CFTC Chair Massad Discusses Ways to Reduce Clearinghouse Risk
Commentary by Bob Zwirb and Steven Lofchie
CFTC Chair Timothy Massad spoke at the Future Industry Association Conference in Boca Raton. In his keynote address, Chair Massad focused on ways the CFTC addresses clearinghouse resiliency.
As clearinghouses become integral to the financial system, Chair Massad stated, the risks they pose to the system overall must be acknowledged and considered by regulators. He highlighted certain "increasing" concerns involving clearinghouses, including (i) assessing the adequacy of recovery plans, (ii) ensuring that clearinghouses have enough capitalization, or "skin in the game," and (iii) addressing whether the potential liability of clearing members is "properly sized or capped."
Ultimately, Chair Massad explained, the CFTC's regulatory goal for clearinghouses is to create a framework that is designed to "strengthen the risk management practices" of derivatives clearing organizations ("DCOs"), "promote financial integrity for swaps and futures markets, and enhance legal certainty for DCOs, clearing members, and market participants." He reported that CFTC regulations for clearinghouses are consistent and current with the Principles for Financial Market Infrastructures ("PFMIs") published by CPMI-IOSCO in 2012.
Chair Massad explained that creating written standards for clearinghouses is a start, but that the CFTC must engage in "extensive" oversight activities – such as daily risk surveillance, analysis of margin models, stress testing, back testing and in-depth compliance examinations – to supervise clearinghouses properly.
Chair Massad went on to stress that regulators must look at the "full picture" when considering issues pertaining to risk mitigation. He stated that capitalization issues for a clearinghouse should be viewed in the context of its overall financial resources, and reasoned that both initial margin and default fund contributions are not enough to cover losses in certain situations. Additionally, he acknowledged that circumstances might arise in which a clearinghouse faces risks beyond that of a default by a clearing member, and regulators have required that clearinghouses maintain capital or other resources sufficient to cover operating costs for one year.
Chair Massad praised the CFTC's clearinghouse policies overall, and noted that more can be done with respect to the frequency of examinations.
See: Chair Massad's Remarks.
Related news: CFTC Plans to Intensify Examinations of CCPs (with Lofchie Comment and Links to Bloomberg News and Streetwise Professor) (September 9, 2014); CFTC Chair Massad Discusses CFTC Cross-Border Priorities (with Lofchie Comment) (March 2, 2015); CFTC Chair Massad Discusses CFTC Priorities (with Lofchie Comment) (February 26, 2015); CFTC Commissioner Wetjen Remarks on CCP Risk-Management Issues (with Lofchie Comment) (December 5, 2014); CME Group Releases White Paper on CCP Issues (with Lofchie Comment) (January 20, 2015); CPMI and IOSCO Issue Report on Recovery of Financial Market Infrastructures (with Lofchie Comment) (October 17, 2014).
Commentary
Hearing a speech in which the Chair of the CFTC states that "[t]he absence of regulation allowed the build-up of excessive risk in the over-the-counter swaps market . . . [which] intensified the crisis [of 2008] and the damage it caused," one wonders whether at some point, a future chair will say, with the benefit of hindsight, that it was the regulatory prescription of a clearing mandate for swaps following the 2008 financial meltdown that "allowed the build-up of excessive risk" in a handful of clearinghouses, which "intensified the crisis [of 2018] and the damage it caused." The problem that will likely confront the CFTC during the next financial crisis might not be what to do when two prominent members of a clearinghouse choose to default, but what happens when more than two or even most of its members suffer a liquidity drain. That risk is akin to the one faced by the financial sector in 2008 in the OTC swaps market, and it is the risk that everyone should be thinking about today with the onset of a mandated system of clearing. Indeed, Chair Massad's statement that, "[a]s we make clearinghouses even more important in the global financial system, we must pay attention to the risks that they can pose" only underscores the problem.
Commentary
The risk that needs more attention is a clearinghouse's demand for more margin in a period of falling prices and declining liquidity – a demand that has the potential to lead to a massive and rapid sell-off of assets. The requirement that clearinghouses maintain sufficient capital to cover one year of operation is trivial in light of the potential cost of the economic risks that flow through a clearinghouse.