| <html> | |
| <title> - HEARING TO REVIEW THE IMPACT OF CAPITAL AND MARGIN REQUIREMENTS ON END-USERS</title> | |
| <body><pre> | |
| [House Hearing, 114 Congress] | |
| [From the U.S. Government Publishing Office] | |
| HEARING TO REVIEW THE IMPACT OF | |
| CAPITAL AND MARGIN REQUIREMENTS ON | |
| END-USERS | |
| ======================================================================= | |
| HEARING | |
| BEFORE THE | |
| SUBCOMMITTEE ON COMMODITY EXCHANGES, ENERGY, AND CREDIT | |
| OF THE | |
| COMMITTEE ON AGRICULTURE | |
| HOUSE OF REPRESENTATIVES | |
| ONE HUNDRED FOURTEENTH CONGRESS | |
| SECOND SESSION | |
| __________ | |
| APRIL 28, 2016 | |
| __________ | |
| Serial No. 114-50 | |
| Printed for the use of the Committee on Agriculture | |
| agriculture.house.gov | |
| ____________ | |
| U.S. GOVERNMENT PUBLISHING OFFICE | |
| 20-029 PDF WASHINGTON : 2016 | |
| ________________________________________________________________________________________ | |
| For sale by the Superintendent of Documents, U.S. Government Publishing Office, | |
| http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, | |
| U.S. Government Publishing Office. Phone 202-512-1800, or 866-512-1800 (toll-free). | |
| E-mail, <a href="/cdn-cgi/l/email-protection" class="__cf_email__" data-cfemail="fa9d8a95ba998f898e929f968ad4999597">[email protected]</a>. | |
| COMMITTEE ON AGRICULTURE | |
| K. MICHAEL CONAWAY, Texas, Chairman | |
| RANDY NEUGEBAUER, Texas, COLLIN C. PETERSON, Minnesota, | |
| Vice Chairman Ranking Minority Member | |
| BOB GOODLATTE, Virginia DAVID SCOTT, Georgia | |
| FRANK D. LUCAS, Oklahoma JIM COSTA, California | |
| STEVE KING, Iowa TIMOTHY J. WALZ, Minnesota | |
| MIKE ROGERS, Alabama MARCIA L. FUDGE, Ohio | |
| GLENN THOMPSON, Pennsylvania JAMES P. McGOVERN, Massachusetts | |
| BOB GIBBS, Ohio SUZAN K. DelBENE, Washington | |
| AUSTIN SCOTT, Georgia FILEMON VELA, Texas | |
| ERIC A. ``RICK'' CRAWFORD, Arkansas MICHELLE LUJAN GRISHAM, New Mexico | |
| SCOTT DesJARLAIS, Tennessee ANN M. KUSTER, New Hampshire | |
| CHRISTOPHER P. GIBSON, New York RICHARD M. NOLAN, Minnesota | |
| VICKY HARTZLER, Missouri CHERI BUSTOS, Illinois | |
| DAN BENISHEK, Michigan SEAN PATRICK MALONEY, New York | |
| JEFF DENHAM, California ANN KIRKPATRICK, Arizona | |
| DOUG LaMALFA, California PETE AGUILAR, California | |
| RODNEY DAVIS, Illinois STACEY E. PLASKETT, Virgin Islands | |
| TED S. YOHO, Florida ALMA S. ADAMS, North Carolina | |
| JACKIE WALORSKI, Indiana GWEN GRAHAM, Florida | |
| RICK W. ALLEN, Georgia BRAD ASHFORD, Nebraska | |
| MIKE BOST, Illinois | |
| DAVID ROUZER, North Carolina | |
| RALPH LEE ABRAHAM, Louisiana | |
| JOHN R. MOOLENAAR, Michigan | |
| DAN NEWHOUSE, Washington | |
| TRENT KELLY, Mississippi | |
| ______ | |
| Scott C. Graves, Staff Director | |
| Robert L. Larew, Minority Staff Director | |
| ______ | |
| Subcommittee on Commodity Exchanges, Energy, and Credit | |
| AUSTIN SCOTT, Georgia, Chairman | |
| BOB GOODLATTE, Virginia DAVID SCOTT, Georgia, Ranking | |
| FRANK D. LUCAS, Oklahoma Minority Member | |
| RANDY NEUGEBAUER, Texas FILEMON VELA, Texas | |
| MIKE ROGERS, Alabama SEAN PATRICK MALONEY, New York | |
| DOUG LaMALFA, California ANN KIRKPATRICK, Arizona | |
| RODNEY DAVIS, Illinois PETE AGUILAR, California | |
| TRENT KELLY, Mississippi | |
| (ii) | |
| C O N T E N T S | |
| ---------- | |
| Page | |
| Conaway, Hon. K. Michael, a Representative in Congress from | |
| Texas, opening statement....................................... 39 | |
| Scott, Hon. Austin, a Representative in Congress from Georgia, | |
| opening statement.............................................. 1 | |
| Prepared statement........................................... 2 | |
| Scott, Hon. David, a Representative in Congress from Georgia, | |
| opening statement.............................................. 3 | |
| Witnesses | |
| Lukken, Hon. Walter L., President and Chief Executive Officer, | |
| Futures Industry Association, Washington, D.C.................. 4 | |
| Prepared statement........................................... 5 | |
| O'Malia, Hon. Scott D., Chief Executive Officer, International | |
| Swaps and Derivatives Association, Inc., New York, NY.......... 8 | |
| Prepared statement........................................... 10 | |
| Deas, Jr., Thomas C., representative, Center for Capital Markets | |
| Competitiveness, U.S. Chamber of Commerce; representative, | |
| Coalition for Derivatives End-Users, Washington, D.C........... 21 | |
| Prepared statement........................................... 23 | |
| Gellasch, Tyler, Founder, Myrtle Makena, LLC, Homestead, PA...... 27 | |
| Prepared statement........................................... 29 | |
| HEARING TO REVIEW THE IMPACT OF | |
| CAPITAL AND MARGIN REQUIREMENTS ON | |
| END-USERS | |
| ---------- | |
| THURSDAY, APRIL 28, 2016 | |
| House of Representatives, | |
| Subcommittee on Commodity Exchanges, Energy, and Credit, | |
| Committee on Agriculture, | |
| Washington, D.C. | |
| The Subcommittee met, pursuant to call, at 10:00 a.m., in | |
| Room 1300 of the Longworth House Office Building, Hon. Austin | |
| Scott of Georgia [Chairman of the Subcommittee] presiding. | |
| Members present: Representatives Austin Scott of Georgia, | |
| Lucas, LaMalfa, Davis, Kelly, Conaway (ex officio), David Scott | |
| of Georgia, Vela, and Kirkpatrick. | |
| Staff present: Caleb Crosswhite, Darryl Blakey, Kevin Webb, | |
| Stephanie Addison, Faisal Siddiqui, John Konya, Matthew | |
| MacKenzie, Nicole Scott, and Carly Reedholm. | |
| OPENING STATEMENT OF HON. AUSTIN SCOTT, A REPRESENTATIVE IN | |
| CONGRESS FROM GEORGIA | |
| The Chairman. Well, good morning. Thank you for joining the | |
| Commodity Exchanges, Energy, and Credit Subcommittee for | |
| today's hearing, which is the second in a series to examine the | |
| implementation of Dodd-Frank over the past 5 years. In | |
| February, we held our first hearing to talk about swap data | |
| standards and transparency. During today's hearing, we will | |
| talk about the unintended consequences of some of the most | |
| important regulations following the financial crisis, the new | |
| capital standards and margin requirements for banks, non-bank | |
| swap dealers, and other market participants. | |
| On a fundamental level, derivatives markets exist for | |
| hedgers, for those businesses and people who have risks that | |
| they seek to manage. And on the Agriculture Committee, we often | |
| think about the businesses that serve the farm economy and | |
| their ability to manage the risks they shoulder on behalf of | |
| their agricultural clients. But there are producers, | |
| manufacturers, merchants, pensions, insurers, and other | |
| businesses across our country that face similar challenges | |
| managing their commodity, foreign exchange, interest rate, and | |
| credit risks. | |
| While Congress has been explicit in its efforts to exempt | |
| these end-users from much of the regulatory burdens associated | |
| with Dodd-Frank, these rules could have impacts on end-users if | |
| they drive intermediaries, like futures commission merchants | |
| and swap dealers, from the markets. If this happens, hedgers | |
| will see their spreads widen, their fees increase, and | |
| liquidity fall. | |
| Without question, the financial crisis could have been | |
| tempered with stronger capital rules and margin requirements. | |
| And today's hearing isn't about the purpose or need for capital | |
| and margin standards; instead, it is about the outsized | |
| consequences of small decisions made when designing these | |
| rules. These decisions, things like how to account for margin | |
| or the differences between cash and cash-equivalents, may seem | |
| small to regulators, but they will be deeply impactful to main | |
| street businesses that rely on derivatives markets to manage | |
| their risks. | |
| Regulation is about choices. Each rulemaking is built from | |
| a thousand little decisions that are supposed to add up to a | |
| desired outcome. Over the past 5 years, financial regulators | |
| have been busy making a lot of decisions, but it isn't entirely | |
| clear if we are reaching the outcome that was intended. | |
| Today, we will examine those decisions and compare the | |
| outcome to Congress' longstanding goal to protect end-users | |
| from bearing the burdens of the financial crisis. Protecting | |
| end-users does not need to be a zero-sum game. I believe we can | |
| both build resilient markets and protect end-users from | |
| unnecessary burdens. | |
| I want to close by thanking our witnesses for the time they | |
| have spent preparing and traveling to be with us today. The | |
| Subcommittee appreciates your willingness to share your talents | |
| and expertise with us today. | |
| [The prepared statement of Mr. Austin Scott follows:] | |
| Prepared Statement of Hon. Austin Scott, a Representative in Congress | |
| from Georgia | |
| Good morning. Thank you for joining the Commodity Exchanges, | |
| Energy, and Credit Subcommittee for today's hearing, which is the | |
| second in a series to examine the implementation of Dodd-Frank over the | |
| past 5 years. In February, we held our first hearing to talk about swap | |
| data standards and transparency. During today's hearing, we'll talk | |
| about the unintended consequences of some of the most important | |
| regulations following the financial crisis: the new capital standards | |
| and margin requirements for banks, non-bank swap dealers, and other | |
| market participants. | |
| On a fundamental level, derivatives markets exist for hedgers, for | |
| those businesses and people who have risks that they seek to manage. | |
| On the Agriculture Committee, we often think about the businesses | |
| that serve the farm economy and their ability to manage the risks they | |
| shoulder on behalf of their agricultural clients. But there are | |
| producers, manufacturers, merchants, pensions, insurers, and other | |
| businesses across our country that face similar challenges managing | |
| their commodity, foreign exchange, interest rate, and credit risks. | |
| While Congress has been explicit in its efforts to exempt these | |
| end-users from much of the regulatory burdens associated with Dodd- | |
| Frank, these rules could have impacts on end-users if they drive | |
| intermediaries, like futures commission merchants and swap dealers, | |
| from the markets. | |
| If this happens, hedgers will see their spreads widen, their fees | |
| increase, and liquidity fall. | |
| Without question, the financial crisis could have been tempered | |
| with stronger capital rules and margin requirements. So, today's | |
| hearing isn't about the purpose or need for capital and margin | |
| standards. Instead, it's about the outsized consequences of small | |
| decisions made when designing these rules. These decisions--things like | |
| how to account for margin or the difference between cash and cash- | |
| equivalents--may seem small to regulators, but they will be deeply | |
| impactful to main street businesses that rely on derivatives markets to | |
| manage their risks. | |
| Regulation is about choices. Each rulemaking is built from a | |
| thousand little decisions that are supposed to add up to a desired | |
| outcome. Over the past 5 years, financial regulators have been busy | |
| making a lot of decisions, but it isn't entirely clear if we're | |
| reaching the outcome that was intended. | |
| Today, we will examine those decisions and compare the outcome to | |
| Congress' longstanding goal to protect end-users from bearing the | |
| burdens of the financial crisis. Protecting end-users does not need to | |
| be a zero-sum game. I believe we can both build resilient markets and | |
| protect end-users from unnecessary burdens. | |
| I want to close by thanking our witnesses for the time they've | |
| spent preparing and traveling to be with us today. The Subcommittee | |
| appreciates your willingness to share your talents and expertise with | |
| us today. | |
| With that, I'll turn to our Ranking Member, Mr. Scott, for any | |
| remarks he might have. | |
| The Chairman. With that, I will turn to our Ranking Member, | |
| Mr. Scott, for any remarks he might have. | |
| OPENING STATEMENT OF HON. DAVID SCOTT, A REPRESENTATIVE IN | |
| CONGRESS FROM GEORGIA | |
| Mr. David Scott of Georgia. Thank you, Mr. Chairman. And I | |
| want to welcome all of our distinguished witnesses. We are | |
| looking forward to your expert testimony in this very, very | |
| important area of the impact of capital and margin requirements | |
| on end-users. | |
| Today's hearing is very, very important, mainly to finding | |
| that right balance between high enough capital and margin | |
| requirements to keep the system safe, and low enough capital | |
| and margin requirements to ensure that the system is profitable | |
| for everyone in the industry. | |
| Our Committee took particular and very great pains over the | |
| years to exempt end-users from the margin and capital | |
| requirements necessary to reform the derivatives markets, for | |
| the simple reason that the farmers, the ranchers, other end- | |
| users, manufacturers, did absolutely nothing to cause the | |
| financial crisis. And we feel, on our Committee, that it is our | |
| job to make sure that this spirit continues in any regulations | |
| in the future. They had nothing to do with the financial | |
| crisis, and that must always be taken into consideration. | |
| Over the years, I have been very, very concerned about | |
| cross-border transactions, and I am very pleased with the | |
| ongoing work of Chairman Massad, who is doing a fine job over | |
| at the CFTC. But Chairman Massad has had a tough, tough battle | |
| in dealing with the issue of the European Union equivalency. | |
| And so I am looking forward very much to getting your | |
| evaluation of that, where you see the progress going, because | |
| if we do not solve this situation with the equivalency issue | |
| with the European Union, it is going to put our end-users, our | |
| manufacturers, our clearinghouses at a very, very serious | |
| competitive disadvantage. | |
| And so I look forward to this hearing, and I want to thank | |
| Chairman Scott for, again, pulling together a very, very timely | |
| hearing. We are dealing on the derivatives case with an $700 | |
| trillion piece of the world's economy. Many people do not know | |
| it is that large. That is huge, and it is growing exponentially | |
| every single day, and that is why this hearing is very | |
| important. | |
| And I thank you, Mr. Chairman, and I yield back. | |
| The Chairman. Thank you, Mr. Scott. | |
| I would like to welcome our witnesses to the table. We have | |
| the Honorable Walter Lukken, President and Chief Executive | |
| Officer of the Futures Industry Association in Washington, | |
| D.C., we have the Honorable Scott O'Malia, Chief Executive | |
| Officer, International Swaps and Derivatives Association, | |
| Incorporated, New York, New York; Mr. Thomas Deas, | |
| representative of the Center for Capital Markets | |
| Competitiveness and Coalition for Derivatives End-Users; and | |
| Mr. Tyler Gellasch, Founder of Myrtle Makena, LLC, Homestead, | |
| Pennsylvania. | |
| Mr. Lukken, please begin when you are ready. | |
| STATEMENT OF HON. WALTER L. LUKKEN, PRESIDENT AND CHIEF | |
| EXECUTIVE OFFICER, FUTURES INDUSTRY | |
| ASSOCIATION, WASHINGTON, D.C. | |
| Mr. Lukken. Mr. Chairman, Ranking Member Scott, and Members | |
| of the Subcommittee, thank you for this opportunity to testify | |
| on the impact of margin and bank capital on the cleared | |
| derivatives markets. | |
| I am President and CEO of FIA, a trade association for the | |
| futures, options, and centrally cleared derivatives markets. | |
| Both margin and bank capital play an important role in | |
| protecting the safety and soundness of the financial system. | |
| Since the financial crisis, their roles have been heightened | |
| with the G20 leaders' commitment to both enhance bank capital, | |
| and require the clearing, and thus, margining of standardized | |
| OTC products through regulated clearinghouses. | |
| While capital and margin are both tools in protecting the | |
| financial system, it is important to distinguish the two, as | |
| each serves a specific function in meeting this important goal. | |
| Bank capital is the amount of funds that a banking | |
| institution holds in reserve to support its banking activities. | |
| Required by national banking regulators under international | |
| standards set by the Basel Committee on Bank Supervision, bank | |
| capital serves as a stable financial cushion to absorb | |
| unexpected losses by banks. Margin, on the other hand, aims to | |
| protect the safety and soundness of the futures and cleared | |
| derivatives markets, rather than specific institutions. | |
| Customers that utilize the futures or cleared derivatives | |
| markets to hedge their risks are required to clear such | |
| transaction through a clearinghouse, and in order to do so, | |
| must post margin with a clearing member. The clearing member, | |
| in turn, manages this collection of margin from its customers, | |
| and guarantees the customers' transactions with a | |
| clearinghouse. The customers' margin is simply a performance | |
| bond that ensures customers make good on their transactions, | |
| which offsets the clearing member's exposure to the | |
| clearinghouse. | |
| Many of the largest clearing members are also affiliated | |
| with prudentially regulated banks, and thus, are required to | |
| hold sufficient capital to ensure their firm, and thus, the | |
| system, is protected. As large financial institutions, these | |
| banks are subject to both CFTC regulation for their future | |
| commission merchant clearing business, as well as bank capital | |
| regulations under the oversight of the Federal Reserve, the | |
| FDIC, and the OCC. These U.S. bank regulators, consistent with | |
| standards set by the Basel Committee, are now implementing a | |
| new type of capital provision known as the leverage ratio. Part | |
| of the goal of the leverage ratio is to set a simple, non-risk- | |
| based floor for capital, including measuring the exposures | |
| arising from futures options and other derivatives | |
| transactions. Unfortunately, the leverage ratio fails to | |
| properly recognize that customer margin posted to a bank- | |
| affiliated clearing member offsets the bank's actual exposure | |
| to the clearinghouse. | |
| The very nature of customer margin is to reduce the | |
| exposure of losses to the clearing member and the | |
| clearinghouse. In recent years, the CFTC, under your oversight, | |
| has made significant improvements to enhance customer margin to | |
| ensure it is always the first line of protection to offset | |
| losses during a default. If left unfixed, the leverage ratio | |
| will result in an inaccurate measurement of the actual economic | |
| exposure of the bank, and assign unwarranted capital charges on | |
| its clearing business. This will lead to higher costs for end- | |
| users and hedgers in our markets. Given these new capital | |
| constraints, bank clearing members are already beginning to | |
| limit the amount and types of clients that they accept to | |
| clear. We also believe the leverage ratio will lead to further | |
| consolidation among clearing members, resulting in fewer | |
| players supporting the safety and soundness of the | |
| clearinghouse. | |
| In the U.S., clearing members have decreased from 94 | |
| clearing firms 10 years ago, to only 55 today. While there are | |
| several factors contributing to this consolidation, capital has | |
| been recently cited by several clearing member banks who have | |
| now exited the clearing business. | |
| Perhaps the most concerning consequence for this Committee | |
| surrounds the leverage ratio's impact on a clearinghouse's | |
| ability to move or port client positions from a defaulting | |
| clearing member to another healthy clearing member during a | |
| crisis. If porting cannot be achieved due to capital | |
| constraints, clearinghouses will be forced to liquidate in a | |
| fire sale client positions during volatile market conditions, | |
| adding unnecessary stress to an unstable marketplace. After | |
| all, the ability of clearinghouses to move customer positions | |
| during the failure of Lehman Brothers in 2008 is one of the | |
| fundamental reasons that policymakers in the G20 determined to | |
| expand clearing to OTC products. | |
| In closing, I would encourage the U.S. regulatory community | |
| to work together through the Basel process in determining how | |
| our margin and bank capital regulations can work in context. | |
| Without a fix, recent efforts by the G20 to increase the use of | |
| clearing may be in jeopardy, and customers in the futures and | |
| cleared swaps markets may face higher costs and less access to | |
| these risk management markets. | |
| Thank you very much, and I look forward to your questions. | |
| [The prepared statement of Mr. Lukken follows:] | |
| Prepared Statement of Hon. Walter L. Lukken, President and Chief | |
| Executive Officer, Futures Industry Association, Washington, D.C. | |
| Introduction | |
| Chairman Scott, Ranking Member Scott, and Members of the | |
| Subcommittee, thank you for the opportunity to discuss capital and | |
| margin matters impacting the derivatives industry. I am the President | |
| and Chief Executive Officer of FIA. FIA is the leading global trade | |
| organization for the futures, options and centrally cleared derivatives | |
| markets, with offices in London, Singapore and Washington, D.C. FIA's | |
| membership includes clearing firms, exchanges, clearinghouses, trading | |
| firms and commodities specialists from more than 48 countries as well | |
| as technology vendors, lawyers and other professionals serving the | |
| industry. FIA's mission is to support open, transparent and competitive | |
| markets, protect and enhance the integrity of the financial system and | |
| to promote high standards of professional conduct. As the principal | |
| members of derivatives clearinghouses worldwide, FIA's clearing firm | |
| members help reduce systemic risk in global financial markets. | |
| Clearing ensures that parties to a transaction are protected from | |
| the failure of a buyer or seller to perform its obligations, thus | |
| minimizing the risk of a counterparty default. The clearinghouse is | |
| able to take on this role because it is backed by the collective funds | |
| of its clearing members who also guarantee the performance of their | |
| clients to make good on their transactions. To protect against default, | |
| clearinghouses require that all transactions are secured with | |
| appropriate margin. Clearing members, acting as agents for their | |
| customers, collect this margin and segregate it away from their own | |
| funds as required by the Commodity Exchange Act. They have long | |
| performed this function for futures customers, who have historically | |
| been required to clear their transactions. More recently, under the | |
| ``Dodd-Frank Act'' (Dodd-Frank) in the U.S. and the ``European Market | |
| Infrastructure Regulation'' (EMIR) in Europe, policymakers determined | |
| to extend the clearing requirement beyond futures and options to | |
| certain over-the-counter swaps, and as such, the role of the clearing | |
| member has expanded. Despite this expansion, over the 10 year period | |
| between 2004 and 2014, the clearing member community in the U.S. has | |
| decreased from 190 firms to 76 firms. | |
| While there are several factors contributing to this consolidation, | |
| today I want to focus on how recent Basel III capital requirements for | |
| prudentially regulated clearing members are lessening clearing options | |
| for end-user customers who use futures and cleared swaps to manage | |
| their business risks. These capital requirements have made it difficult | |
| for many clearing member banks to offer clearing services to their | |
| clients--a result that seems at odds with recent efforts by the Group | |
| of 20 nations (G20) to increase the use of clearing as a counterparty | |
| risk mitigation tool. | |
| At issue is the Basel leverage ratio, a measurement tool used by | |
| banking regulators to determine the amount of leverage that should be | |
| backed by capital. Unfortunately, the Basel leverage ratio fails to | |
| properly recognize that client margin posted to a bank-affiliated | |
| clearing member belongs to the customer, and is provided by the | |
| customer to offset the bank's exposure to the clearinghouse. It does | |
| not belong to the bank. The assumption that this customer margin can be | |
| used by the bank without restriction runs counter to the Commodity | |
| Exchange Act and Commodity Futures Trading Commission (CFTC) | |
| regulations. | |
| The amount of capital under the Basel leverage ratio required to be | |
| held for clearing is estimated between $32 Billion and $66 billion. | |
| Once more products are subjected to clearing under the new G20 clearing | |
| mandates those estimates increase to a range of $126 billion and $265 | |
| billion. End-user clients are beginning to feel the impacts of these | |
| costs, which are likely to increase over time as Basel capital | |
| requirements are fully implemented. | |
| Background--Basel Leverage Ratio | |
| One of the central reforms to bank capital requirements following | |
| the financial crisis was the decision by the Basel Committee on Bank | |
| Supervision (Basel Committee) to implement a new type of leverage ratio | |
| on a global basis. In January 2014, the Basel Committee finalized its | |
| leverage ratio standard. Based on this standard, the Basel leverage | |
| ratio was implemented in the United States by the Federal Reserve | |
| Board, the Federal Deposit Insurance Corporation (FDIC), and the Office | |
| of the Comptroller of the Currency (OCC). While the leverage ratio will | |
| technically not become a legally binding requirement on the largest | |
| U.S. banks until January 2018, it already is effectively being | |
| implemented by the banks as a result of mandatory reporting | |
| requirements and market expectations. Other jurisdictions, including | |
| the European Union, Japan and Switzerland, are also in the process of | |
| implementing leverage ratio standards based on the Basel leverage | |
| ratio. | |
| This Basel leverage ratio would require a bank to hold a minimum | |
| amount of capital relative to not only its on-balance sheet assets, but | |
| also to its off-balance sheet exposures arising from futures, options, | |
| and other derivative transactions. The Basel leverage ratio was | |
| designed to be ``a simple, transparent, non-risk based leverage ratio | |
| to act as a credible supplementary measure to the risk-based capital | |
| requirements''.\1\ While FIA supports the goals of stronger capital | |
| requirements and recognizes the leverage ratio of the Basel III | |
| requirements as an important backstop to keep leverage in check, we | |
| also believe the Basel leverage ratio should accurately reflect the | |
| actual economic exposures of the banking entity. | |
| --------------------------------------------------------------------------- | |
| \1\ Basel Committee on Banking Supervision--Basel III leverage | |
| ratio framework and disclosure requirements, January 2014. | |
| --------------------------------------------------------------------------- | |
| As currently measured, we believe the exposure measure under the | |
| leverage ratio is artificially inflated to capture more than actual | |
| economic exposures with respect to cleared derivatives transactions. In | |
| particular, this real and significant overstatement of actual economic | |
| exposure arises from the failure of the Basel leverage ratio measure to | |
| recognize the exposure-reducing effect of segregated client margin | |
| posted to the bank in the limited context of centrally cleared | |
| derivatives transactions. The inflated economic exposure results in | |
| unwarranted capital costs. | |
| Failure to Recognize Customer Margin | |
| The Basel leverage ratio has failed to properly consider the | |
| exposure-reducing effect of customer margin posted to a prudentially- | |
| regulated banking entity that is acting as an agent to facilitate | |
| derivatives clearing services on behalf of the client. Such customer | |
| margin is posted to a bank-affiliated clearing member to ensure that | |
| the clearing member's exposure to the clearinghouse is lessened while | |
| also allowing the customer access to the cleared derivatives markets' | |
| risk management tools. That is, an end-user that utilizes the futures | |
| market to hedge its business risks is required to clear such a | |
| transaction through a clearinghouse, and in order to do so it must post | |
| margin through a clearing member for the purpose of offsetting exposure | |
| to the clearinghouse. Oftentimes, the clearing member is affiliated | |
| with a bank. Furthermore, Congress, and more specifically this | |
| Committee, through the Commodity Exchange Act, requires the clearing | |
| member to treat margin received from a customer for cleared derivatives | |
| transactions as belonging to the customer and segregated from the | |
| clearing member's own funds. Yet the Basel leverage ratio does not | |
| recognize this margin for its intended purpose--these are customer | |
| funds provided specifically to offset the bank-affiliated clearing | |
| member's exposure in their obligation to pay the clearinghouse on | |
| behalf of the customer. Such customer margin should therefore be | |
| considered an offset in determining the bank's exposure. | |
| Unlike making loans or taking deposits, guaranteeing client trades | |
| exposes the bank to losses only to the extent that the margin collected | |
| is insufficient to cover the clients' obligations. Indeed, to make sure | |
| that such margin is always available to absorb losses arising from the | |
| customer's transaction, CFTC rules require that it be posted in the | |
