Concurring Statement of Commissioner Sharon Y. Bowen Regarding Cross-Border Margin Rule

May 25, 2016

Margin and Capital as the Pillars of Market Safety

Margin and capital are two of the most important tools for risk mitigation for the derivatives markets. Thus it is very important that we get our rules on margin and capital right in order to accomplish the reform required under the Dodd-Frank Wall Street Reform and Consumer Protection Act.¹ As many of you know, last December, I voted against the final margin for uncleared swaps rule because I did not believe that it was strong enough to fully protect our system. As I said in December, adequate margin is fundamental to market safety as it is a “critical shock absorber for the bumps and potholes of our financial markets and for the risk of contagion and spillovers.”² I am even more confident in that view today.

Today we vote on a critical supplement to that margin rule.  Specifically, today’s rule would allow registered dealers to substitute the margin rules of comparable jurisdictions for our rules, when dealing with non-US counterparties, under certain conditions. Needless to say, cross-border regulation is central to our margin rule functioning effectively since our markets are global.

I intend to vote yes for this cross-border rule because I want to give the market legal certainty, as the first compliance date for our margin rules, as well as those of regulators across jurisdictions – September 1, 2016 – looms.³ It is important that market participants have enough time to prepare in advance of this date so as to minimize market instability. We also want to minimize the risk of creating regulatory arbitrage across jurisdictions. While my concerns about our margin regime remain, I recognize that there is no opportunity in today’s cross-border margin decision to remedy those errors.

One of the major drawbacks of our margin rulemaking is that it was not done in conjunction with our capital rulemaking. Margin and capital are intertwined – if our margin rule is weak, our capital rule needs to be stronger to compensate. If both are strong, investors and consumers can be confident that we have learned the lessons of the past, and have placed adequate protections in place against future financial instability. But, if both are weak, we have surrendered our best defenses against contagion. We put the interests of our investors at risk when we view regulation in a piecemeal and non-comprehensive fashion, because we are not seeing the whole picture. So, as I vote today on cross-border margin, my mind is on our upcoming capital rule proposal.

Any firm that aspires to be a swap dealer is aspiring to be a significant player in our economy. They must have the capacity to not only stand ready to be the buyer to each seller and the seller to each buyer, but to maintain those positions over years. Their creditworthiness must be above reproach. In that way, market participants, including commercial end-users who need to hedge, can be confident that their dealer will be there during times of stability and crisis. It is therefore critical to the health of our economy that the market trusts, and with good reason, that our dealers are robust and steadfast – that they are able to withstand the financial swings that are endemic to today’s economy. Thus while strong capital rules may prevent some entities from entering the dealing business, they ultimately benefit the dealers, their customers and the whole economy.

In order to create a capital rule that appropriately manages risk for the American people and our critical economy, our capital rule proposal must:

(1) Not Be Weaker than Our Comparable Prudential Regulators’ Rule: The capital proposal, and subsequent final rule, must be as strong as those of the Prudential Regulators. We are required under law to establish minimum capital requirements that are “comparable” to our Prudential Regulator counterparts “to the maximum extent practicable.”⁴ Not only is this our legal obligation, but it is a sensible one as it prevents entities from gaming the system, and organizing their businesses in order to have the lowest capital requirements possible. We do not want our regulatory framework to be an escape hatch from strong risk management.

(2) Account for the Entire Risk to the Dealer: The capital proposal should also require dealers to hold sufficient capital to cover the entirety of the risk posed by the full gamut of derivatives products that they hold – including those products, which, for various reasons, we did not impose a margin requirement, such as inter-affiliate swaps and swaps with financial counterparties that are below the $8 billion threshold. This is consistent with our mandate under law to “take into account the risks associated with other types of swaps or classes of swaps or categories of swaps engaged in and the other activities conducted by that person that are not otherwise subject to regulation ….”⁵ This is an important requirement. The Congressional authors understood that just because a particular category of swaps that a dealer holds are not subject to a regulatory requirement, does not mean that the dealers, and therefore their customers, are not vulnerable to the risk posed by them.

