A Roundup of Key Business, Technology and Regulatory Developments

Jun 8, 2017


Leverage Ratio

Two influential regulatory officials have indicated that they share the widespread concerns within the derivatives industry regarding the impact of Basel III capital requirements on clearing firms. Although they expressed these views as individuals, their comments suggest that banking regulators are recognizing that the treatment of cleared derivatives under Basel III should be reviewed.

In an article published on April 20, Benoît Cœuré, the chairman of the Committee on Payments and Market Infrastructures, a key standard-setting body at the international level, encouraged banking regulators to consider the impact of the Basel III capital standards on derivatives clearing. He warned that the reduction in the number of clearing members could have implications for systemic risk.

“The prospective further concentration of client clearing business in a smaller number of clearing members would further increase the respective financial risk concentration and could limit the ability to port client positions and collateral in case of member default, heightening potential systemic spillover risks,” wrote Cœuré, who is also a member of the European Central Bank’s governing board.

Also on April 20, Federal Reserve Governor Jerome Powell discussed the unintended consequences of including initial margin in the leverage ratio. Speaking at an event in Washington, D.C., Powell noted that regulators want to see the adoption of clearing, but the leverage ratio makes it more expensive. “We are undermining the clearing mandate and the ability of smaller clients to get their products centrally cleared. I think we need to look again at the calibration of the leverage ratio in the U.S.,” said Powell.

Market participants have been warning for some time that the capital requirements stemming from the leverage ratio will harm the strength and stability of the cleared derivatives markets worldwide unless it is amended to recognize the exposure-reducing effect of the collateral that clearing banks collect from their clients.

Last November, a coalition of 15 industry bodies representing clearing members, asset managers, insurance companies, commodity end-users, hedge funds, derivatives exchanges and clearinghouses sent a joint letter outlining their concerns to Mark Carney, the chairman of the Financial Stability Board, Mario Draghi, the chairman of the Group of Governors and Heads of Supervision, and Stefan Ingves, chairman of the Basel Committee on Banking Supervision.

“We believe that the leverage ratio, as presently constructed, has certain unintended consequences that will make the financial system more fragile, severely undermine the global efforts to bring more derivatives in central clearing, and seriously impair the ability of end-users in the real economy to hedge their market risks,” the groups said in the letter.

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Global Guidelines

The World Federation of Exchanges, which represents more than 200 exchanges, clearinghouses and other market infrastructure operators, published a set of cyber-resilience standards in April. The new standards, which are voluntary, are meant to ensure alignment and common minimum standards for trading venues around the world.

The standards build out a set of cyber-resilience principles that the WFE issued last September. The standards cover eight key areas: strategy and framework; governance; risk identification; protection and controls; monitoring and detection; response and recovery; information sharing; and testing, situational awareness, learning and evolution.

“These guidelines serve as the building blocks upon which WFE members and other global market infrastructure providers can base their individual approaches to cyber,” said Nandini Sukumar, WFE’s chief executive officer.

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Project KISS

On March 15, Chris Giancarlo, the acting chairman of the Commodity Futures Trading Commission, announced a three-pronged plan to renovate derivatives regulation that he called Project KISS, which stands for “keep it simple, stupid.”

Giancarlo, who has been nominated to chair the agency by President Trump, said the CFTC must “reinterpret its regulatory mission” in line with the goals of the Trump administration, focusing on three main themes: fostering economic growth, enhancing U.S. financial markets, and “right-sizing” the CFTC’s regulatory footprint.

This will include an agency-wide review of CFTC rules, regulations and practices to make them “simpler, less burdensome and less costly,” Giancarlo said. He emphasized that this review is not aimed at repealing regulations, but rather applying these rules in ways that put less drag on the U.S. economy.

Giancarlo, who gave the speech at FIA’s 42nd International Futures Industry Conference in Boca Raton, also announced steps to restructure the agency by moving market surveillance functions into the enforcement division and creating a new office of “market intelligence” that will seek to understand trends in trading behavior and market dynamics.

Giancarlo also said the CFTC should continue to work with its overseas regulatory counterparts and international standard-setting bodies. “As our regulatory counterparts continue to implement swaps reforms in their markets, it is critical that we make sure our rules do not conflict and fragment the global marketplace,” he said.

He also vowed to change the CFTC’s rule-making process, focusing on “greater care and precision in rule drafting, more thorough econometric analysis, less contracted time frames for public comment, and a reduced docket of new rules and regulations to be absorbed by market participants.”

In May, the CFTC followed up on Giancarlo’s pledge by issuing a formal call for external input on Project KISS. Market participants and other interested parties have until Sept. 30 to submit their recommendations.

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Clearing Risk

Customers may not be able to find a new home for their cleared derivatives if their clearing member goes into default, several industry participants warned the Commodity Futures Trading Commission at an April 25 meeting of the CFTC’s Market Risk Advisory Committee.

