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71–411 PDF 2012

S. HRG. 112–163 

DERIVATIVES CLEARINGHOUSES: OPPORTUNITIES 

AND CHALLENGES 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TWELFTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING THE OPPORTUNITIES AND CHALLENGES OF DERIVATIVES 

CLEARINGHOUSES 

MAY 25, 2011 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

RICHARD C. SHELBY, Alabama 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

DWIGHT FETTIG, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

LEVON BAGRAMIAN, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

JACK REED, Rhode Island, Chairman 

MIKE CRAPO, Idaho, Ranking Republican Member 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

KAY HAGAN, North Carolina 

TIM JOHNSON, South Dakota 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

JERRY MORAN, Kansas 

ROGER F. WICKER, Mississippi 

KARA STEIN, Subcommittee Staff Director 

GREGG RICHARD, Republican Subcommittee Staff Director 

(II)

C O N T E N T S 

WEDNESDAY, MAY 25, 2011 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Toomey ................................................................................................ 2 

Senator Crapo ................................................................................................... 3 

WITNESSES 

Christopher Edmonds, President, ICE Trust ........................................................ 5 

Prepared statement .......................................................................................... 37 

Responses to written questions of: 

Chairman Reed .......................................................................................... 61 

Terrence A. Duffy, Executive Chairman, CME Group Inc. .................................. 6 

Prepared statement .......................................................................................... 39 

Benn Steil, Senior Fellow and Director of International Economics, Council 

on Foreign Relations ............................................................................................ 19 

Prepared statement .......................................................................................... 46 

Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of Finance, 

Tepper School of Business, Carnegie Mellon University .................................. 21 

Prepared statement .......................................................................................... 49 

Clifford Lewis, Executive Vice President, State Street Global Markets ............. 23 

Prepared statement .......................................................................................... 52 

Don Thompson, Managing Director and Associate General Counsel, JPMorgan 

Chase & Co. .......................................................................................................... 24 

Prepared statement .......................................................................................... 53 

James Cawley, Cofounder, Swaps and Derivatives Market Association ............ 25 

Prepared statement .......................................................................................... 59 

Responses to written questions of: 

Chairman Reed .......................................................................................... 71 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter submitted by Thomas C. Deas, Jr., Vice President and Treasurer, 

FMC Corporation ................................................................................................. 113 

(III)

(1) 

DERIVATIVES CLEARINGHOUSES: 

OPPORTUNITIES AND CHALLENGES 

WEDNESDAY, MAY 25, 2011 

U.S. SENATE, 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND

INVESTMENT, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met at 9:35 a.m., in room SD–538, Dirksen 

Senate Office Building, Hon. Jack Reed, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. Let me call the hearing to order, and I want to 

welcome everyone to the hearing this morning on ‘‘Derivatives 

Clearinghouses: Opportunities and Challenges.’’ The financial crisis 

revealed some significant weaknesses in our financial sector, and 

one of the most problematic was the over-the-counter derivatives 

market. Derivatives contracts involve the transfer of risk from one 

party to another. 

The total notational value of over-the-counter derivatives outstanding at year end increased 645 percent from 1998 to 2008, a 

significant increase. Looking at it another way, back in 1998 and 

1999, derivatives were a relatively small part of the market, but by 

2008 they were a huge and continue to be a huge part of the market. 

According to the Bank of International Settlements, in December 31, 2010, the total notional amount outstanding was $601 trillion 

with a market value of $21 trillion, so there are huge potential benefits or dangers to the financial system. 

The sheer number and amount of over-the-counter derivatives 

transactions which were not regulated by the SEC or CFTC proved 

to be an accelerant during the financial crisis. Uncollateralized 

losses built up. By September 2008, one of the world’s largest insurers, AIG, was on the verge of bankruptcy, triggered by its tremendous investment in credit default swaps. AIG had agreed to 

pay counterparties in its derivatives transactions if certain credit 

events occurred. A series of market events required AIG to post billions in collateral—collateral it did not have. The imminent default 

of AIG would have cascaded throughout the U.S. economy, encompassing private companies, local and State governments, and retirement plans. Accordingly, the Government provided hundreds of 

billions of dollars in extraordinary relief to AIG, most of which was 

2 

paid to AIG counterparties. American taxpayers were exposed to 

billions of dollars in potential losses. 

As a result of that incident, and others, the Dodd-Frank Wall 

Street Reform and Consumer Protection Act of 2010 developed new 

rules for the over-the-counter derivatives market to insulate both 

the U.S. economy and the American taxpayer from any future extraordinary losses in this area. The new rules of the road require 

the use of centralized derivatives clearing organizations, or clearinghouses. Clearinghouses are not a new invention. They have been 

a part of financial transactions for a long time, dating back to European coffee and grain exchanges of the late 19th century and in 

the United States the 1883 creation of the Chicago Board of Trade 

and the futures market. It later became the Board of Trade Clearing Corporation and serves as the counterparty in all transactions 

on the exchange. 

Clearinghouses place themselves in the middle of transactions, 

reducing counterparty risk by mutualizing exposure. Clearinghouses transact business with clearinghouse members, and customer losses are absorbed by these members. Clearinghouses deal 

with risk by constantly evaluating and requiring the posting of 

margin or collateral as insurance. 

In the deficiency Wall Street Reform Act, the mandate to creating clear standardized derivatives is the foundation upon which 

a more transparent and competitive swaps market may begin to 

flourish. Clearinghouses and swap execution facilities, SEFs, 

should allow for better price discovery, more efficient allocation of 

capital, and a healthier and more resilient derivatives sector. 

The purpose of this hearing is to examine both the opportunities 

and challenges posed by a marketplace dependent upon clearinghouses. 

How do we ensure that the clearinghouses themselves do not become significant risks to our economy? What issues affect their 

safety and soundness? What are the best practices of structuring, 

governing, and controlling derivatives clearinghouses? How do we 

minimize conflicts of interest? What barriers to clearinghouse 

membership or services exist? 

All of us have a vested interest in making sure these new derivatives clearinghouses function safely and fairly, and we know from 

past experience that market players are concerned principally with 

their own positions and do not always think of the market as a 

whole when they recommend what the new rules of the road should 

be. Hopefully our hearing this morning will be focused and help everyone focus on the bigger issue: making sure that these risks do 

not again overflow onto the American taxpayer. 

I look forward to hearing from all of our witnesses this morning 

on these issues. 

Before I introduce our first panel, I would like to recognize Senator Toomey, if he has any comments, and then our other colleagues. 

STATEMENT OF SENATOR PATRICK J. TOOMEY 

Senator TOOMEY. Thank you very much, Mr. Chairman, and 

thank you for deciding to do this hearing. I think this is a very imVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
3 

portant topic. I want to thank the witnesses for being here. I will 

just make a brief observation. 

I might be the only former derivatives trader on this panel—on 

this side, anyway—and as such, I just want to observe that with 

the obvious and very significant exception of AIG, I think the reality of the derivatives market during the financial crisis was that 

both the OTC derivatives market and the exchange-traded derivatives actually for the most part functioned extremely well. They 

both have played an enormously important role in allowing financial and nonfinancial institutions to manage risk, and as such, the 

evolution of derivatives since I was involved in this industry back 

in the 1980s to more recent days has been enormously constructive 

for our economy, for the allocation of capital, and for the management of risk. 

We have now decided, for better or for worse, that all over-thecounter derivatives—or I should say most over-the-counter derivatives are going to be cleared and executed through exchanges going 

forward. And I just think it is very, very important that we do this 

in a very cautious fashion, that we have—this is a very complex 

process. It has enormous implications, and I just hope that we will 

do this in a very thoughtful, careful, and I would say, in terms of 

the implementation of these regulations, Mr. Chairman, I think it 

is very important that we do this sequentially rather than trying 

to do this all at once because the sheer volume of regulations is 

staggering. And in addition to doing it sequentially, I think it is 

important that we do it over a period of time that is long enough 

for us to work out the kinks and to allow the market participants 

to adjust to this very, very new regulatory environment. 

I am confident we can do that. I think it is necessary that we 

take that approach so that the tremendous benefits to the economy 

from these tools do not get eroded. 

Thank you very much, Mr. Chairman. 

Chairman REED. Thanks, Senator Toomey. 

Before I recognize Senator Moran, the Ranking Member has arrived, and I would like to recognize Senator Crapo. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Well, thank you, Senator Reed. I apologize. I got 

hung up, and I appreciate you going ahead and not waiting. I 

apologize for any inconvenience. 

Federal Reserve Chairman Ben Bernanke’s speech in April provides a good perspective, I think, on both the opportunities and the 

challenges of clearing. He said, ‘‘ . . . by centralizing and standardizing specific classes of financial transactions, clearinghouses reduce the costs and operational risks of clearing and settlement 

among multiple market participants . . . . However, the flip side 

of the centralization of clearing and settlement activities in clearinghouses is the concentration of substantial financial and operational risk in a small number of organizations, a development 

with potentially important systemic implications.’’ 

In formulating clearinghouse regulations and conducting oversight, regulators need to fully understand the complexity, the interconnectedness, and the potential for systemic risk for clearinghouses. The decisions that regulators and clearinghouses make reVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
4 

garding risk management will have significant implications for the 

soundness of our financial system. 

It is important that the regulators and the market participants 

look carefully at both the individual proposed rules and how the 

overall interaction of all the proposed regulations designed by the 

different regulators either fit together or cause unintended consequences. This is not a simple task, and I would encourage the 

regulators to take the necessary time to get the rules right by incorporating the meaningful public comments and economic analysis 

in their proposed rules. 

I remain concerned that the mandatory clearing requirement 

could force clearinghouses to take on risk that is not adequately 

understood or managed. Some of the international regulators have 

indicated a preference that derivatives denominated in their respective countries or traded by entities subject to their authority be 

cleared via clearinghouses in their respective jurisdictions. 

What kind of systemic risks and regulatory challenges does this 

create? American manufacturing companies, energy producers, and 

farming groups, otherwise known as end users, have testified before Congress that if they were required to clear their over-thecounter risk management transactions, they would lose the benefits 

of customization, and the cost to them of cash collateralization 

would be much more significant and in some cases insurmountable. 

At this point the regulators continue to send mixed signals on 

how end users will be treated. Our witnesses today will provide a 

broad spectrum of views on these and other issues, and I appreciate their time and thoughtfulness in answering these questions. 

And, again, Mr. Chairman, I appreciate your holding this hearing 

today. 

Chairman REED. Thank you very much, Senator Crapo. 

Senator Moran. 

Senator MORAN. Chairman Reed, thank you very much. I have 

no opening statement. I am interested in hearing what our witnesses have to say. I have a 10 o’clock Financial Services and General Government Subcommittee on a similar topic, and I will be departing shortly. 

Chairman REED. Thank you very much, Senator. 

I think just to reinforce what both Senator Crapo and Senator 

Toomey said, this is an opportunity and a challenge in terms of getting this right. I think we want to have it done right. That is why 

we are having this hearing and will have other hearings because 

we have to listen to industry experts and experts from academia 

and from other areas. And I suspect after this hearing we will have 

more questions, and we will have other hearings, but I think we 

have to get it right. I concur. 

Let me just say that all the testimony of the witnesses will be 

made, without objection, part of the record, so there is no need to 

read every word. If you would like to summarize or abridge in any 

way, please feel free to do that. Your testimony will be part of the 

record. Let me introduce the first panel. 

Chris Edmonds is president of the ICE Trust, the wholly owned 

credit default swap clearinghouse of international exchange. Mr. 

Edmonds was named to his post in February 2010. As president of 

ICE Trust, Mr. Edmonds oversees ICE’s U.S. credit derivatives 

5 

clearing operations. Prior to joining ICE, Mr. Edmonds was chief 

executive officer of the International Derivatives Exchange Group, 

LLC, a clearinghouse for interest rate swaps. 

Terrence Duffy has served as the executive chairman of CME 

Group since 2006 when he first became an officer of CME. Previous 

to his current position, he served as chairman of the CME Board 

from 2002 to 2006 and as vice chairman from 1998 to 2002. He also 

has been president of TDA Trading Incorporated since 1981. 

Mr. Edmonds, you may begin. 

STATEMENT OF CHRISTOPHER EDMONDS, PRESIDENT, ICE 

TRUST 

Mr. EDMONDS. Chairman Reed, Ranking Member Crapo, I am 

Chris Edmonds, president of ICE Trust, a limited purpose New 

York bank operating as a clearinghouse for credit default swaps. I 

very much appreciate the opportunity to appear before you today 

to testify on clearing over-the-counter derivatives. 

As background, ICE Trust serves as the leading U.S. clearing- house for credit default swaps, having cleared approximately $11 

trillion in gross notional value since March 9, 2009. Globally, ICE 

Trust and our European counterpart have cleared more than $18 

trillion in CDS since the financial crisis. 

ICE’s experience in energy and credit derivatives demonstrates 

that when clearing is offered to a market, the market overwhelmingly chooses to clear its products. Over the next few months, the 

mandatory clearing and trading provisions of Dodd-Frank should 

take effect, and market participants will be forced to clear over-thecounter derivatives as a matter of law. 

While ICE supports the clearing principles of Dodd-Frank, we respectfully submit that the regulators responsible for determining 

which contracts must be cleared should consider any mandate carefully. ICE believes the best path to meet this goal is to allow clearinghouses and market participants to find the best way to clear 

markets within defined principles, as opposed to promulgating prescriptive rules. In addition, regulators should make certain unnecessary regulatory hurdles and other impediments are removed. 

For example, one key regulatory hurdle to clearing is cooperation 

between regulators. Many over-the-counter derivatives, especially 

credit default swaps, have characteristics of securities and commodities. Close regulatory cooperation between the CFTC and the 

SEC is necessary, and required by law, in order to make sure that 

market participants have legal certainty, including bankruptcy certainty. This is particularly important in regards to portfolio margining allowing security-based and commodity-based derivatives to 

be held in the same account and margined in a holistic manner and 

subject to a single bankruptcy regime. Historically, the CFTC and 

SEC have had little success creating portfolio margining. Without 

portfolio margining relief for CDS specifically, the unintended regulatory divide will create significant and noticeable setbacks for the 

implementation of Dodd-Frank. 

Appropriate regulation of clearinghouses is of utmost importance 

to the financial system. Pursuant to Dodd-Frank, clearinghouses 

will be a key part of the efforts to decrease systemic risk in the derivatives markets. In overseeing clearinghouses, regulators must be 

6 

prudential, understanding their markets, and tailoring regulation 

to ensure market integrity and consumer protection. 

It is also vital to recognize that the over-the-counter derivatives 

markets are global. The U.S. regulators must work within international regulators from a common set of regulatory principles. 

Dodd-Frank has created significant uncertainty over whether a 

transaction will be subject to U.S. regulation or foreign regulation. 

This lack of clarity may begin to have an impact on markets, reducing liquidity and hampering regulatory reform efforts because 

market participants are unsure which laws apply. Therefore, harmonizing regulatory systems across geographies and giving market 

participants clarity is of utmost importance. 

Earlier this month, the CFTC and SEC held a roundtable to hear 

views on the implementation of Dodd-Frank. As the CFTC and 

SEC have come to realize, the legislation cannot take effect all at 

once. 

ICE believes that regulators should pursue an aggressive timetable to implement most sections of Dodd-Frank as soon as possible. While Dodd-Frank requires an enormous effort from both 

market participants and regulators, the cost of uncertainty is much 

greater. ICE has suggested to regulators that they pursue a phased 

implementation plan. This approach has broad-based support from 

market participants and should motivate quicker adoption by the 

industry. 

Flexibility is central to meeting the implementation goals. Regulators have an immense burden to implement Dodd-Frank, but creating a one-size-fits-all prescriptive system of regulations will only 

increase the burden as regulators will be required to constantly 

consider exemptions for markets that do not quite fit the proposed 

model. 

Likewise, market participants will have an easier time meeting 

implementation goals if they have the freedom to meet the goals 

of Dodd-Frank without radically modifying their operations to meet 

prescriptive rules. 

Mr. Chairman, thank you again for the opportunity to share our 

views with you. I would be happy to answer any questions you or 

this Committee may have. 

Chairman REED. Thank you. 

Mr. Duffy. 

STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, 

CME GROUP INC. 

Mr. DUFFY. Chairman Reed, Ranking Member Crapo, Members 

of the Subcommittee, I am Terry Duffy, executive chairman of 

CME Group, which includes our clearinghouse and four exchanges: 

the CME, the CBOT, NYMEX, and COMEX. 

The clearing mandate for OTC swaps should be staged in measured steps. The Committee asked five important questions that deserve direct answers. 

First, the safety and soundness of clearinghouses is a major focus 

of Dodd-Frank. The core principles compel clearinghouses to have 

adequate financial resources, comprehensive risk management procedures, and safeguards against system failures. In addition, DoddFrank includes eight core principles dealing with the safety and 

7 

soundness of clearinghouses. The CFTC is authorized to bring a 

clearinghouse into compliance. However, the CFTC’s proposed new 

rules are so rigid that many impair the flexibility necessary to preserve the safety and soundness of clearinghouses. Indeed, the 

CFTC’s proposed rules governing systemically important clearinghouses increase this systemic risk. 

Regarding the second question, swaps clearing and futures clearing are variations on the same theme. If a swaps contract and a 

futures contract have similar volatility and trade in a mature liquid market, the considerations for clearing the contracts are identical. This should be the case for major plain-vanilla swaps. Thinly 

traded swaps present more difficult problems. Our clearinghouse 

aims to overcome these problems through its admission and risk 

management processes. 

The third question in regards to unique attributes of certain 

asset classes that should be highlighted, the key to safety and 

soundness is risk management based on volatility, liquidity, and 

other characteristics of the market for a swap in a normal and 

stressed circumstance. Futures on U.S. debt and eurodollars are 

easy to liquidate in the event of a default. The same should hold 

true for interest rate swaps based on U.S., UK, and European 

Union instruments. 

As we look at the fourth question, the CFTC should hold off implementing the proposed rules respecting ownership, governance, 

and control of clearinghouses. They can and should wait until there 

is evidence that specific limitations in Dodd-Frank do not adequately control the potential problem. 

The core principles for clearinghouses provide ample protections 

against potential conflicts of interest. They are clear, comprehensive, and easily enforced by the Commission as needed. Section 5(b) 

of the Commodity Exchange Act specifically ensures fairness respecting participant and product eligibility, appropriate governance 

and fitness standards, prevention of conflicts of interest, and appropriate composition of governing boards. Dodd-Frank’s core principles, coupled with CFTC’s enhanced enforcement powers, are sufficient to guard against conflicts of interest. 

The fifth question, end users of swaps with sufficient credit and 

resources to enter into a swap will experience no barrier to clearing 

under Dodd-Frank. A firm that seeks to act as a clearing member 

of a swaps clearinghouse must meet the operational and financial 

requirements of that clearinghouse. These requirements should be 

set sufficiently high to meet the clearinghouse’s obligations under 

Dodd-Frank’s core principles for DCOs. 

Dodd-Frank’s requirements regarding safety and soundness modify a clearinghouse’s obligation to grant open access to any potential clearing member. The issues of managing a default involving 

immature or illiquid swaps contracts require higher admission 

standards than those for a futures clearinghouse. 

I appreciate the time this morning. I look forward to answering 

your questions. 

Chairman REED. Thank you very much, gentlemen, for both of 

your excellent testimonies. 

We are all concerned about safety and soundness. I think that 

is a point of departure. We do not want to create a structure in reVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
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sponse to a financial crisis that could precipitate another financial 

crisis if it is not handled well, so that is the starting point. 

But there are some other aspects, too, in terms of the overall 

scheme of Dodd-Frank. The notion was to pull as many possible derivatives onto, first, a clearing platform, and then within the authority of Dodd-Frank, the regulators could direct that the standardized products—some could be specifically or should be traded. 

So there is that progression to a trading platform. 

But both of you have alluded to the issue of potential conflicts 

of interest in bringing particular products on to the clearing platform. Right now over-the-counter derivatives are a very lucrative 

business, specialized derivatives, and there have been at least 

questions raised about whether there are proper incentives, proper 

rules so that the maximum number of derivatives products will be 

cleared; i.e., people making the decisions have an incentive perhaps 

to keep things off because there is a more lucrative product over 

the counter rather than a clearing platform and a trading platform. 

Both gentlemen, Mr. Edmonds and Mr. Duffy, can you address 

this issue of how do you ensure that there is the fullest possible 

universe of products being cleared? 

Mr. EDMONDS. Mr. Chairman, I believe the way to answer that 

question is these are points-in-time conversations. The standardization of the credit default swap market, for example, has been an 

evolution going on for, you know, we will call it 10 years or so to 

get to the standardization product set that you put in there, investment grade pieces of an index, the investment grade single names, 

and then there is a whole list of other names that we may want 

to clear in the future that at the end of the day do not lend themselves to clearing based on the current tool sets that are available 

to clearinghouses. 

If you ask me the question of where we are going to start, we 

have done a lot to get started in that direction. Where we go is all 

about innovation and competition between, you know, the different 

service providers that act in those markets. I am certain that, you 

know, every day those that Mr. Duffy and I compete with are looking for new ways to bring something else to the clearing which will 

require us to respond, and the same thing happens to Mr. Duffy 

on other products that they have a dominant market share in at 

this point in time. 

So for us, this is about what do we need to get the most systemic 

risk out of the gate to begin with. If you look at the creation of ICE 

Trust back in the fall of 2008 and in the first quarter of 2009, the 

products that represented the most liquidity, the most systemic 

risk, we were trying to put in the clearinghouse impacting the most 

active market participants at that point in time. Things will evolve, 

and we will manage that evolution through commercial reasons because it is good for our shareholders and good for our business. 

Chairman REED. Well, one of the aspects particular with ICE is 

that the owners—that might not be the most precise term—are 

also the broker-dealer banks generally, and they have, I would 

think, conflicting incentives. One is to get standardization products 

onto your platform, but also to keep lucrative over-the-counter 

products in their own trading, which does not have to be cleared. 

And that is a tension that would not exist if your organization was 

9 

composed not of the broker-dealer banks but of other financial entities if it was a truly independent entity. 

Does that sort of compound or complicate your specific dilemma? 

Mr. EDMONDS. Well, I want to take issue with who the owners 

are, and we are a wholly owned subsidiary of a publicly traded 

company, so there are all sorts of rules and regulations around, you 

know, who owns what. I mean, certainly we have a partnership 

with our membership, not dissimilar to any other clearinghouse 

that operates in the United States or, for that matter, around the 

globe. There are only 120-plus or so entities registered with the 

CFTC that can be a clearing member. We started with nine. We 

are up to 15. We continue to grow that, and make no mistake, we 

want as many of those clearing members as we possibly can. 

That does not mean all of those clearing members actually use 

the product that we offer. Some will over time. Some will make the 

decision to make the investment to enter these markets as time 

progresses. Some have not made that decision today. Others are 

being opportunistic, seeing that the opportunity represented by the 

changes with regard to Dodd-Frank are the time for them to make 

that investment and come that direction. 

You know, we are completely open access. Our rule book has said 

we are open access from day one. You provide us with two matched 

trades an accountants gets, we clear and reduce the systemic risk 

associated with that. 

So, you know, I appreciate the point. I think you will have an 

opportunity on the second panel to ask folks what motivates them 

of what they want to keep cleared versus noncleared. From the 

commercial aspects of ICE Trust, we absolutely are incentivized to 

clear as much as we possibly can, both in product and the number 

of times that product is cleared. 

Chairman REED. Mr. Duffy. 

Mr. DUFFY. Well, there are a couple questions I would like to answer for you, sir, on what should be cleared and what should not 

be cleared. The plain-vanilla swaps that are being traded today 

over the counter are obviously prepared to be cleared, so my colleague over here has already demonstrated some of the numbers 

that they have done in the credit market. The interest rate market 

is obviously much easier to even clear. So some of those plain-vanilla swaps are prepared to be cleared. 

Some of the illiquid products or the products that Senator Crapo 

had mentioned that are really some of the issues that we have, and 

I’m sure ICE also. If we today are going to collect 5 days’ margin 

for some of these products that we are going to have in our clearinghouse, that might not even be the tip of the iceberg for some of 

these illiquid products. So you just cannot bring them into clearing 

to blow up the whole system. 

So we do a very rigorous risk management system, so we think 

that bringing the plain-vanilla swaps in first—and as it relates to 

what some have alleged is a cartel or whatever you want to call 

the banks in these clearinghouses, I think you are not giving the 

customer enough sophistication here. When these products become 

more vanilla-like, they want more transparency associated with 

them. They will demand that that happen with that product. It is 

really the illiquid products that are not conducive for clearing 

10 

today. So I do not think anybody is trying to hold them out from 

clearing. I think if the customer, when they trade them, they know 

what is being traded. The more that is being traded, they want to 

make certain that they are getting the best possible price also. And 

the only way they can do that is to seed the market. 

So I do think there is an incentive for the clearinghouses and the 

owners of those clearinghouses to bring them in as they see fit. 

Chairman REED. Just one other point. Sometimes the complexity 

of these products is such that the customer, even sophisticated customers, are not quite sure what their best choice is, and many 

times the information or the structuring is being done not by the 

customer but by the broker-dealer or the financial institution. 

Again, I guess the heart of this question is, Is there real sort of 

pressure by the market and by you to demand more simplified 

products that can, in fact, be usually identified by customers and 

preferred by customers? Is that—— 

Mr. EDMONDS. The simple answer to that is yes. The more standard we can make the products, the easier it is for those products 

to move into the systems. I mean, there are other service providers 

that link up to our clearinghouse, both for Mr. Duffy and myself, 

that they have a responsibility to take this information to perform 

analytics on this information and to take it downstream to the 

other user base, the folks you are talking about that need access 

to this. 

The more simplified we can make those standards, the easier it 

is for them to more quickly adopt those types of instruments and 

put them into the supported category. When they are in the supported category, we have the opportunity to realize our commercial 

interest and generate more revenue from that. So certainly the interests are aligned from that perspective. 

Chairman REED. Thank you very much. Thank you. 

Senator Crapo, please. 

Senator CRAPO. Thank you, Mr. Chairman, and Mr. Edmonds 

and Mr. Duffy, I appreciate you being here. 

I want to focus my questions on the end user issue. Frankly, as 

I try to navigate what the regulators are saying with regard to end 

users, I am not sure that I understand exactly what the proposal 

on the table is as to how we will treat end users. So my first question to you is, how do you understand the treatment of end users 

under what we see now from the various proposed rules? 

Mr. DUFFY. My understanding, Senator, is that any nonfinancial 

party would be considered an end user and thus exempt from the 

clearing mandate. So, example, IBM, a company like that, would 

be exempt from the clearing mandate. If they make the trade, obviously, with a dealer, both parties are exempt because you cannot 

put one side of the trade into the clearinghouse and leave the other 

side out, so it would leave an unbalanced book. My understanding 

is anybody that is nonfinancial is exempt in the end user category. 

Senator CRAPO. Mr. Edmonds, is that your understanding, as 

well? 

Mr. EDMONDS. That would be my understanding. I would add to 

that, there are some requirements in there for those types of transactions Mr. Duffy—— 

Senator CRAPO. Like the margin requirements? 

11 

Mr. EDMONDS. You would have margin requirements between the 

broker-dealer and the end user. So the cost to the end user still has 

an upward trend under that model. 

