AUSTIN (May 1, 2014) - Craig Donohue at the Options Industry Conference in Austin, TX, gave the following speech on May 1, 2014:
Thank you – it's great to be here with you this morning. I especially want to thank our hosts at BATS for providing me with the opportunity to speak with you about the changes that are occurring at OCC and in the post-trade landscape more generally. In particular, I want to take this opportunity to address the recently announced changes to our fee schedule and refunds for 2014.
As you've just heard, the options industry continues to experience strong growth. In the last 10 years, the compound annual growth rate for options has been 13 percent versus 11 percent in futures and just 3 percent in equities. I personally believe that growth will continue as our markets become more global, we innovate exciting new products and services, and institutional users increasingly rely on our markets for their trading and investment needs.
Sustained growth in an industry like ours is a consequence of many things and everyone in this room plays an important role in fostering that growth.
- Exchanges bring buyers and sellers together by providing competitive, transparent and liquid markets.
- Clearing and non-clearing members facilitate both agency and proprietary business in our markets.
- Market makers provide the critical liquidity that makes our markets efficient for public customers to transact.
- And last, but not least, OCC provides financial stability - by guaranteeing the performance of every transaction in our markets.
Last year, OCC cleared more than 4 billion equity derivatives transactions. We hold approximately $100 billion in margin collateral and we move approximately $3-5 billion between buyers and sellers every day. Throughout our 40-year history our clearing fees have remained the lowest in the industry – in most cases by a significant margin.
Additionally, since 1974, OCC has refunded more than $2 billion to clearing member firms who primarily pass on the refund to market users. While I recognize the concerns expressed about our recent fee and refund announcements, I think it is important to consider those temporary measures in light of the longer-term context I've just described.
I'm going to come back to expenses, capital requirements and fees in a minute but before I do that I want to provide some background for you so that you understand the regulatory environment that OCC is now operating in.
As everyone here knows, the 2008 financial crisis exposed major structural weaknesses in our financial market systems. One of the key problems that contributed to the crisis was the fact that the OTC derivatives markets had mushroomed to nearly $600 trillion in gross notional exposures1 outstanding between market participants. This was about 10 times world GDP2 in that same year. The market had grown larger than the supporting infrastructure and risk management mechanisms that it utilized. For example:
- There was a significant backload of unconfirmed trades in the CDS market;
- Many counterparties failed to adequately collateralize their exposures
- Trading and credit extension ground to a halt as counterparties worried about performance of counterparty obligations.
In contrast, our markets functioned extremely well because market participants understood the value of OCC's guarantee and the distinctive features of central counterparty clearing. At OCC:
- We operate on a daily mark-to-market or pay as you go basis;
- We revalue positions and effectuate daily settlements;
- We only accept high quality collateral; and
- We maintain stringent financial and membership requirements, including a substantial guarantee fund and assessment powers to ensure financial stability
Given these differences in the functioning of the listed and OTC markets, it is not surprising that the G20 determined that clearinghouses could reduce systemic risks in OTC derivatives markets3. At the same time, however, policy makers also recognized that shifting OTC derivatives to central counterparties could further concentrate market risks and that central counterparties themselves are perhaps "too big to fail." It is really this recognition that created the paradigm shift for how clearinghouses are now regulated. Former Fed Chairman Ben Bernanke aptly summarized this point of view when he said4:
"What was once a landscape of numerous, separate clearinghouses that operated largely independently from one another has now become dominated by fewer and larger clearinghouses supporting more integrated markets and consolidated, global financial firms. Moreover, the same globally active banks participate in all of the major clearinghouses, and the major clearinghouses often rely on similar sets of banks for payment services, funding, settlement, and emergency liquidity. In such a world, problems at one clearinghouse could have significant effects on others, even in the absence of explicit operational links. The need for strong risk management and oversight will only increase as we go forward." (Emphasis added)
With the passage of Dodd-Frank and similar initiatives around the globe, regulation of central counterparties has been fundamentally transformed. In 2012, a group of international regulators (CPSS/IOSCO) issued Principles for Financial Market Infrastructures5, which set new international standards for systemically important organizations such as central securities depositories, trade repositories, and central counterparties. In July 2012, OCC was designated a systemically important financial market utility (SIFMU) by the Financial Stability Oversight Council. This expanded OCC's regulatory oversight from the SEC and the CFTC to also include the Board of Governors of the Federal Reserve System.
Following on the heels of the PFMI's and the separate rulemakings by the CFTC and Fed, the SEC has now proposed its own rules6 to implement the PFMI standards for OCC and other covered clearing agencies. The net result of this is that regulatory standards for clearing houses are similar to those in place for complex, systemically important banking institutions. This has been a game changer for us. It has increased our need for additional resources, in particular in the control functions such as Compliance, ERM and Internal Audit, in order to ensure that we meet the heightened standards that now apply to us. In 2014, headcount and operating expenses have increased by 15% as we work to ensure that we can comply with the new requirements.
