SEC Trading and Markets Deputy Revisits Margin Requirements, Central Clearing and Risk Management
Commentary by Steven Lofchie
At an ISDA legal forum in New York, SEC Division of Trading and Markets Deputy Director Gary Barnett examined recent regulatory developments concerning (i) the differences between bank and broker-dealer business models (with particular attention to margin requirements), (ii) mandatory clearing in the area of single-name credit default swaps ("CDS"), and (iii) risk governance that includes the potential liability of corporate directors.
Mr. Barnett discussed the differences between the business models of deposit banks and securities broker-dealers comparing the different funding models of banks and broker-dealers; i.e., short-term deposits versus the overnight markets. Using the current global initiative regarding uncleared derivatives margin requirements as a test case scenario, he questioned whether an initial margin posting-and-collection requirement could have a different impact on firms that are funded by these different models.
Mr. Barnett outlined a variety of factors that the SEC must consider when making a mandatory clearing determination. These included (i) the effect of such a determination on competition, and (ii) "the existence of reasonable legal certainty in the event of the insolvency of the relevant clearing house or one or more of its clearing members."
In response to the idea that the mandatory clearing of certain single-name CDS will increase the liquidity of the single-name CDS market and reduce systemic risk, Mr. Barnett reminded industry members that "sufficient relevant liquidity is important in the course of addressing a clearing member's default." He maintained that "liquidity is an important consideration in the analysis of any mandatory clearing determination."
We all bear the risk if the hoped-for liquidity doesn't materialize by the time it's needed. Also, let us not lose sight of other unintended consequences: in my view, if mandatory clearing is forced into an area where the market is not convinced that the risks can or will be adequately managed – so that the only way to not be at risk is not to play the game – the result could be even less liquidity than where it started from.
Mr. Barnett devoted a portion of his address to risk management, which he described as being largely "about self-interest and self-regulation" at financial institutions. He stated that there had been significant improvement since the financial crisis of 2008, with a "focus on stronger internal audit[s], a more proactive compliance function, a strong [chief compliance officer] or [chief risk officer] with appropriate seniority, independence and reporting line, the risk management of all risks of the business (including legal, operational and technology risks)." As to corporate boards, Mr. Barnett said they "are being pressed to be more active, to own the strategic decisions and direction of the company, including its risk strategy, to oversee management, and to function with independence." He observed that many directors were likely to be unhappy with the increased business demands and regulatory risk of the markets currently, but added that "given the state of things before the crisis, the identified need for improvement and the positions taken by various standard setters and regulatory bodies, all of them being pretty consistent, it's hard to imagine a lasting move back to the past."
Mr. Barnett delivered his remarks before the ISDA Annual Legal Forum in New York.
Commentary
Mr. Barnett's comparison of banking and broker-dealer business models could be interpreted as an implicit challenge to some statements by the Board of Governors of the Federal Reserve and other senior banking regulators, that traditional broker-dealer activities like securities lending should be regulated similarly to bank lending. Mr. Barnett's observations on that subject recall earlier discussions of the differences between banking and securities dealing that were led by former SEC Commissioner Daniel Gallagher. See, e.g., SEC Commissioner Gallagher Criticizes Imposition of Bank Capital Requirements on Broker-Dealers (with Lofchie Comment); see also SEC Commissioner Gallagher Submits Comment Letter in Opposition to FSOC Process (with Lofchie Comment), and SEC Commissioner Gallagher Asserts Serious Flaws in Systemic Risk Designation Process (with Lofchie Comment). Banking regulators should attend to the differences laid out so clearly by Mr. Barnett and previously, by former SEC Commissioner Gallagher. Heeding those distinctions might compel them to reconsider their current direction, which often disregards the differences between banking and securities dealing.
Mr. Barnett stated explicitly a critical concern: central clearing is a "solution" that may result in a much bigger problem. In other words, central clearing might be of some value in highly liquid and deep markets, but it likely will create risks if the government imposes it on markets where trading is not especially liquid; i.e., on nearly all security-based swaps and on the vast majority of the types of swaps that are regulated by the CFTC. The contention that central clearing is useful outside of the largest and most liquid markets, such as those for interest rate swaps, is no longer viable. To the SEC's credit, it has never adopted this pretense.
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