, however, uncertain. Similarly uncertain is the assertion that the economy is now more structurally resilient than it was before the crash. By what measure? How resilient would the economy (or housing prices) be if interest rates were to soon rise 2 or 3%?

Vice Chair Fischer’s prescriptions are important to consider in the debate over the degree of control that Congress should exercise with respect to the Federal Reserve. Even if one questions the wisdom possessed by legislators (and is there anyone who does not at one time or another?), one should still accept that certain powers are properly exercised by the legislative branch, or at least are properly overseen by the legislative branch. The powers to be exercised by the legislative branch should include the oversight of the making of rules by the federal financial regulators.

FRB Proposes Rule Requiring Large Banks to Disclose Their Consolidated LCRs

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The Board of Governors of the Federal Reserve System (“FRB”) proposed a rule requiring large banking organizations to disclose several measures of liquidity publicly. If the rule is approved, these measures will comprise the first required public disclosure of a quantitative liquidity risk metric for large banking organizations.

Under the Liquidity Coverage Ratio (“LCR”) rule adopted by the federal banking agencies last September, large banking organizations (with consolidated assets of $50 billion or more) and certain depository institution subsidiaries are required to hold a minimum amount of high-quality liquid assets (“HQLA”) that can be converted into cash easily and quickly. The amount of HQLA held by each large banking organization must be equal to or greater than its projected net cash outflow during a hypothetical stress scenario lasting for 30 days.

Under the proposed rule, large banking organizations would be required to disclose their consolidated LCRs each quarter based on averages over the prior quarter. Firms also would be required to disclose their consolidated HQLA amounts. Additionally, firms would be required to disclose their projected net cash outflow amounts, including retail inflows and outflows, derivatives inflows and outflows, and several other measures.

Comments on the proposal are due by February 2, 2016.

Lofchie Comment: Will this proposed rule motivate banking organizations to maintain appropriate liquidity, as defined by the rule? (Does the rule define liquidity appropriately, or at least correctly from a relative (if not absolute) perspective, in a way that verifies that more liquid firms do better than less liquid firms?) Most significantly, does the rule precipitate a bank run if a bank shows somewhat decreased liquidity? Although the idea that transparency is good is the common wisdom, it is not obvious that the good it provides is unmitigated.

The term “observer” is used in science to refer to the fact that the observation of an event may alter the event. Just so, regulators’ signals that a bank is having liquidity issues may turn a stumble into a fall. In a “nervous” market environment, a bank that discloses a dip in its liquidity, particularly relative to its peers, may find that it is subject to a run.

FRB Governor Powell Addresses Risk of ”Outsized Volatility”; Considers Developments in Treasury Market Structure

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Board of Governors of the Federal Reserve System (“FRB”) Governor Jerome H. Powell discussed variables and possible adaptations to the current market structure that could provide greater or more stable liquidity.

In his remarks at the 2015 Roundtable on Treasury Markets and Debt Management, Mr. Powell addressed the October 15, 2014 episode of “sudden, outsized volatility” in the Treasury markets. He pointed out that further episodes could cause more market participants to react in ways that reduce liquidity, and add to pressures for changes in market structure.

Mr. Powell explained that his preference would be to see changes emerge from a process of experimentation in the marketplace, including both dealers and proprietary trading firms, but noted that regulators and the industry will only be able to evaluate structural innovations if “traders actually use them.” Among the potential changes he discussed were a central limit order book and what he described as high frequency “batch auction” (auction that would take place every millisecond rather than continuously). He concluded that there should be strong evidence that any change in structure represents an improvement before implementing it on a wide scale.

Referencing a recent New York Fed event on Treasury market structure, Mr. Powell mentioned a panel he moderated (which included an asset manager, a broker-dealer and one of the triparty clearing banks) in which there was agreement that: (i) expanded repo clearing would be positive for the market, and (ii) the regulatory requirements related to capital and liquidity are proving demanding for the private sector. Mr. Powell stated that the FRB is open to new solutions that would satisfy regulatory requirements while bringing the benefits of central clearing.

Lofchie Comment: Since the regulators seem so determined to push the benefits of central clearing at every opportunity, it may be useful here to explain why central clearing could be more appropriate in some markets than in others, and why it may not in other markets serve the purposes for which it was supposedly intended.

As a starting matter, central clearing has an obvious benefit in securities markets as compared to swaps markets: in securities markets, there is an object to be delivered, and having a central clearing repository can reduce the risk of failure because it allows for the set-off of delivery obligations. That advantage does not exist in swaps (or other notional) markets, as there is nothing to be delivered. Secondly, as we have previously observed, central clearing works best (in fact, it only works) in markets where the underlying security is extremely liquid, such as U.S. government securities, and thus the market would be perfectly well able to close out transactions without a central pricing mechanism. This is not to say that central clearing is not useful in some situations; rather, that the government would be better off letting the market decide where it is useful.

Notably, and unfortunately, Governor Powell does not say much about “demanding [new] regulatory requirements related to capital and liquidity,” issues of dispute that are within the FRB’s control.

