Daniel K Tarullo: Derivatives regulation
Testimony by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 12 April 2011.
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Chairman Johnson, Ranking Member Shelby, and other members of the Committee, I
appreciate this opportunity to provide the Federal Reserve Board's views on the
implementation of title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (Dodd-Frank Act). The Board's responsibilities with respect to over-the-counter (OTC)
derivatives fall into three broad areas: consultation and coordination with other authorities,
both domestic and international; efforts to strengthen the infrastructure of derivatives
markets; and supervision of many derivatives dealers and market participants.
Consultation and coordination
The Dodd-Frank Act requires that the Commodity Futures Trading Commission (CFTC) and
the Securities and Exchange Commission (SEC) consult with the Board on the rules they are
crafting to implement several provisions of title VII. Immediately after passage of the act, the
staff from the commissions and the Board met to fashion a process for this consultation; at
the Board, we identified members of the staff with relevant expertise, both here and across
the Federal Reserve System. Our staff have commented on proposed rules of the
commissions at each stage of the development process to date. In providing feedback, we
have tried to bring to bear our experience from supervising dealers and market infrastructure
as well as our familiarity with markets and data sources to assist the commissions.
Important coordination activities related to derivatives regulation also are occurring within
international groups. Most prominently, the Group of Twenty (G-20) leaders have set out
commitments related to reform of the OTC derivatives markets that, when implemented by
national authorities, will form a broadly consistent international regulatory approach. Work on
the G-20 commitments is being done by numerous groups of technical and policy experts,
and staff members from the Federal Reserve are actively participating in these groups.
More generally, the Board participates in many international groups that serve as vehicles for
coordinating policies related to the participants and the infrastructure of derivatives markets.
These groups include the Basel Committee on Banking Supervision (Basel Committee),
which has recently enhanced international capital, leverage, and liquidity standards for
derivatives, and the Committee on Payment and Settlement Systems, which is working with
the International Organization of Securities Commissions to update international standards
for systemically important clearing systems, including central counterparties that clear
derivatives instruments, and trade repositories. Public consultation on these revised
international standards is currently under way.
The goal of all of these efforts is to develop a consistent international approach to the
regulation and supervision of derivatives products and market infrastructures as well as to
the sound implementation of the agreed-upon approaches. Our aim is to promote both
financial stability and fair competitive conditions to the fullest extent possible.
Infrastructure issues
The Dodd-Frank Act addressed both the infrastructure of the derivatives markets and the
regulation and supervision of its dealers and major participants. Central counterparties are
given an expanded role in the clearing and settling of swap and security-based swap
(hereafter referred to as "swap") transactions, and the Board believes benefits can flow from
this reform. Since 2005, Federal Reserve staff members have worked with market
participants to strengthen the infrastructure for OTC derivatives, including developing and
broadening the use of central clearing mechanisms and trade repositories. Market
participants have already established central counterparties that provide clearing services for
some OTC interest rate, energy, and credit derivatives contracts. If properly designed,
managed, and overseen, central counterparties offer an important tool for managing
counterparty credit risk, and thus they can reduce risk to market participants and to the
financial system. Both central counterparties and trade repositories also support regulatory
oversight and policymaking by providing more-comprehensive data on the derivatives
markets. The Board is committed to continuing to work with other authorities, both in the
United States and abroad, to ensure that a largely consistent international approach is taken
to central counterparties and trade repositories and that their risk-reducing benefits are
realized.
Title VIII of the act complements the role of central clearing in title VII through heightened
supervisory oversight of systemically important financial market utilities, including
systemically important facilities that clear swaps. This heightened oversight is important
because financial market utilities such as central counterparties concentrate risk and thus
have the potential to transmit shocks throughout the financial markets. The Financial Stability
Oversight Council is responsible for designating utilities as systemically important. Through
its role on the council, the Board helped develop the designation process that was released
for comment in March. Separately, the Board is also seeking comment on proposed
riskmanagement standards that would apply to those designated utilities supervised by the
Board under title VIII.1 As part of title VIII, the Board was given new authority to provide
designated utilities with access to Reserve Bank accounts, payment services, and
emergency collateralized liquidity in unusual and exigent circumstances. We are carefully
considering ways to implement this authority in a manner that protects taxpayers and limits
any rise in moral hazard.