| form of either cash or extremely safe and liquid securities such as | |
| U.S. Treasuries and that such margin be clearly segregated from the | |
| bank's own money. These are customer funds provided specifically by the | |
| customer to offset the clearing member's exposure arising from its | |
| obligation to pay the clearinghouse on behalf of the customer. Such | |
| customer margin should therefore be considered as an offset in | |
| determining the bank's exposure. That is, the very nature of initial | |
| margin posted by a derivatives customer is solely exposure-reducing | |
| with respect to the clearing member's cleared derivatives exposure. | |
| Given these longstanding regulatory requirements and the exposure- | |
| reducing function of margin, it stands to reason that the Basel | |
| leverage ratio should recognize segregated client margin as reducing a | |
| clearing member bank's actual economic exposure to a clearinghouse for | |
| purpose of measuring exposure. Nevertheless, the Basel leverage ratio | |
| does not recognize this plainly exposure-reducing effect when | |
| calculating the clearing member's exposure. | |
| Recently the Basel Committee has proposed to refine its leverage | |
| ratio's calculation of exposure for derivatives. While the Basel | |
| Committee did not propose to include an offset for initial client | |
| margin in cleared derivatives transactions, the Committee requested | |
| information on whether the Basel leverage ratio's failure to recognize | |
| client margin will harm the cleared derivatives market. We plan to | |
| submit a comment letter with data showing that the failure to recognize | |
| the exposure-reducing effect of initial margin will adversely impact | |
| clearing members' business, customers' access to cleared derivatives, | |
| competition, and systemic risk. In fact, many of these effects can | |
| already be observed in the market.\2\ | |
| --------------------------------------------------------------------------- | |
| \2\ See, e.g., SIFMA AMG Submits Comments to the Basel Committee on | |
| Banking Supervision on Higher Prices and Reduced Access to Clearing | |
| Experienced by Asset Managers (Feb. 1, 2016), available at http:// | |
| www.sifma.org/issues/item.aspx?id=8589958563. | |
| --------------------------------------------------------------------------- | |
| To be clear, this has nothing to do with trades undertaken by banks | |
| on their own account. Our concerns solely relate to trades that banks | |
| clear on behalf of their clients. | |
| Negative Consequences | |
| Left unchanged, the Basel leverage ratio will undermine recent | |
| financial regulatory reforms by discouraging banks from participating | |
| in the clearing business, thereby reducing access to clearing and | |
| limiting hedging opportunities for end-users. The failure of the Basel | |
| leverage ratio to recognize the exposure-reducing effect of segregated | |
| margin will substantially and unnecessarily increase the amount of | |
| required capital that will need to be allocated to the clearing | |
| businesses within these banking institutions. Banks will be less likely | |
| to take on new clients for derivatives clearing. Such a significant | |
| increase in required capital will also greatly increase costs for end- | |
| users, including pension funds and businesses across a wide variety of | |
| industries that rely on derivatives for risk management purposes, | |
| including agricultural businesses and manufacturers. As a result, | |
| market participants may be less likely to use cleared derivatives for | |
| hedging and other risk management purposes or, as a result of mandatory | |
| clearing obligations for some derivatives, some market participants may | |
| not be in a position to hedge their underlying risks. | |
| FIA represents bank and non-bank clearing members and I can assure | |
| you that this situation is not one that will benefit the non-bank | |
| clearing firm. In fact, many non-bank clearing members--those clearing | |
| members not subject to Basel III capital requirements--have weighed in | |
| to explain their inability to assume the clearing volume currently done | |
| through banks due to their own balance sheet constraints. Moreover, | |
| these non-bank clearing members are concerned about the broader market | |
| impacts that may arise as a result of fewer access points to the | |
| cleared derivatives markets. This harms farmers seeking to manage | |
| commodity price fluctuations, commercial companies wishing to lock in | |
| prices as they distribute their goods, and pension funds using | |
| derivatives to enhance workers' retirement benefits. The negative | |
| impacts to the real economy are significant. | |
| In addition, the liquidity and portability of cleared derivatives | |
| markets could be significantly impaired, which would substantially | |
| increase systemic risk. The lack of an offset would severely limit the | |
| ability of banks to purchase portfolios of cleared derivatives from | |
| other distressed clearing members--including distressed banks. This | |
| will leave clearinghouses and customers of any failing clearing member | |
| with an added strain during an already stressful situation. Moreover, | |
| as the levels of margin required by clearinghouses increase in times of | |
| stress, Basel leverage ratio capital costs will correspondingly | |
| increase, aggravating the constraint on portfolio purchases. Such a | |
| constraint on providing liquidity to stressed markets would accelerate | |
| downward price pressure at exactly the wrong moment, thereby increasing | |
| risk to the system. | |
| Significantly increased capital costs will also likely result in | |
| market exit by some derivatives clearing members that will find the | |
| business no longer economically viable in terms of producing a | |
| sufficiently high return on equity. The resulting industry | |
| consolidation would increase systemic risk by concentrating derivatives | |
| clearing activities in fewer clearing member banks and potentially | |
| reduce end-user access to the risk mitigation benefits of central | |
| clearing. | |
| The consequences I have just outlined are fundamentally | |
| inconsistent with market regulators' global policies designed to | |
| enhance the appropriate use of centrally cleared derivatives. In | |
| various speeches CFTC Chairman Massad has expressed concern about the | |
| Basel leverage ratio's treatment of initial margin for client cleared | |
| derivatives and the resulting declining population of clearing members | |
| as well as systemic concerns related to the portability of client | |
| positions and margin funds. | |
| Conclusion | |
| While we were disappointed the Basel Committee's consultation did | |
| not include a client margin offset, we were encouraged that the Basel | |
| Committee identified the issue in its consultation, and is seeking | |
| further evidence and data on the impact of the Basel leverage ratio on | |
| client clearing and on banks' business models during the consultation | |
| period. FIA is working with its members and other trade associations on | |
| its response to the Basel Committee's proposed revisions, including | |
| obtaining evidence and data on the impact of the standard. | |
| As part of our response to the Basel Committee, we will identify a | |
| number of options to recognize the risk-reducing effects of initial | |
| margin. These proposals will be consistent with the goals of the Basel | |
| Committee in establishing the Basel leverage ratio. We are hopeful the | |
| Basel Committee will recognize our concerns. FIA appreciates the | |
| Subcommittee's interest in ensuring that banking regulations do not run | |
| counter to the well-established benefits for clients of cleared futures | |
| or the new G20 clearing obligations for swaps. | |
| STATEMENT OF HON. SCOTT D. O'MALIA, CHIEF EXECUTIVE OFFICER, | |
| INTERNATIONAL SWAPS AND DERIVATIVES | |
| ASSOCIATION, INC., NEW YORK, NY | |
| Mr. O'Malia. Chairman Scott, Ranking Member Scott, and | |
| Members of the Subcommittee, thank you for the opportunity to | |
| testify here today. | |
| I would like to thank the Committee for holding this timely | |
| hearing to discuss the ramifications of two major reforms; bank | |
| capital and liquidity rules, and the margin requirements for | |
| non-cleared trades. Both will have a massive and profound | |
| impact on the derivative end-users. | |
| In my testimony, I would like to explain the findings ISDA | |
| has produced to determine the cost impact of the capital rules, | |
| and will emphasize the need for a comprehensive and cumulative | |
| impact assessment. I will also provide an update on the | |
| implementation of the margin rules, and the steps ISDA is | |
| taking to ensure these are implemented in a cost-effective | |
| manner. | |
| Substantial progress has been made to ensure that the | |
| financial system is more robust. The implementation of Basel | |
| 2.5 and Basel III means banks now hold more and better quality | |
| capital than ever before. An additional capital surcharge is | |
| being implemented for systemically important banks, and a | |
| resolution framework is being put in place to wind down failed | |
| banks without taxpayer assistance. This is on top of the global | |
| derivatives market infrastructure reforms, including data | |
| reporting, trading, and clearing. | |
| While many aspects of the new rules have been finalized, | |
| core aspects of the Basel reform agenda, such as the leverage | |
| ratio, net stable funding ratio, fundamental review of the | |
| trading book, are still evolving. As it stands, these reforms | |
| look to significantly increase costs for banks, and may | |
| negatively impact the liquidity of these markets and the | |
| ability of banks to lend and provide crucial hedging services | |
| to corporate pension funds and asset managers. | |
| Recent ISDA analysis suggests that the compliance with just | |
| one of the rules, the NSFR, will require the banking industry | |
| to raise additional long-term funding. We are concerned that | |
| the cumulative impact of the different parts of the banking | |
| capital reform are still unknown, and it is our belief that | |
| regulators shoulder undertake a cumulative impact assessment, | |
| posthaste. Given the continuing concerns about economic growth | |
| and job creation, legislators, supervisors, and market | |
| participants need to understand the cumulative impacts of the | |
| regulatory changes before they are implemented. | |
| When it comes to the health of the global economy, I think | |
| the old tailor's saying holds true: measure twice and cut once. | |
| At this moment, we are cutting our cloth in the dark. ISDA has | |
| been working hard to understand the impacts of the individual | |
| rules, and over the past year we have conducted eight impact | |
| studies. In each case, these studies have indicated sizeable | |
| increases in capital, on top of the increases that have already | |
| occurred as part of Basel III. We have also found the impact | |
| was not uniform across all banks, with certain businesses hit | |
| particularly hard. One good example is the leverage ratio and | |
| its effect on client clearing business. As it stands, the rule | |
| fails to recognize the risk-reducing impact of the initial | |
| margin posted by customers, and this has proved detrimental to | |
| the economics of client clearing, and is in direct conflict | |
| with the G20 objectives of central clearing. | |
| Now let me turn to the final rules regarding the margin for | |
| non-cleared trades. As I noted earlier, these rules will have a | |
| significant cost impact on non-cleared products. According to | |
| the analysis published by the CFTC, the industry may have to | |
| set aside over $300 billion of initial margin to meet these | |
| requirements. ISDA has worked closely with the market at the | |
| global level to prepare for implementation, and I am proud to | |
| say that ISDA and its members have accomplished a great deal. | |
| First, we have established a standard initial margin model | |
| called ISDA SIMM, which all participants can use to calculate | |
| the initial margin requirements. This is nothing short of | |
| revolutionary for the over-the-counter market. Second, we have | |
| worked to draw up a revised margin documentation that is | |
| compliant with the collateral and segregation rules. Third, we | |
| have established a robust governance structure to allow for the | |
| necessary evolution of the model, and to provide regulators | |
| complete transparency into the model development process. | |
| Despite these efforts, challenges remain. The deadline for | |
| implementation of the initial margin requirements for the | |
| largest banks is September 2016. The variation margin, big | |
| bang, is set for March of 2017, which affects all market | |
| participants. | |
| There are still a few important items that need to fall | |
| into place to ensure that the market can move forward | |
| confidently. First, regulators need to send a clear signal that | |
| the ISDA SIMM is fit for purpose, and banks can confidently | |
| begin to apply this model before the 2016 deadline. Second, | |
| regulators must finalize the cross-border rules, which will | |
| result in the recognition of comparable jurisdictions. To date, | |
| the CFTC cross-border margin rules have not been approved, and | |
| if it is not rectified as soon as possible, the hard work to | |
| unify the rules under the Basel Committee IOSCO at that level | |
| will be undermined. In addition, ISDA will not be able to | |
| complete the necessary documentation that will assist dealers | |
| in determining whether their clients fall within scope of the | |
| margin rules by the time the rules go final. | |
| And I appreciate the Committee's interest in ensuring that | |
| the G20 reforms are implemented in a cost-effective manner, and | |
| this ensures that end-users have access to global capital | |
| markets and derivatives markets. You can be confident that ISDA | |
| will continue to work to develop the data on the capital rules | |
| to contribute to a safe but cost-effective capital structure, | |
| as well as facilitate the transition to a new margin regime | |
| that is fully transparent and effective. | |
| I am happy to answer any of your questions. Thank you. | |
| [The prepared statement of Mr. O'Malia follows:] | |
| Prepared Statement of Hon. Scott D. O'Malia, Chief Executive Officer, | |
| International Swaps and Derivatives Association, Inc., New York, NY | |
| Chairman Scott, Ranking Member Scott, and Members of the | |
| Subcommittee. Thank you for the opportunity to testify today. | |
| I would like to thank the Committee for holding this timely hearing | |
| to discuss the ramifications of the last two rule-sets associated with | |
| the Group of 20 (G20) derivatives reforms--bank capital and liquidity | |
| rules, and margin requirements for non-cleared derivatives trades. Both | |
| will have a profound impact on derivatives end-users. | |
| The capital and liquidity rules, which are being developed by the | |
| Basel Committee on Banking Supervision, will be implemented through to | |
| 2019. The margin rules kick in from September this year, and will be | |
| fully phased in by 2020. | |
| My testimony today will address these two important rules. I will | |
| explain the findings ISDA and its members have produced to determine | |
| the cost impact of individual capital rules, and will emphasize the | |
| need for a comprehensive cumulative impact assessment encompassing all | |
| elements of the bank capital and liquidity reforms. I will also provide | |
| a progress update on the implementation of the margin rules, and the | |
| steps ISDA is taking to help regulators and market participants comply | |
| with them in a cost-effective and transparent manner. | |
| Executive Summary | |
| Over the past 6 years, substantial progress has been made to ensure | |
| the financial system is more robust. The implementation of the Basel | |
| 2.5 and Basel III capital and liquidity reforms means that banks now | |
| hold more and better quality capital than ever before. The amount of | |
| common equity capital at the largest U.S. banks has more than doubled | |
| since the crisis. Liquidity requirements are also being phased in to | |
| reduce reliance on short-term borrowing and bolster reserves of high- | |
| quality liquid assets. | |
| This is on top of derivatives market structure reforms that have | |
| been introduced by the Commodity Futures Trading Commission (CFTC) and, | |
| to some extent, the Securities and Exchange Commission (SEC), which | |
| include swap dealer registration, data reporting, trading and clearing | |
| mandates. In addition, a resolution framework is now being put in place | |
| to manage and allow for the orderly resolution of a bank without the | |
| need for taxpayer assistance. | |
| But while many aspects of the new rules have been finalized and are | |
| already implemented, core elements of the Basel reform agenda, such as | |
| the leverage ratio, net stable funding ratio (NSFR) and the Fundamental | |
| Review of the Trading Book (FRTB), are still evolving. | |
| As it stands, these reforms look set to significantly increase | |
| costs for banks, and may negatively impact the liquidity of derivatives | |
| markets and the ability of banks to lend and provide crucial hedging | |
| products to corporate end-users, pension funds and asset managers. | |
| We are concerned that the overall effect of the different parts of | |
| the bank capital reform program is unknown, and it is our belief that | |
| regulators should undertake a cumulative impact assessment post haste. | |
| When it comes to the health of the global financial system and economy, | |
| I think the old tailor's saying holds true--measure twice, cut once. | |
| At the moment, we are cutting our cloth in the dark. Given | |
| continuing concerns about economic growth and job creation, | |
| legislators, supervisors and market participants need to understand the | |
| cumulative effect of the regulatory changes before they are fully | |
| implemented so we can prevent any significant negative impact to the | |
| real economy. | |
| ISDA has been working hard to understand the impact of the | |
| individual elements of the rules. Over the past year, we have conducted | |
| eight impact studies on new capital and liquidity measures. In each | |
| case, those studies have indicated sizeable increases in capital or | |
| funding requirements for banks, on top of the increases that have | |
| already occurred as part of Basel III. | |
| There is literally no one who has any clear idea what the aggregate | |
| impact of each of these rules will be. So far, each new measure has | |
| been looked at in isolation, without considering how it will interact | |
| with other parts of the capital framework. | |
| Significantly, ISDA's analysis shows the impact is not uniform | |
| across all banks, with certain business lines hit particularly hard. We | |
| therefore believe it is crucial that policy-makers not only view the | |
| final capital rules through the prism of the overall impact on capital | |
| levels, but also assess the effect on individual business lines. | |
| That's because the impact of the new rules on individual business | |
| units or product areas could be disproportionate, and the difference | |
| between a bank choosing to stay the course or exit the business. One | |
| good example is the leverage ratio and its effect on client clearing | |
| businesses. As it stands, the rule fails to recognize the risk-reducing | |
| effect of initial margin posted by the customer. This has proved | |
| detrimental to the economics of client clearing and is in direct | |
| conflict with the G20 goals to encourage central clearing of | |
| derivatives. | |
| Having provided my high-level recommendations on the capital and | |
| liquidity rules, I'd now like to turn to the final rules regarding | |
| margin for non-cleared derivatives. | |
| As I noted earlier, these rules will have a significant cost impact | |
| on non-cleared derivatives trades. According to analysis published by | |
| the Federal Reserve and the CFTC, the industry may have to set aside | |
| over $300 billion in initial margin to meet the requirements. | |
| ISDA has worked closely with the market at a global level to | |
| prepare for implementation. I am proud to say ISDA and its members have | |
| accomplished a great deal. | |
| First, we have developed a standard initial margin model called the | |
| ISDA SIMM that all participants can use to calculate initial margin | |
| requirements. In a bilateral setting, having a central resource that | |
| can do this and resolve any disputes over initial margin calls will be | |
| vitally useful for all counterparties. | |
| Second, we've worked to draw up revised margin documentation that | |
| is compliant with the rules, and we're developing a protocol to allow | |
| market participants to make changes to their outstanding margin | |
| agreements as efficiently as possible. This is essential for all market | |
| participants to exchange margin in an orderly and legally compliant | |
| way. | |
| Third, we have established a completely transparent and robust | |
| governance structure to allow for the necessary evolution of the model, | |
| providing both regulators and market participants the confidence that | |
| the model is appropriately updated and available for regulatory review | |
| and validation. | |
| Despite these efforts, challenges remain. In particular, there are | |
| concerns about how the margin rules will work on a cross-border basis. | |
| The requirements were drawn up at a global level by the Basel Committee | |
| and the International Organization of Securities Commissions (IOSCO) | |
| before being implemented by national regulators. That's a process we | |
| support, and has meant the various national rules are largely | |
| consistent. | |
| But differences do exist in the detail, in everything from scope of | |
| the products and entities covered by the rules to settlement times. | |
| This means it is vital that substituted compliance decisions are based | |
| on broad outcomes, rather than rule-by-rule comparisons with overseas | |
| requirements. | |
| The deadline for implementation of the initial margin requirements | |
| for the largest banks (Phase I) is approaching on September 1, 2016. | |
| Following this date is the variation margin `big bang' on March 1, | |
| 2017, which affects all market participants. | |
| There are a few items that need to fall into place to ensure the | |
| market can move forward confidently with these last rules. | |
| First, regulators need to send a clear signal that the ISDA SIMM is | |
| fit for purpose and banks can confidently begin to apply this model to | |
| comply with the September 2016 deadline. | |
| Second, the CFTC must finalize its cross-border margin rules to | |
| ensure substituted compliance determinations can be made for overseas | |
| rules that achieve similar outcomes. | |
| These substituted compliance decisions also should be taken | |
| quickly. Another 3 year wait for a substituted compliance or | |
| equivalence determination, as happened with the U.S./EU central | |
| counterparty (CCP) equivalency standoff, will hobble cross-border | |
| trading and further contribute to the fragmentation of global | |
| derivatives markets. | |
| * * * * * | |
| I'd like to address each of these issues in more detail. Before I | |
| do, I would like to stress that ISDA supports the intention of the | |
| capital reforms to strengthen the resilience of the banking system. We | |
| also support the safe and efficient use of collateral to reduce risk in | |
| the bilateral derivatives market. | |
| In fact, ISDA has worked with its members to drive this objective | |
| for most of its 31 year history. We've also worked closely with our | |
| members over the past 3 years to develop the infrastructure, technology | |
| and documentation to ensure the new margin rules for non-cleared | |
| derivatives can be implemented with minimum disruption to the market. | |
| This is consistent with our mission statement: ISDA fosters safe | |
| and efficient derivatives markets to facilitate effective risk | |
| management for all users of derivative products. In fact, our strategy | |
| statement was recently modified to emphasize the importance of ensuring | |
| a prudent and consistent regulatory capital and margin framework.\1\ | |
| --------------------------------------------------------------------------- | |
| \1\ ISDA mission and strategy statement: http://www2.isda.org/ | |
| about-isda/mission-state- | |
| ment/. | |
| --------------------------------------------------------------------------- | |
| Since ISDA's inception, we have worked to reduce credit and legal | |
| risks in the derivatives market and to promote sound risk management | |
| practices and processes. This includes the development of the ISDA | |
| Master Agreement, the standard legal agreement for derivatives, as well | |
| as our work to ensure the enforceability of netting. We currently have | |
| more than 850 members in 67 countries. Over 40% of our members are buy- | |
| side firms. | |
| * * * * * | |
| While ISDA represents the full cross-section of the derivatives | |
| market, including banks, exchanges, CCPs, asset managers, pension funds | |
| and supranationals, I would like to focus on the impact the capital | |
| rules will have on the banking sector. | |
| Banks play a hugely significant role in the U.S. economy. They | |
| provide access to capital markets and underwrite debt and equity | |
| issuances to ensure companies can raise the financing they require to | |
| expand their businesses. They provide the hedging and risk management | |
| tools that enable U.S. firms to export their goods and services | |
| worldwide. | |
| They provide loans to companies large and small to ensure they have | |
| the capital they need to grow. According to recent figures from the | |
| Federal Reserve, banks currently have more than $2 trillion in | |
| commercial and industrial loans outstanding. To put that into context, | |
| it's roughly the same as the GDP of India. That translates into | |
| business investment, jobs and economic growth. | |
| Banks also provide risk management services to those end-user | |
| companies, creating balance-sheet stability and allowing them to | |
| improve their planning. The certainty that hedging provides gives | |
| companies the confidence to invest in future growth and create new | |
| jobs. | |
| Given the vital role that banks play in our economy, it's important | |
| they are safe and resilient. And, since the crisis, a huge amount of | |
| effort has gone into making sure that they are. | |
| Banks now have to hold much higher levels of capital than before | |
| the crisis--and that capital is required to be of much higher quality, | |
| ensuring it is able to absorb losses. Banks have also had to introduce | |
| new capital conservation and countercyclical buffers, along with the | |
| implementation of a capital surcharge for systemically important banks. | |
| They now have to explicitly hold capital against the risk of a | |
| derivatives counterparty default, and they are in the process of | |
| rolling out new liquidity requirements that are meant to ensure they | |
| have a sufficient stock of assets to withstand a sudden shock in market | |
| liquidity. | |
| According to the Federal Reserve, common equity capital at the | |
| largest eight U.S. banks has more than doubled since 2008, representing | |
| an increase of nearly $500 billion.\2\ Their stock of high-quality | |
| liquid assets has also increased considerably, rising by approximately | |
| \2/3\. | |
| --------------------------------------------------------------------------- | |
| \2\ Federal Reserve Chair Janet L. Yellen, Before the Committee on | |
| Financial Services, U.S. House of Representatives, Washington, D.C., | |
| November 4, 2015: http://www.federalreserve.gov/newsevents/testimony/ | |
| yellen20151104a.htm. | |
| --------------------------------------------------------------------------- | |
| While significant improvements have already been made to the | |
| capital framework, a number of other reforms are either in the | |
| consultation phase or have been finalized but not yet implemented. | |
| Given the increases in capital that have already occurred since the | |
| crisis, policy-makers have recently been at pains to stress that | |
| further refinements should not result in a significant rise in capital | |
| across the banking sector. | |
| In recent months, that message has been given by the G20,\3\ the | |
| Financial Stability Board (FSB),\4\ the Group of Central Bank Governors | |
| and Heads of Supervision (GHOS),\5\ and the Basel Committee itself.\6\ | |
| --------------------------------------------------------------------------- | |
| \3\ G20 Finance Ministers and Central Bank Governors Meeting, | |
| Shanghai, February 27, 2016: http://www.g20.utoronto.ca/2016/160227- | |
| finance-en.html. | |
| \4\ FSB to G20 Finance Ministers and Central Bank Governors, | |
| February 22, 2016: http://www.fsb.org/wp-content/uploads/FSB-Chair- | |
| letter-to-G20-Ministers-and-Governors-February-2016.pdf. | |
| \5\ Basel Committee press release, January 11, 2016: http:// | |
| www.bis.org/press/p160111.htm. | |
| \6\ Basel Committee press release, March 24, 2016: http:// | |
| www.bis.org/press/p160324.htm. | |
| --------------------------------------------------------------------------- | |
| ISDA entirely supports this stance. While changes were needed in | |
| the wake of the financial crisis to bolster the capital held by banks, | |
| it's important this capital is commensurate with risk. Asking banks to | |
| hold ever higher amounts of capital could strangle bank lending, their | |
| ability to underwrite debt and equity, and their willingness to provide | |
| hedging services to end-users. An economy requires capital and | |
| investment to thrive. Choke off the supply of financing, and economic | |
