Saturday, July 23, 2011

Joint SEC, CFTC, Fed Report Outlines Fed’s Role under Dodd-Frank in Oversight of Systemically Important Clearing Entities

The SEC, CFTC and the Fed have submitted a report to Congress mandated by the Dodd-Frank Act on the risk management of clearing entities and derivative clearing organizations that are deemed to be systemically important by the Financial Stability Oversight Council. Section 813 of Dodd-Frank requires that the SEC and CFTC coordinate with the Fed to jointly develop risk management supervision programs for clearing entities that have been designated as systemically important by the Council.

For these purposes, a clearing entity is either a derivatives clearing organization registered with the CFTC or a clearing agency registered with the SEC under Section 17A of the Securities Exchange Act. Broadly, the report and accompanying recommendations enhance the role of the Fed in the regulation and examination of systemically important clearing entities. Ultimately, the agencies envision a mechanism for implementing information sharing through a Memorandum of Understanding among the CFTC, the SEC, and the Fed.

In Title VIII of Dodd-Frank, Congress found that the proper functioning of the financial markets is dependent upon safe and efficient arrangements for the clearing and settlement of securities and derivatives transactions. The entities providing these arrangements are known as financial market utilities. Title VIII applies to financial market utilities designated by the Council as systemically important based on a determination that the failure or disruption to the functioning of the utility could create the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system. Designated clearing entities are a subset of designated financial market utilities.

Generally, the supervisory programs of the SEC, CFTC and the Fed are conducted in an autonomous manner. However, with Title VIII, Congress has provided a new cooperative supervisory framework for designated clearing entities that provides requirements for enhanced risk management, a greater focus on systemic risk both within and across designated clearing entities, an enhanced role for the Board in the supervision of risk management standards for these systemically important financial market utilities and closer consultation among the CFTC, the SEC, and the Board.

It is important to note that the new Title VIII supervisory framework does not replace the existing supervisory programs at the SEC and CFTC. Rather, the new framework builds on each agency’s existing program with an interagency consultative process designed to enhance and reinforce existing supervisory programs through the benefits of shared expertise and information among the CFTC, the SEC, and the Board. The joint report makes five specific recommendations designed to achieve this goal.

First, the CFTC and the SEC should finalize regulations establishing enhanced risk management standards for derivatives clearing organizations and clearing agencies, including designated clearing entities, but in consultation with the Fed. The CFTC and the SEC should continue Fed consultation in connection with future agency rulemakings related to changes in risk management standards for designated clearing entities. Second, the CFTC and the SEC should formalize a process for consulting with the Fed regarding proposed material changes to the rules, procedures, or operations of designated clearing entities.

Third, the CFTC, the SEC, and the Board should implement an ongoing consultative mechanism promoting a shared understanding of potential systemic risks, and an exchange of insights on effective risk management practices and techniques. The ongoing consultative mechanism should consist of an annual planning and coordination meeting, said the report, supplemented by ongoing dialogue and periodic meetings as needed. The purpose of the meeting and ongoing dialogue should be to identify emerging risks, discuss key risk issues that may be examined by each agency, and help inform effective supervisory responses to such risks.

Fourth, the CFTC and the SEC should develop a process for annual consultation with the Fed at least once a year regarding the scope and methodology of their planned examinations of designated clearing agencies for which each is the regulator and providing the Board the opportunity to participate on such examinations. Obviously, the CFTC and the SEC must lead the examinations within their respective jurisdictions as provided for by Section 807(d) of Dodd-Frank. But consultations with the Fed on the scope and methodology of the examinations and participation by the Board on relevant examinations are important elements to enable the Board to carry out its responsibilities under Title VIII. In fact, the Fed expects to participate on each relevant examination of a designated clearing entity where practicable as allowed under Section 807(d)(2) of Dodd-Frank.

Fifth, the CFTC, the SEC, and the Fed should develop a process for appropriate information sharing related to designated clearing entities. Title VIII authorizes such information sharing in Section 809 pursuant to which the agencies plan to develop an appropriate process for regular information exchange. The process should cover procedures for sharing, and preserving the confidentiality of, written and oral information such as examination reports, information about material concerns, and other appropriate confidential supervisory information. The agencies believe that one possible mechanism
for implementing such information sharing may be through a Memorandum of Understanding (MOU) among the CFTC, the SEC, and the Board.

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