Senator CRAPO. And with regard to the margin requirements, is 

it clear to you what that is among the various regulators in the 

proposals we have out today? In other words—— 

Mr. EDMONDS. I do not think we have enough clarify of what direction they are headed. I mean, there have been some conversations at this point in time as it relates to, you know, it cannot be 

any less than what a similar product on the clearinghouse or some 

benchmark that the regulators could look to to begin establishing 

those, but I do not think that we have gotten to a point where it 

is final enough for people to do the cost-benefit analysis yet. 

Senator CRAPO. So if I were to look at two of the important 

issues related to end users, one, their ability to have a customized 

product, and two, the impact of margin requirements, would you 

say that you feel that there is adequate protection for those who 

need a customized product, that they would not be subject to the 

requirement? 

Mr. DUFFY. That would be my understanding of the way the law 

reads, sir. 

Senator CRAPO. So, then, the real question would be, what is the 

impact of the margin requirements, whatever they may be, on this 

portion of our market. Is that a fair question? 

Mr. EDMONDS. I do not see any way that it cannot increase the 

cost of trade. 

Mr. DUFFY. Well, I would also suggest that even though they 

would be exempt from the margin requirements under the end user 

exemption, there are still capital requirements they have to face 

with the broker-dealer that could be simply called something else, 

such as margin. So it may be that they are pledging their cornfields instead of capital or cash for margin, but they are still putting up something on behalf of those transactions. 

Senator CRAPO. And you would agree, also, Mr. Duffy, though, 

that it will undoubtedly drive up the cost of these transactions? 

Mr. DUFFY. I do not know if margin will drive up the cost of 

these transactions, only because I have looked at the growth in the 

futures business that has had margin with it historically and we 

have been able to grow at 20-some-odd percent year over year for 

the last 40 years, 35 years now, and people have participated in 

the marketplace, been able to do risk management just fine with 

the margin requirements that we have in place today. 

Senator CRAPO. Mr. Edmonds, would you—— 

Mr. EDMONDS. I would agree with Mr. Duffy on the growth of the 

futures market. The difference here is, these same types of customized transactions are happening today and this margin is not 

being collected. So at least there is a time value of money associated with the collateral they are going to have to post in some form 

or fashion, or the lien they are going to put on the cornfield or 

whatever that is going to put in there. There is an intrinsic cost, 

whether it is the drafting of a legal agreement, the execution of 

that legal agreement, you know, the lien and things that you need 

in order do that. So while they may not be a direct cost as the picture that Mr. Duffy wants to paint, there is going to be some inVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
12 

trinsic cost associated with just managing the additional requirements that are forthcoming. 

Senator CRAPO. It seems to me that that is going to be a significant impact on capital formation in these companies, that at least 

a lot of them are claiming this to be the case. Do you believe that 

this increased cost that you see, Mr. Edmonds, would increase safety or soundness of the transactions over the current status quo? 

Mr. EDMONDS. Just to clarify the question, for the end user or 

for the market as a whole? 

Senator CRAPO. I would say for the market as a whole. 

Mr. EDMONDS. Certainly, more collateralized positions have a 

safety benefit and a soundness benefit associated with that. I 

mean, if you take the earlier comments by the Chairman as it related to AIG and the developments we experienced there, that was 

a market that was under-collateralized, or not collateralized at all 

in some cases, and they were very customized products, that at 

some point in time had collateral been associated with those positions and there had been an adequate mark-to-market based of 

those positions based on the collateral on hand, we would have 

seen the difficulties being perpetrated by those positions sooner. 

Senator CRAPO. I understand that. I guess the way I am looking 

at this, though, I can understand that if you were to require 100 

percent collateral for every transaction, you would certainly increase safety and soundness of the overall market for those transactions. You might not be increasing it in incrementally justifiable 

levels by doing so. And those in the end user community often disagree with being lumped in with the AIG situation, claiming that 

their industries and their markets had nothing to do with the crisis 

we faced and that the safety and soundness issues that we are 

seeking to solve there simply do not exist, or to any significant 

level, in their markets. How would you address that? 

Mr. DUFFY. Well, I would agree with that, and I think that the 

end users have put on a very good case why they should have exemptions to the Dodd-Frank Act, and I think, obviously, they are 

getting them. Our position at CME has been from the beginning, 

for the last several years, we never believed that there should be 

a mandatory clearing component to Dodd-Frank. We thought there 

should be capital incentives for clearing and then a different capital charge for noncleared products. So we never supported it. But 

the law is what the law is today and we are dealing with it. 

So I think that the end users being carved out the way they are, 

they have done a good job putting their case forward and they deserve the exemption. They did not cause it, I agree with that, nor 

did the futures industry cause this problem. We had a housing bubble and under-capitalized credit default swaps. 

Senator CRAPO. Thank you. Mr. Edmonds, do you want to say 

anything before—— 

Mr. EDMONDS. The only thing I would say to that is to do the 

cost-benefit analysis, Senator, you are looking for, I think the rules 

around margin need to come out. 

Senator CRAPO. Thank you. I appreciate that observation. 

Chairman REED. Senator Merkley. 

Senator MERKLEY. Thank you, Mr. Chair, and thank you all for 

your testimony. 

13 

Mr. Duffy, in your testimony, you noted that the futures market 

performed flawlessly during the financial crisis, and I was wondering if you could take and expand on what went right and what 

insights that might give us in seeking to regulate the rest of the 

derivatives markets. 

Mr. DUFFY. And again, the futures market is different from the 

OTC market. The plain vanilla swaps are closer to the futures market. Some of the products that got us in trouble are these illiquid 

products that even a clearinghouse today would not be able to risk 

manage during the crisis. 

So we were able to function flawlessly during the crisis because 

of a couple things that we have deployed for over 100 years, and 

that is to do risk management on a real-time basis. So we make 

certain that the people who are losing money put up the money. 

The people who are ahead in the market receive that money. So we 

would go back and forth all day long at a zero sum outcome, and 

I think that is very important when you have this type of notional 

values going back and forth in both futures markets and over-thecounter markets. So that is why we operated flawlessly, because 

the risk management discipline that we have put into our company 

over the last 100-plus years. 

Again, I do not know if that would have stopped the crisis, sir, 

of 2008, because the problem, as I said earlier, was not futures 

markets. It was not plain vanilla swaps. It was illiquid swaps. It 

was illiquid credit default swaps. It was under-collateralized swaps 

in a bubble in some other markets. 

Senator MERKLEY. My colleague was asking about kind of the 

impacts on capital formation and putting up margins. I was reading in this article, the CEO of Robinson Oil who noted that when 

he uses derivatives like swaps and options to create fixed plans, he 

just has no idea how much lower his prices possibly should be because the fees are not disclosed, there is not a clearing function. 

And he says, quote, ‘‘At the end of the day, I do not know if I got 

a fair price or really what they are charging me.’’ How does one 

tradeoff kind of understanding essentially the efficiencies of an 

open competitive market in providing derivatives risk management, if you will, at a lower price, versus the issues of capital formation margins that was being raised by my colleague? 

Mr. DUFFY. I think the gentleman that asked the question has 

a very good question because it is very hard to distinguish what 

the costs are when you are doing an over-the-counter transaction 

such as that. On a regulated futures exchange, it is completely 

transparent. All the fees and everything are seen up front so you 

know exactly what you are doing ahead of time. 

So in our world, sir, he would not have that same question. And 

I cannot answer the question in the over-the-counter only because 

there has been a lack of transparency in these markets. 

Senator MERKLEY. OK, great. Anything you would like to add, 

Mr. Edmonds? OK. 

Chairman REED. Senator Toomey. 

Senator TOOMEY. Thank you very much, Mr. Chairman. 

A couple of things I just wanted to follow up on from the previous questions. One, would it be fair to say that—and Mr. Duffy 

in particular, I think you alluded to this—that there are some 

14 

kinds of transactions that probably just never belong on a clearinghouse, right? If they are not uniform, if there is not sufficient liquidity, then it is just not a good fit. Is that a fair statement? 

Mr. DUFFY. That is exactly fair, sir. 

Senator TOOMEY. Yes. So it seems to me that we will always 

have a category of over-the-counter derivatives and it would be up 

to end users to decide whether the customization that they get in 

return for something over the counter outweighs the fact that there 

is not as much transparency, and that is a decision that individuals 

will make. 

Mr. DUFFY. We agree. 

Senator TOOMEY. OK. The other point I wanted to make, follow 

up on my colleague, Senator Crapo’s point, is I do think it is—and 

I know this does not directly affect you gentlemen. My understanding, though, is that the promulgation of the regulations does 

create the possibility that end users will have margin requirements 

in some cases, but not necessarily be required to use clearinghouse, 

but have margin requirements, and I do think that is a potentially 

big problem. 

As to whether or not an end user should have a margin requirement, I think that is a credit decision that should be made by the 

counterparty. The counterparties are capable of making that decision, and the cost to an end user that is not—especially a nonfinancial that does not have ready access to the kind of cash that 

is necessary for a margin call, could actually make the hedging exercise prohibitively impractical. And so I am very concerned. In 

fact, Senator Johanns and I have introduced legislation that would 

deal with this which would really specify and make it clear that 

this requirement would not apply to end users. But I digress. 

To get to the point that I wanted to ask of you, Davis Polk has 

put together a memo that suggests that there are 175 new derivatives provisions coming out of Dodd-Frank. I do not think that is 

comprehensive yet. I think that is what we have so far. And it just 

seems to me that it is really, really important that we sequence the 

implementation in a thoughtful way and over a long enough period 

of time that this is manageable, because it strikes me that it could 

be very problematic if we tried to do this too suddenly. 

Now, you have both indicated importance of sequencing and I 

know you have given a lot of thought to that, but could you just 

underscore, how important is it that the sequencing be right, and 

specifically, could there be some market disruptions if the sequencing is not done appropriately? 

Mr. EDMONDS. I do believe there will be market disruptions if it 

is not done appropriately. Certainly, doing it all at once, the problems with going all at once is you are going to have everyone 

scrambling with a finite bandwidth, both from service providers 

and both their own internal allocation of resources. We talk about 

the cost it would take for folks to respond to that. It would be insurmountable at that point in time. So what you will see is you will 

see liquidity, I think, move away at that point in time. That is a 

real risk. 

The purpose of Dodd-Frank was to remove systemic risk. We 

have got to get to a point that we understand what products have 

the systemic—represent the systemic risk, how they can be cleared, 

15 

how they can be standardized or not standardized, and if they are 

not standardized, what are the capital charges associated with 

that. And then once you get those things figured out, then you have 

got some opportunity for people to see that in a transparent manner, whether it is standard or nonstandard. That means more products being traded in a listed environment, other products not being 

traded but being reported to the STR function that was in DoddFrank, and things of that nature. 

Then you get to a point where execution becomes a lot easier to 

implement over time, because people know what the product is. 

They know what the product specification requires them to do as 

a buyer or seller. They know how it is going to be margined. They 

can properly do capital planning around that. 

Mr. DUFFY. I agree with what Mr. Edmonds said, sir. I think if 

we do not implement sequencing properly, such as putting plain 

vanilla swaps out first and making certain that it is not only dealer-to-dealer, but dealer-to-client at the same exact time so there is 

no disadvantage to the client to get forced into going where the 

dealer wants him to go, I think that is important. 

But also, there are some provisions that the CFTC, that they are 

trying to put forward, such as systemically important DCOs which 

would require a firm like ours, if we were in that category, to put 

up two of our largest clients’ defaults. So what would it do? It 

would introduce a participant to go to a less capitalized clearinghouse that would not have the onerous of CME because we are a 

systemically important organization. That is in there. 

There is also risk that if we have the $50 million, which Chairman Gensler would like to have, put forward to allow people to 

participate in the clearing of swaps and we had that implemented 

and we were to have a default and these people were not able to 

participate in the default, this is another issue that could introduce 

more systemic risk to the system. 

So there are a couple flaws. We are trying to get away from systemic risk. We are concerned that if we push this without doing the 

proper sequencing, we will introduce more systemic risk. 

Senator TOOMEY. Thank you, Mr. Chairman. 

Chairman REED. Thank you, Senator Toomey. 

Senator Kirk. 

Senator KIRK. Thank you. I am obviously representing the 

Chicagoland area, where these markets, and be able to set up a 

database and exchange where buyers’, sellers’ prices are disclosed 

in real time is critical to real-time risk management. 

I wonder, Mr. Duffy, if you could specifically describe your foreign competition. If we have a danger of over-regulating, customers 

will simply manage their risk in markets overseas. Who is on your 

heels and who is hoping that the Congress gets this wrong so that 

you are too heavily encumbered to serve customers and then would 

pick up the business overseas? 

Mr. DUFFY. Well, I think there are a couple that would like to 

see that. Maybe one sitting to my right would like to see that with 

his London operation. There are obviously participants throughout 

Europe that compete with the CME Group, that compete with 

Intercontinental Exchange, also. They have not gone forward with 

any regulation whatsoever. We have passed Dodd-Frank in this 

16 

country. I believe that we have to be very careful. I like being a 

leader, but at the same time, let us do it in a judicious fashion. Let 

us just not overreact, try to implement the whole Act in 2 days. 

I am very concerned about the regulatory arbitrage, Senator, 

that could occur, and the business getting taken off of the U.S. 

markets, putting onto foreign jurisdictions. These banks have books 

all over the world. They do not need to be in the U.S. So if they 

are a non-U.S. bank, they can be in Europe participating in these 

markets without being subjected to the laws of Dodd-Frank. Not 

only do they put CME at a disadvantage, they are going to put U.S. 

banks at a disadvantage. 

Senator KIRK. Right. And then correct me if I am wrong, but my 

impression of European and Chinese interests are that their feeling 

about Dodd-Frank-related regulation is we are completely for it, 

but ‘‘apres vous, Gaston.’’ You guys go ahead and kill your markets 

first. Oh, by the way, we are right behind you. We are going to kill 

our markets as fast as you kill yours—— 

Mr. DUFFY. I think—— 

Senator KIRK. ——fully knowing that they are not going to do 

that, and then they will pick up this business and the employment 

will transfer outside the United States. 

Mr. DUFFY. I absolutely think that is the most realistic fear that 

we have, and I think if people do not recognize it, they are just in 

denial. These markets have grown. They have matured throughout 

Asia. They have grown and matured throughout Europe. They are 

looking for us to make this gigantic mistake. That is why it is critically important that we implement this law in the way that makes 

sense. 

Senator KIRK. So can you describe—characterize the implementation of Dodd-Frank-related activities affecting similar markets in 

Europe. 

Mr. DUFFY. Do you want to address that or do you want me to? 

Mr. EDMONDS. You can start. 

Mr. DUFFY. OK. So the question would be, how does Dodd-Frank 

affect—— 

Senator KIRK. No. Tell me the progress of them putting similar 

regulations—— 

Mr. DUFFY. There is no progress there. There is no progress in 

Europe. The G20 has made some noise that they are going to come 

up with a proposal sometime this summer. I have seen nothing 

coming out of the European Commission or regulators that they are 

going to support any particular new laws. One of the things they 

did say as it relates to position limits that obviously affects both 

of us, that they have recognized if, in fact, they see a problem in 

a market, they have the right to step in. That is about all I have 

seen coming out of Europe, and as far as Asia goes, I have seen 

absolutely zero—— 

Senator KIRK. And have any of them been open about saying, we 

are hoping the Americans cripple their markets? 

Mr. DUFFY. I do not know if they have been open about it, but 

I am pretty certain a lot of the participants in London and other 

places of the world are very much hoping that happens. 

Mr. EDMONDS. Senator, they hold a free option right now. I 

mean, we are sprinting down to this implementation, trying to get 

17 

as much done as possible, trying to get the market to behave. They 

get a full menu. They are going to have the chance to pick what 

they like and what they do not like. There is no obligation for them 

to implement that. 

Mr. DUFFY. Right. 

Mr. EDMONDS. But they have already said that their time line is 

much further than ours. They have already said that this is a 2012 

and after type of event. I mean, if you look at the G20 comments 

that Mr. Duffy made reference to, this is not something they are 

trying to get done yet this calendar year. This is something they 

are going to start talking about in earnest next year, and that was 

to give us complete time to create the menu for them to choose 

from. 

Senator KIRK. So would you rather be them or us right now if 

you were trying to build a business and add clients? 

Mr. EDMONDS. I believe that the, from my personal—my personal 

belief is that we ought to let the commercial competition that takes 

place with very established businesses with very clean track 

records take—and do that. And there will be other innovators that 

come into this market. There will be others who step in. But if they 

are going to rely on prescriptive rules to step in, well, we had better hope that the prescriptive rules have captured everything that 

could possibly go wrong—— 

Senator KIRK. Which—— 

Mr. DUFFY. I would rather be us, sir. I mean, I think this is obviously the greatest country in the world. It has got a great, dynamic 

financial services industry. I would hope that the Congress recognizes that and lets the regulators know that. Let us compete globally. I like being a leader. I think that if we implement small portions of Dodd-Frank, like I said, in a judicious way, I think the rest 

of the world would have no choice but to follow on a few of these 

things. I think if we overreach, which has been what the regulator 

has been doing, that is when our European competition will destroy 

us, on the overreaching of the regulators. So right now, I would 

rather be us, if we do it right. 

Senator KIRK. Thank you, Mr. Chairman. 

Chairman REED. Thank you, Senator Kirk. 

Gentlemen, thank you for your excellent testimony. I presume 

and I know that we will be meeting again, because this issue of implementation is critical and your advice and your insights are absolutely essential to get this right, so thank you both very much. 

Mr. EDMONDS. Thank you, sir. 

Chairman REED. Let me call up the second panel. 

[Pause.] 

Chairman REED. I would like to welcome the second panel and 

begin by introducing Dr. Benn Steil. Dr. Steil is Senior Fellow and 

Director of International Economics at the Council of Foreign Relations in New York. He is also the founding editor of International 

Finance, a scholarly ISI accredited economics journal, as well as a 

cofounder and managing member of Efficient Frontiers LLC, a 

markets consultancy. Dr. Steil’s most recent book, Money, Markets, 

and Sovereignty, was awarded the 2010 Hayek Book Prize. Welcome, Dr. Steil. Thank you. 

18 

Dr. Chester Spatt will be introduced by my colleague, Senator 

Patrick Toomey of Pennsylvania. 

Senator TOOMEY. Thank you very much, Chairman Reed, for this 

opportunity to welcome Dr. Chester Spatt, the Pamela R. and Kenneth B. Dunn Professor of Finance at the Tepper School of Business at Carnegie Mellon University and Director of its Center for 

Financial Markets. The Tepper School consistently ranks among 

the Nation’s very best business schools and Dr. Spatt has taught 

at the university since 1979. Dr. Spatt also served as the Chief 

Economist and Director of the Office of Economic Analysis at the 

SEC from 2004 through 2007. 

In addition to that, he has served as Executive Editor and one 

of the founding editors of the Review of Financial Studies, President and a member of the founding committee of the Society for Financial Studies, and President of the Western Finance Association. 

His coauthored 2004 paper in the Journal of Finance on asset allocation won TIAA–CREF’s Paul Samuelson award for the best publication on lifelong financial security. 

Dr. Spatt earned his Ph.D. in economics from the University of 

Pennsylvania and his undergraduate degree from Princeton University. 

Dr. Spatt, we are pleased that you could be with us today and 

I look forward to your testimony. 

Mr. SPATT. Thank you for that very kind introduction. 

Chairman REED. Our next witness is Mr. Cliff Lewis. Mr. Lewis 

is Executive Vice President of the State Street Global Markets, 

State Street’s investment research and trading arm. In that capacity, he is responsible for the e-Exchange business, which provides 

electronic trading solutions for foreign exchange, precious metals, 

cash, U.S. Treasury securities, futures, money markets, and exchange traded funds. Mr. Lewis joined State Street in 2006 as part 

of the acquisition of Currenex, where he served as Chief Executive 

Officer. Welcome. 

Mr. Don Thompson is Managing Director and Associate General 

Counsel at JPMorgan Chase and Company. He is cohead of JPM’s 

Derivatives Practice Group and Legal Department and cochair of 

the ISDA Documentation Committee. Since 1985, he has represented JPM in its full range of derivatives activities, with a focus 

on regulatory documentation and litigation matters. 

Mr. James Cawley is a founder of the Swaps and Derivatives 

Market Association, an industry trade group with over 20-plus 

dealer and clearing broker members that advocate open access and 

transparency in centrally cleared interest rate swap and credit derivatives markets. He is also the CEO of Javelin Capital Markets, 

an electronic execution venue of OTC derivatives that expects to 

register as a Swaps Execution Facility, or SEF. Previously, Mr. 

Cawley was the founder and CEO of IDX Capital, a New Yorkbased electronic trading platform for credit default swaps executed 

between dealers, so welcome, Mr. Cawley. 

Dr. Steil, please begin. 

19 

STATEMENT OF BENN STEIL, SENIOR FELLOW AND DIRECTOR 

OF INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS 

Mr. STEIL. Thank you, Mr. Chairman—— 

Chairman REED. Could you turn on your microphone, Doctor, 

and let me for the record once again state, all of your statements 

are part of the record. Feel free to summarize and abridge. 

Dr. Steil. 

Mr. STEIL. Thank you, Mr. Chairman, Ranking Member Crapo, 

Members of the Committee. I appreciate the opportunity to testify 

here this morning. 

The collapse of Lehman Brothers and AIG in September of 2008 

highlighted the importance of regulatory reforms that go beyond 

trying to prevent individual financial institutions from failing. We 

need reforms that act to make our markets more resilient in the 

face of such failures, what engineers and risk managers call ‘‘safefail’’ approaches to risk management. Well capitalized and regulated central derivatives clearinghouses to track exposures, to net 

trades and to novate them, to collect proper margin on a timely 

basis, and to absorb default risk have historically provided the best 

example of successful safe-fail risk management in the derivatives 

industry. 

Encouraging a shift in derivatives trading from OTC markets 

without central clearing to organized Government-regulated markets with central clearing is challenging, however, for two reasons. 

First, the dealers that dominate the OTC derivatives business have 

no incentive to accommodate such a shift. Dealers earn approximately $55 billion in annual revenues from bilateral OTC derivatives trading. Some of the largest can earn up to 16 percent of their 

revenues from such trading. It is natural that dealers should resist 

a movement in trading activity onto exchanges and clearinghouses. 

Where compelled by regulation to accommodate it, dealers can 

also be expected to take measures to control the structure of and 

limit direct access to the clearing operations. The use of measures 

such as unnecessarily high capital requirements in order to keep 

smaller competitors or buy-side institutions from participating directly as clearinghouse members are to be expected. Indeed, trading infrastructure providers organized as exclusive mutual societies 

of major banks or dealers have a long history of restricting market 

access. 

For example, in the foreign exchange markets, the bank-controlled CLS settlement system has long resisted initiatives by exchanges and other trading service providers to prenet trades 

through a third-party clearing system prior to settlement. Such 

netting would significantly reduce FX trading costs for many market participants, but would also reduce the settlement revenues 

generated by CLS and reduce the trade intermediation profits of 

the largest FX dealing banks. 

There are, therefore, solid grounds for regulators to apply basic 

antitrust principles to the clearing and settlement businesses in 

order to ensure that market access is not being unduly restricted 

by membership or ownership limitations that cannot be justified on 

safety and soundness grounds. 

20 

Second, some types of derivatives contracts do not lend themselves to centralized clearing as well as others. Customized contracts or contracts which are functionally equivalent to insurance 

contracts on rare events are examples. Since it can be difficult for 

policy makers or regulators to determine definitively whether given 

contracts, new types of which are being created all the time, are 

well suited for central clearing, it is appropriate to put in place certain basic trading regulations in the OTC markets that will serve 

both to make such trading less likely to produce another AIG disaster and to encourage the movement of trading in suitable products onto central clearinghouses. Two such measures would be to 

apply higher regulatory capital requirements for noncleared trades 

in consequence of the higher counterparty risk implied by such 

trades and to mandate trade registration and collateral management by a regulated third party, such as an exchange. 

In establishing the regulatory standards for the clearing of derivatives transactions, it is imperative for lawmakers and regulators to be fully conscious of the fact that the derivatives market 

is effectively international rather than national and that it is exceptionally easy for market participants to change the legal domicile of their trading activities with a keystroke or a simple change 

of trading algorithm. 

In this regard, I would highlight two important areas of concern. 

First, the three major world authorities controlling the structure of 

the derivatives clearing business—the SEC, the CFTC, and the European Commission—each take a very different view of the matter. 

Historically, the SEC has applied what I would term the utility 

model to the industry. The CFTC has applied what I would term 

the silo model. And the European Commission has applied what I 

would term the spaghetti model. 

The SEC’s utility model favors institutions operated outside the 

individual exchanges, in particular the DTC and the equities markets and the OCC and the options markets. This approach has generally performed well in terms of safety and soundness and in encouraging competition among exchanges. It performs poorly, however, in terms of encouraging innovation in clearing and settlement 

services. 

The CFTC’s silo model allows the individual exchanges to control 

their own clearinghouses. This approach has also performed well in 

terms of safety and soundness. The CFTC’s model also encourages 

innovation in product development in a way in which the SEC’s 

model does not. This is because CFTC-regulated futures exchanges 

can capture the benefits of product innovation in terms of generating trading volumes, whereas SEC-regulated options exchanges 

risk seeing trading volumes in new products migrate to other exchanges, all of which use clearing services provided by the OCC. 

On balance, I believe the CFTC’s model is the more appropriate for 

the derivatives industry. 

The second point I would like to make regarding the global nature of the derivatives trading industry is that certain measures to 

curb speculative activity being debated here in Washington are 

likely to push trading activity off-exchange, precisely the opposite 

of Congress’ intent. For example, a so-called Tobin tax on futures 

transactions at the level being discussed last year, two basis points 

21 

or 0.02 percent, would be equivalent to over 400 times the CME 

transaction fee on Euro-dollar futures. It should go without saying 

that a tax this large relative to the current transaction fee on the 

underlying contract would push all of this activity into alternative 

jurisdictions. 

Likewise, commodity market position limits, if not harmonized 

with UK and other national authorities, will merely push such 

trading outside the CFTC’s jurisdiction. There is already an active 

regulatory arbitrage on oil and natural gas futures between the 

CME’s NYMEX exchange, which trades such contracts under CFTC 

regulation, and the Intercontinental Exchange, which trades such 

contracts under FSA regulation in London. In short, we must be 

extraordinarily cautious not to undermine Congress’ worthy goal of 

bringing more derivatives trading under the purview of U.S.-regulated exchanges and clearinghouses by inadvertently providing 

major market participants incentives to do precisely the opposite. 

Thank you, Mr. Chairman. 

Chairman REED. Thank you. 

Dr. Spatt, please. 

STATEMENT OF CHESTER S. SPATT, PAMELA R. AND KENNETH 

B. DUNN PROFESSOR OF FINANCE, TEPPER SCHOOL OF 

BUSINESS, CARNEGIE MELLON UNIVERSITY 

Mr. SPATT. Thank you, Chairman Reed and Ranking Member 

Crapo. I am pleased and honored to have an opportunity to present 

my views to the Senate Subcommittee this morning. As Senator 

Toomey’s introduction indicated, I am a chaired professor at the 

Tepper School of Business at Carnegie Mellon University in Pittsburgh and I also served as Chief Economist of the U.S. Securities 

and Exchange Commission from July 2004 to July 2007. My expertise as a faculty member include such areas as trading mechanisms, derivative securities, asset valuation, financial regulation, 

and the financial crisis. 

