In an address before the 40th annual FIA Boca Raton International Futures Industry Conference, Timothy Massad, Chairman of the Commodity Futures Trading Commission, suggested that long-standing issues that have so far resulted in European regulators not recognizing US clearinghouses as subject to equivalent oversight as under European law may be close to resolution.
Without such a determination, European banks utilizing US clearinghouses will potentially be subject to a penalty capital charge beginning September 15, 2015. (Click here for background in the article, “European Banks Receive a Stay From Taking Capital Hits for Exposure to US Clearinghouses,” in the December 8 to 12 and 15, 2014 edition of Bridging the Week.)
In his presentation, Chairman Massad also provided some insight into how the Commission views the debate about the appropriate level of clearinghouse “skin in the game,” without revealing the likely outcome of the CFTC’s deliberations. (Skin in the game refers to the amount of resources a clearinghouse will contribute to the default waterfall from its own capital, as opposed to its members’ resources).
Chairman Massad distinguished between a bank’s need for capital and a clearinghouse’s. Banks, he said, require capital “to offset losses that may arise frequently.” Clearinghouses, however, require capital to cover a very “unusual event” where “there has been a default of a clearing member, and the resources of the of the defaulter held by the clearinghouse—both initial margin and default fund contribution—are not enough to cover the loss.”
The chairman suggested that a determination of an appropriate level of clearinghouse skin in the game should be viewed in the context of what is an appropriate “alignment of incentives between the clearinghouse and its clearing members.” This is particularly relevant, he said, where the equity of clearinghouses is typically now held by outside investors, not members.
Moreover, said the chairman, it is important to consider issues regarding skin in the game in the context of clearinghouse governance. According to Chairman Massad,
whose interests should be taken into account when a clearinghouse designs its recovery plan and when a clearinghouse faces a default? If the waterfall of resources is not sufficient to cover a default, then how does the clearinghouse decide what happens next, and who should participate in or have input into that decision? How do we ensure there is adequate time for that decision-making process to take place?
Although he did not provide insight regarding his thoughts on the possible answers to these questions, the chairman noted that these and other aspects of clearinghouse recovery plans in case of a extraordinary default by a member will be discussed during a roundtable this week at the CFTC.
(Click here for further background on the skin in the game debate, to view the article, “CME Group Adds Its View to ‘Skin in the Game’ Debate” in the January 19 to 23 and 26, 2015 edition of Bridging the Week) and here to view the article, “…While a Clearinghouse—LCH.Clearnet—Weighs in on Clearinghouse Issues Too” in the December 1 to 5 and 8, 2014 edition of Bridging the Week.)
My View: Issues around clearinghouse recovery generally and the appropriate level of skin in the game were among the many important topics addressed during formal sessions and bar-side conversations at the FIA Boca conference. Another major topic often discussed was the decreasing profitability of futures commission merchants because of, among other reasons, increasing capital requirements and regulatory costs. Outsourcing of FCM back-office functions, issues around automated trading, Bitcoin and opportunities involving China were also addressed. Frankly, other than the discussions regarding Bitcoin, most of the conversations were repetitive of those from last year, although the arguments were better refined after a year of rehearsal. Unfortunately, legislators, regulators and industry participants have failed for many years to look at financial services holistically, and instead have endeavored to address discrete issues within silos, with an eye towards the past rather than the future. This is why, to me, legislators and regulators have enacted laws and rules to promote central clearing, on the one hand, but at the same time have enacted capital rules and other regulations that discourage banks (and other brokers) from facilitating central clearing, on the other hand. Futures commission merchants too have bemoaned the low interest rate environment as hurting profitability, forgetting that they are brokers not banks, while at the same time taking too few actions to increase differentiation from their competitors and to enhance customer service. As a result, they are left to compete solely by offering too low rates. The paradigms of yesterday will not work going forward, and unless legislators, regulators and business leaders recognize this, we are likely to be discussing the same topics next year at Boca too—although the break from the Northeast and Midwest winters will always be appreciated!