SPEECHES & TESTIMONY

Remarks of CFTC Chairman J. Christopher Giancarlo at the Futures Industry Association Law & Compliance Division Conference

“The Tao of Derivatives Clearing: Clearinghouse Resiliency, Recovery and Resolution”

May 10, 2019

 

“It produces them and makes no claim to the possession of them; it carries them through their processes and does not vaunt its ability in doing so; it brings them to maturity and exercises no control over them – this is called its mysterious operation.”

 

Tao Te Ching, 51.

 

INTRODUCTION

 

Good morning.  Thank you for your kind welcome.  It is great to be at FIA’s annual gathering of leading legal and compliance professionals overseeing U.S. and international derivatives markets.

 

This will not be my final speech to FIA – that will be next month in London – but it is likely to be one of my last. I expect to pass the Chairman’s baton sometime in early summer.

 

Nevertheless, at least one portion of this speech will sound the same as many other speeches I have given over the past five years.  That is, I will champion the economic and social utility of derivatives.

 

DERIVATIVES AND RISK MITIGATION

 

Two days ago, I testified at the Senate Appropriations Subcommittee on Financial Services and General Government beside Securities and Exchange Commission (SEC) Chairman, Jay Clayton.  I explained that when people think of the SEC, they think of American markets for capital formation and investment transfer.  Markets where investors with capital find innovators with ideas and products that produce prosperity and create jobs.

 

When people think of the CFTC, they think of futures, options and swaps markets, known as derivatives.  I explained that these are markets - not for capital formation - but for risk mitigation across a wide-range of business risks, including those related to capital formation.  They enable the transfer of risk of variable and sometimes sudden moves in prices, such as in commodities, energy, foreign currency, securities markets and interest rates from those who cannot bear the risk to those that can.  Derivatives markets serve the social good of moderating price, supply and other commercial risks, freeing up capital for job creation and economic growth.  In short, derivatives underpin the working of the American economy.

 

But risk transfer is just that: risk transfer.  It achieves risk efficiency in the financial system, but not risk elimination.  In fact, as a general proposition economic risk cannot be eliminated but can be mitigated through a range of effective risk management practices.[1]

 

One of the primary methods of risk mitigation in derivatives markets is central counterparty (CCP) clearing.   CCP clearing does not extinguish all risk, but it does provide a range of effective risk mitigation functions including professional management, position netting, mutualization and collateralization.  In developed economies, these CCP functions are provided by private sector businesses, known as clearinghouses, which are substantially regulated and supervised by agencies like ours, the CFTC.

 

DERIVATIVES CLEARING: Past and Present

 

The origin of U.S. derivatives clearinghouses go back over a century, providing CCP clearing services to exchange-traded futures and options.  Clearing of some over-the-counter swaps, particularly interest rate swaps (IRS), was available before the 2008 financial crisis,[2] but really took off after implementation of the G-20 efforts to reform the global derivatives markets, including under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).  

 

The CFTC estimates that, in 2007, about 15% of the global outstanding notional amount of interest rate swaps (IRS) was cleared.  By 2018, that percentage had risen to about 60% globally and 80% for U.S.-reporting entities.  As a percentage of notional transaction volume the current percentage is approximately 85% for IRS and 80% for index credit default swaps (CDS).

 

Unquestionably, the swaps clearing mandate has been highly successful.  The result is that a few large swaps clearinghouses have seen dramatic increases in the transactional volume and the amount of cleared positions and the respective value of related margin.  This success has heighted awareness of the integral function of these clearinghouses in the financial system.  It has raised the possibility of clearinghouse failures being transmitted to the global economy and whether regulators and regulatory frameworks are up to the task of supervising them.

 

If you were to read some press reports, you would think that regulators are unaware of, and unprepared for, these challenges.  A recent New York Times article cites “experts” asserting that “regulation has not kept pace” with the growth and importance of derivatives clearing in the wake of the financial crisis, that authorities stake so much trust in CCPs that they have “stepped into the unknown,” and that, prior to last fall’s Nasdaq Clearing default in Sweden, they did not realize that CCPs could suffer losses that challenge or exceed their prefunded default resources, and they had never confronted the question of “What if a CCP blows up?”[3]  

 

Similarly, the Systemic Risk Council, an independent group of former government officials, lawyers and financial professionals, asserts that regulators commonly believe that a CCP’s own recovery plans can substitute for resolution action by authorities, and that there are no high-level principles that guide authorities’ approaches to resolution.[4] 

 

None of this is true.