I think the focus on clearing through central counterparties is a 

natural one and one in which I am sympathetic, potentially both 

to reduce contagion associated with counterparty risk and to make 

the structure of risk more transparent. However, it is unclear to 

me whether the extent of use of clearinghouses, especially the extent of mandatory clearing currently envisioned, will lead ultimately to a reduction in systemic risk in the event of a future crisis. I think it is very important to manage carefully the risk within 

the clearinghouse. I also think it is important that fees for holding 

uncleared derivatives reflect economic costs and not be punitive to 

avoid creating artificial concentration of risk within the clearinghouse. 

The clearinghouse is subject to considerable moral hazard and 

systemic risk, because (a) there is a strong incentive for market 

participants to trade with weak counterparties, (b) concentration of 

risk in the central clearinghouse, and (c) margining would likely 

need to ratchet up in the context of a crisis. I believe that central 

clearing could potentially raise systemic risk substantially. 

In fact, Federal Reserve Chairman Ben Bernanke attributed the 

lack of failure of a clearinghouse during the financial crisis to ‘‘good 

luck’’ in an important speech that he presented at the Atlanta FedVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
22 

eral Reserve conference in April. In fact, he quoted a Mark Twain 

character as emphasizing the theme, that ‘‘if you put all your eggs 

in one basket, you had better watch that basket.’’ I think that is 

the core of the issue involving clearinghouses. 

Now, I think everyone agrees that it is important that clearinghouses not receive ‘‘too big to fail’’ types of guarantees. In fact, 

Chairman Gensler testified before the full Committee to that effect 

in mid-April. But I think that emphasizes the importance of having 

strong risk management. I think strong risk management is absolutely essential to the potential success of the clearinghouse model. 

And indeed, while it is a delicate balance, I would emphasize the 

importance of strong risk management, even at the expense of 

other values. 

The governance of the clearinghouse should reflect strong incentives to control risk. It is important that the leadership and the 

governance of the clearinghouse reflect strong incentives, and in 

particular, I think artificial requirements that most of the directors 

be independent directors are a push in the wrong direction. It is 

important that governance, including board governance and risk 

committee composition, reflect incentives. Much of the commentary 

of regulators has focused upon more abstract notions of ‘‘conflict of 

interest.’’ 

Incentives are very important. Proposals to absolve small members of the clearinghouse of their duties or to allow them to 

outsource their duties, are illustrative of some of the incentive 

problems that I would envision potentially in terms of the operation of the clearinghouse. Incentives are absolutely crucial. 

Analogously, regulators are focused upon access to the clearinghouse by investing firms. Indeed, I think access is an important 

issue but I would resolve tradeoffs in favor of strong risk management. It is actually interesting that in the equity context, the SEC 

actually adopted last fall a role basically eliminating direct unfettered customer access because of the importance in the equity context of managing risk and making sure orders were properly vetted 

by member firms; I view that as an analogous type of issue to those 

in the clearinghouse space. 

There are strong analogies, as well, with respect to the payments 

system. My Carnegie Mellon colleague Marvin Goodfriend, for example, points out how both in the private clearinghouse system before the creation of the Federal Reserve and then in the Federal 

Reserve System itself, direct access is not allowed to the payments 

system essentially as a mechanism to protect the integrity of the 

system. 

Finally, my underlying view on these issues is also strongly informed by the relevance of economic principles for the structuring 

of the clearinghouse, and I do think it is important that we be sensitive to the economic consequences of these contemplated 

rulemakings as we move forward on these important issues. 

Chairman REED. Thank you very much, Doctor. 

Mr. Lewis, please. 

23 

STATEMENT OF CLIFFORD LEWIS, EXECUTIVE VICE 

PRESIDENT, STATE STREET GLOBAL MARKETS 

Mr. LEWIS. Thank you, Senator. Chairman Reed, Ranking Member Crapo, other Members of the Committee, thank you for the opportunity to testify today. Let me also express my appreciation for 

the work that has been done by your staff and yourselves and Congress, the CFTC, and the SEC on the Dodd-Frank implementation. 

State Street is one of the world’s largest custodial banks. We ad- minister over $21 trillion—that is trillion with a ‘‘t’’—dollars of 

other people’s money. That makes us one of the world’s largest 

processors of derivative transactions today and it is why we are 

very interested in the topic you all are working on. 

Now, let me say at the outset that we at State Street support the 

Dodd-Frank mandates for both derivatives clearing and execution. 

We believe that if the rules are properly implemented, these 

changes will bring big benefits to our customers who are investors, 

investors like pension funds, endowments, and mutual funds. At 

the same time, we have to report that our investor clients are extremely concerned by current regulatory uncertainty and the potentially significant incremental costs that may result from the new 

rules. 

Now, let me also emphasize that in relation to central clearing, 

the key issue for State Street is effective implementation of DoddFrank’s requirement that clearinghouses, and I quote, ‘‘permit fair 

and open access.’’ A couple specific comments. 

First, we support the CFTC’s participant eligibility rules as proposed. Specifically, we are very concerned that some clearinghouses 

could try to carry forward their current restrictive membership requirements that bear no relationship to risk reduction, in direct 

contradiction of Dodd-Frank. 

Second, clearing members obviously need the financial and operational resources to execute their duties to customers and the 

clearinghouse. But strong capital rules should be risk-based rather 

than arbitrary. Senator Toomey rightfully emphasized that the current model of futures markets clearinghouses worked well during 

the crisis. The successful wind-down of Lehman as well as other 

such disasters indicates that that model, which includes participation in the liquidation process of an open auction system, not limited to one subset of market participants, is unsurprisingly the 

most successful and reliable. 

Third, both the clearing and execution mandates, we believe, 

should go into effect at the same time. Clearing is most value adding and, frankly, safest only when tied to execution. We do not 

really see how a safe central clearinghouse exists independent of 

liquid and transparent markets. 

Fourth, regulations governing clearinghouse memberships obviously have to be coordinated globally. A number of you have already recognized the fact that there are a tremendous amount of 

U.S. jobs at stake. There is also the fact that regulatory arbitrage 

would completely undermine and perhaps, in fact, worsen the current risk situation. 

Finally, we would make an operational point as sort of plumbers 

in the financial market, which is that at least 6 months is going 

to be required—at least 6 months is going to be required—once the 

24 

rules are completely finalized for our customers to be ready to actually implement them, and I say at least 6 months. 

In conclusion, let me just emphasize that we at State Street 

stand ready to help Congress, the Administration, and the regulators as the process of rule writing and implementation goes forward. And let me also point out that State Street, and obviously 

we are not alone in that, is spending very, very large amounts of 

money to prepare for the implementation of Dodd-Frank and that 

we are investing this way because we believe these rules, again, if 

properly implemented, will bring major benefits to our investor clients. 

Thank you. 

Chairman REED. Thank you very much. 

Mr. Thompson. 

STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND 

ASSOCIATE GENERAL COUNSEL, JPMORGAN CHASE & CO. 

Mr. THOMPSON. Chairman Reed, Ranking Member Crapo, and 

Members of the Subcommittee, my name is Don Thompson. Thank 

you for inviting me to testify today. 

JPMorgan has been an active participant in the development and 

management of clearinghouses. We have direct membership in 77 

clearinghouses covering a variety of markets, such as listed and 

over-the-counter OTC derivatives and equity and fixed-income securities. We are committed to clearing over-the-counter derivatives 

transactions, have been clearing dealer-to-dealer OTC transactions 

for over a decade. Today, we clear over 90 percent of the eligibility 

interdealer interest rate and CDS transactions that we execute. At 

the same time, we have also made significant investments in our 

client clearing franchise, which we expect to grow as requirements 

of clearing under Title VII become implemented. 

While there are a number of critical issues to consider in determining the appropriate market structure and governance for clearinghouses, the most critical is guarding against systemic risk. 

Questions of membership criteria, risk committee structure and 

governance all implicate safety and soundness, so it is essential 

that the regulations carefully weigh those considerations, and I 

commend the Committee for holding this hearing to ensure that 

these proposals are well considered. 

As you are aware, the migration of products that were once traded and managed bilaterally to CCPs will concentrate the risk for 

those transactions at clearinghouses. Clearinghouses do not eliminate credit and market risk arising from over-the-counter derivatives. They simply concentrate it in a single venue in significant 

volume. This concentration of risk, combined with an increase in 

aggregate credit and operational risk at clearinghouses, will result 

in these institutions becoming systemically important. 

Since these institutions are private for-profit entities, it is critical 

that regulations guard against an outcome that would privatize 

profits but potentially socialize losses. Attempts to increase clearing member access or lower clearing member capital requirement 

can be responsibly implemented only if they are coupled with requirements for sound risk management practices, including appropriate limits on the types of transactions subject to the clearing 

25 

mandate, requirements for members of clearinghouses to have capital contributions proportional to the risk that they bring into the 

clearinghouses, elimination of uncapped liability of clearing members, and requirements for clearing members to be able to risk 

manage transactions they bring into clearinghouses. 

We strongly support open access to clearinghouse membership 

and believe it can be achieved without compromising risk management standards. Two critical controls must be in place at each 

clearinghouse to support open access, a clear liability framework 

that caps member exposure and risk limits that are real time and 

proportional to each member’s capital. 

The approach we advocate here is consistent with the approach 

taken by the FSA in their recent comment letter to the CFTC. The 

foundation we are proposing would allow clearing membership to 

be prudently expanded to firms with modest levels of capital, including the $50 million minimum requirement proposed by the 

CFTC. 

Absent proper oversight, clearinghouses are at greater risk of 

failure, which could have significant systemic impact. Failure could 

result for a number of factors, such as lack of proper risk management on the part of members from clearing complex products that 

cannot be properly valued by the clearinghouse or for from competitive actions resulting from a race to the bottom among for-profit 

CCPs. 

Given these risks, we believe that as long as CCPs are structured 

as for-profit entities, the primary regulatory focus should be to ensure that proper risk management, governance, regulatory oversight, and incentive structures are in place. 

It is also worth noting that because derivatives trading and 

clearing is a global business, in order to prevent regulatory arbitrage, rigorous regulatory standards should be applied consistently 

in each of the major global markets, including uniform operating 

principles and consistent on-the-ground supervisory approach. 

We believe that no institution, including clearing members and 

clearinghouses, should be too big to fail. The policy objectives of the 

Act would be well served by promoting systemic stability and ensuring safety and soundness of clearinghouses and by requiring 

that these institutions have adequate capital to absorb losses and 

sufficient liquidity to safeguard the system. 

JPMorgan is committed to working with Congress, regulators, 

and industry participants to ensure that Title VII is implemented 

appropriately and effectively. I appreciate the opportunity to testify 

before the Subcommittee and look forward to answering any questions you may have. 

Chairman REED. Thank you, Mr. Thompson. 

Mr. Cawley, please. 

STATEMENT OF JAMES CAWLEY, COFOUNDER, SWAPS AND 

DERIVATIVES MARKET ASSOCIATION 

Mr. CAWLEY. Thank you, Mr. Chairman. Chairman Reed, Ranking Member Crapo, Members of the Subcommittee, my name is 

James Cawley. I am CEO of Javelin Capital Markets, an electronic 

trading venue of OTC derivatives that will register as a SEF, or 

Swap Execution Facility, under the Dodd-Frank Act. I am also here 

26 

to represent the interests of the Swaps and Derivatives Market Association, which is comprised of multiple independent derivatives 

dealers and clearing brokers, some of whom are the largest in the 

world. 

To ensure that the U.S. taxpayer is never again required to bail 

out Wall Street, we must move away from ‘‘too interconnected to 

fail,’’ where one bank pulls another three with it in the event of 

its failure. Equally important, we must remove the systemic sting 

currently associated with each bilateral derivatives contract and 

that connects financial firms to each other and thus compel these 

contracts into clearing. 

In order to have safe and successful central clearing of OTC derivatives, certain remaining impediments must be removed such 

that clearinghouses ensure that they have truly representative governance structures, offer objective and proportionate risk models, 

provide open access to properly qualified and noncorrelated clearing members, and accept trades on a real-time and execution-blind 

basis such that systemic risk is mitigated while transparency and 

market liquidity are increased. 

With regard to clearinghouse governance, we support CFTC core 

principles O, P, and Q, that require that governance arrangements 

be transparent, fair, and representative of the marketplace. Such 

governance bodies should represent the interests of the market as 

a whole and not just the interests of a few. 

Importantly, clearinghouse membership requirements should be 

objective, publicly disclosed, and permit fair and open access, as 

Dodd-Frank requires. This is important, because clearing members 

act as gatekeepers to clearing, and without open access to clearing, 

you will not have universal clearing adoption, increased transparency, and less than systemic risk. Clearinghouses should seek 

to be inclusive and not exclusive in their membership criteria. 

We should dispense with the myth that swaps are somehow different from other cleared markets and we should not ignore the 

vast experience from those markets, that they have to offer. Importantly, clearinghouses should learn from their own experience in 

the listed derivative space of futures and options. In those markets, 

central clearing has operated successfully since the days of postCivil War reconstruction in this country, nearly 150 years ago, long 

before spreadsheets and risk models. In those markets, 

counterparty risk is spread over 100 disparate and noncorrelated 

clearing firms. It works well, and no customer has ever lost money 

due to a clearing member failure. 

To complement broad participation, clearinghouses should not 

have unreasonable capital requirements. Capital should be a function of the risk a member contributes to the system. Simply put, 

the more you or your customers trade, the more capital you should 

contribute. 

The SDMA supports the CFTC’s call for clearing broker capital 

requirements to be proportionate in scale relative to the risk introduced to the system. We support the CFTC’s call that a clearing 

firm’s minimum capital be closer to $50 million rather than closer 

to the $5 billion or $1 billion threshold that certain clearinghouses 

have originally suggested. 

27 

Certain clearinghouse operational requirements for membership 

that have no bearing on capital or capability should be seen for 

what they are, transparent attempts to limit competition. Specifically, clearing members should not be required to operate swap 

dealer desks just so that they can meet their obligation in the default management process. These requirements can easily be met 

contractually through arrangements with third-party firms or other 

dealers. 

With regard to trade acceptance, clearinghouses and their constituent clearing member firms should accept trades on an execution-blind basis. Clearing firms and their constituent FCMs should 

be prevented from discriminating against certain customer trades 

simply because they dislike the manner in which they have been 

executed or the fact that they may be anonymous. Certain trade 

counterparties should be precluded from exploiting current market 

position to impose documentary barriers to entry that restrict customer choice of execution venue, execution method, and dealer 

choice. Regulators should remain vigilant to such restrictions on 

trade and ensure that they do not manifest themselves in a postDodd-Frank world. 

The SDMA joins the MFA and supports the CFTC requirement 

that trades be accepted into clearing immediately upon execution. 

Regulators should be mindful not to allow clearinghouse workflows 

to increase and not decrease trade latency. Such workflows are 

nothing more than clear attempts to stifle successful OTC derivative clearing. 

In conclusion, the CFTC and the SEC should be commended for 

their excellent work. Both agencies have been transparent and accessible through the entire process and they have adapted to the 

industry’s suggestion where appropriate. We must move away from 

‘‘too interconnected to fail,’’ and as an industry, we must work together to ensure that OTC derivatives clearing is a success and 

that Wall Street never again has to come to Main Street for another bailout. 

Thank you for your time. 

Chairman REED. Thank you very much, gentlemen, for excellent 

testimony. 

We will proceed with our first round, and if appropriate, since we 

have a large panel, we will entertain a second round if there are 

additional questions, but let me begin. 

Dr. Steil, one of the recurring themes of all the witnesses has 

been the globalization of these markets. From your perspective at 

the Council on Foreign Relations, I presume you spend a lot of time 

looking at overseas markets, as well as U.S. markets. How would 

you sort of rate what is going on overseas relative to what DoddFrank is trying to create here in the United States at this time? 

Mr. STEIL. I used to be on the board of a European exchange, so 

I got to see some of that firsthand. I would describe the situation 

in most of the European Union as being confusion. First of all, 

there are contradictions across national jurisdictions. For example, 

the UK is taking very different approaches on certain issues, such 

as bank capital requirements, from the rest of the European Union. 

Second of all, there were regulatory approaches that were put in 

place before the financial crisis that are widely seen now as being 

28 

inappropriate, but are still being pushed forward by inertia. I had 

referred briefly in my testimony, for example, to the European 

Commission’s spaghetti model approach for clearinghouses. Prior to 

the financial crisis, the European Commission wanted to see clearinghouses compete more against each other and they felt that the 

way to do that was to compel them to provide interoperability, 

technological linkages, one to another. 

My concern is that that could produce enormous operational risk 

that could spread from one institution to another and could lead to 

a situation where the clearinghouses compete by lowering their 

margin requirements and other prudential requirements and could 

undermine their ability to make sure that we have a safe and 

sound securities trading system. 

So I think we are more advanced over here right now in terms 

of having a coherent approach, and although I have differences on 

some approaches, I think the thrust is going in the right direction 

and it is a matter of refining individual details. 

Chairman REED. Let me just follow up and ask perhaps the same 

question a different way, and also ask Dr. Spatt to comment. There 

is a real issue here of, going forward, are we advantaged by these 

reforms or disadvantaged, particularly with the competition with 

the European Community and with some of our Asian financial 

centers. And so your sense going forward, then I will ask Dr. Spatt. 

Mr. STEIL. It depends on the individual issue. Let us take the 

issue of clearing certain contracts that are traded in multiple jurisdictions. I mentioned briefly in my testimony natural gas and oil 

futures contracts. These contracts are traded both by the NYMEX 

exchange, which is owned by the CME, which is regulated by the 

CFTC, and by the Intercontinental Exchange, which interestingly 

enough, although it is an American exchange, trades certain of 

these contracts out of London, so to speak. Of course, this is a keystroke that determines jurisdiction—— 

Chairman REED. Right. 

Mr. STEIL. ——under FSA regulations. Margin requirements can 

differ on contracts that are traded in different jurisdictions. 

And in terms of the current debate, for example on position limits on certain commodities, you have seen in the markets evidence 

that any time it looks like position limits may be instituted in the 

U.S. markets, say in natural gas and oil contracts, open interest 

shifts from NYMEX to ICE. I do not think this is coincidental. 

There is great concern in the markets here that if position limits 

are implemented here and not overseas, institutions will be forced 

to liquidate positions in order to get under those requirements, and 

so they start increasing their open interest overseas, and I think 

that is the sort of regulatory arbitrage we need to be concerned 

about. 

Chairman REED. Dr. Spatt, your comments, and then there will 

definitely be a second round because I have questions for the other 

panelists, but I want to give my colleagues a chance. Dr. Spatt? 

Mr. SPATT. Thank you, Senator Reed. I share the concerns about 

the competitiveness issues. I am certainly struck by the discussion 

today about how little movement there has been in Europe and certainly in Asia on these issues. Even the language of the G20 has 

certainly used a much more extended window than is present in 

29 

the Dodd-Frank legislation, and there does not seem to be much 

movement by Europe and Asia even relative to the longer window 

used by the G20. 

This whole issue reminds me of a strong parallel that I observed 

when I was Chief Economist at the SEC. At the time, there was 

a lot of concern about the consequences of Sarbanes-Oxley for listings and lots of interest on the part of European companies to deregister from the U.S. environment and a lot of discussion and debate about that. To the extent that we get it wrong—and I have 

fears that we may be getting it wrong—to the extent that we get 

it wrong, the concern is basically that a lot of the business will flow 

overseas, that the complications in trading overseas are tiny. There 

are obviously major market centers in London and Hong Kong and 

it is relatively easy for most sophisticated traders to redirect their 

orders to what they consider to be a more appropriate environment. 

Chairman REED. I thank you. 

Just before I recognize Senator Crapo, I cannot help but think 

this is somewhat ironic, because, of course, AIG’s financial products 

were located in London so that they could avoid the ‘‘onerous,’’ 

quote-unquote, regulation and they began—they were sort of the 

self-destructive aspect of the company. 

Mr. SPATT. Well, I do think, to the extent that the Administration views the G20 as an important group, I think it is important 

that there be alignment, that does not necessarily mean to simply 

match the current form of Dodd-Frank, but I think it is important 

that there be regulatory alignment between the framework in the 

U.S. and the framework overseas, and that may involve movement 

in both directions. 

Chairman REED. Thank you, Doctor. 

Senator Crapo. 

Senator CRAPO. Thank you, Senator Reed. 

Mr. Thompson, I would like to return to the end user issues that 

I discussed with the first panel a little bit and ask you if you could 

explain how the margin requirements on uncleared groups or 

swaps will impact end users. 

Mr. THOMPSON. Thank you for that, Senator Crapo. I would love 

to be able to do that. The impediment to doing that is as many 

times as I have read the regulations, I still do not entirely understand them because there seems to be an internal inconsistency in 

the regulations themselves. 

They seem to say, on the one hand, we will not require the collection of margin from end users by swap dealers. On the other hand, 

it says that swap dealers are required to negotiate agreements with 

end users which will provide for the mechanics of transfer of margin with respect to their liabilities under uncleared swaps. 

It seems to me difficult to square those two statements, and the 

regulations, as many times as I have read them, do not square the 

circle there, so I remain a little confused about exactly what they 

require in terms of requiring swap dealers to collect margin from 

end users on uncleared swaps. 

Senator CRAPO. And is this a conflict between the approach of 

the SEC and the CFTC versus the approach of the banking regulators? 

30 

Mr. THOMPSON. I believe that that issue is present both in the 

margin release from the banking regulators as well as the margin 

release from the CFTC. Both of them require this concept of swap 

dealers establishing what they call thresholds, presumably which 

will govern the requirement to collect margin once you get above 

the threshold. There is very little, virtually no discussion of how 

those thresholds are set, whether they are done in accordance with 

banks’ ordinary and customary credit practices, whether they will 

be imposed by regulators, whether they can be changed by regulators in a financial crisis. There is a whole level of detail around 

that question which is lacking in both releases. 

Senator CRAPO. From my perspective, and I do not propose that 

I am anywhere close to the expert that you or the others on the 

panel are to these regulations, but it seems to me from what I am 

hearing that—it appears that although there is the confusion you 

described, that there seems to be an understanding that there will 

be somehow an increased margin requirement imposed either as a 

margin requirement or as some kind of other fee on end users. Is 

that a fair assumption? 

Mr. THOMPSON. I think it is natural when you have that kind of 

ambiguity in otherwise very long and comprehensive regulatory releases that people who would be affected by that, most significantly 

the end user community, would be naturally suspicious that there 

is not going to be some requirement imposed in some form or fashion in connection with their liabilities under uncleared swaps. So, 

yes, I think I agree with you. 

Senator CRAPO. And if that is the case, I believe, and I do not 

want to speak for him, but I believe Mr. Edmonds in the first panel 

indicated that that increased margin requirement would be a cost 

on end user transactions that would not necessarily be justified by 

any appropriate increase in safety and soundness. He may or may 

not have intended that. That is what I heard him say. But what 

do you think about that? Do you think that the increased margin 

costs that would come from what we have been discussing would 

be justified in an improvement of safety and soundness? 

Mr. THOMPSON. Well, when I think about that question, which is 

an excellent question, I go back to the statute which authorizes and 

directs the prudential regulators to set margin requirements for 

uncleared swaps, and in that requirement under Section 731, there 

is a requirement that it be appropriate for the risk. 

When you think about end users, your typical corporate nonfinancial entities, there is no evidence that they contributed in any 

significant way to the financial crisis. Their use of over-the-counter 

derivatives is almost invariably risk reducing hedging transactions. 

Furthermore, unlike financial firms, which tend to be very highly 

correlated, such that when Lehman Brothers gets in trouble, people 

start to get the sweats about other financial entities, when you 

think about the end user world, it is a whole host of entities whose 

credit risk has very low correlation. 

So in my mind, that means that imposing onerous margin requirements on those types of entities gets you very, very little reduction in systemic risk and, I would argue, is not appropriate for 

the risk. 

31 

Senator CRAPO. Well, thank you. As I see it, to put it my way, 

it seems to me like we are raising the cost of capital and reducing 

the availability of capital for very little benefit. 

Mr. THOMPSON. That is certainly what we are hearing from our 

clients. 

Senator CRAPO. Thank you. 

Chairman REED. Senator Merkley. 

Senator MERKLEY. Thank you, Mr. Chair. 

Mr. Lewis, I wanted to understand a little bit better the exchanges that have been set up, CME and ICE. An article from December in the New York Times noted that State Street has not yet 

gained full entry into the derivatives trading club, and it mentioned other groups like the Bank of New York, MF Global, 

Newedge. Is that still pretty much the case, or have things changed 

in the course of the last few months? 

Mr. LEWIS. It varies, and we are talking to the clearinghouses. 

I mean, existing clearinghouses, there was no problem when State 

Street decided to enter. The new clearinghouses, many of which 

that were set up with relatively limited membership that consisted 

of the major swap dealers today, who, as Dr. Steil said, make about 

$40 billion a year from market making activities, curiously did not 

have membership requirements that would allow State Street to 

participate, notwithstanding the fact that our capital ratios are better than any of the other top 20 banks in the United States. 

Senator MERKLEY. Right. So I am trying to get a sense, then, of 

how does State Street respond. Do you end up utilizing those exchanges but having to do the deals through those that are members, or do you simply operate through the other exchanges? 

Mr. LEWIS. This is a prospective problem, really, more now. We 

find ourselves in the ironic situation of handling the back-office 

processing for some of our clients, sort of test trades at clearinghouses that we were not allowed to join. I think CME and ICE 

have got proposals in place, with help from some of the existing 

members, including JP, that would let us participate. I think we 

still have a continuing problem with SwapClear at LCH, which apparently has a different model. 

Senator MERKLEY. And so, Mr. Thompson, you do not see any 

systemic issues or problems with State Street participating? 

Mr. THOMPSON. Generally speaking, we are supportive of open 

access. I am not intimately familiar with the State Street legal entity which is seeking to join ICE and CME, but I would just reiterate what I said in my opening statement, which is as long as 

clearinghouse membership is proportional to the risk that clearing 

members bring into the clearinghouse and as long as clearing members have demonstrated risk management capabilities such that 

they can assist actively in the management of a clearing member 

default, we would have no problem with an entity like that becoming a clearing member of a clearinghouse that we are a clearing 

member of. 

Senator MERKLEY. There is a fair amount of discussion of the 

question as to whether risk management arguments are being used 

really out of proportion to keep other players out of the exchanges. 

Do you see kind of an evolution in that argument or kind of a 

32 

movement toward risk assumptions that are reasonable in terms of 

other folks participating? 

Mr. THOMPSON. Well, what I see in that is, on the part of many 

market participants, a recognition, much of which came out of the 

experience we had with Lehman Brothers’ default and how the risk 

management process worked in the LCH, that having the ability to 

independently manage risk contributed to a very successful resolution of the Lehman Brothers bankruptcy with respect to the $9 trillion of derivatives that it had in LCH. 

The LCH mechanic requires all clearing members to be active 

bidders for portions of the portfolio of a defaulting clearing member, which is what Lehman was, and in the LCH Lehman situation, we were able to reallocate their portfolio among existing clearing members without going through the first level in the default 

waterfall, which is the initial margin posted by Lehman, thus not 

putting any member guarantee fund contributions at risk, and 

most critically, not imperiling the solvency of the clearinghouse. So 

we think risk management is a very important feature of the landscape. 

