18 March 2015

Reuters: Regulators must remain vigilant in supervising clearinghouses

Last month the board of the International Organization of Securities Commissions met in Seoul to discuss a number of agenda items, including safeguards for central counterparties, or CCPs.

IOSCO – as the name suggests – is the international forum and standard setter for market regulators such as the Commodity Futures Trading Commission (CFTC), upon which I serve, the Securities Exchange Commission, as well as comparable regulators around the globe. 

It should not be surprising that CCPs were on IOSCO’s agenda, as they have been many times before – market regulators globally (including the CFTC) have had a role in supervising CCPs for generations. Moreover, there is growing interest in CCPs given their increasingly important role in the wake of implementation of G20 financial reforms related to the clearing of derivatives contracts. 

To review, in 2009 policymakers through the G20 determined that swap contracts should be cleared through CCPs when possible, and lawmaking bodies around the globe responded by enacting laws that reflected this policy preference. For its part, the U.S. adopted the Dodd-Frank Act in 2010. 

These reforms are preferable to the pre-crisis market structure for swaps because clearinghouses provide an important risk-reducing service – they act as middlemen between two parties in a trade, and guarantee performance of the trade should either party default. This, in turn, promotes financial stability by reducing counterparty credit risk between financial institutions, enhancing transparency, and facilitating more efficient use of capital through clearing’s netting effects.

These post-crisis reforms, including the Dodd-Frank Act, vaulted CCPs into an unprecedented role in our financial markets.

Today, swap clearing mandates are in effect in the United States and Japan, and other jurisdictions are moving towards their own clearing mandates, resulting in steady growth in the volume of cleared swaps. 

According to International Swaps and Derivatives Association estimates, approximately 16 percent of outstanding swap transactions, measured by notional value, were cleared in the United States by CCPs at the end of 2007. 

By September 2014, 74 percent were cleared based on the CFTC’s data. All other considerations remaining equal, taxpayers should be pleased by this development, which was ushered in by the reform efforts.

This also means that under the new market structure, clearinghouses are connected to almost every major financial firm in the world. 

Consequently, the failure of a CCP could have vast repercussions for the global marketplace.

It is therefore appropriate at this stage of the overall financial-reform effort for regulators to take stock of what has been done so far to ensure the safety of CCPs, and consider what, if any, additional measures should be taken. 

Importantly, the CFTC has been hard at work for years putting in place a framework for effective oversight and regulation of CCPs. Among others, the CFTC most recently approved regulations that are consistent with IOSCO standards for systemically important CCPs, and which include strong requirements that CCPs have sufficient financial resources to withstand the collapse of two of their largest clearing members. These typically would be global banks. 

But there are two important areas (and perhaps others) global market regulators, including the CFTC, should continue to analyze in a coordinated fashion.

First, regulators must determine how to improve CCP transparency with respect to stress tests. Again, the CFTC already has adopted measures to improve CCP transparency, but some clearing members have argued for the disclosure of stress-test results and a more standardized approach to supervisory stress testing to help them better assess the risks associated with a particular CCP. Such additional standards could benefit global regulators as well because they could enable greater coordination in the regulatory community in assessing the risk-management practices of CCPs.

Some, however, have raised questions about additional standardization in stress tests. For example, could standardization inadvertently impede innovation and thoroughness? Would standardized testing promote a “teaching to the test” culture among regulators and CCPs that would dis-incentivize thorough and continuing evaluation and refinement of stress-test methodologies? Could disclosure (together with the other publicly available information) permit someone to reverse engineer the position information of targeted market participants? Could these disclosures be used as a tool for market manipulation? Policymakers need to carefully consider these questions and others. 

Second, market regulators should take a closer look at CCPs' “skin in the game.” What that means in this context is, how much of a CCP’s own capital – and under what circumstances – should become part of its plan for determining who pays in the case of a major clearing member default? These events are extraordinarily rare, but have happened, and the stakes are higher today than before. 

As mentioned, under rules already adopted by the CFTC, CCPs have to retain adequate resources to deal with such an event, and develop a plan to deploy them. The CFTC has been working with its registered CCPs to develop and review those plans, which include the CCP’s capital as well as capital contributions by the clearing members. 

But the amount of capital that a CCP puts at risk, and when it is used vis-a-vis the clearing-member contributions, varies between jurisdictions. The timing and amount of a CCP's capital contributions are critically important because those factors impact the incentives for how CCPs manage risk.

If the consequences of failing to do their job adequately are remote and less than significant, it stands to reason the CCPs might not take their role in the new market structure as seriously. On the other hand, if the balance of resources available to the CCP tilts too much toward the CCP’s own contribution, the prospect of mutualized losses for members could be reduced in a way that discourages optimal risk management by those same members.

To be clear, when it comes to the CCP’s plans for dealing with a member default, there are two very distinct policy objectives for regulators. The first is ensuring CCPs have sufficient financial resources to deal with member defaults, which is quite different from the second: properly aligning incentives for CCPs. While more analysis needs to be done on the latter, I have no reason to believe the current international standards on the former – as implemented by the CFTC – are insufficient.

Full article on Reuters

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