Opening Statement of Commissioner Brian D. Quintenz before the CFTC Market Risk Advisory Committee

December 4, 2018

Due to a previously scheduled official overseas trip, I am unable to participate in today’s meeting of the Market Risk Advisory Committee (MRAC).  However, given the importance to me of the issues presented today, specifically around the leverage ratio and incentives to clearing, I would like to provide the following comments.

Incentives to Clearing

I have previously discussed the importance of regulators evaluating the effects of the post-crisis reforms on the global financial system.[1]  Regulators should carefully examine these reforms holistically to see if their cumulative effect is the desired one, if the reforms are calibrated appropriately vis-à-vis each other, and what incentives or disincentives they create.  This is one reason I am very pleased to see a panel devoted to the impact that various global standards—in particular, the leverage ratio—have had on market participants’ incentive to clear.

The Basel Committee on Banking Supervision adopted the leverage ratio as a non-risk based “backstop” to prevent the build-up of excessive leverage in the banking sector and to complement its risk-based capital framework.[2]  Under this approach, banks must hold a certain minimum amount of capital against their aggregate on- and off-balance sheet exposures, regardless of the actual risk profile of their assets.

As a true and remote backstop metric, a blunt regulatory instrument like the leverage ratio can work.  However, as a binding capital constraint, especially on conditional or probabilistic off-balance sheet exposures, a leverage ratio creates many perverse outcomes and is a poor regulatory construct.  When a risk-neutral capital regime becomes a binding constraint, banks are encouraged to divest themselves of lower risk assets with lower returns in favor of riskier assets with higher rates of return.  This is exactly what we are currently seeing with the leverage ratio’s outsized negative impact on clearing and custody services that are the heart of the futures and swaps markets.

The leverage ratio requires a clearing member futures commission merchant (FCM) to include in its leverage calculation the full exposure resulting from its guarantee of a client’s trade, without reducing this exposure by the amount of segregated margin posted by the client, and then counts this margin as a source of leverage against which additional capital should be held.  This thinking ignores the fact that segregated margin will always be used to absorb client losses before the central counterparty (CCP) looks to the clearing member to absorb any residual losses. When margin is segregated, it remains an asset of the customer.  It is only at the disposal of the clearing member FCM under a client default scenario and then can only be used to reduce the resulting exposure to the clearinghouse.[3]  The clearing member cannot use the margin to leverage itself under any circumstance.  As a result, segregated margin is not just risk-free.  It is actually more than risk-free—it is always risk-reducing.  If the goal of the leverage ratio is to calculate the clearing member’s most accurate exposure for a cleared trade, then it should always use the amount of segregated client margin as an offset.

The impact of this is no small matter.  By one estimate, the average leverage exposure of the 14 largest clearing members was 80 percent higher when they were prohibited from using margin as an offset as compared to when offset was permitted.[4]  In a recent study, 72% of client clearing service providers stated that the leverage ratio, as currently implemented, disincentivizes providing client clearing services.[5]  Additionally, over 2/3 of clients responding to the study stated that they faced challenges in obtaining and maintaining access to clearing.[6]  Moreover, 70% of clients who were able to maintain their clearing services agreements stated restrictions have been placed on their cleared derivatives activity[7]

Unless the treatment of client margin changes, I fear we will see FCMs continue to exit the clearing business and the worrisome trend of FCM consolidation will continue.  As of 2017, the top five swaps clearing members controlled up to 75% of the business.[8]  I am pleased that the Basel Committee on Banking Supervision recently requested input regarding whether a revision to the leverage ratio exposure measure for the treatment of client cleared derivatives would be appropriate.[9]  In addition, I applaud the Federal Reserve Board’s recent proposed rule regarding the Standardized Approach for Calculating the Exposure Amount of Derivatives which includes a question regarding the recognition of collateral for cleared transactions for purposes of the supplementary leverage ratio, including how recognition of collateral may affect the cost of clearing services.[10]  I hope that through these consultative processes, the risk-reducing nature of segregated margin can be recognized by domestic and international regulators.

Again, I would like to thank, in absentia, all of today’s participants and the MRAC membership, as well as Commissioner Behnam for organizing this meeting.