Senator MERKLEY. Mr. Lewis, I am going to turn back to you on 

this. I mean, one issue is membership in the exchange. Another is 

membership in the Risk Committees. The Risk Committees have a 

key role in deciding what gets traded on the exchange, in other 

words, how broadly, what kind of swaps derivatives are there. 

In terms of the other exchanges that you are members of, do you 

also have a role in the Risk Committee, being able to kind of help 

shape what gets traded on the exchange? 

Mr. LEWIS. Yes, and we are most concerned not only for ourselves, but for the buy-side customers that need to participate in 

this who ultimately are at risk in pension funds and mutual funds 

need to be represented in these. 

I think there is a very complicated aspect as to how to run the 

worst-case situation, which is the default of a clearing member, 

and that is where there is a distinction between the practice in the 

U.S., which worked very successfully, and the practice which Mr. 

Thompson just alluded to in LCH in London. In the U.S., it is essentially an open auction, and indeed, in the U.S., the majority of 

the Lehman positions, not surprisingly, were bought by nonclearing 

firms. We would argue that the most open auction, most marketoriented process for handling a liquidation makes sense. We would 

also think that, occasionally, some of these restrictions have less to 

do with safety and more to do with limiting profit opportunity. 

Senator MERKLEY. Thank you very much. Thank you, both of 

you. 

Chairman REED. Well, thank you, Senator Merkley. 

Let me just address a general question. I will start with Mr. 

Thompson, but I wish to call in Mr. Lewis, also, and this might be 

terribly unsophisticated, but it strikes me that in an over-thecounter derivative arrangement, there are substantial fees charged 

by the broker-dealer, and part of those fees are equivalent to margin. They are an attempt to price the risk in every transaction as 

risk. 

And so when we talk about the end user being assessed a margin 

requirement or not assessed a margin requirement, is it not the reVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
33 

ality that there is a built-in risk premium or something like margin 

in there, and the question really is, if there is a requirement under 

these rules to have a formal margin or even a contingent margin, 

the question is really, is that paid for by the issuing broker-dealer 

or is it paid for by the customer, and in these situations where 

there are no competitive market, it could be fully passed on to the 

customer. Is that more of the question we are dealing with here, 

who pays rather than who is covering the risk? 

Mr. THOMPSON. I think there are a couple of levels to that, so let 

me just address each of those in turn. 

Chairman REED. Sure. 

Mr. THOMPSON. First of all, the term ‘‘fees’’ is often used, but it 

is really misleading in the over-the-counter business, which is not 

what we call an agency business, where I sell you a security issued 

by another. We call it a principal-to-principal business, where you 

and I enter into transactions. And so if we are entering into an interest rate swap, what we are really—what you are paying is the 

rate on the fixed rate that you want to pay on your interest rate 

swap, for example. So if you are in open competition with other 

dealers, you would select the dealer who requires you to pay the 

lowest fixed rate. 

Now, embedded in that fixed rate, as you correctly identify, for 

transactions that do not involve margin, is something that we call 

a credit spread, compensation to the dealer for the possibility that 

you may default, and in the derivatives markets, those credit 

spreads are risk based. If you are a hedge fund, you would pay a 

higher credit spread than if you are a AAA corporate. That is essentially how it works. 

Now, when people talk about the cost of margining transactions, 

that is not a cost which is embedded in the fixed rate of the transaction. What people are referring to there is the cost to you of coming up with $10 million or $20 million or whatever the margin requirement is in order for you to be able to fund the margin requirement that I am going to impose on you. I hope that clears it up. 

Chairman REED. I think I am going to ask Mr. Cawley to help 

clear it up and Mr. Lewis to help clear it up. I think it is an excellent answer, but your comments, please. 

Mr. CAWLEY. It would be my pleasure, Mr. Chairman, to clear it 

up. There are essentially two types of fees that the end user is 

charged, some of which are not transparent and some of which are. 

There are—and there has been—Senator Toomey and Senator 

Crapo correctly discussed the clearing fees, the margin or, indeed, 

the capital fees that get held aside for each individual trade, 

whether it be within a clearinghouse where it is an objective fee 

that is dictated by the risk model of that clearinghouse or whether 

it be a subjective fee set by the broker-dealer that extends a credit 

relationship to that entity. 

And it is, indeed, the subjectivity of that fee relationship that got 

us into trouble in 2008, because dealers, incumbent dealers essentially extended open fee relationships to entities such as AIG and 

then requested the bailout. 

But, you know, from the end user standpoint, from what I have 

heard from Chairman Gensler, as we participated in roundtables 

and had meetings with him and read his public comments, it is our 

34 

understanding that there is an exemption for end users vis-a-vis 

margin. That said, end users still have to pay their own way. They 

do not get a free ride on every trade that they do. They have to 

set aside the appropriate amount of capital for each trade, and that 

is only fair, and appropriate within the marketplace. 

The argument against that, then, is, well, you know, is capital 

formation. Well, is this not going to take money off our balance 

sheets if we really had nothing to do with AIG? And we would say 

this. Well, you are trading derivatives, so you have to come in the 

same way as everybody else. 

What you should also look, though, is at the benefits of the lessened execution fees that can occur. For example, if you take a 

standard credit default 5-year trade, if I want to buy default protection on GECC and I get charged five basis points in the bid-offer 

spread for a five million round lot trade, that is $21,000 per trade. 

Now, likewise, in the futures world, the execution fees are ten, 

maybe $10, $15, $20. So you can see the contrast between a transparent liquid marketplace and the lack of transparency in the CDS 

and the interest rate swap markets. 

Now, the way to benefit, then, is to bring these markets into a 

transparent, open, competitive marketplace such that that $21,000 

fee, as one of the gentlemen on the panel correctly surmised that 

it is about $40 or $50 billion of execution fees, you go after—you 

create competition. You bring transparency into the marketplace. 

You bring multiple dealers, not just five or six or ten dealers, but 

30 or 40 or 50 dealers in to compete. And you open up clearinghouses away not just from five or six or ten constituent clearing 

members who also have execution desks, as well, so there may or 

may not be a conflict of interest there, but what you do focus on 

is the benefit of taking that $50 billion worth of execution fees and 

driving it downwards to ten, leaving the resultant $40 billion on 

the balance sheets of corporate America so they can go out and, indeed, hire people and invest in their respective companies and industries. 

Chairman REED. Thank you. And, Mr. Lewis, I want your perspective. 

Mr. LEWIS. Just very briefly, we talk about end users, as I say, 

that are financial institutions that are in this. I think, by and 

large, they view this, unfortunately, as completely an incremental 

cost. And what I think has been lost is the genius of the approach, 

which is really the genius of futures that has proven this for 100 

years, lots of academic research, which is that a more transparent 

market is a more efficient market. The biggest beneficiary of that 

are the price takers, the noncorrelated flow, the investors, if you 

will. The savings of America are better off if you have a transparent market. 

And that is one of the reasons we emphasize so much that you 

have to see both sides of the coin between clearing and the exchange piece, or SEFs, as it is called in this case. I think the measure of success will be that improved efficiency. The more rapidly 

that the clients see that efficiency, the less political problems there 

will be. The more obvious the benefits will be. And I think that it 

is a win–win. 

35 

Alternatively, frankly, if there is not a big improvement in efficiency, then probably some of these risk products may not become 

as important as they are. In fact, some may disappear. 

And the final point I would just observe is that I think the least 

likely outcome and a very uncertain outcome is that the market 

and the products are going to look like they look like today. The 

effect of this is going to be to change things fundamentally, and I 

think if you hold to your guns, change things for the better. 

Chairman REED. Thank you. 

Mr. THOMPSON. Senator Reed, if I might just close with one additional observation—— 

Chairman REED. Sure, and then Professor Spatt. Absolutely. 

Mr. THOMPSON. Yes. When people talk about transparency in the 

context of clearing, I think they are confusing things because you 

are confusing the clearing side of it, which is how trades settle and 

clear, with the execution side of it. And I think it is worth, on the 

execution side, to keep in mind that Dodd-Frank implements a full 

pretrade transparency for execution and post-trade transparency 

for both SEF-executed as well as non-SEF-executed transactions. 

So I think from a public policy perspective, the transparency argument has been had and decided in favor of full market transparency. That is a conclusion that we are totally comfortable with. 

And so I do not see how changing the clearing model really can add 

to the transparency debate which has already been resolved in 

favor of full transparency as required by the statute. 

Chairman REED. Professor Spatt. 

Mr. SPATT. Yes, so on two points. First, on the issue of the SEFs 

and the CCPs, to the extent that the statute is obviously requiring 

post-trade transparency but not universal exchange trading, the 

prices from post-trade transparency can clearly inform collateral 

issues vis-a-vis the CCP, and those do not even have to be real 

time. That is a separate issue from whether it is real-time disclosure. Those prices could be disclosed a day later if real-time disclosure is a severe impediment with respect to liquidity. It seems to 

me those are separate. 

There is one other point I also wanted to make with respect to 

access. The issue of access is not a unique issue with respect to the 

derivatives market. In other contexts, there have been concerns 

about unfettered access. The SEC late last year promulgated a rule 

barring unfettered access by customers that do not go through 

intermediaries because of concerns that that would impose systemic risk on the system, if those orders were not vetted but had 

basic kinds of errors. Analogously, in the history of payment system clearinghouses, both the private clearinghouse systems prior to 

the Federal Reserve and the Federal Reserve, also control access 

because of issues associated with default. 

Chairman REED. Thank you. 

Dr. Steil, you have a comment. You will get the last word. 

Mr. STEIL. Two brief observations on end users. First, generally 

speaking, I do not like the approach of taking a certain class of 

market participants, carving that class out and saying that exemptions apply there, because traditionally, when that has been used 

in other markets, it has produced a regulatory arbitrage that has 

itself produced significant complications and inefficiencies. 

36 

Just very briefly, for example, in the UK markets, you have 

stamp duty on equity trading and you have a carve-out for market 

makers. They do not pay it. So the market makers trade the stocks, 

but other sophisticated investors trade substitutes for the stocks 

called CFDs, or Contracts for Differences, and this has led to endless debate about corporate governance. For example, how do we 

deal with entities that have significant CFD exposures to a given 

company? So I do not like that general approach. 

Second, I think a lot of these end users are either overstating or 

misstating their cases in some cases. FMC Corporation, an end 

user, testified before your parent Committee back in April, and I 

would like to read just one sentence that the Treasurer said. He 

said, ‘‘Our banks do not require FMC to post cash margin to secure 

mark-to-market fluctuations in the value of derivatives, but instead 

price the overall transaction to take this risk into account.’’ 

Now, this means there is no free lunch. First of all, if you post 

margin, you get paid interest on it, so it is not uncompensated. 

Second of all, as you yourself pointed out, if you do not post margin, you expect the bank to take account of this risk and, therefore, 

build it into its price, the bid-ask spread. And in an untransparent 

market, you do not know exactly what that price is. 

From my experience with the mutual fund industry, many traders on the buy side did not like when NASDAQ shifted from an 

opaque dealer market structure in the 1990s to a transparent electronic market structure because then trading cost analysis was 

able to distinguish between good traders and bad traders. And it 

is my perception that a lot of corporate treasurers do not want to 

be subjected to that sort of scrutiny which would naturally emerge 

in a more transparent marketplace. 

Chairman REED. Well, thank you very much, gentlemen. This 

has been very thoughtful and excellent testimony which will help 

us, and it will not be, I am sad to say, the last word on this topic, 

but these were all very, very thoughtful words and I thank you 

very much. 

With that, I would just simply say, some of my colleagues may 

have written questions that they would like to submit. One week 

from today will be the deadline for my colleagues. We would ask 

you, if you do receive written questions, to respond as quickly as 

possible. 

And again, thank you, and with that, I will adjourn the hearing. 

The hearing is adjourned. 

[Whereupon, at 11:27 a.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 

37 

PREPARED STATEMENT OF CHRISTOPHER EDMONDS 

PRESIDENT, ICE TRUST

MAY 25, 2011 

Chairman Reed, Ranking Member Crapo, I am Chris Edmonds, President of ICE 

Trust, a limited purpose New York bank that operates as a clearinghouse for credit 

default swaps. I very much appreciate the opportunity to appear before you today 

to testify on clearing OTC derivatives. 

Background 

ICE has a long, successful, and innovative history in clearing, including clearing 

previously ‘‘unclearable’’ over-the-counter (OTC) derivatives such as energy and 

credit default swaps. ICE owns and operates five derivatives clearinghouses: ICE 

Clear US, a Derivatives Clearing Organization (DCO) under the Commodity Exchange Act, located in New York and serving the markets of ICE Clear US; ICE 

Clear Europe, a Recognized Clearing House located in London that clears ICE Futures Europe, ICE’s OTC energy markets and European credit default swaps (CDS); 

The Clearing Corporation, a DCO and ICE Clear Canada, a recognized clearinghouse located in Winnipeg, Manitoba, that serves the markets of ICE Futures Canada. ICE Trust serves as the leading United States clearinghouse for CDS, having 

cleared approximately $11 trillion in gross notional value since it launched on 

March 9, 2009. Globally, ICE has cleared more than $18 trillion in credit default 

swap volume since the financial crisis. 

Clearing is the cornerstone of U.S. and global regulators’ financial reform efforts. 

Clearing greatly reduces counterparty and systemic risk in the derivatives markets 

for standardized contracts. As an example, since our service came to market we 

have reduced the outstanding risk exposure by greater than 90 percent for the products we offer. In addition, clearing brings transparency, and transparency is a prerequisite for efficient markets and effective regulation. Increased liquidity from 

clearing results in lower transaction costs and tighter bid/ask spreads, reducing the 

cost of hedging price risk and lowering operating costs for businesses. Companies 

operating DCOs, like ICE, have led this effort and have been very successful in their 

efforts to clear OTC derivatives. 

Clearing Over the Counter Derivatives 

ICE’s experience in energy and credit derivatives demonstrates that when clearing is offered to a market, the market overwhelmingly chooses to clear its products. 

While convincing market participants of the advantages of clearing is easy, however, 

the process of clearing an OTC derivative is difficult. For example, in order to clear 

an OTC derivative, the clearinghouse must be able to properly price the contract 

for an accurate mark to market. Marking-to-market is a process common to clearinghouses whereby a clearing participant’s position is priced (marked) on at least 

a daily basis, and to the extent that the clearing participant has incurred a loss, 

the clearing participant must pay the clearinghouse the amount of the loss. The 

daily making-to-market of positions, and the commensurate daily collection of any 

loss (known as variation margin), is a unique discipline of clearinghouses that reduces systemic risk by eliminating the accumulation of losses. In addition, a clearinghouse must determine the correct size and type of contract that it will clear, balancing the risk management objectives of the clearinghouse with the needs of market participants. Finally, the clearinghouse must model risk for the market in order 

to determine how to properly set margin rates. We do this by working in concert 

with our clearing firms, who are required to provide accurate pricing information 

for OTC products. 

For Credit Default Swaps (CDS), which we have cleared since March 2009, we require clearing members to provide accurate and reliable prices on a daily basis. If 

a clearing member submits a price that is out of line with the prices submitted by 

other clearing members, the clearing member is subject to being required to enter 

into a transaction at the out of line price. Requiring clearing members to submit 

to ‘‘executable’’ prices compels clearing members to carefully price the CDS contract. 

Furthermore, requiring clearing members to submit accurate and reliable prices 

limits risk to the clearinghouse by ensuring that one clearing member can assume 

another’s position in the event of default. Over the past 10 years, ICE has gained 

extensive experience with the clearing process—allowing ICE to grow its business 

and reduce system risk by finding new markets and product to clear. 

Over the next few months, the mandatory clearing and trading provisions of the 

Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) should 

take effect, and market participants will be forced to clear OTC derivatives as a 

matter of law. ICE respectfully submits that the regulators responsible for deterVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00041 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
38 

mining which contracts must be cleared should consider any mandate very carefully. 

Many contracts not cleared now are not cleared for good reasons. Some markets 

have structural issues where illiquidity makes the contracts difficult to price. Other 

markets have regulatory hurdles where two or more regulators have different ideas 

on how the market should operate. 

ICE generally supports the clearing principles of Dodd-Frank. ICE believes, however, that the best path to meet this goal is to allow clearinghouses and market participants to find the best way to clear markets within defined principles, as opposed 

to promulgating prescriptive rules for clearinghouses. Many of the proposed rules 

attempt to design a perfect market. Attempts at such market design are not very 

likely to work and may delay implementation of clearing services. At the very worst, 

these efforts may destroy liquidity in certain markets. The best way to quickly 

achieve the clearing objectives of Dodd-Frank is to make sure those unnecessary 

regulatory hurdles and other impediments are removed and to give clearinghouses 

and market participants the freedom to create cleared OTC markets. 

For example, one key regulatory hurdle to clearing is cooperation between regulators. Many OTC derivatives, like CDS, have characteristics of securities and commodities. Close regulatory cooperation between the CFTC and SEC is necessary, 

and required by law, in order to make sure that market participants have legal certainty. This is particularly important in regards to portfolio margining—allowing security-based and commodity-based derivatives to be held in the same account and 

margined together. Historically, the CFTC and SEC have had little success creating 

portfolio margining. After the implementation of Dodd-Frank, the absence of a clear 

and economical portfolio margining regime will discourage CDS clearing. 

Regulation of Clearinghouses 

Appropriate regulation of clearinghouses is of utmost importance to the financial 

system. Pursuant to Dodd-Frank, clearinghouses will be a key part of the efforts to 

decrease systemic risk in the derivatives markets. In order to accomplish this important mission, clearinghouses must be open and transparent, while exercising proper 

risk management controls. However, given the scope, complexity and importance of 

the OTC derivatives, ‘‘one-size-fits-all’’ regulation will not work. Flexibility is important, because regulators must be able to anticipate and respond to future problems—and not just yesterday’s crises. Prescriptive laws and regulations will hamper 

flexibility and create regulatory gaps. To be flexible, regulators must be prudential, 

understanding their markets and tailoring regulation to ensure market integrity 

and consumer protection. 

Regulators need clear lines of jurisdiction. Regulators need to provide certainty 

that they have the power to take actions to uphold the public good. Likewise, market participants need the certainty that their business transactions will not be held 

to conflicting standards of conduct. Further, regulatory certainty reduces the possibility of regulatory arbitrage, or long-term damage to the U.S. financial sector in 

a highly competitive global environment. 

The need for certainty extends beyond U.S. borders. It is vital to recognize that 

the OTC derivatives markets are global: most large companies in the developed 

world use derivatives, and they conduct these transactions with U.S. counterparties. 

Thus, U.S. regulators must work with international regulators from a common set 

of regulatory principles. Right now, Dodd-Frank has created significant uncertainty 

over whether a transaction will be subject to U.S. regulation or foreign regulation. 

This lack of clarity may begin to have an impact on markets, drying up liquidity 

and hampering regulatory reform efforts because market participants are unsure 

which laws apply. Therefore, harmonizing regulatory systems across countries and 

giving market participants is of utmost importance. 

Timing of Implementation 

Earlier this month, the CFTC and SEC held a roundtable to hear views on the 

implementation of Dodd-Frank. Dodd-Frank’s effective date is July 16th or at least 

60 days after a final rulemaking, if one is required. As the CFTC and SEC have 

come to realize, the legislation cannot (effectively or practically) take effect all at 

once. 

ICE believes that regulators should pursue an aggressive timetable to implement 

most sections of Dodd-Frank as soon as possible. While Dodd-Frank requires an 

enormous effort from both market participants and regulators, the cost of uncertainty is much higher. ICE has suggested to regulators that they pursue a threephase implementation plan. Phase 1 would implement transparency initiatives, including the important swap reporting and swap data repository regulations. Phase 

2 would implement the mandatory clearing and trading requirements, building on 

the transparency created by Phase 1. Phase 3 include everything else, such as non 

39 

spot month-position limits, which could constrain the mandatory trading and clearing requirements. This timeline is similar to what other organizations are suggesting, such as the Managed Fund Association. 

Flexibility is central to meeting these implementation goals. Regulators have an 

immense burden to implement Dodd-Frank. Creating a one-size-fits-all prescriptive 

system of regulations will only increase that burden, as regulators will be required 

to continually consider exemptions for markets that do not quite fit the regulator’s 

model. Likewise, market participants will have an easier time meeting implementation goals if they have the freedom to meet the goals of Dodd-Frank without radically changing their operations to meet prescriptive rules. 

Conclusion 

ICE has always been and continues to be a strong proponent of open and competitive markets, and of appropriate regulatory oversight of those markets. As an operator of global futures and OTC markets, and as a publicly held company, ICE understands the importance of ensuring the utmost confidence in its markets. To that 

end, we have continuously worked with regulatory bodies in the U.S. and abroad 

in order to ensure that they have access to all relevant information available to ICE 

regarding trading and clearing activity on our markets. We have also worked closely 

with Congress and regulators at home and abroad to address the evolving regulatory challenges presented by derivatives markets and will continue to work cooperatively for solutions that promote the best marketplace possible. 

Mr. Chairman, thank you for the opportunity to share our views with you. I would 

be happy to answer any questions you may have. 

PREPARED STATEMENT OF TERRENCE A. DUFFY 

EXECUTIVE CHAIRMAN, CME GROUP INC. 

MAY 25, 2011 

Chairman Reed, Ranking Member Crapo, Members of the Subcommittee, thank 

you for the opportunity to respond to the Subcommittee’s questions respecting clearing of swap contracts. I am Terry Duffy, Executive Chairman of CME Group (‘‘CME 

Group’’ or ‘‘CME’’), which is the world’s largest and most diverse derivatives marketplace. CME Group includes four separate exchanges—Chicago Mercantile Exchange 

Inc., the Board of Trade of the City of Chicago, Inc., the New York Mercantile Exchange, Inc., and the Commodity Exchange, Inc. (together ‘‘CME Group Exchanges’’). The CME Group Exchanges offer the widest range of benchmark products 

available across all major asset classes, including futures and options based on interest rates, equity indexes, foreign exchange, energy, metals, agricultural commodities, and alternative investment products. CME also includes CME Clearing, a derivatives clearing organization (DCO) and one of the largest central counterparty 

clearing services in the world; it provides clearing and settlement services for exchange-traded contracts, as well as for over-the-counter (OTC) derivatives transactions through CME Clearing and CME ClearPort®. The CME Group Exchanges serve the hedging, risk management and trading 

needs of our global customer base by facilitating transactions through the CME 

Globex® electronic trading platform, our open outcry trading facilities in New York 

and Chicago, as well as through privately negotiated transactions executed in compliance with the applicable Exchange rules and cleared by CME’s clearinghouse. In 

addition, CME Group distributes real-time pricing and volume data through a global 

distribution network of approximately 500 directly connected vendor firms serving 

approximately 400,000 price display subscribers and hundreds of thousands of additional order entry system users. CME’s proven high reliability, high availability 

platform coupled with robust administrative systems represent vast expertise and 

performance in managing market center data offerings. 

The financial crisis focused well-warranted attention on the lack of regulation of 

OTC financial markets. We learned a number of important lessons and Congress 

crafted legislation designed to reduce the likelihood of a repetition of that disaster. 

However, it is important to emphasize that regulated futures markets and futures 

clearinghouses operated flawlessly. Futures markets performed all of their essential 

functions without interruption and, despite failures of significant financial firms, 

our clearinghouse experienced no default and no customers on the futures side lost 

their collateral or were unable to immediately transfer positions and continue managing risk. Dodd-Frank was adopted to impose a new regulatory structure on a previously opaque and unregulated market—the OTC swaps market. It was not intended to engineer a new regulatory regime for the already robustly regulated futures markets. 

40 

For example, while Congress granted the Commodity Futures Trading Commission (CFTC or Commission) the authority to adopt rules respecting Core Principles, 

it did not direct it to eliminate principles-based regulation. Yet the Commission has 

proposed specific requirements for multiple Core Principles—almost all Core Principles in the case of designated contract markets (DCMs) and DCOs—which would 

eviscerate the principles-based regime that has fostered the ability of CFTC-regulated entities to effectively manage risk for the past decade. 

We support the overarching goals of DFA to reduce systemic risk through central 

clearing and exchange trading of derivatives, to increase data transparency and 

price discovery, and to prevent fraud and market manipulation. Unfortunately, DFA 

left many important issues to be resolved by regulators with little or ambiguous direction and set unnecessarily tight deadlines on rulemakings by the agencies 

charged with implementation of the Act. We have concerns about many of these proposed rulemakings, about which we have previously provided written testimony to 

the Senate Banking Committee and other committees of this Congress. For purposes 

of this hearing, we will focus on the following five questions posed to us by this Subcommittee: 

1. What issues may affect the safety and soundness of clearinghouses, and how 

should those issues be mitigated? 

2. What are the similarities and differences with other cleared products that 

should be considered when establishing clearinghouses for swaps? 

3. Are there unique attributes of certain asset classes that should be highlighted 

when considering adopting a clearing paradigm? How about unique attributes 

of certain market participants? 

4. What best practices should be considered regarding ownership, governance, or 

control of derivatives clearinghouses? 

5. What structural and economic barriers affect access to swap clearing? What 

must be done to eliminate or reduce those barriers? 

Question 1. What issues may affect the safety and soundness of clearinghouses, and how should those issues be mitigated? 

The safety and soundness of clearinghouses is a major focus of Dodd-Frank. The 

Core Principles for derivative clearinghouses compel DCOs to have adequate financial resources, comprehensive risk management procedures and safeguards against 

system failures. In addition, Dodd-Frank includes eight additional Core Principles 

dealing with the safety and soundness of derivative clearinghouses. Moreover, the 

CFTC has been granted increased power to force a derivative clearinghouse to alter 

a procedure or implement a new procedure if it is not in compliance with the Core 

Principles, without the procedural steps previously required. The rigid rules being 

proposed by the CFTC with respect to risk management are unnecessary and destructive of innovation and competition. Such a prescriptive set of requirements will 

force clearinghouses into a rigid methodology for managing risk and inhibit the ability of individuals best positioned to adapt risk management methodologies to changing circumstances. The end result of this would be to increase, rather than reduce 

risk. 

CME Group appreciates the importance to the broader financial system of a regulatory regime designed to ensure that every DCO can perform its role as a central 

counterparty, including performance of its financial obligations during periods of 

market stress. In that regard, the Commission’s DCO Core Principles have functioned admirably and effectively over the years, including during the 2008 financial 

crisis. CME Group can support regulations that enhance the Commission’s existing 

core principle system, if they strike a responsible balance between establishing general prudential standards and prescriptive requirements. 

On March 21, 2011, CME Group, by its CEO Craig Donohue, filed a detailed 17- 

page letter commenting on an additional set of CFTC risk management requirements for clearinghouses. The letter, which will not be repeated here, may be 

accessed at http://comments.cftc.gov/PublicComments/ 

ViewComment.aspx?id=31993&SearchText=. CME’s position on this issue can be 

summarized as follows: 

The Commission’s Notice of Proposed Rulemaking addresses the critically 

important topic of risk management practices at DCOs. Greater use of 

DCOs for OTC derivatives heightens the importance of ensuring that risk 

management at every DCO is robust and comprehensive. The unique risk 

characteristics of OTC derivatives products and markets underscore the importance of DCOs retaining reasonable discretion and flexibility to adapt 

risk management practices as products and markets develop over time. 