| growth will be put at risk. | |
| Unfortunately, recent studies by ISDA suggest that several new | |
| measures will result in increases in capital. While each of the | |
| increases on their own may not result in a significant increase in | |
| capital across the banking sector, they do have an impact on certain | |
| business lines that are important for end-user financing and hedging. | |
| Crucially, though, it's currently not possible to say for sure how | |
| much the new measures, in aggregate, will increase capital requirements | |
| across the banking sector. That's because an overall impact study has | |
| not been conducted on the full set of capital, liquidity and leverage | |
| rules. While the potential for such a study has been limited during the | |
| rule-development phase, we believe a comprehensive analysis is now | |
| possible and necessary in order to help regulators and policy-makers | |
| calibrate the rules at an appropriate level. | |
| ISDA would like to highlight several areas that we believe warrant | |
| further attention. | |
| Leverage Ratio | |
| The central clearing of derivatives transactions is a key objective | |
| of the G20 derivatives reforms and a central tenet of the Dodd-Frank | |
| Act. The leverage ratio is a non-risk based measure meant to complement | |
| risk-based bank capital requirements, and is designed to act as a | |
| backstop. | |
| In its current form, however, the leverage ratio acts to | |
| disincentivize clearing. That's because it doesn't take client margin | |
| into account when determining the exposures banks face as a result of | |
| their client clearing businesses. | |
| Senior figures in the regulatory community already recognize this. | |
| In December last year, Mark Carney, the Governor of the Bank of | |
| England, noted that the current stance of the leverage ratio makes | |
| clearing more challenging, and ``increases concentration, reduces | |
| diversity and reduces financial stability for the system''.\7\ Timothy | |
| Massad, Chairman of the CFTC, has also echoed these sentiments.\8\ | |
| --------------------------------------------------------------------------- | |
| \7\ Risk, December 8, 2015: http://www.risk.net/risk-magazine/news/ | |
| 2438242/carney-leverage-ratio-could-limit-clearing-benefits. | |
| \8\ http://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-31. | |
| --------------------------------------------------------------------------- | |
| Properly segregated client cash collateral is not a source of | |
| leverage and risk exposure. However, as currently proposed, the rule | |
| would require firms to include these amounts in their calculations. | |
| This is unreasonable, as cash collateral mitigates risk. Strict rules | |
| exist to protect this collateral and ensure it cannot be used to fund | |
| the bank's own operations. Instead, it can only be used to further the | |
| customer's activities or resolve a customer default. As such, it acts | |
| to reduce the exposure related to a bank's clearing business by | |
| covering any losses that may be left by a defaulting client. | |
| The failure of the leverage ratio to recognize the risk-mitigating | |
| effect of segregated client cash collateral could mean the amount of | |
| capital needed to support client clearing services increases | |
| considerably. The end result is that the economics of client clearing | |
| would make it extremely difficult for banks to provide this service and | |
| may cause them to pull out of the market, harming liquidity and | |
| limiting opportunities for end-users. This perverse outcome runs | |
| counter to the objective set by the G20, as implemented by Congress in | |
| the Dodd-Frank Act, to encourage central clearing. | |
| ISDA has been drawing attention to this issue for some time, and | |
| the Basel Committee recently reopened the leverage ratio for | |
| consultation. As part of that consultation, the Basel Committee said it | |
| would collect data to study the impact of the leverage ratio on client | |
| clearing, with a view to potentially recognizing the exposure-reducing | |
| effect of initial margin posted by the client. | |
| We welcome that development--although it is disappointing that the | |
| consultation will not consider the recognition of initial margin more | |
| broadly. We will work with members to provide the necessary data for | |
| this consultation. Clearing has become a significant part of the | |
| derivatives market, so it's incredibly important we get this measure | |
| right. | |
| Trading Book Capital | |
| The Basel Committee's FRTB is intended to overhaul trading book | |
| capital rules, replacing the mix of measures currently in place with a | |
| more coherent set of requirements. The changes were primarily targeted | |
| at improving coherence and consistency in the market risk framework. | |
| Market risk capital levels were raised significantly in the immediate | |
| aftermath of the crisis through a package of measures known as Basel | |
| 2.5. Raising capital further was not a stated objective of the FRTB. | |
| Nonetheless, the Basel Committee has estimated the revised market | |
| risk standard would result in a weighted mean increase of approximately | |
| 40% in total market risk capital requirements. But that estimate is | |
| based on a recalibration of quantitative-impact-study data from an | |
| earlier version of the rules. | |
| To better understand the effect, ISDA recently led an industry | |
| impact study based on data submitted by 21 banks. The industry results | |
| show that market risk capital will increase by at least 50% compared to | |
| current levels. However, this assumes all banks will receive internal | |
| model approval for all their trading desks. If all banks do not receive | |
| internal model approval for all trading desks, market risk capital | |
| would increase by 2.4 times. ISDA believes the end result will be | |
| somewhere in between. | |
| Importantly, our study shows a massive cliff effect between | |
| standardized and internal models. If a particular desk were to lose | |
| regulatory approval to use internal models, capital requirements could | |
| immediately increase by multiple times. To give an example, losing | |
| internal model approval under the new rules would result in a 6.2 times | |
| increase in capital for FX desks and a 4.1 times increase for equity | |
| desks.\9\ | |
| --------------------------------------------------------------------------- | |
| \9\ These numbers exclude the so-called residual risk add-on, non- | |
| modellable risk factors and diversification across risk classes under | |
| internal models. | |
| --------------------------------------------------------------------------- | |
| Let me put that into context. Both FX and equity desks are | |
| important for end-user hedging and financing. FX trades allow U.S. | |
| companies operating or selling products in foreign countries to obtain | |
| financing in the U.S., which is typically more cost effective, and | |
| enable them to limit their exposure to foreign currency fluctuations. A | |
| sudden, overnight increase in capital requirements of between four and | |
| six times could stymie the ability of a bank to continue offering that | |
| service, at least in the short-term. We believe these rules should be | |
| carefully reconsidered to prevent lasting harm to actors in the real | |
| economy. (Please see Annex I for a more in-depth consideration of the | |
| impact of the FRTB.) | |
| ISDA welcomes the extensive engagement the Basel Committee has had | |
| with the industry during the development phase of the trading book | |
| rules. We have proposed technical modifications and refinements | |
| throughout the process, and will continue to provide feedback during | |
| the monitoring phase. | |
| Net Stable Funding Ratio | |
| The NSFR is designed to ensure banks fund their activities with | |
| sufficiently stable sources of funding to avoid liquidity mismatches. | |
| ISDA supports the intention of this rule. One of the issues raised | |
| by the financial crisis was the gap between short-term borrowings of | |
| banks versus their long-term lending. Even ahead of this rule coming | |
| into effect in January 2018, banks have significantly reduced their | |
| reliance on short-term wholesale financing.\10\ | |
| --------------------------------------------------------------------------- | |
| \10\ Federal Reserve Chair Janet L. Yellen, Before the Committee on | |
| Financial Services, U.S. House of Representatives, Washington, D.C., | |
| November 4, 2015: http://www.federalreserve.gov/newsevents/testimony/ | |
| yellen20151104a.htm. | |
| --------------------------------------------------------------------------- | |
| Nonetheless, we are concerned about the impact of the NSFR on the | |
| derivatives business, and believe the rule as it stands will hinder the | |
| ability of end-users to access hedging products. | |
| In particular, the rule currently requires banks to hold extra | |
| stable funding equal to 20% of derivatives liabilities, without taking | |
| into account any margin posted. This measure was not offered for public | |
| notice and comment, and the impact was never studied. ISDA understands | |
| the need to capture contingent liquidity risks, but the rule in its | |
| current form is overly conservative and duplicates other measures that | |
| already capture contingent liquidity risks to some extent, such as the | |
| liquidity coverage ratio. We therefore believe the 20% blanket add-on | |
| should be replaced with something more risk sensitive and properly | |
| calibrated. | |
| We also are concerned by the lack of recognition of high quality | |
| liquid assets (HQLAs) received as margin. This means that U.S. | |
| Treasuries, which count as cash equivalents in the liquidity coverage | |
| ratio, are treated as if they were illiquid assets with no funding | |
| value. We believe the NSFR should give funding benefit for HQLAs like | |
| U.S. Treasuries. | |
| The U.S. banking agencies released a proposed rule earlier this | |
| week. We will review this rule and update the Committee of any new | |
| developments. | |
| Internal Models | |
| ISDA believes capital requirements should be globally consistent, | |
| coherent and proportionate to the risk of a given activity. | |
| As a result, we're concerned about the regulatory shift away from | |
| internal models that have been utilized under supervision by Prudential | |
| Regulators. Internal models are the cornerstone of prudent risk | |
| management, as they enable banks to identify and appropriately measure | |
| risk across various dimensions. | |
| The move away from internal models has occurred in several areas: | |
| the recent decision by the Basel Committee to restrict the use of | |
| internal models for credit risk-weighted assets; the ditching of the | |
| advanced measurement approach for operational risk and the use of | |
| models for CVA; and the proposal to introduce capital floors, | |
| potentially on both the inputs and outputs of capital models. | |
| Some regulators have highlighted complexity and variation in risk- | |
| weighted assets (RWAs) as a rationale for wanting to restrict the use | |
| of internal models. ISDA understands these concerns, but believes there | |
| are ways to address trepidation about RWA variability without | |
| eliminating internal models--through greater consistency and | |
| transparency of model inputs, or through ongoing benchmarking exercises | |
| that help regulators better understand the source of any differences in | |
| the way banks value their portfolios. | |
| We need to strike the right balance between standardization and the | |
| ability of banks to maintain focus and expertise in identifying and | |
| appropriately measuring the underlying risks in their businesses. | |
| Internal models are much more sensitive to risk and better align | |
| with how banks actually manage their business. In comparison, | |
| standardized models are relatively blunt, meaning the required capital | |
| charge for holding a particular asset might not adequately reflect its | |
| risk. This can lead to poor decision-making: a bank might choose to | |
| pull back from low-risk assets, counterparties or businesses where | |
| capital costs are relatively high. Conversely, they might opt to invest | |
| in higher-risk assets that appear attractive from a capital standpoint. | |
| These issues were what prompted the Basel Committee to create | |
| incentives for the use of risk-sensitive internal models in the first | |
| place via Basel II. All models, standard or risk-based, have inherent | |
| weaknesses, but increasing transparency and applying benchmark testing | |
| can identify possible shortcomings. It simply isn't necessary to | |
| reverse course from Basel II and insist on an over-simplified standard | |
| model. | |
| We believe, as a general point, that capital levels should reflect | |
| risk as closely as possible. A less risk-sensitive capital framework | |
| leads to the possibility of a misallocation of capital and an increase | |
| in systemic risk by encouraging herding behavior in the market. This | |
| raises the possibility of all market participants failing to identify | |
| emerging risks that do not necessarily exist today. Making decisions in | |
| a business that is intrinsically about taking and managing risk, based | |
| on a capital framework that is being made purposely less risk | |
| sensitive, creates its own hazards. | |
| Along these lines, we were pleased to see the Committee recognize | |
| the value of internal models in its bill reauthorizing the Commodity | |
| Exchange Act.\11\ Unfortunately, the CFTC's current approach for | |
| internal model approval in its proposed capital rule makes it | |
| impossible for entities that are not subsidiaries of U.S. bank holding | |
| companies or SEC-registered security-based swap dealers to seek CFTC | |
| model approval (see Annex II). This highlights the need for further | |
| dialogue between the House, Senate, the CFTC and the SEC on this | |
| subject. | |
| --------------------------------------------------------------------------- | |
| \11\ H.R. 2289, the Commodity End-User Relief Act. | |
| --------------------------------------------------------------------------- | |
| Overall, a non-risk-based capital framework is also likely to lead | |
| to a rise in total capital requirements across the bank--essentially | |
| because standardized models tend to be more conservative. | |
| Margin for Non-Cleared Derivatives | |
| I would now like to turn to the margin rules. | |
| As I mentioned in my introductory remarks, the implementation of | |
| margin rules for non-cleared derivatives from September will mark the | |
| completion of the last of the 2009-2011 G20 derivatives reform | |
| objectives. From that date, the largest banks will be required to | |
| exchange initial and variation margin on their non-cleared derivatives | |
| trades. All other entities covered by the rules will be subject to | |
| variation margin requirements beginning next March, with initial margin | |
| obligations phased in over a 4 year period. | |
| ISDA has worked tirelessly for the past 3 years to prepare for | |
| implementation, and efforts have stepped up since U.S. Prudential | |
| Regulators and the CFTC published their respective final rules at the | |
| end of last year. | |
| ISDA Standard Initial Margin Model (ISDA SIMM) | |
| A central part of this project is the development of the ISDA SIMM, | |
| which will be available for firms to use to calculate how much initial | |
| margin needs to be exchanged. The model is now finished from a design | |
| perspective. ISDA has been touring the globe in recent months, showing | |
| the methodology to regulators, alongside a transparent governance | |
| structure, in order to smooth the path to implementation. We have | |
| shared all the data that went into the development of this model, along | |
| with the calibration, the back-testing results and independent | |
| validation confirming the model meets the requirements of a one-tailed | |
| 99% confidence interval over a 10 day horizon. | |
| We have found the U.S. Prudential regulators,\12\ the CFTC\13\ and | |
| the European Supervisory Authorities' Joint Assessment Team\14\ to be | |
| thoroughly engaged and knowledgeable. However, as the implementation | |
| date of September 1, 2016 draws closer, it is important that regulators | |
| move quickly to acknowledge that the ISDA SIMM is fit for service. | |
| Without the ISDA SIMM, firms are likely to utilize the fallback | |
| solution of standard tables, which were developed by the Basel | |
| Committee and IOSCO as the most conservative approach and are more | |
| costly. | |
| --------------------------------------------------------------------------- | |
| \12\ Federal Reserve, Office of the Comptroller of the Currency, | |
| Federal Deposit Insurance Corporation. | |
| \13\ The National Futures Association, which was recently | |
| designated by the CFTC to oversee the model application. | |
| \14\ The Joint Assessment Team was established in early 2015, with | |
| the aim to assess the compliance of the different initial margin models | |
| to the requirements of the draft joint regulatory technical standards | |
| on the European Market Infrastructure Regulation and the Basel | |
| Committee-IOSCO framework: https://www.esma.europa.eu/sites/default/ | |
| files/library/2015/11/2015-1381_- | |
| _annex_to_the_statement_by_steven_maijoor_esas_joint_committee_- | |
| _econ_hearing_ | |
| 14_september_2015.pdf. | |
| --------------------------------------------------------------------------- | |
| Phase I banks have already begun their operational builds in | |
| preparation for the September 1, 2016 implementation date. Timely | |
| approval of the model at the firm-level is critical. | |
| Credit Support Annex--Facilitating the Flow of Margin | |
| Another big focus has been preparing for the necessary revisions to | |
| ISDA credit support documentation in each jurisdiction. We're making | |
| very good progress here, and the first margin-compliant document was | |
| published earlier this month. ISDA is also developing a protocol to | |
| ensure the changes can be made to outstanding agreements as efficiently | |
| as possible. | |
| There's still a lot that still needs to be done, but ISDA is | |
| working hard to deliver solutions in advance of the regulatory | |
| mandates. | |
| There is one impediment that is standing in the way--the lack of | |
| final rules from the CFTC regarding the application of U.S. rules | |
| abroad. Without these rules, we cannot complete the legal agreements to | |
| facilitate the exchange of collateral. This is important to meet the | |
| September 1, 2016 implementation deadline. | |
| Finalizing the Cross-Border Rules | |
| While the margin rules were developed and agreed at a global level, | |
| the national proposals published by U.S., European and Japanese | |
| regulators initially contained a number of important differences. | |
| Variations even emerged between the proposals issued by U.S. Prudential | |
| Regulators and the CFTC. | |
| In letters to national authorities,\15\ ISDA highlighted those | |
| differences and suggested a more globally consistent approach. | |
| Ultimately, many of the biggest variations were ironed out in the final | |
| rules--but some still remain. | |
| --------------------------------------------------------------------------- | |
| \15\ http://www2.isda.org/functional-areas/wgmr-implementation/. | |
| --------------------------------------------------------------------------- | |
| Let me first address the inconsistencies among international rules. | |
| Final rules from U.S. Prudential Regulators and the CFTC require | |
| variation margin to be settled the day after execution of the trade, or | |
| T+1. This approach is more or less mirrored in European rules. In | |
| comparison, Japanese proposals require variation margin to be exchanged | |
| as soon as practically possible, while Singapore and Hong Kong | |
| regulators have proposed T+2 and T+3, respectively. | |
| These differences matter, and the tighter time frame set by U.S. | |
| and European regulators will make it practically difficult for U.S. | |
| firms to trade with Asian counterparties. | |
| There are also differences in the treatment of non-netting | |
| jurisdictions, the scope of instrument coverage, and the scope of | |
| applicability. These variations add to the complexity of complying with | |
| the rules in multiple jurisdictions. | |
| Turning to the U.S. rules, the CFTC's cross-border margin proposal | |
| is inconsistent with current CFTC cross-border guidance for swaps that | |
| are cleared and executed on a swap execution facility (SEF). Unlike the | |
| cross-border guidance, the CFTC cross-border margin proposal defines | |
| `U.S. person' as entities that have a ``significant nexus'' to the | |
| U.S., even if they are domiciled or organized outside the U.S. It also | |
| includes a different interpretation of non-U.S. entities guaranteed by | |
| a U.S. person. This interpretation may lead to a single trade being | |
| subject to margin rules in multiple jurisdictions. | |
| In addition, U.S. prudential rules appear to recognize that a non- | |
| cleared swaps transaction arranged by personnel or agents of non-U.S. | |
| banks located in the U.S. would be excluded from mandatory margining. | |
| However, this contrasts with the position taken in the CFTC cross- | |
| border guidance, which imposes clearing, SEF-trading and reporting | |
| requirements on trades between a non-U.S. swap dealer and a non-U.S. | |
| person if those transactions are arranged, negotiated or executed in | |
| the U.S. This requirement is currently subject to no-action relief,\16\ | |
| but that relief expires in September. The CFTC should reconcile its | |
| cross-border guidance and the cross-border margin proposal with U.S. | |
| prudential rules to ensure consistency for all swaps rules. | |
| --------------------------------------------------------------------------- | |
| \16\ CFTC Letter No. 15-48: http://www.cftc.gov/idc/groups/public/ | |
| @lrlettergeneral/documents/letter/15-48.pdf. | |
| --------------------------------------------------------------------------- | |
| On a positive note, we appreciate that the CFTC allows for a | |
| substituted compliance regime in its cross-border margin proposal. | |
| Under that proposal, swap dealers and major swap participants would be | |
| able to post margin under foreign rules when trading with a non-U.S. | |
| counterparty not guaranteed by a U.S. person--but that would depend on | |
| those foreign rules being deemed comparable with U.S. requirements. | |
| Market participants are concerned about the timing of these | |
| comparability determinations given the proximity of the implementation | |
| date. No determinations have been made so far with respect to margin | |
| rules, and the market has had no guidance on whether such | |
| determinations might be forthcoming. | |
| Under the proposed cross-border margin rules, substituted | |
| compliance will be granted if the rules of foreign jurisdictions are | |
| consistent with the Basel Committee-IOSCO standards, which is positive. | |
| We are concerned, however, that the final rules will require an | |
| element-by-element analysis of overseas regimes. | |
| ISDA believes that substituted compliance should be determined by | |
| whether a jurisdiction is consistent on an outcomes basis with the | |
| Basel Committee-IOSCO margin recommendation. | |
| While U.S. Prudential Regulators included requirements for cross- | |
| border trades in their final rules, the CFTC has yet to publish its | |
| final rule. With the new regime scheduled for implementation from | |
| September, it means there's just 4 months to issue the final rule and | |
| make substituted compliance decisions. Timing is critical as ISDA is | |
| developing the legal documentation that will assist market participants | |
| in determining whether they will fall within the scope of the margin | |
| rules. Without the CFTC's final cross-border margin rule, it will be | |
| difficult for ISDA to finalize these documents by the effective date of | |
| the rules. | |
| We urge the CFTC to publish its final cross-border margin rule as | |
| soon as possible to maximize the possibility of substituted compliance | |
| decisions before the rules of other jurisdictions become effective. | |
| Conclusion | |
| To sum up, banks today are significantly stronger and more | |
| resilient than they were before the crisis. Capital levels have already | |
| increased significantly. But a balance needs to be struck between | |
| making banks ever stronger by layering on additional capital and | |
| encouraging them to lend and facilitate hedging transactions. | |
| As the Commissioner of the Japanese Financial Services Agency, | |
| Nobuchika Mori, said at ISDA's annual general meeting in Tokyo earlier | |
| this month: | |
| ``We had better think carefully whether thick walls are | |
| enough to attain our dual goal of financial stability and | |
| growth. The Japanese heavy battleships Yamato and Musashi had | |
| the thickest walls, but we know that they were not resilient | |
| against air power. Instead of blindly trusting the thickness of | |
| the walls, we need to assess and strengthen the entire | |
| framework of prudential regulatory and supervisory policy.'' | |
| \17\ | |
| --------------------------------------------------------------------------- | |
| \17\ Keynote address ``From static regulation to dynamic | |
| supervision'' by Nobuchika Mori, Commissioner, Financial Services | |
| Agency, Japan at ISDA's 31st Annual General Meeting, Tokyo, April 13, | |
| 2016: http://www2.isda.org/attachment/ODI5OQ==/JFSA%20Speech.pdf. | |
| Global regulatory bodies have recognized this fact, and have called | |
| for further refinements to the capital framework to be made without | |
| significantly increasing capital across the banking sector. | |
| However, ISDA studies have shown that new requirements will result | |
| in higher capital levels. How much is too much? At what point is the | |
| balance overly skewed in one direction, to the detriment of growth? | |
| At the moment, no one knows. | |
| ISDA believes a comprehensive impact study is necessary in order to | |
| provide regulators the information they need to make this decision. | |
| That study should cover all facets of the regulatory framework and | |
| consider the impact on all derivatives counterparties to ensure | |
| regulators are fully aware of the implications of further change. | |
| Finally, ISDA is doing all it can to ensure the infrastructure, | |
| systems and documentation are in place to facilitate implementation of | |
| new margining requirements from September. But we remain concerned | |
| about cross-border implications. It is vital the substituted compliance | |
| framework is based on broad outcomes, rather than a line-by-line | |
| comparison of national rule-sets. We also urge the CFTC to issue its | |
| final rules as soon as possible. | |
| I would like to close by expressing my sincere appreciation of the | |
| Committee's work and its commitment to exploring the impact of Dodd- | |
| Frank implementation through these hearings. | |
| Thank you. | |
| Annex I | |
| derivatiViews | |
| From the Executive Office of ISDA | |
| FRTB: One Piece of the Capital Puzzle \18\ | |
| --------------------------------------------------------------------------- | |
| \18\ ISDA derivatiViews, April 21, 2016: https:// | |
| isda.derivativiews.org/2016/04/21/frtb-one-piece-of-the-capital-puzzle/ | |
| --------------------------------------------------------------------------- | |
| With any jigsaw puzzle, it takes time before the full picture | |
| starts to become visible. Look at any single piece in isolation, and | |
| the picture is unrecognizable. Slot several of the pieces into place, | |
| and the image slowly starts to take shape. | |
| A comparison of sorts can be made with the package of capital, | |
| leverage and liquidity reforms being introduced by the Basel Committee | |
| on Banking Supervision. The Group of 20 (G20) has set out the picture | |
| it wants to end up with: a Basel III framework with an increase in the | |
| level and quality of capital banks must hold compared with the pre- | |
| crisis Basel II. | |
| But the G20 has also decreed that any work to refine and calibrate | |
| elements of the Basel III rules prior to their finalization and | |
| implementation should be made without further significantly increasing | |
| overall capital requirements across the banking sector. (http:// | |
| www.g20.utoronto.ca/2016/160227-finance-en.html) This is where it's | |
| hard to see how the pieces come together. | |
| The latest segment of the capital jigsaw to be slotted into place | |
| is the Fundamental Review of the Trading Book (FRTB), an initiative to | |
| overhaul market risk requirements. In its January publication of the | |
| final FRTB framework, the Basel Committee estimated the revised | |
| standard would result in a weighted mean increase of approximately 40% | |
| in total market risk capital requirements. That estimate, though, was | |
| based on a recalibration of quantitative-impact-study data from an | |
| earlier version of the rules. | |
| As a result, ISDA decided to lead an additional industry study [2] | |
| (http://www2.isda.org/attachment/ODM0OA==/QIS4 2015 FRTB Refresh | |
| Report_Spotlight__FINAL.pdf) based on data from 21 banks to determine | |
| the impact of the final requirements--and the results were unveiled at | |
| ISDA's 31st annual general meeting in Tokyo last week. | |
| The study shows an overall increase in market risk capital of | |
| between 1.5 and 2.4 times compared to current market risk capital. The | |
| lowest estimate of 1.5 times assumes all banks will receive internal | |
| model approval for all desks. If all banks fail the internal model | |
| tests for all trading desks, market risk capital would increase by 2.4 | |