Executives from banks, trading firms and clearinghouses commented that even though “porting” of customer positions worked successfully in past instances of clearing member defaults, they are not certain that it will work going forward. One reason is the introduction of the Basel III leverage ratio, which has made it more expensive for clearing members to hold customer margin. This has raised a concern that clearing members will be unwilling to take on new business during a period of market stress.

Dale Michaels, executive vice president for financial risk management at OCC, the U.S. equity derivatives clearinghouse, urged regulators to address this concern to ensure portability in a stressed situation, and noted that some of OCC’s members have cut back on providing clearing services because of the capital requirements. This concern is “no longer theoretical,” said Michaels. “Even in peace time, clearing members are asking business to leave.”

Sebastiaan Koeling, managing director at Optiver U.S., the Chicago-based subsidiary of the Dutch trading firm, added that the leverage ratio is reducing the availability of clearing for market makers, which in turn is reducing their ability to provide liquidity. He added that porting will be particularly challenging for options market makers. There are only three clearing firms that have the ability to provide cross-margining for trading firms that make markets in both equities and options, he explained, and if one of these clearing firms were to default, the other two would be unlikely to take on its customers.

Ed Pla, head of clearing and execution at UBS, noted that in addition to the leverage ratio, several other factors have come into play since the introduction of mandatory clearing for swaps. These include an increase in the notional amounts being cleared, a decrease in the number of clearing members, and a concentration of market share among clearing firms, especially among the firms that clear swaps. Pla expressed concern about these trends and warned that porting is “very untested in the new regime.”

CFTC staffers echoed these concerns. Robert Wasserman, chief counsel in the agency’s clearing and risk division, commented that when Refco failed in 2005, several futures commission merchants competed for the firm’s customer accounts. When Lehman Brothers failed in 2008, only one firm stepped forward to take that firm’s customer accounts, and when MF Global failed in 2011, the customer accounts had to be split up among multiple firms. “The trend line has been going in the wrong direction,” he said. “The ability to find homes for customers [has become] much less likely.”

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Automated Trading

On May 1, FIA and the FIA Principal Traders Group submitted a joint comment letter opposing overly prescriptive regulation of automated trading. The comment was filed in response to the Commodity Futures Trading Commission’s supplemental notice of proposed rulemaking regarding Regulation AT.

The comment letter detailed the principles that should form the basis of any automated trading regulation, and offered recommendations on risk controls, testing, order cancellation tools and unique identifiers. The letter also expressed the groups’ opposition to the CFTC’s proposal to access proprietary source code used to operate automated trading systems without the legal protections provided by the subpoena process.

“Proposed Regulation AT is too prescriptive and is neither necessary nor appropriate to address the risks of automated trading,” said Walt Lukken, president and CEO of FIA. “If the Commission still finds it necessary to move forward with regulations, we recommend replacing the current proposal with a principles-based approach that recognizes the importance of risk controls in protecting our markets while encouraging market innovation by being flexible enough to adapt to the pace of technological advances.”

The letter represents FIA and FIA PTG’s third comment letter on this proposed regulation. Additionally, FIA and FIA PTG provided a detailed response to the CFTC’s 2013 concept release on risk controls and system safeguards for automated trading environments. These comments build upon industry-wide surveys of risk management procedures and six papers on best practices and guidelines for automated trading systems.

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Trump Nomination

On May 2, the Senate confirmed the nomination of Jay Clayton to serve as chairman of the Securities and Exchange Commission. The nomination was approved in a 61 to 37 vote, with several Democrats joining their Republican colleagues in supporting the nomination. He was sworn into office on May 4.

Clayton, formerly a partner at the law firm of Sullivan & Cromwell, brings to the agency years of experience advising financial corporate executives on how to raise capital and engage in mergers, acquisitions and spin-offs.

During the Senate hearing on his nomination, Clayton stressed that as SEC chairman he will focus on encouraging more companies to raise capital in the stock markets. He noted that the number of initial public offerings has declined in recent years, and said he will seek to reduce the burdens of becoming a public company. Regarding enforcement, he said regulators could achieve more by suing individuals rather than pressuring companies to pay large fines.

While in private practice, Clayton advised a long list of public and private companies on a wide range of matters, including securities offerings, mergers and acquisitions, corporate governance, and regulatory and enforcement proceedings. During the financial crisis, he advised Bear Stearns on its sale to J.P. Morgan, Barclays in its purchase of the core U.S. business of Lehman Brothers shortly after that firm’s bankruptcy, and Goldman Sachs in its negotiations with Warren Buffett on a $5 billion infusion of capital.

In 2014, he advised Alibaba, the Chinese ecommerce company, on its initial public offering. That offering raised $25 billion, making it the largest IPO in U.S. history. He also has experience with commodity trading firms. In 2012 he advised a group of investors that formed Castleton Commodities through the purchase of the energy trading joint venture backed by Louis Dreyfus and Highbridge Capital. Three years later he advised Castleton on its acquisition of Morgan Stanley’s oil merchant business.

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