41 

Risk management is not an assembly line type of process that can be 

commoditized, codified and deployed in such a way as to ensure that risk 

management regimes of DCOs remain prudent and agile. Indeed, very few 

aspects of risk management can be standardized across all cleared markets 

to such an extent that a rules-based regime can describe each potential condition that can arise and the necessary actions that can and should be 

taken to mitigate risk. CME Group is therefore very concerned that certain 

provisions in the proposed regulations would diminish CME Clearing’s ability to effectively manage risk by requiring each DCO to employ the same 

rigid, standardized risk management procedures. 

Consistent with the CFTC’s approach in a number of other rulemakings, 

regulations proposed in the NPR further the CFTC’s retraction of the highly 

successful principles-based regime that has permitted U.S. futures markets 

to prosper as an engine of economic growth for this Nation, to a restrictive, 

rules-based regime that will stifle growth, innovation, and flexibility in risk 

management. As we have noted in comment letters in response to other 

proposals, Congress not only preserved principles-based regulation in the 

Dodd-Frank Act, it reinforced the vitality of that regime by expanding the 

list of core principles applicable to DCOs. Although DFA granted the CFTC 

the authority to adopt regulations with respect to core principles, it did not 

direct the CFTC to eliminate principles-based regulation. Rather, DFA 

made clear that DCOs were granted reasonable discretion in establishing 

the manner in which they comply with the Core Principles. 

Furthermore, certain of the proposed prescriptive regulations would impose 

significant costs not only on DCOs and their clearing members, but on the 

CFTC, with little or no corresponding regulatory benefit. In that regard, 

CME Group is very concerned that the CFTC has not performed the required cost/benefit analyses with respect to the rulemaking proposals in the 

NPR. Aside from certain information provided in connection with recordkeeping and reporting requirements, the ‘‘cost/benefit analysis’’ with regard 

to the regulations proposed in connection with the Core Principles consists 

of little more than the following two assertions: (1) ‘‘With respect to costs, 

the Commission has determined that the costs to market participants and 

the public if these regulations are not adopted are substantial’’; and (2) 

‘‘With respect to benefits, the Commission has determined that the benefits 

of the proposed rules are many and substantial’’. In requiring the CFTC to 

consider costs and benefits of its proposed actions, Congress requires an actual and concrete estimate of costs of agency action. The mere uncertainty 

of cost estimates does not excuse the CFTC from issuing such an estimate. 

The performance of actual and concrete cost/benefit analyses is particularly 

important for any regulator proposing to adopt regulations that would increase the costs of central clearing of OTC derivatives. 

One of the CFTC proposals which causes us great concern is the CFTC’s proposal 

to establish lower financial resource requirements for nonsystemically important 

DCOs, an approach we believe will exacerbate rather than ameliorate systemic risk. 

The CFTC relies on Title VIII of Dodd-Frank in proposing Regulation 39.29, which 

would require a DCO that is deemed systemically important (a SIDCO) to comply 

with substantially different and higher financial resources requirements than any 

DCO that the Financial Stability Oversight Council does not designate as systemically important. As proposed, Regulation 39.29 would: (1) require a SIDCO to maintain financial resources sufficient to meet its financial obligations notwithstanding 

a default by the two clearing members creating its largest financial exposures; (2) 

limit a SIDCO’s use of assessment powers to cover financial resources requirements 

relating to a default by the clearing member creating its second largest financial exposure; and (c) for purposes of valuing its assessment powers, require a SIDCO to 

apply the same 30-percent haircut and 20-percent post-haircut cap on assessments 

as proposed for nonsystemically important DCOs in Regulation 39.11(d). 

Any regulation should subject all DCOs to the same substantive financial resources requirements, and subject systemically important DCOs to more frequent 

stress testing and reporting requirements. We believe this approach is better designed to achieve Dodd-Franks’ objectives of promoting robust risk management, 

promoting safety and soundness, reducing systemic risk and supporting the broader 

financial system. 

Setting a lower bar for nonsystemically important DCOs with regard to financial 

resources requirements (and, presumably, for certain other DCO core principles, including Core Principle D regarding risk management) would allow those DCOs to 

offer lower guaranty fund and margin requirements. In addition to putting SIDCOs 

42 

at an unfair competitive disadvantage, this approach would likely attract additional 

volume to at least some nonsystemically important DCOs and transform them into 

de facto SIDCOs. However, until such time as they were designated SIDCOs by the 

Council and given sufficient time to come into compliance with the higher requirements for SIDCOs, they would be operating under the lower and less costly standards for nonsystemically important DCOs. This would contravene Title VIII’s stated 

objectives of promoting robust risk management, promoting safety and soundness, 

reducing systemic risk and supporting the broader financial system. 

CME Group therefore urges that all DCOs be subject to the same substantive financial resources requirements. We suggest that, rather than adopting Regulation 

39.29 as proposed, the Commission should adopt a regulation that subjects SIDCOs 

to more frequent stress testing and reporting requirements than any DCOs the 

Council does not designate as systemically important. For example, a SIDCO might 

be required to conduct bi-monthly stress tests of its ability to cover its default obligations (rather than monthly stress testing, as proposed for all DCOs), and to submit to the Commission the reports required under proposed Regulation 39.11(f) on 

a monthly basis (rather than a quarterly basis, as proposed for all DCOs). This alternative approach comports with the Council’s recent statement that systemically 

important financial market utilities should be ‘‘subject to enhanced examination, supervision, enforcement and reporting standards and requirements.’’ 

CME Group is a staunch supporter of robust and comprehensive risk management 

practices throughout the cleared derivatives markets. As further explained below, 

we are supportive of those aspects of the proposed regulations that seek to implement appropriate and cost-effective measures to build upon the principles-based regime the CFTC has overseen in recent years and that performed admirably during 

the recent financial crisis. It is that regime that should be extended to the cleared 

swaps markets, and not an untested rules-based regime that, at least in part, appears to be based upon arbitrary assumptions and rigid concepts about how DCOs 

should manage risk. 

Question 2. What are the similarities and differences with other cleared 

products that should be considered when establishing clearinghouses 

for swaps? 

If a swap contract and a futures contract have similar volatility and trade in a 

mature, liquid market, which should be the case for the major plain vanilla swaps, 

the considerations for clearing the contracts are identical. Thinly traded swaps 

present more difficult management processes, which our clearinghouse aims to overcome through its admission and risk management processes. 

This similarity between swaps and futures for a large part of the OTC market 

counsels in favor of adopting the clearing rules that have worked so successfully in 

futures markets. Indeed, a focus of Dodd-Frank is to bring the OTC swaps market 

into a regulatory scheme similar to that which allowed the futures markets to function flawlessly throughout the financial crisis. If the CFTC and the SEC are to meet 

the goals of Dodd-Frank to transition from the world of unregulated, uncleared OTC 

trading to a world more nearly approximating the highly successful futures model 

clearing, they should adhere to the principles which have already proven effective 

in the management of risk. Instead, the proposed clearing rules require a significant, untested, and costly revision of an approach that has proved successful in the 

futures model and require that this new model be implemented in an impossibly 

short time frame. 

For example, it does not make sense to impose an entirely new regime for segregation of customer assets for swap clearing, which will impose significant costs on 

participants and undermine efficient risk mitigation, when the existing model of futures clearing has provided 100 percent protection against loss due to customer default. In its Advanced Notice of Proposed Rulemaking (ANPR), however, regarding 

segregation of customer funds, the Commission notes that it is considering imposing 

an ‘‘individual segregation’’ model for customer funds belonging to swaps customers. 

A Notice of Proposed Rulemaking on this subject is forthcoming and appears to impose a form of ‘‘individual segregation’’ model for swaps clearing but not for futures 

clearing. Such a model would impose unnecessary costs on derivatives clearing organizations (DCOs) and customers alike. As noted in the ANPR, DCOs have long followed a model (the ‘‘baseline model’’) for segregation of collateral posted by customers to secure contracts cleared by a DCO whereby the collateral of multiple futures customers of a futures commission merchant (FCM) is held together in an omnibus account. If the FCM defaults to the DCO because of the failure of a customer 

to meet its obligations to the FCM, the DCO is permitted (but not required), in accordance with the DCO’s rules and CFTC regulations, to use the collateral of the 

FCM’s other futures customers in the omnibus account to satisfy the FCM’s net cusVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00046 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
43 

tomer futures obligation to the DCO. Under the baseline model, customer collateral 

is kept separate from the property of FCMs and may be used exclusively to ‘‘purchase, margin, guarantee, secure, transfer, adjust or settle trades, contracts or commodity option transactions of commodity or option customers.’’ A DCO may not use 

customer collateral to satisfy obligations related to an FCM’s proprietary account. 

In its ANPR, the Commission suggests the possibility of applying a different customer segregation model to collateral posted by swaps customers, proposing three 

separate models, each of which requires some form of ‘‘individual segregation’’ for 

customer cleared-swap accounts. Each of these models would severely limit the 

availability of other customer funds to a DCO to cure a default by an FCM based 

on the failure of a customer to meet its obligations to the DCO. The imposition of 

any of these alternative models first, is outside of the Commission’s authority under 

DFA and second, will result in significant and unnecessary costs to DCOs as well 

as to customers—the very individuals such models are allegedly proposed to protect. 

CME Group recognizes that effective protection of customer funds is critical to 

participation in the futures and swaps markets. This fact does not, however, call for 

a new segregation regime. The baseline model has performed this function admirably over the years, with no futures customers suffering a loss as a result of an 

FCM’s bankruptcy or default. There is no reason to believe it will not operate as 

well in the swaps market. DFA did nothing to change this segregation regime as 

applied to futures, and as noted above, a focus of DFA is to bring the OTC swaps 

market into a regulatory scheme similar to that which allowed the futures markets 

to function flawlessly throughout the financial crisis. To this end, it is unreasonable 

to believe that Congress would intend to require a different scheme of segregation 

of customer funds and as a result, a different margining and default model than 

that currently used in the futures markets. Imposing such a conflicting model would 

complicate the function of DCOs intending to clear both futures and swaps. Indeed, 

the statutory language adopted in Section 724 of DFA does nothing to compel such 

a result. 

The imposition of a different customer segregation system could undermine the 

intent behind DFA by imposing significantly higher costs on customers, clearing 

members, and DCOs intending to clear swaps and injecting moral hazard into a system at the customer and FCM levels. A change from the baseline model would interfere with marketplace and capital efficiency as DCOs may be required to increase 

security deposits from clearing members. That is, depending on the exact methodology employed, DCOs may be forced to ask for more capital from clearing members. 

Based on CME Group’s initial assessments, these increases in capital requirements 

would be substantial. For example, CME Group’s guarantee fund would need to double in size. Aside from these monetary costs, adoption of a segregation model would 

create moral hazard concerns at the FCM level. That is, the use of the new proposed 

models could create a disincentive for an FCM to offer the highest level of risk management to its customers (if the oversight and management of individual customer 

risk was shifted to the clearinghouse) and continue to carry the amount of excess 

capital they do today. 

Imposition of the suggested systems could increase costs and decrease participation in the CFTC-regulated cleared-swaps market because customers may be unable 

or unwilling to satisfy resultant substantially increased margin requirements. FCMs 

would face a variety of increased indirect costs, such as staffing costs, new systems 

and compliance and legal costs and direct costs such as banking and custodial fees. 

FCMs would likely, in turn, pass these costs on to customers. Additionally, smaller 

FCMs may be forced out of business, larger FCMs may not have incentive to stay 

in business, and firms otherwise qualified to act as FCMs may be unwilling to do 

so due to the risk and cost imposed upon the FCM model by individualized segregation. This could lead to a larger concentration of customer exposures at fewer FCMs, 

further increases to margin and guarantee fund requirements, and further increased 

costs to customers. All of these consequences would lead to decreased participation 

in U.S. futures and swaps exchanges and result in loss of jobs in the United States. 

Question 3. Are there unique attributes of certain asset classes that should 

be highlighted when considering adopting a clearing paradigm? How 

about unique attributes of certain market participants? 

As noted above, a thorough understanding of the liquidity and other characteristics of the market for a swap in normal and stressed circumstances is the key to 

safety and soundness in clearing. Different swaps with different liquidity and other 

varied characteristics, put simply, carry with them different risks. Interest rate 

swaps based on U.S., UK, and EU instruments should be easy to liquidate in the 

event of a default as are futures on U.S. debt or Eurodollars. Single name credit 

44 

default swaps are expected to require an elaborate preset process and direct participation for clearing members. 

These differences in swaps, as well as the simple fact that Dodd-Frank imposes 

a brand new clearing regime on the OTC swaps market, counsels in favor of a slow 

phasing-in of swap clearing. The Commission’s proposed rules for mandatory clearing and trading of swaps should be revised to stage the transition from the existing 

market structure so that the participants may make the technical and documentary 

changes necessary to avoid technological and legal risks. We believe that the following template will make the transition to clearing swaps under DFA the quickest, 

least costly and most complete and effective. 

Stage 1: Continued Voluntary Clearing. 

• The Commission’s first action must be to avoid impairment of the current successful clearing process for swaps and swaps converted to futures. 

• The Commission should promptly make the requisite finding, pursuant to Section 5c(b), that a DCO, which is clearing swaps as of the effective date of DFA, 

will be permitted to continue clearing swaps of the same class and will also be 

permitted to clear any swap that is economically equivalent to any futures contract that it was clearing prior to the DFA effective date. 

• The Commission should approve the collateral and risk management practices 

and procedures that were in place as of the DFA effective date pending further 

notice. This means that the traditional form of customer segregation must continue and any of the proposed alternatives to limit or eliminate fellow-customer 

risk must be delayed until all of the remaining stages for implementing mandatory clearing have been approved. DCOs must be permitted to operate pursuant 

to the Core Principles, as amended by DFA, during this period. 

• The CFTC should also demonstrate that it will abide by its commitment to preserve the cross margining benefits currently available to the users of ClearPort. 

The Commission should adopt a regulation that treats any ClearPort product 

that is cleared as a future as of the DFA effective date, but which is subsequently cleared as a swap, as entitled to be carried in a 4d account with customer futures contracts. 

Stage 2: Mandatory Clearing of Certain Dollar Denominated Swaps. 

• Promptly after the effective date of DFA, the Commission should make an initial determination, pursuant to CEA section 2(h)(2)(A)(i), that all U.S. dollar denominated swaps that are structurally and economically equivalent to swaps 

that are being cleared by a DCO or ICE Trust as of the DFA effective date are 

subject to the mandatory clearing requirement. This determination, if it becomes final, will subject more than 60 percent of the swaps market—that has 

not been exempted from the defined term by the Department of Treasury—to 

mandatory clearing. Next, ‘‘the Commission shall provide at least a 30-day public comment period regarding any determination made under clause (i).’’ Section 

2(h)(2)(A)(ii) 

• At this point, section 2(h) provides a clear path for anyone who objects to the 

finding to make its views known and to invoke an additional review process by 

the Commission, taking into account the factors described in section 2(h). The 

review process should be staged so that final determinations are made first for 

the highest volume swaps. 

• The Commission should not adopt differing start dates for different classes of 

traders for mandatory clearing of particular types of swaps. 

• This proposal will (i) preserve customer choice in clearing, (ii) bring the largest 

volume of swaps into clearinghouses as soon as possible, and (iii) allocate the 

Commission’s resources in an efficient manner. 

Stage 3: Reconsider and Repropose Regulations Respecting the Operation of DCOs. 

• Do not deviate from the Core Principles regulatory regime without cause. 

• Do not change the method of customer segregation without cause (as further 

discussed above). 

Stage 4: Registration of SEFs. 

• Finalize rules respecting the structure and operation of SEFs. 

• Allow an adequate number of days for SEFs to become operational and to test 

connections to DCOs, SDRs, and customers. 

• Implement mandatory trading requirement. 

45 

Stage 5: Mandatory Clearing of Dollar Denominated Swaps Listed for Clearing Post 

DFA Effective Date. 

Stage 6: Mandatory Clearing of Swaps Denominated in G7 Currencies. 

Question 4. What best practices should be considered regarding ownership, 

governance, and control of derivatives clearinghouses? 

The extensive rules proposed by the CFTC respecting ownership, governance and 

control of derivative clearinghouses can and should wait until there is evidence that 

the specific limitations in Dodd-Frank do not adequately control the potential problem. The Core Principles for derivative clearinghouses are clear, comprehensive and 

easily shaped and enforced by the Commission on an as necessary basis. Section 5b 

of the CEA specifically insures: fairness respecting participant and product eligibility, appropriate governance fitness standards, prevention of conflicts of interest 

and appropriate composition of governing boards. The CFTC drafted these provisions. In the event that Dodd-Frank does prove insufficient, which is highly unlikely, the Commission could consider drafting ‘‘best practices’’ or safe harbors for 

ownership, governance, and control rather than extremely prescriptive measures 

like those in the proposed rules. 

The Commission’s proposed rules regarding the mitigation of conflicts of interest 

in DCOs, DCMs and SEFs (Regulated Entities) exceed its rulemaking authority 

under DFA and impose constraints on governance that are unrelated to the purposes of DFA or the CEA. Section 726 conditions the Commission’s right to adopt 

rules mitigating conflicts of interest to circumstances where the Commission has 

made a finding that the rule is ‘‘necessary and appropriate’’ to ‘‘improve the governance of, or to mitigate systemic risk, promote competition, or mitigate conflicts of 

interest in connection with a swap dealer or major swap participant’s conduct of 

business with, a [Regulated Entity] that clears or posts swaps or makes swaps available for trading and in which such swap dealer or major swap participant has a material debt or equity investment.’’ The ‘‘necessary and appropriate’’ requirement constrains the Commission to enact rules that are narrowly tailored to minimize their 

burden on the industry. The proposed rules are not narrowly tailored but rather 

overbroad, outside of the authority granted to it by DFA and needlessly burdensome. The Commission proposed governance rules and ownership limitations that affect 

all Regulated Entities, including those in which no swap dealer has a material debt 

or equity investment and those that do not even trade or clear swaps. Moreover, 

the governance rules proposed have nothing to do with conflicts of interest, as that 

term is understood in the context of corporate governance. Instead, the Commission 

has created a concept of ‘‘structural conflicts,’’ which has no recognized meaning outside of the Commission’s own declarations and is unrelated to ‘‘conflict of interest’’ 

as used in the CEA. The Commission proposed rules to regulate the ownership of 

voting interests in Regulated Entities by any member of those Regulated Entities, 

including members whose interests are unrelated or even contrary to the interests 

of the defined ‘‘enumerated entities.’’ In addition, the Commission is attempting to 

impose membership condition requirements for a broad range of committees that are 

unrelated to the decision making to which Section 726 was directed. 

The Commission’s proposed rules are most notably overbroad in that they address 

not only ownership issues but the internal structure of public corporations governed 

by State law and listing requirements of SEC regulated national securities exchanges. More specifically, the proposed regulations set requirements for the composition of corporate boards, require Regulated Entities to have certain internal 

committees of specified compositions and even propose a new definition for a ‘‘public 

director.’’ Such rules in no way relate to the conflict of interest Congress sought to 

address through Section 726. Moreover, these proposed rules improperly intrude 

into an area of traditional State sovereignty. It is well established that matters of 

internal corporate governance are regulated by the States, specifically the State of 

incorporation. Regulators may not enact rules that intrude into traditional areas of 

State sovereignty unless Federal law compels such an intrusion. Here, Section 726 

provides no such authorization. 

Perhaps most importantly, the proposed structural governance requirements cannot be ‘‘necessary and appropriate,’’ as required by DFA, because applicable State 

law renders them completely unnecessary. State law imposes fiduciary duties on directors of corporations that mandate that they act in the best interests of the corporation and its shareholders—not in their own best interests or the best interests 

of other entities with whom they may have a relationship. As such, regardless of 

how a board or committee is composed, the members must act in the best interest 

of the exchange or clearinghouse. The Commission’s concerns—that members, enumerated entities or other individuals not meeting its definition of ‘‘public director’’ 

46 

will act in their own interests—and its proposed structural requirements are wholly 

unnecessary and impose additional costs on the industry—not to mention additional 

enforcement costs—completely needlessly. 

Question 5. What structural and economic barriers affect access to swap 

clearing? What must be done to eliminate or reduce those barriers? 

An end user of swaps with sufficient credit and resources to enter into a swap 

will experience no barrier to clearing under Dodd-Frank. A firm that seeks to act 

as a clearing member of a swaps clearinghouse must meet the operational and financial requirements of that clearinghouse, which should be set sufficiently high to 

meet the clearinghouse’s obligations under Dodd-Frank’s Core Principles for DCOs. 

Dodd-Frank’s requirements regarding safety and soundness modify a clearinghouse’s obligation to grant open access to any potential clearing member. The issues 

of managing a default involving an immature or illiquid swap contract require higher admission standards than for a futures clearinghouse. 

The Commission’s proposed rules regarding submissions by DCOs seeking approval to clear swaps may, however, provide a barrier to access to clearing simply 

because they impose extreme difficulty and expense on a DCO seeking to clear a 

given swap. The proposed regulations treat an application by a DCO to list a particular swap for clearing as obliging that DCO to perform due diligence and analysis 

for the Commission respecting a broad swath of swaps, as to which the DCO has 

no information and no interest in clearing. In effect, a DCO that wishes to list a 

new swap would be saddled with the obligation to collect and analyze significant 

amounts of information to enable the Commission to determine whether the swap 

that is the subject of the application and any other swap that is within the same 

‘‘group, category, type, or class’’ should be subject to the mandatory clearing requirement. 

The proposed regulation eliminates the possibility of a simple, speedy decision on 

whether a particular swap transaction can be cleared—a decision that the DFA 

surely intended should be made quickly in the interests of customers who seek the 

benefits of clearing—and forces a DCO to participate in an unwieldy, unstructured, 

and time-consuming process to determine whether mandatory clearing is required. 

Regulation Section 39.5(b)(5) starkly illustrates this outcome. No application is 

deemed complete until all of the information that the Commission needs to make 

the mandatory clearing decision has been received. Completion is determined in the 

sole discretion of the Commission. This proposed regulation is one among several 

proposals that imposes costs and obligations whose effect and impact are contrary 

to the purposes of Title VII of DFA. The costs in terms of time and effort to secure 

and present the information required by the proposed regulation would be a significant disincentive to DCOs to voluntarily undertake to clear a ‘‘new’’ swap. This process to enable an exchange to list a swap for clearing is clearly contrary to the purposes of DFA. 

Thank you for allowing us to respond to these important questions. 

PREPARED STATEMENT OF BENN STEIL 

SENIOR FELLOW AND DIRECTOR OF INTERNATIONAL ECONOMICS, COUNCIL ON

FOREIGN RELATIONS

MAY 25, 2011 

Thank you Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee for the opportunity to present to you this morning my views on the important subject of derivatives clearing. 

The collapse of Lehman Brothers and AIG in September of 2008 highlighted the 

importance of regulatory reforms that go beyond trying to prevent individual financial institutions from failing. We need reforms that act to make our markets more 

resilient in the face of such failures—what engineers and risk managers call ‘‘safefail’’ approaches to risk management. Well capitalized and regulated central derivatives clearinghouses to track exposures, to net trades and to novate them, to collect 

proper margin on a timely basis, and to absorb default risk have historically provided the best example of successful ‘‘safe-fail’’ risk management in the derivatives 

industry. 

Compare the collapse of the large hedge fund Amaranth in 2006 with the collapse 

of AIG in 2008. Both were laid low by derivatives exposures. Yet whereas the failure 

of Amaranth caused barely a ripple in the markets, owing to its exposures having 

been in centrally cleared exchange-traded natural gas futures contracts, the failure 

of AIG precipitated justifiable concerns of widespread market contagion that ultimately required a massive and enormously controversial Government intervention 

47 

and bailout to contain. Had AIG been building derivatives exposures on-exchange 

rather than in the OTC markets, its reckless speculation would have been brought 

to a halt much earlier owing to minute-by-minute exposure tracking in the clearinghouse and unambiguous mark-to-market and margining rules. The long, drawn-out 

wrangling between AIG and Goldman Sachs over the collateral required to cover 

AIG’s deteriorating derivatives positions would never have been possible had a 

clearinghouse stood between the two. Furthermore, AIG’s net exposures in the marketplace would not have been the subject of rumor or surmise, but a simple matter 

of record at the clearinghouse. 

Encouraging a shift in derivatives trading from OTC markets without central 

clearing to organized, Government-regulated markets with central clearing is challenging, however, for two major reasons. 

First, the dealers that dominate the OTC derivatives business have no incentive 

to accommodate such a shift. Dealers earn approximately $55 billion in annual revenues from OTC derivatives trading. Some of the largest earn up to 16 percent of 

their revenues from such trading. The movement of such trading onto exchanges 

and central clearinghouses has the potential to widen market participation significantly, to increase the transparency of prices, to reduce trading costs through the 

netting of transactions, and in consequence to reduce the trading profits of the largest dealers materially. It is natural, therefore, that dealers should resist a movement in trading activity onto exchanges and clearinghouses. Where compelled by 

regulation to accommodate it, dealers can also be expected to take measures to control the structure of, and limit direct access to, the clearing operations. The use of 

measures such as unnecessarily high capital requirements in order to keep smaller 

competitors or buy-side institutions from participating directly as clearinghouse 

members are to be expected. 

Indeed, trading infrastructure providers organized as exclusive mutual societies of 

major banks or dealers have a long history of restricting market access. For example, in the foreign exchange markets, the bank-controlled CLS settlement system 

has long resisted initiatives by exchanges and other trading service providers to 

prenet trades through a third-party clearing system prior to settlement. Such netting would significantly reduce FX trading costs for many market participants, but 

would also reduce the settlement revenues generated by CLS and reduce the trade 

intermediation profits of the largest FX dealing banks. Other settlement service providers such as DTCC have no incentive to offer competition to CLS, as they are 

owned by the very same banks. There are therefore solid grounds for regulators to 

apply basic antitrust principles to the clearing and settlement businesses in order 

to ensure that market access is not being unduly restricted by membership or ownership limitations that cannot be justified on safety and soundness grounds. 

Second, some types of derivatives contracts do not lend themselves to centralized 

clearing as well as others. Customized contracts, or contracts which are functionally 

equivalent to insurance contracts on rare events, are examples. Since it can be difficult for policy makers or regulators to determine definitively whether given contracts—new types of which are being created all the time—are well suited for central clearing, it is appropriate to put in place certain basic trading regulations in 

the OTC markets that will serve both to make such trading less likely to produce 

another AIG disaster and to encourage the movement of trading in suitable products 

onto central clearinghouses. Two such measures would be to apply higher regulatory 

capital requirements for noncleared trades, in consequence of the higher 

counterparty risk implied by such trades, and to mandate trade registration and collateral management by a regulated third party, such as an exchange. 

In establishing the regulatory standards for the clearing of derivatives transactions, it is imperative for lawmakers and regulators to be fully conscious of the 

fact that the derivatives market is effectively international, rather than national, 

and that it is exceptionally easy for market participants to change the legal domicile 

of their trading activities with a keystroke or a simple change of trading algorithm. 

In this regard, I would highlight two important areas of concern. 

First, the three major world authorities controlling the structure of the derivatives clearing business—the SEC, the CFTC, and the European Commission—each 

take a very different view of the matter. Historically, the SEC has applied what I 

would term the ‘‘utility’’ model to the industry, the CFTC has applied what I would 

term the ‘‘silo’’ model, and the European Commission has applied what I would term 

the ‘‘spaghetti’’ model. The broad benefits of each are depicted in the matrix below. 

