Friday, October 23, 2020

SEC, CFTC hope to revive ‘dead’ security futures market with new margin rule

By Amanda Maine, J.D.

The CFTC voted unanimously and the SEC voted 3-to-2 to approve a joint final rule to harmonize the minimum margin level for security futures held in a futures account with the minimum margin level for security futures held in a securities portfolio margin account. The new margin rule would lower the margin requirement for an unhedged security futures position from 20 percent to 15 percent. A number of commissioners on either Commission supported the final rule to kickstart the currently nonexistent U.S. security futures market. Two SEC commissioners, however, questioned the need for a new rule when demand for security futures has been historically low. All commissioners voted in favor of issuing a joint request for comment on updating the Commissions’ rules for portfolio margining and related positions. The final rule and the request for comment were approved at the first-ever joint open meeting of the CFTC and the SEC, which was held virtually with audio webcast on the CFTC’s website (Customer Margin Rules Relating to Security Futures, Release No. 34-90244, October 22, 2020).

Security futures margin requirements. Under the current rules, unhedged security futures held in a futures account are subject to a higher margin level than unhedged security futures held in a securities account approved for portfolio margining. In keeping with the Commissions’ efforts to harmonize their rules, the amendments will result in a margin requirement of 15 percent for an unhedged security futures position. Clark Hutchison, director of the CFTC’s Division of Clearing and Risk, noted that the final rule establishes a floor to be levied by clearinghouses or intermediaries, who will be free to set higher margin amounts if they feel it is appropriate for the mitigation of risk.

Hutchison said that the issue of harmonizing the margin requirement was first raised by OneChicago LLC, which operated a security futures exchange, in 2008, when it requested that the CFTC and SEC conduct a joint rulemaking to amend the minimum 20 percent customer margin level established in CFTC Rule 41.45(b) and SEC Rule 403(b) to 15 percent. Hutchison acknowledged that, with the exit of OneChicago from the market in September 2020, there are currently no security futures contracts listed for trading on U.S. exchanges, resulting in the rules not having an immediate impact. However, the rules may reduce future costs of participating in a security futures market.

CFTC Chairman Heath Tarbert also remarked that the market for security futures is effectively "dead" but noted that it has taken off in other jurisdictions such as Europe. He expressed hope that the amendments would help "jumpstart" the security futures market, a sentiment echoed by his SEC counterpart Chairman Jay Clayton, who said the new rules may help bring life to a dead market.

CFTC Commissioner Dawn Stump spoke in favor of the new margin requirement, calling it sound public policy rooted in years of consideration and contemplation. However, she expressed regret that the Commission did not take this "common sense" step 12 years ago when first approached by OneChicago. She also objected to the adopting release’s rejection of OneChicago’s interpretive arguments that the Commissions can adopt risk-based margining for security futures even absent a change in factual circumstances, stating that the Commission should not be offering advisory opinions on questions that are not being asked. Stump also observed that risk-based margining for security futures is permitted in Europe and that rejecting it in the U.S. can put the country at a competitive disadvantage.

SEC Commissioner Hester Peirce also supported the final rule, noting that despite the "long and tortured" history of single stock futures in U.S. markets, potential is there. Peirce said that advocates have argued that margin requirements have played a role in suppressing this market, and the final rule takes a small step towards changing that. However, she expressed concern that the final rule may not be enough to make single stock futures a viable product and that the Commissions may want to explore shifting to a risk-based approach if a market does fail to develop.

Advising that she cannot support the final rule without more analysis, SEC Commissioner Allison Herren Lee said that the demand for security futures has been historically low for reasons that are unrelated to margin differences. She added that with no active exchange currently in existence, there is enough time to more thoroughly evaluate how to encourage security futures.

Echoing her colleague’s concerns, SEC Commissioner Caroline Crenshaw objected that the final rule did not articulate a sufficient rationale for making this change. "We have not explained why the existing margin is too high or otherwise identified a problem that would be solved by lowering the required level of margin to 15 percent," she said.

The CFTC commissioners (Chairmen Talbert and Commissioners Quintenz, Behnam, Stump, and Berkovitz) voted to approve the final rule. SEC Chairman Clayton and SEC Commissioners Roisman and Peirce also voted to approve the final rule, while Commissioners Lee and Crenshaw dissented. The new rule will be effective 30 days after publication in the Federal Register.

Request for comment on portfolio margining. All 10 commissioners voted to approve a release requesting comments on portfolio margining of uncleared swaps (under the CFTC’s jurisdiction), non-cleared security-based swaps (under the SEC’s jurisdiction), and related positions. Portfolio margining, which generally refers to the cross margining of related positions in a single account to allow netting of appropriate offsetting exposures, can reduce the margin requirements of the account holder who holds these products in a single account, explained SEC Trading and Markets Director Brett Redfearn.

An entity’s ability to offer portfolio margining of different product types will depend on its registration status, Redfearn said—that is, as a broker-dealer, a securities-based swap dealer, a futures commission merchant, or a swap dealer. The request for comments release takes into account these different types of registrants, Redfearn advised. It also makes note of certain differences in the margin and segregation requirements of the SEC and the CFTC, including asking how these differences should be addressed in the context of portfolio margining, he explained.

Commissioners from both the SEC and the CFTC commented that the request for comment is a good first step to approaching portfolio margining, and heralded the opportunity to further harmonize the agencies’ regulations. Chairman Clayton noted that since 2012, the Commissions have coordinated to permit portfolio margining of cleared credit default swaps that are swaps and securities-based swaps in a CFTC-cleared swaps account. Examining whether to permit portfolio margining on uncleared swaps and non-cleared securities-based swaps is another important way for the agencies to increase their collaboration, Clayton said. SEC Commissioner Elad Roisman said that this area is one that might benefit from a harmonized regulatory framework, resulting in more effective and efficient oversight while limiting unnecessary costs. This is not to say, Roisman continued, that the SEC should completely defer to CFTC regulations. The request for comment is "a prudent first step" in exploring areas for regulatory harmonization, he remarked.

Commissioner Crenshaw warned that the Commissions should proceed with caution, advising that without a central clearing counterparty, the risk of default is borne by the parties to the transaction, and the risks are particularly acute with respect to complex and customized transactions such as uncleared swaps and non-cleared security-based swaps. Although she has concerns about the risks presented by portfolio margining, the request for comment is an appropriate place to begin consideration of the topic.

The releases are No. 34-90244 (final rule) and No. 34-90246 (request for comment).