| times. ISDA believes the end result will be somewhere in between, but | |
| this will depend on two key variables: interpretation of rules on a so- | |
| called P&L attribution test and whether the calibration of capital | |
| floors applies to market risk. | |
| The former is particularly important--and currently problematic. | |
| Under the FRTB, banks have to apply for regulatory approval to use | |
| internal models for each trading desk, with approval dependent on | |
| passing a P&L attribution test (essentially comparing internal capital | |
| systems with front-office models). But there is currently a lack of | |
| clarity over how this test will work in practice, while banks have not | |
| had time to develop the infrastructure that would enable them to | |
| produce the data required for the test. | |
| Without more certainty on the methodology, and without knowing | |
| whether or at what level capital floors will be set, it is difficult to | |
| accurately estimate the ultimate impact. But it is unlikely all banks | |
| will receive internal model approval for all desks, meaning the end | |
| result may be closer to 2.4 times than 1.5 times. | |
| Crucially, the study shows the final FRTB framework hasn't | |
| eliminated a cliff effect between standardized and internal models. If | |
| a particular desk loses model approval, capital requirements could | |
| immediately increase by multiple times. This had been something the | |
| Basel Committee had wanted to eliminate. | |
| The FX and equity markets are most affected. Losing internal model | |
| approval under the new rules would result in a 6.2 times increase in | |
| capital for FX desks and a 4.1 times increase for equity desks.\19\ | |
| --------------------------------------------------------------------------- | |
| \19\ These numbers exclude the so-called residual risk add-on, non- | |
| modellable risk factors and diversification across risk classes under | |
| internal models. | |
| --------------------------------------------------------------------------- | |
| These are big increases, and come on top of the jump in capital | |
| requirements already envisaged in Basel III. The question is whether | |
| this single piece of the jigsaw suggests the final picture will be out | |
| of line with what the G20 expects. To put it more simply, will this | |
| piece, when combined with other changes in the capital framework, | |
| ultimately result in further significant increases in capital across | |
| the banking sector? The honest answer is that no one knows. | |
| We do, however, know that large increases in capital could mean | |
| certain business lines end up becoming uneconomic. This could severely | |
| affect the ability of banks to provide risk management services and | |
| reduce the availability of financing for borrowers. At a time when some | |
| jurisdictions are increasingly focused on initiatives to generate and | |
| sustain economic growth, that's a concern. | |
| Summary of the Industry Study on the Final FRTB Rules \20\ | |
| --------------------------------------------------------------------------- | |
| \20\ http://www2.isda.org/attachment/ODM0OA==/ | |
| QIS4%202015%20%20FRTB%20Refresh | |
| %20Report_Spotlight__FINAL.pdf | |
| --------------------------------------------------------------------------- | |
| FRTB QIS4 Refresh_Spotlight | |
| b Significant step in right direction--Highlights: | |
| d SA methodology overall capital charge is 2.4 compared to current | |
| market risk capital (QIS4: 4.2 ); and | |
| d Residual risk add on in standard rules has reduced to 6% (QIS4: | |
| 49%) of total SA capital. | |
| b NMRF remains a big component of internal models approach capital | |
| charge 30% (QIS4: 29%) | |
| b Cliff effect between standard rules and internal models remains | |
| because: | |
| d Banks were asked to assume most desks obtain model approvals in | |
| the QIS instructions. In reality most banks are likely to | |
| lose model approval for a number of desks due to stringent | |
| tests; | |
| d Capital floors based on some percentage of standardized approach | |
| will be imposed; and | |
| d Cliff effect between the IMA and SA varies materially between and | |
| within risk classes, which may result in significant | |
| reallocation of capital and business activity. | |
| ------------------------------------------------------------------------ | |
| SA to IMA * | |
| ------------------------------------------------------------------------ | |
| Interest rate risk 3.0 | |
| Credit spread risk 2.0 | |
| Equity risk 4.1 | |
| Commodity risk 2.9 | |
| Foreign exchange risk 6.2 | |
| ------------------------------------------------------------------------ | |
| * SA excluding residual risk add on & IMA excluding NMRF. | |
| * Results based on data contributed by 21 banks, refreshing earlier QIS4 | |
| analysis based on final FRTB rules. | |
| b Charges on securitization products improved in the final text, | |
| however, when looking at capital for the securitization | |
| portfolio including hedges, we see a significant increase in | |
| capital versus current levels. | |
| b The results of P&L Attribution test and the calibration of the | |
| capital floor based on standard rules need to be considered to | |
| assess the full capital impact and how the change will | |
| translate to bank business models. | |
| <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> | |
| Annex II | |
| Under the CFTC's proposed capital rule, non-bank swap dealers that | |
| are subsidiaries of an entity with capital models approved by the | |
| Federal Reserve or SEC can seek CFTC approval of such internal models | |
| to calculate their related CFTC capital requirements. | |
| Unfortunately, this approach leaves some ISDA members with no | |
| ability to seek CFTC model approval to calculate regulatory capital | |
| requirements. Specifically, those members that are neither a subsidiary | |
| of a U.S. bank holding company nor an SEC-registered security-based | |
| swap dealer will be unable to seek CFTC model approval. This holds true | |
| for swap dealers that are subsidiaries of non-U.S. financial | |
| institutions subject to robust home-country prudential regulation in a | |
| jurisdiction that is a member of the G20 or a member of the Basel | |
| Committee. | |
| Without an approved model, a swap dealer will be required to use a | |
| rigid standardized approach to calculate capital and margin | |
| requirements. The significantly higher costs associated with the | |
| standardized approach would make continued swap activity severely cost- | |
| prohibitive. The significant cost increase will result in higher costs | |
| for end-users and create an unlevel playing field among dealers engaged | |
| in the same business, in the same markets, with the same customers. We | |
| do not believe that an aim of the Dodd-Frank Act was to cause | |
| significantly higher costs for end-users, or for regulators to pick | |
| winners and losers among swap dealers and major swap participants. | |
| Nonetheless, these are the likely outcomes if model approval is unduly | |
| restricted. | |
| We understand there has been a productive dialogue between the | |
| CFTC, SEC and market participants on these issues and we encourage it | |
| to continue. ISDA also appreciates that the House and Senate CFTC | |
| reauthorization bills provide for consultation between regulators on | |
| models, and authorize non-bank swap dealers to use comparable models to | |
| the extent bank swap dealers use an approved model. | |
| The Chairman. Mr. Deas. | |
| STATEMENT OF THOMAS C. DEAS, Jr., REPRESENTATIVE, | |
| CENTER FOR CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER OF | |
| COMMERCE; REPRESENTATIVE, COALITION FOR DERIVATIVES END-USERS, | |
| WASHINGTON, D.C. | |
| Mr. Deas. Good morning, Chairman Scott, Ranking Member | |
| Scott, and Members of the Subcommittee. | |
| I am Tom Deas, testifying on behalf of the U.S. Chamber's | |
| Center for Capital Markets Competitiveness and the Coalition | |
| for Derivatives End-Users. I am also Chairman of the National | |
| Association of Corporate Treasurers. | |
| The Chamber and the Coalition for Derivative End-Users, | |
| along with NACT, represent hundreds of companies across the | |
| country that employ derivatives to manage risk in our day-to- | |
| day business activities. | |
| First, let me sincerely thank, both the Chairman, the | |
| Ranking Member, and the Members of this Committee for doing so | |
| much to protect derivative end-users from the burdens of | |
| unnecessary regulation. When it comes to main street | |
| businesses, the Members of this Committee have worked together | |
| to get things done. Last year, you led the charge in enacting | |
| both the end-user margin bill and the centralized treasury unit | |
| bill, directly benefitting the end-user community. We sincerely | |
| appreciate these efforts. | |
| Congress did this because they recognized that end-users do | |
| not engage in the kind of risky, speculative derivatives | |
| activity that became evident during the financial crisis. End- | |
| users comprise less than ten percent of the derivatives | |
| markets, and we use derivatives to hedge the risks in our day- | |
| to-day business activity. We are offsetting risks, not creating | |
| new ones. | |
| We support the Dodd-Frank Act's goal of increasing | |
| transparency in, and reducing systemic risks of, the | |
| derivatives markets. However, at this point, almost 6 years | |
| after passage of the Act, there are still areas where the | |
| continuing uncertainty compels end-users to appeal for | |
| legislative and regulatory relief. End-users are also seeing | |
| the cumulative impacts of the elaborate web of new rules and | |
| regulations, including those placed on our counterparties; that | |
| is, rules that require our counterparties to meet certain tests | |
| regarding capital, liquidity, and margin, are leading to | |
| significant realized and potential impacts on end-users. | |
| Despite being exempted from the capital and margin | |
| requirements, end-users still face the distinct possibility | |
| that our hedging activities will become too costly because of | |
| the new and higher capital requirements, margin and liquidity | |
| requirements, imposed on our counterparties. | |
| For example, under the net stable funding ratio, long-term | |
| funding costs will discourage dealer involvement in | |
| derivatives, thereby reducing available counterparties and | |
| liquidity for end-users. We understand the banking regulators | |
| have proposed their net stable funding ratio rule this week, | |
| and we are in the process of reviewing it and its impacts on | |
| end-users. | |
| Another example is the supplemental leverage ratio, which | |
| does not permit the clearing member to receive credit for the | |
| segregated initial margin posted by its end-user customers. The | |
| failure of the SLR to recognize the risk-reducing effect of | |
| segregated client collateral will likely lead to fewer banks | |
| willing to provide clearing services for customers, and will | |
| likely increase costs to end-users generally. | |
| Differences in the credit valuation adjustment risk capital | |
| charge between the United States and other jurisdictions, such | |
| as Europe, also create competitive disadvantages. Europe | |
| provides an exemption that avoids the CVA charge being factored | |
| onto the pricing, and passed on to end-users, however, in the | |
| United States no such exemption exists, leading to the | |
| potential for large pricing differences when trading with U.S. | |
| compared to EU banks. | |
| Many end-users engage in derivatives with both non-bank, as | |
| well as bank swap dealers, and we are concerned about the | |
| impact on liquidity of certain restrictions on models for non- | |
| bank swap dealers, which would not permit the use of internal | |
| models for computing market risks, and counterparty credit | |
| charges for capital purposes. This approach requires non-bank | |
| swap dealers to hold significantly more regulatory capital, | |
| which ultimately will force them potentially to exit the | |
| business, leaving end-users with fewer choices for access to | |
| risk mitigation tools. | |
| To summarize, end-users are concerned about the apparent | |
| disparity between an exemption from clearing and margin | |
| requirements on the one hand, and the pass-through costs | |
| resulting from new capital and liquidity rules imposed on their | |
| counterparties. We also fear that cross-border regulatory | |
| uncertainty and conflict could put American companies at an | |
| economic disadvantage. Although these capital and liquidity | |
| rules do not create affirmative requirements directly on end- | |
| users, they, nevertheless, create real impacts and costs. The | |
| imposition of unnecessary burdens on end-users restricts job | |
| growth, decreases investment, and undermines our | |
| competitiveness around the globe, leading to material | |
| cumulative impacts on corporate end-users and our economy. | |
| Thank you again for your attention to the needs of end-user | |
| companies. | |
| [The prepared statement of Mr. Deas follows:] | |
| Prepared Statement of Thomas C. Deas, Jr., Representative, Center for | |
| Capital Markets Competitiveness, U.S. Chamber of Commerce; | |
| Representative, Coalition for Derivatives End-Users, Washington, D.C. | |
| The U.S. Chamber of Commerce is the world's largest business | |
| federation, representing the interests of more than three | |
| million businesses of all sizes, sectors, and regions, as well | |
| as state and local chambers and industry associations. The | |
| Chamber is dedicated to promoting, protecting, and defending | |
| America's free enterprise system. | |
| More than 96% of Chamber member companies have fewer than 100 | |
| employees, and many of the nation's largest companies are also | |
| active members. We are therefore cognizant not only of the | |
| challenges facing smaller businesses, but also those facing the | |
| business community at large. | |
| Besides representing a cross section of the American business | |
| community with respect to the number of employees, major | |
| classifications of American business--e.g., manufacturing, | |
| retailing, services, construction, wholesalers, and finance-- | |
| are represented. The Chamber has membership in all 50 states. | |
| The Chamber's international reach is substantial as well. We | |
| believe that global interdependence provides opportunities, not | |
| threats. In addition to the American Chambers of Commerce | |
| abroad, an increasing number of our members engage in the | |
| export and import of both goods and services and have ongoing | |
| investment activities. The Chamber favors strengthened | |
| international competitiveness and opposes artificial U.S. and | |
| foreign barriers to international business. | |
| The Coalition for Derivatives End-Users represents the views | |
| of end-user companies that employ derivatives to manage risks. | |
| Hundreds of companies and business associations have been | |
| active in the Coalition on both legislative and regulatory | |
| matters and our message is straightforward: financial | |
| regulatory measures should promote economic stability and | |
| transparency without imposing undue burdens on derivatives end- | |
| users, who are the engines of the economy. Imposing unnecessary | |
| regulation on derivatives end-users, parties that did not | |
| contribute to the financial crisis, would fuel economic | |
| instability, restrict job growth, decrease productive | |
| investment and hamper U.S. competitiveness in the global | |
| economy. | |
| Mr. Chairman, Ranking Member Scott, other Members of the | |
| Subcommittee, thank you for inviting me to testify at this important | |
| hearing, which focuses on matters of significant concern to the end- | |
| user community. I am Thomas C. Deas, Jr., Chairman of the National | |
| Association of Corporate Treasurers, an organization of treasury | |
| professionals from several hundred of the largest public and private | |
| companies in the country. I am testifying today on behalf of both the | |
| U.S. Chamber of Commerce (``Chamber'') and the Coalition for | |
| Derivatives End-Users (``Coalition''). The Chamber is the world's | |
| largest business federation, representing the interests of more than | |
| three million businesses of all sizes, sectors, and regions. The | |
| Coalition includes more than 300 end-user companies and trade | |
| associations, including the National Association of Corporate | |
| Treasurers. Collectively, the Chamber and the Coalition represent a | |
| wide and diverse population of domestic and international commercial | |
| businesses and trade associations. | |
| As detailed below, we strongly believe that there are many capital | |
| and liquidity requirements impacting our counterparties that will | |
| directly impede the ability of end-users to effectively manage risks | |
| and result in higher costs for the end-user community, and ultimately | |
| consumers. Specifically, these include: | |
| <bullet> The Net Stable Funding Ratio; | |
| <bullet> The Supplemental Leverage Ratio; | |
| <bullet> Restrictions on Models for Non-Bank Swap Dealers; | |
| <bullet> Competitive Issues Surrounding the Credit Valuation | |
| Adjustment; | |
| <bullet> The Swap Dealer De Minimis Threshold; and | |
| <bullet> The Cumulative Impact of Capital Rulemakings on End-Users | |
| Background | |
| The Chamber's mission is to ensure America's global leadership in | |
| capital formation by supporting robust capital markets that are the | |
| most fair, transparent, efficient, and innovative in the world. As part | |
| of that mission, the Chamber recognizes the acute need for commercial | |
| end-users to effectively manage risk. Similarly, the Coalition, | |
| representing the engines of our domestic and global economy, has | |
| consistently supported financial regulatory measures that promote | |
| economic stability and transparency without imposing undue burdens on | |
| derivatives end-users. | |
| At the outset, let me thank the Members of this Subcommittee and | |
| the full Committee for their bipartisan efforts and focus on ensuring | |
| that Main Street businesses have the tools and access to capital | |
| necessary to operate and grow. Last year, you led the charge in | |
| enacting key legislation to protect end-users, including the end-user | |
| margin bill, which clarified that end-users are not subject to margin | |
| requirements for their uncleared swaps, and the centralized treasury | |
| unit bill, which helped ensure that end-users can continue to use a | |
| risk-reducing best practice. Similarly, the Commodity End-User Relief | |
| Act includes several provisions that will provide immediate relief to | |
| end-users who rely on risk management tools to keep their operations | |
| and businesses running during times of uncertain volatility. | |
| Despite these laudable efforts, however, end-users still face the | |
| distinct possibility that their hedging activities will become too | |
| costly because of new and higher capital, margin and liquidity | |
| requirements imposed on their bank and non-bank counterparties. In | |
| essence, this means that the significant progress Congress has made to | |
| ensure that end-users do not bear the brunt of costs associated with | |
| derivatives risk management, including exemptions from clearing and | |
| margin requirements, are pyrrhic victories. In particular, I wish to | |
| highlight the impact of the following capital and liquidity | |
| requirements, which have resulted either in higher costs for end-users | |
| (or will do so once fully implemented) or will incentivize end-user | |
| counterparties to leave the market altogether. | |
| Net Stable Funding Ratio | |
| The Chamber and the Coalition believe that the Basel Committee of | |
| Banking Supervision's net stable funding ratio (``NSFR'') which would | |
| lead to billions in additional funding requirements for derivatives | |
| activities, does not take into account the impacts on end-users. This | |
| is especially concerning given that many of the provisions of the NSFR | |
| would further restrict end-users' ability to hedge by increasing the | |
| cost of risk management and could lead to decreased liquidity in the | |
| derivatives markets. We understand that the Prudential Banking | |
| Regulators released their proposed rules on the NSFR earlier this week | |
| and we will be carefully reviewing their proposals and evaluating the | |
| impact on end-users. | |
| In particular, the concern is two-fold: (1) long-term funding costs | |
| required under the NSFR limit and discourage dealer involvement in | |
| derivatives and derivatives-related transactions, effectively reducing | |
| liquidity in the market that end-users rely on to hedge risk; and (2) | |
| costs associated with capital-raising in a less liquid market would | |
| inevitably be borne by derivatives end-users and consumers. The | |
| immediate impact of the NSFR can already be seen as fewer bank | |
| counterparties are willing to extend longer-term credit, including in | |
| the form of swaps used to hedge long-term exposures. Additionally, the | |
| costs to hedge are likely to be passed on to end-user companies in the | |
| form of increased fees or transaction costs, less favorable terms, and | |
| collateral requirements.\1\ | |
| --------------------------------------------------------------------------- | |
| \1\ A January 2015 study of the OTC derivatives market by Oliver | |
| Wyman concluded that the NSFR's treatment of OTC derivatives would | |
| require an additional $500 billion in long-term funding, generating $5- | |
| $8 billion in incremental costs to the industry, with a cost increase | |
| of 10-15% for derivatives transactions. | |
| --------------------------------------------------------------------------- | |
| These concerns are particularly reflected in the add-on costs | |
| associated with counterparty payables; the treatment of | |
| uncollateralized receivables; the lack of collateral offsetting | |
| provisions; and the liquidity squeeze related to the treatment of | |
| corporate debt. For example, requiring dealer counterparties to provide | |
| required stable funding for 20% of the negative replacement cost of | |
| derivative liabilities (before deducting variation margin posted) is a | |
| clear example of the direct burdens that would affect end-users' | |
| ability to efficiently mitigate risk. | |
| Another concern under the NSFR is the treatment of dealers with | |
| respect to uncollateralized net receivables, which could require 100% | |
| long-term funding. As we are now seeing, end-users are being required | |
| to collateralize transactions with cash margin to meet the stringent | |
| Basel III leverage ratio requirements. Or, if a dealer counterparty did | |
| not demand collateral, the costs of long-term funding could simply be | |
| passed on to end-users through embedded derivatives fees. | |
| Moreover, we believe that disproportionate discounting of | |
| collateral posted forces dealers to mitigate costs elsewhere. As a | |
| result, in implementing the NSFR, the Prudential Banking Regulators | |
| should align collateral posted by commercial end-users with long-term | |
| funding obligations under NSFR. This is particularly true because, | |
| while most end-users are exempted from posting margin for their | |
| derivatives with bank counterparties, the ``back to back'' hedges | |
| entered into by banks to offset end-user transactions are still subject | |
| to mandatory clearing and margin requirements. Consequently, the costs | |
| borne by banks to offset end-user transactions are passed on to the | |
| very end-users that were meant to be exempt from the costs of mandatory | |
| clearing and margin requirements--and ultimately to consumers. | |
| Further, the NSFR's treatment of corporate debt could hinder end- | |
| user capital raising efforts. The NSFR does not take into account the | |
| maturity of end-user-issued debt when determining a dealer's required | |
| stable funding and would restrict liquidity in the corporate debt | |
| markets by requiring dealers to raise 50-85% long-term funding to | |
| support their inventory, which would discourage market making. End- | |
| users rely on market-based funding and the importance of liquid markets | |
| for corporate bonds and commercial paper (``CP''). To cite a real-world | |
| example of the costs and diminished liquidity from these rules, many | |
| corporate treasuries issue CP daily to balance their funding | |
| requirements. If they are faced with a same-day payment that they | |
| identify too late in the day to complete a placement in the market of | |
| the required CP, their bank CP dealer frequently will take the paper | |
| overnight for its own account and fund-out the requirement the next | |
| day. The NSFR rules require the bank to hold 85% of that overnight | |
| funding as long-term funding--at a cost over ten times the overnight | |
| amount. Ultimately this liquidity will no longer be available to end- | |
| user treasury departments. Accordingly, the Prudential Banking | |
| Regulators should carefully consider the impact of the NSFR's 50-85% | |
| long-term funding requirements on end-users. | |
| Supplemental Leverage Ratio | |
| The supplemental leverage ratio (``SLR'') penalizes high quality | |
| assets and acts as a disincentive to market participants to provide | |
| clearing services. The SLR does not permit the clearing member to take | |
| ``credit'' for the segregated initial margin posted by its customer | |
| that is expressly for the purpose of limiting the clearing member's | |
| exposure to derivatives. Further, segregated initial margin in the form | |
| of cash may be required to be added to a clearing member's balance | |
| sheet exposure, requiring additional capital. The overall result of the | |
| SLR seems to ignore the fact that for derivatives cleared on behalf of | |
| a customer, the customer's segregated initial margin must be held to | |
| margin the customer's positions and cannot be used as leverage by the | |
| clearing firm. | |
| Ultimately, the failure of the SLR to recognize the risk-reducing | |
| effect of segregated client collateral will likely lead to fewer banks | |
| willing to provide clearing services for customers, thus constraining | |
| the ability of end-users that clear derivatives to access central | |
| clearing. Further, even end-users that do not clear their derivatives | |
| will likely see the impact of the SLR in the form of increased costs | |
| for hedging, as their bank counterparties will see their clearing costs | |
| increase on their back to back hedges and will pass those costs along | |
| to end-users. We are hopeful that regulators can work together to get | |
| this right in the United States and abroad. | |
| Restrictions on Models for Non-Bank Swap Dealers | |
| Another significant issue directly impacts non-bank swap dealers, | |
| many of which routinely do business with end-users. As proposed in | |
| 2011, the CFTC's capital rules for non-bank swap dealers do not permit | |
| the use of internal models for computing market risk and counterparty | |
| credit risk charges for capital purposes. Instead, they must use the | |
| ``standardized approach,'' which measures market risk according to | |
| standards established by the Basel Committee on Banking Supervision, | |
| generally requiring capital for both ``general'' and ``specific'' | |
| risks. | |
| These two approaches differ significantly, particularly with | |
| respect to dealing in commodity derivatives. For many asset classes, | |
| non-bank swap dealers using the standardized approach would be required | |
| to hold regulatory capital potentially hundreds of times more than swap | |
| dealers using the internal models approach. This regulatory disparity | |
| will ultimately force those dealers to exit the business, leaving end- | |
| users with fewer choices for access to risk mitigation tools. Moreover, | |
| the disparity creates an unlevel playing field between bank and non- | |
| bank dealers participating in the same markets, ultimately resulting in | |
| higher costs for end-users. | |
| In this respect, Section 311 of the Commodity End-Users Relief Act | |
| would permit the use of comparable financial models by non-bank swap | |
| dealers and major swap participants. This provision would help ensure | |
| comparability in capital requirements across all swap dealers (whether | |
| bank or non-bank) and eliminate a commercial disparity that only raises | |
| costs on end-users that decide to do business with non-bank swap | |
| dealers. | |
| Competitive Issues Surrounding the Credit Valuation Adjustment | |
| European policymakers have implemented capital charges on | |
| derivatives positions significantly more favorable to end-users than | |
| the U.S. Prudential Banking Regulators. The European approach | |
| recognizes that end-users' hedging activities are in fact reducing | |
| risks, and accordingly, exempts end-user derivatives transactions from | |
| the credit valuation adjustment (``CVA'') risk capital charge, which | |
| would otherwise require the calculation and subsequent holding of | |
| capital to mitigate counterparty credit risk in a derivatives | |
| transaction. The absence of a U.S. exemption puts American companies at | |
| a meaningful competitive disadvantage compared to our European | |
| competitors. | |
| In particular, we note that lack of a CVA exemption forces end- | |
| users to enter into credit support enhancement agreements that a bank | |
| would normally not deem necessary in the absence of regulation. If | |
| banks require collateral, end-users may be put in the position of | |
| borrowing from financial institutions to finance the margining | |
| associated with those transactions, resulting merely in a shift of risk | |
| between financial institutions. This result contradicts the objective | |
| of facilitating end-user access to capital, drives costs directly to | |
