For release on delivery
2:15 p.m. EDT
June 23, 2017
Central Clearing and Liquidity
Remarks by
Jerome H. Powell
Member
Board of Governors of the Federal Reserve System
at
The Federal Reserve Bank of Chicago Symposium on Central Clearing
Chicago, Illinois
June 23, 2017
Thank you for inviting me to speak today.1 The Federal Reserve Bank of Chicago and
Darrell Duffie have provided a valuable public service in hosting this annual symposium on
central clearing. I will start my remarks by taking stock of the progress made in strengthening
central counterparties (or CCPs), and then offer some thoughts on central clearing and liquidity
risks.
The huge losses suffered by the American International Group (AIG) on its over-the-
counter derivatives positions contributed to the financial crisis and highlighted the risks in
derivatives markets. In response, the Group of Twenty nations committed in 2009 to moving
standardized derivatives to central clearing. Central clearing serves to address many of the
weaknesses exposed during the crisis by fostering a reduction in risk exposures through
multilateral netting and daily margin requirements as well as greater transparency through
enhanced reporting requirements. Central clearing also enables a reduction in the potential cost
of counterparty default by facilitating the orderly liquidation of a defaulting member's positions,
and the sharing of risk among members of the CCP through some mutualization of the costs of
such a default.
But central clearing will only make the financial system safer if CCPs themselves are run
safely. Efforts to set heightened expectations for CCPs and other financial market infrastructures
have been ongoing for years, with the regulatory community working collectively to clarify and
significantly raise expectations. These efforts resulted in the Principles for Financial Market
Infrastructures (or PFMI), which was published in 2012 by the Committee on Payments and
Market Infrastructures (CPMI) and the International Organization of Securities Commissions
(IOSCO). The PFMI lays out comprehensive expectations for CCPs and other financial market
infrastructures.
Recent Accomplishments
Extensive work has been done to implement the PFMI.2 The joint CCP work plan agreed
to in 2015 by the Financial Stability Board (or FSB), CPMI, IOSCO, and the Basel Committee
on Banking Supervision (or BCBS) laid out an ambitious program to provide further guidance on
the PFMI and better understand interdependencies between CCPs and their members.3
CPMI and IOSCO will soon publish more granular guidance on CCP resilience, focusing
on governance, stress testing credit and liquidity risk, margin, and recovery planning. While this
guidance will not establish new standards beyond those set out in the PFMI, I believe that it will
encourage CCPs and their regulators to engage in thoughtful dialogue on how they could further
enhance their practices.
The FSB has led the work on resolution planning for CCPs, publishing draft guidance
this past February. The guidance covers a range of topics, including the powers that resolution
2
In 2013, CPMI-IOSCO launched a multi-level, multi-year monitoring program to evaluate how the principles and
responsibilities in the PFMI are being implemented around the world. Several different assessments have been
completed to date and the findings have provided important insight on both the progress and methods by which
authorities and CCPs have sought to implement the PFMI. In 2014, CPMI-IOSCO published supplemental
guidance and a menu of recovery tools to help financial market infrastructures, including CCPs, meet the
expectations in the PFMI that all financial market infrastructures have a comprehensive and effective recovery plan.
3
While the work done in the context of the joint work plan represents significant regulatory efforts related to CCPs,
progress is also being made on a parallel path. In particular, it is important to highlight the adoption and
implementation of the SEC's Covered Clearing Agency Standards, which further strengthens the risk management
standards that clearing agencies registered with the SEC must meet. In addition, the SEC and the industry have been
working jointly to shorten the settlement cycle to two days for many securities products, culminating in the SEC's
adoption of amendments to Rule 15c6-1(a) earlier this year.
authorities need in order to effectively resolve a CCP, the potential incentives related to using
various loss-allocation tools in resolution, the application of the "no creditor worse off"
safeguard, and the formation of crisis management groups--a key step in facilitating cross-border
regulatory coordination in the event of a failure of a systemically important CCP.
Ensuring the safety of the system also requires an understanding of the interdependencies
between CCPs and their clearing members. Work on this is ongoing. Preliminary analysis
confirms that there are large interdependencies between banks and CCPs, including common
exposures related to financial resources held to cover market and credit risk, as well as common
lending and funding arrangements.