 

The CFTC has been a global leader in clearinghouse supervision for decades before the 2008 financial crisis and since.  Our regulatory framework requires that CCPs use multiple layers of protection to support their resiliency.  It ensures that no member default, however large, involving any number of members, will place the CCP in a position where it cannot meet its obligations. 

 

In 2016, my former colleague and predecessor, Chairman Tim Massad, confirmed the comprehensive work of the CFTC in derivatives clearinghouse supervision and our cooperation in critical international efforts at standard setting.[5]

 

Today, I want to review the design of CCP clearing and the standards that apply, both internationally and under the CEA and CFTC regulations.  I will tell you about the determination and effectiveness of the CFTC’s regulatory supervision of US clearinghouses and how we are advancing the swaps clearing mandate of the G-20 and Dodd-Frank Act.  I will show you how, under my leadership, the CFTC is: recommitted to critical Dodd-Frank swaps market mandates, including Title II’s Orderly Liquidation Authority, working more effectively with fellow U.S. and overseas clearinghouse supervisors, resolution authorities and standard setting bodies, and enhancing CCP oversight with greater quantitative analytical capabilities appropriate for a 21st Century regulator.

 

Chairman Massad also noted that there are three “Rs” to CCP regulation and oversight: Resiliency, Recovery and Resolution.[6]  Those elements remain at the center of the CFTC’s work. 

 

Clearinghouse Resiliency

 

Let start with the first “R” of resiliency. The CFTC’s regulatory framework provides multiple and overlapping layers of support for CCP resiliency, including clearing member qualification,[7] member-posted collateral, daily settlement, default management planning, and mutualized default resources.  They are designed to mitigate the risk to the CCP, and to support the CCP’s ability to meet its obligations even where some of these layers of support fail.

 

For example, with respect to member qualification, CFTC-regulated clearinghouses, which we call derivatives clearing organizations, or DCOs for short, are required to have risk-based admission criteria and continuing participation requirements for their clearing members, as well as risk limits for each clearing member and rules to require clearing members to have their own risk management policies and procedures.[8]

 

Every member is required to post collateral, the amount of which is reviewed and adjusted (as necessary) every business day, and DCOs are required to use margin models that call for collateral that is commensurate with the risks of each product and portfolio, and are reviewed and back-tested on a regular basis.[9]  Moreover, by collecting losses and paying gains at least once each day (i.e., variation margin), DCOs mitigate their counterparty credit exposure.

 

For the rare occasions when a member does default, DCOs are required to have well-designed default rules and procedures and default management plans, and to test those plans at least annually. 

 

Finally, each DCO is required to maintain pre-funded default resources, most of which are mutualized, to cover the one – or, in the case of the most systemically important DCOs, two – largest exposures in excess of margin in extreme but plausible market conditions, calculated based on stress testing, subject to stringent standards for the DCO’s design, conduct, analysis and review of those stress tests.[10]

 

These standards are informed by, and are consistent with, the relevant international standards, the Principles for Financial Market Infrastructures (“PFMI”), which were developed by what is now the Committee on Payments and Market Infrastructures and International Organization of Securities Commissions (CPMI-IOSCO).  CFTC plays a leading role in CPMI-IOSCO’s work on standards for CCPs, including by co-chairing CPMI-IOSCO’s Policy Standing Group.

 

Clearinghouse Supervision

 

The CFTC approaches its supervision of clearinghouse resiliency from two different perspectives: qualitative examinations and quantitative risk surveillance.

 

I.     Examination Function

 

The clearinghouse examination program is conducted by the CFTC’s Division of Clearing and Risk (DCR) under the experienced leadership of Deputy Director Julie Mohr.  The goal of her examination program is to identify weaknesses in CFTC-regulated DCOs before those weaknesses result in enterprise or systemic risk.  It looks for areas of non-compliance with CEA core principles and CFTC regulations that are critical to a safe and efficient clearing process.  It also prescribes remediation actions to correct any weaknesses that may be identified.