48 

The SEC’s utility model favors institutions operated outside the individual exchanges; in particular the DTCC in the equity markets and the OCC in the options 

markets. This approach has generally performed well in terms of safety and soundness, and in encouraging competition among exchanges. It performs poorly, however, 

in terms of encouraging innovation in clearing and settlement services. 

The CFTC’s silo model allows the individual exchanges to control their own clearinghouses. This approach has also performed well in terms of safety and soundness. 

The recent decision of the CME to raise margin requirements on silver trading is 

evidence of the model working well, in terms of the exchange placing a premium 

on the integrity and solvency of its clearing operations rather than trying to maximize short-term speculative trading volumes. The CFTC’s model also encourages innovation in product development in a way in which the SEC’s model does not. This 

is because CFTC-regulated futures exchanges can capture the benefits of product innovation in terms of generating trading volumes, whereas SEC-regulated options exchanges risk seeing trading volumes in new products migrate to other exchanges, 

all of which use clearing services provided by the OCC. The CFTC model, in consequence, does not promote competition from new trading venues in the same way 

that the SEC model does. It does, however, promote wider direct market participation in clearing systems, as demutualized exchanges have a commercial interest in 

expanding such access to buy-side institutions that dealers normally want to exclude. This reduces trading costs and expands market liquidity. 

The European Commission’s spaghetti model, enshrined in its so-called ‘‘Code of 

Conduct’’ for the industry, compels the EU’s clearinghouses to interoperate with 

each other. It also encourages both exchanges and clearinghouses to compete 

against each other. Like the SEC’s model, however, it can be expected to dampen 

incentives for product innovation, as clearing competition makes it more difficult for 

exchanges that own clearinghouses to maximize their trading and clearing revenue 

returns on new product development. More importantly, this model, I believe, is not 

conducive to ensuring safety and soundness, as it encourages clearinghouses to cut 

margin requirements and other prudential measures as a way to attract business 

from, or prevent business from moving to, other clearinghouses. It also injects a 

major element of operational risk into the business, in consequence of each clearinghouse being vulnerable to failures of technology or risk management in others. 

On balance, I believe that the CFTC’s model is the most appropriate for the derivatives industry, and I believe that the unworkability of the European Commission’s spaghetti approach will ultimately oblige it to move back in the CFTC’s direction. Although the CFTC’s approach does not promote interexchange competition as 

directly as the SEC’s model, it is important to note that new competitors are, in 

fact, entering into the futures business. ELX, founded in 2009, and NYPC, a recent 

joint venture between the NYSE and the DTCC which facilitates cross-margining 

of multiple products, are now competing with the CME in the financial futures 

space. 

49 

The second point I would like to make regarding the global nature of the derivatives trading industry is that certain measures to curb speculative activity being debated here in Washington are highly likely to push trading activity ‘‘off exchange’’— 

precisely the opposite of Congress’ intent. For example, a so-called Tobin Tax on futures transactions at the level being discussed last year, 2 basis points (0.02 percent), would be equivalent to over 400 times the CME transaction fee on Eurodollar 

futures. It should go without saying that a tax this large, relative to the current 

transaction fee on the underlying contract, would push all of this trading off the 

CME and into alternative jurisdictions. 

Likewise, commodity market position limits, if not harmonized with UK and other 

national authorities, will merely push such trading outside the CFTC’s jurisdiction. 

There is already an active regulatory arbitrage on oil and natural gas futures between the CME’s NYMEX exchange, which trades such contracts under CFTC regulation, and the Intercontinental Exchange (ICE), which trades such contracts under 

FSA regulation in London. We have seen indications of movement in trading from 

NYMEX to ICE in line with market perceptions of the likelihood of such limits being 

imposed in the United States. In short, we must be extraordinarily cautious not to 

undermine Congress’ worthy goal of bringing more derivatives trading under the 

purview of U.S.-regulated exchanges and clearinghouses by inadvertently providing 

major market participants incentives to do precisely the opposite. 

Thank you, Mr. Chairman, for the opportunity to present my views today on this 

important issue. 

PREPARED STATEMENT OF CHESTER S. SPATT 

PAMELA R. AND KENNETH B. DUNN PROFESSOR OF FINANCE, TEPPER SCHOOL OF

BUSINESS, CARNEGIE MELLON UNIVERSITY

MAY 25, 2011 

I am pleased and honored to have the opportunity to present my views to the Senate Subcommittee on Securities, Insurance, and Investment at its hearing today on 

‘‘Derivatives Clearinghouse: Opportunities and Challenges.’’ I am the Pamela R. and 

Kenneth B. Dunn Professor of Finance at the Tepper School of Business at Carnegie 

Mellon University, where I have been a faculty member since 1979. I also served 

as the Chief Economist of the U.S. Securities and Exchange Commission in Washington, DC, from July 2004 until July 2007. My expertise as a faculty member includes such areas as trading mechanisms, derivative securities, asset valuation, financial regulation, and the financial crisis. In addition to my faculty position my 

current affiliations include serving as a Research Associate of the National Bureau 

of Economic Research, Senior Economic Advisor to Kalorama Partners, and a member of both the Shadow Financial Regulatory Committee and Financial Economists 

Roundtable. I also was one of the founders and the second Executive Editor of the 

Review of Financial Studies, which quickly emerged as one of the preeminent journals in financial economics, as well as a Past President and Program Chair of the 

Western Finance Association. 

The changes in how our financial markets trade and clear derivative securities 

and swaps that now are being implemented are fundamental to the design of these 

markets. In the aftermath of the financial crisis the focus on migrating standardized 

swaps and derivatives to clear through central counterparties (CCPs) is a natural 

one and one to which I am sympathetic as an attempt to reduce the contagion associated with counterparty risk and make the structure of risk much more transparent. However, it is unclear whether the extent of use of clearinghouses will ultimately lead to a reduction in systemic risk in the event of a future crisis. Additionally, it will be crucial to manage carefully the risks within the clearinghouses. To 

the extent that risks or the fees of the clearinghouse are lower compared to 

uncleared derivatives, market participants could choose to increase their risk exposures. Of course, it is important that the fees for holding uncleared derivatives reflect economic costs and not be punitive to create artificial concentration of risk 

within the clearinghouse and also that the clearinghouse be sensitive to the incentives to dump transactions into it that are not marked properly. 

The clearinghouse structure is potentially subject to considerable moral hazard as 

there is a strong incentive for market participants to trade with weak counterparties (who may offer more favorable pricing), subject to their eligibility to clear 

through a centralized counterparty (CCP). However, at some point a CCP may not 

be willing to clear contracts from a weak counterparty because of the risk associated 

with the counterparty being unable to deliver on its dynamic margin obligations on 

a going forward basis. Then the CCP would be subject to serious counterparty risk. 

50 

1Speech at the Federal Reserve Bank of Atlanta conference on April 4, 2011. 

2 Roe, M., ‘‘Derivatives Clearinghouses Are No Magic Bullet’’, Wall Street Journal, May 6, 

2010. 3 ‘‘Pudd’nhead Wilson in Washington’’, Wall Street Journal editorial, April 23–24, 2011, p. 

A14. 

In situations where trading with weak counterparties (and effectively with the CCP) 

is especially attractive to other market participants, there is a greater risk exposure 

to the overall economy. For this reason and also because of the concentration of risk 

in the CCP, it is easy to anticipate that central clearing actually could raise systemic risk substantially in the event of a financial crisis. 

A number of observers have emphasized the absence of clearinghouse failures in 

the United States during the recent financial crisis. Of course, not every potential 

financial crisis is the same with respect to its causes, scale or transmission. Consequently, in my judgment we can only take limited comfort for the future from the 

absence of failure of a clearinghouse during the recent financial crisis. Indeed, Federal Reserve Chairman Ben Bernanke attributed the lack of failure of a clearinghouse during the financial crisis to ‘‘good luck’’ 1 in a speech at the recent Atlanta 

Federal Reserve Bank conference. Of course, many institutions that were previously 

thought to be essentially impervious and under various forms of Federal oversight 

either did collapse or would have collapsed without massive Federal guarantees (including Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Bear Stearns, Citigroup 

and Bank of America). It is generally recognized that clearinghouses can fail, 2 and 

indeed, a recent editorial in the Wall Street Journal 3 cited such relatively recent 

failures as those in France in 1974, Kuala Lumpur (Malaysia) in 1984 and Hong 

Kong in 1987. The regulatory and supervisory system will require much more of 

clearinghouses in the future than during the recent financial crisis, potentially amplifying their vulnerability. In his Atlanta Federal Reserve speech Chairman 

Bernanke summarized this point as follows, ‘‘As Mark Twain’s character 

Pudd’nhead Wilson once opined, if you put all your eggs in one basket, you better 

watch that basket.’’ Of course, this not only highlights the potential importance of 

regulatory supervision of the clearinghouse, but also that clearinghouses should be 

properly designed to limit their risk exposure. 

One of the challenges confronting the supervisor of the clearinghouse is whether 

the clearinghouse could require the possibility of a ‘‘bailout’’ to ward off failure. At 

hearings of the Senate Banking Committee in mid-April CFTC Chairman Gary 

Gensler agreed that the clearinghouses would not receive ‘‘too big to fail’’ guarantees 

or subsidies. Arguably, this is reflective of a political environment, which is now 

quite unsympathetic to the use of such guarantees. But this highlights the crucial 

importance of strong risk management of the central counterparty to avoid the potential collapse of a major clearinghouse in a financial crisis. While it’s a delicate 

balance, the importance of strong risk management potentially could be even at the 

expense of other values, such as promoting more competitive pricing of clearinghouse services. 

A key role of the clearinghouse is to make trading entities informationally insensitive to their specific counterparties. At the same time, there is a danger of a potentially large increase in systemic risk unless the risk is well managed by the clearinghouse, because the clearinghouse is a risk management platform that concentrates the risk in the economy. Thus, the governance of a clearinghouse must reflect a strong incentive to control risk and internalize the costs and benefits associated with alternative collateral standards. Limiting greatly the role of trading firms 

in the governance and promoting ‘‘independent directors’’ (who would lack the incentives to focus on managing and minimizing the risk and perhaps in some instances 

relevant experience) would create significant challenges and even reluctance by 

trading firms to allocate capital to the clearinghouse and back-stop the risks of the 

clearinghouse. Mutualization of risk is essential to the success of a clearinghouse 

model and affording protection against the ultimate risks being borne by society in 

the form of ‘‘too big to fail’’ guarantees. Yet the commentary of regulators focuses 

upon the more abstract notion of ‘‘conflicts of interest’’ in governance, without explicit focus on the incentives to control the underlying risks that would arise in the 

clearinghouse model. In light of this it is crucial that the governance of the clearinghouse, including the composition of the Board and especially the Risk Committee, 

reflect the importance that the broader society places on the elimination of ‘‘too big 

to fail’’ guarantees. To the extent policy makers choose to concentrate risk within 

a clearinghouse, it is crucial that the risk management of the clearinghouse mitigate 

the underlying systemic risk, including a strong risk management structure and 

governance aligned with that goal. 

51 

4 ‘‘SEC Adopts New Rule Preventing Unfiltered Market Access’’, Press Release 2010-210, November 3, 2010. http://www.sec.gov/news/press/2010/2010-210.htm; Also see, discussion in J. 

Angel, L. Harris, and C. Spatt, 2011, ‘‘Equity Trading in the 21st Century’’, Quarterly Journal 

of Finance, 1, 1–53. 5 Analogously, allowing the composition of directors to focus on risk management incentives 

and expertise also is a substitute for ‘‘too big to fail.’’ 6M. Goodfriend, 1990, ‘‘Money, Credit, Banking, and Payments System Policy’’, in U.S. Payments System: Efficiency, Risk, and the Role of the Federal Reserve, edited by David B. Humphrey, Kluwer Academic Publishers; also reprinted in Federal Reserve Bank of Richmond Economic Review, January/February 1991, pp. 7–23. 

Incentives are crucial to ensure that there is a reasonable attempt to align the 

incentives of various parties. For example, in the event of a crisis clearing members 

would potentially contribute financial and human capital to the CCP. It would create incentive problems to absolve smaller members of these duties (except for the 

limits related to their underlying capital contribution) or to allow them to outsource 

these to third parties whose incentives would not be aligned. It also is important 

to ensure that in the event of a crisis that the clearing members have funding available for their contingent capital obligations—to the extent that individual CCPs are 

unable to monitor their clearing members along such lines, it may be important for 

the regulator to supervise this to avoid a default cascade that would jeopardize the 

clearinghouse through a sequence of defaults. In fact, it’s important for the regulator to be sensitive to the complications that arise from the incentives of a set of 

profit-maximizing clearinghouses. 

Analogously, regulators are focused upon ‘‘access’’ to the clearinghouse by investing firms—but it is important to recognize that this is not a traditional trading platform, but an organization in which mutualization of risks by the membership is fundamental. Indeed, members should be required to have appropriately high capital 

pledged to protect the organization in that they are counterparties whose risk is 

being accepted by the clearinghouse and indeed, the members become the ultimate 

guarantors through the mutualization of risk. 

The issue of ‘‘direct access’’ surfaces in a number of different forms across markets—for example, requiring that orders be presented through intermediaries would 

be a way to protect markets against obvious errors in order presentation. Indeed, 

because of concerns about ‘‘direct access’’ in equity trading the SEC adopted a rule 

late last year eliminating direct unfiltered customer access in the order transmission process due to the systemic risk that would create for our system of equity 

clearance and settlement. 4

Another crucial policy choice is whether the clearinghouse would likely be a recipient of a bailout in the event of a failure in its risk management. The strong political consensus against the possibility of a bailout emphasizes the importance of 

strong risk management by the clearinghouse and a governance system, including 

restrictions on access through nonmembers and a board structure that makes risk 

management the central priority. From an economist’s perspective this highlights 

how restricting direct access is a partial substitute for ‘‘too big to fail.’’ 5 Using governance and access (as compared to other governmental regulatory tools) to enhance 

the competitiveness of pricing of clearinghouse services comes at the cost of making 

a bailout of the clearinghouse more likely. 

The analogy between risk management for a swaps clearinghouse and that for the 

clearinghouse for a payments system is striking. In the payment systems context 

my colleague Marvin Goodfriend [1990] writes, 6 ‘‘[I]t was efficient for private clearinghouses before the Fed to limit their membership to a relatively exclusive core of 

banks, allowing other banks access to the clearing system through agent-member 

banks. This suggests that it is efficient for the Fed to restrict direct access to its 

national clearing system as well, both to protect Fed lending generated in the payments systems and to protect the interbank credit market.’’ Goodfriend [1990] also 

observes that it is valuable ‘‘to restrict direct access to its national clearing system 

as well, to protect Fed daylight overdrafts and the interbank credit market.’’ In the 

context of a derivatives and swaps clearinghouse restriction on direct access by nonmembers leads to a system in which the clearinghouse members are responsible to 

protect the integrity of the clearinghouse. In that sense restrictions on direct access 

help assure financial stability and protect society against bearing greater costs from 

implicit ‘‘too big to fail’’ guarantees for the clearinghouse. If the clearinghouse member has strong incentives to monitor its customers, by imposing much of the risk 

created by customer losses on the introducing member, then a strong compatible 

risk management system will result. 

The absence of failures of clearinghouses in the financial crisis has been viewed 

by some as offering reassurance about the inherent stability of the clearinghouse 

model. Indeed, the clearinghouse model has a number of attractive features, such 

52 

7For example, see, ‘‘Derivatives, Clearing and Exchange-Trading’’, Statement No. 293 of the 

Shadow Financial Regulatory Committee, April 26, 2010, http://fic.wharton.upenn.edu/fic/policy percent20page/Statement%20No.%20293- 

%20Derivatives,%20Clearing%20and%20Exchange%20Trading.pdf. 

as, netting of exposures and greater transparency of risks. At the same time, this 

model presents greater sources of vulnerability due to concentration of risk and 

greater moral hazard at the customer level because there is no pricing differential 

or penalty imposed on weak counterparties as long as they are acceptable to the 

clearinghouse. In addition, to the extent that financial services firms believe they 

have essentially fully transferred various risks to the clearinghouse they likely will 

bear additional risks (systemic and otherwise) because of their enhanced risk-bearing capacity. It is extremely important to recognize and acknowledge the implications of the endogeneity of risk. Improvements in the management of collective risk 

potentially will incentivize financial services firms to take on more risk at the margin. For example, decisions about leverage will emerge endogenously. It is important 

to bring considerable caution and skepticism to discussions about risk management 

in the clearinghouses, especially in light of their broader contemplated role. 7

My underlying view on the relevance of economic principles to the structuring of 

clearinghouses also highlights the broader point that in restructuring the derivatives and swaps markets it is important to be sensitive to the economic consequences of contemplated rulemakings and undertake cost-benefit analyses that 

will identify these consequences and help to inform rule proposals. 

PREPARED STATEMENT OF CLIFFORD LEWIS 

EXECUTIVE VICE PRESIDENT, STATE STREET GLOBAL MARKETS

MAY 25, 2011 

Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee, 

thank you for the opportunity to testify today regarding the clearing-related provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. 

As an initial comment, I commend the CFTC for their efforts to date on DoddFrank implementation, where they are working on a broad range of highly complex 

issues, on a very aggressive timeframe. 

State Street is one of the world’s largest custodial banks and processors of derivatives transactions, and we support regulations which will benefit our customer base 

of large, buy-side, institutional investors, such as pension funds, mutual funds, and 

endowments. We support the Dodd-Frank mandates for both derivatives clearing 

and execution, which we believe will reduce global systemic risk, and, properly implemented, benefit our institutional investor customer base. 

Like most market participants, our buy-side clients are concerned by the current 

regulatory uncertainty and the potentially significant cost and market liquidity impacts that may result from the new rules. At State Street, we are well positioned 

to provide our clients with full-service clearing and other services that can help 

them realize the benefits of the new derivatives regime, through enhanced transparency, more open execution platforms, and central clearing. 

In relation to central clearing, the key issue for State Street is effective implementation of the Dodd-Frank Act’s requirement that clearinghouse membership requirements ‘‘permit fair and open access.’’ Open access will reduce systemic risk by avoiding concentration of clearing activity with a small number of existing ‘‘dealer’’ members, and benefit the buy-side by allowing netting across dealers on swaps that clear 

through the same clearinghouse. 

State Street intends to pursue membership in a variety of derivatives clearinghouses, and the Dodd-Frank requirement for open access is an important element 

in our ability to increase competition in the clearing services marketplace. 

I’d like to make a few specific recommendations: 

First, we support the CFTC’s participant eligibility rules as proposed, but note 

these rules will require vigilant oversight by the CFTC. The proposed rules recognize the critical importance of strong clearinghouse risk management practices, 

while, at the same time, permit broader clearinghouse membership, reducing systemic risk and allowing buy-side market participants to benefit from alternative 

clearing member business models. As we noted in our comment letter to the CFTC, 

we are concerned that some clearinghouses will carry forward their current restrictive membership requirements, in direct contradiction of the spirit and intent of 

Dodd-Frank. 

53 

Second, clearing members must be required to demonstrate the necessary financial and operational resources to execute their duties to customers and the clearinghouse. Strong capital rules are important, but should be risk-based rather than arbitrary dollar amounts. We have suggested linking capital requirements to other riskbased clearinghouse measures, such as a multiple of default fund contributions. 

Other arbitrary requirements linked to a dealer-specific business model, such as a 

minimum swap book, are not risk-based and will prohibit membership by nondealer 

firms. Outsourcing of certain functions should be allowed, provided that the execution risk associated with such outsourcing rests with the member firm and not the 

clearinghouse. By way of example, the current model of the futures markets showed 

itself well structured to handle such crises, as the successful wind-down of Lehman’s 

futures positions by nonmembers demonstrated at the time of its bankruptcy. 

Third, both the clearing and the execution mandates should go into effect at the 

same time. 

Clearing is most effective when tied to execution, providing market participants 

with greater transparency, tighter spreads and cost reduction. Phasing-in the clearing requirement in advance of the execution requirement would burden market participants with increased costs while denying them the corresponding benefits. If 

some form of phasing is deemed necessary by the CFTC, it should be done by instrument and require that as each new instrument is folded under the regulatory regime, both the clearing and execution requirements attach simultaneously. 

Fourth, to the extent possible, regulations governing clearinghouse membership 

rules should be coordinated globally, to avoid regulatory arbitrage that could frustrate the Dodd-Frank requirements for open access. 

Finally, in order to allow the markets and participants to adjust to new ways of 

doing business, we suggest that a 6-month transition period be given between finalization of the mandatory clearing and execution rules and mandatory compliance. 

The final rules will provide certainty to the markets as to what the new regulatory 

demands are, and only then will businesses be in a position to plan and adapt accordingly. 

Again, State Street strongly believes in the importance of the clearing and execution mandates as spelled out in Dodd-Frank, and we stand ready to help Congress, 

the Administration and the regulators as the process of rule writing and implementation goes forward. 

Thank you for the invitation to testify before you today. I will be happy to take 

your questions. 

PREPARED STATEMENT OF DON THOMPSON 

MANAGING DIRECTOR AND ASSOCIATE GENERAL COUNSEL, JPMORGAN CHASE & CO. 

MAY 25, 2011 

Chairman Reed, Ranking Member Crapo, and Members of the Committee, my 

name is Don Thompson, and I am a Managing Director and Associate General 

Counsel at JPMorgan Chase & Co (JPMC). I head our derivatives legal group and 

have been actively involved in implementation of Title VII of the Wall Street Reform 

and Consumer Protection Act (the ‘‘Act’’). Thank you for inviting me to testify today 

on the opportunities and challenges of derivatives clearinghouses (CCPs). 

JPMC has been an active participant in the development and management of 

clearinghouses with direct membership in 77 clearinghouses for a variety of markets 

including listed and over-the-counter (OTC) derivatives, equity and fixed income securities. We are committed to clearing OTC derivatives transactions and have been 

clearing dealer-to-dealer OTC transactions for a decade. Today major swap dealers 

clear over 90 percent of eligible interdealer interest rate and CDS transactions. At 

the same time, we have also made significant investments in our client clearing 

franchise, which we expect to grow as the requirements of clearing under Title VII 

become implemented. 

While there are a number of critical issues to consider in determining the appropriate market structure and governance for clearinghouses, the most critical is 

guarding against systemic risk. Questions of membership criteria, risk committee 

structure and governance all implicate safety and soundness, so it is essential that 

regulations carefully weigh these considerations. 

As the Committee is aware, the migration of products that were once traded and 

managed bilaterally to clearinghouses will concentrate the risk from these transactions at CCPs. CCPs do not eliminate credit and market risk arising from derivatives; they simply concentrate it in a single location in significant volume. This conVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00057 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
54 

centration of risk combined with an increase in aggregated credit and operational 

risks at CCPs will result in these institutions becoming systemically important. 

Since these institutions are private, for-profit entities, it is critical that regulations guard against an outcome that would privatize profits but potentially socialize 

losses. Attempts to increase clearing member access or lower clearing member capital requirements can be responsibly implemented only if they are coupled with requirements for sound risk management practices. These practices should include appropriate limits on the types of transactions that are subject to the clearing mandate, requirements for members of clearinghouses to have capital contributions proportional to the risk they introduce to the CCP, elimination of uncapped liability of 

clearing members and requirements for clearing members to be able to risk manage 

the transactions they bring to the CCP. We strongly support open access to clearinghouse membership, and believe it can be achieved without compromising risk management standards. Two critical controls must be in place at each clearinghouse to 

support open access: a clear liability framework that caps each member’s exposure, 

and risk limits that are real-time and proportional to each member’s capital. With 

this foundation, the clearing membership can be prudently expanded to firms with 

modest levels of capital, including the $50 million minimum proposed by the CFTC. 

Absent proper oversight, CCPs are at greater risk of failure, which could have significant systemic implications. Failure could result from a number of factors, such 

as a member’s lack of proper risk management, from clearing complex products that 

cannot be properly valued by the CCP, or from actions resulting from a ‘‘race to the 

bottom’’ among for-profit CCPs. 

Given these risks, we believe that as long as CCPs are structured as for-profit 

entities, the primary regulatory focus should be to ensure that proper risk management, governance, regulatory oversight and incentive structures are in place, as discussed in greater detail below. 

It is also worth noting that because derivatives trading and clearing is a global 

business, in order to prevent arbitrage, rigorous regulatory standards should be applied consistently in each of the major global markets, including uniform operating 

principles and a consistent on-the-ground supervisory approach. 

Safety and Soundness of Clearinghouses 

In considering clearinghouse membership requirements and their impact on clearinghouse safety and soundness, it is important for policy makers to keep in mind 

the nature of a clearinghouse. A clearinghouse is structured to provide for mutual 

sharing of counterparty risk among members. Each clearing member is exposed to 

the counterparty credit risk of all other members and, by extension, all clients clearing trades via other members. Clearinghouses themselves provide a very small portion of the capital which backs the performance of the clearinghouse, and the vast 

majority of the financial resources of a clearinghouse is provided by the members 

through their contributions to the guaranty fund as well as collateral posted by the 

clearing members. To the extent of their liability, each member is delegating risk 

management of its capital to the clearinghouse, which in many cases is a private, 

for profit entity. Each member is also exposed to the capital, liquidity and operational capabilities of other members, to the client risk introduced by every other 

member as well as the risk management processes put in place by those members 

and by the clearinghouse. A clearinghouse that is prudently managed must have 

adequate margin and guarantee fund resources and must refresh its calculations 

daily and intraday to adjust its resources to changing market conditions. 

There are additional measures that should be considered in order to enhance the 

safety and soundness of clearinghouses: 

1. Clearinghouses should have a credible resolution plan, given their interconnectedness to the financial markets and the associated systemic risk implications. Such resolution plans should be tested regularly and reviewed by regulators. 

2. On-site inspections by regulators should be conducted at regular and frequent 

intervals. The sufficiency of clearinghouse financial safeguards should be regularly evaluated against the results of such tests, and adjusted as appropriate. 

3. The liability of clearing members to the clearinghouse should be clearly ascertainable and capped. Unlimited liability of members towards the clearinghouse 

to absorb clearinghouse losses has the effect of maintaining the solvency of the 

clearinghouse at the expense of its participants, a trade-off that likely would 

lead to systemic risk concentration, not mitigation. Unlimited liability is the 

worst of all worlds: large financial institutions will be interconnected, but will 

have no idea of their exposure to any other particular institution, and neither 

the incentive nor the means to mitigate the risk. 

55 

4. In determining the appropriateness of a clearinghouse financial safeguards 

package there should also be an appropriate balance between initial margin 

and guarantee fund contributions. This balance should not be allowed to vary 

significantly across clearinghouses. If initial margin is set too low, there will 

be an incentive to push risky and unbalanced positions through the clearinghouse as participants recognize that the risk introduced in the clearinghouse 

will be subsidized by other clearing members through guaranty fund contributions. The amount of initial margin customers are required to post, together 

with the degree of protection afforded such margin, may adversely affect the 

incentives of customers to select prudently managed clearinghouses, contributing to moral hazard and instigating a race to the bottom. 

