In its third and final meeting of 2018, the CFTC’s Market Risk Advisory Committee (MRAC) recently convened and focused on a variety of clearinghouse risk and vendor risk management issues. The day’s ambitious agenda included panels on (1) clearinghouse governance structures and risk management; (2) non-default losses in recovery and resolution; (3) a discussion of recent reports and developments relative to CCP resolution, leverage rations, and incentives to clear; and (4) oversight of third-party service providers and vendor risk management.
Commissioner Rostin Behnam, MRAC’s sponsor, noted in his opening remarks, “As market infrastructure continues to evolve, the issues examined within the MRAC will continue to evolve with it.” He elaborated, “One of the major changes since the financial crisis and Wall Street Reform has been the growth of central clearing, which has played a significant role in reducing systemic risk throughout the global financial ecosystem; however, given this growth, market participants and regulators must continually have fresh discussions about current risk management and governance policies of central counterparties.”
Newly-formed Interest Rate Benchmark Reform subcommittee comes out of the gate. Interest Rate Benchmark Reform Subcommittee Chairman Thomas Wipf told the MRAC that there is a wide variety of where parties are in the transition away from LIBOR to its replacement, the Secured Overnight Financing Rate (SOFR). He noted that some users are far along in the process, but other, infrequent users and issuers have a way to go.
Commissioner Behnam also took the occasion of the meeting to announce the appointment of members to the subcommittee that has been charged with providing reports and recommendations to the MRAC regarding ongoing efforts to transition U.S. dollar derivatives and related contracts from LIBOR to a risk-free rate (RFR), and the impact of such transition on the derivatives markets. The appointed members of the subcommittee are noted here.
Clearinghouse risk management—tensions between CCP’s and clearing members. The day’s first panel, facilitated by Robert Steigerwald from the Federal Reserve Bank of Chicago, featured an overview of current risk management and governance issues with a focus on the balancing of interests and incentives between the clearinghouse and its members. Alice Crighton, speaking on behalf the FIA, which represented clearing member perspectives, underscored the need to have CCP incentives aligned with that of clearing members. She observed this was not always the case and asserted that the CCPs need to have skin in the game to the same extent of its clearing members.
Lee Betsill, director and Chief Risk Officer at the CME Clearinghouse, took issue with Crighton’s assertion that there was a misalignment between CCPs and their members. He noted that the CME, like most clearinghouses, took clearing member views into consideration, and added CCPs have no incentive to shortcut risk management concerns because their revenue base is dependent on sound risk management practices.
Commissioner Quintenz expresses concerns from overseas over leverage ratios. Commissioner Brian Quintenz took the opportunity to advance his view regarding the role of leverage ratios in the risk management mix as he weighed in from his overseas travels. He characterized the leverage ratio, which constrains a bank’s capital as “a true and remote backstop metric [and] a blunt regulatory instrument” that creates many perverse outcomes and is a poor regulatory construct.
He further observed that “we are currently seeing with the leverage ratio’s outsized negative impact on clearing and custody services that are the heart of the futures and swaps markets.” He further noted, “Unless the treatment of client margin changes, I fear we will see FCMs continue to exit the clearing business and the worrisome trend of FCM consolidation will continue” and further indicated that as of 2017, the top five swaps clearing members controlled up to 75 percent of the business.
Oversight of third-party service providers and vendor risk management. The day’s final panel examined the oversight of third-party service providers and vendor risk management, an area that has seen dramatic growth in light the proliferation of fintech-related services. Behnam noted that exchanges, clearinghouses, intermediaries, commission registrants, and their customers are increasingly employing a wide-array of vendors that provide a multitude of different services, and each relationship carries its own risks.
Salman Banaei, executive director of IHS Markit, a public company fintech service provider, laid out five core principles for third-party risk management in his presentation, which focused on documentation, non-discrimination/equal treatment for providers, open dialogue, responsiveness, and proportionality between the extent of reliance and market benefits.
In his remarks, Commissioner Behnam noted, “all of these entities continue to increase the number and complexity of relationships with vendors through the outsourcing of business and regulatory compliance functions, registrants must ensure that they have appropriate management and control functions to address the associated risks.” He added, “At the heart of those relationships is the ability of market participants to know with whom they are doing business, both directly and indirectly, and what risks may arise from third-party service providers.”
Behnam concluded that this panel will be the start of a longer conversation by MRAC and potentially a subcommittee with the ultimate goal of providing the CFTC with surgical recommendations – as needed – to ensure market safety, transparency, and resiliency.