 

DCR prioritizes its examination resources to meet statutory requirements.  Systemically important DCOs (known as SIDCOs)[11] are formally examined annually using a risk assessment process to establish examination priorities. CFTC staff also has supervisory meetings with the management of SIDCOs six times a year to discuss material changes in business, such as key operational systems or collateral on deposit.  DCOs that are not SIDCOs but elect to opt-in to the SIDCO regulatory requirements (“Subpart C DCOs”) are examined at least every three years.  All other DCOs are examined based upon individual risk assessment.  The risk assessment considers the varying impact of all 17 core principles[12] on a DCO’s safety and resilience through such matters as potential compromised systems, loss of data and inability to clear contracts or manage risk. 

 

The CFTC’s SIDCO examination program is conducted in coordination with the Board of Governors of the Federal Reserve System (Federal Reserve) pursuant to authority under Title VIII of Dodd-Frank.  Upon becoming Chairman, I committed the CFTC to a cooperative relationship with the Fed on SIDCO examinations.  Today, with the firm support of Federal Reserve Governor Lael Brainard, our two organizations work in close collaboration on SIDCO examination scope, priorities, methodology and conclusions. 

 

Many CFTC-registered DCOs are also registered, authorized or otherwise recognized to operate in overseas jurisdictions.  The CFTC works cooperatively with overseas market regulators to conduct a supervisory program that efficiently and effectively identifies areas of risk.  The CFTC has had a highly successful working relationship of almost two decades with UK regulators responsible for CCPs, most recently the Bank of England.  Staff from DCR and the Bank of England consult regularly on clearinghouse supervision, and regulatory and policy, matters.

 

Examinations are just one method of oversight.  DCOs are required to file many different types of information throughout the year, including quarterly financial resource reports and annual certified financial statements.  DCR staff analyzes these filings to determine compliance with requirements such as financial resources and liquidity facility arrangements.  DCOs are also required to report a range of matters, including hardware or software malfunctions and cyber-security events that may materially impact clearing as well as many operational developments.  These filings and regular dialogue allow agency staff to have a current in-depth understanding of the risk profile of regulated clearinghouses.

 

II.     Risk Surveillance Function

 

As I said, the CFTC’s clearinghouse examination program is designed to produce a qualitative understanding of our DCO registrants and any deficiencies in resilience.  We couple that with a comprehensive clearinghouse risk surveillance program that provides a quantitative risk analysis of our clearing eco-system.  

 

The CFTC’s clearinghouse risk surveillance program is led by former CFTC Chief Economist Sayee Srinivasan.  The program has three core functions:

 

  1. Margin model oversight
  2. Daily risk surveillance
  3. Supervisory stress tests

 

A.       Margin model oversight

 

Margin models are the first line of defense of derivatives clearing.  This idea is based on the simple premise that if a customer cannot afford initial margin, the customer cannot trade.  

 

The CFTC prescribes rules for DCO margin models and monitors their performance.  The CFTC’s margin model team works closely with DCOs to ensure that models are being implemented adequately to capture the different risk factors of particular products.  The goal of the team is to be able to regularly review every margin model.  Recently, the team conducted a study of the manner in which CCPs’ margin models are capturing the risks from concentrated positions. 

 

DCO margin models continue to grow in complexity and sophistication.  The CFTC is determined to expand its quantitative model analysis capabilities to keep pace.

 

B.       Daily risk surveillance

 

One of the CFTC’s most effective tools is its daily risk surveillance program, a data-driven, real-time risk management function.  The program brings together market intelligence, agility, data savvy and analytics to analyze risk during the trading day.

 

In conducting this work, the CFTC has been endowed with a unique – and uniquely useful – set of regulatory data, namely, large trader reports for both futures and swaps positions.  This information enables risk surveillance staff to understand and analyze cleared positions at the clearing member and beneficial owner levels, including across CCPs.

 

Using a myriad set of dynamic dashboards, daily position reports and payment records, the risk surveillance team actively monitors the performance of CCPs, clearing members and their clients.  The team views risk exposures from cleared derivatives, including futures, options and swaps, and ties them to clearinghouse margins and financial resources of the clearing members.  The team also has the ability to aggregate a firm’s risk exposures across different clearinghouses, trading venues and clearing members.

