During the past decade, the focus in the derivatives clearing space has been the implementation of new clearing mandates for over-the-counter (OTC) products – a response to the last crisis.
But no one could have predicted what was to come, and as a crisis of a different sort emerged and the pandemic surged in 2020, the global derivatives markets experienced a real-time stress test, surviving heightened volatility, increased volumes, and interest from a wider variety of market participants.
In the early days of 2020, we were all reflecting on the 10 years since the passage of the Dodd-Frank Act, which established the OTC clearing mandate in the United States. But, as the new COVID-19 crisis emerged, we were quickly reminded that there is never time to rest on our laurels. Rather, we once again had to learn the lesson that we are building and simultaneously operating an infrastructure project in a constantly shifting environment. The construction on this project will never end, and requires continuous adaptation. Why does it always take a crisis to bring this point back into focus?
I’m not suggesting that we can plan for every crisis; quite the contrary. I’m suggesting it is time to acknowledge that we cannot. Once we accept our inability to predict the next crisis, we should use the lessons learned from past experience to look for opportunities to reinforce the system.
Equally important, we must have frequent and honest dialogue with the public (as well as policymakers) about the utility of the clearing system – and also its limitations. In 2008 and 2009, I had a front-row seat to the debate around various solutions considered in response to the financial crisis. At the time, I was working on the legislative team tasked with devising things such as the new clearing mandate for OTC derivatives.
After the G-20 leaders determined that central clearing was a solution to issues that arose during the precursor to the financial crisis, many people I encountered were confused when told that central clearing does not eliminate risk – but rather, in some cases, is a preferred method of managing risk in a world of interconnected counterparties. These nuanced distinctions need to be reinforced because too often our clearing system faces blame in the midst of challenging times due to misconceptions about its function and a misunderstanding of its bounds.
Back to basics
So, let’s start recovering from the current crisis by getting back to the basics: Let’s be clear about clearing.
We start by acknowledging that everyone here is in the business of managing uncertainty. At the Commodity Futures Trading Commission (CFTC), we regulate markets designed to help those facing uncertainty from inherent business risks. Those of you in the audience represent central counterparties tasked with mitigating uncertainty of counterparty performance in those markets.
When asked as children what profession we might choose once grown up, none of us likely said “I want to be in the uncertainty management business.” I rather had planned to be a teacher, but here we are in the uncertainty management business during a time of great global uncertainty. Getting back to the basics, I think there are two foundational elements that will move us forward during this time of uncertainty – collaboration and education (ok, maybe I can still live out my dream of being a teacher).
First, I need to note that the views I express today are my own and not necessarily those of the Commission I am proud to serve upon, nor my fellow Commissioners.
Managing Uncertainty – The Ultimate “Derivative” of COVID-19
Let me start with why it’s incumbent upon all of us to educate the public about the utility of derivatives. Confronting the challenges of the pandemic reminds us of derivatives’ primary function, which is “risk management” – the response to uncertainty. We must ensure the public understands that the critical function of our markets is managing uncertainty in providing the goods and services we all rely upon.
The recent pandemic has highlighted the ever-present uncertainty in our lives with regard to things we often take for granted, and it extends well beyond the obvious public health concern. For example, how will my mom’s teacher pension plan be impacted just as she nears retirement? What about the availability of goods we routinely seek? Remember how hard it was to find rice and paper goods last spring, at least in the U.S.?
All of these concerns have reinforced the need for derivatives as a tool relied upon by food and energy suppliers, manufacturers, mortgage providers, and retirement plan managers to manage uncertainty so they can effectively deliver the goods and services we have come to expect.
Our obligation is to spread the word: Derivatives are risk management tools that are especially critical in times of uncertainty.
Note to Social Media “Influencers”: #Derivatives #Food #Retirement #Mortgages
I know this sounds rudimentary to those of us operating in this space every day, but the evidence of misconception and misunderstanding is widespread. We need look no further than recent trading activity and market volatility triggered by posts on online message boards and social media platforms. Do the authors and readers of this misinformation realise they are unknowingly jeopardising the utility of these markets, to the detriment of those who have committed their hard-earned income to college savings and pension plans? Probably not.
