On December 11, the Commodity Futures Trading Commission (CFTC) Market Risk Advisory Committee (MRAC) held a public meeting. The meeting covered current topics including central counterparty risk and governance, market structure developments, climate-related risk, and innovative and emerging technologies affecting the derivatives and related financial markets.
Below is a summary of the meeting prepared by Delta Strategy Group.
CCP RISK AND GOVERNANCE, INTERNATIONAL PERSPECTIVE
Richard Haynes, CFTC Division of Clearing and Risk, Deputy Director
- Recent events such as the invasion of Ukraine and COVID have shown major impacts on the cost and availability of liquidity across different markets. We saw a need for additional transparency and additional information on demand for liquidity. This work is especially important to end-users who demand access to liquidity pools during periods of abnormally high pressure. Clearinghouses have updated their margin models, and we welcome the sophistication of these models and the way they are designed to respond to large events.
UPDATE FROM CCP RISK AND GOVERNANCE SUBCOMMITTEE
Technology and Operations—Third Party Risk
Julie A. Mohr, CFTC Division of Clearing and Risk, Deputy Director
- We are working to ensure that DCOs are considering third-party vendors that have sufficient protections for cybersecurity. Some of these vendors serve critical functions for DCOs such as cloud storage, and it is vital that they do not bring a large amount of risk to DCOs.
Don Byron, Futures Industry Association, SVP, Head of Global Industry Operations & Execution
- Recent cyber-attacks show the importance of industry participating in regular cyber preparedness exercises. It is important to stand up an industry-wide group that serves as a trusted forum for key stakeholders to discuss cyber incident management and resilience planning.
Recovery and Resolution
Alessandro Cocco, on detail at the Department of the Treasury, Senior Policy Advisor
- The workstream plans to issue a report in Spring 2024. The report will address resilience as the first line of defense, as well as liquidity and CCP recovery. It is important that DCOs remain resilient as the first line of defense. The ability of a DCO to recover from losses depends on an FCMs ability to recover from losses, if needed. The choice of recovery tools has policy implications as guaranteed fund replenishment means losses are allocated to FCMs, ultimately flowing to bank shareholders. Liquidity is crucial for a CCP’s ability to recover from a default and is influenced by factors like volatility, concentration, market specific liquidity, and central bank access.
Juan Blackwell, Ontario Teachers’ Pension Plan, Head of Credit & Counterparty Risk Management
- Clearing cash securities could create a cycle where the CCP needs undoubted liquidity to ensure they can buy the other side. International harmonization is critical for those who need to hedge in multiple markets. A consequence of harmonization may be that there are fewer FCMs. We need transparency in liquidity models. More transparency across CCPs will be better for the market and financial stability. We will further discuss default waterfall, depth of backstop facilities and central bank access, and a need for greater margin model transparency.
Bob Wasserman, CFTC Division of Clearing and Risk, Chief Counsel and MRAC Member
Open Discussion
- The Financial Stability Board issued a consultation report in September on resolution-specific resources for systemically important CCPs. The main point of the consultation is that resolution authorities for systemically important CCPs should have access to a set of resolution specific resources and tools that meet certain criteria. The comments on the report highlighted a need for flexibility in resolution implementation and a holistic view across recovery through resolution. There was broad agreement that quantitative analysis in necessary, and industry participants opposed the use of the Variation Margin Gains Haircutting (VMGH) for non-default losses. The CFTC approved a rule proposal for DCO recovery and wind-down on June 7. Some commenters expressed a need for more substance in the plans, while other commenters found the proposal overly detailed. The SEC is also working on a rulemaking on clearing agency recovery and orderly wind-down plans.
Margin and Collateral
Dmitrij Senko, Eurex Clearing AG, Chief Risk Officer
- The objective of our workstream is to enable market participants in liquidity planning and risk management by providing information on how margin models react to specific market conditions, including how margin calls work in different market scenarios. Strengthening the framework around procyclicality is necessary. Initial margin should cover CCP losses during default management. Beyond the core purpose of margin to act as first line of defense to collateralize cleared exposures, margin calls can influence procyclicality. Addressing margin transparency and anti-procyclicality issues may require a combined approach.