| end-users, and does nothing to mitigate risk within the financial | |
| system, as the risk is simply being transferred from one bank to | |
| another. | |
| Swap Dealer De Minimis Threshold | |
| Finally, we believe that the CFTC should follow clear Congressional | |
| intent and promptly draft an interim final rule that makes clear that | |
| the swap dealer de minimis exception threshold shall remain at the $8 | |
| billion gross notional level or be raised. The Chamber and Coalition | |
| are concerned that any decrease below the current $8 billion level | |
| could reduce liquidity and the availability of counterparties for end- | |
| users to trade with, thereby concentrating risk in fewer counterparties | |
| and negatively impacting end-users' ability to hedge. | |
| Indeed, we believe that the swap dealer de minimis exception should | |
| remain broad enough to exclude swap dealing activities that do not rise | |
| to the level of systemic significance, either because the level of | |
| activity or the type of transaction. Lowering the threshold from the $8 | |
| billion gross notional amount would needlessly and unnecessarily | |
| capture a significant number of additional market participants and | |
| require them to register as swap dealers or, more likely, reduce their | |
| available products and services to derivatives end-users to ensure they | |
| remain below the thresholds. | |
| Any decrease from the current threshold would likely cause a | |
| further consolidation of swap dealing activities, reducing | |
| competitiveness and potentially increasing risk. Such changes to the | |
| market would reduce liquidity to end-users, reduce counterparty | |
| selection and increase interconnectedness of counterparties--results | |
| that run contrary to the goals of the Dodd-Frank Act. | |
| In this respect, we fully support Section 310 of the Commodity End- | |
| Users Relief Act, which would set the de minimis threshold of swap | |
| dealing at $8 billion. This section would ensure that the de minimis | |
| threshold could only be amended or changed through a new affirmative | |
| rulemaking by the CFTC. | |
| Cumulative Impact of Capital Rulemakings on End-Users | |
| In summary, we believe the legislative intent of the Dodd-Frank Act | |
| was to exempt end-users from having to use their own capital for | |
| mandatory margining of derivatives transactions, diverting these funds | |
| from investment in business expansion and ultimately costing jobs. The | |
| imposition of additional capital requirements by U.S. Prudential | |
| Banking Regulators would undermine this intent by forcing our bank | |
| counterparties to hold much more of their own capital in reserve | |
| against end-users' derivatives positions, passing on the increased | |
| costs to these end-users. | |
| The larger point, which I know this Subcommittee appreciates, is | |
| that the cumulative effect of new derivatives regulation threatens to | |
| impose undue burdens on end-users. The indirect but potentially even | |
| more onerous regulation of end-users through bank capital and liquidity | |
| requirements serves to discourage end-user risk management through | |
| hedging and would effectively negate the benefits of Congress's clear | |
| intent to exempt end-users from margin requirements. The importance of | |
| smart prudential regulation that promotes Main Street business has been | |
| echoed by Members of Congress, including by Chairman Conaway, who has | |
| noted that bipartisan efforts must ``protect end-users from being roped | |
| into reporting, registration, or regulatory requirements that are | |
| inappropriate for the level of risk they can impose on financial | |
| markets. It is clear that end-users did not cause the financial crisis, | |
| they do not pose a systemic risk to the U.S. financial markets, and | |
| they should not be treated like financial entities.'' \2\ | |
| --------------------------------------------------------------------------- | |
| \2\ Press Release, Congressman Conaway Praises Approval of the | |
| Customer Protection and End User Relief Act, U.S. Representative Mike | |
| Conaway (Apr. 9, 2014), available at http://agriculture.house.gov/news/ | |
| documentsingle.aspx?DocumentID=1110. | |
| --------------------------------------------------------------------------- | |
| We need a regulatory system that allows Main Street to effectively | |
| use derivatives to hedge commercial risk, resulting in key economic | |
| benefits; one that allows businesses--from manufacturing to healthcare | |
| to agriculture to energy to technology--to improve their planning and | |
| forecasting, manage unforeseen and uncontrollable events, offer more | |
| stable prices to consumers and contribute to economic growth. End-users | |
| are entering into derivatives to mitigate the business risks they face | |
| in their day-to-day business activities. In this respect they are | |
| fundamentally different from swap dealers who maintain an open book of | |
| exposures against which posting of cash margin is not unwarranted. | |
| However, when rules intended to apply to swap dealers directly or | |
| indirectly burden end-users, it is the end-user segment of our economy | |
| that bears the higher costs. The imposition of unnecessary burdens on | |
| end-user businesses restricts job growth, decreases investment and | |
| undermines our competitiveness in Europe and elsewhere across the | |
| globe--leading to material cumulative impacts on corporate end-users | |
| and our economy. | |
| Thank you and I am happy to address any questions that you may | |
| have. | |
| The Chairman. Mr. Gellasch. | |
| STATEMENT OF TYLER GELLASCH, FOUNDER, MYRTLE MAKENA, LLC, | |
| HOMESTEAD, PA | |
| Mr. Gellasch. Chairman Scott, Ranking Member Scott, | |
| Chairman Conaway, and other Members of the Committee, thank you | |
| for inviting me here today. | |
| The testimony I am going to give today represents my views, | |
| and not those of the trade association or others members. | |
| And I agree with your remarks. I actually believe that we | |
| can have more resilient markets and still protect end-users. | |
| And I also want to start today by recognizing the obvious; that | |
| inadequate regulation of derivatives turned the mortgage crisis | |
| into a worldwide financial meltdown. And in response to that | |
| crisis, regulators around the world designed rules to make our | |
| markets more fair, more transparent, more stable, and less | |
| likely to cause the next financial crisis. | |
| I think it is clear they have actually done that. But | |
| unlike some of my colleagues here today, I want to share with | |
| you that these important reforms are not actually having a | |
| profound negative impact on real end-users. And the elaborate | |
| web of rules, that my colleagues referenced a moment ago, don't | |
| actually apply to them, and in part because of your hard work, | |
| but in part because of smart choices also made by our | |
| regulators. | |
| Today's topic focuses largely on margin and capital, and I | |
| think that is actually the most important part of the crisis. | |
| The largest firms, AIG and the banks, had hundreds of billions | |
| of dollars on their balance sheets, and yet they still were not | |
| able to weather the storm, in large part because they had | |
| inadequate margin from their counterparties, and they had | |
| inadequate capital to absorb the losses, so the taxpayers did. | |
| And I want to explore for a moment exactly what margin and | |
| capital are. As Mr. Lukken said, margin is the first line of | |
| defense for a counterparty. It is an asset often extremely | |
| liquid in securities that are used to satisfy the obligation. | |
| And it has been a hallmark of our capital markets for decades | |
| around the world, and it is actually the only reason to promote | |
| liquidity in times of financial stress. Capital, by contrast, | |
| ensures that the firm has enough of its own, not borrowed, | |
| money to meet the foreseeable obligations; essentially, to stay | |
| solvent. If margin is the first line of defense for a | |
| counterparty in the time of a crisis, then capital and leverage | |
| limits are the last before the bailout. | |
| Once the crisis hit, everyone realized that we needed more | |
| margin and capital in the system, and the G20 summits focused | |
| squarely on those issues. And that is actually what Dodd-Frank | |
| did as well. And now we are hearing from many of the largest | |
| banks and financial firms and their trade groups here, that the | |
| requirements on them will have, and I will again use their | |
| words, profound negative impacts, or impede the ability of end- | |
| users to manage their risks. And I am here to say I | |
| respectfully disagree, and the reason is, frankly, simple math. | |
| And let me use an example from real life that I am familiar | |
| with, and it is a real commercial end-user, it was a parts | |
| supplier in Michigan who has a $100,000 loan with an interest | |
| rate risk associated with that, and they want to engage in | |
| perhaps a swap to fix that risk. So now they go to a bank with | |
| a 7\1/2\ percent capital requirement. Okay. So the real risk | |
| for them may be just $1,000, the actual full risk. So the | |
| market value is $1,000. The capital for that is about $75, 7\1/ | |
| 2\ percent of that. But we are not even talking about the $75 | |
| on this $100,000 swap. We are talking about the difference | |
| between that being borrowed money and that being the financial | |
| firm's own money. | |
| So what is the difference there? That is actually about | |
| $7\1/2\. So what we are really talking about on a $100,000 swap | |
| is an incremental cost to the bank or to the large financial | |
| firm of basically a ham sandwich downstairs. That is the amount | |
| of money we are actually talking about. That is the profound | |
| impact of the cost that we are worried about being passed on to | |
| the end-users. | |
| Again, the end-user itself isn't posting any margin. It is | |
| not posting any capital. It doesn't have to keep those things. | |
| And those folks were appropriately exempted from the | |
| regulation. | |
| So one thing I want to take a few moments to talk about is | |
| who are the financial firms. Obviously, we have the largest | |
| banks who are familiar with capital and margin requirements | |
| that have applied to them for decades, but we also have the | |
| largest financial services firms. We have the insurance | |
| companies, we have the hedge funds, mutual funds, the futures | |
| commission merchants, we have those folks. I would argue that | |
| actually that bucket is precisely the bucket that these rules | |
| are designed to target, and the reason is AIG, Long-Term | |
| Capital Management, MF Global, those are the firms that we | |
| actually do have to worry about. And for them, margin and | |
| capital rules, some of them may apply, and some of them are not | |
| very familiar with it, and I recognize that. | |
| And then, of course, we have the real end-users, the | |
| farmers cooperatives, the manufacturers, they had nothing to do | |
| with this crisis, and no one agrees that they did. What is | |
| interesting is we are doing our best now, and with your | |
| Committee's great work, making sure that these rules don't | |
| apply to them. | |
| The last point I want to make is something that my | |
| colleagues also referenced with respect to the cross-border | |
| issues. I share the concerns with both mutual recognition and | |
| making sure that our regulators work collaboratively around the | |
| globe. | |
| With respect to whether or not we exempt, or our regulators | |
| cede jurisdiction to others, I would say be very careful. It | |
| was, in fact, the London trading desks of some of the largest | |
| firms that led to some of the large losses, so I would urge | |
| them to be careful. | |
| Again, thank you for inviting me here today, and I look | |
| forward to any questions. | |
| [The prepared statement of Mr. Gellasch follows:] | |
| Prepared Statement of Tyler Gellasch, Founder, Myrtle Makena, LLC, | |
| Homestead, PA | |
| Chairman Conaway, Ranking Member Peterson, Chairman Scott, Ranking | |
| Member Scott, and other Members of the Committee, thank you for | |
| inviting me here today. | |
| Effective derivatives regulation is an incredibly important topic | |
| for our economy, and one in which I have deep interest. A little more | |
| than 7 years ago, I left private law practice and joined the Senate | |
| staff at a time when our country was facing the worst financial crisis | |
| in generations. As counsel to a senior United States Senator who also | |
| chaired the Senate Permanent Subcommittee on Investigations, I had the | |
| privilege of assisting the Senator with investigating the causes of the | |
| crisis and crafting legislation designed to prevent future crises. | |
| Later, I had the privilege of helping regulators carefully implement | |
| that legislation as intended. | |
| I now run a small consulting firm, Myrtle Makena, and also serve as | |
| Executive Director of the Healthy Markets Association, an investor- | |
| focused nonprofit coalition focused on equity market structure issues. | |
| The testimony I give today represents my own views, and not necessarily | |
| those of my association or its members. | |
| The Financial Crisis | |
| This Committee is continuing a conversation that began in earnest | |
| as the world was coming to grips with the worldwide financial meltdown. | |
| Beginning in the fall of 2008, over the course of just a few months, | |
| U.S. regulators began pouring several trillion dollars into the | |
| financial markets to help prop up and save some of the largest | |
| financial firms.\1\ Many people remember the $700 billion Troubled | |
| Asset Relief Program (TARP), which pumped tens of billions of dollars | |
| into AIG, Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, | |
| Morgan Stanley, Wells Fargo, and others.\2\ | |
| --------------------------------------------------------------------------- | |
| \1\ The U.S. Government and regulators used more than a dozen new | |
| and previously existing programs (and more than 21,000 transactions) to | |
| provide trillions of dollars in assistance to U.S. and foreign | |
| financial institutions to promote liquidity and prevent a financial | |
| collapse. That's on top of the FDIC and Treasury Department extending | |
| guarantees to trillions of dollars in assets for a range of | |
| institutions and markets. See, e.g., Press Release, Department of the | |
| Treasury, Treasury Announces Temporary Guarantee Program for Money | |
| Market Funds (Sept. 29, 2OO8), available at http://www.treasury.gov/ | |
| press-center/press-releases/Pages/hp1161.aspx; see also, Temporary | |
| Liquidity Guarantee Program: Fourth Quarter 2010, FDIC. | |
| \2\ See, https://www.treasury.gov/initiatives/financial-stability/ | |
| reports/Pages/TARP-Housing-Transaction-Reports.aspx. | |
| --------------------------------------------------------------------------- | |
| But why did AIG \3\ and the banks need rescuing in the first place? | |
| What went wrong? How could these enormous firms, with hundreds of | |
| billions of dollars on their balance sheets--and billions more off | |
| their balance sheets--suddenly teeter on the brink of collapse? The | |
| answer is why we're here: margin and capital. Or more importantly, it | |
| was the lack of them. | |
| --------------------------------------------------------------------------- | |
| \3\ Other non-bank financial firms also suffered enormous losses. | |
| Some were bailed out (directly or indirectly), while others were not. | |
| For example, Lehman Brothers Holdings Inc., with more than 209 | |
| registered subsidiaries spanning 21 countries, was not bailed out, | |
| leaving courts around the world wrestling with how to apply more than | |
| 80 different jurisdictions' insolvency laws to untangle more than | |
| 900,000 outstanding derivatives contracts. Michael J. Fleming and Asani | |
| Sarkar, The Failure Resolution of Lehman Brothers, Federal Reserve Bank | |
| of New York Economic Policy Review (Dec. 2014), available at https:// | |
| www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf. | |
| --------------------------------------------------------------------------- | |
| It is worth recalling how that happened. Beginning in the 1990s, | |
| the swaps market grew rapidly as a remarkably efficient way to transfer | |
| risk between parties.\4\ And while many people appreciate that a | |
| mortgage crisis precipitated the financial crisis, what most people | |
| don't know (or at least didn't until The Big Short) was how bad | |
| mortgages on Main Street actually helped cause a financial crisis on | |
| Wall Street. That happened through big bets, particularly in swaps, and | |
| lack of margin and capital to back up those bets.\5\ | |
| --------------------------------------------------------------------------- | |
| \4\ These efforts were aided by increased financial engineering, | |
| standardization of terms and basic contracts (such as the development | |
| of the ISDA Master Agreement, Credit Support Annex, and CDS Model), and | |
| deregulation. See also Futures Trading Practices Act of 1992 and the | |
| Commodity Futures Modernization Act of 2000. | |
| \5\ For example, suppose I borrow $10 from Lending Corp and promise | |
| to pay it back $11 next year. Lending Corp might be worried that I | |
| won't pay it back. So Lending Corp could buy insurance, called a credit | |
| default swap, from Swap Corp. This swap may cost Lending Corp 25 . Swap | |
| Corp collects 25 today, and if I don't pay back Lending Corp in 1 | |
| year, Swap Corp pays Lending Corp $11. Either way, Lending Corp should | |
| make a 7.5% return on its loan to me ($11-$0.25). That seems reasonable | |
| enough. | |
| Now suppose ten other firms all buy the same ``insurance'', even if | |
| they don't have any interest in my repaying Lending Corp? They're just | |
| speculating on me repaying Lending Corp. Each time, Swap Corp will | |
| dutifully collect their 25 , giving it $2.25. | |
| If I repay Lending Corp, Lending Corp gets its $11, and Swap Corp | |
| will keep its $2.25 in payments. But what if I don't repay Lending | |
| Corp? Swap Corp will suddenly owe $110. Unless Swap Corp has | |
| significant backup capital, Swap Corp may not have enough money to pay | |
| up. After all, it only took in $2.25. And what about Lending Corp and | |
| the other ten firms, who may now be relying on that $110 to pay their | |
| bills? There's the potential for chaos. | |
| Swap out the name Swap Corp from my example and call it AIG. In the | |
| run up to the crisis, AIG sold this type of default insurance on | |
| billions of dollars of mortgage-related products. It dutifully | |
| collected the quarters, but when it came time to pay up the dollars, it | |
| didn't have the money. | |
| This highly stylized example is also overly conservative. In many | |
| instances, the party selling protection (e.g., AIG), charged | |
| significantly less than the 2.5% suggested above. This premium was | |
| often sold as basis points, often settling well-below 1%. The rapid | |
| rise in perceived risk of default may often lead to a rapid rise in CDS | |
| premium rates. Still, the overall rates were below what one might | |
| suggest. For example, during the Greek debt crisis days of 2010, 5 year | |
| CDS on Greek sovereign debt jumped to a little over 4%. The impacts of | |
| these changes, however, are often dramatic on the borrower, as the | |
| increased CDS prices are often priced into the sales of new debt. | |
| --------------------------------------------------------------------------- | |
| The Senate Permanent Subcommittee on Investigations conducted a | |
| years-long bipartisan investigation into figuring out how bad mortgages | |
| turned into a global financial crisis, and wrote up its findings in a | |
| comprehensive staff report.\6\ So too did the Financial Crisis Inquiry | |
| Commission.\7\ Other Congressional committees, prosecutors and | |
| regulators also researched the issues. They all found that financial | |
| firms had created financial instruments linked to mortgages that | |
| increased the level of risk and leverage to financial firms--in | |
| particular, because of inadequate margin and capital. | |
| --------------------------------------------------------------------------- | |
| \6\ Wall Street and the Financial Crisis: Anatomy of a Financial | |
| Collapse, Homeland Security and Government Affairs, Permanent | |
| Subcommittee on Investigations, Majority and Minority Staff Report, | |
| (Apr. 13, 2011) (``Senate Financial Crisis Report''). | |
| \7\ Final Report of the National Commission on the Causes of the | |
| Financial and Economic Crisis in the United States, Financial Crisis | |
| Inquiry Commission, (2011), available at https://www.gpo.gov/fdsys/pkg/ | |
| GPO-FCIC/pdf/GPO-FCIC.pdf. | |
| --------------------------------------------------------------------------- | |
| Because these financial instruments were traded with so little | |
| margin and the firms had so little capital, once any doubt was raised | |
| about the ability of the other side to pay up, it immediately imperiled | |
| the liquidity--and quickly, the solvency--of the entire system. | |
| In many ways, what the government did in 2008 and early 2009 was | |
| funnel money to all of the major financial firms so they could make | |
| good on their bets. For AIG, this meant that taxpayers effectively gave | |
| AIG enough money to post margin and pay its bets,\8\ while also buying | |
| out some of the bets directly.\9\ Thus, AIG's collapse may be thought | |
| of as a poster child for what happens when there are inadequate | |
| counterparty credit protections--again, margin and capital.\10\ | |
| --------------------------------------------------------------------------- | |
| \8\ Press Release, AIG Discloses Counterparties to CDS, GIA, and | |
| Securities Lending Transactions, American International Group, Inc., | |
| March 15, 2009, (``AIG Press Release''), Attachment A. For example, | |
| after receiving billions in TARP funds in September 2008, AIG used a | |
| whopping $52 billion to support trading done by its London-based | |
| Financial Products group. Of that, it funneled $22.4 billion to its | |
| counterparties as collateral for CDS trades and another $12.1 billion | |
| paying back municipalities. That doesn't count the $43.7 billion used | |
| to pay back firms (largely banks) with securities lending deals, nor | |
| the $29.6 billion a Federal Reserve-sponsored financing unit, Maiden | |
| Lane III, used to pay AIG and its counterparties for its CDS contracts. | |
| AIG Press Release. For just the CDS collateral bets, AIG paid out as | |
| CDS collateral $4.1 billion to Societe Generale, $2.6 billion to | |
| Deutsche Bank, $2.5 billion to Goldman Sachs, and $1.8 billion to | |
| Merrill Lynch. AIG Press Release, Attachment A. | |
| \9\ See, e.g., AIG Press Release, Attachment B (reflecting payments | |
| of $6.9 billion to Societe Generale, $5.6 billion to Goldman Sachs, | |
| $3.1 billion to Merrill Lynch, and $2.8 billion to Deutsche Bank). | |
| \10\ As Senator Chris Dodd stated in early 2010, ``But what was | |
| once a way for companies to hedge against sudden price shocks has | |
| become a profit center in and of itself, and it can be a dangerous one | |
| as well, when dealers and other large market participants don't hold | |
| enough capital to back up their risky best and regulators don't have | |
| information about where the risks lie. AIG was a classic example, of | |
| course, where that happened.'' 156 Cong. Rec. S5828-01 (July 14, 2010) | |
| (statement of Hon. Chris Dodd, U.S. Senator). Interestingly, AIG was | |
| warned before the collapse that its bets were bad. The model for Ryan | |
| Gosling's character from The Big Short, Greg Lippmann, told Senate | |
| investigators that he spent hundreds of hours trying to convince AIG to | |
| stop buying RMBS and CDOs, and stop selling single name credit default | |
| swaps (CDS) on those securities. Senate Financial Crisis Report, at | |
| 343. | |
| --------------------------------------------------------------------------- | |
| Regulatory Response to Financial Crisis--Increasing Margin and Capital | |
| for Derivatives Trading | |
| Almost immediately, governments around the world recognized that | |
| swaps and those who trade a significant amount of them needed to be | |
| better regulated. In September 2009, the G20 Summit in Pittsburgh | |
| reflected a commitment by world leaders to strengthen the international | |
| financial regulatory system by, amongst other things: | |
| <bullet> Building high quality capital and mitigating pro- | |
| cyclicality; | |
| <bullet> Improving over-the-counter derivatives markets, including by | |
| requiring ``non-centrally cleared contracts . . . to higher | |
| capital requirements''; and | |
| <bullet> Addressing cross-border resolutions and systemically | |
| important financial institutions by year-end 2010.\11\ | |
| --------------------------------------------------------------------------- | |
| \11\ G20 Leaders Statement: The Pittsburgh Summit (Sept. 2009). | |
| By that time, we in the United States were already working on | |
| parallel legislation to make many of those enhancements. The key | |
| components to reform, now embodied by the Dodd-Frank Act, were | |
| --------------------------------------------------------------------------- | |
| generally: | |
| <bullet> Imposing a comprehensive reporting regime to ensure that | |
| regulators (and firms) would have a better understanding of the | |
| number, scope, and nature of derivatives trades; | |
| <bullet> Reducing counterparty credit risks, by increasing clearing, | |
| margin and capital requirements; | |
| <bullet> Reducing systemic risks by enhancing capital requirements; | |
| and | |
| <bullet> Enhancing market integrity by improving business conduct, | |
| increasing transparency, and expanding authorities to police | |
| market abuses. | |
| Each of these areas is complex, and the details have taken time to | |
| iron out. For example, one area I know of interest to many of you is | |
| how the supplemental leverage ratio may impact liquidity for some end- | |
| users. In the same vein, Title III of the Terrorism Risk Insurance | |
| Program Reauthorization Act of 2015 exempted certain swaps from margin | |
| requirements.\12\ Making sure the true ``end-users'' are not unduly | |
| negatively impacted by the new rules is an important goal. That said, I | |
| generally think the current rules do a very good job of that. | |
| --------------------------------------------------------------------------- | |
| \12\ This mandate was implemented as an interim final rule, which | |
| became effective on April 1, 2016. See Margin Requirements for | |
| Uncleared Swaps for Swap Dealers and Major Swap Participants, Commodity | |
| Futures Trading Commission, 81 Fed. Reg. 636 (Jan. 6, 2016). | |
| --------------------------------------------------------------------------- | |
| Now, after 6 years of discussions, proposals, and court battles, | |
| many of the rules are just now being finalized.\13\ In one of the most | |
| important rulemakings completed since the financial crisis, the U.S. | |
| Prudential Regulators and the CFTC have recently finalized margin | |
| rules.\14\ While some aspects of the rules have been practically | |
| mandated for years through safety and soundness supervision, the | |
| provisions technically are coming on-line over the next year or so. | |
| --------------------------------------------------------------------------- | |
| \13\ Foreign regulators are engaged in a similarly slow process, as | |
| many of their rules are also not yet in effect, and may be yet again | |
| delayed beyond 2017. Silla Brush and John Detrixhe, EU Weighs Softer | |
| Derivatives Rules as MiFID Delay Bogs Down, Bloomberg, Apr. 16, 2016. | |
| \14\ Margin and Capital Requirements for Covered Swap Entities, | |
| Office of the Comptroller of the Currency, Treasury, Board of Governors | |
| of the Federal Reserve System, Federal Deposit Insurance Corporation, | |
| Farm Credit Administration, and the Federal Housing Finance Agency, 80 | |
| Fed. Reg. 74840 (Nov. 30, 2015); see also Margin Requirements for | |
| Uncleared Swaps for Swap Dealers and Major Swap Participants, Commodity | |
| Futures Trading Commission, 81 Fed. Reg. 636 (Jan. 6, 2016). In | |
| general, the Prudential Regulators (e.g., the Board of Governors of the | |
| Federal Reserve System) are setting the capital and margin rules for | |
| the swap dealers and major swap participants under their purview, and | |
| the markets regulators (e.g., the CFTC) are setting the same rules for | |
| the swap dealers and major swap participants under their purview. These | |
| rules are not the same, nor would necessarily I expect them to be, | |
| given the different regulators and regulated entities. | |
| --------------------------------------------------------------------------- | |
| Role of Margin and Capital Requirements | |
| Ensuring swaps transactions have sufficient margin and capital is | |
| at the center of the reform effort--precisely because those who lived | |
| through it saw how dangerous the lack thereof was to the system.\15\ | |
| But why is that? Why do margin and capital play such an important role | |
| in the experts' approach to addressing the regulatory failings of the | |
| 2008 financial crisis? In no small part, it is because they address the | |
| systemic breakdowns of 2008. Both serve the same ultimate goal of | |
| ensuring that parties are able to meet their financial obligations, but | |
| they each go about achieving their objectives in different ways. | |
| --------------------------------------------------------------------------- | |
| \15\ See G20 Leaders Statement: The Pittsburgh Summit (Sept. 2009). | |
| --------------------------------------------------------------------------- | |
| For the benefit of those watching at home, margin is just | |
