In response to a growing reliance on their services, the Securities and Exchange Commission has adopted rules that establish enhanced standards for the operation and governance of securities clearing agencies. The changes apply to entities that are either designated as systemically important or involved in complex transactions, such as security-based swaps.
The move, yet another battle in the war against systemic risk in the financial markets, is also welcome news for banks in the European Union that would otherwise face billions of dollars in capital surcharges related to their derivatives trades and other cross-border financial activities with parties in the United States.
“The use of clearing agencies is critical to the safety and efficiency of securities trading, enabling billions of dollars of securities to change hands smoothly every day,” Chairman Mary Jo White said prior to the SEC’s Sept. 28 vote. “At the same time, their centralized role in concentrating and managing financial exposures, which has grown significantly since the financial crisis, can raise systemic risk concerns.”
Securities clearing agencies perform a range of services needed for the effective operation of the securities markets, including acting as intermediaries between the parties to a securities transaction, ensuring that funds and securities are correctly transferred between parties and, in some cases, assuming the risks of a party defaulting on a transaction by acting as a central counterparty. The SEC serves as the supervisory agency for four of the designated clearing agencies, and the Commodity Futures Trading Commission serves as the supervisory agency for the remaining two.
The SEC rule comes amid an evolving international regulatory landscape and will likely expedite equivalency negotiations with its European counterparts and their recognition of U.S. central counterparties. Should the European Commission deem the U.S. regulatory regime similar enough to its own requirements, EU banks will be spared billions of dollars in capital charges that would be attached to derivatives trades settled at clearinghouses based in the United States. The European Union plans to start demanding either regulatory equivalency with other countries or the capital charge on Dec. 15.
The SEC’s new requirements follow the CFTC’s March 16 approval of a substituted compliance framework for dually registered counterparties located in the European Union.
“The determination reflects the CFTC’s efforts to ensure that central counterparties (CCP’s) on both sides of the Atlantic are held to high standards, thereby promoting financial stability,” the agency said at the time. It followed “extensive analysis” to understand whether differences in with European regulatory regimes were significant, while identifying European Market Infrastructure Regulation requirements that are comparable to corresponding Commission rules.
‘Wall Street nearly ground to a halt’
A full understanding of the importance of CCPs and recent regulatory developments requires a quick history lesson. In the late 1960s and early ’70s, “Wall Street nearly ground to a halt” because manual back office processes could not keep up with the increasing volume of securities transactions,” explained Commissioner Kara Stein. Clearance and settlement problems led to the failure of numerous broker-dealers.
“Ultimately, the imposition of punitive capital charges on OCC’s EU-bank affiliate clearing members will trickle down to exchanges and market participants and would adversely impact the entire marketplace.”
Craig Donohue, CEO, Options Clearing Corp.
To resolve what became known as the “paperwork crisis,” Congress directed the SEC to establish “a safe, sound, and efficient clearance and settlement system” with “due regard for the public interest, the protection of investors, the safeguarding of securities and funds, and maintenance of fair competition.” Clearing agencies became a central part of this new system, standing in-between market participants and helping to ensure securities were efficiently transferred and paid for. “They also improved investor confidence by providing a financial backstop for cleared securities transactions,” Stein said.
A lot changed amid the financial crisis of 2008. Concerns about the liquidity of some of the largest financial firms in the world caused many to question whether these firms could meet their financial obligations. “This worry spread throughout the financial markets and destabilized firms and businesses around the globe. The financial markets seized up, as firms sought to minimize their counterparty risk exposure,” Stein recounted.
In response, Congress, with Title VII and VIII of the Dodd-Frank Act, moved to enhance clearance and settlement systems and address concerns about concentrated counterparty risk. It did so by calling upon the SEC to establish standards for security-based swap-clearing agencies and adopt risk management standards governing systemically important clearing agencies. “Much like building codes, these standards are supposed to prevent or mitigate the spread of a fire,” Stein said. “Congress did not want clearing agencies to be nodes of risk that could cause a new financial conflagration.
The new requirements adopted on Sept. 28, apply to SEC-registered securities clearing agencies designated as systemically important by the Financial Stability Oversight Council and those involved in “complex transactions.”
Agencies covered by the new rules will be subject to new requirements regarding, among other things, their financial risk management, governance, recovery planning, operations, and disclosures to market participants and the public.
Specifically, the SEC will require covered entities to:
Have policies and procedures that establish qualifications of members of boards of directors and senior management of a covered clearing agency, specify clear and direct lines of responsibility, and consider the interests of relevant stakeholders in the covered clearing agency.
Have policies and procedures for recovery and wind-down planning.It also would require policies and procedures designed to ensure that risk management and internal audit personnel have sufficient authority, resources, independence from management, and access to the board to fulfill their functions effectively.
Establish policies and procedures for daily stress testing, monthly review, and annual validation of credit risk models.
Have policies and procedures regarding setting and enforcing appropriately conservative “haircuts” and concentration limits and subjecting them to annual review at least annually.
policies and procedures for marking positions to market, collecting margin on at least a daily basis, and conducting daily back-testing, monthly sensitivity analyses, and annual model validation.
