[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
____________
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20-029 PDF WASHINGTON : 2016
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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
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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\
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\1\ ISDA mission and strategy statement: http://www2.isda.org/
about-isda/mission-state-
ment/.
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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\.
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\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.
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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\
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\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.
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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\
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\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.
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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\
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\9\ These numbers exclude the so-called residual risk add-on, non-
modellable risk factors and diversification across risk classes under
internal models.
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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\
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\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.
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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.
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\11\ H.R. 2289, the Commodity End-User Relief Act.
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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.
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:
The Net Stable Funding Ratio;
The Supplemental Leverage Ratio;
Restrictions on Models for Non-Bank Swap Dealers;
Competitive Issues Surrounding the Credit Valuation
Adjustment;
The Swap Dealer De Minimis Threshold; and
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\
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\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.
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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\
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\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.
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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.
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\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.
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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\
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\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.
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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.
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\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.
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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\
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\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.
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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:
Building high quality capital and mitigating pro-
cyclicality;
Improving over-the-counter derivatives markets, including by
requiring ``non-centrally cleared contracts . . . to higher
capital requirements''; and
Addressing cross-border resolutions and systemically
important financial institutions by year-end 2010.\11\
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\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
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generally:
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;
Reducing counterparty credit risks, by increasing clearing,
margin and capital requirements;
Reducing systemic risks by enhancing capital requirements;
and
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.
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\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).
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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.
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\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.
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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.
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\15\ See G20 Leaders Statement: The Pittsburgh Summit (Sept. 2009).
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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.
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\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.
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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\
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\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.
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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.
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\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).
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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.
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\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).
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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\
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\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.
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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.''
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\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.
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\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.
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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\
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\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.
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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\
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\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.
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\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\
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\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).
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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\
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\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:
Improve reporting of derivatives so firms and regulators can
better understand their exposures and risks;
Reduce counterparty credit risks by pressing for more
centralized clearing and imposing basic capital and leverage
restrictions; and
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.]
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