| collateral. Just like the collateral of the home reduces the bank's | |
| risk of the borrower's default on a mortgage, so too does margin | |
| directly reduce the risk that the trading counterparty won't pay--often | |
| called counterparty credit risk. | |
| Most commonly, this margin is broken into two components--initial | |
| and variation. The initial margin is what the participants pay at the | |
| beginning of the relationship. The variation margin changes as the | |
| values of the relevant trading positions change, such as due to the | |
| regular fluctuations of our many markets. As a party looks increasingly | |
| likely to pay up, the margin could and should increase to reflect that, | |
| because if it did not, the other party would be more exposed | |
| financially to the risk of its counterparty not paying--again, its | |
| counterparty credit risk.\16\ However, margin often comes with a direct | |
| cost to the party required to post it. Margin is typically in the form | |
| of cash, Treasuries, or other extremely liquid, stable value | |
| securities. This provides a stable and known value, but it also | |
| provides effectively no return for the party posting it. It isn't able | |
| to help them right now, nor is it likely to grow much in value. This | |
| often leads many firms to resist having to post margin. | |
| --------------------------------------------------------------------------- | |
| \16\ Here, for simplicity, I treat both initial and variation | |
| margin collectively as margin. However, it should be noted that the | |
| ratio of obligations between the two may be significant. And there is | |
| no clear-cut ``right'' mix. Policymakers may elect to require lower | |
| initial margin in return for requiring greater sensitivity and higher | |
| potential variation margin. This comes with increased variability in | |
| margin costs for participants. Conversely, increasing initial margin | |
| may be accompanied by decreased variation margin requirements. This may | |
| stabilize margin level for participants, but may also result in higher | |
| overall margin levels and costs. | |
| --------------------------------------------------------------------------- | |
| That said, because of its efficacy at reducing counterparty credit | |
| risk, margin has been a hallmark of capital and derivatives markets for | |
| nearly a century. Why? Because, at its most basic form, margin enables | |
| market liquidity in a highly efficient way. By posting margin, multiple | |
| parties can trade with each other without massive amounts of due | |
| diligence, a costly and time consuming endeavor. Put another way, | |
| without margin, parties are trading with each other only to the extent | |
| that they fully trust the other party will pay them back, even if they | |
| go bust.\17\ | |
| --------------------------------------------------------------------------- | |
| \17\ Notably, derivatives enjoy highly preferential treatment under | |
| the bankruptcy code, making them far more likely to be paid in the | |
| event of bankruptcy than other types of liabilities, such as pensions | |
| (or even secured creditors). This treatment may both incentivize the | |
| use of derivatives, but it also may lead to sub-optimal social or | |
| financial outcomes, something that U.S. Senator Elizabeth Warren has | |
| highlighted when proposing to repeal this treatment. See, e.g., | |
| Interview of Elizabeth Warren, U.S. Senator, C-SPAN, Nov. 13, 2013, | |
| available at http://www.c-span.org/video/?c4473182/senator-warren- | |
| derivatives-seniority-bankruptcy. For a review of some of the economic | |
| impacts of this special treatment, see Patrick Bolton and Martin | |
| Oehmke, Should Derivatives Be Privileged in Bankruptcy?, Journal of | |
| Finance (2015), available at http://papers.ssrn.com/sol3/ | |
| papers.cfm?abstract_id=2023227. Preferential treatment notwithstanding, | |
| some might also say that the 2008 financial crisis proved that the | |
| ultimate guarantors of those private and implicit promises are the | |
| American taxpayer. | |
| --------------------------------------------------------------------------- | |
| In the over-the-counter (OTC) markets, the amount of collateral | |
| required and the quality of collateral has evolved significantly over | |
| the past several years. Before the crisis, financial firms, of course, | |
| would regularly pledge collateral, but the amount was typically | |
| relatively low. Many non-financial firms previously were able to trade | |
| without pledging any collateral (the increased risk was just priced | |
| into the contract). To the extent collateral was pledged, it could be | |
| working assets. | |
| Not requiring margin is effectively an embedded loan. There is | |
| nothing inherently wrong with embedding a loan in a trading | |
| transaction, but we should be clear about what it is in practice: the | |
| party not requiring margin is taking the risk that it will not get paid | |
| back. It is reasonable to expect that a financial firm in most | |
| circumstances will be able to manage the risks of extending that type | |
| of credit to an ordinarily sized, non-financial end-user. That is | |
| essentially their business, after all. Moreover, those trades make up a | |
| relatively modest part of the overall trading going on in these | |
| markets. | |
| Since the crisis, and in response to regulatory efforts around the | |
| world, an increasing percentage of derivatives trades are centrally | |
| cleared. As centralized clearing has taken root, the total collateral | |
| used to support non-cleared derivatives has fallen.\18\ Non-financial | |
| firms still generally aren't required by regulators to post margin or | |
| maintain specific capital. | |
| --------------------------------------------------------------------------- | |
| \18\ International Swaps and Derivatives Association, Inc., ISDA | |
| Margin Survey 2015, at 3 (Aug. 2015) (reflecting a decrease from $5.34 | |
| trillion in 2013 to $5.01 trillion in 2014). | |
| --------------------------------------------------------------------------- | |
| Overall, the amount of collateral and the quality of the collateral | |
| required across the system has generally increased, in part driven by | |
| renewed oversight from banking supervisors and in part driven by market | |
| demands on counterparties, including through central clearinghouses. | |
| Thus, between the increase in centralized clearing and the increase in | |
| amount and quality of collateral in non-cleared trades, the risk that a | |
| party will be unable to pay up on its trade is today much lower than it | |
| was just a few years ago. | |
| Capital, by contrast, indirectly reduces counterparty credit risk | |
| by ensuring that a firm generally has enough assets to pay all of its | |
| reasonably foreseeable obligations. This is particularly important for | |
| a derivatives dealer, such as a bank or firm like AIG, since this | |
| protects from concentration risks that trade-specific margin | |
| requirements may not adequately address. Here, adequate capital | |
| requirements help supplement margin rules. If margin is the first line | |
| of defense, capital is the last. | |
| Capital also has one big advantage over margin. Unlike margin, | |
| which typically produces little or no financial return for the posting | |
| party, capital is not pledged away, nor is it necessarily in super- | |
| stable, super-low yielding assets. It can, and often will, provide a | |
| modest return to the holder. | |
| Disparate Impacts of Margin and Capital Requirements on Different Types | |
| of Firms | |
| Before specifically addressing some of the concerns about market | |
| impacts of margin and capital rules, I want to acknowledge the distinct | |
| differences between firms engaged in swaps trading, and how margin and | |
| capital requirements might impact them differently. | |
| First, there are the largest banks and bank-affiliated firms. For | |
| these firms, financial assets are relatively easy to come by. They are, | |
| after all, financial institutions with relatively low borrowing costs | |
| and often-excellent access to a wide array of assets.\19\ They also | |
| have complex oversight and risk management systems (including | |
| sophisticated risk modeling systems) \20\ that allow them to monitor | |
| and manage their cash-flow requirements. In addition, they have | |
| historically conditioned to having capital and margin requirements. For | |
| these firms, incremental increases on margin or capital requirements | |
| are not likely to have profound impacts on how they do business. | |
| Changing margin and capital rules can, however, impact their overall | |
| profitability to the extent that it may restrict their leverage and | |
| increase costs for accessing high-quality assets. | |
| --------------------------------------------------------------------------- | |
| \19\ In response to the financial crisis, however, regulators | |
| around the world, particularly banking and Prudential Regulators, have | |
| taken steps to improve the quality and quantity of capital held by | |
| financial firms. | |
| \20\ Bank regulatory capital requirements, and compliance with | |
| them, have in recent years become increasingly complex, and model- | |
| driven. However, the efficacy of these models to provide meaningful | |
| evaluations of risk is nevertheless limited in many respects. For | |
| example, even basic metrics, such as Value-at-Risk, may be | |
| significantly altered by revisions to how the calculations are made, or | |
| the values of the inputs. For a detailed case study of potential | |
| failures of risk modeling, please see JPMorgan Chase Whale Trades: A | |
| Case History of Derivatives Risks and Abuses, Homeland Security and | |
| Government Affairs, Permanent Subcommittee on Investigations, Majority | |
| and Minority Staff Report, at 165-213, (Mar. 15, 2013). | |
| --------------------------------------------------------------------------- | |
| Next, outside of the handful of the mega-banks, there are the other | |
| financial firms. These firms are likely regulated by the Commodity | |
| Futures Trading Commission and the Securities and Exchange Commission. | |
| They have traditionally operated under much less proscriptive capital | |
| regulatory regimes than banks, a fact that was highlighted by the | |
| collapses of Lehman Brothers, MF Global, and Bear Stearns. In addition, | |
| depending upon their business, these firms may not have significant | |
| amounts of liquid assets readily available for posting margin. Of | |
| course, some of these firms are deeply involved in swaps trading, and | |
| may have material swaps exposures, while most do not. Some are very | |
| familiar with posting liquid assets as margin while others are not. | |
| Further, while some of these firms may have sophisticated trade and | |
| risk management systems, including complex modeling capabilities, most | |
| do not.\21\ | |
| --------------------------------------------------------------------------- | |
| \21\ One of the key issues facing a firm under U.S. rules is | |
| determining whether it has ``material swap exposures.'' However, I | |
| understand that some non-bank financial firms may have difficulty in | |
| making such a determination without significant revisions to their | |
| oversight systems or outside assistance. | |
| --------------------------------------------------------------------------- | |
| Finally, we have the non-financial firms. They include farmers, | |
| agricultural firms, manufacturers, and thousands of other firms that we | |
| might think of as the true ``end-users''. If properly defined, these | |
| firms comprise a very small percentage of overall swaps trading. And | |
| for them, margin or capital rules would seem unnecessary, | |
| inappropriate, and unduly burdensome. In addition, many do not | |
| typically have liquid financial assets available to use for posting | |
| margin, nor do they typically operate under a concept of regulatory | |
| capital. Imposing these limitations may have profoundly negative | |
| impacts on their operations. That's why Congress and regulators have | |
| already generally exempted these firms from the margin and capital | |
| requirements. | |
| Regulations, Liquidity, and Costs | |
| Many have worried that banking and derivative regulations may | |
| reduce the number of counterparties, decrease liquidity, and increase | |
| costs for market participants.\22\ To date, I have seen no evidence of | |
| margin and capital requirements disrupting markets or increasing costs | |
| for ``end-users.'' | |
| --------------------------------------------------------------------------- | |
| \22\ It is important to note that ``liquidity'' has no precise | |
| definition. For my purposes, I define it as the ``ability to rapidly | |
| execute sizable securities transactions at a low cost and with a | |
| limited price impact.'' Global Financial Stability Report, | |
| International Monetary Fund, at 53 (Oct. 2015) (``IMF Global Financial | |
| Stability Report''), available at https://www.imf.org/External/Pubs/FT/ | |
| GFSR/2015/02/pdf/text.pdf. | |
| --------------------------------------------------------------------------- | |
| Of course, concerns about the potential impacts of new rules on | |
| liquidity and costs are equally present in a broad swath of financial | |
| markets, including Treasuries, corporate bonds, and equities.\23\ The | |
| results of the limited studies so far have been encouraging. | |
| --------------------------------------------------------------------------- | |
| \23\ For example, in the Omnibus appropriations bill this past | |
| year, Congress directed the Securities and Exchange Commission's | |
| Division of Economic and Risk Analysis to provide Congress with a | |
| report on the impact of the Volcker Rule and other regulations, such as | |
| Basel III, on ``(1) access to capital for consumers, investors, and | |
| businesses, and (2) market liquidity, to include U.S. Treasury markets | |
| and corporate debt.'' As one of the drafters of both the Volcker Rule | |
| legislation and the multi-agency rule to implement it, I will be | |
| interested in this study's findings. | |
| --------------------------------------------------------------------------- | |
| Despite dire prognostications, these reforms seem to not be | |
| negatively impacting liquidity. According to the International Monetary | |
| Fund, liquidity measures in the bond markets in the U.S., Europe, and | |
| even emerging market economies are generally better than 2007 | |
| levels.\24\ For example, when experts at the Federal Reserve Bank of | |
| New York looked late last year at the corporate bond markets, they | |
| found that liquidity is better than it has been at any time since the | |
| financial crisis.\25\ Bid-ask spreads are tighter than they have been | |
| in years and trading price impacts are way down.\26\ All while dealer | |
| inventories have fallen.\27\ So the sky hasn't exactly fallen--unless | |
| you're a bank with declining inventories and trading revenues. Even | |
| then, decreased bank revenues may be more of the results of stable | |
| asset prices, a near zero interest rate environment, and other non- | |
| regulatory factors.\28\ | |
| --------------------------------------------------------------------------- | |
| \24\ IMF Global Financial Stability Report, at 58. | |
| \25\ Tobias Adrian, et. al, Has Corporate Bond Liquidity Declined?, | |
| Liberty Street Blog, Federal Reserve Bank of New York, Oct. 5, 2015, | |
| available at http://libertystreeteconomics.newyorkfed.org/2015/10/has- | |
| us-corporate-bond-market-liquidity-deteriorated.html#.Vx2DtHopko0 | |
| (looking at corporate bond markets). | |
| \26\ Id. | |
| \27\ Id. | |
| \28\ IMF Global Financial Stability Report, at 67 (``Risk appetite | |
| and funding liquidity seem to be the main drivers [of bond market | |
| liquidity], but indirectly the results point to an important role for | |
| monetary policy.''). | |
| --------------------------------------------------------------------------- | |
| Coming back to the swaps world, despite dire warnings of the demise | |
| of all liquidity and skyrocketing costs, to date, there doesn't seem to | |
| be much of any impact on the real ``end-users''--the farmers and | |
| manufacturers. Indeed, a recent study by the Bank of England found that | |
| enhanced swaps requirements from Dodd-Frank, including central | |
| clearing--which itself includes margin and certain other requirements | |
| on members--as well as trades through swap execution facilities, | |
| resulted in enhanced market liquidity and a significant reduction in | |
| execution costs.\29\ | |
| --------------------------------------------------------------------------- | |
| \29\ Evangelos Benos et. al, Centralized trading, transparency and | |
| interest rate swap market liquidity: evidence from the implementation | |
| of the Dodd-Frank Act, Staff Working Paper No. 580, (January 2016), | |
| available at http://www.bankofengland.co.uk/research/Documents/ | |
| workingpapers/2016/swp580.pdf. (finding significant cost savings in the | |
| interest rate swaps markets as a result of these changes). | |
| --------------------------------------------------------------------------- | |
| Additional facts bear out the story that effective derivatives | |
| regulation is beginning to work without imposing new negative | |
| ramifications on the markets. | |
| First, the OTC derivatives market is still enormous. According to | |
| the Bank of International Settlements, the total notional amount of OTC | |
| derivatives outstanding at the end of June 2015 was $553 trillion,\30\ | |
| about 79% of which involved interest rate derivatives.\31\ The gross | |
| market value of these positions was $15.5 trillion.\32\ | |
| --------------------------------------------------------------------------- | |
| \30\ Bank of International Settlements, OTC derivatives statistics | |
| at end-June 2015, at 1 (Nov. 2015), available at http://www.bis.org/ | |
| publ/otc_hy1511.pdf. | |
| \31\ Id., at 2. | |
| \32\ Id., at 1. | |
| --------------------------------------------------------------------------- | |
| Second, true ``end-users'' are almost entirely exempted from new | |
| derivatives rules, including the margin and capital requirements. | |
| Third, to date, I have seen no credible study demonstrating | |
| increased costs or burdens on ``end-users'' resulting from these | |
| regulations. The writing has been on the wall--even if not the final | |
| rules--for more than 6 years. Margin and capital have been increasing | |
| for years now, and yet end-users still seem to be able to trade what | |
| they need.\33\ | |
| --------------------------------------------------------------------------- | |
| \33\ I note that much of the single name CDS market remains largely | |
| stalled. That said, to the extent that the products served a valuable | |
| purpose, I expect there to be continued use of other financial products | |
| to hedge credit risks, as well as continued efforts to restart the CDS | |
| products. The IntercontinentalExchange's buyside-centric CDS trading | |
| platform announced last August is a timely example. Mike Kentz, ICE | |
| plans single-name CDS platform, Reuters, Aug. 31, 2015, available at | |
| http://www.reuters.com/article/markets-derivatives-cds- | |
| idUSL1N1161A520150831. In fact, in a headline that echoes from the run- | |
| up to the financial crisis, it was recently reported that due to | |
| ``tightness'' in the availability of some asset-backed securities, some | |
| investors may be increasingly turning to credit derivatives. See, Joy | |
| Wiltermuth, Investors Turn to CMBS derivatives for liquidity, Reuters, | |
| Apr. 22, 2016, available at http://www.reuters.com/article/usa- | |
| corpbonds-abs-idUSL5N17N4TL (reflecting that total notional values in | |
| derivative CMBX contracts increased from $141 billion to $181 billion | |
| from 2015 to 2016). | |
| --------------------------------------------------------------------------- | |
| Fourth, the mix of firms providing swaps trading services has been | |
| changing for a long time before the advent of new regulations. The | |
| largest banks unquestionably have traditionally enjoyed a huge | |
| advantage in the trading markets, with extremely low funding costs, | |
| large balance sheets, and sophisticated trading and risk management | |
| operations. Those advantages have helped drive consolidation here, just | |
| as it has in other financial services areas--and it is not unique to | |
| derivatives trading. | |
| How margin and capital rules will impact that consolidation, | |
| however, remains unclear. I understand this Subcommittee has heard from | |
| some non-bank financial firms that new rules--particularly for capital | |
| requirements--may unnecessarily restrict their ability to engage in | |
| swaps trading.\34\ On the other hand, some large banks themselves and | |
| outside consultants have started modeling out whether and how they | |
| might be better off spinning out some or all of their derivatives | |
| trading operations to avoid the new rules. | |
| --------------------------------------------------------------------------- | |
| \34\ See, e.g., CFTC Reauthorization, Before the House Committee on | |
| Agriculture, Subcommittee on Commodity Exchanges, Energy and Credit, | |
| 114th Cong. (2015) (statement of Mark Maurer, Chief Executive Officer, | |
| INTL FCStone Markets, LLC), available at http://agriculture.house.gov/ | |
| uploadedfiles/maurer_testimony.pdf. | |
| --------------------------------------------------------------------------- | |
| To me, it is at least worth exploring whether isolating derivatives | |
| trading operations in separately capitalized firms that are outside of | |
| the taxpayer-protected banks could be beneficial for the markets and to | |
| removing an implicit taxpayer subsidy for the largest participants. | |
| Nevertheless, I suspect the key funding and capital advantages of the | |
| largest banks will ultimately prevail as they have since well before | |
| the crisis. | |
| In sum, the new rules don't seem to be changing much other than | |
| simply imposing moderately enhanced protections for counterparties at | |
| the cost of moderately higher margin and capital for the major players | |
| in these markets. | |
| International Regulatory Coordination and Cross-Border Regulation | |
| As the financial crisis unfolded, regulators around the world | |
| immediately recognized that swaps regulation needed to be effectively | |
| coordinated across national boundaries. | |
| AIG was a New York-based firm whose London-based Financial Products | |
| unit brought down its worldwide operations. But this was not the first | |
| or the last U.S.-based firm to suffer from financial troubles resulting | |
| from trading done abroad. In fact, offshore derivatives trading has | |
| played key roles in collapses ranging from Enron to Lehman Brothers. | |
| And in 2012, it was the London-based trading group of JPMorgan Chase | |
| using ``excess deposits'' to trade illiquid credit derivatives that | |
| cost it approximately $6.2 billion. In each case, the U.S. firm was on | |
| the hook for losses. | |
| Regulators have been acutely aware of these instances, and the | |
| risks of regulatory gaps and arbitrage. The Pittsburgh Summit laid out | |
| the blueprint for the G20. In the United States, Congress empowered the | |
| regulators by saying that they could regulate swaps trading that has | |
| ``a direct and significant connection with activities in, or effect on, | |
| commerce in the United States.'' \35\ This broad jurisdictional | |
| authorization was deemed critical, because, as a CFTC Chief Economist | |
| later put it, ``risks taken by foreign affiliates, subsidiaries, and | |
| branches of U.S. parent companies are usually borne by the U.S. | |
| parent.'' \36\ | |
| --------------------------------------------------------------------------- | |
| \35\ Dodd-Frank Wall Street Reform and Consumer Protection Act, | |
| Pub. L. 111-203, 722, (2010). | |
| \36\ Declaration of Sayee Srinivasan, Chief Economist, Commodity | |
| Futures Trading Commission, Mar. 14, 2014 (cited in Securities Industry | |
| and Financial Markets Association, et. al, v. CFTC, Civ. N. 13-1916, 5 | |
| (Sept. 16, 2013), available at https://secure.fia.org/downloads/ | |
| SIFMAvCFTCOpinion.pdf). | |
| --------------------------------------------------------------------------- | |
| The creation of artificial jurisdictional divides between different | |
| international regulators poses one of the greatest risks to effective | |
| oversight of these markets. The largest financial firms have dozens, if | |
| not hundreds, of affiliated entities around the world, all designed to | |
| support the overall business. If a firm can avoid capital requirements | |
| or margin rules by simply shifting its trading, technology, or basic | |
| reporting structure to another jurisdiction, it may likely do it. But | |
| the risks may still remain where they were before. Policymakers and | |
| regulators in the United States should be cautious about exempting | |
| foreign branches or affiliates of U.S.-based firms from any of our | |
| rules, but margin and capital in particular.\37\ | |
| --------------------------------------------------------------------------- | |
| \37\ U.S. regulators have proposed to link application of many | |
| aspects of the Dodd-Frank-related reforms to the presence or absence of | |
| a ``guarantee.'' See, e.g., Margin Requirements for Uncleared Swaps for | |
| Swap Dealers and Major Swap Participants--Cross-Border Application of | |
| the Margin Requirements, Commodity Futures Trading Commission, 80 Fed. | |
| Reg. 41376 (July 14, 2014). Legislators and experts have long expressed | |
| concerns that this could easily lead to the ``de-guaranteeing'' of | |
| swaps, while not changing any of the fundamental relationships between | |
| affiliated entities. See, e.g., Letter from Jeff Merkley, U.S. Senator, | |
| et. al, to Hon. Gary Gensler, Chairman, CFTC, et. al, July 3, 2013, | |
| available at https://www.merkley.senate.gov/news/press-releases/ | |
| senators-urge-cftc-sec-to-close-major-swaps-loophole-and-prevent- | |
| bailouts-from-implied-us-guarantees-on-swaps; see also Letter from | |
| Americans for Financial Reform to Hon. Tim Massad, Chairman, Commodity | |
| Futures Trading Commission, and Mary Jo White, Chair, Securities and | |
| Exchange Commission, Nov. 25, 2014, available at http:// | |
| ourfinancialsecurity.org/wp-content/uploads/2014/11/De-Guaranteeing- | |
| Letter1.pdf. The CFTC sought to address some of these risks by | |
| finalizing guidance on its definition of ``U.S. person'' in July 2013. | |
| Interpretive Guidance and Policy Statement Regarding Compliance With | |
| Certain Swap Regulations, Commodity Futures Trading Commission, 78 Fed. | |
| Reg. 45292 (July 26, 2013). These risks could also be more effectively | |
| addressed through the imposition of appropriate margin requirements for | |
| trades done by foreign affiliates. | |
| --------------------------------------------------------------------------- | |
| To date, the U.S. regulators have been extremely active in | |
| collaborative international efforts to impose largely similar | |
| derivatives oversight regimes around the world. | |
| U.S. policymakers and regulators should continue the work, and the | |
| recent mutual recognition determination is a great step forward. | |
| However, I would strongly recommend against further delaying | |
| implementation of critical reforms on the grounds of imposing rules | |
| only where there may be complete international consensus. Foreign | |
| regulators are no more immune to lobbying efforts from the largest | |
| financial firms than those in the U.S. And we must be cognizant that | |
| multinational firms may seek to play domestic and foreign regulators | |
| off each other. | |
| Last, while different regimes may be similar, they are not | |
| identical. While some regulators may focus heavily on margin, others | |
| may focus more on capital. Some regimes place greater emphasis on | |
| reporting requirements than others. This is natural, as it is within | |
| our fifty states to see differences in any number of regulatory areas. | |
| Path Forward | |
| U.S. regulators and policymakers should not forget the lessons of | |
| the past decade, where inadequate regulation of derivatives blew whale- | |
| sized holes through the balance sheets of some of the largest financial | |
| firms in the world, forcing regulators and U.S. taxpayers to step into | |
| the markets with trillions of dollars just to save the world's | |
| economies. | |
| It seems only fitting that, in the aftermath, regulators have | |
| worked together to develop comprehensive regulatory regimes to: | |
| <bullet> Improve reporting of derivatives so firms and regulators can | |
| better understand their exposures and risks; | |
| <bullet> Reduce counterparty credit risks by pressing for more | |
| centralized clearing and imposing basic capital and leverage | |
| restrictions; and | |
| <bullet> Reducing systemic risks by imposing heightened capital and | |
| leverage requirements on financial firms. | |
| These are important goals. I urge you to keep the pressure on the | |
| regulators to get the job done. We are in mile 25 of this marathon. Now | |
| is the time to finish implementing these essential rules to protect | |
| U.S. businesses, municipalities, and families. I have confidence that, | |
| with your support, our regulators will be able to implement smart and | |
| effective derivatives rules that will continue to promote--not hinder-- | |
| our economy. | |
| Thank you for the opportunity to speak with you today, and I look | |
| forward to any questions. | |
| The Chairman. Before we go into questions, I want to remind | |
| people that any Member may submit their opening statement for | |
| the record. I should have mentioned that prior to the | |
| testimony, I apologize, but anybody who has an opening | |
| statement is certainly welcome to submit it for the record. | |
