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For release on delivery 1:00 p.m. EDT June 4, 1993 C l e a r a n c e and Settlement of D e r i v a t i v e P r o d u c t s R e m a r k s by Susan M. P h i l l i p s M e m b e r , B o a r d of G o v e r n o r s of the F e d e r a l R e s e r v e S y s t e m FIA New York Operations Division Workshop June 4, 1993 I am p l e a s e d to be able to p a r t i c i p a t e and t i m e l y p r o g r a m . I would with you my thoughts about management: settlement the-counter first, like to t a k e t h i s o p p o r t u n i t y to s e v e r a l a s p e c t s of f i n a n c i a l a p p r o p r i a t e public of d e r i v a t i v e s , (OTC) m a r k e t s , in c o m i n g to its recent in t h i s i n t e r e s t i n g policies toward both t h o s e traded and, second, share system risk c l e a r a n c e and on e x c h a n g e s and in over- some of the B o a r d ' s t h i n k i n g d e c i s i o n to d e l e g a t e m a r g i n authority for stock i n d e x f u t u r e s to the C o m m o d i t y F u t u r e s T r a d i n g C o m m i s s i o n . Y o u m i g h t w o n d e r what Board's policy some m a y interest consider stems from in c l e a r a n c e and its b r o a d risks. settlement responsibility, B e c a u s e w e a k n e s s e s in c l e a r a n c e and financial s t r u c t u r e and by n e w rapidly including derivative r e i n f o r c e d by rapid responsibilities settlement instruments. in c l e a r i n g a r r a n g e m e n t s c h a n g e s in m a r k e t created by legislation. are aware, the OTC f i n a n c i a l d e r i v a t i v e s m a r k e t s h a v e since the m i d - 1 9 8 0 s , F e d e r a l R e s e r v e has active players. and b a n k i n g o r g a n i z a t i o n s regulatory Furthermore, for settlement o p e r a t i o n of c l e a r a n c e and instruments, for d e r i v a t i v e s has been interest p r o b l e m s , the Board has In recent y e a r s the B o a r d ' s i n t e r e s t no doubt The B o a r d ' s s t a b i l i t y and c o n t a i n i n g p o t e n t i a l c l o s e l y the d e s i g n and systems for systems, which as the n a t i o n ' s c e n t r a l b a n k , systems are a p o t e n t i a l s o u r c e of s y s t e m i c examined is the F e d e r a l R e s e r v e a t e c h n i c a l or l e g a l s u b j e c t . maintaining financial market systemic specifically As you grown for w h i c h the r e s p o n s i b i l i t y are among the m o s t after a m u l t i - y e a r d e b a t e on the r e g u l a t i o n of s t o c k i n d e x f u t u r e s m a r g i n s , C o n g r e s s passed the F u t u r e s T r a d i n g P r a c t i c e s Act regulatory of 1992, w h i c h among other t h i n g s a s s i g n e d this a u t h o r i t y to t h e F e d e r a l R e s e r v e . As a g e n e r a l m a t t e r , the F e d e r a l R e s e r v e b e l i e v e s that the sound and e f f i c i e n t o p e r a t i o n of c l e a r a n c e and settlement s y s t e m s for - 2 - derivatives is, and must remain, the primary responsibility of the private sector. That is, public policy interests in such systems are best served by developing broad and flexible standards and by allowing private market participants latitude to determine how best to meet those standards, rather than by attempts to micro-manage through regulation. In the remainder of my remarks today, I will try to illustrate this philosophy by discussing the Federal Reserve's policies regarding the clearance and settlement of OTC derivatives and appropriate levels of margin for stock index futures. Policies Toward Clearance and Settlement of OTC Derivatives To date, banks and other intermediaries or "dealers" in OTC derivatives have taken a fundamentally different approach to the management of counterparty credit and liquidity risks than the approach utilized for exchange-traded products. No clearing house yet has been formed to net OTC derivatives contracts multilaterally by substituting itself as seller to every buyer and buyer to every seller. Nor have the practices of daily payment of variation margin and posting of performance bond collateral been widely adopted. Rather, individual counterparties manage risks bilaterally. Counterparties are selected on the basis of credit ratings and evaluations. Credit exposures are carefully measured and controlled. Claims and obligations arising from multiple contracts between two counterparties typically are netted bilaterally, usually through a standardized agreement developed by the International Swap Dealers Association (ISDA). Several years ago the Federal Reserve and other central banks undertook a thorough study of clearance and settlement arrangements for payments and for foreign exchange contracts. The study included a detailed analysis of proposals to create clearing houses for forward -3- foreign exchange contracts. The analysis was summarized in the Report of the Committee