Category Archives: Derivatives

OFR Publishes Working Paper on Process Systems as a Modeling Paradigm for Analyzing Systemic Risk

Posted on by

The Office of Financial Research (“OFR”) published a working paper titled “Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.” The paper proposes a methodology to quantify systemic risk. More specifically, it proposes that signed directed graphs (“SDGs”), modeling methodologies that are used extensively in process systems engineering, can be used to create frameworks that (i) address the cause and effect of financial instability feedback loops and (ii) can automate the identification and monitoring of potential vulnerabilities. More generally, the paper asserts that a process systems engineering framework is a “useful model” with which to analyze potential hazards and instabilities in the financial system that may not be apparent from a “network-based perspective” on large financial systems.

Lofchie Comment: It has never seemed apparent that the central clearing of swaps makes the financial system safer. Much of what clearinghouses do to improve safety comes at the expense of clearing members and their customers. Because the pricing “signals” that clearing members send have more power than those of individual market participants, any change in valuation declared by a clearinghouse may affect the market and market participant behavior generally and quickly in ways that could be negative. As a result, the actions taken by individual market participants in order to protect themselves may in fact do damage to the safety of the larger financial system.

To put this into more concrete terms, under the logic set out in the paper, if a clearinghouse determines that the value of a commodity has declined, and that the volatility of the commodity has increased, then market participants will come under immediate pressure to sell the commodity in order to pay for losses on the decline and because the cost of financing the required margin has risen. Additionally, clearing members and their customers cannot protect themselves by contract against the margin demands of the clearinghouse (as they could against other private parties).

The paper confirms the concern that clearinghouses are at least a potential source of systemic risk. Query: under what circumstances/assumptions does the model show that clearinghouses increase or decrease systemic risk?

See: OFR Working Paper: Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.

 

U.S. House Committee on Agriculture Holds Hearing to Examine the CFTC’s 2015 Agenda

Posted on by

The U.S. House Committee on Agriculture held a hearing to review the futures, options and swaps markets overseen by the CFTC. CFTC Chair Timothy Massad was the sole witness.

Chair Massad focused his testimony on the CFTC’s key priorities for 2015 and on reviewing what it has accomplished since his time as Chair began.  Chair Massad stated that the CFTC intends to make markets work for commercial end users and has undertaken actions to achieve this goal. The actions include, among other things: (i) proposing a rule on margin for uncleared swaps; (ii) amending its rules for transactions with special entities to allow local utility companies to hedge risks in the energy swaps market; (iii) proposing rules to exempt end users and commodity trading advisors from certain recordkeeping requirements; (iv) clarifying the CFTC’s position on when forward contracts with embedded volumetric optionality may be excluded from being considered swaps; (v) harmonizing rules (such as those for certain commodity pools) with those of the SEC; and (vi) adjusting the settlement deadline for FCMs to post “residual interest” so as not to burden the margin collection process. 

Chair Massad also outlined areas on which the CFTC will focus in 2015, including:

  • the new regulatory framework for swaps;
  • a harmonized cross-border framework;
  • robust enforcement and compliance efforts;
  • cybersecurity, information security and business continuity challenges; and
  • retrospective regulatory reviews of CFTC rules.

Chair Massad also advocated for the CFTC FY 2016 budget increase, stating that the new budget is necessary in order to fulfill the CFTC’s goals and responsibilities.

Lofchie Comment: Quite a bit in Dodd-Frank and in the rules thereunder genuinely needs fixing. No doubt the process will continue for many years to come. Accordingly, it is good to see that “retrospective regulatory review” is high on Chair Massad’s agenda. In a reasonable world (if that is not a contradiction in terms), “retrospective statutory review” would be high on the Congressional agenda as well, since it is a review that could be accomplished more easily if every attempt at a correction were not painted as an attack on The Night Watch.

See: Hearing Notice; Webcast of Hearing; Chair Massad’s Testimony.