(3) Include Effective Elements of Strong Capital Models: Our capital proposal should take into consideration respected, and effective capital models from other regulators. As of now, we have two well-regarded capital models: the Basel rules for banks, and the Securities and Exchange Commission’s (SEC’s) rule for Broker-Dealers. The Basel rule has many positive attributes – including the fact that it not only has strong capital requirements but also a liquidity, leverage and funding ratio. ⁶ We need look no further than financial companies before the 2008 crisis to understand the need for leverage requirements. For instance, it was estimated that, prior to the crisis, some firms had debt that was 30 to 40 times their net capital.⁷ And we have very present examples of commercial companies that evidence the need for funding requirements.⁸ The SEC’s broker dealer rule also has its positives including that it does not allow for internal models, which came under fire after the crisis for allowing excessive leverage,⁹ and it is liquidity-based such that the dealer is obligated to maintain highly liquid assets to cover its liabilities.¹⁰ Our capital rule proposal should be as strong, if not stronger, than these models.

(4) Address Risks Posed by Swap-Dealing of Non-Financial Companies: Some commercial entities are also registered as swap dealers, and others may decide to do so in the future. Having commercial end-users that are engaging in more than a de minimis amount of swap dealing may increase market risk. Thus it is important that we are able to isolate their swap dealing business from the regular business, so that we can properly track their activities as a dealer.

(5) Be Based on Data-Driven Risk Assessment, Not Industry Preference: As a regulator, anything that we propose needs to be based on our data-driven risk assessment, not on the desire to ensure that all entities that want to be dealers are able to maintain their current business models without any changes. In response to our proposal, market participants are then free to provide data to explain why our risk assessment may be inappropriate and to inform us of the pragmatic restraints. While encouraging more entrants into the market maybe a regulatory goal, doing all we can to prevent the next catastrophic financial crisis that wipes out pensions, is our fundamental goal.

Experience has taught us that comprehensive, well-considered review is critical when considering major regulations. Ten years ago, too many people in industry did not engage in such well-considered review when crafting complicated financial deals.  In the end, that lack of consideration came back to haunt us all when the mortgage bubble burst and unexpectedly exposed many large financial institutions to massive losses that threatened the entire financial system.  In the end, the American public had to save the system at great expense, and the ensuing rescue left many angry, alienated, and disaffected.  Today, nearly eight years later, that anger still exists.  We all pay a great price when we move forward in finance with insufficient analysis and review.

Thus, for the sake of market certainty, I am voting yes to this rule. But I encourage my fellow Commissioners to work with me to develop a strong, comprehensive capital rule so that the American people can have the appropriate safeguards to secure our economy. Thank you.

¹ Pub. L. 111–203, 124 Stat. 1376 (2010).

² http://www.cftc.gov/PressRoom/SpeechesTestimony/bowenstatement121615a

³ “Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,” 81 FR 636, 675 (Jan. 6, 2016).

⁴ Commodity Exchange Act (CEA) 6s(e)(3)(D).

⁵ CEA 6s(e)(2)(C).

⁶ With the exception of the capital charge to the segregated customer funds that have been set aside to secure cleared products. See “Speech of Commissioner Sharon Y. Bowen at George Washington Law, 2016 Manuel F. Cohen Lecture,” Feb. 4, 2016, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opabowen-8.

⁷ E.g., Julie Satow, "Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers,” The New York Sun (September 18, 2008) (“[B]roker dealers … [had] debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1.”), available at http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/; Alan S. Blinder, “Six Errors on the Path to the Financial Crisis,” New York Times (January 25, 2009) (stating that in 2008, securities firms had leverage ratios of “33 to 1”), available at http://www.nytimes.com/2009/01/25/business/economy/25view.html?_r=0.

⁸ Jasmine Ng and David Yong, “Noble Group Gets $3 Billion in Credit Facilities,” Bloomberg.com (May 12, 2016), available at http://www.bloomberg.com/news/articles/2016-05-12/noble-group-agrees-3-billion-credit-facilities-with-lenders. See also Sarah Kent, Scott Patterson, and Margot Patrick, “Glencore Discloses More Details on Financing,” The Wall Street Journal (October 7, 2015), available at http://www.wsj.com/articles/glencore-reveals-financing-deals-to-fend-off-critics-1444137982.

⁹ See supra note 7.

¹⁰ Securities Exchange Act (SEA) Rule 15c3-1.

Last Updated: May 24, 2016