Category Archives: Derivatives

Streetwise Professor Examines “Fundamental Tension” Underlying CCP Resolution Authority

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In response to reports that the European Commission (“EC”) is finalizing legislation on Central Counterparty (“CCP”) recovery, University of Houston Finance Professor Craig Pirrong outlined the sources of “fundamental tension” that underlie the final resolution authority. Citing a statement in the EC’s Executive Summary Sheet that the contemplated framework is likely to involve “a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders” (emphasis supplied), Professor Pirrong concluded that the prospect of trampled rights “calls into question the prudence of creating and supersizing entities with such latent destructive potential.”

Professor Pirrong argued that the resolution authority potentially will “impose large costs on members of CCPs, and even their customers, [which] raises the burden of being a member, or trading cleared products,” and consequently, disincentivizes membership. He also asserted that “[t]he prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that push[] it over the edge.” According to Professor Pirrong, the irony is that these measures to protect CCPs will lead to a “reduced supply of clearing services, and reduced supply of the credit, liquidity and capital that [such CCPs] need to function.”

In addition, Professor Pirrong cautioned that with discretionary power comes “inefficient selective intervention” and the potential to influence costs. “[T]his makes it inevitable,” he warned, that the body will be subjected to intense rent-seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens.”

SEC Adopts Enhanced Regulatory Framework for Securities Clearing Agencies

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The SEC voted to adopt final rules to require securities clearing agencies that are deemed systemically important or that are involved in complex transactions (“covered clearing agencies”) to “establish, implement, maintain, and enforce policies and procedures reasonably designed to address all major aspects of [their] operations, including [their] governance, risk management (including financial, business, and operational risks), access requirements, and settlement and depository systems.” In addition, the SEC voted to propose the application of these enhanced standards to all SEC-registered central counterparties.

The adopted rules apply to SEC-registered securities clearing agencies that have been designated as systemically important by the Financial Stability Oversight Council (“FSOC”). The rules require a covered clearing agency to have policies and procedures that, among other things:

  • establish the qualifications of members of boards of directors and the senior management of covered clearing agencies, specify clear and direct lines of responsibility, and consider the interests of relevant stakeholders in covered clearing agencies;
  • address recovery and wind-down planning;
  • address daily stress testing, monthly reviews and annual validation of credit risk models;
  • set and enforce appropriately conservative haircuts and concentration limits, and subject them to review annually at the very least;
  • mark positions to market, collect margin at least daily, and conduct daily backtesting and monthly sensitivity analyses, and perform model validation at least annually;
  • address holding “qualifying liquid resources” that are sufficient to withstand the default of the participant family that would generate the largest aggregate payment obligation in extreme but plausible market conditions;
  • test the sufficiency of their liquidity providers;
  • provide for holding liquid net assets funded by equity equal to at least six months of current operating expenses in order to allow covered clearing agencies to continue operations during a recovery or wind-down; and
  • maintain a viable plan, which must be approved by boards of directors and updated at least annually, for raising additional equity should that of covered clearing agencies fall close to or below the required amount.

In his statement at the open meeting, SEC Commissioner Michael S. Piwowar emphasized that he voted for the final rule and proposal, but expressed his misgivings:

I support today’s adopting and proposing releases as the best approach we currently have at setting heightened standards for the clearing agencies we regulate. However, this entire effort has the eerie feeling of re-arranging deck chairs on the Titanic. I hope that history will prove me wrong, but I fear that the Dodd-Frank Act has created too many icebergs for our financial system to safely navigate.

SEC Commissioner Kara M. Stein expressed reservations about the laxity of the final rules, which she said only “marginally decrease the risk posed by systemically important clearing agencies.”

Comments on the final rules must be submitted within 60 days after their publication in the Federal Register. If adopted, the final rules also will become effective 60 days after their publication in the Federal Register. Covered clearing agencies will be required to comply with the final rules no later than 120 days after the effective date.