Discussion:
Jennifer Han, MFA: Is client collateral and margin segregated? Where does that fit in the event of a default? Can one client’s margin be used to cover another client’s default losses? Senko: There are different client access models, such as strongly segregated, individually segregated, each with varying levels of segregation for client margin. In terms of the waterfall, margin serves as the first line of defense.
Bob Wasserman, CFTC: The key to successful porting relies on having willing transferees. The decreasing number of FCMs is making the process more uncertain. The attractiveness of porting is diminishing due to the reduced FCM count, and the impact of bank capital rules may further deter potential transferees.
Juan Blackwell: If Initial Margin (IM) does not remain sacrosanct, I do not believe recovery order resolution for a CCP can work.
Lee Betsill, CME Group: In a clearing member default at CCP, one of our first priorities is to look to port clients to non-defaulting clearing members. We have successfully ported positions to non-defaulting clearing members along with associated collateral.
UPDATE FROM MARKET STRUCTURE SUBCOMMITTEE
Part One: Futures Commission Merchant Capacity
Ashwini Panse, Intercontinental Exchange, Inc., Head of Risk Oversight for ICE Clear Netherlands, Chief Risk Officer for the North American Clearinghouses
- We have observed a 70 percent decline in the total number of Futures Commission Merchants (FCMs), primarily led by the exit of many independent FCMs who are neither registered as broker dealers, nor affiliated with banks. Increases in minimum capital requirements has resulted in the near elimination of the “shell” FCMs. The remaining FCMs are well-capitalized, but providing FCM services has become expensive with the costs of regulatory compliance increasing since Dodd-Frank. FCMs across the board have been able to absorb the growth in client activity and meet margin requirements, including in periods of market volatility. Basel III can impact client clearing and has the potential to further reduce capacity of cleared markets.
Discussion:
Alicia Crighton, FIA: The inclusion of the Credit Valuation Adjustment charge for client cleared derivatives as well as the inclusion of the notional value of the client cleared leg in the GSIB calculation are the most problematic parts of Basel III.
Andrew Nash, Morgan Stanley: The subcommittee should address the impact on portability and to customer access of clearing services in the coming year.
Marine Rosenberg, JPMorgan: We are concerned that the proposed Basel III Endgame will further disincentive bank affiliated FCMs from providing clearing services.
Part Two: Treasury Market Reform
Samuel Schulhofer-Wohl, Federal Reserve Bank of Dallas, Senior Vice President and Senior Advisor to the President
- The Interagency Working Group has made efforts to evaluate policy issues and options in different areas related to financial markets. Notable progress has been made, including improvements in data collection, the Treasury’s buy-back program, and proposals for broader central clearing. Broader central clearing would support more efficient data collection that could enhance transparency. Work beyond the SEC’s clearing proposal would be needed to achieve the benefits of broader central clearing. The SEC’s segregation of customer funds proposal is a potential pathway to lower the cost of customer clearing. The challenges and potential costs associated with broader central clearing emphasize the need to distinguish between private and social costs.
Ann Battle, International Swaps and Derivatives Association, Senior Counsel, Market Transitions & Head of Benchmark Reform
- Over the next six to nine months, the workstream plans to concentrate on the Treasury cash futures basis trade. The goal is to create a detailed presentation in the beginning of next year that will lead to recommendations and best practices for risk management. The workstream aims to contextualize the size of the basis position in the growing market and understand the motivations behind such positions. We will analyze recent proposals like the SEC’s proposal on additional treasury clearing and the SEC’s dealer registration proposal.
Jennifer Han, Managed Funds Association, Chief Counsel and Head of Global Regulatory Affairs
- The supply of Treasuries has grown since 2000 to support the expanding government debt. Preserving robust participation by a diverse group of market participants ensures that demand keeps up with supply and that government funding costs are kept low as debt continues to expand. Basis trading when there is a price dislocation between Treasury futures and underlying cash Treasuries benefits liquidity, dampens volatility, reduces bid ask spread, and lowers the cost of government borrowing. Counterparty banks determine margin requirements on hedge fund financing arrangements. The Fed noted that imposing additional limits could have negative impacts on treasury markets.