So, here is our opportunity to step up and educate the public about our markets. I am pleased that the CFTC has recently initiated a new advisory encouraging the public to research and understand the commodity futures markets, physical markets and securities markets before trading based on information on social media.
Coming Soon to a Clearinghouse Near You: Retail Interest
Education is a shared responsibility between the regulator and you, the infrastructure providers. And it is no small task because the range of sophistication possessed by those trading products cleared at our regulated Central Counterparties (CCPs) is vast.
For example, it is evident that retail interest in the derivatives markets has increased significantly. The CFTC’s Global Markets Advisory Committee (GMAC), which I sponsor, held a meeting just last month highlighting some of the recent trends relative to retail interest in the derivatives markets. During that meeting, the CFTC’s Market Intelligence Branch (MIB) discussed the increased numbers of retail participants in certain derivatives markets, as well as how the markets we regulate at the CFTC are being impacted by retail interest in certain exchange-traded funds (ETFs).
Signs of this changing landscape of market participants are apparent. First, we have seen increasing listings by CFTC-registered exchanges of “micro” and “micro e-mini” futures and options contracts that allow participants to gain exposure to the futures markets at a much lower cost and capital requirements compared with standard futures contracts. Indeed, it has been reported that the CME expects to launch a new micro bitcoin futures contract in early May.
Second, last year, the CFTC granted designations to four new futures exchanges whose business models focus on retail traders. Some do not yet have contracts listed for trading, but one that does has seen modest – but steady – participation.
This appears to be a global trend. At our recent GMAC meeting, we also heard from a representative of the Ontario Securities Commission, who noted that they have seen both a significant rise in the past decade in the number of online trading platforms offering derivatives products to retail customers, and significant acceleration in the number of retail participants opening trading accounts over the past year.
If increased retail participation in the derivatives markets is a trend that is here to stay, how does that change the way we, the regulators, and you, the infrastructure providers, fulfil our obligations? This evolution in the make-up of derivatives market participants requires us all to think about whether our regulations and practices are fit-for-purpose in this new landscape.
From a regulatory perspective, I believe the CFTC’s principles-based regulatory framework provides flexibility to respond to changing market dynamics. Yet, we must constantly evaluate what, if any, adaptations need to be made to account for the expanding variety of participants trading and seeking access to clearing services.
From an industry perspective, given increased retail demand, how will CCPs and their clearing members need to adapt? How do the risk profiles of the various clients need to be accounted for, and how does that impact initial margin expectations? This goes to my point that we are simultaneously operating and building the infrastructure of our constantly changing markets and clearing system.
Innovation – We are Constantly Updating the Textbook
In a world where human nature prefers certainty, human regulators can sometimes fall into the trap of viewing new products and market innovation with scepticism. But here again, we are reminded that our job is facilitating uncertainty management for those facing inherent business risks. And with new uncertainties emerging every day, we need innovative solutions.
This requires constant education, such that the potential merits of new products can be weighed against the unknowns in an informed manner. Regulators must be open-minded and willing to take some risks of our own, lest we inadvertently limit valuable solutions. Again, education is key, and sometimes we should be the students rather than the teachers.
In the past few years, regulators have spent much time learning of many new proposed solutions. For example, there is obviously increasing interest in listing and clearing derivatives on digital assets. We also are seeing exchanges that intend to list event contracts for hedging risks from the anticipated outcomes of future events. And, last year, the industry added $21 billion to ESG mutual funds and ETFs, an indication of increased investor demand which inevitably leads to interest in the development of related derivatives products that will be regulated by the CFTC.
It is not particularly remarkable to consider that as risks evolve, derivatives contracts will develop in response – this progression is a rather common evolution. In fact, the CFTC already regulates almost 150 climate-related derivatives products developed in response to identified vulnerabilities faced by various end users. The remarkable takeaway here is the tremendous ingenuity that goes into building these innovative products.
