Remarks of Chairman Timothy Massad before the CME Group Global Financial Leadership Conference

November 16, 2015

As Prepared for Delivery

Thank you very much, and thank you Terry for that kind introduction. It’s great to be back at this important conference. As always, I greatly appreciate CME for its leadership in the derivatives markets – and for continuing to work collaboratively with the CFTC.

It’s also an honor to follow Alan Mulally on stage today. I met Alan during my time at the Treasury Department – where I had the responsibility of overseeing the Troubled Asset Relief Program – commonly known as TARP.

Many of you will recall that one of the components of TARP was the assistance to the automotive industry. This was a challenging effort – one that remains an important reminder of the speed by which what started as a financial crisis rippled across our economy, affecting millions of jobs, manufacturing and economic growth in many sectors.

Although Ford was the only major American car manufacturer that did not directly take any TARP funds, Alan was nevertheless a strong supporter For example, he testified before Congress on how the rescue of the other major U.S. auto companies helped Ford indirectly, because all three relied on common networks of suppliers and dealers. His word meant that we were all in it together. His leadership was critical and I am grateful for it.

Today I’ve been asked to provide a “global regulatory overview and outlook.” This is a complicated topic. The inherent challenge – that we live in a world of global financial markets regulated by many distinct national regulators – is fairly obvious. But in the aftermath of the 2008 financial crisis, the worst since the great depression, regulators have worked hard to coordinate efforts in many areas. Bank regulators and central banks came together to agree on common changes to capital requirements. And as many of you know, in 2009 the leaders of the G-20 nations agreed to a framework to reform the then-$600 trillion dollar global over-the-counter swaps market, which was largely unregulated.

Central Clearing’s Key Role in the Regulatory Framework

Today I’d like to discuss one aspect of that framework, which is central clearing and in particular, the regulation of clearinghouses. I want to do so because it will be a critical focus of regulators all over the world for the next several years. And I believe it is a subject of great interest to all of you.

Clearinghouse regulation will command this attention for a number of reasons. Paramount among them is that while we have made great progress in the implementation of central clearing for swaps, that very progress raises concerns about clearinghouses. Some have suggested that by requiring greater central clearing we are creating new concentrations of risk in the financial system. I believe that the clearinghouse model is a good one and that this concern can be addressed. But this tension is indicative of a basic challenge that regulators often face. There is a tendency —often a requirement—that regulators look backward and address the causes of past failures or problems. We are often playing “catch up” to the forces of market evolution, such as in response to the global financial crisis.

But we also must look forward. We must create a regulatory framework that works for the new challenges ahead. We must recognize that what we do as regulators – in response to a market failure or otherwise – affects how the market evolves, sometimes in unanticipated, and unintended, ways. So we must strive for sensible regulation that achieves our objectives – preventing fraud and manipulation, promoting integrity, transparency and fairness, and avoiding systemic risk – while providing a strong foundation where markets can meet the needs of customers and continue to grow and innovate.

The focus on clearinghouses is important because of the critical role that central clearing has played, and can continue to play, when it comes to innovation in our markets. Central clearing itself is one of the great innovations of modern financial markets. And in large part, the success of central clearing has led to market innovations that have been nothing short of astounding.

Many of you have been participants – and indeed, leaders – in the innovation that has transformed our derivatives markets. And central clearing was critical to that. In the space of a few decades, a futures industry once limited to contracts on storable agricultural products expanded to a vast range of physical commodities and then to intangible commodities like interest rates, stock indices and currencies.

The leap from physical commodities to financial – and less tangible – instruments required the development of futures contracts that did not require physical delivery. That was a development that Leo Melamed, one of the pioneers of the futures markets and Chairman Emeritus of the CME, described as “breaking the genetic code” of futures.

This spiral of innovation has brought great benefits to the global economy. Businesses of all kinds can hedge routine commercial risk, whether it is related to the corn harvest, fluctuations in world oil prices, volatility in interest rates or currencies, or the ups and downs of equity prices.

Private sector ingenuity has been innovation’s driving force. But our regulatory framework helped ensure transparency and integrity, which promotes participation. And our rules did not stand in the way of innovation –indeed, in some cases, we helped further it. It is important that we continue to have a regulatory framework that provides a foundation for innovation. A key piece of this is ensuring that central clearinghouses continue to play a vital role in such growth.

Clearinghouse Regulation

Let me begin by describing what I expect we will see over the next few years with respect to the regulation of clearing and clearinghouses.

As I noted, we have made great progress in implementing the G-20 agreement to mandate the clearing of standardized swaps. In the United States, clearing is now mandated for most interest rate and credit default swaps. Today, approximately 75 percent of swap transactions are being cleared, as compared to only about 15 percent in 2007.

