Transcript An Overview Of Futures Markets

An Overview of
the CFTC and the Regulation of
Derivatives Clearing Organizations
James L. Carley
Director
Division of Clearing and Intermediary Oversight
Who is the Commodity Futures
Trading Commission (“CFTC”)?
 The CFTC is an independent agency of the U.S.
government which was created by Congress in
1974.
 The CFTC’s mandate is to regulate commodity
futures and option markets in the United States.
 The CFTC also has the authority to regulate the
activities of persons acting as intermediaries for
U.S. customers trading on non-U.S. markets.
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What is the mission of the
CFTC?
 The mission of the CFTC is to protect market users and the
public from fraud, manipulation, and abusive practices
related to the offer and sale of commodity futures and
options and to foster open, competitive, and financially
sound commodity futures and option markets.
 The CFTC’s primary goals are customer protection, the
integrity of the nation’s commodity markets and the
financial integrity of the intermediaries in those markets.
 The CFTC fulfills its mandate through the enforcement of
the provisions of the Commodity Exchange Act and rules
promulgated there under.
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What does the CFTC regulate?
 Markets which list and trade futures and options on futures
 Clearing houses which clear transactions that take place on
regulated futures markets or on over-the-counter (OTC)
markets.
 Market participants such as intermediaries, traders, trading
advisors and commodity pool operators.
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CFTC Regulation of OTC Clearing
 President’s Working Group on Financial Markets
(Treasury, Fed, SEC, CFTC) released a report on
Over-the-Counter Derivatives Markets and the
Commodity Exchange Act in November 1999:
– “Clearing of OTC derivatives has the potential to
reduce counterparty risks associated with such
transactions through risk management techniques that
may include mutualizing risks, facilitating offset, and
netting.”
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CFTC Regulation of OTC Clearing
 PWG:
– Because clearing tends to concentrate risks,
Congress should enact legislation to provide for
a comprehensive regulatory framework.
– Legislation would encourage the development
of clearing systems by:
• clarifying their legal status;
• subjecting them to appropriate supervision; and
• ensuring that U.S. firms and markets are not
competitively disadvantaged relative to their foreign
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counterparties.
What is clearing?
 Clearing is the process by which trades in futures
and options are processed, guaranteed and settled
by an entity known as a clearing house.
 A clearing house acts as the central counter party
to and guarantor of all trades that it has accepted
for clearing from its clearing members. The
clearing house “becomes the buyer to every seller
and the seller to every buyer”, through a process
known as “novation.”
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Who is involved in clearing?
 Clearing houses have a legal relationship only with entities
that they have admitted as clearing members.
 Clearing houses have no legal relationship with the
customers of their clearing members.
 Clearing members are generally institutions such as futures
commission merchants and broker/dealers that have the
financial, risk management, and operational capabilities to
function as clearing members.
 Clearing members are also subject to minimum capital
requirements by both the clearing house of which they are
members and the CFTC.
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The Clearing Process - Clearing houses undertake
some or all of the following activities:
 Match, guarantee and settle all trades and register positions
resulting from such trades.
 Perform mark-to-market calculations of all open positions
at least once a day and oversee the resulting cash flows
between clearing member firms.
 Manage the risk exposure that clearing firms present to the
clearing house.
 Perform the exercise and assignment of options contracts.
 Facilitate, but not guarantee, the delivery of physical
commodities.
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What clearing houses can do:
 Clearing houses permit multilateral netting of positions and
settlement payments.
 Assuming contracts are fungible (interchangeable),
clearing houses offset positions.
 Clearing houses enable clearing members to substitute the
credit and risk exposure of the clearing house for the credit
and risk exposure of each other.
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What clearing houses can do:
 Clearing houses maintain a package of financial safeguards
that are designed to mitigate losses in the event a clearing
member defaults on its obligations to the clearing house.
 In the event of such a default, the clearing house will meet
the obligations of the defaulter by first utilizing the
collateral pledged to it by the defaulter.
 If such collateral is insufficient to cure the entire amount of
the defaulted amount, then the clearing house will utilize
the components of its financial safeguards package to take
care of the remaining defaulted amount.
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What clearing houses can do: Hypothetical scenario
of clearing house default management
 A clearing member defaults on an obligation to a clearing
house in the amount of $100 million. The default is in
respect of the proprietary positions of the clearing member.
