Comment Text:
Chairman Timothy Massad
Commodities Futures Trading Commission
Three Lafayette Centre
1155 21st Street NW
Washington DC, 20581
[email protected]
Re: Do Not Weaken Derivatives Risk Protections
Dear Chairman Massad:
This week, the Commission faces key decisions in finalizing a crucial protection against derivatives risk, namely the rules governing mandatory provision of margin for derivatives transactions. In a letter to the Commission on its proposed margin rules, AFR outlined the importance of requiring advance margin provision in derivatives transactions, highlighting the incredible $2.7 trillion in increased margin demands over less than two years during the financial crisis of 2007-2008 and the stress that put on the financial system. By requiring routine margin for derivatives, especially initial margin which provides a key buffer against future price changes and unforeseen increases in exposures, these rules will help to ensure that derivatives users understand and plan for the risks created by derivatives.
This letter, addresses one important area of these margin rules, namely requirements for inter-affiliate margin in transactions between swap dealers and affiliated entities. This issue has taken on increased prominence in recent months due to intense lobbying by major Wall Street banks to reduce or eliminate requirements for initial margin in inter-affiliate transactions. The margin rule recently finalized by prudential regulators did weaken inter-affiliate margin standards somewhat, but retained the critical requirement that affiliates and subsidiaries of insured depository institutions (IDIs) post initial margin in swaps with the IDIs. By retaining this requirement, the prudential regulators protected depository subsidiaries and the public. The initial margin requirement is particularly important since, as mentioned above, it is this type of margin that provides a buffer against the kind of rapid unanticipated changes in exposures that can occur during situations of financial stress.
The Commission should, at minimum, retain a similar requirement with respect to the most significant entities that you supervise, namely registered swap dealers. The Commission’s October, 2014 re-proposal on margin rules included a comprehensive set of requirements for inter-affiliate margin. In the final rule, you should at least require that affiliates and subsidiaries of swap dealers post initial margin in any inter-affiliate transaction with a swap dealer.
I realize that the swap dealers regulated by the Commission differ from IDIs, in that they do not benefit from deposit insurance provided by the U.S. government. However, this difference does not negate the systemic importance of providing inter-affiliate margin protections for these entities. These swap dealers are generally key subsidiaries within large, complex global financial institutions that have numerous major operating subsidiaries active in dozens of countries. Requiring margin for inter-affiliate transactions involving such major subsidiaries is extremely important for orderly resolution of these institutions. The experience of the 2008 financial crisis showed us that the orderly resolution or recovery of large global financial institutions is crucial to the stability of the overall financial system, even when they do not include a major insured depository bank. The disorderly failure of Lehman Brothers, a large global financial firm that did not include a significant IDI but was a major player in global derivatives markets, clearly had a massive impact on financial stability.
Permitting significant un-margined derivatives exposures involving key affiliates of large global financial institutions means that financial distress will spread much more rapidly within these entities, from a single troubled affiliate to other parts of the institution. It will mean that the top management of the firm will have fewer options in remediating distress, for example by selling a major subsidiary entity. Such a recovery plan will be more difficult if the subsidiary has many un-margined exposures to other affiliates, exposures that would have to be margined prior to sale. Finally, these un-margined exposures will present a major barrier to the rapid and orderly resolution and restructuring of a failing international financial firm, either by regulators or by the courts in bankruptcy. This barrier would be even greater because it is likely that un-margined derivatives exposures would extend across national borders, meaning that a swap dealer would more likely to be exposed to subsidiaries in other jurisdictions operating under different bankruptcy laws or possibly resolution regimes. By making resolution more difficult, a broad exemption from inter-affiliate margin would contribute to the problem of “too big to fail.”
FDIC Chairman Gruenberg highlighted this problem in a speech earlier this year on orderly resolution Chairman Gruenberg described the problem of interconnections within large complex financial institutions and the issues it creates for orderly resolution and financial stability:
“The actions the firms are being required to take focus in particular on reducing the interconnectedness between legal entities within the firms….These firms are extremely complex with hundreds, if not thousands, of legal entities, which operate on a business line—not legal-entity—basis. While business lines stretch across multiple legal entities, foreign and domestic, failure occurs on a legal-entity basis. The inability to resolve one legal entity without causing knock-on effects that may propel the failure of other legal entities within the firm makes the orderly resolution of one of these firms extremely problematic.
To improve resolvability, firms must…address cross-guarantees and potential crossdefaults that spread risk and tie disparate legal entities and operations together…Actions that promote separability of material entities will lessen the problem of knock-on effects created by interconnectedness, potentially allowing a firm to place its troubled entity into bankruptcy, or its existing resolution regime. Such an outcome would increase the likelihood that failure would be orderly, minimizing any potential instability for the financial system as a whole, a problem that greatly influenced policymakers' responses in 2008.”
Any rule which did not require inter-affiliate transactions between key subsidiaries in a global banking group to be fully margined would work directly against the goals laid out by Chairman Gruenberg here. Un-margined derivatives transactions create large credit exposures between subsidiaries that lead to precisely the ‘knock-on effects’ and cross-defaults that spread risk rapidly within a major financial institution. They create major practical problems in separating a single failing subsidiary from the rest of the institution and resolving that subsidiary on a standalone basis.
It is realized that in our divided financial regulatory system the CFTC does not have any direct responsibility for orderly resolution of a failing financial firm. Yet experience of the 2008 financial crisis and also the creation in Dodd-Frank of a Financial Stability Oversight Council (FSOC) that includes the CFTC, shows that the Commission should make every effort to coordinate with other regulators and to consider the effects of its rules on broader issues of financial stability. We thus urge the Commission to retain key margin protections and to consult carefully with the prudential regulators, through the FSOC and directly, concerning the implications of inter-affiliate margin for resolution of large complex entities and for financial stability more broadly.
Such consultation could also include discussion of regulatory arbitrage issues that could be created by a significant divergence between margin requirements for inter-affiliate transactions involving IDIs and those involving major subsidiaries of financial institutions that were swap dealers but not IDIs. Some have claimed that the funding advantages that exist for IDIs justify exempting non-IDI subsidiaries from margin requirements. Americans for Financial Reform has favored, and continues to favor, additional action to separate derivatives dealing from insured depositories. However, exempting non-IDI swap dealers from basic risk protections such as margin requirements would be a completely inappropriate response to concerns regarding the intermingling of swap dealing and publicly insured deposits. As discussed above, these exemptions would create significant barriers to effective recovery and resolution of major international financial institutions crucial to financial stability. They would also not be effective in actually addressing the problem of funding derivatives dealing using insured deposits.
The CFTC’s original margin proposal, while not perfect, did lay out a comprehensive set of basic margin protections for derivatives transactions. The Commission should not weaken its original proposal by providing broad exemptions from inter-affiliate margin requirements.
Yours sincerely,
Robert E. Rutkowski
cc: House Minority Leadership
2527 Faxon Court
Topeka, Kansas 66605-2086
P/F: 1 785 379-9671
E-mail: [email protected]