 

In addition, the team has developed the capability for daily stress tests.  Using a range of tools, they stress test positions at an account level on an intra-day basis.  So if there is a sharp intra-day move in prices, one that could potentially require a large variation margin payment to be collected, staff will be on the phone with the relevant DCO and clearing member or futures commission merchant, to ensure that they are able to fulfill their payment obligations.

 

CFTC staff is adept at using an array of data streams to gain visibility into market conditions and counterparty exposures.  While the development of swap data repositories and uniform product and transaction identifiers remains to be perfected through the concerted efforts of the CFTC, fellow regulators and international bodies, the CFTC is not hindered from monitoring swaps trading activities of non-U.S. operations of U.S.-based entities.

 

In fact, the CFTC receives and analyzes an enormous amount of cleared swaps data as a result of the large increase in swaps clearing in the CFTC-regulated clearinghouses.  This allows the agency to monitor the vast amount of derivatives across the major product types held by large U.S. bank holding companies (BHCs) in the UK, where most BHCs have subsidiaries.  Relevant UK authorities, with whom the CFTC works closely, receive detailed data on the remainder of these derivatives.  This effective transparency into the derivatives exposure of overseas subsidiaries of U.S. banks is in stark contrast to the situation prior to the 2008 financial crisis.​

 

C.       Supervisory stress tests

 

Just over a week ago, the CFTC released its annual supervisory stress test.[13]  This is the CFTC’s third major testing of overall clearinghouse systemic resiliency to major financial shocks.[14]  The exercises are meant to probe for vulnerabilities across the derivatives clearing eco-system, not just at one DCO.[15]  This latest study examined DCOs operated by CME Group and LCH Group.

 

The results of the recent study indicate that the two clearinghouses are adequately provisioned to be able to absorb defaults from some extraordinary stressful market moves.  Previously, their resources were measured using a standard of extreme but plausible market moves. The latest study utilized extreme and highly implausible scenarios in order to measure the size of shocks necessary to exhaust their pre-funded resources.  The results showed that it would take intra-day market moves bigger than those of the 2008 financial crisis to have any meaningful impact on the pre-funded resources of the two clearinghouses.  This study also stress tested the liquidation risk component of the two DCOs’ margin models for IRS, and found them to be robust in hundreds of different scenarios.  The CFTC’s supervisory stress tests conducted to date provide comfort that the large, systemically important CCPs have robust risk management systems to absorb shocks from extreme market moves.

 

Historically, CFTC supervisory stress tests have examined futures and options separately from swaps, and even within the different types of swaps, IRS risks as distinct from CDS. Yet, all trading markets are tightly inter-connected – a bank could do a crude oil commodity swap with an airline and turn around and hedge the risk from the swap in the futures markets.  It is reasonable to assume that if a large firm were to default, it would be defaulting across all of these different markets.  That is why the CFTC risk surveillance team is preparing to aggregate programmatically risk exposures across these different markets, and conduct routine stress tests by shocking different markets and assessing potential impact on larger risk exposures.

 

We believe the combination of the examinations, the activities performed during the continuous monitoring program, analysis performed by the risk surveillance program, and discussions with our fellow regulators around of the globe allow the CFTC to have a strong supervisory program and one in which all DCOs are being monitored for compliance.

 

Default by Nasdaq Clearing (Sweden):  Before I turn to clearinghouse recovery and resolution, I want to briefly address the default at Nasdaq Clearing in Sweden, which was the subject of the recent New York Times article I referenced earlier.  The journalists never reached out to the CFTC to discuss the matter.  Perhaps they knew that the CFTC does not regulate Nasdaq Clearing.  Had they contacted us, however, we would have directed them to our risk surveillance program, which surprisingly did not feature in their article.  Moreover, we would have pointed out the unlikelihood today of a SIDCO admitting an individual as a clearing member. Had they asked me, I would have expressed confidence that the CFTC’s risk surveillance program would have questioned the trading activity and margin model adequacy of what was clearly a dominant position by an individual market participant in an asset class with thin trading liquidity.  I would have explained that the CFTC’s regular reviews of DCOs’ margin models, concentration charges and default management plans surely would have identified the potential for the default described in the article.

