That’s what banks, broker-dealers and even their fund manager customers might face should the US Securities and Exchange Commission’s new oversight rules for six large systemically important market infrastructures be implemented.
Four years after the US adopted the Dodd-Frank Wall Street Reform Act, the SEC has finally come up with a proposed new rulebook. The revisions are designed to control the systemic risk associated with the concentration of clearing and related functions in these six organizations.
Specifically, they are intended to reduce the possibility that the collapse of one of the market infrastructure’s members — or the entity itself — will wreak havoc on the financial market as a whole. Hence, they subject so-called covered clearing agencies to more stringent risk management controls and governance practices which would also likely bring them in line with international regulatory recommendations, such as those issued in April 2012 by the joint Committee on the Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (CPSS-IOSCO).
The SEC already regulates the six organizations: Depository Trust Company, Fixed Income Clearing Corp., National Securities Clearing Corp., Options Clearing Corp., CME and ICE in some fashion either alone or with other regulatory bodies, such as the Commodity Futures Trading Commission (CFTC). Five of the six organizations: FICC, NSCC, OCC, CME and ICE stand between trading partners as middlemen in case one of the two defaults on its settlement obligation. Although the DTC does not serve the same operational role, its inclusion in the group relates to its responsibility to ensure cash and securities are transferred when trades must be settled. Therefore, it falls under the legal definition of a covered clearing agency.
The 2010 Dodd-Frank legislation gave the SEC and the CFTC to right to police the over-the-counter derivatives market with the SEC in charge of security-based swaps. A key pillar of the law is to reduce counterparty risk by requiring more swap trades to be processed through clearinghouses, prompting concerns of risk converging in the hands of fewer financial firms and clearinghouses.
Yet another part of the law requires the US Financial Stability Oversight Council (FSOC) to designate the largest market utilities as systemically important clearinghouses, therefore subject to heightened oversight. The FSOC identified the same six organizations in 2012 and the CFTC has already adopted a new rulebook for the organizations it oversees. The SEC says its new rulebook for covered clearing agencies is similar to the CFTC’s.
While most of the SEC’s 400-plus page rulebook simply tweaks current statutes, there are some brand new legal requirements, says the regulatory agency. With the proposed rules still subject to change and none of the covered clearing agencies willing to publicly comment on them, it is difficult to predict just how much these changes will ultimately impact the hundreds of their bank and broker-dealer members. But that isn’t preventing financial firms from thinking — and talking — about them.
“At the very least, there could be a trickle down effect on participant fees, initial and variation margin requirements as well as contributions to default funds,” speculates one operations manager at a New York-based broker-dealer, who has reviewed the massive document.
Of the six organizations governed by the new statutes, only one — the OCC — has come under sharp public criticism from the SEC. In a letter sent to the OCC last September, the SEC cited over two dozen “systemic weaknesses in risk management and operations,” which the OCC is now seeking to quickly address in a string of rule changes.
The SEC’s proposed changes to the status quo may alter how the covered clearing agencies work with their members, and how the members work with their own clients. With the assistance of several regulatory compliance and operations specialists, FinOps Report has selected six of the new requirements as potentially meaningful to our readers. Those interested in a more detailed analysis, can read the full text of the SEC’s proposal and respond to the regulatory agency’s request for comments. They are due within 60 days after the publication of the proposal on March 12.
Improved Framework for Risk Management: New Rule 17Ad22(e)3
While covered clearing agencies already have written and enforceable policies and procedures to address risk management, the SEC wants them to take a “broad comprehensive approach.” The risk management policies and procedures must be designed holistically, be consistent with each other and work effectively to mitigate the risk of financial losses to member firms and participants in the broader financial market. The covered clearing agencies must not only identify, measure and monitor risk — which they already do — but they must also review their policies and procedures on a specified periodic basis and have them approved annually by their board of directors.
Likewise, they must review their procedures for winding down and recovering from financial failure and revise them to meet the new risk requirements. A potentially far more significant change, says the SEC, is ensuring risk management is an independent function — separate from other operations — with an internal audit unit reporting to either the full board of directors or the board’s independent audit committee. The internal audit function should, says the SEC, provide a rigorous and independent assessment of the effectiveness of the covered clearing agency’s risk management and control processes.
Practical Implications: While providing unbeholden power to establish policy to risk and audit functions is undoubtedly good news for the entire financial market, it may trigger some changes to the existing best practices of the covered clearing agencies.
Collateral Requirement: New Rule 17Ad22(e5)
Covered clearing agencies would need to not only establish written policies and procedures to limit the assets they accept as collateral, but also create and enforce policies for “appropriately conservative haircuts and concentration limits.” The conservative haircuts and concentration limits would kick in if the covered clearing agency needed additional collateral to manage its own or its participants’ credit exposures.
Practical Implications: Covered clearing agencies likely have already adopted stringent collateral management policies regarding acceptable assets and haircuts used for low-quality collateral, as market prices can change on a dime. However, as one US brokerage operations executive tells FinOps, a more thorough review of the procedures could prompt banks and broker-dealers to change the types or mix of assets they use as collateral, or accept that it will become a lot more costly for them to use the same ones they do now. Such a scenario could ultimately have a trickle-down cost impact on fund managers who must provide their clearing agents — banks and broker-dealers — with the collateral they need to back their deals.
