Monday, May 16, 2011

Hedge Fund Industry Seeks Greater Transparency in SEC Regulations on Central Counterparty Clearing Agencies

While generally supportive of SEC proposals facilitating the prompt and accurate clearing and settlement of security-based swap transactions, the hedge fund industry called for more transparency for central counterparty clearing agency policies and procedures, in particular regarding the setting of margin requirements and minimum net capital requirements. In a letter to the SEC, the Managed Funds Association said that a lack of transparency in these areas could lead to clearing agencies implementing their policies and procedures in a manner that is not responsive to the risk objective they intended the policies or procedures to address, thereby embedding competitive barriers to access.

For example, risk management structures for scaling net capital requirements, if not applied in an objective and transparent manner, could have the same restrictive effect as an excessive net capital threshold, which would hinder competition and undermine the open access goals of the Dodd-Frank Act and the proposed rules. In addition, the MFA noted that transparency furthers SEC policy objectives by permitting all market participants to evaluate the risk management strengths of clearing offerings and make informed choices. In addition, transparency of reserve calculation requirements will also provide a useful benchmark for future regulation of margin and capital calculations for non-cleared trades.

The MFA supports the SEC’s proposed Rule 17Ad– 22(a)(5) definition of net capital, which would have the same meaning as set forth in the Exchange Act’s broker-dealer net capital rules. The definition will ensure that clearing agencies use a consistent calculation methodology as to the level of capital required for clearing membership rather than allowing them to choose different less standardized calculations that could have the effect of making it difficult for certain types of otherwise eligible entities to qualify for clearing membership. Noting , however, that for institutions other than banks and broker-dealers net capital is not as clearly defined a concept, the MFA suggested that the Commission clarify in the proposed definition what the equivalent concept would be for non-bank or non-broker-dealers.

Proposed Rule 17Ad–22(b) sets forth standards applicable to clearing agencies that provide central counterparty services. The MFA supports standardizing the manner in which these clearing agencies set margin requirements. In addition, the hedge fund association recommend that the SEC require each clearing agency to make available to its customers its methodology for setting margin, so that customers can calculate with precision the margin they will need to post with respect to any given transaction.

In the MFA’s view, mandating transparency will enable market participants to anticipate when a central counter party clearing agency may require additional margin and be prepared to respond to margin calls, thereby increasing market stability and decreasing the likelihood that a market participant will experience a liquidity shortage due to an unexpected increase in margin. Provided that the market has such transparency, the MFA agrees that the clearing agencies should have flexibility to modify margin requirements as necessary, including the imposing of special margin requirements or requiring intraday posting of margin.

The proposal seeks to increase access to central counterparty clearing agency membership by mandating that such agencies allow persons with net capital equal to or greater than $50 million to obtain membership. The hedge fund industry agrees that $50 million is a reasonable maximum net capital requirement because it signifies a threshold level of financial expertise. While some market participants support a higher net capital requirement, arguing that it will decrease the risk that a clearing member could not meet its obligations to the clearing agency in the event of a margin call or default, the MFA believes that the ability to meet a higher minimum net capital requirement does not necessarily equate to posing less risk. For example, a large entity with significant net capital may have exposures and be extended in a variety of different ways that result in it posing greater systemic risk than a smaller entity with less net capital and less exposure.

An entity’s ability to meet assessments or margin calls in a default scenario is not a matter of size or net capital, posited the MFA, but whether the entity has appropriate resources measured against its contingent obligations. According to the MFA, the proposal to provide an option for a clearing agency to scale requirements applicable to each clearing member in a way that reflects the exposure that the particular entity would bring to the table as a clearing member is the most appropriate way to allow clearing agencies to manage the risk that a clearing member will not be able to meet its obligations.

In that regard, the MFA urged the SEC to require that central counterparty clearing agencies determine such scaling by objective, risk-based methodologies based on reasonable stress and default scenarios and consistently applied to all clearing members. The Proposing Release references the Fixed Income Clearing Corporation’s tiered membership standards as an example of capital-related requirements that differentiate between types of participants. Although the MFA believes that it is appropriate to permit central counterparty clearing agencies to develop scalable membership standards to address their risk management concerns, the association is generally opposed to tiers in membership, which could have discriminatory or anti-competitive effects.

The MFA also noted that the SEC proposal to retain flexibility for risk management purposes by allowing clearing agencies to condition membership on a higher net capital requirement diverges from the CFTC proposals on risk management for derivatives clearing organizations, which do not allow for divergence from the $50 million net capital requirement for membership.

In the spirit of consistent regulation, the MFA urged the SEC to eliminate from the final rules a clearing agency’s ability to increase the net capital requirement. The MFA believes that allowing the scaling of net capital requirements proportionate to the risk posed by the participant to the clearing agency should be sufficient.

Similarly, the MFA noted that the SEC’s proposed regulations differ from current CFTC regulations requiring futures clearinghouses to publish daily settlement prices broadly, free of charge to the public. Moreover, CFTC exemption orders for cleared OTC derivatives also require daily publication of price information to the public at no charge. The MFA sees no rationale for having the practices for the securities-based swap market diverge from futures and other cleared markets; and thus urged the SEC to harmonize its practice with that of the CFTC and require clearing agencies to broadly publish end of day settlement prices at no charge.

In the MFA’s view, requiring free publication of daily price settlement data by central counterparty clearing agencies would have many beneficial results, including creating a baseline for clearing agencies to confirm prices, allowing for a comparison between prices in the bilateral and cleared markets, and establishing a source of historical pricing data.