on Interbank Netting Schemes (Lamfalussy Report), which was published by the Bank for International Settlements (BIS) in November 1990. The central conclusion of that report was that netting arrangements--both bilateral and multilateral--have the potential to reduce systemic risks, if properly structured. The Report set out minimum standards for the design and operation of cross-border and multicurrency netting schemes, which are broadly applicable to payment systems and to clearing houses for foreign exchange forward contracts or other OTC derivatives. These standards address the legal enforceability, transparency, and operational reliability of both bilateral and multilateral netting arrangements. They also address the credit and liquidity safeguards that the central counterparty (clearing house) in a multilateral system must employ to ensure its financial integrity. The standards are broad statements of principle rather than an attempt to identify best practices or to endorse or prescribe specific risk control mechanisms. For example, with respect to the credit and liquidity safeguards that a clearing house must impose, the standards simply indicate that limits must be placed on the maximum level of credit exposure to each participant and that sufficient liquidity resources must be available to ensure timely completion of settlement in the event of the failure of the single largest participant. I would note that even this minimum standard poses a challenge that may not be met by all existing clearance and settlement systems for derivative instruments. The standards are stated in general terms partly because of concerns about moral hazard. If market participants come to see central banks as taking direct responsibility for the stability of - 4 - netting or settlement systems, their incentives to manage risks prudently would be undermined. The Lamfalussy Report emphasized that the minimum standards are not intended to diminish the responsibility of market participants for ensuring that netting systems have adequate credit, liquidity, and operational safeguards. The decision to avoid endorsing a specific approach to risk management also reflected the Lamfalussy Committee's conclusion that quite different designs of clearing systems for derivatives were feasible. In particular, the Committee studied carefully the relative merits of centralized and decentralized risk management systems for a clearing house. The Committee recognized the proven effectiveness of the centralized, collateral-based systems employed by futures and options clearing houses. approach also is feasible. But it concluded that a decentralized Such an approach seeks to preserve incentives for bilateral credit risk management by allocating losses to participants on the basis of their bilateral dealings with a failed participant. The Report concluded, however, that the system's liquidity risks probably would need to be managed centrally. Bankers currently working to develop clearing houses for spot and forward foreign exchange contracts are, in fact, pursuing one type of decentralized credit risk management. Rather than seeking to force the evolution of clearing methods for OTC derivatives along particular lines, central banks and banking regulators have focused on refining capital requirements to provide appropriate incentives for market participants to adopt riskreducing innovations and on reducing uncertainty about the legal enforceability of netting agreements. With respect to capital requirements, last December the Federal Reserve revised its risk-based capital requirements for banking organizations for certain low-risk -5collateralized transactions such as • securities lending. These revisions, which apply to OTC derivatives exposures, recognize the risk-reducing effects of collateral and margining procedures. Specifically, capital requirements were eliminated for credit exposures that are collateralized by cash or government securities, provided that the collateral value is adjusted each day to exceed the exposure by some positive margin. The Board chose not to specify minimum margin levels but expects banking organizations to maintain prudent levels, taking into account the volatility of the exposures and of the collateral values. The Federal Reserve and other banking supervisors in the G-10 countries also have proposed to revise risk-based capital requirements to provide stronger incentives for the development and utilization of sound netting arrangements for OTC derivatives. The existing Basle Capital Accord provides only limited recognition of the potential for netting to reduce credit risks. Among bilateral netting agreements, only one particular restrictive form is recognized--that is, bilateral netting by novation of foreign exchange obligations for the same currency and value date. With respect to multilateral netting arrangements, the existing Accord recognizes the