CFTC Divisions Caution Firms on Risks of Extreme Market Volatility

The CFTC Divisions of Market Oversight ("DMO"), Swap Dealer and Intermediary Oversight ("DSIO"), and Clearing and Risk ("DCR") (collectively, the "Divisions") warned regulated entities "to prepare for the possibility that certain contracts may continue to experience extreme market volatility, low liquidity and possibly negative pricing."

In a Staff Advisory on Risk Management and Market Integrity under Current Market Condition, the Divisions encouraged designated contract markets ("DCMs"), futures commission merchants ("FCMs"), and derivatives clearing organizations ("DCOs") "to regularly assess whether their risk controls and related mechanisms are reasonably designed, fit for purpose, and appropriately implemented." The Divisions also urged theses entities to take steps to make their customers aware of the risks.

DCMs

The Divisions advised DCMs to "remain mindful" of their obligations under the CEA Core Principles and various CFTC rules, including:

  • Core Principle 4, which requires a DCM to prevent "manipulation, price distortion, and disruptions of the delivery or cash-settlement process" by mandating market surveillance and compliance, in addition to conducting enforcement practices and procedures;

  • Core Principle 5, which requires a DCM to reduce the risk of market manipulation or congestion by implementing position limitation or position accountability for speculators;

  • Core Principle 6, which requires a DCM to (i) establish rules for the purpose of exercising emergency authority (i.e., having the ability to liquidate or transfer open positions within a contract or to suspend trading within a contract) and (ii) mandate any market participant in a contract to satisfy special margin requirements; and

  • Core Principle 12, which requires a DCM to implement rules that encourage "fair and equitable trading" on the contract market.

FCMs

As to the obligations of FCMs to maintain robust risk management systems, the Divisions emphasized the importance of, as well as their responsibility to:

  • oversee customer accounts to ensure that an FCM is (i) collecting an adequate amount of initial margin and (ii) meeting its obligation to customers by maintaining a sufficient residual (proprietary) interest in customer-segregated accounts to meet its collective customer obligations;

  • examine its risk management programs in order to ensure compliance with CFTC Rules 1.11 ("Risk Management Program for futures commission merchants") and 1.73 ("Clearing futures commission merchant risk management"); and

  • take the necessary steps concerning contracts as they near their expiration date so that both an FCM and its customer can (i) satisfy their respective financial obligations and (ii) fulfill their responsibilities to "make or take deliveries" on futures contracts.

Additionally, the Divisions advised FCMs to refamiliarize clients with the risk disclosure provided under CFTC Rule 1.55 ("Public disclosures by futures commission merchants"). This is a requirement for FCMs prior to opening a futures trading account. Specifically, the Divisions recommended that FCMs remind their clients – as detailed under the disclosure – of the possibility of experiencing losses greater than the amount deposited with an FCM.

DCOs

To successfully meet the requirements concerning risk management programs, the Divisions reminded DCOs of their responsibilities, among others, to (i) employ the appropriate tools and processes necessary to manage the risks associated with discharging DCO responsibilities (e.g., using models to generate initial margin requirements sufficient to cover potential future exposures to clearing members); and (ii) execute back tests on a regular basis for products that are subject to "significant" market volatility, in order to test for compliance of initial margin requirements.

Due to the economic impacts of COVID-19, the Divisions also cautioned DCOs of the potential for contracts to experience both price volatility and negative pricing.

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