| I would like to remind Members that they will be recognized | |
| for questioning in order of seniority for Members who were here | |
| at the start of the hearing. After that, Members will be | |
| recognized in order of arrival. I appreciate Members' | |
| understanding. | |
| Mr. Lukken, so I understand that capital requirements are | |
| important to the big banks, but this is the Agriculture | |
| Committee. Why should our nation's farmers and ranchers be | |
| concerned? | |
| Mr. Lukken. Well, in the futures markets, a significant | |
| amount of the cleared business runs through a bank-affiliated | |
| FCM. If you look at the stats the CFTC puts out, it is | |
| somewhere in the order of 87 percent of the cleared products | |
| come through bank-affiliated FCMs. And so this is going to have | |
| knock-on effects that will affect agricultural customers, who | |
| will have to pay more as a result of that. Many of them are | |
| using bank-affiliated clearing members to clear some of their | |
| business. | |
| In addition, there is less capacity on behalf of these non- | |
| bank affiliates. So even though, if they reach a capital | |
| constraint because of the leverage ratio, there is not capacity | |
| elsewhere to accept these types of positions in non-bank- | |
| affiliated FCMs. So these costs will have to be passed on to | |
| customers. It's going to be more than a ham sandwich, as Mr. | |
| Gellasch indicated. I mean the numbers are significant. We are | |
| estimating somewhere in the order currently of $32 to $66 | |
| billion of costs will be as a result of this. So those costs | |
| will have to be passed on in significant ways to customers. | |
| I would like to make the point too that this is not just | |
| talking about swap products that were in the over-the-counter | |
| markets that have come into clearing, this is affecting futures | |
| products; products that have nothing to do with the financial | |
| crisis are now being taxed as a result of these provisions. | |
| That affects farms directly and users directly, and should be | |
| of concern to this Committee. | |
| The Chairman. Thank you. Mr. O'Malia, in your testimony, | |
| you stated that the impact of the new rules on individual | |
| business units or product areas could be disproportionate to | |
| the difference between a bank choosing to stay the course or | |
| exit the business. | |
| Generally speaking, what drives the banks' capital | |
| allocation decisions? | |
| Mr. O'Malia. Right now, it is the rules. The rules are | |
| having a huge impact on where they are going to allocate | |
| capital. And as Walt pointed out in his testimony, and in mine, | |
| the leverage ratios are a very good example of that. These | |
| requirements are going up, and all of these rules in a | |
| cumulative impact are not being fully assessed. So we have a | |
| multitude of these rules being developed now that are going to | |
| be implemented over the next 4 years that individually have | |
| serious consequences to the investment decisions and the | |
| capital decisions that each of these banks are going to have to | |
| make, which will have pass-on effects. I can tell you, in | |
| developing these rules at the CFTC, we were very cognizant of | |
| how this would impact end-users, and we worked very hard to | |
| make sure that the margin rules did not impact end-users. That | |
| is not the case with the capital rules. There is no exemption | |
| in the U.S. capital rules for end-users. | |
| The Chairman. Mr. Deas, the concerns you shared in your | |
| testimony are highly technical and nuanced. Did the Prudential | |
| Regulators consult with the hedgers who use derivatives for | |
| risk management purposes to understand how the rules would | |
| impact your ability to use these markets, and do you think that | |
| the regulators understand your concerns? | |
| Mr. Deas. Mr. Chairman, thank you. Well, certainly, both | |
| the Chamber and the Coalition for Derivative End-Users have | |
| been very active in submitting comment letters and other ways | |
| to make the Prudential Regulators aware of the concerns of end- | |
| users, but I would have to say that there has not necessarily | |
| been a very active two-way dialogue in that regard. | |
| The Chairman. Gentlemen, thank you for your testimony. | |
| I now recognize the gentleman from Georgia, Mr. Scott, for | |
| 5 minutes. | |
| Mr. David Scott of Georgia. Okay, thank you, Chairman | |
| Scott. | |
| I would like to see if we could get to this issue of the | |
| cross-border. I mean in each of your testimonies you all | |
| touched upon it, and it is a very, very critical issue. | |
| Now, we have been wrestling with this equivalency situation | |
| with the EU for the last, seems like 2 years. It has just been | |
| ongoing, it was supposed to have been resolved last June, then | |
| it skipped and they said we will resolve it in October, the | |
| deadline was stretched to December. So where are we now? How | |
| serious is this? Mr. Deas, you touched upon it, and each of you | |
| have, but there is something else that worries me about this. | |
| You take other countries that the European Union has dealt with | |
| on equivalency, you take countries like Singapore that have the | |
| same robust, strong regulatory regime as the United States, | |
| Australia, as the United States, and they have EU equivalency. | |
| Now, what is going on over there? Why is this discrimination | |
| happening by the EU to our United States, when they are | |
| allowing other regimes with the equal robust regime to come in | |
| and get that equivalency? Is there something rotten in the | |
| cotton that we are not hearing about here, because what you | |
| have, to me, is you have the United States and you have the | |
| European Union are the two mightiest markets here, and it could | |
| very well be, maybe European Union is saying, maybe we need to | |
| cause a little more difficulty here, so that they can get a | |
| gain on the competitive edge. Am I right or wrong about that? | |
| Mr. Lukken. I will take a first shot at that. I mean this | |
| is a very important issue for our industry, because it is a | |
| global marketplace, as you mentioned. The EU and the United | |
| States have reached a tentative agreement on that, and that is | |
| still working its way through the European Commission and the | |
| European Parliament, but it has to go into effect by a deadline | |
| in June. The problem is that there was a lack of transparency | |
| and lack of a process involved with this. Something that should | |
| have, as you mentioned, taken months, took years in order to | |
| work its way through. | |
| That was the derivatives side. The securities side is still | |
| not decided. The SEC and the EU have not reached a decision on | |
| equivalence on the securities clearinghouse side. So this is | |
| still playing itself out. What was as a trade association tried | |
| to say is let's develop a process. We have due process here in | |
| the United States, the CFTC has to abide by certain APA | |
| recognition or APA transparency. There should be a process | |
| developed here so the EU and the U.S. can enter into these | |
| decisions, people can voice their concerns, and we can quickly | |
| get past these things. | |
| But equivalence does not mean exactly the same. Equivalence | |
| means that these things are comparable, and we have the same | |
| outcomes. That is where we tend to stumble between the EU and | |
| the U.S. | |
| Mr. O'Malia. Ranking Member Scott, this is a great issue, | |
| and as Walt pointed out, it is a global market and, therefore, | |
| we need global rules. We have been working very hard to make | |
| sure to minimize the differences between the rule-sets, and to | |
| ensure that you can have comparable regulation. That is what | |
| was set out in the G20 objectives. That is what we believe is | |
| the outcome in many of these regulations, as you pointed out, | |
| with Singapore, the EU as well. | |
| These rules are not going to be identical. You cannot read | |
| them word-for-word and come up with identical rules, but the | |
| outcomes are the same. And so we are pushing very hard, whether | |
| it is data, whether it is trader execution, how you comply on | |
| the firm's buy-side, sell-side, end-user, it does not matter. | |
| We are all working together to make sure you have comparable | |
| rules. | |
| One recent frustration is, and I touched on this in my | |
| testimony, is the CFTC's own rules on cross-border have been | |
| inconsistent. On one hand, they put out the guidance 2 years | |
| ago that really kicked off some frustration globally about | |
| equivalence with the cross-border equivalence decisions | |
| coming--or that need to come as a result of the non-margin | |
| rules--or the margin for non-cleared rules, excuse me, they | |
| have a different position. The definition of U.S. person is | |
| different. So we would urge the Commission to: first, finalize | |
| its rules, and then be consistent with the Prudential | |
| Regulators' regulations that are already out. And then we | |
| probably ought to go back and re-evaluate the current guidance | |
| that they have issued. | |
| Mr. David Scott of Georgia. Right. My time is up, Mr. | |
| Chairman. If we have another round, I would certainly like to | |
| come back and ask what impact this controversy is having on our | |
| end-users. | |
| The Chairman. We should have time for another round. | |
| I now recognize the gentleman from Texas, Mr. Conaway, the | |
| big Chairman, for 5 minutes. | |
| OPENING STATEMENT OF HON. K. MICHAEL CONAWAY, A REPRESENTATIVE | |
| IN CONGRESS FROM TEXAS | |
| Mr. Conaway. Well, thank you, Chairman. And full and fair | |
| disclosure, Austin and I finished up the mark-up--last night, | |
| or early this morning--at about 2:45, so I am not necessarily | |
| hitting on all four cylinders. | |
| Belt and suspenders is a phrase that CPAs use a lot, and I | |
| am a CPA, but as I look at this, net stable funding ratio, | |
| supplementary Basel 2.5, Basel III, capital surcharges, at what | |
| point does it get to be too much? Are we overlapping these kind | |
| of things? And so that is the question, that is more broader to | |
| look at and step back and see now that we have all these rules | |
| in place for the most part, what is it we have actually done to | |
| ourselves, and how has this actually stopped any kind of a | |
| meltdown, going forward. | |
| And I would like to get in the weeds a little bit. Scott, | |
| in your testimony, you talked about the ability of a bank to | |
| use internal models to calculate their capital requirements. If | |
| that is eliminated, then it is estimated that they would have | |
| to come up with 2.4 times as much capital as their internal | |
| modeling would have described. Are internal models that bad? | |
| That seems like a pretty dramatic differential between the way | |
| the regulators would want and the way the banks have seen, | |
| because they are responsible to the shareholders at the end of | |
| the day as well. What causes that big difference? | |
| Mr. O'Malia. Yes, well, it is important to put it in a bit | |
| of perspective. Following Basel II, regulators came up with the | |
| idea that, actually, you should have more risk-sensitive models | |
| appropriate to the bank, and they allowed for internal models | |
| to be used. And these are supervised, overseen models. These | |
| are not out of sight and out of mind. The regulators get a look | |
| at these. And they were developed to be more risk-sensitive, | |
| which is the appropriate evaluation. In the recent submission | |
| on the FRTB, fundamental review of the trading book, they have | |
| a higher standard for internal models. They have potentially | |
| reduced the ability to use internal models, and the difference | |
| on various asset classes could see a sizeable increase in | |
| capital requirements, and as you noted, and our research shows, | |
| it could be as high as 2.4 times more capital. | |
| There is no perfect model, and we think that internal | |
| models should be used, and we are in favor or making them more | |
| transparent and working with the regulators to ensure that | |
| standard data is used, benchmarking is used, to make sure that | |
| they have a high level of confidence in the models so they can | |
| be used. If you go to a standard model, they are less risk- | |
| sensitive, more conservative, and will require more capital. | |
| And we want to make sure that we don't have kind of a standard | |
| model they used, kind of a one-size-fits-all which is | |
| inappropriate for the industry. | |
| Mr. Conaway. Got you. Mr. Gellasch, you mentioned, and | |
| pardon me if I mispronounced your last name, a ham sandwich. | |
| Mr. Gellasch. Yes. | |
| Mr. Conaway. Whose hide did that ham sandwich come out of? | |
| Mr. Gellasch. Pardon? | |
| Mr. Conaway. Whose hide did that ham sandwich come out of? | |
| Mr. Gellasch. The banks'. Actually, they are the ones who | |
| actually have---- | |
| Mr. Conaway. What was their profit margin before the ham | |
| sandwich? | |
| Mr. Gellasch. So that is, actually, a really interesting | |
| question. So if you---- | |
| Mr. Conaway. I guess there is a profit margin too. | |
| Mr. Gellasch. Pardon? | |
| Mr. Conaway. Is it okay for the banks to make money? | |
| Mr. Gellasch. Absolutely. | |
| Mr. Conaway. Okay. | |
| Mr. Gellasch. Absolutely. | |
| Mr. Conaway. So that ham sandwich cost didn't get passed on | |
| to the end-user? | |
| Mr. Gellasch. We don't know. And so out of $100,000 swap, | |
| the $7\1/2\ or so of the incremental cost of having it---- | |
| Mr. Conaway. Is that a number you would multiple by--to get | |
| to the $8 trillion? In other words, the ham sandwich is a | |
| pretty trivial amount, obviously, but do they do a lot of | |
| $100,000 swaps? | |
| Mr. Gellasch. No, but a lot of end-users do. And so you | |
| start to talk about $100,000 swaps or $1 million swaps or | |
| $100,000 swaps, the actual incremental cost here is just the | |
| incremental cost of, whether or not it is borrowed money or | |
| whether or not it is their own money. That is the difference | |
| between the capital. So that is actually the number we have to | |
| worry about. It is not the total amount of capital that they | |
| have, it is the cost of that being borrowed money or---- | |
| Mr. Conaway. Give me a perspective. I know what a ham | |
| sandwich is, but what was the profit margin to the bank before | |
| the ham sandwich, and is the extra cost of the ham sandwich | |
| worth them staying in the business? | |
| Mr. Gellasch. So, yes, and the answer is almost assuredly | |
| yes. And so the market risk for them was $1,000 on the example | |
| I used, so the market risk was $1,000 for them. They may very | |
| well charge, we are talking about hundreds of dollars. So the | |
| incremental cost to them is literally a few percentage points. | |
| Mr. Conaway. Okay. They charged $100 for $1,000---- | |
| Mr. Gellasch. They may charge $100 for $1,000 to be willing | |
| to take that interest---- | |
| Mr. Conaway. And you are pretty confident that that charge | |
| won't go to $107.50? | |
| Mr. Gellasch. I can't say I am---- | |
| Mr. Conaway. To the end-user. | |
| Mr. Gellasch. So the question is how much of that will be | |
| passed on, and the answer is we haven't seen it. So a lot of | |
| these rules have actually already been---- | |
| Mr. Conaway. Based on your background, have you ever seen | |
| anything that wasn't passed on? | |
| Mr. Gellasch. Yes. To the extent that there are limitations | |
| on that. I would say, we do have, actually, a relatively | |
| competitive environment. One of the things we have actually | |
| seen as some of these rules have come on is in the interest | |
| rate environment, we have actually seen bid-ask spreads narrow, | |
| we have actually seen liquidity in some cases actually improve. | |
| We have actually seen costs come down. | |
| Mr. Conaway. You keep using the word, and I am way over my | |
| time, you keep using the word some and I am just trying to get | |
| a perspective on that, because you are the only person who has | |
| ever come in here, other than a regulator, that is happy with | |
| the rules as you seem to be. | |
| And I yield back. | |
| Mr. Gellasch. I wouldn't actually say I am as happy as I | |
| am, but I do think that they are generally very good rules. | |
| The Chairman. All right, the chair now recognizes the | |
| gentlelady from Arizona, Mrs. Kirkpatrick. | |
| Mrs. Kirkpatrick. Thank you. Mr. O'Malia, I want to follow | |
| up on your comment that one-size-doesn't-fit-all in terms of | |
| capitalization. Can you give me an example of what you mean by | |
| that? | |
| Mr. O'Malia. Sure. Thank you for the question. So the | |
| analysis we have been doing on the FRTB, and we would be happy | |
| to provide it, there is an annex in there that does elaborate a | |
| little bit more on my testimony. | |
| Mrs. Kirkpatrick. I would appreciate that. | |
| Mr. O'Malia. Yes. So the analysis we looked at, using the | |
| internal model, we believe that the FRTB capital model will | |
| increase capital requirements, risk-weighted basis, 1.5 times. | |
| Without the ability to use internal models, we believe that | |
| could go to 2.4 times the capital requirements. | |
| Now, it is not completely binary. Some banks may be able to | |
| use capital models, some may not, but it is in that range of | |
| the capital increase that we have estimated for the FRTB rule | |
| that was just recently released. | |
| Now, it would also have, due to our estimates, impacts on | |
| FX, foreign exchange, you could see in that asset class as well | |
| as securitization and equities. But as an example, and kind of | |
| at the high end, FX could go up by 6.4 times, based on our | |
| analysis. Now, this would be a big impact, and people would use | |
| FX hedgers, end-users for commercial operations for the global | |
| operations. Right? They are paying salaries, recouping revenue, | |
| raising money in different countries. That would have a big | |
| impact. And keep in mind, these are global rules. These are not | |
| just U.S.-specific rules. So this affects all the global | |
| exchanges in dealing with this. So this is not just U.S.- | |
| specific. But those are specific examples that I could give | |
| you, and we have plenty more details in our more thorough study | |
| that we have included. | |
| Mrs. Kirkpatrick. I would appreciate that. Has there ever | |
| been a situation where a market participant had insufficient | |
| capital, and if so, what happened? | |
| Mr. O'Malia. Under the Basel---- | |
| Mrs. Kirkpatrick. Market participant. | |
| Mr. O'Malia. Yes, well, they have had regulators who insist | |
| they raise that capital requirement. | |
| Mrs. Kirkpatrick. But what really happens aside from that, | |
| I mean in impacts? | |
| Mr. O'Malia. You have a conversation with your regulator | |
| and they expect you to put more capital behind it. | |
| Mrs. Kirkpatrick. But can you give me an example of where | |
| there was a market participant who did not have enough capital? | |
| Mr. O'Malia. We can---- | |
| Mr. Lukken. I would just---- | |
| Mrs. Kirkpatrick. Any---- | |
| Mr. Lukken. I mean---- | |
| Mr. O'Malia. Yes. | |
| Mr. Lukken.--the prudential banking regulators would | |
| require you either to go out in the debt markets to raise more | |
| capital, or issue stock to raise more capital, but you would be | |
| out of compliance with prudentially regulated regulations that | |
| require a certain amount of minimum capital, and---- | |
| Mrs. Kirkpatrick. I guess what I am trying to find out what | |
| is a commonsense sort of approach to good capitalization? So | |
| you are basically saying it is in the hands of the regulators. | |
| I get that because of the regulations, but I am trying to find | |
| out are those regulations sensible, is there another standard | |
| for looking at what makes good capitalizations. That is what I | |
| am trying to get at. | |
| Mr. O'Malia. Well, in that case, you and I are looking for | |
| the same thing. What we see is the individual rules are being | |
| promulgated and we are watching them individually. What we | |
| haven't done, and what we would be strong in favor of, is kind | |
| of looking at the comprehensive. And we have to look at the | |
| individual business lines as well. The leverage ratio, for | |
| example, is a tax on clearing that is diametrically opposite | |
| with what the market regulators have kind of urged market | |
| participants to do; put more into clearing, which is the right | |
| thing to do. But then the capital rules kind of send the | |
| conflicting message in tax and clearing by not recognizing the | |
| initial margin as risk offsetting. | |
| Now, the individual rules we will look at and try to assess | |
| the impacts on individual businesses, and those rules are being | |
| developed currently. Right? We haven't seen the final rules in | |
| most cases, and they will be developed and implemented over the | |
| next 4 years. So we are trying at this point, at this important | |
| point, before they are fully implemented, let's understand the | |
| real ramifications of the individual rules on the individual | |
| businesses, and let's do a cumulative impact to really | |
| understand the broader economics. | |
| Mrs. Kirkpatrick. Thank you. That is what I am after. And | |
| my time is running out, but I would appreciate more information | |
| on that. I will tell you that it has been my experience that, | |
| in crafting legislation and regulations, too many times we do | |
| think that one-size-fits-all, and it doesn't work. So I | |
| appreciate the panel's testimony. | |
| I yield back. | |
| The Chairman. The chair recognizes the gentleman from | |
| Mississippi, Mr. Kelly, for 5 minutes. | |
| Mr. Kelly. Thank you, Mr. Chairman. And, Mr. O'Malia, in | |
| your testimony you say that we need to understand the | |
| cumulative effect of these regulatory changes on the economy | |
| before they are fully implemented, and I agree with you. | |
| However, I am assuming the proponents of the changes would | |
| argue that the potential adverse effects of the economy could | |
| be much greater if we don't expeditiously implement the | |
| changes. How do you respond to such claims? | |
| Mr. O'Malia. Well, we have time to do that now. There is | |
| nothing to stop these rules from going forward and doing the | |
| cumulative impact assessment right now. These are Basel rules, | |
| they are going be promulgated and moving forward. The leverage | |
| ratio, fundamental review of the trading book, are near final | |
| anyway but they have time to be implemented over the next 4 | |
| years. | |
| We do believe that a cumulative impact assessment, and | |
| really looking at the individual business line impacts, would | |
| be informative to understanding the ramifications. | |
| A lot of people, and with all due respect to Mr. Gellasch | |
| and his ham sandwich, a lot of these rules have not been fully | |
| implemented and costed-in. As I mentioned, the non-cleared | |
| margin rules have yet to take effect. Those are going to have a | |
| $300 billion impact. These are CFTC numbers, not my numbers, | |
| CFTC numbers. And those are going to be real ramifications. The | |
| capital rules are not finished yet, and are going to be phased- | |
| in over the next 4 years. We haven't seen the full price of | |
| this. We have seen what the cost of clearing has done. We have, | |
| SIFMA AMG has put out and surveyed their members, $34 trillion | |
| under management from those asset managers, pension fund | |
| managers, and they are saying from their membership, yes, we | |
| are seeing price increases, these are going up, we are seeing | |
| fewer people that we can deal with in this derivatives | |
| ecosystem. And it is an ecosystem. Right? You need risk | |
| managers and you need hedgers, and all of that has to work | |
| together. And these capital rules, as I said earlier, aren't | |
| exempting end-users. Right? These costs will be passed on. | |
| Mr. Kelly. And kind of going back on your line, and | |
| following up with what Chairman Conaway talked about, it is | |
| easy to say when things don't generate income or revenue, that | |
| those costs are passed on to the banks. However, I spent quite | |
| a bit of my time in the districts speaking with banks and | |
| constituents, and my experiences have been that most of the | |
| time, whether it is a ham sandwich or a Mercedes Benz, that | |
| that cost is generally always passed on to the consumer, | |
| because the margins keep getting thinner in this world and | |
| generally that is passed on to the consumers, which basically | |
| blocks people out from being able to get income that they need. | |
| Do you agree? | |
| Mr. O'Malia. I fully agree with you, sir. | |
| Mr. Kelly. Thank you. Mr. Lukken, why did the G20 call for | |
| the imposition of margin and higher capital requirements, and | |
| how does the posting of margin and holding additional capital | |
| reduce systemic risk? | |
| Mr. Lukken. Well, the G20 looked at the example of the | |
| futures markets and how well they worked during the financial | |
| crisis. And when Lehman Brothers went down, the futures | |
| business easily moved to other clearing members that were | |
| healthy and able to accept those positions. So that ability to | |
| port something from a failing institution to a healthy market | |
| participant allowed the markets to function, to price discover | |
| during that process, while some of the over-the-counter markets | |
| froze up with uncertainty. | |
| And so they looked at that example and said clearing seemed | |
| to work during a crisis situation. Let's consider bringing some | |
| of these products in a more transparent, regulated environment | |
| that allows for daily posting of margin, so when people put on | |
| transactions, they are able to put up this performance bond | |
| that ensures there is money sitting there, cash money regulated | |
| by the CFTC, in case one of those parties defaults. And that is | |
| the first line of protection. You talk to any clearinghouse, | |
| talk to Chairman Massad of the CFTC, it is always there in a | |
| crisis. | |
| And what we are asking is simple math. Recognize that it is | |
| always going to be there during a default, and subtract it from | |
| the exposure that the bank has to the clearinghouse. It is | |
| cash. It is easy to measure. It is simple math. So please do | |
| that so that we are not taxing clearing as these products come | |
| into this more healthy, regulated environment. | |
| Mr. Kelly. And I had another question, but I am going to | |
| run out of time. I thank all you witnesses for being here and | |
| taking the time to explain this extremely complex math to most | |
| of us regular folks. | |
| And, Mr. Chairman, with that, I yield back. | |
| The Chairman. The chair now recognizes the gentleman from | |
| Oklahoma, Mr. Lucas, former chair of the full Committee. | |
| Mr. Lucas. Thank you, Mr. Chairman. | |
| And one of the great things about the Committee hearing | |
| process, as the Committee knows, and I am sure our witnesses | |
| have experienced, there are issues that are so important that | |
| they have to be discussed and discussed and discussed in order | |
| to burn it in. | |
| So in that regard, Mr. Lukken, I would like to turn to you, | |
| and be specific about once again discussing in the many | |
| instances where clearinghouse members or banks that are subject | |
| to the Basel capital rules which require them to hold that | |
| capital against the guarantee they provide for their clients. | |
| As I have personally repeatedly said in many of these hearings, | |
| and in conversations even with Chair Yellen, we can all agree | |
| that banks have exposure in the event their clients are unable | |
| to fulfill their obligations, and should hold capital against | |
| that. We all agree on that, but I am concerned about my | |
| constituents in the energy and ag business, how are they going | |
| to find access to their risk management tools if the margin | |
| posted isn't even recognized under the Basel leverage ratios. | |
| Would you expand for just a bit on that because, after all, as | |
| has been discussed here earlier, if the banks don't want to | |
| participate in this, they don't have to, reducing competition | |
| and reducing the opportunities for my constituents in the real | |
| world. Would you expand on that? | |
| Mr. Lukken. And the effects are not theoretical. We have | |
| already had four bank clearing members pull out of the | |
| business, citing that capital is too expensive to continue on | |
| in this world. There are others on the sidelines that are | |
| waiting to determine whether these will be implemented, and | |
| whether it will be fixed by the time these provisions go into | |
| effect in 2018. | |
| So this has real consequences on end-users. They may have | |
| less access to clearing members because there are less choices, | |
| and as we see in the numbers I cited, they are decreasing | |
| significantly over the last several years. And that will | |
| expedite itself if this is not fixed in our community. | |
| I would want to mention too the costs as banks measure | |
| this, they measure things in business units. As one of these | |
| banks may look at this, they will look at the clearing business | |
| itself and realize that the capital that that clearing business | |
| has to rent in order to make a return is so expensive because | |
| of this lack of an offset that it is just we are not willing to | |
| do that within that business unit of the bank. We have other | |
| more profitable parts of the bank that we will put that capital | |
| towards, whatever that might be. | |
| And so I realize that we talk about some of these costs, | |
| but the cost to the clearing business is significant. It is not | |
| a hugely profitable part of these banks, and so these types of | |