 

SEC Publishes Text of Regulation SBSR; Commissioners Dissent after Discovery of Comment Letter

Posted on by

The SEC released the texts of previously adopted Regulation SBSR, which prescribes the reporting and public dissemination of security-based swap transaction data, and Regulation SDR, which requires security-based swap data repositories (“SDRs”) to register with the SEC. The SEC vote to adopt the rules occurred on January 14, 2015.

The SEC also published the text of the additional proposed rules, rule amendments and guidance related to Regulation SBSR and the reporting and public dissemination of security-based swap transaction data.

According to SEC Commissioners Gallagher and Piwowar (the “Commissioners”), the delay in the publishing of the text of these rules is due to an “extensive comment letter” discovered by the SEC shortly after the vote to adopt the rules. The Commissioners explained that the comment letter covered a range of “key issues,” and was submitted by an organization whose membership will be responsible for reporting nearly all security-based swaps subject to reporting under Regulation SBSR.

The Commissioners said that they asked the SEC to publish the comment letter and reopen the comment period for Regulation SBSR in order to account for the inadvertent internal process failure, and to afford the comment letter the same consideration that had been provided to others. Instead of granting that request, the Commissioners explained, the SEC chose to publish the previously adopted releases, which were modified to include references to the omitted comment letter.

Therefore, the Commissioners stated, they did not support the publication of the modified rulemaking release, “as it glosses over a significant failure of our internal processes.” They also continued to dissent on the substance of Regulation SBSR for the reasons set forth in their original statement.

See: Text of Adopted Regulation SBSR; Text of Regulation SDR; Text of Proposed Rule; Commissioner Gallagher and Piwowar’s Dissent.
Related news: SEC Adopts Rules to Increase Transparency in Security-Based Swaps Market (January 15, 2015).

See also: The Purloined Letter by Edgar Allen Poe.

 

ESMA Issues Feedback Statement on Central Clearing of Non-Deliverable Forwards

Posted on by

The European Securities and Markets Authority (“ESMA”) published a statement regarding its consultation paper on the clearing obligation for non-deliverable foreign exchange forwards (“NDFs”).

The European Markets Infrastructure Regulation requires ESMA to draft technical standards for the clearing obligations of different derivative classes. The statement summarizes the feedback received in response to the consultation paper.

Based on the feedback that it received, ESMA stated, it is not proposing a clearing obligation on the NDF classes at this stage. ESMA explained that more time is needed to address appropriately the main concerns raised during the consultation.

See: ESMA Feedback Statement.

 

FIA and FIA Europe Issue Third Report in a Series Covering ESMA MiFID II Regulations

Posted on by

The Futures Industry Association (“FIA”) and FIA Europe issued the third in a series of special reports that cover technical requirements on MiFID II regulations by the European Securities Markets Authorities (“ESMA”).

The third special report provides an overview of ESMA’s proposals in its December 19, 2014 Consultation Paper and the draft Regulatory Technical Standards on (i) post-trading issues for derivatives, (ii) indirect clearing and (iii) post-trade transparency requirements.

The MiFID II regulations will become effective on January 3, 2017.

See: Third Special Report: Derivatives under MiFID II – Part 2.
Related news: FIA and FIA Europe Issue Their Second Report in a Series Covering ESMA MiFID II Regulations (January 23, 2015); FIA and FIA Europe Issue First in a Series of Special Reports Regarding Summaries of ESMA MiFID II Regulations (January 16, 2015).

 

Senator Warren and Representative Cummings Request Information from Banks Regarding Swaps Trading Practices

Posted on by

U.S. Senator Elizabeth Warren (D-MA) and House Representative Elijah E. Cummings (D-MD) sent letters to multiple banks, requesting information about how the institutions will alter their swaps trading practices in response to the passage of Section 630 of the 2015 Consolidated and Further Continuing Appropriations Act (“Section 630”) (i.e., the amendments to the swaps “push-out” requirements of Section 716 of Dodd-Frank).

