Monday, August 30, 2010

SEC-CFTC Roundtable Illuminates Major Issues in Implementing Derivatives Provisions of Dodd-Frank

An SEC-CFTC roundtable on implementing the derivatives provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act discussed the very important and difficult issues of access to derivatives clearing organizations, clearinghouses, and security-based and non-security based swap execution facilities. There are also significant governance, risk management, and conflict of interest issues surrounding the clearing of OTC derivatives. Dodd-Frank mandates that the SEC and CFTC adopt regulations implementing the derivative provisions of Title VII. The roundtable was co-chaired by Robert Cook, SEC Director of Trading and Markets and Ananda Radhakrishnan, CFTC Director of Clearing and Intermediary Oversight. The roundtable was also composed of SEC and CFTC staffers, industry representative and former Federal Reserve Board Governor Randy Kroszner.

Governor Kroszner said that, in determining what derivatives are eligible for clearing, the SEC and CFTC should consider giving strong incentives through capital requirements and collateral requirements, but not necessarily mandating each individual product. The Commissions will be struggling with the heart of the issues that clearinghouses have been struggling with since they started to function as the guarantors of contracts, he noted, and that is getting the balance right between having access and having enough clearing members, making sure there is enough trading and drawing things off the exchange, but also ensuring that those members have the wherewithal to withstand the shocks to make the clearinghouse something that will reduce systemic risk and reduce interconnectedness rather than increase it.

More specifically, Mr. Radhakrishnan, CFTC Director of Clearing and Intermediary Oversight, noted the importance of finding the balance between open access, fair access and the desire for sound risk management. If you have a clearinghouse that is dominated by a group of people, he asked, does that achieve the objective of fair and open access. It is also important to avoid conflict of interest while at the same time ensuring that all decisions are being made by the clearinghouse according to its risk management.

Mr. Kroszner said that the law is very clear on what should prevail, and that is open access, fair, open, unfettered access, and transparency. Risk management is better done in a default scenario if there are more members participating in an auction. And to say, for example, that a Swaps and Derivatives Market Association (SDMA) member firm that clears a large amount of treasuries is somehow ineligible or unqualified to be a member of a clearinghouse is not addressing the issues properly. The former Fed Governor also pointed out that Section 731 of the Dodd-Frank Act discusses this issue in a different way in regards to conflicts of interest. Section 731 requires that banks establish structural and institutional safeguards and supervisory barriers and informational partitions between those who trade and those who provide clearing services in what they call in the SDMAs "the Chinese Wall provision." This is a very good provision, emphasized Gov. Kroszner, because it goes directly to the issue of the conflict between trading and clearing.

Currently, annually, there is estimated to be about $300 to $500 million made clearing, and there are between $400 and $60 billion being made trading. So, in the former Fed official’s view, this discussion of clearing and access to clearing is really just a proxy about access to trading, because that is where the revenues are. And the law is clear, he reiterated, open access is the fundamental principle.

Robert Cook, SEC Director of Trading and Markets, sees a growing consensus favoring open access to swap execution facilities, both security-based and non-security-based. In his view, the main issues are how to ensure that open access happens and what are the potential conflicts that the SEC and CFTC need to anticipate and prevent in order to ensure that there is open access. Under the statute, the SEC and CFTC are meant to consider potential rules governing ownership and voting and control of a swap execution facility by particular types of parties in order to ensure that outcome. Given the goal of open access, the SEC official asked what types of conflicts do the Commissions need to try to anticipate and prevent. He also asked if the Commissions should treat particular parties mentioned in Dodd-Frank, such as bank holding companies differently or the same.