Having pushed for the move to greater central clearing, global authorities have a
responsibility to ensure that CCPs do not themselves become a point of failure for the system.
The progress I have just described is helping to meet this responsibility by making central
clearing safer and more robust. Global authorities also have a responsibility to ensure that bank
capital standards and other policies do not unnecessarily discourage central clearing. In my
view, the calibration of the enhanced supplementary leverage ratio (SLR) for the U.S. global
systemically important banks (G-SIBs) should be reconsidered from this perspective. A risk-
insensitive leverage ratio can be a useful backstop to risk-based capital requirements. But such a
ratio can have perverse incentives if it is the binding capital requirement because it treats
relatively safe activities, such as central clearing, as equivalent to the most risky activities. There
are several potential approaches to addressing this issue. For example, the BCBS is currently
considering a proposal that would set a G-SIB's SLR surcharge at a level that is proportional to
the G-SIB's risk-based capital surcharge. Taking this approach in the U.S. context could help to
reduce the cost that the largest banks face in offering clearing services to their customers.
The Federal Reserve is also considering other steps. First, we are developing an
interpretation of our rules in connection with the movement of some centrally cleared derivatives
to a "settled-to-market" approach. Under this approach, daily variation margin is treated as a
settlement payment rather than as posting collateral. Under our capital rules, this approach
reduces the need for a bank to hold capital against these exposures under risk-based and
supplementary leverage ratios. Second, we are also working to move from the "current exposure
method" of assessing counterparty credit risk on derivative exposures to the standardized
approach for counterparty credit risk (SA-CCR). The current exposure method generally treats
potential future credit exposures on derivatives as a fixed percentage of the notional amount,
which ignores whether a derivative is margined and undervalues netting benefits. SA-CCR is a
more risk-sensitive measurement of exposure, which would appropriately recognize the
counterparty risks on derivatives, including the lower risks on most centrally cleared derivatives.
Central Clearing and Liquidity
CCPs are different from most other financial intermediaries in the sense that the CCP
stands between two parties to a cleared transaction whose payment obligations exactly offset
each other. A CCP faces market or credit risk only in the event that one of its members defaults
and its required initial margin or other pre-funded financial resources are insufficient to cover
any adverse price swings that occur during the period between the time of default and the time
that the CCP is able to liquidate the defaulting party's positions.
However, like most other financial intermediaries, CCPs do face liquidity risks. Their
business model is based on timely payments and the ability to quickly convert either the
underlying assets being cleared or non-cash collateral into cash. For this reason, CCPs should
carefully consider liquidity when launching new products and only offer clearing of products that
can be sold quickly, even in times of stress. Liquidity problems can occur in central clearing
even if all counterparties have the financial resources to meet their obligations, if they are unable
to convert those resources into cash quickly enough. The amount of liquidity risk that CCPs face
can sometimes dwarf the amount of credit or market risk they face. This is particularly true for
the clearing of cash securities such as Treasuries. In that case, the securities being cleared are
extremely safe and likely to rise in value in times of stress. But in contrast to most cleared
derivatives, the cash payments involved are very large because counterparties exchange cash for
the delivery of the security on a gross basis.
I will look at these risks from two perspectives, first in terms of the payments that CCPs
must make, and then in terms of the payments they expect to receive.
Payment Flows from CCPs
In the case of a member's default, a CCP must be equipped to make the cash payments
owed to non-defaulting counterparties when due. This requirement can be met as long as there is
sufficient margin, mutualized resources such as the guarantee fund, or the CCP's own resources
held in cash and in the required currency. But if those funds are held in securities, then the CCP
will need to convert them to cash, either by entering into a repurchase agreement, or using them
as collateral to draw on a line of credit. And if the CCP holds either cash or securities
denominated in a currency different from the one in which payment must be made, it will need to
either engage in a spot FX transaction or in an FX swap.