risk-reducing effects of futures - style margining. Banks are not required to maintain capital to support credit exposures to clearing houses that employ such safeguards. The new G-10 proposal, which was issued for public comment at the end of April, would among other things expand recognition of bilateral netting arrangements for capital adequacy purposes to encompass all such arrangements that are effective under relevant laws and that comply with the other minimum standards of the Lamfalussy Report. Furthermore, the proposal indicated a willingness to - 6 - recognize multilateral netting arrangements that utilize a decentralized risk management model. However, the development of concrete proposals for capital treatment of such credit exposures was deferred until the details of the developing arrangements become clearer. The Lamfalussy standards emphasize the critical importance of the legal enforceability of netting agreements. If a counterparty measures its credit exposure on a net basis but the netting agreement is not enforceable, the true exposure is the gross exposure. The counterparty thus could face losses and liquidity pressures far larger than expected and, quite possibly, larger than could readily be absorbed. In some foreign jurisdictions, doubts about the legal enforceability of netting agreements remain a significant impediment to their use. By contrast, a series of legislative changes in the United States has provided substantial legal certainty regarding the enforceability of such contracts. The latest change was a far-reaching provision of the FDIC Improvement Act (FDIGIA). This provision validated under U.S. law all netting contracts between and among depository institutions, securities broker - dealers, and futures commission merchants. Furthermore, it authorized the Federal Reserve Board to broaden the coverage to other financial institutions if it determines that doing so is appropriate to reduce systemic risk. In early May, the Board issued a proposed rule that would broaden the definition of financial institution to include all legal entities that are large-scale dealers in the OTC derivatives markets. Implementation of this proposal would eliminate uncertainty about the legal enforceability of netting agreements between certain affiliates of broker/dealers and insurance companies that are active dealers in the OTC derivatives market and - 7 - banks and other entities that already meet the statutory definition of financial institution. The Federal Reserve also has sought to ensure that U.S. commodities laws do not impose unnecessary impediments to riskreduction capabilities in the OTC derivatives markets. In a letter supporting the CFTC's proposal to exempt OTC derivatives from certain provisions of the Commodity Exchange Act, the Board stressed the importance of the elimination of restrictions in previous policy statements on bilateral credit enhancements, such as collateral or margining arrangements. The Board also urged the Commission to permit the development by market participants of clearing house arrangements for OTC derivatives. Although the Commission's final action stopped short of permitting a clearing house for OTC derivatives, the analysis of the potential public benefits of a clearing house that accompanied the final rule appears broadly consistent with the analysis and conclusions of the Lamfalussy Report. Specifically, the Commission indicated that the design and operation of clearing facilities should be driven by the needs and desires of market participants, clearly a view shared by the Federal Reserve Board. If market participants come forward with such a proposal, the Commission's exemptive authority provides it the flexibility to design an appropriate regulatory framework. I should note the Board has never suggested that an OTC derivatives clearing house be wholly unsupervised. There are potential systemic risk concerns related to such a facility. Indeed, the Governors of the G-10 central banks (including the Federal Reserve) have endorsed a principle, set out in the Lamfalussy Report, that an OTC derivatives clearing house that conducts settlements in foreign currencies or has foreign bank p a r t i c i p a n t s should be subject to official o v e r s i g h t . as a starting point The L a m f a l u s s y m i n i m u m standards are intended for analyzing the i m p l i c a t i o n s of a clearing house's d e s i g n and o p e r a t i o n for systemic risks to financial m a r k e t s and market p a r t i c i p a n t s , both in the United States and abroad. P o l i c i e s R e g a r d i n g A p p r o p r i a t e M a r g i n Levels for Stock Index Futures The B o a r d ' s p h i l o s o p h y of setting broad c l e a r a n c e and settlement standards for arrangements and leaving it to market p a r t i c i p a n t s to d e t e r m i n e how best to meet these standards has also been applied in its