- The SEC’s dealer proposal will force many private funds to curtail their participation in the markets. The SEC’s treasury clearing proposal is counterproductive as it singles out hedge funds for a cash clearing mandate, which risks limiting their participation in the Treasury market. We should improve data collection through Trade Reporting and Compliance Engine (TRACE) and expand the use of voluntary central clearing in the dealer-to-customer segment.
Part Three: Block Implementation Rule
Ann Battle, International Swaps and Derivatives Association, Senior Counsel, Market Transitions & Head of Benchmark Reform and MRAC Member
Open Discussion
- We support the CFTC’s extension of the new block threshold until July 1, 2024. This extension will allow for a better understanding of trading volumes and implications for market participants. The subcommittee developed questions for trading venues and data repositories which aim to assess the needs of market participants trading blocks. The subcommittee supports coordination with industry groups and intends to streamline future requests for data to enhance understanding of critical issues efficiently.
Part Four: Post-Trade Risk Reduction
Guy Rowcliffe, OSTTRA, Co-CEO and Chief Commercial Officer
- We are close to a near-final recommendation (expected for January). We recommend exemptions from CFTC regulations to enhance the operation of post-trade risk reduction services. We will recommend that the Commission considers adopting exemptions from the CFTC clearing obligation, from the trade execution requirement and from real-time reporting requirements for swap transactions that are created to complete post-trade risk reduction services. There is a need for market participants to have access to efficient risk reduction techniques and that has been reinforced by recent market volatility. The goal is to improve systemic risk reduction in derivatives portfolios. The final recommendation will include detailed criteria for the proposed exemptions.
CLIMATE RELATED MARKET RISK
Tamika Bent, Chief Counsel to Commissioner Kristin N. Johnson, MRAC Designated Federal Officer
- The CFTC recently issued guidance which outlines factors Designated Contract Markets (DCMs) should consider when listing contracts related to voluntary carbon credits (VCCs). The guidance aims to ensure that DCMs comply with core principles, such as preventing manipulation and disruptions in physical delivery or cash settlement processes. Key factors include transparency, additionality, permanency, risk of reversal, governance frameworks, tracking mechanisms, and measures to prevent double counting. DCMs are required to actively monitor VCC derivative contracts, specify inspection or certification provisions, and submit contract details to the CFTC. There are potential areas not addressed in the environmental commodity market for spot transactions. There may be vulnerabilities in these markets that require additional regulatory action.
Kerstin Mathias, City of London Corporation, Director of Policy and Innovation
- We need international standards for disclosing sustainability-related information. VCMs are an effective tool to address climate change. The industry would benefit from a high-integrity market and voluntary standards developed by groups like the VCM Integrity Initiative. There is room to build on these standards and enhance the infrastructure supporting voluntary carbon markets. It is important to engage in international collaboration in the regulation of these markets.
FUTURE OF FINANCE
Jai Massari, Lightspark, Co-Founder and Chief Legal Officer
- Looking ahead, we should explore four topics likely to impact CFTC regulated markets: Vertical integration, risk management and governance, cyber resilience, and digital IDs. There are benefits and risks associated with integrated custody services and conflicts of interest in crypto exchanges. We need clear guidance on risk management and governance expectations for new services or those using new technologies. With increasing reliance on technology in financial services, we need to develop standards for technological resilience. Digital IDs show promise in improving data security, privacy, interoperability, and competition.
Kevin Werbach, University of Pennsylvania, Liem Sioe Liong / First Pacific Company Professor, Professor of Legal Studies and Business Ethics, and department chair at the Wharton School
- The use of blockchain and digital assets in the financial space is evolving and there is a shift toward a more regulated environment which focuses on risk management mechanisms. The digital asset industry has developed technical solutions to address various risks, and the subcommittee should explore these solutions to enhance the understanding of evolving regulatory technology capabilities. For AI, we should examine issue areas like data privacy, systemic risks due to the centralized use of foundation models, and the future convergence of AI and blockchain technologies.