 

Clearinghouse Recovery and Resolution

 

Let’s now turn to the second and third “Rs” - recovery and resolution.

 

Our exam function and the risk surveillance function are designed to ensure that CCPs are resilient. But what if a CCP faces a default that goes beyond “extreme but plausible”?  This takes us into the realm of Recovery.

 

Both the PFMI and CFTC regulations require SIDCOs and Subpart C DCOs to maintain recovery plans that identify scenarios that may potentially prevent the DCO from being able to meet its obligations and provide its critical services as a going concern, and to assess the effectiveness of a full range of options for recovery or orderly wind-down.[16]  Critically, they are also required to “adopt explicit rules and procedures that address fully any loss arising from any individual or combined default relating to clearing members’ obligations ….”[17]  I repeat.  Any loss.  These explicit rules and procedures are important parts of the “clear plan to cope with a meltdown.”

 

As suggested in the CPMI-IOSCO guidance on Recovery Plans, DCOs use a variety of recovery tools to address the possibility that default losses will exceed pre-funded resources.  These include limited assessment powers that can expand the financial resources available, as well as tools such as gains-based haircutting and partial tear-up of contracts (for cases where auctions cannot successfully liquidate positions).  The implementation of these tools enables a pre-determined plan and procedure to enable a DCO to survive ANY loss, no matter how large.  CFTC staff are also working both internally and in coordination with regulatory partners, both domestic and international, to enhance their understanding of potential impacts of the use of these tools.

 

While our SIDCOs and Subpart C DCOs can address fully any uncovered credit loss, what happens if the events that lead to such a loss fatally undermine member or market confidence in the DCO, and thus members are, for example, unwilling to replenish mutualized resources?  This leads us to the final R – Resolution, known in the United States as “Orderly Liquidation Authority.”

 

I.     Orderly Liquidation Authority

 

The New York Times asserts, “In the United States, it is unclear which regulator would deal with a failure.” 

 

Far from unclear, Title II of the Dodd-Frank Act manifestly gives the Federal Deposit Insurance Corporation (FDIC) “Orderly Liquidation Authority” for a failed SIDCO.[18]  Furthermore, the U.S. Treasury Department October 2017 Report[19] confirms without qualification that the FDIC would be in charge of the failure resolution of financial market infrastructure, such as a systemically important clearinghouse. 

 

Under my Chairmanship, the CFTC has recognized and endorsed the FDIC’s Orderly Liquidation Authority under Title II of Dodd-Frank.  CFTC staff has worked diligently with counterparts at the FDIC to better the FDIC’s understanding of how derivatives clearing works, including default management and recovery and extreme tail scenarios.  The work has included development of resolution scenarios tailored to the unique clearinghouse business model.  Because of this work, the CFTC and FDIC today have in place protocols to respond to the highly unlikely event of a failure of a systemically important clearinghouse.

 

 In addition, I have personally led regular multilateral discussions between CFTC staff and colleagues from the FDIC, the Bank of England, the Federal Reserve and the SEC examining hypothetical failure and recovery and resolution of systemically important clearinghouses.  This work started with discussions of approaches to common problems and comparing legal frameworks for clearinghouse resolution in the U.S. and the UK.  Staff analyzed respective rulebooks and diverse approaches for resolving CCPs.  Later, we considered hypothetical default and non-default loss scenarios and resolution strategies to address them, as well as continuity of access to clearinghouses for major global banks in resolution.[20]

 

II.     International Standards for Clearinghouse Recovery and Resolution

 

Of course, the CFTC has also participated actively in international standard-setting work on CCP resolution at the Financial Stability Board (“FSB”).  The CFTC has also co-led, along with the FDIC, crisis management groups (“CMGs”) for CME and ICE Clear Credit, to aid in coordination with authorities in other jurisdictions that consider these CCPs systemically important.  This work – domestic, bilateral and international – is a prime example of how regulators cooperate to address significant issues.

