This week, as Americans mark the solemn sixteenth anniversary of 9/11, a historic financial event is also being remembered: eight years ago, the G20 met and set new global rules for centrally cleared swaps in central counterparties (CCPs) trading.
To mark the occasion, Commodities Futures Trading Commission Chairman Christopher Giancarlo wrote an op-ed in the French daily Les Echoes entitled “Deference is the Path Forward in Cross-Border Supervision of CCPs.”
The piece was even written in French, according to the CFTC press release, which helpfully provided an English language translation.
“Eight years ago this month,” Giancarlo stated, “in the aftermath of a crushing, global financial panic, the G-20 leaders met in Pittsburgh where they wisely agreed to strengthen the international financial system to support economic recovery and to foster sustained and balanced growth.
Together, the world leaders agreed upon several key reforms: where appropriate, trade all standardized derivative or ‘swap’ contracts on regulated trading platforms; centrally clear swaps at central counterparties (CCPs); report swap trades to trade repositories; and subject non-centrally cleared trades to higher capital requirements.
What are Central Counterparties (CCPs) and their Clearinghouses
A CCP, “is an organization that exists in various European countries to help facilitate trading done in European derivatives and equities markets. These clearing houses are often operated by the major banks in the country to provide efficiency and stability to the financial markets in which they operate. CCPs bear most of the credit risk of buyers and sellers when clearing and settling market transactions,” the website Investopedia states. “A central counterparty clearing house is a corporate entity that reduces counterparty, operational, settlement, market, legal and default risk for traders.”
“People bring contracts to the clearinghouse and the clearinghouse steps between the buyer and the seller,” explaines attorney Jerrold Salzman, speaking on behalf of the CME Group before a House Agriculture Committee hearing in June. “It collects from those who lose and pays to those who win. It manages a matchbook is what we call it.”
SWAPS were part of a basket of sophisticated derivatives which were largely unregulated before the 2008 financial crisis.
Credit Default Swaps (CDS) were a global market, which bet on the failure of millions of baskets of loans and reached as much as $100 trillion – a number that had no real relationship to the value of the loans they were derived from because it was arbitrarily created by the markets of each country that traded them.
Remarkably, in the US before the crisis, each individual swap had an unlimited size, regardless of how big the basket of loans. Theoretically, a $200 million basket of car loans, could trade tens of billions of dollars in CDS, if the traders trading the CDS could create a big enough market.
Collateralized debt obligations (CDOs) also let banks offload the risk of thousands of bundled loans like mortgages, car loans, and student loans; before 2008, CDOs were almost entirely unregulated.
Derivatives from Fannie Mae and Freddie Mac products – the two mammoth securitizers of real estate loans – were also largely unregulated and with similar results.
The loans the swaps were derived from were advertised as being in the safest categories, even though they were carrying increasingly risky loans, to the point where almost all were holding toxic amounts of debt.
Before the 2008 crisis, these swaps operated in the wild, wild West of high finance and needed serious reform. In the US, Dodd-Frank created a new regulatory framework for these products and many more.
2008 G20 Summit Agreement
In 2009, the twenty biggest economies, the G20, met in Pittsburgh, Pennsylvania and laid the groundwork for CCPs and central clearinghouses.
The G20 agreement stated that it would “take action at the national and international level to raise standards together so that our national authorities implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage,” and continued, “All standardized OTC derivative contracts should be traded on exchanges or exchange trading platforms and cleared through central counterparties by the end of 2012 at the latest.”
In his op-ed, Giancarlo stated that “the G-20 leaders pledged their efforts to the consistent implementation of global standards rather than identical implementation. It follows that the best route to ‘consistent implementation’ is the through mutual deference to comparable foreign regulatory frameworks.”
CFTC Deference to Overseas Regulatory Counterparts in the Futures and Swaps Markets.
Giancarlo also asserted that the CFTC has long deferred to the regulatory framework of the regulator where the swap originated.
Giancarlo noted, “At the U.S. Commodity Futures Trading Commission, we have a long history of regulatory deference to overseas regulatory counterparts in the futures and swaps markets. Our regulatory framework for futures gives non-U.S. intermediary firms direct access to U.S. customers on the basis of compliance with regulation of their home jurisdiction. We take a similar approach for many requirements applicable to non-U.S. swaps dealers and major swaps participants.
“More recently, as part of the common approach between the European Commission and the CFTC in the regulation and supervision of cross-border CCPs, the CFTC allowed certain EU-based CCPs seeking to operate in the United States to comply with corresponding EU regulatory requirements. This arrangement increases regulatory coordination necessary so that market participants may hedge operational risks in efficient and resilient global markets. It also promotes financial stability by helping to ensure that CCPs based in multiple jurisdictions are held to the same high standards. In a time of administrative budget constraints, regulatory deference enables us to work smarter, not harder, in pursuit of common regulatory principles.
“These deference arrangements not only support the cross-border activities of different actors in the financial markets, but also help avoid fragmentation in the markets, protectionism, and regulatory arbitrage. In fact, CFTC staff is looking at how we can incorporate deference into other parts of our regulatory framework and form stronger bilateral and multilateral alliances with other regulators.”