Responding to Mr. Cook, Jason Kastner, SDMA Vice Chair, noted that if you look at the progress of the legislation into the final hours there was the notion that a swap execution facility may operate by any means of interstate commerce. A previous version of the bill required electronic trading, he said, and so the issue is can you trade swaps with ``two paper cups and a string and carrier pigeons’’, or is it required that they be on an electronic screen. And another issue is whether there should be a request for quote model or should there be a fully disintermediated market where anybody can join any bid and offer and anybody can participate in an open way. He pointed out that the goal of Dodd-Frank is to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency. The only way that you can have pre- trade price transparency is if it is on a screen and everyone can see it ahead of time, he said. Thus, he urged the Commissions to consider this when they are thinking about the definition of the swap execution facility and rule construction and electronic versus carrier pigeon and when the SEC and CFTC think about requests for quote versus disintermediated market.

Heather. Slavkin of the AFL-CIO said that another issue arising in this context is the question of the timeliness of information received by various players in the market. She understands that the SEC has probably been looking at the issue of collocation with regard to the exchanges, and sees this as a potential issue that could arise as well in the context of the swap execution facilities. Thus, she urged the Commissions to consider who is getting what information, when they are receiving it, and what they can do with that information once they receive it.

Former Fed Governor Kroszner emphasized the importance of getting risk management right, because there are now very strong incentives to get things onto the platforms making everyone interconnected to the clearinghouse. So, in order to avoid the kind of crises that we saw, the clearinghouse has to be seen as very strong, he said, seen as basically bulletproof so that an individual member going down will not cause the sort of cascading concerns we saw in late 2008. And so it is crucial that members have the right incentives for risk management. It may be difficult when two types of members on the exchange might have different incentives to get their approaches to risk management right, you could have some institutions that have very little capital because they might be willing to take more risks and want the exchange or the central clearer to take more risks than otherwise.

A number of people have made the point, noted Gov. Kroszner, that the idea behind migrating these things onto central clearing platforms and potentially on exchanges is to try to reduce those risks since you've got to think about the incentives that people with different amounts of capital might have for ensuring good risk management. This goes to the historic struggle of clearinghouses and exchanges trying to get more things onto the exchange, but also making sure that the risks can be managed by the exchange or by the clearinghouse.

James Hill speaking for SIFMA, said that the industry has been focused very much on what happens when a member defaults and you have to unwind the portfolio or inject more capital into the clearinghouse. But the related piece is who can inject risk into the clearinghouse. So, the clearing members, in addition to contributing capital to the clearinghouse and margin, they interact with their customers and put trades into the clearinghouse. And because the FCM ultimately has a risk to its customer, if its customer defaults, the FCM has to carefully risk manage the amount of trades it takes from any one customer and put into the clearinghouse. And so not only do you have to be worried about someone's ability to fund the clearinghouse in a default scenario, noted SIFMA, but you have to be concerned and focused on their ability to risk manage their customer relationships so that they don't put trades into the clearinghouse that could otherwise destabilize the clearinghouse. So, it's not just a wind-down that you have to be concerned about, observed SIFMA, but also the injection of risk into the clearinghouse.

In the view of Jonathan Short of ICE, if you get the governance of the clearinghouse right, a lot of these problems will go away. Risk management is paramount, he emphasized. The reason there is a mandate for clearing in Dodd-Frank is to make the financial system more stable, and, while there are conflicts that have to be dealt with, Mr. Short has never heard the Dodd-Frank Act described as legislation aimed at simply promoting competition among financial institutions. That really wasn't the gist of what Congress was doing here, he added, and, while all of these things need to be considered and balanced, if you create a system that allows too much risk or unmanageable risk to come into the clearinghouse we are going to be right back in front of Congress again with hearings and major problems.