Clearinghouse Access 

We strongly support regulation aimed at mitigating conflicts of interest. We also 

support full implementation of the open access core principles set out by Congress 

in the Act with a risk-based framework that allows clearing members to clear client 

and house activity in proportion to their capital. We note that the Lynch amendment, which would have restricted equity ownership of interests in clearinghouses 

and swap execution facilities by swap dealers, was not part of the final text of the 

Act passed by Congress and signed by the President; however, proposed rules include such restrictions. 

We believe that all clearinghouses should provide open access to whoever meets 

certain minimum objective criteria. In our view, the fact that a clearinghouse relies 

almost exclusively on the capital of its members places a great emphasis on the ability of a member to absorb any losses resulting from: (a) the house and client risk 

that a clearing member introduces into the clearinghouse; and (b) mutualization of 

the risks introduced by every other clearing member and those clearing members’ 

clients. Given the loss mutualization feature of clearinghouses, we believe that the 

financial stability of clearinghouses depends on the requirements that must be satisfied for a member to qualify as a clearing member. Those criteria, however defined, 

should require clearing members to hold a minimum amount of capital. In addition, 

it is our view that the way to provide open access to new clearing members while 

promoting the safety and soundness of clearinghouses would be to provide clearing 

members with the ability to clear house and client risk in proportion to the amount 

of capital available to them as well as to funded margin and guarantee fund contributions. We do not support any exclusionary practices. 

Interaction of Corporate Governance and Risk Management 

We support regulations requiring the creation of a risk committee at all clearinghouses. In addition, we believe it would be appropriate to provide for the separation 

of the corporate governance function (Board of Directors) from the risk management 

function (Risk Committee) within a clearinghouse. 

Risk Committee 

We believe that the Risk Committee should be comprised of a majority of clearing 

member representatives, with the remainder open to clearinghouse and client participation. We support a requirement for at least 10 percent of the Risk Committee 

to be composed of client representatives with relevant expertise, and the balance to 

be open to participation by independent representatives. We believe that the main 

focus of the Risk Committee should be the preservation of the guarantee fund that 

is utilized to safeguard the clearinghouse and its members against defaults, taking 

into account prudent risk management standards, including mitigation of systemic 

risk. The main focus of the Board would be to promote the commercial interests of 

the clearinghouse. We expect that in most cases the Risk Committee and the Board 

would be able to achieve a productive balance between those two interests. We support a requirement for the Board to consult with the appropriate regulator prior to 

rejecting a recommendation by the Risk Committee on matters of risk. In our view 

all matters relating to risk would fall within the purview of the Risk Committee. 

This would include all matters related to margin and the sizing of the guarantee 

fund, membership criteria and membership application, and the enumeration of 

products eligible for clearing. Regulators have identified sound risk management 

standards as well as open access as key factors that must be addressed in determining whether a particular type of swap is suitable for clearing. 

Board of Directors 

With respect to the corporate governance function of SEFs, exchanges, and clearinghouses, we support encouraging a balance of views being represented on the 

Board of Directors. We think that a 35 percent requirement for independent directors will be problematic to implement in practice because it will be difficult to idenVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00059 Fmt 6621 Sfmt 6621 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
56 

tify a sufficient number of individuals who are not already involved in the industry 

and who have an appropriate level of practical market experience. In our view the 

desired balance between different interests can be achieved by identifying different 

classes of interested parties and encouraging a diverse representation of those interests in the Board of Directors. This would be done by requiring that no single class 

of interested parties achieves more than 65 percent of the seats on the Board. Each 

SEF, exchange and clearinghouse should be able to determine how to fill the remainder of the seats. Regulators would monitor compliance with the letter and the 

spirit of this provision. In our opinion, the different classes of interested parties vary 

depending on the type of entity: In the case of clearinghouses the classes would be: 

(a) clearing members whose capital is at risk if another clearing member or one of 

its clients fails; (b) end users, who have an interest in protecting their collateral and 

in keeping clearing costs low; and (c) other investors and infrastructure providers 

(e.g., technology providers, SEFs, exchanges, and clearinghouses), who have an interest in increasing profitability. 

In the case of SEFs, the classes would be: (a) liquidity providers; (b) liquidity takers; and (c) other investors and infrastructure providers (e.g., technology providers, 

exchanges, and clearinghouses), who have an interest in increasing profitability. 

In the case of exchanges, the classes would be: (a) liquidity providers; (b) liquidity 

takers; and (c) other investors and infrastructure providers (e.g., technology providers, SEFs, and clearinghouses), who have an interest in increasing profitability. 

These limitations would have the added benefit of promoting competition and discouraging vertical integration of exchanges, SEFs, and clearinghouses. 

All those who bring risk into the clearinghouse or profit from the operations of the clearinghouse should have ‘‘skin in the game’’ 

We think it is essential to the development of a sound clearing infrastructure that 

those whose capital is at risk can participate in the risk management of clearinghouses. Clearinghouses rely almost exclusively on the margin and guarantee fund 

contribution of clearing members to manage systemic risk and counterparty risk. 

In a vertically integrated model, shareholders in a holding company that owns 

clearinghouses and exchanges (and in the future may also own SEFs) are exposed 

to a fraction of the risk that clearing members are exposed to through loss 

mutualization. There is no current requirement for clearinghouses to provide a first 

loss piece to the financial waterfall package and in most structures the clearinghouse ‘‘skin in the game’’ contribution is minimal compared with the overall size of 

the guarantee fund. For this reason the large majority of the capital at risk of a 

clearinghouse is composed of the margin and guarantee fund contributed by clearing 

members. 

In addition to the financial resources required to satisfy the financial safeguards 

core principles set out in the Act we support introducing a requirement for clearinghouses to carry a first-loss risk component as well as a mezzanine risk component 

in the waterfall of financial safeguards. This would establish a direct link between 

the earnings that a clearinghouse derives from cleared activity and the contribution 

of that clearinghouse to its own financial safeguards package. We would support 

regulations that require a clearinghouse to retain in a segregated deposit account, 

on a rolling basis, 50 percent of the earnings from the previous four years. We observe that this amount would represent approximately 10 percent of the clearinghouse enterprise value, therefore achieving a reasonable balance between risk and 

reward for clearinghouse shareholders. In addition, it would be appropriate for at 

least 50 percent of the retained earnings to have a first loss position in the financial 

waterfall. This solution would accomplish the goal of greater systemic stability, and 

would scale over time the contribution by the clearinghouse to its own financial 

safeguards package without large decreases or increases at any one resizing date. 

We recommend that the clearinghouse contribution be subject to a minimum floor 

of $50 million, to provide adequate protection and provide increased confidence in 

the markets while market participants ramp up access to clearing services. In our 

view this would incentivize clearinghouses to manage risk in a prudent manner. We 

would also support limits on the ability of clearinghouses to upstream dividends resulting from clearing fees to their holding companies when a clearing member defaults. The introduction of a first loss position and the introduction on limits on the 

upstreaming of dividends for clearinghouses would result in significant benefits 

from a systemic stability point of view. 

Limitations on Voting Rights 

The best way to promote a successful implementation of the clearing requirement 

of the Act is to ensure that clearinghouses are fully equipped to manage risk in a 

prudent manner, while providing open access to clients and clearing members. In 

57 

order to achieve this purpose, clearinghouses should be able to attract financial and 

intellectual capital from those who have experience in the products that the clearinghouse intends to clear, as well as from new participants into the market. 

We note that the OTC derivatives market is sufficiently diversified at present. A 

market survey published by ISDA on October 25, 2010, shows that the five largest 

U.S.-based dealers hold 37 percent of the outstanding derivatives market (equity, 

rates, credit). In our view this data is more representative of the global nature of 

the OTC derivatives market than other data that has been quoted out of context 

in the debate regarding conflict of interest. That data was focused exclusively on a 

restricted number of U.S. institutions and was not intended to represent a survey 

of the OTC market, which is global. To assume that dealers would acquire 

shareholdings in a clearinghouse or otherwise gain influence over a clearinghouse 

with a view to impede or narrow the implementation of the clearing requirement 

would be inconsistent with the reality of today’s markets. On the contrary some participants in the OTC markets have made significant investments into the capital of 

clearinghouses well in advance of a legal requirement to clear being introduced or 

proposed in the U.S. or in Europe. 

At this point in the development of market infrastructure, it is essential to promote competition between clearinghouses, exchanges, and SEFs. With respect to 

clearinghouses, we note that in today’s markets there are a maximum of three clearinghouses per asset class that are able to clear OTC derivatives. In some asset 

classes there is no clearinghouse currently clearing. There is no specific reason to 

apply limits only to those who have the expertise and the funds to finance a clearinghouse and who are exposed to losses if the risk management of the clearinghouse 

fails. We believe that preventing those whose capital is at risk from acquiring the 

right to vote on the governance of the entities that perform a key role in the OTC 

markets is not necessary to achieve the policy objectives set out by Congress in the 

Act. For this reason we support a limit on voting rights that would apply to each 

class of market participants irrespective of whether they are clearing members, 

SEFs, exchanges, enumerated entities, or other types of entities or individuals. This 

would promote open access and greater competition among clearinghouses. 

Given that preference shares and other types of nonvoting shares are a way to 

provide liquidity into the clearinghouse and have no effect on corporate governance, 

we believe that it would not be appropriate to apply limitations on the ownership 

of nonvoting shares. 

No Free Riding—Clearing Member Resources 

We do not believe that there should be a two-tiered approach to membership, 

where some clearing members are subject to loss mutualization and others are not. 

A clearinghouse will rely on the financial resources waterfall set out in CFTC proposed §39.11. This includes funded guarantee fund contributions by a clearing member. CFTC proposed §39.11 also contemplates the ability of a clearing organization 

to assess a clearing member for additional default fund contributions. We believe 

that it is important to make sure that a clearing member will have sufficient liquid 

capital to fund additional guarantee fund assessments, in proportion to house and 

client business cleared by that clearing member. 

We believe it would be appropriate to require that clearing members have the 

ability to provide daily executable binding quotation for all points in the curve for 

all products cleared. Clearinghouses must be able to mark to market all positions 

at the end of each trading day. Clearing members must provide daily prices for all 

points of the maturity curve rather than relying on whether the cleared product 

trades on an exchange or a SEF on that day. 

In our view it is essential to require that clearing members have the operational 

ability to sustain the flow of client and house positions into the clearinghouse, including porting books of liquid and illiquid positions at times of market distress. In 

times of market stress or crisis, it is imperative that clearing members be able to 

act quickly in order to address the risk management aspects of defaults. By way 

of example, if a clearing member fails, the clearinghouse will conduct an auction to 

absorb the losses caused by that clearing member failure. The provision of liquidity 

by surviving members during that auction is key to the survival of a clearinghouse 

that deals in OTC instruments. 

Default management is not a responsibility that can be outsourced without introducing new risks to the stability of the clearinghouse. We think third-party pricing 

and outsourced default management services can disappear quickly in a crisis, as 

the provider of the service may have to focus their resources on their own survival. 

For this reason we believe it is preferable that clearing members or their affiliates 

be able to participate in the default management process. In the alternative, we 

would support a structure that would allow a clearing member to outsource pricing 

58 

and default management services to another provider so long as the third-party provider of pricing and default management services is not allowed to undertake the 

provision of those services to more than one clearing member (including for itself 

or an affiliate). 

To ensure the correct incentives are in place during an auction of a failed member’s portfolio, we recommend that any loss incurred by the clearinghouse as a result of the auction be absorbed first by the guarantee fund contributions of those 

members that fail to submit a bid. Any remaining loss should be distributed among 

the bidding clearing members in reverse proportion to the strength and size of their 

bid. This mechanism will ensure that all members are treated equally going in to 

an auction, and that appropriate financial incentives exist to provide exit liquidity 

to the clearinghouse. In addition, we believe this mechanism creates a fair outcome 

for all members by subordinating the guarantee fund capital of any bidder that is 

subject to a failed outsourcing arrangement. 

Guarantee fund assessments ensure members have appropriate liquidity to 

meet potential capital calls in a crisis 

We support the CFTC proposal requiring clearinghouses to haircut the value of 

unfunded assessment and to cap the percentage of the financial resources package 

that can be met by the value of assessments. 

We note that CFTC proposed §39.11 also refers to the own capital contribution 

of a clearinghouse as a component of the financial resources package. We believe 

that it would be appropriate for the Commission’s regulations to provide greater 

granularity and require that if a clearinghouse enumerates its own capital as part 

of the waterfall, that clearinghouse must provide sufficient assurances that its capital will be available to meet those obligations and will not be reallocated to serve 

other purposes at the discretion of that clearinghouse. 

It should be noted that a clearing member may have committed to additional assessments at more than one clearinghouse. We believe it would be appropriate for 

regulators to adopt a risk-based analysis to determine the likelihood that a clearing 

member will be able to meet its assessment obligations across all clearinghouses. 

Systemically Important Clearing Houses 

We believe that in the new market structure landscape, that no entity should be 

too big to fail. In our view, this principle applies equally to clearing members, clearinghouses, and clients. Given the loss mutualization feature of clearing, it is only 

by requiring each participant to have skin in the game that we can ensure all the 

parties involved in bringing risk into the system have an incentive to act in a manner that is prudent, safe, and sound. We believe it is appropriate for members, clients and clearinghouse shareholders to have skin in the game. This principle is of 

particular relevance for those entities that are deemed systemically important by 

the Financial Stability Oversight Council pursuant to Title VIII of the Act. 

Regulatory Coordination 

In our view, coordination between regulators who have authority over clearinghouses will be a key component of systemic stability. One significant element will 

be the ability of regulators to look across clients, clearing members, exchanges, 

SEFs, and clearinghouses for any factors that could increase systemic risks. We 

think it is appropriate to monitor the activity of clients, clearing members exchanges, SEFs, and clearinghouses for undue concentration with a view to identify 

those that pose a systemic risk and take action to mitigate problematic situations 

before they exert a significant impact on the financial systems. 

Conclusion 

We believe that no institution, including clearing members and clearinghouses, 

should be too big to fail. The policy objectives of the Act would be well served by 

promoting systemic stability and ensuring safety and soundness of exchanges, SEFs, 

and clearinghouses, and by requiring that these institutions have adequate capital 

to absorb losses and sufficient liquidity to safeguard the system. JPMC is committed 

to working with Congress, regulators, and industry participants to ensure that Title 

VII is implemented appropriately and effectively. I appreciate the opportunity to 

testify before this Committee and look forward to answering any questions you may 

have. 

59 

PREPARED STATEMENT OF JAMES CAWLEY 

COFOUNDER, SWAPS AND DERIVATIVES MARKET ASSOCIATION

MAY 25, 2011 

Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee, my 

name is James Cawley. I am CEO of Javelin Capital Markets, an electronic execution venue of OTC derivatives that expects to register as a SEF (or ‘‘Swaps Execution Facility’’) under the Dodd Frank Act. 

I am also here to represent the interests of the Swaps & Derivatives Market Association or ‘‘SDMA,’’ which is comprised of multiple independent derivatives dealers 

and clearing brokers, some of whom are the largest in the world. 

Thank you for inviting me to testify today. 

To ensure that the U.S. taxpayer is never again required to bail out Wall Street, 

we must move away from ‘‘too inter connected to fail’’ where one bank pulls another 

three with it—in the event of its failure. Equally important, we must remove the 

systemic ‘‘sting’’ currently associated with each bilateral derivatives swap contract 

that connects financial firms to each other and thus compel these swaps contracts 

into clearinghouses as mandated under the Dodd-Frank Act. 

In order to have safe and successful central clearing of OTC derivatives, certain 

remaining impediments must be removed such that clearinghouses ensure that they 

have truly representative governance structures, offer objective and proportionate 

risk models, provide open access to properly qualified and noncorrelated clearing 

members and accept trades on a ‘‘real time’’ and ‘‘execution blind’’ basis such that 

systemic risk is mitigated while transparency and market liquidity are increased. 

Clearinghouse Governance and Membership 

With regard to clearinghouse governance, we support CFTC Core Principles O, P, 

and Q, that require that governance arrangements be transparent, fair and representative of the marketplace. Such governance bodies should represent the interests of the market as a whole and not just the interests of the few. 

Importantly, clearinghouse membership requirements should be objective, publicly 

disclosed and permit fair and open access; as Dodd-Frank requires. 

This is important because clearing members act as the ‘‘gatekeepers’’ to clearing. 

Without open access to clearing, you will not have universal clearing adoption, increased transparency, and lessened systemic risk. 

Clearinghouses should seek to be inclusive, not exclusive in their membership criteria. 

We should dispense with the myth that swaps are somehow different from other 

cleared markets and thus the vast experience from those markets should be ignored. 

Instead, clearinghouses should learn from their own experience in the listed derivatives space—of futures and options. 

In those markets, central clearing has operated successfully since the days of post 

Civil War Reconstruction nearly 150 years ago; long before spreadsheets and risk 

models. In those markets, counterparty risk is spread over a hundred disparate and 

noncorrelated clearing firms. It works well. No customer has ever lost money due 

to a clearing member failure. 

To complement broad participation, clearinghouses should not have unreasonable 

capital requirements. Capital should be a function of the risk a member contributes 

to the system; simply put, the more you or customers trade, the more capital you 

contribute. 

The SDMA supports the CFTC’s call for clearing broker capital requirements to 

be proportionate and scale relative to the risk introduced to the system. We support 

the CFTC’s call that a clearing firm’s minimum capital be closer to $50 million, 

rather than closer to the $5 billion or $1 billion threshold as certain clearinghouses 

have originally suggested. 

Certain clearinghouse operational requirements for membership that have no 

bearing on capital or capability should be seen for what they are—transparent attempts to limit competition. 

Specifically, clearing members should not be required to operate swap dealer 

desks just so they can meet their obligation in the default management process. 

These requirements can easily be met contractually through agreements with third 

party firms or dealers. 

With regard to conflicts of interest within a clearing member, Dodd-Frank is clear; 

dealer desks should not be allowed to influence their clearing member colleagues 

and strict Chinese walls should exist. 

60 

Derivatives Trade Integrity 

With regard to trade acceptance, clearinghouses and their constituent clearing 

member firms should accept trades on an ‘‘execution blind’’ basis. Clearing firms 

should be prevented from discriminating against certain customer trades, simply because they dislike the manner in which they have been executed or the fact that 

they may be anonymous. 

Certain trade counterparties should be precluded from exploiting current market 

position to impose documentary barriers to entry that restrict customer choice of 

execution venue, execution method, or dealer choice. Regulators should remain vigilant to ensure that such restrictions on trade do not manifest themselves in a post 

Dodd-Frank world. 

With regard to trade integrity, execution venues, clearing members and clearinghouses should, as the regulators require, work together to ensure that executed 

trades settle or are accepted into clearing as quickly as possible. 

The SDMA, joins with the MFA, and supports the CFTC requirement that trades 

be accepted into clearing immediately upon execution or trade submission. Regulators should be mindful not to allow clearinghouse workflows that seek to increase 

and not decrease trade latency. Such workflows should be seen for what they are— 

clear attempts to stifle successful OTC derivative clearing. 

Conclusion 

In conclusion, the CFTC and the SEC should be commended for their excellent 

work. Both agencies have been transparent and accessible throughout the entire 

process. They have adapted to industry suggestion when appropriate. 

We must move away from ‘‘too interconnected to fail.’’ As an industry, we must 

work together to ensure that OTC derivatives clearing is a success such that Wall 

Street never again has to come to Main street for another bail out. 

Thank you. 

61 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM CHRISTOPHER EDMONDS 

Q.1. Does your swaps clearinghouse have minimum capital requirements as part of your ownership and governance standards? 

A.1. Yes. 

Q.2. If so, what are they? 

A.2. ICE Clear Credit’s Rule 201(b)(ii), in relevant part, currently 

provides that ‘‘ . . . no applicant shall be admitted or permitted to 

remain, as applicable, as a Participant unless, in ICE Clear Credit’s sole determination: 

(1) if it is an FCM or a Broker-Dealer, (A) it has a minimum of $100 million of Adjusted Net Capital and (B) it 

has Excess Net Capital that is greater than 5 percent of 

the Participant’s Required Segregated Customer Funds; or 

(2) if it is not an FCM or a Broker Dealer, it has a minimum of $5 billion in Tangible Net Equity (provided that 

in the case of (1) or (2), this requirement may, at the discretion of ICE Clear Credit, be met by a Parent if such 

Parent provides a guarantee pursuant to Rule 205); 

For purposes of this clause (ii): 

‘‘Adjusted Net Capital’’ for a Participant that is an FCM, 

shall be as defined in CFTC Rule 1.17 and as reported on 

its Form 1-FR-FCM or FOCUS Report or as otherwise reported to the CFTC under CFTC Rule 1.12, and for a Participant that is not an FCM but is a Broker-Dealer, shall 

be its ‘‘net capital’’ as defined in SEC Rule 15c3-1 and as 

reported on its FOCUS Report; 

‘‘Excess Net Capital’’ for a Participant that is an FCM or 

a Broker-Dealer shall equal its ‘‘excess net capital’’ as reported on its Form 1-FR-FCM or FOCUS Report or as otherwise reported to the CFTC under CFTC Rule 1.12; 

‘‘Participant’s Required Segregated Customer Funds’’ shall 

equal (i) the total amount required to be maintained by 

such Participant on deposit in segregated accounts for the 

benefit of customers pursuant to Sections 4d(a) and 4d(f) 

of the CEA and the regulations thereunder and (without 

duplication) pursuant to the rules of relevant clearing organizations for positions carried on behalf of customers in 

the cleared OTC derivative account class plus (ii) the total 

amount required to be set aside for customers trading on 

non-United States markets pursuant to CFTC Rule 30.7. 

‘‘Tangible Net Equity’’ shall be computed in accordance 

with the Federal Reserve Board’s definition of ‘‘Tier 1 capital’’ as contained in Federal Reserve Regulation Y Part 

225 Appendix A (or any successor regulation thereto), in 

the case of a bank or other Participant subject to such regulation, or otherwise shall be the Participant’s equity less 

goodwill and other intangible assets, as computed under 

generally accepted accounting principles. 

Q.3. What role do these capital requirements play in managing 

clearinghouse and counterparty risk? 

62 

A.3. The role of capital is secondary to the initial margin and guaranty fund collateral that a clearinghouse collects from its clearing 

participants, nevertheless, capital requirements are a fundamental 

and important component of a clearinghouse risk management regime. Capital requirements are a measurement of a clearing participant’s ability to meet its financial obligations to the clearinghouse. 

Section 725(c) of Dodd-Frank entitled Core Principles for Derivatives Clearing Organizations provides in relevant part that each 

derivatives clearing organization shall establish appropriate admission and continuing eligibility standards including sufficient financial resources to meet obligations arising from participation in the 

derivatives clearing organization. 

The Bank for International Settlements in its Recommendations 

for Central Counterparties (CCP) (Recommendation 2: Participant 

requirements 4.2.2) states in relevant part ‘‘to reduce the likelihood 

of a participant’s default and to ensure timely performance by the 

participant, a CCP should establish rigorous financial requirements 

for participation. Participants are typically required to meet minimum capital standards. Some CCPs impose more stringent capital 

requirements if exposures of or carried by a participant are large 

or if the participant is a clearing participant. Capital requirements 

for participation may also take account of the types of products 

cleared by a CCP . . . .’’ 

Q.4. How would reducing these capital requirements impact the 

risk profile of the clearinghouse, as well as the ability of new potential clearing members to join the clearinghouse? 

A.4. As indicated above, the clearinghouse model relies, in part, on 

having adequately capitalized clearing participants in order to 

manage its counterparty risk. There is a direct correlation between 

the level of an entities regulatory capital and its ability to meet its 

counterparty obligations to a clearinghouse. 

Q.5. How is your clearinghouse risk committee constituted? How 

many members are there? 

A.5. Pursuant to ICE Clear Credit rule 503(a), the composition of 

the Risk Committee shall be as follows: 

(i) The Risk Committee shall consist of twelve members. 

(ii) Each member of the Risk Committee shall have risk 

management experience and expertise and shall be subject 

to the approval of the Board, such approval not to be unreasonably withheld, conditioned or delayed. 

(iii) Three of the members of the Risk Committee shall be 

comprised of (A) a member of the Board who is independent in accordance with the requirements of each of 

the New York Stock Exchange listing standards, the U.S. 

Securities Exchange Act of 1934, as amended, and 

IntercontinentalExchange, Inc.’s Board of Director Governance Principles (such requirements, the ‘‘Independence Requirements’’ and such member, the ‘‘Independent ICE 

Manager’’) and (B) two officers of ICE Clear Credit from 

among the Chief Executive Officer, President, Chief Financial Officer and Chief Risk Officer, each appointed by ICE 

63 

US Holding Company L.P. (including any successor, the 

‘‘ICE Parent’’), a Cayman Islands exempted limited partnership, by written notice to the Board; 

(iv) The other nine members of the Risk Committee will be 

appointed as specified below (the ‘‘Participant Appointees’’); 

(v) The nine Participant Appointees will include one member appointed by each Participant Group that includes or 

is Affiliated with one of the following: Bank of America, 

N.A.; Barclays Bank PLC; Citibank, N.A.; Credit Suisse 

Securities (USA) LLC; Deutsche Bank AG; Goldman Sachs 

International; JPMorgan Chase Bank, N.A.; Morgan Stanley Capital Services, Inc.; and UBS AG. ‘‘Participant 

Group’’ means a Participant and its Affiliates, if any, such 

that, if two or more Participants are Affiliates, collectively 

they shall constitute a Participant Group. 

(vi) The composition of the Participant Appointees shall be 

reconstituted on March 14, 2012, and each one year anniversary thereafter (or if any such day is not an ICE Business Day, the next ICE Business Day) as follows (each 

such anniversary, a ‘‘Risk Committee Reconstitution Date,’’ 

and the twelve full consecutive calendar months (including 

March through February) ending at the calendar monthend prior to a Risk Committee Reconstitution Date, an 

‘‘Eligibility Determination Period’’) (subject to paragraph 

(ii) above): 

(A) among those Participant Groups that have an incumbent member on the Risk Committee, those Participant 

Groups that have the six highest Participant Activities for 

the immediately preceding Eligibility Determination Period (each, a ‘‘Top Six Incumbent Participant Group’’) shall 

have the right to retain such member on the Risk Committee until the next Risk Committee Reconstitution Date; 

(B) among the Participant Groups that are not Top Six Incumbent Participant Groups, the Participant Groups that 

have the three highest Participant Activities for the immediately preceding Eligibility Determination Period (each, 

an ‘‘Eligible Participant Group’’) shall have the right to appoint or retain, as applicable, a member on the Risk Committee until the next Risk Committee Reconstitution Date; 

(C) each Participant Group that has an incumbent member 

on the Risk Committee but is not entitled to retain such 

member as provided above shall cause its Risk Committee 

member to resign or otherwise remove such member from 

the Risk Committee effective as of the applicable Risk 

Committee Reconstitution Date; and 

(D) each Participant Group that has the right to appoint 

a member to the Risk Committee as provided above and 

that does not have an incumbent member on the Risk 

Committee shall notify the Board in writing on or prior to 

the applicable Risk Committee Reconstitution Date of the 

individual appointed by such Participant Group to the 

Risk Committee; provided, however, that the failure to 

64 

provide such notice shall not result in the loss of the right 

of such Participant Group to appoint a member to the Risk 

Committee. 