Lofchie Comment: In statements that might have sounded familiar to Goldilocks, the three SEC commissioners voiced three different views on the final rules: Commissioner Stein said that they do too little, but are better than nothing, Commissioner Piwowar complained that they comprise a part of an ill-conceived scheme of regulation that exacerbates the problem of too-big-to-fail, while Chair Mary Jo White declared that the rules are just right.

ISDA Report Concludes That Single-Name CDS Market Has “Positive Impact”

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An ISDA-commissioned review of the “empirical academic literature” concluded that single-name credit default swaps (“CDS”) have a “positive impact on the supply of credit to many reference entities underlying traded CDS, suggesting the ability of lenders to hedge their credit exposures can make them more willing to extend credit.”

The review examined over 260 published academic articles and working papers. It determined generally that single-name CDS spreads:

  • contain valuable information about the probability and severity of adverse credit events that an underlying reference entity may experience during the life of a CDS;
  • reflect a risk premium that protection sellers demand in compensation for exposure to reference-entity-specific and systematic risks (both credit-related and non-credit-related);
  • are anticipatory and contain information regarding future announcements about the credit risk and financial condition of an underlying reference entity;
  • are used by financial institutions to achieve their desired risk/return profiles and commercial objectives;
  • have a beneficial effect on the supply of credit to borrowers that are reference entities underlying traded CDS;
  • are the primary market for price discovery, as compared to corporate bonds, and often precede equity markets in processing new information about underlying reference entities; and
  • when first introduced, have an adverse effect on the liquidity of related debt and equity markets.

Lofchie Comment: Market participants enter into swaps for a reason: swaps provide benefits. It would be preferable for regulators to devise a regulatory scheme that maximizes the benefits of swaps to the economy (including to issuers that are the subjects of those swaps) rather than one that minimizes the number of swap transactions.

CFTC Commissioner Giancarlo Criticizes U.S. Regulators’ Refusal to Delay Swaps Margin Rules

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CFTC Commissioner J. Christopher Giancarlo reprimanded U.S. prudential regulators and the CFTC for ordering swap dealers to meet a contested September 1 deadline for the implementation of certain margin requirements that are applicable to uncleared swaps.

In March 2015, IOSCO and the Basel Committee on Banking Supervision published a final policy framework establishing (i) standards for margin requirements for uncleared swaps, and (ii) a phased-in implementation period for the requirements with an initial implementation date of September 1, 2016. Last week, regulators in Australia, Hong Kong and Singapore announced that their implementation of the requirements would be delayed, which followed the pattern of a similar announcement by the European Commission several months before. Notwithstanding these announced delays, the CFTC and U.S. prudential regulators decided to proceed with the original implementation date.

Commissioner Giancarlo called that decision a “failure of U.S. trade negotiation,” and cited it as “yet another example of the failure of U.S. policymakers to negotiate harmonization in regulations . . . in a manner that does not place American markets at a competitive disadvantage.”

In his statement, Commissioner Giancarlo stated he was astonished at regulators’ “blindness to commercial reality,” and noted that American markets now will have a higher margin structure, which he emphasized will give a competitive advantage to major overseas derivatives markets. He also emphasized ramifications of the decision that could prove dangerous to the economy:

Even from a practical standpoint, the coming days will be enormously challenging for U.S. market participants as dealers are still working to finalize account documentation. Some observers warn of a liquidity crunch because certain dealers will not be ready to trade with other dealers. Unfortunately, U.S. regulators appear more concerned with sticking to an arbitrary deadline than the health of American markets and American market participants.

Commissioner Giancarlo warned that the United States will lose its negotiating leverage in the event of further delays.

Lofchie Comment: Kudos to Commissioner Giancarlo for prioritizing commercial realities. When Dodd-Frank first was adopted, certain U.S. regulators asserted that the rest of the world would follow their example whether or not the rules made any sense. That assertion has proved to be incorrect. In many cases, the Europeans have gone their own way (sometimes adopting more sensible rules, sometimes adopting rules that seem even less sensible), but they have not adhered to the strictures of U.S. regulators. Knowing now that the Europeans will follow their own path, U.S. regulators should not place U.S. firms at a material competitive disadvantage.