FDIC Vice Chair Hoenig Discusses Regulatory Capital

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FDIC Vice Chair Thomas M. Hoenig asserted that “while there has been progress in improving capital regulation, much remains undone.” In remarks made before the 18th Annual International Banking Conference at the Federal Reserve Bank of Chicago, he argued “there is no place for complacency regarding the stability of our financial system” within “the context of the future of large, internationally active banks.”

Vice Chair Hoenig emphasized that global banks “are not as well capitalized as some within the industry would have you believe.” As to:

  • Risk Prediction: Vice Chair Hoenig questioned “whether the effect of such a requirement that is designed to make a firm more resolvable once that firm has failed, could – prior to failure – increase the firm’s leverage and thereby its likelihood to default” and noted that it would be unlikely that “regulators would . . . successfully anticipate the source of future crises.”
  • Equity Capital: Vice Chair Hoenig stressed that this approach: (i) is “based on equity capital and thus would not require such extraordinary insight from regulators”; (ii) “acknowledges that regulators cannot predict events and it ensures a safer system because well capitalized institutions are better able to withstand shocks and survive crises”; and (iii) uses simple leverage measures instead of risk-based capital measures, “which eliminates relying on the best guesses of financial regulators to guide decisions.”

Vice Chair Hoenig described the “ever-changing sources of risk” in the derivatives market and highlighted “the potential for unanticipated events and risks, including resolution challenges, associated with the growing use of Central Counterparties.” Among other issues, Vice Chair Hoenig stressed that “we cannot ignore the reality that international financial linkages across countries are more important now than they were even just five years ago” and urged global banks to adjust their risk models accordingly.

In addition, Vice Chair Hoenig called on regulators to promote “trust built on equity capital” and argued that “the system-wide benefits of strong equity capital would appear to far exceed the aggregate economic costs over the business cycle and thus should not be ignored.” He stated that “contrary to some claims, equity capital, in fact, supports sustainable risk taking over the course of the cycle by removing the necessity of regulators to pick winners and losers, thus allowing the owners of the capital to take their own risks, run their own firms and absorb their own losses without public support.”

Lofchie Comment: While the tone of this speech suggests that the regulators should be praised for their accomplishments in making the financial system better, one may also make a fair argument that the speech describes a series of regulatory mis-judgements and regulatory over-confidence, with the result being a financial system that is in many respects more fragile than it was before the crisis.

Let’s start with central clearing. In the words of Vice-Chair Hoenig: “Increased use of clearing has changed the locus of these exposures, it has not lessened risks to the system. The migration of standardized derivatives to clearing was a policy decision intended to make the system safer, but without question it elevates the systemic importance of safe and sound operations by central counterparties (CCPs). The potential for unanticipated events and risks, including resolution challenges, associated with the growing use of CCPs is a subject of concern to many observers and is being studied by international groups.”

Contrast Vice-Chair Hoenig’s current realization, with, for example, a snippet from a 2012 piece written by Craig Pirrong:

“[In] the aftermath of the financial crisis, clearing has become a deus ex machina to solve all the problems inherent in derivatives markets. In particular, clearing has been advanced as a panacea for systemic risk arising from derivatives markets; that is, the risk that derivatives contracts can serve as the cause of insolvency of major financial institutions, and a channel of contagion by which the failure of one institution could cause the failure of others. There is considerable room for skepticism about these claims. They are not predicated on a thorough analysis of the economics of clearing. Indeed, many of the claims made on behalf of clearing are patently wrong.”

It should be noted that the above quote from Mr. Pirrong is fairly representative of his remarks over the last several years.

How is it that Mr. Pirrong can be so out front on this issue? One possibility is that banking regulators tend not to fully consider the multiplicity of reactions that market participants may have to regulatory change; i.e., regulators calculate that if one raises the capital ratio for banks, banks will be safer (not considering that liquidity will be reduced, credit will move outside of banks and the economy will be generally dampened). This does not mean that increasing capital is a zero sum game; rather, it probably is beneficial to a point, but at another point, it can arguably turn harmful as liquidity is reduced. Mr. Pirrong, by contrast, seems to think of the markets in more fluid terms; when one condition (or rule) is changed, market participants react to that change. For the most part, those changes are reasonably predictable; i.e., raise fixed costs/reduce the number of market participants, and Mr. Pirrong, at least as to central clearing, has done a reasonably good job at thinking through the consequences.

ISDA Asserts That SEF Rules Diminish Global Liquidity Pools

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ISDA published a research note titled Cross-Border Fragmentation of Global Interest Rate Derivatives: The New Normal? The research note is the fourth in a series that charts the changes in global liquidity pools since the U.S. swap execution facility (“SEF”) rules were implemented in October of 2013.

Significantly, the report found that the new rules have contributed to the separation of trading between U.S. and European markets with respect to European interest rate swaps. According to the report, before the implementation of U.S. SEF rules, approximately twenty-five percent of euro interest rate swaps (“IRS”) activity was composed of trades between European and U.S. dealers. Currently, that percentage is down to about ten percent.

Lofchie Comment: Evidence of the damage done to the United States as a global financial center by various Dodd-Frank rules is mounting. SEF rules in particular do not reduce systemic risk. To the extent to which these rules actually serve to separate markets and reduce global liquidity, their consequences are the opposite of their intended purpose.