Rocky Road To OTC Reform

Terry Flanagan

CFTC rules on clearing organizations are being viewed negatively within industry.

The transition from a bilateral toward a centrally executed and cleared model for OTC derivatives may be less smooth than expected if the Commodity Futures Trading Commission goes ahead with rules unveiled this week on derivatives clearing organizations (DCOs).

Critics from the outside as well as within the CFTC itself say that the new rules are overly restrictive, will stifle completion, and are inconsistent with a global approach to derivatives reform.

“It is too early to tell what the massive clearing rulebook means, but our initial concern is that the rules seem too prescriptive,” said John Damgard, president of the Futures Industry Association.

“The science of risk management continues to evolve rapidly and risk exposures can change drastically in a very short period of time,” Damgard said. “We hope that this rule will not interfere with the ability of clearinghouses to adjust their risk management policies and procedures as they see fit.”

CFTC commissioner Scott O’Malia, in an eight-page dissent, said that he disagreed with the “prescriptive requirements” of the final rule, especially one that prohibits a DCO from requiring more than $50 million in capital from any entity seeking to become a swaps clearing member.

“This number makes a great headline, mainly because it is so low,” O’Malia said. “It also sends an unequivocal message to DCOs that have clerking members that are primarily dealer banks. However, in adopting and interpreting this requirement, the Commission may unwisely limit the range of legitimate actions that DCOs can take to manage their counterparty risks.”

Equally troublesome, O’Malia said, are the rule’s margin requirements for covering potential liquidations in the event of a default by a clearing member.

Under the requirements, a DCO would be required to specify margin requirements to cover a liquidation period of five days in order to cover the DCO’s potential future exposures during the interval between the last collection of variation margin and the time within which the DCO could liquidate the defaulting clearing member’s position.

In the event that a futures contract is converted to a swap, this would result in the DCO margining such swap contract using a minimum of five days instead of one day for futures, O’Malia said.

Such a scenario could occur because under separate rules proposed by the CFTC for designated contract markets (DCMs), a DCM is prohibited from listing any contract for trading unless an average of at least 85 percent of the total volume of such contract is traded on the centralized market. This could result in DCMs having to delist hundreds of futures contracts.

Eris Exchange, which currently offers trading in an interest rate swap futures contract that replicates the economics of a standard OTC interest rate swap, has opposed the 85 percent requirement.

Forcing a “futurized” swap to delist from a DCM and re-list on an SEF results in disparate treatment for a DCM, according to Eris Exchange. “While the Dodd-Frank Act allows a DCM to offer the trading of swaps, the 85 percent centralized market requirement effectively overrides the Dodd-Frank Act,” it said in a comment letter.

O’Malia also said that the CFTC was taking an inconsistent approach toward international coordination, especially with the CPSS-IOSCO consultation on financial market infrastructure, which has still to be finalized.

Noting that the CFTC plans to review its provisions after CPSS and IOSCO finish their work in 2012, O’Malia suggested that it hold off on prescriptive rulemaking.

“What are the implications of requiring DCOs to incur costs to comport with prescriptive requirement now when the Commission might change such requirements next year?” he said.

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