Innovation is the lifeblood of the derivatives industry, and welcoming innovation in financial markets is at the heart of what we do at the CFTC. It is not an accident that the CFTC is structured to be nimble in order to enable innovation. That was an intentional decision by our Congress, and one that I am proud to promote. Our self-certification process for new products was deliberately designed to give the initiative and option to exchanges to certify a new derivatives product, and list the product for trading the following day, in order to avoid impeding innovative development in the context of ever-evolving financial markets.
Family Counselling for CCPs and Their Clearing Members
This gets me to the importance of collaboration. It is incumbent upon each CCP to design a plan for the impact of any new product on the risk profile and management of the clearing infrastructure. And yes, you will need to explain this to your regulator in Washington, London, Paris, Singapore, or Tokyo. But equally important as the dialogue with your regulators is the need for an early communication plan with your members.
As I mentioned previously, we are all in the uncertainty management business, and your business model is a partnership with your members. Perhaps we can avoid some unnecessary impediments to offering clients the new products they seek if there is better communication among all those tasked with risk managing the clearing of such products.
I realize this is a tall order because development and regulatory approval processes present constantly shifting dynamics. But I offer the observation that perhaps more well-informed stakeholders can minimise opposing interpretations being delivered to regulators, which only serves to frustrate and belabour the approval process, thereby delaying solutions.
This is the part of the programme where you likely expect me to talk about other matters that seem to divide CCPs and their members (margin models and governance come to mind). Well, to be honest, I would like to be on the receiving end, rather than the delivery, of that speech. That is, rather than competing white papers, I hope you all might lead discussions with your members to design solutions. Please don’t take that as an indication that I am naïve to the difficulty of such a task, or that I believe all is well and good and regulators have no role to play. Rather, I implore you all to find some common ground and bring solutions to the table to help us do our job in the spirit of collaboration, which I have already indicated is critical to our path forward.
Private sector solutions focused on making the clearing system safer will yield far better results than a government-dictated, one-size-fits-all-approach. In contrast, failing to find common ground among yourselves likely results in governments responding in the face of pressure, often without industry collaboration.
Derivatives League Unite – The Global Alliance
Collaboration is not only an expectation for the clearing market infrastructure, but also for the international regulatory community. We all know these markets are global, but too often we are stuck in a jurisdictional mindset. We must do better when responding to current and future challenges than we did in the past decade implementing reforms after the financial crisis. And one of the lessons learned during this past decade is that we must trust our regulatory colleagues around the globe.
No two regulatory bodies should be expected to put forward identical rules – comparability must be the standard. Without deference to comparable regulatory regimes, we subject the very infrastructure we depend upon to deliver reforms, such as CCPs, to a confusing web of compliance issues, or worse, a market that is fragmented and less systemically sound.
As the G-20 leaders grappled with the financial crisis in 2009, regulated CCP infrastructure was hailed as a means to alleviate problems presented by a previously undesirable web of interconnected counterparties to bilateral OTC transactions. CCPs were not a contributing factor to the crisis, but rather a potential solution.
If we as regulators expect CCPs to offer a global solution, and we implement comparable requirements for these CCPs, then our regulatory similarities should provide the basis to support regulatory deference between jurisdictions. Moving in the opposite direction undermines the coordination and consistency envisioned by the G-20, as well as all of the work regulators have committed to date. More concerning is that duplicative oversight complicates, rather than improves, the intended risk-management benefits of increased clearing of OTC transactions.
A Case Study – Exempt DCOs
I acknowledge that the U.S. has not always been as deferential as I believe we should, and there is tremendous confusion regarding recent attempts to establish a registration exemption process for non-U.S. CCPs to offer clearing to U.S. clients. As you know, the U.S. implemented its OTC clearing mandate and the requisite infrastructure requirements ahead of other jurisdictions. And it is my view that as other jurisdictions adopted their own measures to achieve these common goals, the CFTC should have long ago revisited our policies with respect to allowing U.S. persons access to non-U.S. OTC markets. After all, we have been doing so for over 30 years with regard to listed futures. We don’t need to reinvent the entire deference process for OTC products.