Risk-Based Margin System: Rule 17Ad(e)6
While clearinghouses do mark-to-market their participants’ positions each day and can collect variation margin daily, the SEC will now be allowing them to also do so on an intraday basis to cover the potential settlement risk from intraday price movements. The SEC is also requiring clearinghouses to conduct backtests on their margin system at least once each day and a “confirming sensitivity” analysis of its margin resources, parameters and assumptions for backtesting at least monthly, or even more frequently depending on the liquidity of the products cleared and overall market volatility. Test results must be reported to the appropriate independent decision-makers, such as the board of directors or risk management committee.
Practical Implications: The SEC doesn’t clarify just how much its new rules differ from current practice as clearinghouses can make intraday margin calls and do have margin risk testing and validation procedures. However, by codifying the formerly voluntary guidelines, the regulatory agency is putting members of clearinghouses on alert about the potential for quick intraday margin calls. At the same time, it provides the clearinghouses with the comfort of a clear mandate to take extra precautions in meeting their margin risk management requirements. Naturally, clearinghouses will likely have to review their current practices to ensure they are up to snuff.
Liquidity Risk: New Rule 17Ad(e)7:
The SEC wants to make certain that the covered clearing agencies can meet their financial obligations to deliver funds and securities when necessary. Although the clearing agencies do have written procedures to monitor liquidity risk, they aren’t as granular as the regulatory agency wants. The SEC wants covered clearing agencies to have sufficient liquidity to effect same-day or even intraday and multi-day settlement of payment obligations with a ” high degree of confidence.”
Such a scenario requires each of the covered clearing agencies to have sufficient “qualifying” liquid assets on hand which would include cash, assets readily available and convertible into cash, or other assets that are available and eligible for pledging with a relevant central bank — aka the Fed. Guesswork isn’t good enough, so each of the covered clearing agencies must monitor their liquidity providers carefully, and annually test the validity of their liquidity risk models.
Practical Implications: The covered clearing agencies, predict brokerage operations experts, shouldn’t have too much difficulty meeting the liquidity risk requirements, but as the SEC itself note some would have to update their current policies or adopt new ones. The cost of any change would ultimately be passed onto member firms, regardless of whether the covered clearing agency relied on its members or third-parties. Just one example: a covered clearing agency opting to use prearranged funding arrangements — a very-cost effective approach — might obligate its members add securities to a collateral pool the agency could use to back its borrowing. Likewise, clearing brokers may also incur the costs of having to act as counterparties to repurchase agreements.
General Business Risk: New Proposed 17Ad22(e)15
“This proposed provision appears to closely mirror proposed new European regulations for securities depositories,” says one European brokerage operations expert in London. As highlighted in a previous article posted by FinOps on January 17, Harmonizing European Depositories May be a Bumpy Ride, the proposed CSD-R, if implemented, would mandate that European depositories at a minimum have six months of operating capital on hand. Those with banking licenses would face additional requirements including capital reserve charges.
The SEC wants covered clearing agencies to be prepared not only if one of their members defaults on its payment obligation, but also if the clearing agency’s revenues decrease or expenses increase. Such a scenario could result in the covered clearing agency facing the need to charge for a loss against capital. Therefore, the SEC says that the clearing agencies must have sufficient liquid net assets, funded by equity, to be equal to whichever of the following is greater: six months of operating expenses or an amount determined by its board of directors to be sufficient to facilitate an orderly recovery or winddown of critical operations and services. The covered clearing agency must also have procedures in place for how it will raise additional equity if its equity falls close to or below the amount required by the new provision.
Practical Implications: This is another area where costs to membership may increase, if the clearing agency is not already holding this level of reserves. Based on the most conservative hypothetical case the SEC has modeled, the DTC could need an additional US$166 million in additional equity at most; while the FICC would need US$62 million; the NSCC would need US$89 million, and OCC would need US$68 million. That scenario envisioned that cash on a balance sheet was funded by liabilities first, with the residual funded by equity. Should cash on each covered clearing agency’s balance sheet be funded pro-rata by equity and liabilities, DTC, FICC, ICE, NSCC would need no additional equity, OCC would still need US$68 million.
Tiered Participation Agreements: Proposed Rule 17ad22(e19)
This provision of the new rules appears to be the most confusing to fund managers contacted by FinOps. The SEC doesn’t specifically explain what it wants the clearinghouses to do they don’t already as a matter of practice. The SEC just says that the covered clearing agencies should review and manage the material risks arising from the tiered participation by implementing and enforcing written procedures. This means that the risk profile of underlying institutional investors is as potentially as material to the risk incurred by the covered clearing agencies as that of the participants.
Because the covered clearing agencies just deal directly with their participants, they cannot fathom how financially sound the indirect users of the organizations are. Should one of those “indirect” users go bust, both the direct member of a covered clearinghouse and the clearinghouse itself could be affected.
Although there are no current rules mandating that clearinghouses monitor their risk from such indirect participants, they may be requiring members to notify them — the covered clearing agency — if a transaction reflects a proprietary or customer position; or requiring members to specify the value of an end customer’s collateral.
Practical Implications: Though the covered clearing agencies may already have practices in place to monitor second-tier risk, this rule change puts an even greater onus to manage that indirect risk. How that may play out on members and their customers is currently an open question as the SEC itself says it doesn’t want the compliance burden to accidentally cause a reduction in the number of service providers.
“The SEC may just want to codify current practice and there is no indication it will force the covered clearing agencies to have direct contact with the end customers of member firms,” one US fund management operations specialist in New Yorks tells FinOps.
However, at a minimum, he expects that covered clearing agencies will review their current policies to ensure they are getting enough information from their bank and broker-dealer members about indirect participants a timely basis. Banks and broker-dealers, who act as correspondent clearing firms, should also be preparing for the possibility of additional information and new policies in what they need from their customers.