Centrally cleared, exchange-traded derivatives markets have flourished over the last several decades. Under substantial regulation at all critical points in the ecosystem, (i.e. brokers, clearing members, exchanges and central counterparties (CCPs)), these markets proved to be resilient during the 2008 financial crisis. The regulatory regime for these markets included requirements respecting record-keeping, price reporting and transparency, and intermediated access to centralized counterparties such as OCC. Providing robust, independent risk management of financial transactions under the comprehensive regulatory oversight of and examination by the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC), OCC has served as the foundation for secure markets in the U.S. listed equity options markets since 1973.
Following the 2008 financial crisis, global policymakers borrowed the key tenets of centrally cleared, exchange-traded markets in mandating regulatory reform of the over-the-counter (OTC) derivatives markets. To date, neither the G20 reforms nor the new capital requirements for important financial market participants -- particularly, the Basel III regime that covers banks and their affiliated entities -- are fully implemented. Yet, international policymakers have already embarked on efforts to re-write the rules that underpin the regulatory framework for CCPs such as OCC in "further guidance" issued by the International Organization of Securities Commissions (IOSCO) earlier this summer.
Like most U.S. CCPs, OCC supported the enhanced regulatory requirements imposed on CCPs in conjunction with OTC regulatory reform. This includes requirements that expanded and complicated our compliance obligations, increased the amount and detail of day-to-day oversight and scrutiny by policymakers, and raised the cost of doing business in our markets. We are seriously concerned, however, that repeated cycles of new and overly prescriptive regulation of centrally cleared markets will undermine the core objective of OTC regulatory reform: mandating the use of CCPs for standardized OTC derivatives products and financially incentivizing the use of CCPs in markets where there is no mandate to centrally clear such OTC derivatives.
Notably, the incredibly prescriptive nature of the new IOSCO "guidance" poses model and contagion risk for cleared markets globally by, for example, attempting to create uniform stress testing and risk management requirements for all CCPs. IOSCO's new approach would eliminate virtually any discretion that a CCP currently possesses to tailor its risk management framework to the business and the services it provides. This interferes with a CCP's ability to continue to successfully manage its unique credit, liquidity, operational and business risks. Moreover, the cost of capital to continue to support cleared and regulated derivatives markets stands to cut off access to CCPs, increase concentration risk among intermediaries and market markets, eliminate incentives to use cleared markets and drive banks to riskier markets that provide a better return-on-equity on their investments.
Recent data supports that we are on the verge of this pendulum swing, including a working paper by the Office of Financial Research (OFR) titled "Does OTC Derivatives Reform Incentivize Central Clearing?" The paper's main objective "is to gauge whether the higher capital and margin requirements adopted for bilateral contracts create a cost incentive in favor of central clearing, as intended." The study's results show that the cost comparison of cleared versus bilateral derivatives "does not necessarily favor central clearing and, when it does, the incentive may be driven by questionable differences in CCPs' default waterfall resources." Of significance is that the OFR paper did not consider the relative costs once the leverage ratio requirements are implemented. As discussed in a recent paper by Darrell Duffie, over-simplified approaches to bank capital models such as the new leverage requirement, which treats all assets as though equally risky, drives "balance-sheet management of some of the largest banks to be determined in significant part by these new requirements. This has implied a shift by some large banks away from low-risk low-profit intermediation."* Banks and bank affiliates must comply with the leverage ratio requirement in 2018. We should expect to see capital requirements for centrally cleared markets increase with the implementation of the leverage ratio and further elimination of any incentives to clear OTC derivatives.
The foregoing data also is supported by anecdotal evidence that banks and bank affiliates are reducing the capital they allocate to market making and agency services in the U.S. listed equity options markets. Specifically, we've heard the business case to deploy capital to support client clearing and market making activity in equity options markets is becoming increasingly more challenging and may force certain entities to exit the client-clearing business altogether unless policymakers clarify soon that banks and bank affiliates may (i) delta adjust their notional exposures and (ii) offset certain risk exposures within a portfolio for market marking activity in the U.S. listed equity options markets. Providing certainty to banks and bank affiliates that they may calculate their capital requirements for listed U.S. equity options portfolios is consistent with the Securities and Exchange Commission's net capital rules and the Standardized Approach for measuring counterparty credit risk exposures (SA-CCR), the latter of which was supposed to be adopted by U.S. policymakers in January 2017. Providing such certainty also would preserve incentives for banks and bank affiliates to deploy capital to centrally cleared markets and continue to facilitate client access to these markets.
I was struck by recent comments in a Milken Institute blog on clearing where the author said "central clearing does not magically dissolve risk, but only transforms it." That is a rather superficial argument to make when credit default swaps were unsettled, either under - or poorly collateralized, marked to myth, and not subject to reporting, record-keeping or multilateral netting mechanisms across all system participants. At OCC we do not claim to be magicians, but we do more than just "transform" markets. We greatly reduce the systemic risks that were actually realized from the poorly regulated but highly profitable un-cleared OTC market.
The unintended, adverse consequences of the combination of overly prescriptive regulations on CCPs and exorbitant capital requirements for banks and bank affiliates in light of the risk of listed U.S. equity options products will be increased systemic risk and disruption to the use and continued growth of these critically important financial markets. We can mitigate, if not avoid, such consequences if we take action now.
So, let's hit the pause button on the current efforts to re-regulate centrally cleared, exchange-traded markets. Let's do a holistic assessment with a robust cost/benefit analysis, to ensure efforts to prevent the next financial crisis are not actually fueling it. Let's take appropriate corrective action to address identified problems. I am not advocating for de-regulation of centrally cleared, exchange-traded markets or a return to a pre-2008 regulatory and capital regime. Instead, I am advocating for smarter regulation.
Risk permeates every aspect of the global economy and centrally cleared, exchange-traded derivative markets provide a secure marketplace for managing those risks. Supporting the continued use of transparent, fair and resilient derivatives markets, like those cleared by OCC, through a smart and proven regulatory framework with meaningful oversight, is exactly what policymakers across the globe sought to do in 2008. We should not let a false notion of perfection become the enemy of good.
To learn more about OCC's thought leadership on industry issues, visit OCC's Blog.
* Darrell Duffie, Financial Regulatory Reform after the Crisis: An Assessment, at pp. 48-49 (June 2016).