Unfortunately, after a decade of little progress, I believe that in 2019, we rushed to propose an incomplete path for non-U.S. CCPs (which we refer to as derivatives clearing organizations or DCOs) to obtain an exemption from DCO registration to clear OTC transactions for U.S. clients, based on comparable regulation in the CCP’s home country (the “Exempt DCO Proposal”).
Most notably, the 2019 Exempt DCO Proposal would have disallowed any U.S. OTC client from accessing a CCP that is exempt from registration with the CFTC through its futures commission merchant (FCM). This makes no sense, as U.S. clients are today permitted to engage in similar arrangements for their futures clearing needs abroad.
And, worse, it would set a potentially irreversible precedent. Even if the CFTC subsequently recognised the merits of extending to OTC products an FCM system that is already familiar to U.S. persons engaged in foreign futures, the CCPs would likely have already made a commercial decision to abandon any potential future engagement from FCMs.
Rather than find ways to enable a CFTC-registered FCM to facilitate clearing for U.S. clients, these CCPs would likely have focused instead on building their U.S.-facing offering to avail themselves of the only path permitted under the Exempt DCO Proposal for obtaining a registration exemption – one that, oddly, would disallow the use of an FCM, thus effectively killing any hope U.S. clients have of applying to the OTC markets the efficiency of a clearing system that has worked for many years in listed futures.
Although some individual jurisdictions might benefit if the CFTC were to advance the 2019 Exempt DCO Proposal, we cannot ignore the fact that its lack of optionality would likely be irreversible, and thereby limit choices for U.S. clients, even if the CFTC sought to correct the policy later.
Despite my pleas to re-propose the pathway for non-U.S. CCPs to obtain a DCO registration exemption to clear OTC transactions for U.S. clients based on comparable home-country regulation, with enhancements sought by U.S. clients, no such effort was made last year. From my perspective, leaving this undone could result in long-lasting limitations on the options U.S. clients want and deserve.
Location-Based Policies Run Counter to Our Shared Goals
I would now like to make a brief comment about location-based policies, and to acknowledge that balancing the global nature of CCPs and the financial stability within each individual jurisdiction is a challenge.
However, I take seriously our responsibility at the CFTC to help market participants and infrastructure providers achieve the commitment our governments made at the G-20 Summit in 2009 to increase utilisation of central clearing. This responsibility requires global access to global markets. As such, we must permit CCPs around the globe to compete, and we must seek to minimise location-based limitations among jurisdictions implementing comparable principles for their CCPs, because such access limitations run counter to our goal of increasing central clearing around the world.
Additionally, I believe such polices run afoul of their very justification. That is, they can actually contribute to, rather than mitigate, financial instability within a jurisdiction by ignoring the global nature of these markets, leaving those within their confines without access to clearing and thereby without access to markets for which there is a clearing mandate.
If we are truly committed to the outcome we all agreed to a decade ago, such location-based policies have no place in the discussion. It is counterproductive to mandate clearing and then disallow those who need access to derivatives from utilising the clearing infrastructure best suited to their needs – clearing infrastructure that may very well be outside their home country.
The bottom line: In order to create a stronger, more resilient clearing system, we must work together and collaborate across our borders in our global markets. This responsibility lies first and foremost among regulators. Let’s not allow past mistakes or constantly shifting geopolitical dynamics to jeopardise our progress.
If I was in fact living out my childhood dream of being a teacher, I would award you all an A+ for your attention today. I look forward to each of us working on the assignments of enhanced educational efforts and better collaboration. Thank you for allowing me the opportunity to share with you my thoughts on how we can continue to promote central clearing while strengthening our clearing system to build a resilient infrastructure for our global markets into the future.
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.