CFTC Releases Staff Report on Swap Dealer De Minimis Exception

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The CFTC issued a Final Staff Report on whether to lower the Swap Dealer De Minimis Exception threshold. Unless the CFTC takes further action, the threshold is scheduled to decrease from $8 billion to $3 billion in December 2017. The scheduled threshold change is provided under Regulation 1.3(ggg), jointly issued by the SEC and the CFTC in May 2012, stating that “a person is not considered to be a swap dealer unless its swap dealing activity exceeds an aggregate gross notional amount threshold of $3 billion over the prior twelve-month period, subject to a phase-in period during which the threshold would be set at $8 billion.” The Final Report, prepared by the Division of Swap Dealer and Intermediary Oversight, reviewed available data and comments by interested parties in order to determine how changes to the current $8 billion de minimis threshold might affect the swap markets.

In the Report, CFTC staff noted that if the de minimis threshold was lowered to $3 billion, approximately 84 additional entities trading in interest rate swaps (“IRS”) and credit default swaps (“CDS”) might have to register as swap dealers. Conversely, if the threshold was raised to $15 billion, approximately 34 fewer entities trading in IRS and CDS might need to register as swap dealers.

CFTC staff concluded that only a substantial increase or decrease in the de minimis threshold would have a significant effect on the amount of IRS and CDS activity that is covered by swap dealer regulation, as measured by notional amount, transactions, or unique counterparties. For that reason, staff made no recommendations concerning whether to (i) set the threshold at the current $8 billion dollar level, (ii) allow the threshold to fall to $3 billion, as scheduled, or (iii) delay the threshold reduction in order to afford enough time for the CFTC to obtain better data.

CFTC Commissioner J. Christopher Giancarlo issued a separate statement in which he criticized the Final Staff Report for failing to make any recommendations, and expressed disappointment with the CFTC for not eliminating, or at least extending, the automatic phase-in of the $3 billion threshold. Commissioner Giancarlo argued that the CFTC “has already witnessed the negative results of setting a de minimis threshold too low, as was the case with utility special entities,” and maintained that dropping to such a level in the broader swap marketplace would “cause many non-financial companies to curtail or terminate risk-hedging activities with their customers, limiting risk-management options for end-users.”

Lofchie Comment: The Report raises a basic question. If the de minimis threshold dropped to $3 billion, will firms that deal in swaps totaling from $3 to $8 billion: (i) register with the CFTC as swap dealers, or (ii) reduce or eliminate their swap-dealing activities? The most likely answer is that most firms would not register, since the costs of regulation would be too high to allow them to stay in the market as smaller regulated dealers. CFTC staff should have made a stronger effort to answer the question. Staff might have attempted to estimate (i) the cost of registering as a swap dealer, and (ii) the profits of dealing in swaps. It is fair to conclude that unless the first amount is materially greater than the second, small firms likely would leave the market.

Instead of focusing on the effect that a reduction in the swap dealer threshold might have on the number of firms willing to deal in swaps, CFTC staff chose to concentrate on a far less significant question: how many additional swaps would smaller dealers enter into if they were required to register? According to the Final Staff Report, the number of additional swaps appears to be immaterial, which suggests that the threshold should not be reduced, particularly if the reduction could chase small dealers out of the market.

Regulators Highlight Progress in Treasury Market Structure

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In 2015, staff members from the U.S. Treasury Department (“Treasury”), the Board of Governors of the Federal Reserve System (“FRB”), the Federal Reserve Bank of New York, the SEC and the CFTC (collectively, “Joint Member Agencies”) issued a Joint Staff Report on the U.S. Treasury Market. The report detailed the “significant volatility” that took place in the Treasury markets on October 15, 2014 and involved record trading volumes, an unusually rapid round trip in prices, and a deterioration in liquidity in a short amount of time.

