European Commission Vice President Valdis Dombrovskis officially became the new EU Commissioner for Financial Stability, Financial Services and Capital Markets Union on July 16. Two days later, he traveled to Washington, D.C., to meet with his counterpart, Treasury Secretary Jack Lew, for the latest round of EU-U.S. talks on financial regulation.
Dombrovskis, the former prime minister of Latvia, replaced U.K. national Jonathan Hill after the Brexit referendum. During his visit to Washington, the two sides announced several changes to the existing framework for transatlantic cooperation. The talks, which are held twice a year, will include a wider range of participants, with the Commodity Futures Trading Commission and the European Securities and Markets Authority now getting a seat at the table.
The two sides issued a joint statement on July 26 outlining the topics that were discussed at the July meetings. The topics included several issues of interest to FIA members, including clearinghouse resolution, OTC derivatives reforms, data transfer and protection and the finalization of the G-20 financial reforms. The next meeting will take place in Brussels in February 2017.
During a speech in Washington, Dombrovskis explained that the new framework will result in more frequent meetings among the regulators and said that the purpose is to identify potential problems at an earlier stage of the regulatory process. Dombrovskis, who was elected to the European Parliament in 2004 after serving three terms as Prime Minister of Latvia, said the new framework will provide "a solid basis for improved cooperation" and pointed to the agreement on clearinghouse equivalence finalized earlier this year as an example of progress in this area.
Resilience, Recovery and Resolution
Three high-level groups of international regulators issued a coordinated package of reports on Aug. 16 that are aimed at strengthening the safety and resiliency of derivatives clearinghouses worldwide.
In response to the announcement, FIA issued a statement highlighting its work on this issue and emphasizing the importance of global consistency in clearinghouse standards. "We’re pleased that these regulatory efforts echo FIA’s goal of ensuring that the risks of central clearing are both transparent and effectively managed,” said FIA President and Chief Executive Officer Walt Lukken.
Two of the reports came from the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions. The first report assessed financial risk management practices and recovery planning at a sample group of 10 central counterparties in nine jurisdictions. The assessment focused on the implementation of certain parts of the Principles for Financial Market Infrastructures, a set of global standards issued in April 2012.
The report found that CCPs have made "important and meaningful progress" in implementing arrangements consistent with the standards, but identified "gaps and shortcomings" in several areas and called for "prompt action" by CCPs to address these issues. Three areas were identified as "serious issues of concern" that need to be addressed by the end of 2016: recovery planning, the level of financial resources and stress testing frameworks.
CPMI-IOSCO also published a consultative report that proposes “more granular” guidance on six "key aspects" of financial risk management and recovery planning:
• Governance and disclosure
• Credit and liquidity stress testing
• Coverage of credit and liquidity resource requirements
• CCPs’ contribution of their own financial resources to losses
• Development of recovery plans
The regulators set a mid-October deadline for feedback on the consultation and said they expect to issue a final report in the first half of 2017.
Two other reports related to clearinghouse standards were issued by the Financial Stability Board, the international body established by the Group of 20 to monitor the global financial system. First, the FSB issued a "discussion note" that identified questions and considerations related to the development of "effective resolution strategies" for CCPs that have gone past the point of recovery. The FSB explained that although it already has guidance for managing the failure of a financial institution, more specific guidance is needed to ensure that any CCP can be resolved without resulting in a government bailout or contagion to other parts of the financial system. The FSB said responses to the discussion note will help inform the development of guidance on CCP resolution, and added that it expects to propose that guidance early next year and finalize it by July.
The FSB also released a progress report on the “CCP Workplan” developed by international regulators to coordinate their efforts to enhance CCP resilience, recovery and resolution. The progress report summarizes several other initiatives now under way or coming soon, including an analysis of clearing incentives, a follow-up review of financial risk management practices, a framework for supervisory stress testing and an analysis of “interdependencies” within the clearing system.
On June 29, the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions released a set of guidelines for strengthening cybersecurity at exchanges and other financial market infrastructures. The CPMI-IOSCO report is the first internationally agreed guidance on cybersecurity for the financial industry.
The guidance is intended to add momentum to the industry’s ongoing efforts to enhance financial market infrastructures’ ability to pre-empt cyber-attacks, respond rapidly and effectively to attacks and achieve faster and safer recovery objectives if the attacks succeed.
The report outlines key elements that cybersecurity frameworks should include:
• Involvement of board and senior management in cyber resilience strategies
• The ability to resume operations quickly after a cyber-attack
• Effective use of good-quality threat intelligence and rigorous testing
• Instilling a culture of cyber risk awareness and ongoing re-evaluation and improvement of systems at every level within an organization.
Regulators in Europe and Asia have delayed the implementation of margin requirements for non-centrally cleared derivatives into next year, even as regulators in the U.S., Canada and Japan remained committed to the September deadline set by international agreement.