In the letter, Senator Warren and Rep. Cummings requested information from the banks so as to “aid in our oversight of the impact of Section 630.” Information requested includes:

  • the definition of the term “hedging” and “risk management purposes” that the firm will use to determine which swaps trades can now be made under Section 630;
  • the total value of derivatives contracts the institution holds for each of “hedging” and “risk management purposes,” and the total value of swaps derivatives contracts the institution holds for each of these purposes;
  • the types of transactions included in the term “structured finance swap” as used in Section 630, and the value of these transactions;
  • copies of the institution’s application to the Office of the Comptroller of the Currency to delay implementing Dodd-Frank Section 716;
  • a description of any “operation and credit risks” the institution would have experienced had it been required to implement the provisions of Section 716; and
  • the total value of swaps the institution would have “pushed out” under Section 716 absent the changes in Section 630, and the total value of swaps the institution now expects to “push out.”

Senator Warren and Rep. Cummings requested the information be provided by February 26, 2015, and request a briefing from an official of the institutions by February 19, 2015.

See: Senator Warren’s Press Release and Links to Letters.
Related news: Senate Approves Appropriations Bill Amending Swaps Push-Out Rule (December 15, 2014); Congress to Vote on Bill to Repeal Swaps Push-out Requirements (December 11, 2014).

 

CFTC Commissioner Giancarlo Releases Swaps Trading Rules White Paper

Posted on by

CFTC Commissioner J. Christopher Giancarlo released a white paper titled “Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank” (the “White Paper”), which proposes an alternative to the CFTC’s swaps trading framework.

The White Paper is critical of the implementation of the swaps trading framework, asserting that there is a “fundamental mismatch” between the CFTC’s framework and the “distinct liquidity and trading dynamics of the global swaps market.” According to the White Paper, the CFTC framework is “highly over-engineered, disproportionately modeled on the U.S. futures market and biased against both human discretion and technological innovation.” 

The White Paper identifies a number of adverse consequences of the “flawed” swaps trading rules, and proposes an alternative swaps trading framework that “better aligns with swaps market dynamics and is more true to congressional intent.” The alternative framework is built upon five tenets:

  • “comprehensiveness,” by subjecting the broadest range of U.S. swaps trading activity to CFTC oversight;
  • “cohesiveness,” by removing “artificial segmentation” of swaps trading and regulating all CFTC swaps trading in a holistic fashion;
  • “flexibility,” by permitting trade execution through “any means of interstate commerce” and allowing “organic development of swaps products and market structure”;
  • “professionalism,” by establishing requirements for product and market knowledge through requiring, for example, swaps broker testing, as well as requirements for professionalism and ethical behavior for swaps market personnel; and
  • increased transparency.

See: “Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank” by Commissioner Giancarlo; Commissioner Giancarlo’s TabbFORUM Speech; CFTC Press Release.

 

IOSCO Issues Final Report on Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives

Posted on by

IOSCO published a final report, titled “Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives,” which outlines standards that are intended to reduce risk in the non-centrally cleared OTC derivatives markets.

The risk mitigation standards in the report were developed in consultation with the Basel Committee on Banking Supervision and the Committee on Payments and Market Infrastructures. They stem from a proposed standards report that was published in September 2014.

The final report focuses on a number of ways in which risk standards can be applied in key areas to reduce risks in the non-centrally cleared OTC derivatives market. These include:

  • financial entities and systemically important non-financial entities’ employing risk mitigation techniques;
  • executing written trading relationship documentation prior to a trade;
  • sending trade confirmations as soon as practicable after execution;
  • agreeing on the valuation process with counterparties;
  • ensuring portfolio reconciliation;
  • agreeing on policies and procedures for assessing and engaging in compression; and
  • agreeing to dispute resolution procedures with counterparties.