 

Yet, work on clearinghouse recovery and resolution has not been confined to direct action by the CFTC and fellow regulators.  The CFTC also actively participates in, and in some cases co-leads, the important work of international standard setting and systemic risk authorities concerning derivatives clearing.  That work includes the FSB promulgation of the FMI annex to the Key Attributes (“FMI Resolution Annex”) in October 2014,[21] and Guidance on CCP Resolution and Resolution Planning (“CCP Resolution Guidance”) in July 2017.[22]  Similarly, CPMI-IOSCO published guidance on CCP Recovery in 2014,[23] and updated that guidance in 2017.[24]

 

Systemic Risk Council Letter:  The SRC’s statement that the FSB’s recent work on CCP resolution is “as welcome as it is overdue” is as catchy as it is ill-informed.  It disregards the significant work that has been accomplished over the past five years.  The SRC Letter demands what is already extant and available – a “set of high-level principles that will guide [FSB’s] approach to CCP resolution.”  

 

In fact, such principles are thoroughly set forth in the FSB and CPMI-IOSCO documents discussed above. They call for, and the recovery plans and rules of CFTC-supervised SIDCOs establish, recovery arrangements that allocate, fully and comprehensively, any uncovered credit loss.  Moreover, such recovery plans are both enforceable and transparent, at least for CFTC-regulated SIDCOs, leaving members’ exposure to loss measurable, manageable and controllable.  Tools discussed in the CPMI-IOSCO PFMI recovery guidance – including gains-based haircutting, in conjunction with partial tear-up – are readily available to accomplish those standards. 

 

Yet, it is inarguably true that recovery plans and rules, while necessary, are not sufficient.  The SRC Letter appears to knock down a straw man when it refers to a “belief, not uncommonly held among regulators, that a CCP’s own recovery plans can substitute for resolution.”  Neither I, nor CFTC staff, believe any such thing, nor do the other regulators, both U.S. and international, with whom I discuss CCP resolution regularly. 

 

Rather, as noted above, we work to ensure that the CCPs that we regulate have thorough, viable and well-developed recovery plans and rules to avoid the necessity for resolution, and to serve as the foundation for resolution planning.[25]  It is because of the extraordinary systemic importance of the CCPs that we regulate, in particular our SIDCOs, that CFTC staff have been working so keenly and continuously with their colleagues at the FDIC, the Federal Reserve, the SEC and the Bank of England on further developing our own regulatory readiness and strategies to oversee the implementation of clearinghouse recovery and resolution.

 

The SRC claims that the recovery tools discussed in the CPMI-IOSCO guidance will themselves cause systemic risk.  Yet, the SRC does not explain how that would be so.  It also does not explain how self-liquidation – the only recovery approach among many that the SRC suggests members might take – would cause a systemic crisis.  What about other recovery tools?  Nor does the SRC grapple with the systemic implications of incentives that would be created if losses in resolution – and rights in the CCP – are allocated differently than in recovery.

 

Instead, the SRC calls for the FSB to overreach its authority with an extraordinary set of measures requiring CCPs to: (1) issue, during business as usual, debt that they do not need, and (2) participate in a mutualized international CCP-default fund invested in the Bank for International Settlements.  These are unprecedented and unexplored arrangements that would likely engender unintended consequences.

 

DERIVATIVES CLEARING: The Way Forward

 

Turning back to the CFTC’s swaps clearing regulatory and supervisory framework, we undoubtedly have a strong foundation, but we cannot, are not, and will not rest on our laurels. 

 

Let me give you a flavor of some of the things we aspire to do in the coming months and years:

 

We want to continue to enhance our qualitative DCO examination capabilities while keenly expanding our quantitative analysis competence and proficiency.  We want not only to assess the resiliency of clearinghouses, but the entire client clearing industry, including clearing members and futures commission merchants (“FCMs”).  I have tasked the risk surveillance team with leveraging the rich data available to us to develop analytical capabilities for more sophisticated monitoring of the cleared derivatives ecosystem.  For example, we want to be able to quantify the potential impact of the withdrawal of a large FCM from the client clearing business.  We want to be able to assess the risk of large client bringing down an FCM.  We want to measure the true impact on client clearing caused by inaptly calibrated capital rules and “gold-plated” leverage ratios.

 

We also want to expand the scope of our risk analysis to cover both cleared and uncleared swaps. Regulated firms do not look at cleared risks as distinct and separate from uncleared risks.  Neither should regulators.  Risk exposures should be managed in a holistic manner.  In the coming months, we expect to be able to issue a proposal to amend Part 45 of our rules to enable collection of risk measures for swaps, especially uncleared swaps.

