At an April 25 meeting of the CFTC's Market Risk Advisory Committee, CFTC staff and industry representatives discussed ways to enhance the process used by clearinghouses for managing the default of a clearing member. The discussion centered on a set of recommendations that were developed last year by a subgroup of the advisory committee under the leadership of Susan O'Flynn of Morgan Stanley.
Although the recommendations are not binding on the CFTC or market participants, they are intended to encourage changes in clearinghouse practices and serve as a guide for regulators. CFTC Commissioner Sharon Bowen, who oversees the committee, asked CFTC staff to present a response to the recommendations and assess the progress being made in the areas covered by the recommendations. In addition, the text of recommendations has been updated and expanded, and now includes insight on areas where agreement has not been reached.
The discussion focused on three main topics: improvements in coordination among clearinghouses, the impact of the leverage ratio on the availability of clearing, and concerns about the ability to port customer positions out of a defaulting clearing firm. The discussion also included a briefing from CFTC staff on a joint test of default management procedures at three clearinghouses that is taking place this week.
Progress on Clearinghouse Coordination
Kate Meyer, an associate director in the CFTC's division of clearing and risk, commented that the recommendations are "thoughtful and useful" and noted that some of them have already been achieved. For example, clearinghouses have created a global directory with contact information for decision makers and risk personnel at clearinghouses. In addition, clearinghouses are working together to coordinate the rotation of traders from clearing members to participate in default management drills, a key concern for clearing members.
Meyer also welcomed the recommendation for improving default-related communications to clearing members and customers. She observed that communication during the failure of MF Global was good, but some improvements are needed, particularly with respect to the status of positions held by non-defaulting customers. Sunil Cutinho of CME Clearing commented that this was an important "lesson" from MF Global, and said CME has taken steps to obtain more information about customers so that it can communicate directly with them in case of a default.
Another area of progress is the harmonization of the processes used to auction proprietary positions held by a defaulting clearing member. For example, a working group with representation from 15 clearinghouses has developed uniform terminology for auctions, which will make it easier for participants to understand the rules and conventions. Another example was brought up by Sunil Cutinho of CME and Dale Michaels of OCC. They said CME and OCC are using the same third-party infrastructure for running tests of their auction processes, which reduces the operational burden on participating firms, and they invited other clearinghouses to use that infrastructure.
John Lawton, the acting director of the CFTC's division of clearing and risk, briefed the meeting on another example of cooperation, a joint default exercise involving CME Clearing, Eurex Clearing and LCH.Clearnet that began on April 24. The joint "fire drill" is designed to simulate the default of a single clearing firm that is a member of all three clearinghouses. Lawton said the simulation includes positions in interest rate swaps and equity derivatives and assumes "Brexit-like" conditions for market volatility and liquidity. He said the exercise will test several stages of the default management process, including the implementation of hedges and the auction of the clearing firm's positions. Regulators from the CFTC, the Bank of England, the Bundesbank and Bafin are monitoring the exercise and will analyze the results. (For more information on this exercise, see the FIA Special Report issued in November when it was announced.)
One area identified by the committee as needing further work is the expansion of auctions to include customers as well as clearing members. The recommendations encourage clearinghouses to allow customers to submit bids as a way to improve the auction results. Participants in the meeting expressed support for this idea, but they said that certain conditions and protections, such as the confidentiality of the process and the obligations on bidders, are needed to avoid negative outcomes such as front-running.
Concerns about Porting
Porting was the area of greatest concern for the participants in the discussion. Several participants commented that even though porting did work in the past, they are not certain that it will work going forward. One reason is the introduction of the Basel III leverage ratio, which has made it much more expensive for clearing members to hold customer margin. This has raised a concern that clearing members will pull back on their willingness to take on new business during a period of market stress, and may even reduce their existing business.
Dale Michaels of OCC urged regulators to address this concern to ensure portability in a stressed situation, and noted that some of OCC's members have cut back on providing clearing services because of the capital requirements. This concern is "no longer theoretical," said Michaels. "Even in peace time, clearing members are asking business to leave."
Sebastiaan Koeling of Optiver added that the leverage ratio is reducing the availability of clearing for market makers, which in turn is reducing their ability to provide liquidity. He added that porting will be particularly challenging for options market makers. There are only three clearing firms that have the ability to provide cross-margining for trading firms that make markets in both equities and options, he explained, and if one of these clearing firms were to default, the other two would be unlikely to take on its customers.
Ed Pla of UBS noted that in addition to the leverage ratio, several other factors have come into play since the introduction of mandatory clearing for swaps. These include an increase in the notional amounts being cleared, a decrease in the number of clearing members, and a concentration of market share among clearing firms, especially among the firms that clear swaps. Pla expressed concern about these trends and warned that porting is "very untested in the new regime."
CFTC staffers echoed this concern. Robert Wasserman, chief counsel in the agency's clearing and risk division, commented that when Refco failed in 2005, several FCMs competed for the firm's customer accounts. When Lehman Brothers failed in 2008, only one firm stepped forward to take that firm's customer accounts, and when MF Global failed in 2011, the customer accounts had to be split up among multiple firms. “The trend line has been going in the wrong direction,” he said. "The ability to find homes for customers [has become] much less likely."
The committee's recommendations did not address the leverage ratio, which is determined by banking regulators, but the recommendations did address the potential obstacles to porting created by other regulations, such as "know your customer" requirements. The committee noted that clearing members would have to perform KYC checks on any customers seeking to port their positions from a defaulting clearing firm. This would be not only time consuming but also duplicative to what had been done at the defaulting firm.
The committee recommended that the industry and regulators develop mechanisms to enable clearing members to service customers of a defaulting clearing member on an interim basis, possibly with exemptions or temporary waivers granted by regulators. The committee also recommended that the industry reduce the operational burden of porting by developing "robust and automated porting capabilities" and using these capabilities on a more regular basis.
Click here for a recording of the MRAC meeting
Click here for meeting agenda and other documents
Click here for the updated text of the recommendations
Click here for a list of the members of the MRAC