In addition, the report recommends that regulators implement rules that require the above procedures as soon as possible, and that regulatory regimes be harmonized to facilitate cross-border transactions.

See: Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives.
Related news: IOSCO Publishes Consultation Report on Risk Mitigation for Non-Centrally Cleared OTC Derivatives (September 18, 2014).

CFTC Chair Massad Continues Urging Cross-Border Harmonization of Swaps Rules

Posted on by

In the keynote address before the Monetary Authority of Singapore, CFTC Chair Massad continued to advocate for cross-border harmonization.

Chair Massad reiterated his belief that the G-20’s agreements to reform the swaps market can only go so far, explaining that it is incumbent upon regulators to develop rules that implement the G-20’s commitments. He also stated that the best way to continue to grow domestic and international financial markets is to create a sound regulatory framework, which must “bring transparency, integrity, and oversight, but, at the same time, provide predictability to market participants, and encourage innovation and competition.”

Chair Massad explained that clearing is “perhaps the most important reform in terms of reducing systemic risk,” but noted that central clearing does and will not eliminate risk. While the CFTC is working with European regulators to harmonize rules, he commented, the CFTC does not take the view that every clearinghouse must register with it. 

He identified margin standards and stress testing as two areas that are “critical pieces of this discussion” of harmonizing clearinghouse supervision. Chair Massad further stated that setting margin requirements for uncleared swaps is an opportunity for global regulators to make the rules in the U.S., Asia and Europe “substantially similar” from the outset.

Chair Massad called on regulators in Asia to become even more involved in the process of establishing swap data and trade repositories. Additionally, he mentioned the recent CFTC approvals of Bursa Malaysia and SGX as foreign boards of trade, stating that the approvals show “the increasing interconnectedness of the global derivatives markets and the importance of Asia in that development.” With this increasing interconnectedness, Chair Massad reiterated that the CFTC is committed to a coordinated regulatory approach.

Lofchie Comment: The CFTC is substantially improved under the leadership of CFTC Chairman Massad. His efforts to reach out to international regulators to urge the development of a common approach is a significant step-up from the CFTC previously asserting that it would go it alone.

That said, there is still an inherent weakness to Chairman Massad’s approach. The major problems that he inherited were not just ones resulting from the CFTC’s interaction with other regulators. The more fundamental problems are with the CFTC’s rules themselves: they were rushed through, with little consideration of their economic effect, based upon a statute (Dodd-Frank) that was likewise rushed through. The Chairman should not try to convince the Asian regulators to adopt a similar set of flawed rules. The Asian regulators are not under reciprocal political pressure to copycat our rules. Chairman Massad might want to consider using the reluctance of the Asian regulators to follow the U.S. “model” as a reason to rethink our own rules.

Lofchie Wikipedia Selection.

See: Chair Massad’s Remarks.
Related news: In Japan, CFTC Chair Massad Discusses Cross-Border Harmonization (January 22, 2015); CFTC Chair Massad Discusses Cross-Border Harmonization (January 21, 2015); Chair Massad Announces Trip to Asia to Discuss Swaps Market Reform (January 14, 2015).

 

FIA and FIA Europe Issue Their Second Report in a Series Covering ESMA MiFID II Regulations

Posted on by

The Futures Industry Association (“FIA”) and FIA Europe issued their second special report in a series that covers technical advice and consultation documents by the European Securities Markets Authorities (“ESMA”) on MiFID II regulations.

The special report provides an overview of ESMA’s proposals in its Consultation Paper, including the draft Regulatory Technical Standards on the trading obligation for derivatives, as well as ESMA’s proposals concerning the definition of “liquid market” in relation to the transparency requirements for derivatives.

The MiFID II regulations will become effective on January 3, 2017.

See: Second Special Series Report.
Related news: FIA and FIA Europe Issue First in a Series of Special Reports Regarding Summaries of ESMA MiFID II Regulations (January 16, 2015).