In a May 10, 2017 address, acting Chairman of the Commodity Futures Trading Commission (CFTC) J. Christopher Giancarlo highlighted some unintended consequences regulation is having on the swaps markets. In his speech before the International Swaps and Derivatives Association 32nd Annual Meeting in Lisbon, Portugal Giancarlo talked about the changes to swaps trading liquidity, market fragmentation and regulatory comity in the post-reform global swaps markets. After providing an overview of how some aspects of the misapplication and miscalibration of regulatory reforms were harming global liquidity, he provided some astute observations on how to alleviate some of the harm being done to swaps markets in particular.
As part of the President’s executive order on Core Principles for Regulating the United States Financial System, Giancarlo said that the CFTC recently completed a review of the impact of existing regulation on the financial system. From this review, the CFTC has identified several areas where regulation is impeding liquidity and the movement of capital. Giancarlo notes that one major way that regulation is affecting liquidity is by forcing banks to change their structures as a result of new capital requirements.
"bank-dealer firms have shifted significantly from the principal model to the agency model of securities dealing. Therefore traditional market-makers no longer hold such ability to support trading liquidity by risking capital and holding inventory. Rather than buying or selling financial instruments to hold on their own account until counterparties are found, dealers increasingly prefer matching customer orders, thereby avoiding the need for overnight capital or exposure to cash flow risk from margin calls. Depth and immediacy – two key features of liquidity – have been affected by these changes."
Giancarlo also singled out the supplementary leverage ratio as a regulatory reform measure having serious unintended adverse consequences on swaps markets, and ultimately, on the resiliency of financial markets as a whole.
"[The] SLR is a perfect example where regulators, who focused narrowly on the goal of increasing bank capital, failed to appreciate the impact on another important risk buffer, central clearing. This has undermined the resiliency and efficiency of the financial markets."
The misapplication of the SLR, Giancarlo said, "reduces the already-narrow profit margins of bank-owned [future commission merchants] (FCMs).” Consequently, the ratio’s effect on segregated customer margin payments passed on to CCPs for clearing "is causing many of the largest banking institutions to reduce their willingness be in the FCM business.” He also noted that the current implementation of the SLR does not take into account the offsetting of outstanding derivative contracts in a portfolio. In addition, Giancarlo said, "the current applications treats the notional size of a derivative contract as representative of the total potential risk of that contract, altogether ignoring the exposure-reducing effect of margin for clearing firms.”
Chairman Giancarlo has some solutions in mind, however, to alleviate the SLR’s negative effects on liquidity:
- Exclude customer cash collateral held at the CCP from the bank’s leverage calculation.
- Take customer collateral held at the CCP into account in computing potential future exposure in a manner consistent with the Basel Committee on Bank Supervision’s standardized approach to counterparty credit risk.
While the effect of global financial reforms has been overall positive, making the global financial system more resilient by enhancing capital reserves of banks and other financial institutions, Giancarlo said the time has come for "a better understanding of how the various reforms work together.” He has committed to working with his counterparts in other jurisdictions to combat regulatory fragmentation on the basis of comity, not uniformity. He also announced a goal to alleviate some regulatory burdens to allow and encourage more global participation in the U.S. trading markets. To achieve this, Giancarlo said that the CFTC will move to a flexible, outcomes-based approach for cross-border equivalence and substituted compliance.
The full text of Chairman Giancarlo’s address is available via: http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-22