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April 17, 2014

New CFTC head tackles OTC unintended consequences | risk article

The new Chairman of the CFTC is making a fast start in tackling the unintended systemic risk consequences of Dodd-Frank's Title VII derivatives rules.  Could this avert a future FCM concentration risk crisis and enable legacy stockpiles of uncollateralized counterparty risk to be more easily reduced in response to the capital incentives?   Let's hope so.

CHECK THE DATE – FAKE.

The new Chairman of the CFTC is making a fast start in tackling the unintended systemic risk consequences of Dodd-Frank's Title VII derivatives rules.  Could this avert a future FCM concentration risk crisis and enable legacy stockpiles of uncollateralized counterparty risk to be more easily reduced in response to the capital incentives?   Let's hope so.

Massad comments in public forum

Taking aim at some of the emerging problems with the new OTC regime incoming CFTC Chairman, Tim Massad, announced what could be a far-reaching set of proposals to adjust the rules.  "It's clear from discussion with fellow commissioners, our colleagues at the Federal Reserve, academics and key industry representatives that – left as is – our mandated clearing, SEF trading and bilateral margin regime could add systemic risk or at best inhibit its reduction".

Recent behind closed doors discussions with select industry and regulator representatives have been kept secret.  Chairman Massad was happy enough with progress to comment in an aside from yesterday's public meeting.  "Looking at it with a fresh eye, I am concerned that cleared client risk in the eventual mature state will dominate dealer risk even though notionals will be dominated by clearing members.  If this happened it could create unacceptable risk build up in FCMs.  Also I am advised that the clearing and SEF mandates may inhibit the natural response of financial firms to reduce bilateral risk given the incentive effects of bilateral margin and capitalization of uncollateralized counterparties.  Neither of these were the intent of the rules and we are looking at fixing these problems before they happen so as to make the system less risky."

Specifically the proposals outlined can be summarized as follows:
  1. Exempting from the clearing mandate trades between two parties who are both subject to the bilateral BCBS / IOSCO margin rules
  2. Redefining the US agency FCM model putting clients and the CCP in a more conventional principal counterparty relationship 

Easier reduction of legacy systemic risk

"By preventing mutually risk reducing bilateral trades between a pair of counterparties because such trades have to clear and trade on a SEF, the CFTC has effectively dug a trench around the stockpile of legacy portfolio systemic risk making it harder to reduce", a London based head of CVA trading opined.  "This imaginative exemption may do more to reduce systemic counterparty risk than the rest of Dodd-Frank put together, since it will free up banks and later buy side firms to respond to the capital incentives and mutually trade down counterparty risk with clearing exempt risk-offsetting trades between a pre-defined pair of counterparties."

Minimizing FCM systemic risk build up and enabling FCM economic viability
 
"It looks like the CFTC is starting to get the joke" said one US bank's New York City based head of client clearing.  "Punishing FCMs for risks they either do not bear or did not originate is just going to drive them out of OTC client clearing.  We could be creating an intraday credit and concentration issue.  We don't want OTC to become another tri-party repo problem.  It feels like we're past hoping the BCBS tweaking the Basel III rules is going to materially change the subsidy / capitalization issue so we need to look at the client clearing model itself.  After all, why should client clearing providers put up default fund contributions on behalf of clients or hold capital against client-risk-driven default fund contributions or IM?"

FCMs funding and capital costs on client cleared portfolios includes the associated:

  • Default fund contribution funding costs,
  • Basel III default fund contribution capital and
  • CFTC FCM minimum capital threshold of 8% of client IM

The new client clearing model changes are thought to include requiring clients themselves to pay their default fund contributions on their portfolios instead of the FCMs, having CCPs themselves manage client defaults directly whilst FCMs still provide short-term liquidity to the CCP and financing to clients but not remaining in their operational intermediary role as today.  A first reading of the changes would mean that counterparty RWA and default fund contributions on client portfolios would be substantially eliminated from FCMs.  If CFTC can also adjust their own FCM capital rules to alleviate the 8% of client IM problem – FCMs could have a business with sustainable return on capital and therefore there might be no shortage of willing providers.

"The proposal was not intuitive at first as it breaks the prior idea of no mutualization risk for clients" said a leading buy side representative.  "However, the estimates I've seen indicate the mutualized risk would be quite limited given IM are set at "defaulter pays" levels.  If this enables FCMs to back off the risk charges they are currently advancing in clearing price negotiations and it takes most of the risk out of portability by removing the disincentive to port inwards caused by the default fund costs of an incoming portfolio, this could be a good trade off even with the additional default fund contribution cost and risk."

For more details

Please read the attached article and check with the author for the back story


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