| costs are really bearing down on whether these clearing members | |
| decide to stay in the business or not. | |
| Mr. Lucas. And access is critically important to my | |
| constituents. As we have gone through this downturn in the last | |
| 6 months broadly in ag and energy prices, had those tools not | |
| have been available to my folks back home to soften this, we | |
| would be in dramatically worse shape. | |
| Let's go one step further. In your testimony you note, | |
| referencing Basel III and the capital requirements, you note | |
| that the consolidation of the futures commission merchants, | |
| something like 60 percent over the last 10 years, expand for a | |
| moment on, in addition to the capital issues, what is driving | |
| this consolidation within the industry? | |
| Mr. Lukken. I think it is fixed costs. I mean if you can | |
| look at whether it is the fixed costs of regulation, more | |
| volume is necessary to flow through these intermediaries in | |
| order to make it a profitable business. And so you have people | |
| who are shuttering businesses, people who are merging, so you | |
| are seeing that over that period of time where people are | |
| deciding to either just get out of the business itself or to | |
| offer to try to merge those businesses in order to get more | |
| volume to go through those things. | |
| So that is regulator costs, we realize that, and some of | |
| those are very important and needed, don't get me wrong, but it | |
| is capital costs and it is this cumulative effect that Scott | |
| mentioned. We have to look at all the costs that are being | |
| thrown onto this system, and that is going to cause less people | |
| to be participating in that system, by definition. | |
| Mr. Lucas. So ultimately, if we have an environment where | |
| no one wants to participate, that means the opportunities for | |
| my farmers and my energy folks are reduced, and those few | |
| opportunities come at a higher cost, and they ultimately suffer | |
| the real prices. | |
| Mr. Lukken. Absolutely. | |
| Mr. Lucas. Thank you, Mr. Chairman. I yield back. | |
| The Chairman. The chair now recognizes the gentleman from | |
| Illinois, Mr. Davis. | |
| Mr. Davis. Thank you, Mr. Chairman. And thank you and all | |
| the witnesses. | |
| Kind of a follow-up to my colleague, Mr. Kelly, and my | |
| colleague, Mr. Lucas', line of questioning. Mr. Lukken, now, if | |
| the banking regulators won't recognize the customer margin as | |
| reducing the clearing members' exposure, are the Basel | |
| standards actually discouraging, in your opinion, the | |
| collection of client margin, and thereby, as Mr. Lucas talked | |
| about, the effect on his constituents and my constituents, and | |
| all of our constituents, who want to use this process, are they | |
| discouraging clearing? | |
| Mr. Lukken. Yes. We are already seeing certain clearing | |
| members divorcing themselves of clients in order to reduce the | |
| capital burden in this area. So as I mentioned, some have | |
| gotten out of the business. But, beyond that, there are people | |
| who are shedding clients, off-boarding them in order to get | |
| into compliance with the standards. So yes, yes, it is | |
| happening, and yes, it is discouraging clearing. | |
| Mr. Davis. So you are reducing the amount of clearing | |
| members that would want to participate in this process for our | |
| constituents to participate in the futures, the options, the | |
| swaps market, et cetera, therefore, reducing the number of | |
| clearing members, which wouldn't that ultimately raise the | |
| cost? | |
| Mr. Lukken. Absolutely, and that is what we are seeing. | |
| Mr. Davis. So much more than a ham sandwich. | |
| Mr. Lukken. Absolutely. And like I said, this is being | |
| viewed from the futures side of the business, which is normally | |
| a small part of these institutions. So it is much bigger cost | |
| for those business segments than it is for the entirety of the | |
| bank, which is having a huge impact. | |
| Mr. Davis. Okay, so premium ham sandwich or the whole hog. | |
| Well, actually, the whole hog would probably cost less on the | |
| market, right? | |
| Mr. Gellasch. Just to add a quick interesting point on | |
| that. One of the things we have seen is actually the | |
| consolidation is a real concern. It is actually one that is not | |
| unique to this. The largest financial institutions have cheaper | |
| borrowing costs and economies of scale that smaller firms | |
| simply do not. | |
| When you talk about whether---- | |
| Mr. Davis. So you would rather us just have the larger | |
| firms? | |
| Mr. Gellasch. Absolutely not. The challenge there is the | |
| same thing we have in this context as we do all other business | |
| lines that banks and financial firms are engaged in. We have | |
| seen a consolidation that is not just in the derivatives and | |
| not just in these markets, but in others as well. We have seen | |
| that in commercial banking as well. | |
| One of the things that is really important here is when we | |
| talk about what that means, what that consolidation means. Does | |
| it mean higher costs or not. Actually, I would look at is the | |
| actual cost of doing a trade, what that means in terms of | |
| pricing, what that means in terms of bid-ask spread for doing | |
| that trade, and what the implementation cost is for that trade. | |
| And actually, by those measures, actually, costs are coming | |
| down, notwithstanding this consolidation. So I just want to | |
| make that point. | |
| Mr. Davis. So costs are coming down, consolidations are | |
| happening, we have in the banking sector, as we have seen in | |
| the rural area that I represent, there aren't as many community | |
| banks anymore. It seems to me that we are getting to the point | |
| where we might actually have too many, we are getting to the | |
| point where we only have the banks that are too big to fail. | |
| Are we going to see the same thing on the clearing side, Mr. | |
| O'Malia? | |
| Mr. O'Malia. I just find some of this to be, on one hand | |
| you have the argument that this doesn't cost anything more than | |
| a ham sandwich, then you are talking about massive dislocation | |
| and concentration of things. The regulators intended for these | |
| to have change behavior. Right? They imposed capital | |
| requirements to increase the quality and the quantity of | |
| capital. The costs are going up, and they are not going up by a | |
| little bit or a ham sandwich, they are going up by billions of | |
| dollars. And to Walt's point, there is consolidation and there | |
| are people making decisions about whether they are going to be | |
| in this business or that business, and there will be thousands | |
| of layoffs as a result of that. That is going to have huge | |
| ramifications, not to mention the service they are provided. | |
| And whether it is the Coalition of End-Users or it is SIFMA | |
| AMG, they are all raising their hand saying, ``Hey, regulator, | |
| pay attention, the cost to serve my customers or to manage the | |
| pension funds that we do, is going up. Clearing costs are going | |
| up.'' The fact that you don't--as a result of capital. And they | |
| have pointed at the capital rules. | |
| Mr. Davis. And my constituents---- | |
| Mr. O'Malia. So you can't have it both ways. | |
| Mr. Davis. And my constituents are losing access to be able | |
| to participate in this marketplace too, correct? And, Mr. | |
| O'Malia, I have a question for you really quick. You stated in | |
| your testimony that we need to understand the cumulative effect | |
| of these regulatory changes on the economy before they are | |
| fully implemented. I agree. You just briefly touched on that a | |
| second ago. I am assuming the proponents of these changes would | |
| argue that the potential adverse effects on the economy could | |
| be much greater if we don't expeditiously implement the | |
| changes. I mean can you expand on that and your testimony a | |
| little bit? | |
| Mr. O'Malia. Yes. Well, I guess the proponents shouldn't | |
| worry if it is only going to cost a ham sandwich, they | |
| shouldn't be afraid of the facts on this one. So let's move on, | |
| let's do a cumulative impact study if there is no harm there. | |
| So the facts are going to tell us where this thing ends up, and | |
| at the end of the day, we will all be better informed as a | |
| result of that. And that is exactly where we should be. We | |
| should understand the cumulative impact as well as the | |
| individual business line impact. | |
| Mr. Davis. Thank you. My time has expired, Mr. Chairman. | |
| The Chairman. The chair recognizes the gentleman from | |
| California for 5 minutes. | |
| Mr. LaMalfa. Well, thank you, Mr. Chairman. And my | |
| constituents would rather that we talk about a tri-tip | |
| sandwich, given the ranches we have up there, or maybe move on | |
| from the sandwich. | |
| Mr. O'Malia, we were talking earlier about the CFTC has yet | |
| again to put out the final rule on cross-border trades, and the | |
| implementations that are going to be required for that in | |
| approximately 4 months, is my understanding, which is a very | |
| short window of time for the final rule. And so important | |
| compliance decisions are also needed as well. So if the CFTC | |
| does not come to a decision in this timeline, and the | |
| discussions continue to drag on, what would the effects be on | |
| the uncleared swap marketplace? | |
| Mr. O'Malia. Confusion, in one word, but it is more complex | |
| than that. So we would appreciate the CFTC moving expeditiously | |
| to put out its final rules. We would like them to be as | |
| consistent as possible with the global framework. | |
| Mr. LaMalfa. So say it again. You don't want speed, you | |
| would rather have---- | |
| Mr. O'Malia. No, we do want speed. We want both. | |
| Mr. LaMalfa. You do want, okay, I heard wrong. | |
| Mr. O'Malia. We want speed and consistency. Obviously, with | |
| the end deadline a few months away, it is important that we | |
| know what the final rules are going to be so we can draft the | |
| appropriate documentation to link the industry together. | |
| Mr. LaMalfa. How possible is it going to be that it is | |
| going to be speedy and consistent at this point? | |
| Mr. O'Malia. Excuse me. Depends on how soon they get this | |
| out. If we have the final rules, excuse me---- | |
| Mr. LaMalfa. Yes, take a moment. | |
| Mr. O'Malia.--sooner rather than later, then we will be in | |
| much better shape. What we are trying to do is---- | |
| Mr. LaMalfa. Well, how do you feel they are doing on | |
| issuing them at this point? Do you think they are going to be | |
| pretty snappy getting them out, or---- | |
| Mr. O'Malia. We don't know. It is up to the Commission to | |
| figure that one out. And we hope sooner and we hope consistent, | |
| consistent with the other regulators. | |
| Mr. LaMalfa. Does it have to be a difficult process, or it | |
| would be pretty straightforward? | |
| Mr. O'Malia. I think they are making it more difficult than | |
| it is. | |
| Mr. LaMalfa. Yes. | |
| Mr. O'Malia. It should be more consistent. And | |
| unfortunately, the CFTC is in a tough position. Either they are | |
| going to submit rules that are consistent with their original | |
| guidance 3 years ago on cross-border, or they are going to | |
| submit rules that are consistent with the Prudential Regulators | |
| on non-cleared margin. And if they go with the Prudential | |
| Regulators, then they are inconsistent with their original | |
| cross-border guidance on who a U.S. person is, and some of | |
| these other factors. So either way, they really need to kind of | |
| step back and ultimately revisit their entire cross-border | |
| strategy, because it is making the entire process more complex. | |
| It does create some ill will in Europe, which is going to | |
| create a pushback. | |
| Mr. LaMalfa. Yes. How big has that pushback been? I mean we | |
| have been hearing about that for at least a year or more that | |
| it is a threat. What has the effect been so far, or has it | |
| really come to pass yet? | |
| Mr. O'Malia. Well, obviously, the CCP recognition and the | |
| equivalency took 3 years to get through. I think it is really | |
| important. Nobody wants to have rules that create gaps. Right? | |
| We want, and I can understand, and having been a former | |
| Commissioner, Walt has been a former Commissioner, you want to | |
| draft rules that are consistent, and you want to make sure that | |
| you have thought of everything. But that doesn't mean that you | |
| regulate everything. And we can rely on the global partners | |
| here because, at the end of the day, they have really developed | |
| rules that are going to achieve the same outcome. Data | |
| reporting, largely the same in the outcome, but they can't | |
| share data because they don't have it in a format that works. | |
| Trade execution is a big factor that is coming into play with | |
| the European rules around the corner. We have seen fractured | |
| liquidity in the markets today. Are you going to fix that or | |
| are you going to sustain that, is a big question. Are you going | |
| to recognize a global liquidity pool or are you going to have | |
| regulatory friction that divides the markets. | |
| The non-cleared, I would have to give regulators a lot of | |
| credit on the non-cleared margin. Those rules are as consistent | |
| as any rule-set they have developed yet today. And the goal has | |
| been to make sure that we have a global non-margining | |
| framework. So I do compliment the regulators on that. Now it is | |
| down to the final strokes. Let's put forward a cross-border | |
| system that recognizes that they are nearly identical, and we | |
| move on from there so our members can deal with these rules, | |
| and you substitute compliance, so you either have to comply | |
| with the rules in one country or the other, but not both. | |
| Mr. LaMalfa. Right. That sounds very sensible. Quickly, on | |
| compliance decisions between outcome-based and element | |
| approach. You mentioned that a little bit earlier as well. Can | |
| you elaborate just a little bit on why the outcome-based is the | |
| preferred approach? | |
| Mr. O'Malia. Well, let's take, for example, end-user, the | |
| definition of end-user in the U.S. has one definition and end- | |
| user in Europe has another definition. If you look at that and | |
| you try to do it on an equivalent basis, you are going to come | |
| up with a different outcome. You are not going to say those are | |
| not equivalent end-users. Pension funds, for example, are end- | |
| users in Europe but they are not here. So applying those rules, | |
| if you go at a very granular level, you are going to find some | |
| differences, and you can never find equivalency, you can never | |
| trust the other regime. And, therefore, the industry is left | |
| compliant with two sets of rules, which is exactly where we are | |
| on trade execution, exactly where we are on data reporting. | |
| Mr. LaMalfa. Thank you. Thank you, Mr. Chairman. | |
| The Chairman. We are going to get a second round of | |
| questioning. I am going to recognize Mr. Scott from Georgia | |
| first in that second round. | |
| Mr. David Scott of Georgia. Yes, thank you. I want to | |
| continue my first line of questioning, and to pick up on my | |
| colleague that just spoke on the other side, concerning the | |
| cross-border, and specifically this situation with the EU. | |
| And I want to ask you all, is this putting our American | |
| businesses at a competitive disadvantage right now? That is | |
| what I want to hear. If you are a clearinghouse, if you are | |
| someone like ICE, the IntercontinentalExchange, if you are a | |
| CME, if you are a farmer, if you are a manufacturer, if you are | |
| an American risk manager, hedge manager, does this uncertainty | |
| at this moment in time, is this putting our American businesses | |
| at a disadvantage in the global markets? | |
| Mr. O'Malia. That is the same question the regulators in | |
| Europe or in Asia ask their constituents as well. Everybody | |
| wants to make sure that they protect their industry, they | |
| protect their people, they protect their markets, and I | |
| understand that. And that does create tension at the beginning | |
| of any conversation on equivalence. And they want to make sure | |
| that they have thought of everything. And we want to make sure | |
| that the outcomes achieve the same thing, because you do not | |
| want to have an unlevel playing field that tips one way or | |
| another. | |
| Now, we don't have all the rules completed in Europe yet, | |
| so it is tough to tell on some of these competitive issues | |
| around trade execution. We did get to an outcome, or we have a | |
| draft outcome on CCP recognition that would make the | |
| jurisdictions equivalent. | |
| Mr. David Scott of Georgia. But if you, Mr. O'Malia, if you | |
| had to answer my question right now, would you say is this | |
| uncertainty, this delay year after year, month after month, is | |
| it putting American businesses at a competitive disadvantage? | |
| Mr. O'Malia. I would answer yes, I mean because uncertainty | |
| always leads people to do less of something in order to account | |
| for that uncertainty. So the outcome, if the United States was | |
| not recognized by Europe, and it looks like we are going to be, | |
| there is a transition here, but many of the European banks that | |
| are members of the CME, of ICE, could not participate in those | |
| markets. It would be the capital punitive damages would be so | |
| high that they would just have to be out of the business. And | |
| again, what does that do? Well, that shrinks choices for | |
| customers that can't access markets through those clearing | |
| members, it is going to necessarily raise costs because of | |
| that. And so yes, it is going to cause an immediate impact. | |
| Mr. David Scott of Georgia. Right. And do you feel that it | |
| would be helpful in any way for us here in Congress to begin to | |
| put on the table and discuss any retaliatory means that might | |
| be necessary, whether you take them or not, but there ought to | |
| come a time when we need to stand up for our American | |
| businesses and say enough of this. We don't deserve this level | |
| of disrespect for our American businesses. Is there something, | |
| a message that we can send here in Congress to let them know | |
| that this has to be straightened out, it is unfair to our | |
| businesses? | |
| Mr. O'Malia. Well, your oversight responsibilities on this | |
| Committee have been helpful. You have talked about this issue | |
| in several hearings and that has gotten Chairman Massad | |
| leverage in these negotiations. But, the rest of the government | |
| is also important. The Treasury Department represents the | |
| United States in these types of negotiations. So your oversight | |
| responsibilities have helped to break this logjam, yes. | |
| Mr. David Scott of Georgia. Yes. I wanted to get to Mr. | |
| Deas as well in my last minute here, Mr. Deas, because if I | |
| remember in your testimony, you really hit on this competitive | |
| disadvantage. What say you about this? | |
| Mr. Deas. Well, thank you, Representative Scott. It is an | |
| important issue, and I can tell you that, just to bring it | |
| home, if we are competing against European companies whose | |
| regulators have exempted derivatives they enter into from | |
| higher capital requirements, then we as American companies are | |
| going to bear a higher cost for hedging the risk inherent in | |
| our business activity. And we have estimated that the | |
| difference here could be ten or 15 percent of the hedging | |
| costs. | |
| Mr. David Scott of Georgia. Yes. | |
| Mr. Deas. And we would have to either absorb that cost or | |
| pass it through to the customer, putting us at a competitive | |
| disadvantage. | |
| Mr. David Scott of Georgia. Thank you very much, Mr. | |
| Chairman, I appreciate that because, especially Europe, because | |
| if it weren't for America, those folks in Europe would be | |
| speaking German right now. | |
| The Chairman. More of them than already are. Yes, sir. | |
| Thank you, Mr. Scott. I have a couple of questions, Mr. | |
| O'Malia, that I would like to follow up on. Are margin and | |
| capital rules complimentary? If so, should they be developed | |
| and implemented in tandem to minimize regulatory overreach? | |
| Mr. O'Malia. Right now, they are moving forward in tandem. | |
| And we ought to look at them for the cumulative impact that | |
| they are going to be having to the business. They happen to be | |
| coming in at the same time, and businesses are making very | |
| difficult decisions right now about how they deploy that | |
| capital. | |
| The margin rules are separate, and that is going to have a | |
| big impact on the pricing of the OTC market. And we have yet to | |
| see kind of how it will be phased in and what the costs of that | |
| will be. That will be phased in over the next 4 years. But, now | |
| is the time to ask ourselves a question about the cumulative | |
| impacts of these, and spot the problems before we create some | |
| of these problems that we have identified today. | |
| The Chairman. You pretty much answered my next question. I | |
| am going to ask it anyway. You just answered it as no, maybe in | |
| a little longer manner, but the question is, is that how the | |
| CFTC and the Prudential Regulators approach their respective | |
| rulemakings, ensuring that the capital regulations took into | |
| consideration the risk-producing effects of the margin | |
| requirements? | |
| Mr. O'Malia. We would obviously like to see the CFTC get | |
| their cross-border rules out quickly. That has been a big | |
| holdup. But by and large, the margin rules on a global basis | |
| are fairly consistent. | |
| The Chairman. Has the Basel Committee, the Financial | |
| Stability Oversight Council, or any other body, undertaken a | |
| review of the potential cumulative impact of the various margin | |
| and capital requirements to ensure that those regulations are | |
| not unduly duplicative or overburdening the markets and their | |
| participants? | |
| Mr. O'Malia. Not that I am aware of. | |
| The Chairman. Thank you, gentlemen, for being here. And the | |
| chair now recognizes the gentleman from Illinois for 5 minutes. | |
| Mr. Davis. Thank you, Mr. Chairman. | |
| Mr. Deas, quickly, I have a question for you. | |
| Mr. Deas. Yes, sir. | |
| Mr. Davis. In your testimony, you comment that requiring | |
| dealing counterparties provide required stable funding for 20 | |
| percent of the negative replacement cost of derivative | |
| liabilities before deducting the variation margin posted is a | |
| clear example of the direct burdens that would affect end- | |
| users' ability to efficiently mitigate risk. Can you elaborate, | |
| since we talked about end-users a lot in this hearing, can you | |
| elaborate how this requirement directly impacts them? | |
| Mr. Deas. Congressman, I will be very happy to. Thank you | |
| for that question. | |
| Mr. Davis. Thank you. | |
| Mr. Deas. Well, end-users deal with these banking | |
| institutions as derivate counterparties who are represented by, | |
| in some cases, over 200,000 employees. And the only way those | |
| employees act, or are directed by the management of the bank, | |
| is to price their derivative transactions, as an example, on | |
| the incremental cost. So the way it would work in this regard, | |
| the assessment of the market-to-market risk of an uncleared | |
| derivative would generate a funding requirement that has to be | |
| held in reserves equal to 20 percent of that exposure, and | |
| according to the net stable funding requirements, they have to | |
| hold 50 to 85 percent of that funding in long-term funding, | |
| either equity the bank has issued or long-term preferred stock, | |
| or long-term debt that they have issued, the cost of which has | |
| to be passed on to end-users. And we estimate that the effect | |
| of that is to increase the hedging cost by ten to 15 percent. | |
| Mr. Davis. Ten to 15 percent? | |
| Mr. Deas. Yes, sir. | |
| Mr. Davis. Much higher than what we heard in some of the | |
| testimony earlier today. | |
| Mr. Deas. Yes, sir. | |
| Mr. Davis. Thank you. Mr. Lukken, we have had some | |
| discussion on, and you mentioned in your oral statement that | |
| other jurisdictions overseas are in the process of implementing | |
| the leverage ratio standards based on the Basel leverage ratio. | |
| How far along are the EU, Japan, and Switzerland in | |
| implementing these new standards based on Basel? | |
| Mr. Lukken. Well, they are in the midst of--Basel III was | |
| implemented in 2010, but there are revisions that are out for | |
| comment right now. And, in fact, they have talked about the | |
| leverage ratio in that consultation, and they are asking for | |
| data on whether that should be fixed. | |
| Europe has taken a different direction on this. Mark | |
| Carney, who is the Governor of the Bank of England, has come | |
| out with the same concerns that I am talking about today, which | |
| is why are we taxing clearing in this capital regime. And so | |
| the Europeans are thinking about going their own direction. So | |
| if, indeed, Basel decides not to recognize margin in these | |
| capital provisions, then Europe may decide to legislate its way | |
| out and just not implement the leverage ratio to tax clearing. | |
| That would be very harmful for the markets. We are trying to | |
| have internationally coordinated standards here through the | |
| Basel Committee, and if Europe is going its own way and the | |
| U.S. is punitively taxing clearing, that will end up harming | |
| U.S. businesses in the long-term. | |
| So there is a process and this is happening over the next | |
| several years, but major decisions on this are being made for | |
| the next several months, and so today's hearing is very | |
| relevant and timely in that regard. | |
| Mr. Davis. Okay, and take it a little bit further. Can you | |
| state for the Committee, you believe, or don't you, that this | |
| may cause problems for banks that obviously fall under multiple | |
| jurisdictions? | |
| Mr. Lukken. Absolutely. This is an international issue, but | |
| international regulators have differences of opinion on this. | |
| And so, the fact that there is a disagreement between the | |
| market regulator, the CFTC on this, and the Prudential | |
| Regulators here in the United States, that may have | |
| international consequences on how this standard is put into | |
| place internationally. | |
| Mr. Davis. So we have seen that Members of the European | |
| Parliament, Kay Swinburne, a Welsh Member of the European | |
| Parliament, has brought up this idea of the EU fixing | |
| unilaterally the leverage ratio, even if other jurisdictions | |
| like the U.S. are in opposition. Now, I mean do you foresee | |
| such an effort there, or do you think, as you just mentioned | |
| before, that there might be a better compromise through other | |
| means? | |
| Mr. Lukken. Well, our hope is that this works its way | |
| through the Basel process and there is a satisfactory | |
| resolution, but you have Members like Kay Swinburne, Markus | |
| Ferber, who I met with last week, as a Member of the Parliament | |
| in Europe, Jonathan Hill, the European Commissioner that covers | |
| these markets. I mentioned Mark Carney. So there is growing | |
| consensus in Europe. I can't predict what their legislature | |
| will do there, but there is growing consensus that this is a | |
| problem that needs to be fixed one way or another. | |
| Mr. Davis. So you would like the agencies to fix it and | |
| keep the politicians out, right? | |
| Mr. Lukken. Exactly. Like I said, this is simply measuring | |
| the actual economic exposure of banks. We are not asking for an | |
| exception. To me, this is just measuring it right. Let's | |
| measure what the actual risk is and then let's move on. | |
| Mr. Davis. And keep the politicians out, just like here. | |
| Mr. Lukken. Exactly. | |
| Mr. Davis. Thank you. | |
| Mr. Lukken. Yes. | |
| The Chairman. Gentlemen, thank you for being here for this | |
| review of the impact of capital and margin requirements on end- | |
| users. Before we adjourn, I would like my Ranking Member, Mr. | |
| Scott, to make any closing remarks he has. | |
| Mr. David Scott of Georgia. Well, just very briefly, Mr. | |
| Chairman. This has been a very, very important hearing, and a | |
| very essential one. But I do hope a message has gone out from | |
| us Members in Congress, particularly on this cross-border | |
| thing. First, each of you recognize and articulated that this | |
| failure to deal with equivalency situation with the EU | |
| definitely puts the American businesses, manufacturers, end- | |
| users, and all of those, clearinghouses, at a distinct | |
| competitive disadvantage. And it is my hope, and the reason I | |
| stressed this is that I served on this Committee, Ranking | |
| Member, mostly on the Financial Services Committee but I am | |
| also a Member of the NATO Parliamentary Assembly, and some of | |
| these same people I deal with also deal with the EU. And that | |
| is why I want a very strong message going out here today that | |
| we need to stop this foolishness with discriminating against | |
| American businesses, or else there will be retaliatory moves | |
| made. | |
| The Chairman. Thank you, Mr. Scott. | |
| Under the rules of the Committee, the record of today's | |
| hearing will remain open for 10 calendar days to receive | |
| additional material and supplementary written responses from | |
| the witnesses to any questions posed by a Member. | |
| This hearing of the Subcommittee on Commodity Exchanges, | |
| Energy, and Credit is adjourned. | |
| [Whereupon, at 11:27 a.m., the Subcommittee was adjourned.] | |
| [all] | |
| </pre><script data-cfasync="false" src="/cdn-cgi/scripts/5c5dd728/cloudflare-static/email-decode.min.js"></script></body></html> | |