Maintain policies and procedures that address holding “qualifying liquid resources” sufficient to withstand the default of the participant family that would generate the largest aggregate payment obligation in “extreme, but plausible market conditions.”
Maintain procedures that provide for holding liquid net assets funded by equity equal to at least six months of current operating expenses so that the covered clearing agency can continue operations during a recovery or wind-down.
Establish a viable plan—approved by the board of directors and updated at least annually—for raising additional equity should its equity fall close to or below the amount required.
The adopted rules will become effective 60 days after publication in the Federal Register. Affected securities clearing agencies must comply with the requirements within 120 days of the effective date.
A related proposal would apply the newly adopted rules to other categories of securities clearing agencies, including all SEC-registered securities clearing agencies that are central counterparties, central securities depositories, or securities settlement systems.
“Clearing agencies are vital pieces of our market infrastructure, and their role in the financial markets is only increasing,” Commissioner Michael Piwowar said prior to the vote. The current state of central counterparty clearing agency regulation “is one of the things that keeps me awake at night … I am concerned that our best supervisory programs cannot overcome bad policy decisions.”
In early discussions surrounding post-crisis financial reform, Dodd-Frank Act policymakers settled on CCPs as “a near-miraculous way to address risk in the financial system” and significantly reduce systemic risks, he said. “Soon, policy makers began to view these long-standing cogs in the market infrastructure as giant black boxes that took in risk, and then poof, magically eliminated it from the system. With this simplistic view of the markets in hand, policy makers then determined that the most effective way to address risks in the system was to cram as many transactions as possible into CCPs via the Dodd-Frank Act’s extensive clearing mandate.”
Not surprisingly, Piwowar said, it did not take long for market participants and regulators to recognize that, despite efforts to reduce systemic risk, the Dodd-Frank Act did the exact opposite. “It created an entirely new class of too-big-to-fail entities with the power to bring down the entire financial system,” he suggested.
Piwowar supported the SEC’s moves, but added that these efforts have “the eerie feeling of re-arranging deck chairs on the Titanic.”
“I hope that history will prove me wrong, but I fear that the Dodd-Frank Act has created too many icebergs for our financial system to safely navigate,” he said.
Stein also had concerns about the new requirements. “There is too much wiggle room. Standards for systemically important clearing agencies should be clear and unambiguous.”
For example, the new rule requires that covered clearing agencies that are clearing the most complicated and riskiest financial products use models to figure out what will happen when the markets experience stress. “This sounds good,” Stein said. “However, the rule qualifies this requirement. It says such analysis only needs to be done when ‘relevant’ or ‘where practical.’ These terms are vague and left for the clearing agencies to interpret. This is like requiring a construction company that is building a skyscraper to only comply with the building standards it wants to follow.”
Stein ultimately supported the rule, “but only because it marginally decreases the risk posed by systemically important clearing agencies.”
The SEC’s actions were praised by Options Clearing Corp., the world’s largest equity derivatives clearing organization. “This was an important priority for the OCC and the-U.S. listed options industry,” says CEO Craig Donohue. It is “a critical step toward an equivalency agreement between the SEC and the European Commission that will allow central counterparties who are subject to SEC regulation to be eligible for recognition by the European Securities and Markets Association and for attaining qualified central counterparty (QCCP) status for purposes of European capital regulation.
Recognition of U.S. central counterparties subject to the SEC’s jurisdiction is important, he said, because it would allow European Union banks and their bank affiliates’ exposure to those CCPs to be subject to a lower risk weight in calculating their regulatory capital. “Without such recognition, a CCP cannot admit firms established in the European Union to membership,” Donohue says. “It cannot clear for trading venues established in the European Union, nor can it clear products subject to the clearing mandate for market participants established in the European Union.” In this scenario, for his firm, EU affiliate clearing members’ risk-weighted asset exposures would increase to more than $75 billion, up from approximately $924 million, requiring them to maintain additional capital of approximately $5.25 billion.
“Ultimately, the imposition of punitive capital charges on OCC’s EU-bank affiliate clearing members will trickle down to exchanges and market participants and would adversely impact the entire marketplace,” he said.
While the SEC’s new rules should facilitate cross-border regulatory equivalency with the European Union, Piwowar cautioned U.S. regulators against putting international demands ahead of what is best for domestic markets. The topic of clearing agency oversight, he said, has been dominated by the Principles for Financial Market Infrastructures (PFMI), developed under the auspices of the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions. Around the world, regulators are being pressured to conform to these standards.
“It must have been tempting for SEC staff to merely seek to codify the PFMI and then congratulate themselves for a job well done,” Piwowar said. “This would have been the easy approach, but it would have been the wrong approach. Simply porting over international standards would have failed to fully account for the agency’s obligation to regulate these entities under the mandates of the Securities Exchange Act of 1934 and ignored the unique perspectives we have gained through years of supervision in this area.”
The SEC’s final rule, he was pleased to say, reflects “a staff decision to not take the easy way out” and “establish effective regulation tailored to the Commission’s unique mandate and experiences, while creating a regulatory structure that is consistent with the PFMI.”