Haimera Workie, SEC Deputy Associate Director, Trading and Markets, said that the Dodd-Frank asks the Commissions to think about restrictions with respect to swap participants, major swap participants, bank holding companies and nonbank financial institutions. When the Commissions are thinking about conflicts and potential restrictions, asked the SEC official, how should they think about them, either collectively within that group, or individually within those subgroups. Mr. Kastner referred the SEC and CFTC staffs to Section 726, which deals with rulemaking on conflicts of interest, what he called Lynch Light, and for the Commissions to consider certain ownership and control restrictions in DCOs. The SDMA strongly supports restrictions on ownership and restrictions on control in DCOs, and the reason why is because if you have a club which is closed and which controls not only what goes into the clearinghouse but who can become a member of it, it does not address the issues of too big to fail and too interconnected to fail. Thus, he strongly suggested that as the Commissions consider the implementation of Section 726, they move forward and impose restrictions because, if they do not, there is a real risk that we are going to end up right back where we started again.

Nancy Schnabel, CFTC Special Counsel in the Division of Clearing and Intermediary Oversight, has heard concerns about the potential tying of execution and clearing. It seems as if the circumstances surrounding clearing now may be slightly different than what have previously happened when LCH was first formed, noted special counsel, for instance by the interdealer banks. There are issues of incentives and conflicts of interest connected to eligibility of clearing.

It is SIFMA’s view that, and Dodd-Frank appears to require this, that clearinghouses be agnostic as to where they accept trades from, so clearinghouses should be open to any swap execution facility. SIFMA believes that there will be multiple SEFs in the marketplace from multiple products, and the clearinghouses should accept trades from multiple SEFs which is consistent with Dodd-Frank’s goal of increasing clearing.

Similarly, SIFMA believes that SEFs should be clearing agnostic as well, meaning that an SEF should be set up to allow the people using the facility to choose which clearinghouse they want to go to. So that clearinghouses should be agnostic and the SEFs, themselves, should be agnostic. SIFMA emphasized that this will ensure that the maximum amount of clearing that can occur will in fact occur.

With regard to members of the clearinghouse, SIFMA believes that anybody who has the capital and the expertise to evaluate risk should be allowed to be a member. But in terms of whether or not those clearing members should have a say in what gets cleared, the key is that the clearing members themselves are the ones who capitalize the clearinghouse. Thus, with respect to all the OTC derivatives clearinghouses, the clearing members have the overwhelming preponderance of capital in the entity. So, for example, XYZ clearinghouse, the clearing members may have put in $5 billion. The clearinghouse itself probably has about $20 to $50 million. So the overwhelming preponderance of capital in the clearinghouse is put up by the clearing members.

In evaluating what trades should be cleared, advised SIFMA, a balance must be struck between the goal of increasing clearing and risk management. You don't want to put trades in the clearinghouse that can't be appropriately risk-managed. So if you put trades in the clearinghouse that are illiquid and can't be valued properly, reasoned SIFMA, what will happen is when a clearing member defaults, there will be insufficient collateral with respect to that trade because it wasn't properly valued in the clearinghouse, and the surviving clearing members will be stressed from an economic perspective in
taking positions the value of which cannot be readily ascertained. Thus, SIFMA told the Commissions that it is critical that only trades that can be appropriately risk-managed be put into the clearinghouse.

SIFMA anticipates that most of the clearinghouses will look to their clearing members to help them valuate which trades are appropriate from a clearing perspective, which is consistent with the economic incentives because the clearing members are the ones who have the overwhelming preponderance of the capital in the clearinghouse. Noting that it is the clearing members that have their capital at risk, SIFMA urged the Commissions to give them a say in helping the clearinghouse evaluate which trades are acceptable for clearing and which trades are too risky or can't be valued, or are too illiquid or not standardized and, therefore, should not be cleared.

A colloquy between Ms. Schnabel, CFTC special counsel, and Mr. Hill of SIFMA revealed that, when SIFMA speaks of the capital of the clearing members that is at risk, it speaks of the default fund and not margin. Ms. Schnabel noted that margin is thus still the first line of defense, and that can be provided by customers as well. SIFMA agreed, but added that, when a clearing member is defaulting and markets are illiquid, if the margin is insufficient, then you look to the default fund to make sure the clearinghouse stays solvent.