On August 2, 2016, the Joint Member Agencies issued a statement highlighting actions and accomplishments over the past year that “further enhance the public and private sectors’ understanding of changes to the structure of the U.S. Treasury market and their implications.” The Joint Member Agencies reaffirmed the findings in the Joint Staff Report and voiced their commitment to following the steps that it contained.

The Joint Member Agencies highlighted the following actions, among others:

  • The Treasury published a request for information about the evolution of the U.S. Treasury market structure as part of a comprehensive official sector review of the U.S. Treasury market.
  • The Treasury, the CFTC, the SEC and the FRB signed a memorandum of understanding (“MOU”) in order to permit the sharing of information about U.S. Treasury cash and related derivative markets among the agencies. The MOU will facilitate the analysis of major market events.
  • On July 19, 2016, the SEC published a proposed FINRA rule that would require member brokers and dealers to report U.S. Treasury cash market transactions to a centralized repository. The SEC also requested comments on the proposal.
  • The SEC published proposed amendments that would enhance the transparency and oversight of alternative trading systems, and solicited public comment on whether such rules should be applied to systems that trade only U.S. Treasury securities.
  • The CFTC published and requested comments on a proposed rule concerning specific aspects of automated trading in futures markets, including U.S. Treasury futures. The proposal covers pre-trade risk controls and requirements (i.e., registration with the CFTC, and development, testing and monitoring standards) for market participants using algorithmic trading systems on U.S. futures exchanges.

Lofchie Comment: The Joint Member Agencies’ statement makes no mention of two significant issues in the government securities markets. First, only one major clearing bank for government securities is expected to exist in the near future. Second, the new leverage limitations are reported to damage the repo market in government securities significantly. These negative developments are probably the result of new regulations.

The disappointing thing about the Joint Member Agencies’ statement is not the potential of the rules it mandates for creating negative or unintended consequences, since new rules are merely experiments that may succeed or fail, and failed experiments are sometimes necessary. What disappoints is that the agencies seem unwilling to acknowledge those failures, which is like refusing to analyze the results of unsuccessful scientific experiments. It would be better for the agencies to acknowledge and address failure openly, since examining past mistakes is the best way to learn from them.

CFTC Proposal to Mandate Broader Clearing of Interest Rate Swaps Receives Conditional Support

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Several leading industry groups and market participants offered support for a CFTC proposal to amend CFTC Rule 50.4(a). The proposal would require certain interest rate swaps that are denominated in certain currencies, or that have certain termination dates, to be subject to mandatory clearing.

In comments on the proposal:

  • The Managed Funds Association expressed strong support for the proposal and urged the CFTC to harmonize mandatory clearing with the requirements of other jurisdictions.
  • ISDA expressed strong support for CFTC efforts to harmonize its clearing mandate with those of other countries, but encouraged the CFTC to ensure that data on (i) the impact of its clearing mandate on liquidity and risk management for a particular product, and (ii) the mandate’s interaction with the mandatory trading requirement and “made available-to-trade” (“MAT”) process, “are appropriate and accurate.” ISDA also urged the CFTC to avoid “prioritizing harmonization of clearing mandates” over concerns relating to liquidity and risk management.
  • LCH Group Limited (“LCH”) voiced support for the CFTC initiative and for CFTC leadership in fostering international harmonization. LCH emphasized that the “OTC derivatives marketplace is global in nature and . . . this Proposed Determination . . . will promote certainty and international consistency for all market participants.”
  • CME Group Inc. (“CME”) expressed general support for the proposal, but recommended that “CFTC implementation of clearing obligations takes into account the timing of clearing mandates in other jurisdictions and ensures that the timing does not create an imbalance in the competitive landscape for market participants across jurisdictions.”
  • SIFMA Asset Management Group (“SIFMA”) expressed general support for the proposal, but argued that the determination “must not be considered in a vacuum in light of the clearing mandate’s status as a condition precedent” for a made-available-to-trade (“MAT”) determination. SIFMA urged the CFTC to harmonize clearing requirements with those in non-U.S. jurisdictions in a manner that is consistent with those jurisdictions’ “implementation timing.” Accordingly, SIFMA recommended that the CFTC defer the compliance date for any final clearing mandate until 180 days after a regulator in a non-U.S. jurisdiction has adopted an analogous mandate, and that it should do so with a phased-in approach by counterparty type.
  • Citadel LLC (“Citadel”) expressed “full support” for the proposal, and applauded the CFTC for “recognizing the important role of central clearing in achieving the Dodd-Frank Act objectives of reducing interconnectedness, mitigating systemic risk, increasing transparency and promoting competition in these markets.” Citadel urged the CFTC not to be concerned about the impact of its determination on the companion MAT requirement, and argued that such an assessment would not be “part of the criteria for determining whether OTC derivatives are suitable for mandatory clearing.”