 The clearing house first utilizes the clearing member’s
collateral that is pledged to it by the clearing member. This
amounts to $50 million.
 The clearing house satisfies the remaining default amount
of $50 million by resorting to its clearing fund. At the time
of the default, the value of the clearing fund is $500
million and is made up of clearing fund deposits of all
clearing members.
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How clearing can help in the current credit situation
in the U.S. energy markets
 By functioning as the central counter party to
transactions, the regulated clearing house will
substitute its credit for that of the parties to the
trade.
 This will allow counter parties to “free up”
bilateral credit lines, thus allowing them to trade
more frequently.
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What clearing houses cannot do:
 Clearing houses do not completely eliminate counter party
credit risk. Clearing members are always subject to the risk
of default or failure by the clearing house itself.
 Clearing house protections do not generally flow to the
customers of clearing member firms.
 Customers of clearing firms are always subject to the risk
of that firm’s inability to meet its obligations to the
customer. This inability may arise based upon a default of
another customer, so a clearing firm customer is always
subject to the risk of fellow customers.
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Regulation of clearing houses –
Registration requirement of certain Derivatives Clearing
Organizations (“DCOs”)
 All clearing houses that seek to provide clearing services
with respect to futures contracts and options on such
futures contracts must register with the CFTC as
derivatives clearing organizations(“DCOs”) before they
can begin providing such services.
 The registration requirement is imposed by Section 5b(a)
of the Commodity Exchange Act.
 DCOs that are not required to register may nevertheless
voluntarily register with the CFTC.
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Regulation of clearing houses –
Exceptions to requirements to register as a DCO
 The clearing house was “grandfathered” in to DCO status
at the time of the enactment of the Commodity Futures
Modernization Act in December 2000; or
 The futures contract or option on such futures contract that
the clearing house seeks to clear is either excluded from
the Commodity Exchange Act or exempted by the Act; or
 The futures contract or option on such futures contract that
the clearing house seeks to clear is a security futures
product and the clearing house is a clearing agency
registered under the Securities Exchange Act of 1934.
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Regulation of clearing houses –
Compliance with DCO Core Principles
 To obtain and maintain registration, a DCO must comply
with the thirteen (13) DCO Core Principles .
 These Core Principles are imposed by Section 5b(c)(2) of
the Commodity Exchange Act.
 The CFTC has the responsibility to oversee DCOs to
ensure continued compliance with DCO Core Principles.
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Regulation of clearing houses –
The thirteen (13) DCO Core Principles
1. Adequate financial, operational and managerial
resources.
2. Appropriate standards for participant and product
eligibility.
3. Adequate and appropriate risk management
capabilities.
4. Ability to complete settlements on a timely basis.
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Regulation of clearing houses –
Thirteen (13) DCO Core Principles (cont.)
5. Standards and procedures to protect member and
participant funds.
6. Efficient and fair default rules and procedures.
7. Adequate rule enforcement and dispute resolution
procedures.
8. Adequate and appropriate systems safeguards, emergency
procedures and plan for disaster recovery.
9. Obligation to provide necessary reports to allow CFTC to
oversee activities.
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Regulation of clearing houses –
Thirteen (13) DCO Core Principles (cont.)
10.
Maintenance of all business records for five (5) years
in a form that is acceptable to CFTC.
11.
Publicize rules and operating procedures.
12.
Participation in appropriate and applicable domestic
and international information-sharing agreements.
13.
Avoidance of actions that are unreasonable restraints
of trade or that impose anti competitive burdens on
trading.
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Forms of clearing house organization
 An operating division of an exchange,
 A subsidiary of the exchange, or
 An independent entity that provides clearing
services for a market.
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Who clears now? - DCOs currently registered
with the CFTC
 The Clearing Corporation
 NYMEX Clearing House
 CME Clearing House
 New York Clearing Corporation
 Kansas City Board of Trade Clearing
Corporation
 MGE Clearing House
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Who clears now? - DCOs currently registered
with the CFTC
 London Clearing House
 The Options Clearing Corporation (OCC)
 Guaranty Clearing Corporation
 EnergyClear Corporation
 Intermarket Clearing Corporation
 OnExchange Clearing Corporation
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