Wednesday, December 10, 2014

Regulators Still Haunted by Risk Concentration

[This story previously appeared in Securities Regulation Daily.]

By Mark S. Nelson, J.D.

Global regulators and the derivatives industry can do more to lessen the threat posed by risk concentration at clearinghouses, CFTC Commissioner Mark P. Wetjen told an audience at the FIA Asia Derivatives conference in Singapore. Wetjen outlined a few proposals that may help clearinghouses, but he raised key questions that must be answered before regulators adopt enhanced disclosure rules. He also said he planned to call a meeting of the CFTC’s Global Markets Advisory Committee to talk more about derivatives clearing and other issues.

Wetjen acknowledged that some in the derivatives markets worry that the CFTC’s rules, and the industry’s more general principles for financial market infrastructures, are too weak. Standardized stress tests could remedy any deficiencies by boosting transparency.

While generally backing further discussion of standardization, Wetjen cautioned that such a move could increase industry confusion over the applicable standards and stifle innovation. Wetjen also said greater transparency about stress test assumptions could result in market manipulations, even when central counterparties’ (CCPs’) disclosures remain anonymous. Wetjen urged the CFTC to issue a concept release on standardization.

Likewise, Wetjen said the CFTC can reduce uncertainty about how CCPs implement their default waterfalls by adopting a new rule and pressing for global harmonization of regulatory standards. He said the CFTC could do its part by seeking public comment on a release, but these issues also could be addressed by an advisory committee.

Wetjen had opened his speech by re-telling the story from a year ago of how a Korean securities firm’s trading glitch caused it to default, resulting in a loss at an affiliated clearinghouse. Wetjen said CCPs have several options for handling these situations via loss mutualization provisions in a default waterfall. In the Korean example, Wetjen said the clearinghouse never had a loss because its default waterfall would have applied its own capital only after using the contributions from non-defaulting members.

Moreover, Wetjen said CCPs should adopt contingency plans to aid their recovery or wind-down in response to systemic events. These plans ensure that key services are not disrupted. The plans also seek to stop one firm’s problems from spreading to the wider market.

Wetjen suggested that the CFTC’s recovery mandates for systemically important firms could be extended in some manner to all CCPs. But as part of the CFTC’s ongoing discussions of these matters, regulators and industry participants should think carefully about whose collateral would be part of a recovery plan and whether certain market participants should ever be exposed to some losses. Wetjen said these discussions should focus on the role of customer collateral from non-defaulting members and on risks often born by pensions and endowments.