While I am still relatively new in my tenure at OCC, let me make one thing very clear – these additional resources are critically necessary. They support our core mission in terms of risk management, operational integrity and internal controls.
Another important aspect of these new standards relates to minimum regulatory capital. Government officials and regulators have determined that clearinghouses should maintain liquid financial resources equivalent to 6 months of operating expenses7 to ensure against general business losses. I think it is hard to argue rationally that this requirement is unsound when one considers the central role we play in supporting our capital markets and the functioning of the broader economy. Earlier in my remarks I mentioned that most of OCC's working capital has been refunded each year to market participants, including a $47 million refund for 2013 that will be paid by September of this year8. Because of that, OCC's net working capital is approximately $25 million or the equivalent of approximately one and a half months of operating expenses. I think it is self-evident that a systemically important financial institution like OCC that holds nearly $100 billion in customer margin and guarantees the performance of all obligations to market participants should maintain equity capital in line with the new requirements – even if the new requirements did not exist.
So, let me bring you to January when I joined OCC as Executive Chairman. The PFMIs and the CFTC rules on liquid financial requirements had already been adopted and the Fed's rules had already been proposed in early January. While the SEC's proposed rules were still in development, we were aware that it was likely they would be published very shortly and would likely be effective in 2014. That left us with a potential shortfall of approximately $67 million and the prospect that we might not be in compliance with requirements that have been in development for several years.
Between January and March we worked diligently to identify various alternatives for raising equity capital. The new standards speak to shareholders' equity and retained earnings and not debt or other contingent capital arrangements. Raising equity capital in an organization like OCC is challenging because we are a private company, our shareholder exchanges do not and never have received dividends, refunds or other distributions. As I mentioned earlier when referring to the $2 billion in refunds that users have received, it is our clearing members and their customers who receive pass through refunds who have benefited from OCC's strong financial performance.
Given the timing limitations and constraints on raising equity capital, our Board unanimously approved the elimination of the discount, effectively returning to our rack rates and the suspension of refunds in 2014 sufficient for OCC to be 100% compliant with these new requirements by the end of 2014. In our announcement, we highlighted that we expect these changes to impact 2014 but we do not expect such impacts to materially carry over into 2015 or subsequent years.
In closing, let me say a couple of things:
- First, we recognize the impact that these changes have on you – neither OCC management nor the Board took this decision lightly.
- Second, I think we could have and should have communicated in a much better fashion with you on this topic – nevertheless I am here today in the spirit of doing that and I thank you for the opportunity to do so. While I only have 15 minutes with you and my time is coming to an end here, I will be around the rest of the day and I welcome further dialogue with you.
- Third, I want to assure you that we are working on developing a 5-year forward looking model of expenses, capital requirements, fees and refunds so we can return to a more predictable and transparent model for dealing with you - our valued stakeholders
- Finally, and perhaps most importantly, I want to unequivocally reaffirm our strong commitment to maintaining low cost, efficient operations while we continue to provide sound risk management solutions and financial stability to market participants.
In my view, the regulatory paradigm shift that we are going through is very positive for OCC. I believe these changes will make us even stronger and more resilient. Thank you for your continued support of OCC and thank you for allowing me to speak to you this morning.
1 http://www.bis.org/publ/otc_hy0805.pdf Bank for International Settlements – OTC derivatives market activity in the second half of 2007, published May 2008
2 http://data.worldbank.org/indicator/NY.GDP.MKTP.CD/countries?display=graph According to the World Bank Group, Global GDP in 2007 was approximately $56.5 Trillion (in USD)
3 http://www.g20ys.org/upload/files/Washington_1.pdf In the Washington Summit on November 15, 2008 the declarations on Prudent Oversight stated, "Supervisors and regulators, building on the imminent launch of central counterparty services for credit default swaps (CDS) in some countries, should: speed efforts to reduce the systemic risks of CDS and over-the-counter (OTC) derivatives transactions; insist that market participants support exchange traded or electronic trading platforms for CDS contracts; expand OTC derivatives market transparency; and ensure that the infrastructure for OTC derivatives can support growing volumes.
4 http://www.federalreserve.gov/newsevents/speech/bernanke20110404a.htm Clearinghouses, Financial Stability, and Financial Reform, remarks by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System at the 2011 Financial Markets Conference sponsored by the Federal Reserve Bank of Atlanta Stone Mountain, Georgia on April 4, 2011
5 http://www.bis.org/publ/cpss101a.pdf Principles for financial market infrastructures by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO)
6 http://www.sec.gov/rules/proposed/2014/34-71699.pdf Standards for Covered Clearing Agencies
7 http://www.federalreserve.gov/newsevents/press/other/20140110b.htm Federal Reserve System, Financial Market Utilities, Notice of Proposed Rulemaking
8 https://www.theocc.com/getmedia/e4733089-3aa0-4ec2-9057-95345f5e35e7/occ_ar2013_financials.pdf Note 8 of OCC's 2013 Annual Report