Futures Industry Grapples with Swaps

Terry Flanagan

Under CFTC rule, FCMs that are also clearing members would be required to screen customer orders.

The futures industry is requesting that regulators refrain from imposing rigid risk management rules as it prepares for an influx of cleared swaps transactions.

While futures commission merchants (FCMs) have extensive experience managing the risk of futures, they have less experience managing the risks of swaps.

“Risk management best practices are continually evolving as markets and technology evolve,” John Damgard, president of the Futures Industry Association, said in a letter to the Commodity Futures Trading Commission. “This is particularly true today, as the market structure for cleared swaps and the technology necessary to support these markets are uncertain at best.”

Under a proposed CFTC rule, FCMS that are also clearing members would be required to establish credit and market risk-based limits based on position size, order size, margin requirements, and similar factors.

In addition, the proposed regulations would require use of automated means to screen orders for compliance within the risk-based limits.

“The advent of commonly accepted metrics for monitoring credit risk brought along with it the challenge of performing the calculations within reasonable time constraints,”  Charlie Sanchez, senior industry consultant for RiskAdvisory, told Markets Media.

It is commonly accepted that enterprise risk management has been a desire of trade groups from the beginning, but was impractical due mostly to technology constraints.

“In the end, most have settled on disaggregated views, commonly several layers below the preferred perspective. In light of recent changes brought about by the now infamous credit crunch, credit risk managers are being asked once again to rethink the challenge,” Sanchez said.

“The ability to aggregate commodity types, trade types, and geographies to reflect the true exposure to a counterparty is being made possible by enabling more advanced analytics within the context of a high-performance computing revolution,” he said.

The FIA says that the CFTC rule would impose obligations on clearing member FMS that are difficult, if not impossible, to meet.

This is particularly true of the proposed requirement that a clearing member FCM use automated means to screen orders for compliance with risk-based limits. This is because the technology to perform such pre-execution reviews with respect to each customer doesn’t exist.

Also, to the extent pre-execution reviews are technologically possible, they are usually conducted by the executing broker, and not by the clearing member FCM (unless the FCM is also the executing broker).

Many futures customers execute orders through one or more members, and clear the resulting trades at another. Institutional advisors managing multiple accounts may allocate their customers’’ trades to a number of FCMs.

Clearing member FCMS have no ability to screen these customers’ trades before such trades are executed, Damgard said.

“To the contrary, they may not be aware of the trades until later in the day, when they are given up to the FCM,” he said. “For their part, executing brokers can only be expected to enforce position size or order size controls.”

Instead, the FIS required the CFTC to consider relying on derivatives clearing organizations to assure that their respective clearing members have adequate risk management policies and practices, as the CFTC has already proposed in its risk management requirements for DCOs.

CME, for example, provides that clearing members must have procedures in place to demonstrate compliance in mentoring the credit risks of accepting trades, including give-up trades, of specific customers, monitoring the risks of proprietary trading, limiting the impact of significant market moves through the use of tolls such as stress testing or position limits, and monitoring account activity on an intraday basis.

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