The Clear Outcome

Thank you to the World Federation of Exchanges for inviting me to participate in this year’s WFEClear Conference, and thank you to the Bolsas y Mercados Españoles for hosting all of us. I must first give my standard disclaimer: The views I share today are my own and do not necessarily reflect the views of the United States Government, my fellow commissioners, or the Commodity Futures Trading Commission (“CFTC”), on which I am proud to serve.

Throughout the programming over the next few days, the WFE organisers have highlighted a few themes that I would like to echo – clearing incentives, clearing structures and market resilience – by offering my thoughts on certain current regulatory developments in the United States. I believe these developments risk undermining the post-financial crisis goals, carefully evaluated and laid out by the G-20 in 2009, of increasing the use of central clearing, strengthening the clearing system, and reducing systemic risk.¹

Before I get into these developments, I think it may be instructive to take a step back in time to September 2009 and that meeting of the G-20 leaders, which was held in Pittsburgh, Pennsylvania. This seminal moment may seem like just yesterday to many in this room, but it has been almost 15 years since that meeting. Although a lot has happened since 2009, many of the themes from that meeting in Pittsburgh are still relevant, and we continue to be well served by the goals that were articulated at that important summit.²

Unless you are a fan of the Pittsburgh Steelers football team (American football, that is), or an alumnus of the University of Pittsburgh, you may be wondering (like I did): Why Pittsburgh? A few hours’ drive East would take you to Philadelphia, a city of historical significance to the United States. Or perhaps the summit could have been held in New York City, the seat of financial power in the United States thanks to Alexander Hamilton’s ambition to create a national bank.³

So, why Pittsburgh? Well, it turns out that New York City was the first choice for the summit, but when that did not work out, it was instead held in Pittsburgh to highlight the city’s economic transformation from the home of America’s steel industry to a hub of high-tech innovation.⁴

Pittsburgh has an interesting history that started well before the city’s economic turnaround. I am admittedly a bit of a history nerd. I enjoy learning about the origins of the towns and cities throughout the United States, and I stumbled across a truly unusual historical fact about Pittsburgh – the story of how it came to be spelled with an “h” at the end. While there are other cities in the United States sharing this name, Pittsburgh, Pennsylvania is the only city that is spelled using the “h” at the end of its name.

The mysterious existence of this silent “h” at the end of Pittsburgh dates back to 1758, in a letter sent to William Pitt, 1^st Earl of Chatham, informing him that his name was being given to the territory – Pittsbourgh (or Pittsburgh) – with an “h.”⁵ When the city, then Pittsburgh, was chartered in 1816, an apparent printing error dropped the “h” from the charter.⁶ However, despite the missing “h” in the charter, the citizens of Pittsburgh continued to spell the city’s name with an “h.”⁷

While it might seem as though this should have been the end of that story, in 1891, the United States Government stepped in to correct this supposed spelling error.⁸ The United States Board on Geographic Names declared that an “h” does not belong in the names of towns ending in “burg.”⁹ And, in case there was any doubt as to the government’s decree being the correct outcome to this persistent spelling issue, the Board pointed to the misprinted city charter to bolster its argument that the “h” did not belong in Pittsburgh.¹⁰

But the good people of Pittsburgh did not see a problem with their preferred spelling of Pittsburgh, and they certainly did not accept the government’s edict on the impropriety of a silent “h” in the names of towns ending in “burg.” In fact, the Pittsburgh Gazette, the University of Pittsburgh, and the Pittsburgh Stock Exchange refused to accept the government’s new spelling and continued to use the “h” in spelling “Pittsburgh” until the Board on Geographic Names gave up the fight approximately 20 years later and officially restored the original spelling in 1911.¹¹

I am sharing this story for a reason other than making all of us relive our fears of the dreaded elementary school spelling bee. There are numerous lessons in this story that we can learn from and apply today. First, proofreading is important. Second, change is not always positive. And third, imposing a solution that is contrary to the interests of those who bear its consequences is not the best way for a government to exercise its power.