But as you well know, central clearing is not a panacea. While it allows us to monitor and mitigate risk, it does not eliminate it. And so there will be a lot of focus on making sure clearinghouses are strong and resilient.

It’s important to note that this focus on clearinghouses will involve a mix of authorities. It will include market regulators like the CFTC, which have been responsible for overseeing clearinghouses for some time. But it will also involve prudential regulators concerned about relationships between clearinghouses and the large financial institutions under their supervision. And it will involve central banks, who are focused overall on financial stability. Under Dodd Frank, for example, both the FDIC and the Federal Reserve now have certain responsibilities with respect to the clearinghouses in our markets, although we remain the primary supervisor.

It will also involve a public discussion – one that is already taking place – where clearing members, buy-side participants and others are actively weighing in with views.

I noted the concerns that some have raised about creating new concentrations of risk in the financial system. Some of the other concerns raised by voices in this discussion include:

• The adequacy of the resources available to cope with a member default, including capital or skin in the game and the sufficiency of the guaranty fund;
  
  
• The interdependencies and interconnections of clearinghouses, especially because large clearing members are often active at multiple clearinghouses; and
  
  
• The risks of imposing assessments – and making calls for additional initial margin on clearing members— particularly large, systemically important ones – at times of great stress.
  
  

Now you might say: clearinghouses survived, indeed performed well, during the global financial crisis without government liquidity or other direct support. Isn’t that proof of the resiliency of the model? But others have questioned whether that would have happened without the extraordinary government support for major financial institutions during that time – institutions whose affiliates were clearing members.

I believe that it is possible to devise good, pragmatic approaches to all of these concerns, and I believe we have already accomplished a lot in that regard. So let me highlight some of the activities that regulators are undertaking domestically and internationally that are exploring these issues.

Domestic Efforts. Here in the U.S., we at the CFTC have been involved in the oversight of clearinghouses for many years. And since the crisis, we have been particularly focused on the resiliency of clearinghouses.

We have substantially strengthened our requirements regarding risk management and transparency. We did an extensive revision of our rules after the passage of Dodd-Frank, and incorporated international standards into our regulations. We strengthened customer protection measures. And we have enhanced our examination, compliance, and risk surveillance programs.

We are also actively working on recovery and resolution planning and the adequacy of resources and procedures applicable in the event of a major problem. We are working with the major clearinghouses to review their recovery plans and rule changes, and are engaged in discussions with them and other market participants on how significant problems would be handled. That includes exploring auction procedures to increase efficiency and participation; considering whether, under what circumstances, and to what extent, gains-based haircutting is an appropriate tool to allocate losses; examining the tools available to a clearinghouse, such as partial tear-ups, in order to re-establish a matched book; and discussing the governance mechanisms over the use of recovery tools – and the transparency regarding the potential use of those tools. We are also working with the FDIC on resolution planning.

International Efforts. On the international front, there is a group formed under the auspices of the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) that is looking at a number of issues pertaining to clearinghouse strength and stability. The CFTC is co-chairing this effort. This work includes looking at margin methodologies and the resources available to a clearinghouse in the event of a default, including “skin in the game.” It includes looking at standards for stress tests so that clearinghouse risk can be compared across borders. It includes assessments of the implementation of the Principles for Financial Market Infrastructures, known as the PFMIs. And it includes looking at the adequacy of recovery planning.

In addition, we are involved in additional efforts led by the Financial Stability Board to examine resolution planning for clearinghouses, including international coordination, as well as the interdependencies among global clearinghouses and major clearing members.

Of course, CME and other clearinghouses, have themselves been focused on these issues – particularly since the crisis. I applaud the attention they are devoting to these matters, as well as their engagement with us and with market participants. I know many of you representing clearing members and major market participants have been very focused on these issues. And that dialogue among clearinghouses, market participants, and regulators is precisely what we need to address these issues.

Some Thoughts on the Way Forward

As we engage in this dialogue, there are likely to be lots of views expressed on complex, often highly technical subjects like anti-procyclicality measures—almost an oxymoron, if you will—or gains-based haircutting, which is also a mouthful.

I won’t descend into the uber-technical today. Instead, I’d like to articulate a few basic ideas that I think are worth keeping in mind so that we keep our perspective, and not lose sight of the forest for the trees. I will mention three here today—the importance of daily risk management, the importance of continuity of function, and the importance of a robust clearing member industry.