Principle seven of the PFMI addresses these liquidity risks, calling for all CCPs to meet a
"Cover 1 standard"--that is, to hold enough liquid resources in all relevant currencies to make
payments on time in the event of the default of the clearing member that would generate the
largest payment obligation under a wide range of potential stress scenarios. More complex CCPs
and those with a systemic presence in multiple jurisdictions are encouraged to meet a "Cover 2
standard." The PFMI also provide guidance on the resources that qualify in meeting these
requirements: cash held at a central bank or a creditworthy commercial bank, committed lines of
credit, committed repurchase agreements, committed FX swap agreements, or highly marketable
collateral that can be converted into cash under prearranged and highly reliable funding
arrangements.
There are two sets of risks involved here. First, where should CCPs put their cash? As
central clearing has expanded, CCPs have had to deal with increasingly large amounts of cash
margin. CCPs can deposit some of these funds with commercial banks. But regulatory changes
have made it more expensive for banks to take large deposits from other financial firms, and in
some cases banks may be unwilling to accept more cash from a CCP. And many of the largest
banks are also clearing members, which introduces a certain amount of wrong-way risk. A
clearing-member default could be especially fraught if the defaulting bank also held large cash
balances for the CCP. For this reason, CCPs may prudently place limits on the amount deposited
at a given institution. In order to diversify their holdings, many also place cash in the repo
market. If it is available, the ability to deposit cash at a central bank allows for another safe,
flexible, and potentially attractive option--a subject I will return to later.
Second, how can CCPs be assured that they will be able to convert securities into cash or
draw on other resources in times of stress? The PFMI uses the words "committed" and "pre-
arranged" in describing qualifying liquid resources. Indeed, the PFMI does not view spot
transactions on the open market as reliable sources of liquidity during times of stress. The
Federal Reserve has strongly supported this approach. Liquidity plans should not take for
granted that, at a time of stress involving a member default, lines of credit, repurchase
agreements, or FX swaps could be arranged on the spot. Committed sources of liquidity are
more likely to be available. They also allow market participants and regulators to make sure that
plans are mutually consistent. If a CCP has arranged for a committed liquidity source, then the
provider should account for it in its own plans and demonstrate that it can meet its commitment.
Of course, this liquidity is not free, nor should it be. Regulatory changes have forced
banks to closely examine their liquidity planning and to internalize the costs of liquidity
provision. The costs of committed liquidity facilities will be passed on to clearing members.
These costs are perhaps highest in clearing Treasury securities, where liquidity needs can be
especially large. To meet its estimated needs, DTCC's Fixed Income Clearing Corporation
(FICC) is planning to institute a committed repo arrangement with its clearing members. Despite
initial concerns, the industry seems prepared to absorb these costs, but they will not be trivial for
many members.4
Payment Flows to CCPs
While initial and variation margin help mitigate credit risk in central clearing, they can
also create liquidity risk. Clearing members and their clients are required to make margin
payments to CCPs on a daily basis, and in times of market volatility these payments may rise
dramatically. This source of liquidity risk can occur even in the absence of a default. For
example, after the UK referendum on Brexit, the resulting price swings triggered many CCPs to
make substantial intraday and end-of-day margin calls. Fortunately, members had prepared and
were able to make the needed payments, but the sums involved caught many off guard and the
experience served as a useful warning.
According to data from the Commodity Futures Trading Commission (CFTC), the top
five CCPs requested $27 billion in additional margin over the two days following the
referendum, about five times the average amount.5 In most cases, clearing members have an
hour to meet intraday margin calls. Clearing members have no choice but to hold enough liquid
resources to meet the range of possible margin calls, as the consequences of missing a margin
call are considerable.
Brexit was only the most recent example in which margin calls were unexpectedly large.