Returning to where I started, the G-20 leaders recognised at their Pittsburgh meeting that the cleared financial derivatives markets remained resilient during the financial crisis¹² – and, of course, we know what happened in the uncleared, over-the-counter derivatives markets.

With that understanding, the G-20 leaders determined that clearing of standardised derivatives through central counterparties (“CCPs”) offered a solution to limit the counterparty credit risk of interconnected derivatives trading in the financial system.¹³ Thus, increasing central clearing through CCPs became a goal for derivatives markets across the globe, and much of the risk held by individual institutions has shifted to the central clearing model over the past decade.¹⁴

But recent policy proposals in the United States risk upending the success we have experienced through the efforts of the G-20 and the move to central clearing. In connection with their implementation of the Basel III framework, United States prudential bank regulators recently proposed increased risk-based capital requirements for banks providing client clearing services, despite the recognition by the G-20 leaders of the beneficial, risk-reducing effect of clearing derivatives.¹⁵

This proposal, which we refer to as the Basel III Endgame Proposal, would diverge from (rather than harmonise with) the approach of our international colleagues, and would have a significant – and negative – impact on derivatives markets.

First, it would disincentivise firms from offering client clearing services to derivatives end-users – which is directly contrary to the goal of the G-20 leaders to increase the use of central clearing. The Futures Industry Association has compiled data showing that the Basel III Endgame Proposal would increase the capital required to engage in client clearing activities by more than 22 percent.¹⁶ Banks are likely to react to this financial disincentive by passing along the higher cost of providing client clearing services to their customers and/or decreasing the extent to which they offer client clearing services. Either result would undermine our shared post-financial crisis goal of increased clearing.

Second, the Basel III Endgame Proposal would weaken the clearing system by exacerbating the downward trend in the number of entities offering client clearing services. In January 2004, there were 177 futures commission merchants (“FCMs”) registered with the CFTC.¹⁷ Twenty years later, as of January 2024, there are 62 FCMs registered with the CFTC¹⁸, representing a 65% decline. But over the same period, there has been a dramatic increase in customer funds held at FCMs to support derivatives trading. In January 2004, FCMs held over $87 billion of customer funds.¹⁹ Today, that smaller number of FCMs is holding five-and-a-half times that amount of customer funds – $490 billion.²⁰ And of that customer money, approximately 60% is concentrated in the top five FCMs.²¹

By worsening this downward trend in the availability of entities to provide clearing services, the Basel III Endgame Proposal would weaken the clearing system, not strengthen it. In clearinghouses, when a clearing member fails, losses are mutualised among members. But with fewer members available amongst which a loss can be mutualised, clearing membership becomes a riskier activity – perhaps beyond the risk tolerance of some firms that might then choose to no longer remain members of a clearinghouse…and thus continues a vicious cycle.

Third, a further decline in the number of FCMs would create systemic risk. In addition to concentration concerns, a decline in the number of FCMs would raise serious challenges regarding the portability of customer positions should a clearing member fail. Consider this potential scenario: a clearing member defaults, and its customers’ positions need to be ported to a different clearing member; however, porting those positions proves difficult or even impossible because the Basel III Endgame Proposal has both decreased the number of clearing members and reduced client clearing capacity at the remaining clearing members. This outcome of the Basel III Endgame Proposal would increase systemic risk, not reduce systemic risk.

At the end of the day, then, these changes to bank capital requirements under the Basel III Endgame Proposal would have significant negative effects on cleared derivatives markets. The consequences would be most acute with respect to derivatives that are required to be cleared pursuant to post-financial crisis reforms. And these negative effects would be felt, first and foremost, by the end-users that our markets are supposed to serve – farmers, ranchers, energy producers, energy consumers, pension plans, endowments and businesses both small and large.

Derivatives end-users would confront increased risk if the Basel III Endgame Proposal is adopted. Those that wish to clear through more than one FCM to mitigate the risk of their funds being tied up if their FCM fails may not be able to do so if the universe of FCMs dwindles. Worse, the resulting increased cost of hedging might compel end-users to leave some of their activities unhedged – and thus far riskier than they need to be.