(E) ‘‘Participant Activity’’ means, for a specified Eligibility 

Determination Period and with respect to a particular Participant Group, the aggregate volume of Trades during 

such time submitted to, and accepted for clearing by, ICE 

Clear Credit by members of such Participant Group, which 

such volume shall be measured in terms of aggregate notional amount of Trades so submitted and accepted. In the 

event that a Combination of Participants occurs prior to 

the applicable Risk Committee Reconstitution Date, all 

Participant Activity of such Participants (and their Affiliates) shall be aggregated together for purposes of determining the Participant Activity of the resulting Participant 

Group for the corresponding Eligibility Determination Period. 

(F) ‘‘Combination’’ means any event in which a Participant 

(or its Affiliate) obtains Control of another Participant that 

was previously not an Affiliate of such Participant (or any 

Person that Controls such other Participant) or a Participant (or any Person that Controls such Participant) is 

merged with another Participant that was previously not 

an Affiliate of such Participant (or any Person that Controls such other Participant). 

(vii) Intentionally omitted in Rules for formatting. 

(viii) Notwithstanding anything to the contrary herein, if 

at any time on or after the DCO/SCA Conversion Date but 

prior to the first Risk Committee Reconstitution Date, 

there is a Combination involving Participants where more 

than one of the relevant Participant Groups had the right 

to appoint a member of the Risk Committee, then, as of 

the date of consummation of such Combination, (A) such 

Participant Groups shall, collectively, have the right to appoint only one member of the Risk Committee and the Participant Group resulting from such Combination shall take 

all actions necessary to remove all but one of their previously appointed members effective as of the date of consummation of the Combination and (B) the vacanc(ies) of 

the Risk Committee will be filled by the Participant 

Group(s) that had the highest Participant Activit(ies) (over 

the 12-month period from and including March 2010 to 

and including February 2011) among those Participants 

that, as of the date of consummation of such Combination, 

did not have the right to appoint a member to the Risk 

Committee (in order of the level of such Participant Activity, from highest to lowest) effective as of the date of consummation of such Combination. 

(ix) Notwithstanding anything to the contrary herein, if at 

any time on or after the first Risk Committee Reconstitution Date, there is a Combination involving Participants 

where more than one of the relevant Participant Groups 

had the right to appoint a member of the Risk Committee, 

65 

then, as of the date of consummation of such Combination, 

(A) such Participant Groups shall, collectively, have the 

right to appoint only one member of the Risk Committee 

and the Participant Group resulting from such Combination shall take all actions necessary to remove all but one 

of their previously appointed members effective as of the 

date of consummation of the Combination and (B) the 

vacanc(ies) of the Risk Committee will be filled by Participant Group(s) that had the highest Participant Activit(ies) 

(over the immediately preceding Eligibility Determination 

Period) among those Participants that, as of the date of 

consummation of such Combination, did not have the right 

to appoint a member to the Risk Committee (in order of 

the level of such Participant Activity, from highest to lowest) effective as of the date of consummation of such Combination. 

(x) Notwithstanding anything to the contrary herein, if at 

any time all Participants in a Participant Group with the 

right to appoint a member of the Risk Committee are in 

Default or have had their status as Participant terminated 

as a result of being a Retiring Participant, (A) such Participant Group shall immediately lose the right to appoint a 

member to the Risk Committee and (B) at the date of such 

Default or termination, the Participant Group that had the 

highest Participant Activity (over the period from and including March 2010 to and including February 2011 or, if 

on or after the first Risk Committee Reconstitution Date, 

over the immediately preceding Eligibility Determination 

Period) among those Participants that, as of the date of 

such Default or termination, did not have the right to appoint a member to the Risk Committee, shall have the 

right to appoint a member to the Risk Committee effective 

as of the date of such Default or termination. 

(xi) A Participant Group may appoint an individual to be 

a member of the Risk Committee only if such individual is 

an employee of one of the Participants in such Participant 

Group or an Affiliate thereof. Any member of the Risk 

Committee may be removed at any time, with or without 

cause, by the Participant Group that appointed such member pursuant to this Rule 503. In the event a vacancy occurs on the Risk Committee as a result of the retirement, 

removal, resignation, or death of a member thereof, such 

vacancy shall be filled by an individual designated by the 

relevant Participant Group. 

(xii) Within five ICE Business Days of the end of each Eligibility Determination Period, ICE Clear Credit shall, 

based on its books and records, deliver to each Participant 

Group a good faith determination of the identity of (A) the 

Top Six Incumbent Participant Groups and (B) the Eligible 

Participant Groups, and shall inform each of the Top Six 

Incumbent Participant Groups and the Eligible Participant 

Groups of its right to appoint a member to the Risk Committee as of the next Risk Committee Reconstitution Date 

66 

pursuant to this Rule; provided, however, that ICE Clear 

Credit and its Affiliates, Board and officers shall have no 

liability with respect to the delivery of such good faith determination. For the sake of clarity, such good faith determination shall identify only the Participant Groups mentioned above, and shall not set forth the Participant Activity levels of such Participant Groups. In the event any Participant Group disputes in good faith ICE Clear Credit’s 

good faith determination of the Top Six Incumbent Participant Groups or the Eligible Participant Groups, the disputing Participant Group and the Risk Committee shall 

submit such dispute for resolution to 

PricewaterhouseCoopers LLP (or, if such firm shall decline 

or is unable to act or is not, at the time of such submission, independent of ICE Clear Credit, the disputing Participant Group or any member of the Risk Committee, to 

another independent accounting firm of international reputation mutually acceptable to the disputing Participant 

Group and the Risk Committee) (such firm, the ‘‘Independent Accounting Firm’’), which shall, within 30 ICE 

Business Days after such submission, determine and report to ICE Clear Credit, the disputing Participant Group 

and the Risk Committee, and such report shall be final, 

conclusive and binding on the disputing Participant Group, 

the Risk Committee and ICE Clear Credit. The disputing 

Participant Group shall be solely responsible for the fees 

and disbursements of the Independent Accounting Firm. 

ICE Clear Credit and its Affiliates, Board and officers 

shall have no liability in connection with the determination of the Independent Accounting Firm. 

(xiii) If, by written agreement of the Risk Committee and 

the Board, ICE Clear Credit is determined to have established multiple risk pools (each, a ‘‘Risk Pool’’), ICE Clear 

Credit will create a new and separate risk committee for 

each such Risk Pool. In such event, (A) each such new risk 

committee will have, with respect to its Risk Pool, the 

same rights, responsibilities and operational procedures as 

the Risk Committee has under this Chapter, and (B) to the 

extent practicable, the composition of such other risk committee will be determined on the same basis as the Risk 

Committee is determined hereunder (taking into account, 

instead, the applicable volume or usage metric with respect to such Risk Pool as determined by the Risk Committee), with the rules for such composition being determined by the Board, in consultation with the Risk Committee 

Q.6. What role do they have in controlling access to the clearinghouse? 

A.6. Both the Risk Management Committee and the newly established Risk Management Subcommittee, described below, are consultative committees and have no authority to accept or deny clearing participants. 

67 

Importantly, the authority to accept or deny clearing participants 

vests solely with the ICE Clear Credit Board of Managers. 

Nevertheless, in anticipation of proposed CFTC regulations relating to the mitigation of conflicts of interest being promulgated, ICE 

Clear Credit recently adopted the following Rules 510 and 511 to 

establish a Risk Management Subcommittee that will be consulted 

prior to determining the standards and requirements for initial and 

continuing clearing participant eligibility and prior to approving or 

denying clearing participant applications. 

510. Subcommittee Specified Actions. 

ICE Clear Credit shall not take nor permit to be taken any 

of the following actions without prior consultation with the 

Risk Management Subcommittee (‘‘Subcommittee Specified 

Actions’’): 

(a) Determine products eligible for clearing; 

(b) Determine the standards and requirements for initial 

and continuing Participant eligibility; 

(c) Approve or deny (or review approvals or denials of) Participant applications described in Rule 202 (or any successor Rule thereto) or the other ICE Provisions; 

(d) Modify this Chapter of the Rules or Modify any of the 

responsibilities, rights or operations of the Risk Management Subcommittee or the manner in which the Risk Management Subcommittee is constituted as set forth in the 

Rules. 

511. Composition of the Risk Management Subcommittee; 

Confidentiality. 

(a) The composition of the Risk Management Subcommittee shall be as follows: 

(i) The Risk Management Subcommittee shall consist of 

five members. 

(ii) Each member of the Risk Management Subcommittee 

shall have risk management experience and expertise and 

shall be subject to the approval of the Board, such approval not to be unreasonably withheld, conditioned or delayed. 

(iii) Two of the members of the Risk Management Subcommittee shall be public directors as defined in CFTC 

Rule 1.3(ccc) (‘‘Independent Public Directors’’) appointed by 

ICE Clear Credit. The Board must make such finding upon 

the appointment of the member and as often as necessary 

in light of all circumstances relevant to such member, but 

in no case less than annually. 

(iv) One member of the Risk Management Subcommittee 

shall be a Non-Participant Party. Such member will be 

nominated by the buy-side Advisory Committee of ICE 

Clear Credit. 

(v) Two of the members of the Risk Management Subcommittee shall be composed of representatives of Participants who are members of the Risk Committee. Such 

members shall be nominated by the Risk Committee. 

68 

(vi) No member of the Risk Management Subcommittee 

may be subject to statutory disqualification under CEA 

Section 8a(2) or Section 3(a)(39) of the Securities Exchange 

Act, or other applicable CFTC or SEC regulations. 

Q.7. How is ICE Clear Credit planning to satisfy the open access 

provisions in the Dodd-Frank Act? 

A.7. Since its inception, ICE Trust, now known as ICE Clear Credit, has supported open access and will continue to do so pursuant 

to Dodd-Frank. (It should be noted that from a business model perspective, it is generally in ICE Clear Credit’s interest to receive 

more transactions to clear.) 

Specifically, ICE Trust Rule 314 (Open Access for Execution 

Venues and Trade Process Platforms) previously provided: 

ICE Trust shall ensure that there shall be open access to 

the clearing system operated by ICE Trust pursuant to 

these Rules for all execution venues (including, without 

limitation, designated contract markets, national securities 

exchanges, swap execution facilities and security-based 

swap execution facilities) and trade processing platforms. 

ICE Trust may impose (a) reasonable criteria to determine 

whether an execution venue has the capability to deliver 

the necessary quality of service to be granted access to ICE 

Trust, (b) reasonable criteria to determine whether a trade 

processing platform has the capability to deliver the necessary quality of service to be granted access to ICE Trust 

and connected through the ICE Trust application programming interface, (c) reasonable requirements as to risk filters and other credit risk management standards with respect to transactions to be submitted to ICE Trust for 

clearing, and (d) reasonable costs on such execution venues 

and trade processing platforms and Participants that use 

such venues and platforms; provided that in each case 

such criteria or costs shall not unreasonably inhibit such 

open access and shall comply with applicable law. 

ICE Clear Credit Rule 314 was recently amended slightly to read 

as follows: 

ICE Clear Credit shall ensure that, consistent with the requirements of CEA Section 2(h)(1)(B) and Securities Exchange Act Section 3C(a)(2), there shall be open access to 

the clearing system operated by ICE Clear Credit pursuant to these Rules for all execution venues (including, 

without limitation, designated contract markets, national 

securities exchanges, swap execution facilities and security-based swap execution facilities) and trade processing 

platforms. ICE Clear Credit may impose (a) reasonable criteria to determine whether an execution venue has the capability to deliver the necessary quality of service to be 

granted access to ICE Clear Credit, (b) reasonable criteria 

to determine whether a trade processing platform has the 

capability to deliver the necessary quality of service to be 

granted access to ICE Clear Credit and connected through 

the ICE Clear Credit application programming interface, 

69 

(c) reasonable requirements as to risk filters and other 

credit risk management standards with respect to transactions to be submitted to ICE Clear Credit for clearing, 

and (d) reasonable costs on such execution venues and 

trade processing platforms and Participants that use such 

venues and platforms; provided that in each case such criteria or costs shall not unreasonably inhibit such open access and shall comply with applicable law. 

Q.8. How would you expect the open access provisions to impact 

your business model, as well as the overall role of clearinghouses 

in the swaps market worldwide? 

A.8. As indicated above, ICE Trust, now known as ICE Clear Credit, has always supported open access. ICE Clear Credit is agnostic 

with respect to the execution venue provided that the execution 

venue meets ICE Clear Credit’s reasonable eligibility standards 

and submits transactions to ICE Clear Credit on behalf of ICE 

Clear Credit’s authorized clearing participants. 

Q.9. Given the policy objective of Title VII to increase the clearing 

of swaps, how would you structure the implementation of the new 

Dodd-Frank clearing requirements to provide the greatest incentives for market participants to clear their trades? 

A.9. Specifically, clearing participants will be incented to clear if 

the Dodd-Frank provisions calling for the CFTC and SEC to approve portfolio margining between correlated commodity-based 

swaps and security-based swaps are implemented. ICE Clear Credit has submitted to the CFTC and SEC its draft request for portfolio margin treatment with respect to the commodity-based swaps 

(CDS indices) and security-based swaps (single name CDS) that 

ICE Clear Credit clears. 

More generally, centralized clearing fundamentally reduces 

counterparty risk and provides financial stability as a result of 

sound and transparent risk management practices. All clearing 

participants are required to post collateral in the form of initial 

margin and all clearing participants’ cleared positions are marketed-to-market on a daily basis. In addition, clearing participants 

are required to contribute to the clearinghouse’s guaranty fund 

which serves as a mutualized financial backstop in the event that 

a clearing participant should default on its obligations. The implementation of new Dodd-Frank requirements should be structured 

in a manner that promotes the fundamental safety and soundness 

principles of centralized clearing. 

Q.10. Are there certain entities or asset classes that should be 

cleared before others? 

A.10. Generally, the more standardized and liquid swaps are more 

appropriately cleared. 

Q.11. Could you describe the current policies and procedures used 

by your clearinghouse to prevent conflicts of interest in decision 

making about clearing swap trades? 

A.11. See responses to Question 2 above. 

70 

Q.12. How do you expect the provisions of the Dodd-Frank Act that 

seek to minimize conflicts of interest to impact the governance and 

voting composition of your Boards of Directors? 

A.12. The provisions of Dodd-Frank relating to conflicts are unlikely to impact ICE Clear Credit given its corporate governance 

structure. The majority of ICE Clear Credit’s Board of Managers 

are independent (6/11). Three of the remaining Board members are 

representatives of ICE management. The remaining two Board 

members are representatives of the clearing participants. 

Q.13. How do you ensure that neither a single shareholder nor a 

small group of shareholders can dominate the clearinghouse and 

determine its policies? 

A.13. Technically, ICE Clear Credit has a single shareholder—ICE 

Inc. ICE U.S. Holding Company L.P. is the sole member of ICE 

Clear Credit. ICE Inc. (a public company) wholly owns the company that serves as the General Partner (GP) of ICE U.S. Holding 

Company L.P. None of the Limited Partners have the right to elect 

the Board of Managers of ICE Clear Credit. The GP of ICE U.S. 

Holding Company L.P. elects the Board of Managers of ICE Clear 

Credit. The Limited Partners of ICE U.S. Holding (that include the 

former owners of The Clearing Corporation) merely maintain a limited economic interest in the profits of ICE Clear Credit. 

Q.14. One concern is that members could restrict access either directly or indirectly by controlling the ability to enter into correspondent clearing arrangements. What are the best approaches 

to ensuring fair and open access? 

A.14. As noted above, the ICE Clear Credit clearing participants do 

not govern ICE Clear Credit. Instead, the ICE Clear Credit Board 

of Managers, a majority of whom are independent, govern ICE 

Clear Credit. Moreover, as noted above, ICE Clear Credit has an 

open access policy as codified in its Rules. 

Q.15. Some have argued that members could actually lower risk 

controls and be incentivized to take on greater risk positions in a 

clearinghouse environment. How does the clearinghouse management team evaluate the risk controls? 

A.15. The clearing participants of a clearinghouse mutualize the 

risk of all of the clearing participants as a result of contributing 

to the clearinghouse’s guaranty fund. Since each clearing participant’s capital is exposed to the risk of other clearing participants, 

the clearing participants are financially incented to ensure that 

risk controls are appropriate and are not lowered. In addition, as 

noted above, the ICE Clear Credit Board of Mangers is vested with 

the sole authority to determine the risk controls of ICE Clear Credit. 

Q.16. What incentives exist to ensure risks are properly evaluated 

and not exposed to influence from members? 

A.16. See above response. It is in the economic interest of clearing 

members who serve on the Risk Committee to ensure that risks are 

properly evaluated. Nevertheless, at ICE Clear Credit, the Risk 

Committee has no authority and is merely a consultative comVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00074 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
71 

mittee. As noted above, only the ICE Clear Credit Board of Managers has authority to make risk-related decisions. 

Q.17. It was recently reported that ICE Clear Credit is reducing 

its minimum adjusted net capital for members from $1 billion to 

$50 million (plus $20 million in one-time guarantee fund contributions and a variable rate on how much the member exposes the 

clearinghouse). How does this change balance access with safety 

and soundness? 

A.17. See response to Question 1 above that references ICE Clear 

Credit’s current minimum adjusted net capital requirements. The 

$50 million number comes from the CFTC’s proposed minimum adjusted net capital requirement. ICE Clear Credit has not considered lowering its adjusted net capital requirement to $50 million. 

Q.18. Both the U.S. Department of Justice and the European Commission have become concerned about the possibility of anticompetitive practices in credit derivatives clearing. In your opinion, 

what factors give rise to these concerns? 

A.18. ICE Clear Credit does not know and will not speculate regarding any factors that might give rise to concerns of the U.S. Department of Justice. ICE Clear Credit respectfully refers the Committee to the European Commission’s press release dated April 29, 

2011. 

Q.19. Do those same factors extend to the clearing of other products? And how should we address those factors? 

A.19. Again, ICE Clear Credit does not know and will not speculate 

regarding any factors that might give rise to concerns of the U.S. 

Department of Justice. 

RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED 

FROM JAMES CAWLEY 

Q.1. What are your perspectives on the current rules proposed by 

the CFTC and SEC on the ownership and governance of clearinghouses? How would reducing minimum capital requirements for 

clearinghouse membership impact the risk profiles of clearinghouses as well as the ability of new potential clearing members to 

join clearinghouses? 

A.1. Please see the attached SDMA comment regarding Implementation of Conflicts of Interest Policies and Procedures, dated June 

3, 2011 (hereafter ‘‘Conflicts Letter’’). 

Q.2. How do you anticipate clearinghouses will coordinate with exchanges and swap execution facilities (SEF) on the clearing and 

trading of swaps? What would be the positive and negative impacts 

of a vertically integrated clearinghouse-SEF model when compared 

with more independent role for clearing and execution venues? 

A.2. Please see the attached SDMA comment regarding OTC Derivative Market Integrity and Real-Time Trade Processing Requirements, dated June 3, 2011. 

Q.3. Both the U.S. Department of Justice and the European Commission have become concerned about the possibility of anticompetitive practices in credit derivatives clearing. What factors 

72 

give rise to these concerns? Do those same factors extend to the 

clearing of other products? And how should we address those factors? 

A.3. There are two key factors that indicate anticompetitive practices. The first factor is that all or most of the sales for a particular 

product or service are provided by a small number of sellers. This 

high concentration of market share is known as ‘‘market power.’’ 

The second factor is high barriers to entry into the market. Barriers to entry are anything that prevents a potential competitor’s 

ability to enter the market and include high capital costs, control 

of resources and intellectual property. 

All of these factors give rise to concerns in the clearing of credit 

derivatives and extend to the clearing of other products. The clearinghouses that clear credit derivatives have market power. It is 

well established that 80 percent of the market is controlled by 10 

dealers. These dealers and the clearinghouse they control are an oligopoly (i.e., a small group of firms that exert monopoly like control 

over the market). They have sought to maintain their market 

power through restrictive clearinghouse participant eligibility 

standards. 

For further detail on these restrictive standards, and our 

thoughts on how to address these issues, please see the Conflicts 

Letter. 

Q.4. Should there be restrictions on the ownership of clearinghouses by major swaps dealers? Why or why not? 

A.4. Please see the attached SDMA comment regarding Implementation of Conflicts of Interest Policies and Procedures, dated June 

3, 2011. 

Q.5. Is the clearing function a natural monopoly? Why or why not? 

A.5. The clearing function is not a natural monopoly. A natural monopoly exists in a market where barriers to entry are substantial 

costs or the use of infrastructure that cannot be reasonably duplicated by a competitor. Two examples of this type of infrastructure 

are electrical grids and railroad bridges. 

This is not the case in clearing function. Clearing does not rely 

upon infrastructure that cannot be reasonably duplicated. It relies 

upon capital. There is no limit in the amount of capital that can 

be used. Please see the Conflicts Letter for a discussion of how the 

use of capital should be applied to clearing risk. 

Q.6. While the benefits of encouraging clearing are widely acknowledged, increased clearing brings some risks of its own. What steps 

would you recommend our regulators take to reduce and contain 

systemic risk at clearinghouses? 

A.6. Since their inception clearinghouses have played a vital role 

in the market by managing the default risk of counterparties and 

spreading that risk over the members of the clearinghouse. This 

system is most effective when the group of clearing members is 

large and uncorrelated, and conversely, least effective when the 

group is small and correlated. Systemic risk is especially problematic in the current environment where clearinghouses are monopolies controlled by a handful of highly correlated firms. In the event 

of clearing member default where there are a small number of corVerDate Nov 24 2008 16:15 Mar 02, 2012 Jkt 048080 PO 00000 Frm 00076 Fmt 6602 Sfmt 6602 L:\HEARINGS 2011\05-25 DERIVATIVES CLEARINGHOUSES -- OPPORTUNITIES AND CH
73 

related clearing members there is a greater chance that other 

clearing members may also default. 

In order to reduce systemic risk the regulators must require that 

clearinghouses have a large, noncorrelated group of clearing members. This can only be accomplished through clearing membership 

standards that are based upon fair and open access. Please see the 

Conflicts Letter for a further discussion of this topic. 

Q.7. How should regulators properly oversee the dynamic risk 

management process in a real-time manner? 

A.7. To oversee the dynamic risk management process in real-time 

the regulators must have adequate technology resources. Without 

adequate technology there can be no real-time monitoring of any 

function. Adequate technology has three components. The first 

component is technology infrastructure that meets current industry 

standards. Second, the regulators must have direct connectivity to 

the clearinghouses. Third, the regulators must have software that 

can perform real time monitoring of risk management functions. 

The software can either be provided by the clearinghouses to the 

regulators or a program developed by the regulators. 

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ADDENDUM 1 

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83 

84 

85 

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88 

89 

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91 

92 

ADDENDUM 2 

93 

94 

95 

96 

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99 

100 

101 

102 

103 

104 

105 

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109 

110 

111 

112 

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ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

LETTER SUBMITTED BY THOMAS C. DEAS, JR., VICE PRESIDENT AND 

TREASURER, FMC CORPORATION 

Dear Chairman Johnson and Ranking Member Shelby, I very much appreciate 

your having given me the opportunity to present the views of end users on the complex topic of derivatives reform at the Committee’s hearing on April 12, 2011. I was 

speaking as the Vice President and Treasurer of FMC Corporation, as the President 

of the National Association of Corporate Treasurers, and on behalf of the Coalition 

for Derivatives End Users, on whose steering committee I serve. I also very much 

appreciate your efforts on behalf of end users as we join with you to bring about 

sensible reform of derivatives. 

I would like to respond for the record to comments made at a subsequent hearing 

of the Subcommittee on Securities, Insurance, and Investment on May 25, 2011. Dr. 

Benn Steil, Senior Fellow and Director of International Economics of the Council on 

Foreign Relations asserted that margining by end users would bring about increased 

transparency and that treasurers oppose margin requirements in order to conceal 

the inefficiency of their unmargined derivatives transactions. 

We believe that Dr. Steil’s analysis reflects several flawed assumptions. For example, he assumes that corporate treasurers do not have access to market pricing information and also that policy makers intended margin as a mechanism to address 

transparency gaps in the over-the-counter (OTC) derivatives market. Both of these 

assumptions are flat wrong. 

End users generally value the ability to customize their derivatives transactions. 

Because customized derivatives have unique attributes that affect their price, some 

have suggested that end users are unable to discern the appropriate price of a derivative. In fact, corporate treasurers today have access to tools that allow them to 

price unique transaction structures. When corporate treasurers enter into hedging 

arrangements to mitigate risk, they utilize these tools to identify the appropriate 

price prior to transacting. Moreover, like any consumer, corporate treasurers comparison shop to ensure they get the best price. They often do this by conducting 

competitive auctions that ensure the best execution is achieved. 

Although end users generally execute at the best price available to them, there 

are situations in which treasurers may opt to execute transactions slightly above 

market levels. Contrary to Dr. Steil’s assertion, such situations are not indicative 

of a treasurer’s inability to achieve efficient pricing outcomes. For example, a treasurer generally attempts to mitigate counterparty credit risk by executing transactions with multiple counterparties. If a given counterparty is especially competitive in other credit products such as letters of credit to facilitate foreign trade payments or undrawn credit lines committed for future use, corporate treasurers may 

find that a disproportionate amount of credit risk consisting of future credit commitments together with derivatives may be with a single counterparty. An excess concentration of counterparty credit risk will generally be unacceptable for an end user. 

In order to spread its counterparty credit risk across multiple banks, treasurers will 

often choose to accept a price from a bank that may be slightly wide of the best 

price. Contrary to Dr. Steil’s assertion, prudence dictates that companies weigh not 

only the price of a given transaction, but also factors such as counterparty credit 

risk and even legal risks. 

A report published November 1, 2010, by the International Swaps and Derivatives 

Association (ISDA) entitled, ‘‘Interest Rate Swap Liquidity Test’’, found that the difference in pricing between the best and worst quotes for any interest rate swap in 

their sample was just 1.3 basis points (a range of from 0.0000 percent to 0.0130 percent). The average difference between the best and worst quotes for each swap was 

just 0.38 basis points (0.0038 percent). ISDA concluded that the narrow spreads between the best and worst quotes attest to an extremely competitive marketplace for 

uncleared and unmargined OTC derivatives and that the benefits to counterparties 

with collateralized swap documentation consistent with margining would be ‘‘extremely modest.’’ 

Though end users already have access to pricing information that enables them 

to secure efficient market pricing, end users have long supported efforts to increase 

transparency in the OTC derivatives market by increasing access to such information and lowering the cost of obtaining it. The Dodd-Frank Act and its associated 

rules employ several mechanisms aimed at increasing transparency. For example, 

regulators have proposed requirements for banks to disclose midmarket swap prices 

to their customers. Additionally, Dodd-Frank includes a real-time reporting requirement and a trading requirement, each aimed at increasing pricing transparency for 

market participants. 

114 

However, margin was not among the policy tools implemented to increase pricing 

transparency. Rather, margin was intended to reduce systemic risk by dictating that 

certain market participants back their trades with cash. It is the cash and committed credit that margin requirements would tie up, to the detriment of productive 

investment in their businesses that concerns corporate treasurers, not any incremental disclosure that such requirements might bring. 

Though we appreciate Dr. Steil’s desire to increase transparency in a manner that 

benefits end users, we believe his analysis inaccurately characterizes the motivations of corporate treasurers. In particular, his analysis ignores the trade-offs inherent in the decisions treasurers make when managing their risks. 

Thank you for your consideration of these comments. Please let me know if you 

have any questions or if I can be of assistance in further elaborating these ideas.