Margin calls were also quite large after the stock market crash of October 1987. That episode
helps to demonstrate how complicated payments flows can be and why liquidity risk also needs
to be viewed from a macroprudential perspective, considering potential risks to flows across the
system. After falling about 9 percent the week before, on October 19, 1987, the S&P 500 stock
market index fell about 20 percent. Margin calls were about 10 times their normal size, and
caused a very complicated set of payment flows across multiple exchanges, CCPs, and banks.6
The next slide helps to represent the ensuing payment flows.7 Calls requesting payment
are on the left in red. When making a margin call, a CCP requests payment from its clearing
members. Clearing members in turn request margin payments from the customers for whom
they are clearing, and those customers must then direct their bank to make the payment. If
everything works as it should, payments (in green, on the right) will ensue. The customer's bank
will deliver the requested payment to the clearing member's bank (or payment bank). The
payment bank will then deliver the funds to a settlement bank used by the CCP, and the
settlement bank will then credit the funds to the CCP. In theory, each of these payments would
have to happen sequentially, but often parties offer intraday credit (represented by the dashed
orange lines) to help smooth these flows. For example, the settlement bank may provide
intraday credit to the clearing member, sending funds to the CCP before the member has
delivered funds to the payment bank or before those funds have been transferred to the
settlement bank. Clearing members or the customer's bank may also provide intraday credit to
their customers, again making payments before funds have been received in order to help speed
the payments chain.
Over the course of October 19, 1987, the system worked largely as I have just described.
But on October 20, every single link in these payments and credit chains was interrupted. This is
represented graphically in the next slide. By that morning, many settlement banks and clearing
members had yet to receive offsetting payments for credit that had been extended the previous
day. Goldman Sachs and Kidder, Peabody had together extended $1.5 billion in credit that had
not yet been paid.8 As a result, some firms pulled back on providing further credit, which then
forced each link of the payments chain to operate sequentially. Payments slowed, with the
unintended consequence that uncovered positions grew larger and stayed open for even longer.
Without credit, some customers were unable to meet their margin calls and were forced to
liquidate their positions. This gridlock sparked fears that a clearing member or even a CCP
would be forced to default. The Federal Reserve reacted to this threat by encouraging banks to
continue to extend credit and by injecting funds into the system to help ensure that credit was
available. The 1987 stock market crash did not leave much lasting impact on the economy, but if
these liquidity problems had been allowed to cause the default of a major clearing member or
even a CCP then it could have had a much more serious impact. While this might seem like
simply an interesting bit of history, the payments chains involved in central clearing are still very
similar today. To guard against the same sorts of liquidity risk today, we need to make sure that
every link in these chains will work as it is intended to under stress.
While neither Brexit nor the October 1987 crash involved a clearing member default,
these incidents do point to the potential complications of such a default. I have already discussed
the steps that a CCP might need to take in the event of a default to meet its liquidity needs.
Some of those needs, such as committed lines of credit or repo agreements, could involve
tapping financial resources at the same banks that are clearing members. Thus, clearing
members may need to juggle several different liquidity exposures simultaneously in the event of
a default. They may face draws on committed sources of liquidity, and if there are market
stresses around the default, which seems a near certainty, they may at the same time face a
sudden increase in intraday margin calls and their own internal demands for more liquid
resources.9 These are risks that we should seek to understand better.
Policy Implications
The Federal Reserve is the primary supervisory authority for two designated financial
market utilities (or DFMUs), and plays a secondary role relative to the six other DFMUs. As a
central bank, we are particularly concerned with liquidity issues.10 I will address four policy
issues that need careful consideration as the public sector and market participants continue to
address liquidity risks in central clearing.
Stress Testing
The 1987 stock market crash showed that we need to look at liquidity risks from a
systemwide perspective. That event involved multiple CCPs and also involved multiple links in
the payments chains between banks and CCPs. Conducting supervisory stress tests on CCPs that
take liquidity risks into account would help authorities better assess the resilience of the financial
system. A stress test focused on cross-CCP liquidity risks could help to identify assumptions
that are not mutually consistent; for example, if each CCP's plans involve liquidating Treasuries,
is it realistic to believe that every CCP could do so simultaneously?
Authorities in both the United States and Europe have made progress in conducting
supervisory stress tests of CCPs. In the United States, the CFTC conducted a useful set of tests
of five major CCPs last year.11 The tests analyzed each individual institution's ability to
withstand the credit risks emanating from the default of one or more clearing members. This
was innovative and necessary work. It would be useful to build on it by adding tests that focus
on liquidity risks across CCPs and their largest common clearing members. Such an exercise
could focus on the robustness of the system as a whole rather than individual CCPs. The
European Securities and Markets Authority is already expanding its supervisory stress testing
exercise to incorporate liquidity risk. A similar exercise here in the United States should be
seriously considered.