Ultimately, the increased hedging costs resulting from adoption of the Basel III Endgame Proposal would mean price increases for those buying a house or a car, purchasing food to feed their families, or paying their electricity bills to keep the lights on. Given the global nature of today’s derivatives markets, I would not expect these consequences to be confined to America’s shores.

To end on a positive note, during a recent Congressional hearing, Federal Reserve Chairman Powell stated he expects that the Basel III Endgame Proposal would be significantly revised, and that the Federal Reserve Board would reach consensus on “broad and material” changes to the Proposal by the end of this year.²² For the overall strength and resilience of the global clearing system, I hope these changes reflect what I believe is the most important lesson of the Pittsburgh “h,” – namely, imposing a government-mandated solution that is contrary to the interests of those in the derivatives markets that will bear its consequences is not the best way for a government to exercise its power.

Of course, bank capital requirements are critical to our collective efforts to prevent another financial crisis. But addressing capital requirements should not impose undue costs on providing client clearing services. Such a result would undermine the G-20’s goals, harm derivatives end-users that rely on clearing services, increase risk in the global financial system, and raise the cost of living for our families.

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_{1 See generally Leaders’ Statement from the 2009 G-20 Summit in Pittsburgh, Pennsylvania (September 24-25, 2009), GRP. OF TWENTY, available at https://www.fsb.org/wp-content/uploads/g20_leaders_declaration_pittsburgh_2009.pdf.} 

_{2 Id.} 

_{3 Am. Experience, Establishing a National Bank, PUB. BROAD. SYS., available at https://www.pbs.org/wgbh/americanexperience/features/establishing-national-bank/ (last visited Mar. 18, 2024).}

_{4 Paul Owen, G20 Meeting: Why Pittsburgh?, THE GUARDIAN (Sept. 24, 2009), available at https://www.theguardian.com/world/2009/sep/24/g20-meeting-why-pittsburgh (last visited Mar. 18, 2024).} 

_{5 The Pittsburgh ‘H’, VISIT PITTSBURGH, available at https://www.visitpittsburgh.com/things-to-do/arts-culture/history/the-pittsburgh-h/ (last visited Mar. 18, 2024).} 

_{6 Id.} 

_{7 See Id.} 

_{8 Id.} 

_{9 Id.} 

_{10 Id.} 

_{11 Id.}

_{12 supra note 1.} 

_{13 Id.} 

_{14 Economic Bulletin Issue 8/2016: Looking Back at OTC Derivative Reforms – Objectives, Progress and Gaps, EUROPEAN CENT. BANK (Dec. 21, 2016), available at https://www.ecb.europa.eu/pub/pdf/ecbu/eb201608.en.pdf.} 

_{15 Regulatory Capital Rule: Large Banking Organizations and Banking Organizations with Significant Trading Activity, 88 Fed. Reg. 64,028 (Sept. 18, 2023).} 

_{16 Walt Lukken, Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity, FUTURES INDUS. ASS'N, 2 (Jan. 16, 2024), available at https://www.fia.org/sites/FIA - 2023 Basel Endgame Comment Letter.pdfdefault/files/2024-01/FIA%20-%202023%20Basel%20FIA - 2023 Basel Endgame Comment Letter.pdfEndgame%20Comment%20Letter.pdf.}

_{17 Selected FCM Financial Data as of January 31, 2004, COMMODITY FUTURES TRADING COMM'N (2004), available at https://www.cftc.gov/sites/default/files/files/tm/fcm/tmfcmdata0401.pdf.} 

_{18 Selected FCM Financial Data as of January 31, 2024, COMMODITY FUTURES TRADING COMM'N (2024), available at https://www.cftc.gov/sites/default/files/2024-03/0120-20FCM%20Webpage20Update20-20January202024.pdf.} 

_{19 supra note 17.} 

_{20 supra note 18.} 

_{21 Id.}

_{22 Christopher Rugaber, Federal Reserve’s Powell: Regulatory Proposal Criticized by Banks Will be Revised by End of Year, ASSOCIATED PRESS (Mar. 7, 2024), available at https://apnews.com/article/inflation-economy-housing-rates-prices-federal-reserve-87ffd50b57a391a1bfd0eed17dde1ddd.}