The European Commission informed lawmakers in June that it expects to finalize the rules before the end of the year, and that firms covered by the first phase of the margin requirements will be required to comply "before the middle of next year." In August, the Australian Prudential Regulation Authority and the Monetary Authority of Singapore published notices to delay the commencement of margin requirements for uncleared derivatives. Final rules in both jurisdictions will be issued in the coming months to allow institutions to continue to prepare for implementation.
The delays prompted the Financial Stability Board, the international body established by the Group of 20 to monitor the global financial system, to issue a warning that these differences in implementation timetables need to be resolved urgently. The U.S., Japan and Canada are the only three countries that will meet an internationally agreed deadline of Sept. 1 for the rules to start phasing in, the FSB said on Aug. 26 in a progress report on derivatives reforms. And more than half of the 24 jurisdictions that the FSB reviewed are not on track to implement variation margin requirements by a second deadline of March 2017. The FSB said the delays raise concerns about the incentives to use central clearing and the potential for regulatory arbitrage, and said all jurisdictions "should urgently take steps to meet the internationally agreed schedule."
Preparing for a Default
The Commodity Futures Trading Commission issued a staff letter on July 21 that provides detailed guidance on the issues that clearinghouses should take into account as they develop their recovery plans and wind-down plans. The CFTC noted that the development of these plans is a "critical element" of risk management and contingency planning, and noted that it has been working with its international counterparts on these issues.
“Clearinghouses have taken on an increased importance in the global financial system, and the CFTC is focused on making sure they remain strong and resilient,” CFTC Chairman Tim Massad said. “Today’s staff guidance, which will help clearinghouses improve their recovery plans and wind-down plans, is a critical part of that effort.”
The guidance highlighted certain topics that clearinghouses should analyze in developing these plans, which are intended to spell out what steps a clearinghouse would take in case of credit losses, liquidity shortfalls and other risks that could threaten its viability. A recovery plan is designed to keep a clearinghouse operating, while a wind-down plan would guide the process of terminating, selling or transferring its services. The topics covered in the guidance include:
• The range of adverse scenarios that a clearinghouse should consider
• The potential impact of those scenarios on a clearinghouse, its members and other stakeholders
• The types of tools available for use in a recovery situation and the order in which they would be used
• The range of wind-down options that could be used in case recovery fails
• The financial resources needed to cover the costs associated with recovery and wind-down
• The potential impact of "interconnections and interdependencies" among clearinghouses, their affiliates, service providers and other relevant stakeholders.
Regulatory experts at PwC, the accounting and consulting firm, commented that the CFTC’s guidance “significantly raises the bar on the depth and breadth of analysis” required from U.S. clearinghouses and is likely to set a precedent for similar requirements in other countries. PwC also noted that the CFTC’s guidance “goes materially beyond” comparable guidance for banking organizations, and pointed to the fact that clearinghouses will be required to deliver detailed analysis of at least eight business and operational scenarios such as a settlement bank failure or a cyber-attack, as well as risk scenarios resulting from the default of one or more of their clearing members.
One potential result is that clearinghouses will need to increase their financial resources, leading to higher costs for clearing members, PwC said. On the other hand, the guidance requires clearinghouses to involve their clearing members in the development, review and updating of their plans, which PwC said will provide the industry with “greater transparency into CCP operations and resilience.”
CME Group is seeking regulatory approval for new rules that will allow market participants to become "direct funding participants" of CME’s clearinghouse. This type of member will be able to clear trades for its own account and post collateral directly to CME, provided that its obligations to the clearinghouse are guaranteed by a futures commission merchant.
CME is the latest clearinghouse to propose an alternative membership model in response to changes in the economics of clearing. Eurex Clearing recently launched a new account structure called ISA Direct for buy-side clearing of interest rate swaps, (insert link to June article), and ICE Clear Europe offers a “sponsored principal” account structure that allows clients to become direct counterparties to the clearinghouse.
The clearinghouses are rolling out these new structures because of the cost pressures on clearing firms, according to Tom Lehrkinder, an analyst at Tabb Group. In a report released in August, Lehrkinder explained that the new models may provide clearing firms with some relief from the impact of the leverage ratio and other capital requirements. “The costs around allocating capital usage are driving self-clearing schema as the industry begins to more closely track and assign capital usage across the brokerage firm,” he said.
According to draft rules submitted by CME to the Commodity Futures Trading Commission in July, a direct funding participant will not be required to make a contribution to CME's guaranty fund. Instead, the FCM acting as its guarantor will have to adjust its guaranty fund contribution to account for the direct member's activity. The guarantor will have the ability to set risk controls on the direct member's activity, but those controls will be implemented by the clearinghouse, rather than the FCM.
CME pointed to several benefits for direct funding participants, including the elimination of a pro rata loss allocation that a customer of an FCM might face in the event of an FCM default, as well as reduced exposure to "transit risk" in the movement of collateral. CME also stated that providing a direct funding participant with a guarantee will require less capital for a FCM than holding a customer's cash on its balance sheet.