decisions margins regarding the appropriate levels of on s t o c k - i n d e x futures and options on futures. Futures Trading P r a c t i c e s Act, primary r e s p o n s i b i l i t y for setting m a r g i n levels remains with the exchange and But must federal oversight file any Under the its clearing o r g a n i z a t i o n . of the process is e s t a b l i s h e d . Contract markets rules e s t a b l i s h i n g or changing levels of m a r g i n on such c o n t r a c t s w i t h the Federal Reserve. The Board may at any time request a contract market to alter margin levels and, if the contract market fails to respond, the Board may direct it to alter m a r g i n levels. Such a u t h o r i t y may also be delegated fully or in part to the CFTC. The statute indicates that the Board's oversight intended to ensure that m a r g i n levels are appropriate f i n a n c i a l i n t e g r i t y of the contract market to prevent systemic risk." "to preserve the or its clearing system or The Board b e l i e v e s that this objective requires the e x c h a n g e and its clearing system to implement management system that authority is can cover any losses and meet a risk financial o b l i g a t i o n s in a t i m e l y m a n n e r in the event of a default by a large participant. has applied This is, of course, the same broad standard the Board in e v a l u a t i n g whether clearing systems for OTC d e r i v a t i v e s and other financial instruments adequately contain potential systemic risks. Margin requirements are a key financial safeguard in the risk management systems utilized by futures exchanges and their clearing entities. Nonetheless, other risk management tools are equally important to the financial integrity of a contract market. These tools include capital requirements for futures commission merchants, membership requirements for exchange and clearing members, audit and supervision capabilities, and the full range of safeguards employed by clearing organizations, especially the daily (and intraday) collection and payment of variation margin, loss-sharing arrangements with member firms, and the availability of bank credit lines. These other components of exchange and clearing house risk management systems are critical because margins typically are not set (and for short positions simply cannot be set) to cover all potential future losses from extreme movements in prices. Rather, margins typically are intended to cover only 95 to 99 percent of price movements, based upon historical experience. Thus, price movements in excess of margin levels are expected but cannot be allowed to jeopardize the integrity of the contract market. The capital and liquidity of member firms typically must be sufficient to cover anticipated margin deficiencies. And if a member were to default on its contractual obligations, the risk management system employed by the contract market must be designed to ensure that such losses can be covered. The clearing organization must also have systems, procedures, and liquidity resources that allow it to meet its obligations to other participants in a timely fashion. An assessment of the level of margins necessary to protect the financial integrity of the contract market and prevent systemic -10- risk must take into account the strength of these other critical elements of the risk management system. In principle, a contract market with relatively stringent membership and capital requirements and sizable liquidity facilities may achieve an adequate degree of protection with relatively low levels of margin. At the other end of the spectrum, higher margins would be advisable for markets with less strict membership and capital requirements or smaller liquidity resources. The CFTC is most familiar with and has the most comprehensive authority over these risk management systems, and, thus, is in the best position to make judgments about appropriate margin levels and to ensure that such levels are maintained. For this reason, in late March the Board delegated its authority over stock-index futures margins to the CFTC until further notice. The Board expects that the CFTC will review the appropriateness of margin levels in light of the statutory objective and the strength of the contract market's overall risk management system. The CFTC has agreed to report to the Board annually on its experience in reviewing such levels. Conclusion I hope that my remarks today provide you with a better understanding of the principles that underlie the Federal Reserve's efforts to strengthen clearance and settlement arrangements for derivative products. The private sector, with regulatory and central bank support and encouragement, has made significant progress in this area in recent years. I look forward to working with market participants and fellow regulators to achieve further improvements. Thank you.
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