Lofchie Comment: CEA Section 2(h) should be amended to specify that any determination that a swap is subject to mandatory exchange trading must be initiated by regulators, in light of market conditions, and not by exchanges. Unbundling the mandatory exchange-trading element of the CEA from the mandatory clearing element would give the CFTC more latitude to make its clearing determination without being forced to approve the mandatory exchange trading of the swap.

Representative Peter DeFazio Introduces Bill to Tax Trading

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Representative Peter DeFazio (D-OR) introduced legislation, titled “Putting Main Street FIRST: the Finishing Irresponsible Reckless Speculative Trading Act,” that would levy a 0.03% tax on certain securities purchases (including stock, partnership interests and debt instruments) and derivative transactions. Mr. DeFazio stated that the legislation is intended to “discourage the same speculative financial trading that led to the 2008 Wall Street collapse and 2010 ‘Flash Crash.'”

The Joint Committee for Taxation determined that the proposed tax would raise $417 billion over a ten-year period, according to Mr. DeFazio. He asserted the importance of that figure:

The only way we can level [the American economy’s “playing field”] is if we rein in reckless speculative financial trading and curb near-instantaneous high-volume trades that create instability in the stock market and our national economy. These financial practices have no intrinsic value, and exist to make a quick buck for already-wealthy speculators.

The proposed tax would apply to transactions that occurred after December 31, 2017.

Lofchie Comment: Financial trading had nothing to do with the market collapse in 2008 (although suggesting that it did clearly helped Michael Lewis sell books). Representative DeFazio appears to be either unfamiliar or unimpressed with evidence showing that a single trader’s activity (not one of the type disparaged by the Representative) precipitated the Flash Crash. See Findings Regarding the Market Events of May 6, 2010. Apart from that, the practices that would be taxed by his bill essentially are market-making activities. The focus on those specific activities is valuable, providing liquidity to the market and lessening the spread between buyers and sellers. There is a wealth of data contradicting Representative DeFazio’s assertions. See, e.g., The Diversity of High-Frequency Traders, Studies Indicate That High-Frequency Trading Is Beneficial to Canadian Equity Market, and FIA Releases Futures Volatility Study.

Second, Representative DeFazio should consider how much business will be taken out of the country if punitive taxes are imposed on trading. Such financial regulatory measures, which have no basis in economic policy, are of a kind that give Brexit a real chance of succeeding. The United Kingdom has only to adopt sensible regulations and allow other countries to destroy their own markets for the exit to work in its favor.

Third, this bill is geographically biased. It hits the local economies of places that are financial centers: New York, New England and New Jersey. Let’s hope that local politicians reject this suicidal form of populism for the good of both national and regional economies.

If the Representative from Oregon is so interested in putting Main Street businesses “FIRST,” then perhaps he should, to borrow from the Representative’s own rhetoric, consider a tax on high-tech click-through businesses run by fabulously wealthy elitists that destroy local brick-and-mortar businesses. He wouldn’t even have to change the acronym in the bill’s title to accommodate his new target, since the bill could be called “FIRST: the Frenzied Internet Robots Stifle Two-legged store owners Act.” A better option, however, is for him to tone down his rhetoric and engage other representatives in a reasoned, grounded, reality-based discussion about doing what is right for the economy and the country as a whole.