 

We want to map the inter-connectedness of regulated derivatives markets to the broader financial system and study risk transmission throughout.  Undoubtedly, the CFTC’s regulatory authority is limited to a portion of the global derivatives markets (a materially large portion).  So while some of our efforts will be centered on the data directly reported to us, we will be looking to collaborate with other relevant authorities, including our partners across Washington at the SEC, to routinely assess vulnerabilities in the global financial system.  Nevertheless, we want to use our unique data sets and our growing quantitative analysis capability and draw upon the emerging field of network science to explore and diagnose systemic fragilities and mitigate critical vulnerabilities and escalating risk patterns. 

 

CONCLUSION

 

Unquestionably, the G-20 swaps clearing mandate has been highly successful.  The result is that a few large swaps clearinghouses have seen dramatic increases in the volume of cleared transactions and the value of posted margin.  The success has heighted awareness of the integral function of these clearinghouses in the financial system and the possibility of clearinghouse failures being transmitted to the global economy.  It raises the legitimate question of whether market regulators can stay abreast of rapid growth and pace of change.

 

This regulatory challenge is compounded by the fundamental data and technological transformation of modern financial and derivatives markets.  The amount of market data continues to grow exponentially and become infinitely more granular, quantitative data analysis increasingly drives commercial trade execution and strategy, and limited agency funding requires increasing operational efficiency.

 

The world’s preeminent derivatives markets need the world’s most advanced technological competency and risk analysis capability.  I believe that the CFTC and, indeed, all market regulators here and abroad, must boldly transform themselves into quant-driven agencies conducting risk surveillance and analysis using broad data collection, automated data analysis and state-of-the-art artificial intelligence. 

 

I have previously said that the CFTC must become a highly effective, 21st Century regulator. Under my watch, the CFTC has recommitted itself to the Dodd-Frank swaps clearing mandate and Orderly Liquidation Authority; has worked more effectively and cooperatively with fellow U.S. and overseas clearinghouse supervisors, resolution authorities and standard setting bodies; and has enhanced its CCP oversight with greater qualitative understanding and quantitative analytical capabilities appropriate for a 21st Century regulator.

 

The CFTC aspires to nothing less than to match its effective market intelligence and risk surveillance with unparalleled quantitative data analytical capability.  We intend to continue to be thought leaders on evolving issues in derivatives markets and their role in global systemic risk mitigation.  The CFTC is ready to lead the world in quantitative risk analysis and drivatives market regulation:  QuantReg.

 

I look forward to hearing from all of you – leaders in law, our markets and in technology – as we move forward with our transformation.  It’s an exciting world we live in; one filled with new ideas, innovations and opportunities.  And we at the CFTC look forward to confidently and proactively stepping into the future.

 

Thank you.

 


[1] Aggregate or systematic risks in an economy cannot be eliminated; they can only be allocated across counterparties through markets for various financial instruments, e.g., stocks, futures, derivatives, etc. See William F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” The Journal of Finance 19(3), pp. 425-442 (“[T]here will be a consistent relationship between their [i.e., individual securities’] expected returns and what might best be called systematic risk…”).  In other words, systemic “risk management,” includes both deciding how much systematic risk to bear and evaluating the opportunities and costs of eliminating individual risks.  See also Frank Knight, Risk, Uncertainty, and Profit (1921), available at: https://fraser.stlouisfed.org/files/docs/publications/books/risk/riskuncertaintyprofit.pdf.)

[2] In 2005, I was involved in an independent effort to develop central clearing for credit default swaps that ultimately contributed to the development of ICE Clear Credit, a leading clearer of credit derivative products. See, e.g., GFI Group Inc., GFI Group Inc. and ICAP plc To Acquire Ownership Stakes In The Clearing Corporation, PRNewswire, Dec. 21, 2006, available at: http://www.prnewswire.com/news-releases/gfi-group-inc-and-icap-plc-to-acquire-ownership-stakes-in-the-clearing-corporation-57223742.htmlSee also Testimony Before the H. Committee on Financial Services on Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 112th Cong. 8 (2011) (statement of J. Christopher Giancarlo).

