Wednesday, February 28, 2018

Commissioner Quintenz’s remarks to Structured Finance Industry Group don’t stay in Vegas

By Brad Rosen, J.D.

It’s often said that what happens in Vegas stays in Vegas. Notwithstanding, the exact opposite was the case as CFTC Commissioner Brian Quintenz delivered the keynote address before the Structured Finance Industry Group conference in Las Vegas, Nevada.

Quintenz led off his remarks asserting that the Dodd-Frank market reforms resulted in fundamental misalignments between the financial capital rules and those economic incentives necessary for a healthy economy. He further questioned whether these reforms were successful in addressing the structural weaknesses in the global financial system.

The commissioner stated, “questions remain as to whether some of those reforms accurately target the specific risks intended, if the reforms are calibrated appropriately vis-à-vis each other, and what incentives or disincentives they create.” He continued, “My concern is that, ten years post crisis, many regulators (the CFTC included) failed to appropriately assess the risks that they sought to control and that, as a result, we may be dis-incentivizing activity necessary to a healthy market and economy.”

Quintenz did not shy away from a clear and direct criticism of Washington D.C. and its traditional regulatory approaches, noting, “I think regulators everywhere always need to revisit any one-size-fits-all approach to derivatives risk. Because history has certainly shown us that when Washington prices financial risk, it usually gets it wrong.” The remainder of Commissioner Quintenz’s remarks focused on the following three areas where he views derivatives risks as being mispriced and misapprehended: (1) measuring derivatives exposure, (2) recognizing risk-reducing offsets, and (3) calculating margin for uncleared swaps.

Swap dealer capital and measuring derivatives exposure. Quintenz noted that swap dealer registration subjects entities to significant costs and regulatory burdens, and that capital costs are often a determinative factor in a firm’s decision to remain, or to become a swap dealer. If capital costs are too expensive, he noted, firms will leave the market, and the swaps markets over time will become less liquid, more heavily concentrated, and less competitive.

On this score, Quintenz supports the general approach taken by CFTC staff in their December 2016 capital proposal. That proposal provides for alternative capital approaches and permits firms to choose the approach that best matches their corporate and operating structures. The commissioner asserted, “I believe it is critically important that the CFTC finalize a capital rule that is appropriately calibrated to the true risks posed by an entity’s swap dealing business.” Quintenz also noted that the CFTC currently has the opportunity to further refine its proposed capital calculation to better reflect the true risk of a swap dealer’s exposure.

Supplementary Leverage Ratio. Commissioner Quintenz noted supplementary leverage ratio (SLR) obligates banks to hold a certain minimum amount of capital against their aggregate on- and off-balance sheet exposures, regardless of the actual risk profile of their assets. According to Quintenz, a major problem with SLR is that it penalizes banks providing clearing services by treating segregated customer margin as an exposure of the bank.

He pointed out that customer margin funds are typically segregated from the FCM’s own funds and held by a CCP or a third-party custodian bank. Quintenz is particularly troubled that under SLR, the required calculations prohibit a clearing member FCM from reducing this exposure by the amount of segregated margin posted by the client and then counts it as a source of leverage against which additional capital should be held. Quintenz exclaimed, “margin is not just risk free. It is actually more than risk free—it is always risk-reducing.

Quintenz sees SLR as a severe obstacle to the future health of the FCM community. He observed, “The impact of this is no small matter. Without relief, I fear we will see additional FCMs exit the clearing business and the worrisome trend of FCM consolidation will continue. In recent years, five major banks have shuttered their swaps clearing businesses. As of 2017, the top five swaps clearing members controlled up to 75 percent of the business.”

Ten-day liquidation period for uncleared swaps. Quintenz noted that under CFTC final rules called for by Dodd-Frank, initial margin for uncleared swaps must be calculated using either a standardized, grid-based method or models. When using models, firms must use a ten-day liquidation period for all swaps, regardless of the swap’s underlying liquidity or risk profile.

Commissioner Quintenz advocated for relaxing these requirements, noting, “Although the ten-day liquidation period is consistent with international standards and rules adopted by U.S. prudential regulators, there does not appear to be any empirical evidence to justify the selection of a ten-day window.” He added, “it is unclear why the rules assume, for example, that an uncleared commodity swap should have a liquidation period ten times longer than a cleared commodity swap.”

In concluding, Quintenz noted that that Commission will endeavor to keep a keen eye on whether the costs imposed on derivatives by the total domestic regulatory framework are calibrated to actual risk or creating perverse outcomes. He committed, “When we identify areas where regulations misprice risk and punish derivatives markets, we will confer with our regulatory counterparts and assist them in better understanding the reality of those impacts.”

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