On Dec. 11, the U.S. Commodity Futures Trading Commission held a public meeting of its Market Risk Advisory Committee, a group of market participants and public policy experts that provides input into CFTC rulemaking.
The committee, which operates under the leadership of Rostin Behnam, one of the five CFTC commissioners, discussed plans to develop policy recommendations in four areas: market structure, clearinghouse risk, the Libor transition, and climate change risk. In all four areas, the members of the advisory committee are working to deliver "actionable recommendations" to the CFTC by the end of 2020.
The most contentious area of discussion was clearinghouse risk. The subcommittee formed to work on this issue includes representatives of derivatives clearinghouses such as CME Group, Eurex Clearing and LCH as well as market participants such as Blackrock and J.P. Morgan. Although the two industry executives chairing this group said they are committed to reaching consensus wherever they can, it was clear from the discussion that there are intense disagreements within the group on the issue of "skin in the game," i.e., how much capital clearinghouses should contribute to their default funds.
Regarding Libor transition, the committee heard presentations from CME and LCH, the two primary clearinghouses for interest rate swaps, on their plans to switch to SOFR-based discounting and payment alignment interest in mid-October 2020. Several members of the committee commented that this switch will create operational challenges for market participants and could lead to "turbulence" in the market. The committee therefore agreed to hold a "table top" demonstration ahead of that date to test the process and support industry-wide preparations.
In a related announcement, CFTC Chairman Heath Tarbert announced at the beginning of the meeting that the agency will act next week to support the Libor transition. Tarbert said the agency will issue a series of letters providing "no-action relief" on the treatment of certain long-outstanding interest rate swaps if they are amended to add a fallback provision or to remove Libor as the reference rate. The relief will allow these "legacy swaps" to be amended without triggering the application of mandatory clearing requirements and other rules implemented by the CFTC after the passage of Dodd-Frank. Tarbert noted that the relief was requested by the Alternative Reference Rate Committee, a quasi-official body set up by the Federal Reserve Bank of New York to guide the Libor transition in the U.S.
CCP risk and governance
This subcommittee is chaired by Lee Betsill, chief risk officer of CME Group, and Alicia Crighton, chief operating officer, prime services, US clearing, at Goldman Sachs and a member of FIA's board. The group includes representatives from five clearinghouses as well as several clearing firms and other market participants (click here for a list of members).
In their presentation, Betsill and Crighton said the group decided to consider seven specific topics and agreed to divide the work into two subsets:
- Stress testing
- Liquidity framework
- Principles of default management
Governance and capital
- Governance and transparency
- CCP capital and default resources
- Non-default losses
They said the goal is to provide the CFTC with an update on their work by midyear and recommendations by year end. They acknowledged that it will be difficult to reach consensus on certain issues, but that this would not hold up work on other areas where there is more agreement.
Kristen Walters, global chief operating officer of risk and quantitative analysis group at BlackRock, spoke up about her firm's concerns about systemic risk in the clearing system. Chief among those concerns is the amount of capital that the clearinghouses put into their default funds, which are used to absorb losses when a member defaults. Walters said it is "absolutely critical" for clearinghouses to hold a significant amount of their own capital in these funds to ensure their incentives are aligned with market participants that use their clearing services, and she commented that a similar principle applies to banking and insurance organizations.
That comment prompted Robert Steigerwald, a senior policy advisor at the Federal Reserve Bank of Chicago, to interject that central counterparties are very different from banks and insurance companies from a systemic risk perspective, and for that reason they should not be regulated in the same way. Walters then clarified that her comments were not intended to include that both sets of firms should be regulated the same way.
Marnie Rosenberg, global head of clearinghouse risk and strategy at J.P. Morgan, also joined the discussion to emphasize the importance of these issues to her firm. She said her bank is "very aligned" with Blackrock's views, and added that the working group also should focus on margin requirements for exchange-traded derivatives.
This subcommittee, which is chaired by Lisa Shemie, the chief legal officer for the FX and SEF venues operated by Cboe, and Stephen Berger, global head of government and regulatory policy at Citadel, has divided its work program into three broad categories—trading, clearing and reporting—plus several issues that span more than one category. Most of the work program is related to swaps markets rather than futures and options.
The list of issues in the work program consists of the following:
- Swap dealer landscape
- Swap trading protocols
- Process and scope of the "Made Available to Trade" designation
- Post-trade name give-up
- Evolution of dealer-to-dealer vs dealer-to-customer markets
- Open access vs vertical integration for exchanges and CCPs
- Position limits
- Scope of clearing mandate
- Clearing member concentration
- Client clearing offerings
- Straight-through processing
- Cleared vs uncleared margin methodologies and levels
- Portfolio margining
- Pre-trade transparency regime
- Post-trade transparency regime
- Block trade thresholds
- Reporting and identifying package transactions
Additional issues that overlap working groups
- Treatment of FX products
- Libor to SOFR transition
- Equivalency determinations
- Codification of guidance and no-action letters
Shemie and Berger said they are aiming to release their first set of recommendations by June.
The chairman of this subcommittee, Robert Litterman of Kepos Capital, said the group has set a June deadline for delivering a report to the advisory committee on financial and market risks related to climate change. For example, the report will focus on ways in which market participants can improve the integration of scenario analysis and climate stress testing into their risk management and reporting.
"I anticipate that the heart of the report will be a section on the implications for market oversight policies, including disclosures, governance, strategy, risk management and conduct," he said in his presentation to the committee. "We will also try to identify and make recommendations with respect to the types of scenarios and stress tests as well as data and analytics that need to be developed and used."
Litterman added that the group also intends to recommend additional derivatives and other market products that may improve the hedging of climate-related financial risks.
Interest rate benchmark reform
Tom Wipf, a Morgan Stanley executive who is chairing this subcommittee, provided an update on recent developments in the Libor transition in the U.S. He also discussed a joint effort with the CFTC's chief economist to calculate the value of the legacy swaps linked to Libor and the amount of margin that would be required if these swaps lost their legacy status as a result of Libor-related amendments.
Wipf also discussed the proposals put forward by CME and LCH for moving to SOFR-based discounting and price alignment interest on cleared swaps. He welcomed the efforts the two clearinghouses are making to coordinate their plans, but he warned that there will be operational challenges and potential market turbulence when these changes are put into effect in mid-October 2020. For that reason, he urged the committee to organize a "table-top demonstration" with both clearinghouses to simulate the effects of this switch and help market participants prepare for the impact. This recommendation was approved by the committee.
Agha Mirza, global head of interest rate products at CME, and Dennis McLaughlin, group chief risk officer at LCH, each gave detailed presentations on their plans to transition to SOFR-based discounting and PAI for dollar-denominated interest rate swaps (click here for CME presentation; click here for LCH presentation). Both presentations also discussed how the clearinghouses plan to compensate market participants for changes in the value and risk profile of cleared swaps caused by the switch to SOFR-based calculations.