[3] Jack Ewing and Milan Schreuer, “How a Lone Financial Trader Shook the World’s Financial System,” New York Times, May 3, 2019 (“NYT Article”), available at: https://www.nytimes.com/2019/05/03/business/central-counterparties-financial-meltdown.html.

[4] Systemic Risk Council Letter, dated March 18, 2019 (“SRC Letter”), responding to FSB Discussion Paper: “Financial resources to support CCP resolution and the treatment of CCP equity in resolution”, 15 November 2018 on the resolution of distressed central counterparty clearing houses (CCPs), at:  https://4atmuz3ab8k0glu2m35oem99-wpengine.netdna-ssl.com/wp-content/uploads/2019/03/CCP_Resolution_-_SRC_-_March18__2019.pdf.

[5] Statement of Chairman Timothy Massad on Release of Reports on CCP Resilience, Recovery and Resolution, August 16, 2016, available at: https://www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement081616.

[6] Id.

[7] It is highly unlikely that a SIDCO today would admit an individual as a clearing member.

[8] Reg. §§39.12(a), 39.13(h)(1) and (5).

[9] Reg. §39.13(g).  Back-testing is an ex-post comparison of observed outcomes with expected outcomes derived from the use of margin models.

[10] CCPs employ stress testing as a key component of prudent risk management practices.  In addition to sizing pre-funded default resources, the core functions of this tool are liquidity resource sizing and identification of material impacts of “tail” events on clearing member and customer exposures.

[11] Title VIII of the Dodd-Frank Act permits the U.S. Financial Stability Oversight Council (“FSOC”) to designate certain firms, including a derivatives clearinghouse, as a Systemically Important Financial Market Utility (“SIFMU”).  Part 39 of the CFTC’s regulations allow for the designation of SIFMUs as systemically important DCOs (“SIDCOs”).

[12] See generally CEA Section §5b, 7 USC §7a-1(c)(2).

[13] CFTC, CCP Supervisory Stress Tests: Reverse Stress Test and Liquidation Stress Test (2018), available at: https://www.cftc.gov/system/files?file=2019/05/02/cftcstresstest042019.pdf.

[14] CFTC, Supervisory Stress Test of Clearinghouses (2016), available at: https://www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/file/cftcstresstest111516.pdf; and CFTC, Evaluation of Clearinghouse Liquidity (2017), available at:  https://www.cftc.gov/sites/default/files/idc/groups/public/@newsroom/documents/file/dcr_ecl1017.pdf.

[15] The DCOs are primarily responsible under CFTC rules for stress testing their own organizations, subject to CFTC oversight.

[16] Reg. §39.39.

[17] Reg. §39.35(a) (emphasis supplied).

[18] This is confirmed by the statute’s reference to “covered financial company” (i.e., an entity subject to resolution under Title II) that is a commodity broker having “member property.”  Only registered DCOs can have “member property” in this context. See Dodd-Frank §210(m)(1)(B).

[19] U.S. Treasury, A Financial System That Creates Economic Opportunities - Capital Markets, October 2017, at: https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf

[20] I believe the procedural mechanism that the five regulators developed to move the work forward – periodic principal-level meetings, with staff working to advance the principals’ agenda between principal-level meetings – has become a model for work in other areas where the issues presented require effective, productive multilateral work of a small handful of regulators (as opposed to the standard setting done by the established international groups).

[21] Key attributes for effective resolution regimes, II Annex 1, Part I:  Resolution of Financial Market Infrastructures (FSB 2014), available at:  http://www.fsb.org/wp-content/uploads/r_141015.pdf.

[22] Guidance on Central Counterparty Resolution and Resolution Planning (FSB 2017), available at: http://www.fsb.org/wp-content/uploads/P050717-1.pdf.

[23] Recovery of Financial Market Infrastructures (CPMI-IOSCO 2014), available at: https://www.bis.org/cpmi/publ/d121.pdf.

[24]   Recovery of Financial Market Infrastructures (revised 2017) (CPMI-IOSCO), available at: https://www.bis.org/cpmi/publ/d162.pdf.

[25] See CCP Resolution Guidance ¶7.2 (“Given the close relationship between resolution and recovery, the development of the resolution plan should start with the CCP’s recovery plan.”).