Ensuring Efficiency
The industry collectively needs to ensure that the liquidity flows involved in central
clearing are handled efficiently and in a way that minimizes potential disruption. As I noted,
there was some concern about the size of margin calls following Brexit, and certain CCPs have
taken measures to address this. For example, LCH has subsequently made changes to its
intraday margining procedures in an effort to reduce liquidity pressures on its clearing members,
allowing them to offset losses on their client accounts with gains on the house account.12
Other CCPs are also actively engaged in efforts to increase their efficiency. FICC is
looking at potential solutions using distributed ledger technology to clear both legs of overnight
repo trades, which could allow for greater netting opportunities and thereby reduce potential
liquidity needs.13 Several CCPs are also looking at ways to expand central clearing to directly
include more buy-side firms, which could also offer greater netting opportunities. Doing so
could also offer new sources of liquidity if the new entrants are able to take part in the CCP's
committed liquidity arrangements. Diversification of sources of liquidity would offer tangible
benefits--CCPs would avoid relying on the same limited set of clearing members for all of their
liquidity needs. As one example, the Options Clearing Corporation established an innovative
pre-funded, committed repurchase facility with a leading pension fund.
As regulators, we should encourage innovations that increase clearing efficiency and
reduce liquidity risks where they meet the PFMI and our supervisory expectations.
Central Bank Accounts
As I discussed earlier, CCPs have a complicated set of decisions on how and where to
hold their cash balances. Title VIII of the Dodd-Frank Act authorized the Federal Reserve to
establish accounts for DFMUs, and we now have accounts with each of the eight institutions that
the Financial Stability Oversight Council has so designated. These accounts permit DFMUs to
hold funds at the Federal Reserve, but not to borrow from it.14 Allowing DFMUs to deposit
balances at the Federal Reserve helps them avoid some of the risk involved in holding balances
with their clearing members. Doing so also provides CCPs with a flexible way to hold balances
on days when margin payments unexpectedly spike and it is difficult to find banks that are
willing to accept an unexpected influx in deposits. In such a case, it may also be too late in the
day to rely on the repo market. The availability of Fed accounts could help avoid potential
market disruptions in those types of circumstances.
Cross-Border Cooperation
The lessons from Brexit also point to the need for cross-border cooperation. Brexit
triggered payments flows to CCPs across many jurisdictions. As far as liquidity risks are
concerned, it is immaterial whether a CCP is based in the United States or abroad so long as it
clears U.S. dollar denominated assets and must make and receive U.S. dollar payments. There
are different possible approaches to such cross-border issues. Efforts to address these liquidity
risks should carefully take into consideration the effect that they would have on the broader
financial system. For example, splintering central clearing by currency area would fragment
liquidity and reduce netting opportunities, which in the case of events like Brexit could actually
trigger even greater liquidity risk. In my opinion, we should be searching for cooperative
solutions to these issues.
Conclusion
In the years following the financial crisis, one of the primary lessons for market
participants and their regulators was the criticality of liquidity risk management. Financial firms
such as Lehman Brothers and AIG struggled to obtain sufficient liquidity to meet their
obligations. Liquidity is also a crucial concern in central clearing, and while regulatory reforms
have done much to strengthen both CCPs and their clearing members, we should continue to
make progress in creating a more robust and efficient system.
Typical Payments Chains Between CCP and Clearing Customers
CCP
Settlement Bank may provide
intraday credit to Clearing Member
Settlement Bank
Payment Bank
Clearing Member may provide
credit to Customer
Clearing Member
Customer
Customer's Bank may provide
credit to Customer
Customer's Bank
Payments Chains on October 20, 1987
CCP
Settlement Bank may provide
intraday credit to Clearing Member Settlement Banks
ceased providing credit
and slowed payments
Settlement Bank
Payment Banks
slowed payments
Payment Bank
Clearing Members
Clearing Member may provide
ceased providing credit
credit to Customer
and slowed payments
Clearing Member
Customer's Banks
ceased providing credit
Customer
and slowed payments
Customer's Bank may provide
credit to Customer
Customer's Bank