Supervisory issues
Although central counterparties will provide an additional tool for managing counterparty
credit risk, enhancements to the risk-management policies and procedures for individual
market participants will continue to be a high priority for supervisors. As the reforms outlined
in the act are implemented, the most active firms in bilateral OTC markets likely will become
active clearing members of central counterparties. As such, the quality of risk management
at these firms importantly affects the ability of the central counterparty to manage its risks
effectively and to deliver risk-reducing benefits to the markets.
Capital and margin requirements are central to the prudential regulation of financial
institutions active in derivatives markets as well as to the internal risk-management
processes of such firms. Title VII requires that the CFTC, the SEC, and prudential regulators
adopt capital and margin requirements for the noncleared swap activity of swap dealers and
major swap participants. The Board, the Office of the Comptroller of the Currency, the
Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, and the Farm
Credit Administration are responsible for adopting capital and margin requirements for swap
dealers and major swap participants that are banks or other prudentially regulated entities.
The commissions are responsible for adopting capital and margin requirements for swap
dealers and major swap participants that are not supervised by a prudential regulator. The
prudential regulators and the commissions are consulting in developing the rules, and all
agencies must, to the maximum extent practicable, adopt comparable standards.
Earlier today, the Board and the other prudential regulators released for public comment a
proposed rule on capital and margin requirements. Our proposal will be open for public
comment for 60 days, and we look forward to receiving the public's comments.
For capital, our proposal relies on the existing regulatory capital requirements, which already
specifically address the unique risks of derivatives transactions. Beyond the current
requirements, the Board and the other U.S. banking agencies played an active role in
developing the recent Basel III enhancements to capital requirements agreed to by the Basel
Committee in December 2010. Basel III will, among other things, strengthen the prudential
framework for OTC derivatives by increasing OTC derivatives' risk-based capital and
leverage requirements and by requiring banking firms to hold an additional buffer of
highquality, liquid assets to address potential liquidity needs resulting from their derivatives
portfolios.
Our proposal for margin imposes initial and variation margin requirements on the noncleared
swaps held by swap dealers or major swap participants that have a prudential regulator. For
swaps with a nonfinancial end-user counterparty, the proposed rule would not specify a
minimum margin requirement. Rather, it would allow a banking organization that is a dealer
or major participant to establish a threshold, based on a credit exposure limit that is approved
and monitored as part of the credit approval process, below which the end user would not
have to post margin. For swaps with other counterparties, the proposal would cap the
allowable threshold for unsecured credit exposure on noncleared swaps. In addition, the
proposal would only apply a margin requirement to contracts entered into after the new
requirement becomes effective.
A much discussed part of the act is the requirement that banks push portions of their swap
activity into affiliates or face restrictions on their access to the discount window or deposit
insurance. Under the push-out provisions, banking organizations with deposit insurance or
access to the Federal Reserve's discount window will have to reorganize some of their
derivatives activity, pushing certain types of swaps out of subsidiary banks and into distinct
legal entities that will require their own capitalization and separate documentation of trades
with existing customers. The act permits domestic banks to continue to engage in derivatives
activities that have been a traditional focus of banks, including hedging activities and dealing
in interest rate swaps, currency swaps, certain cleared credit default swaps, and other swaps
that reference assets that banks are eligible to hold. However, because of the specific
language contained in the act, this exemption for traditional bank derivatives activities does
not apply to U.S. branches of foreign banking firms that by law have access to the Federal
Reserve's discount window. A possibly unintended effect of the act's push-out provision may
be to require some foreign firms to reorganize their existing U.S. derivatives activities to a
greater extent than U.S. firms. Proposed rules to implement this section are still under
development by the banking agencies.
Conclusion
As the implementation process for the act continues, the challenge facing the Board is to
enhance supervision, oversight, and prudential standards of major derivatives market
participants in a manner that promotes more-effective risk management and reduces
systemic risk, yet retain the significant benefits of derivatives to the businesses and investors
who use them to manage financial market risks. The Board is working diligently to achieve
these goals.