MRAC Reviews Agency Coordination in a CCP or Bank Resolution

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The CFTC Market Risk Advisory Committee (“MRAC”) examined (i) the Central Counterparty (“CCP”) Risk Management Subcommittee’s draft recommendations for the ways in which CCPs can coordinate their efforts when preparing for the default of a significant clearing member, and (ii) the roles the FDIC and the CFTC play in the resolution of banks and central counterparties.

At an open hearing, FDIC and CFTC staff presented a number of topics including: (i) the Title II Process under the Dodd-Frank Act, (ii) special accountability for the company management of global systemically important banks, (iii) access to the orderly liquidation fund, (iv) international engagement, and (v) derivatives clearing organization (“DCO”) resolution.

CFTC Commissioner Sharon Bowen expressed support for CCP coordination in general terms, “since it is highly likely that the default of a significant clearing member would occur in an environment where multiple CCPs and clearing members are affected.” She encouraged the FDIC, as the resolution authority for CCPs, and the CFTC, as the primary regulator for CCPs, to communicate and coordinate efforts.

CFTC Chair Timothy Massad emphasized the CFTC’s leadership in promoting cooperation and coordination.

It has been a priority of mine since taking office, and it is also a priority of regulators around the world, as evidenced by the agreement between U.S. and international regulators last year, to implement a four-part workplan to examine clearinghouse resiliency standards, recovery and resolution planning, and interdependencies among clearinghouses and clearing members. I am pleased that the CFTC is leading much of this work.

 

Lofchie Comment: The need for so-called coordination between CCPs evidences one of the negative consequences of both Dodd-Frank and mandatory clearing: materially increased interconnected risk through clearing members. Dodd-Frank (and similar legislation throughout the world) has resulted in fewer clearing counterparties, and these remaining counterparties, which now are smaller in number and larger in size, are each more connected with the other counterparties through the increased mandatory use of clearing corporations. Even as regulators talk about reducing interconnectedness, the implementation of burdensome regulatory policies drives mid-sized firms away from certain activities. That, combined with government-mandated linkages through clearing corporations, likely increases interconnectedness, perhaps to a material extent.

Questions about interconnected risk are worth considering. Answers might demonstrate that the results of coordination are themselves questionable. Even assuming that the regulations are moving markets in the right direction (and that is an assumption), the specifics of coordination demonstrate that not all of the results are good. At best, they’re mixed.

SEC Chair White Highlights Regulatory Initiatives for Investment Companies

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SEC Chair Mary Jo White outlined new agency initiatives in investment company regulation. She delivered her remarks before the 2016 General Membership of the Investment Company Institute.

As to contemporary asset management initiatives, Chair White identified the following as the most significant areas for regulation: conflicts of interest, registration, reporting and disclosure, portfolio composition and operational risks. Chair White highlighted the recent rulemakings on liquidity and derivatives as examples of the SEC’s new focus.

Chair White stated that the Division of Investment Management is reviewing fund disclosure effectiveness, and the SEC staff is undertaking further review of exchange-traded funds. While emphasizing technology risks, the use of service providers and the importance of accurate portfolio pricing, Chair White encouraged funds to focus on valuation, performance advertising and issues that may arise when funds make payments to intermediaries for the distribution of fund shares.

Lofchie Comment: The SEC’s proposals regarding liquidity and derivatives have been subject to significant negative reaction. The common theme from both industry and academic critics is that these proposals are economically simplistic and only appear to reduce risk. This may work for the economically unsophisticated (e.g., those who believe that all derivatives are inherently risk-creating), but in reality, those fearful of derivatives would increase risk by discouraging the use of hedging techniques that employ derivatives.

Chair White acknowledged that the SEC received critical feedback on both proposals. Regarding the derivatives proposal, she stated: “many commenters, however, are not in favor of the proposal’s portfolio limitations and some have provided a range of suggested modifications and alternatives.” Concerning the liquidity proposal, she noted: “many [commenters] expressed concerns about the liquidity classification framework and operational challenges for swing pricing.” It remains to be seen how, or even whether, the SEC will respond to these important criticisms.