The Importance of Daily Risk Management. First, while we need to plan for recovery and resolution of a clearinghouse, we must remember that clearinghouse resiliency is primarily about daily risk management. Sometimes in the current discussions about clearinghouse resiliency, the activities that comprise ongoing risk management don’t get much attention. But those activities—the daily margining practices, the stress and back testing, the oversight and ongoing risk surveillance—are critically important. Those activities —carried out by the clearinghouses, the clearing members, and us—are essential. No recovery plan --and no set of rules that kick in when there is a problem – can take the place of these everyday activities.

For example, at the CFTC, our risk surveillance program involves robust oversight at the clearinghouse, clearing member and large trader level. We have extensive daily margin, position and other reporting requirements that enable us to engage in daily risk surveillance. We look at market risk, liquidity risk, credit risk and concentration risk. We seek to identify who is at risk, the magnitude of that risk, and how that risk compares to available financial resources.

Of course, we are a regulator and our role is one of oversight. The clearinghouses themselves have the front line responsibility here – and it is their practices that are most critical to risk management.

The practices and involvement of clearing members are critical too. And transparency is very important. Because clearinghouses mutualize risk, it’s important that clearing members—and customers-- have sufficient knowledge of the risk management practices of a clearinghouse – and sufficient input into decisions that may affect overall risk of the clearinghouse.

The Importance of Continuity in the Event of a Default. Second, we must remember the importance of continuity of function should a clearinghouse face a significant default or other problem. As a result, our contingency planning must account for different scenarios. These include, what happens if a clearing member that is critical to the provision of settlement services defaults? Or perhaps even more fundamental, in the event of a default, it is difficult to conduct an auction or to transfer positions unless the price discovery process continues. And the price discovery process cannot continue unless clearing continues.

Some have suggested that a potential solution is to have more than one clearinghouse for each product.

This idea is attractive in theory, but it may be difficult to achieve, particularly in futures. The liquidity is often specific to a particular product at a particular exchange. And even with swaps, which are not tied to a particular platform, market participants may prefer concentrating their activity at a single clearinghouse where they can achieve certain efficiencies.

So I am simply saying that in our contingency planning, we must remember that a clearinghouse is part of a system, and continuity of these key functions is critical.

The Importance of a Robust Clearing Member Industry. Third, and finally, an important part of that system is a robust clearing member industry. Particularly as we discuss recovery and resolution planning with our bank regulator colleagues, we must make sure this is well understood. While there are some parallels, you cannot develop a clearinghouse recovery or resolution plan in the same way as you might for a failing bank.

The importance of a robust clearing member industry is obvious when we think about what happens if there is a default by a clearing member. For example, when firms like Lehman Brothers and MF Global collapsed, clearinghouses were able to run successful auctions and transfer customers’ positions to other FCMs. We must continue to have that ability today.

Therefore we must consider the factors that affect the health of the clearing member industry. Now there are many factors at play here. Time does not permit me to discuss this issue in a complete way, but it is one that is very much on our minds at the CFTC. In particular, I know concerns have been raised—and I have expressed them myself—about the effects of bank capital requirements on clearing. I support having strong capital requirements on banks, but I am concerned about how the supplementary leverage ratio (SLR) measures a clearing member’s exposure arising from cleared derivatives.

I recognize that the bank regulators have devised the SLR as an important backstop, and they are reluctant to modify it. I think that is particularly true when it comes to modifications related to central clearing, for I know they have concerns about the overall risks posed by clearinghouses, and the relationship of clearinghouses to the large financial institutions under their jurisdiction.

I believe the various international and domestic efforts I discussed earlier are a means to work through those issues and address their questions. The challenge, of course, is that it may take some time for these workstreams to be completed. But market forces don’t always wait, and in the meantime the capital requirements may have significant adverse effects on the clearing industry. Instead of a backstop, there is a concern that the requirements are driving business decisions, such as about whether a clearing firm can afford to maintain certain customers, or be in the business at all. And if the clearing member industry becomes weaker, then it may become harder to address the very concerns about clearinghouse resiliency that these workstreams are considering.

I started my speech by talking about the challenge regulators face in having to look backward and address the problems of the past, but still create a framework that works going forward. Our actions affect how markets evolve, and a challenge is to avoid unintended consequences. And I think we need to be mindful of that as we address these very important issues pertaining not only to clearinghouse resiliency but to financial stability generally.

Let me conclude on this note: I have described what I believe will be an intensive focus on clearinghouses over the next year or so. I believe that our financial system will emerge stronger from this work, because I believe that central clearing remains one of the great innovations of modern finance – and that model remains sound. I also believe central clearing and clearinghouses will continue to play the vital role in the development of our markets that they have played for decades. And that is critical, because as regulators, our task should be to not just fix the failures of the past, but to create a framework for the growth and innovation of the future.

Thank you for inviting me today.

Last Updated: November 16, 2015