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| "Customer Choice" in the Selection of a Clearing House
— Remarks by Neal Wolkoff, chief operating officer and executive vice
president, New York Mercantile Exchange, Inc. |
| Futures Industry Association's International Futures Industry Conference,
Boca Raton, Florida |
| 03/13/2003 |
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Recently, there has been discussion throughout the futures industry regarding the concept of "Customer Choice" for clearing. "Customer Choice" would allow executions occurring on a designated contract market ("DCM") to be cleared at any registered Designated Clearing Organization ("DCO"), whether or not the DCO is a part of, or affiliated with, the DCM where the execution took place. We at the New York Mercantile Exchange ("NYMEX") broadly favor market competition, and ourselves face market competition daily from both regulated exchanges and unregulated derivatives markets, some of which offer clearing services. We oppose any initiative based on the "Customer Choice" concept1. We believe that, notwithstanding the appeal of its name, "Customer Choice" would threaten the price determination function of regulated markets, and enhance systemic risk. For that and other good public policy reasons, it has been ignored, and indeed prohibited, by Congress.
For many years, futures contracts have been cleared by the same exchange, or an affiliated clearing house, offering trading in those contracts. This practice has been left undisturbed by Congress, the Justice Department and the Commodity Futures Trading Commission ("CFTC") throughout the history of the futures industry. Nothing in the passage of the Commodity Futures Trading Commission Act of 1974, which established the CFTC and substantially amended the Act, affected the legitimacy of this established and accepted business practice, nor did subsequent amendments to the Act in 1978, 1982, 1986, 1992, 1995 or 2000.
With respect to the CFMA, the new provisions relating to DCOs have been something
of a "sea change," but primarily with respect to the express statutory permissibility
for the first time of clearing off-exchange derivatives instruments. Previously,
such derivatives had not been recognized under the Act as acceptable for clearing,
perhaps to distinguish such transactions from futures contracts, which needed
to be executed on a regulated futures exchange before being cleared.2
These new provisions were legislative recognition of the policy determination
that clearing as practiced by the futures exchanges provides significant systemic
benefits to the financial system and that the use of clearing should be expanded
to the non-exchange-traded derivatives markets.
The creation, however, of a separate category for DCOs, as occurred with passage of the CFMA, was not intended to create a "sea change" in how traditional, regulated futures and options contracts were to be treated for clearing purposes. The lack of concern by Congress with the connection of futures execution and futures clearing is shown by the fact that all existing domestic exchanges and clearing houses were simply grand-fathered (into their applicable category) as acceptable, registered contract markets and/or designated clearing organizations, with no new requirements or legislatively imposed conditions addressed to such organizations. By acting as it did, Congress in no way expressed its displeasure at the longstanding regulatory scheme that tied execution and clearing of regulated futures contracts together. Its statutory treatment is an unambiguous and unconditional ratification by Congress of the long-standing status quo.
Prior to passage of the CFMA, there were several clearing organizations that were not futures exchanges, and thus not directly regulated by the CFTC. This group included The Board of Trade Clearing Organization ("BOTCC"), which is among the largest clearing organizations in the world as a function of volume cleared.3 To provide greater legal certainty with respect to regulation of clearing entities, and to provide a mechanism - which is competitive - to clear non-regulated derivatives, Congress created the new statutory category of DCO.
The creation of this new category was in large measure a tacit recognition of the business reality that such clearing entities needed to be regulated by an entity (the CFTC) with clear oversight authority. Additionally, the creation of the DCO category opened a competitive door among existing and newly registered clearing houses to compete for services to off-exchange derivatives transactions. The creation of the DCO category did not call into question the long-standing legitimacy of a futures exchange directing where its contracts may be cleared, and the legislative history does not support a contrary conclusion.
The federal regulatory scheme that governs futures exchanges and clearing houses that are incorporated in the U.S. exists because of a finding by Congress that these markets represent a "national public interest by providing a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair and financially secure trading facilities." (Section 3(a) of the Act). Since the inception of federal regulation of futures markets in the 1920s, Congress has sought to preserve the integrity of price formation as the bedrock principle underlying the function of futures exchanges.
Exchange prices are relied upon throughout commerce as benchmarks for many products that affect the lives of consumers, small and large, everywhere. As an example, NYMEX gasoline prices for the New York Harbor affect pump prices in Alabama, among many other places, although a number of people and companies in the commercial chain of filling gas tanks, and getting them filled, in Mobile do not use NYMEX and may never have heard of it.
NYMEX, by fulfilling its core statutory functions of price discovery and risk shifting (or hedging), allows the refiner to obtain its crude oil at the best possible price, and to sell to the consumer at the best possible price. At any given time, because of the liquid and transparent futures markets, consumers pay the lowest price possible, which has been arrived at in the most transparent and competitive way yet devised.
Unlike securities regulation, which seeks to enable fair and efficient capital formation, futures regulation has had throughout its history this very different goal and public policy emphasis of the discovery of open and competitive price formation for important commodities.
Exchanges historically have devoted great time and expense in developing the terms for new contracts or in amending the terms for existing contracts. NYMEX's experiences have been principally with contracts involving physical delivery, and such contracts generally require extensive market analysis and also extended and ongoing consultations with commercial market participants in the underlying physical markets. These efforts are intended to maximize the likelihood that a contract's terms will result in convergence in price between the futures and cash commodity markets upon the termination of the futures contract.
Permitting a futures exchange to have effective control over its own products and particularly control over where executed transactions in those products will be cleared advances the public interest function identified by the Act in the following ways:
- Liquidity is focused. If transactions could be executed on an exchange trading floor or electronic platform, and thereafter be cleared anywhere, then the customer's incentive to trade in one place and focus liquidity - which is the bedrock of competitive price determination - is brought into question. Conversely, by providing execution together with clearing, a marketplace can best assure its own consistent and ongoing liquidity. If a customer can execute anywhere, and yet have the FCM controlling his or her positions clear them at a different clearing house, this would diminish the ability of any market to preserve its core liquidity and price determination functions. Liquidity can be split away from a currently liquid market to another market lacking the pre-existing depth of liquidity. Public policy is not advanced by such an outcome.
Under the CFMA, over-the-counter (OTC) trades in exempt commodities such as energy and metals products do not have a defined role in price determination of goods and services unless executed on an electronic platform operating as an exempt commercial market and unless the CFTC makes a specific finding that such a price discovery role exists for a product on a particular platform. Since liquidity of OTC markets seemingly is not a statutory concern of the Act, any damage to liquidity by allowing freedom of choice for clearing OTC contracts is also a much different issue than is the concern for markets that have a statutory function of price determination to be met. Clearing freedom for OTC contracts is explicit under the Act, but for exchange-executed transactions, Congress continues to allow exchanges to control the destiny of their own products.
- Systemic risk is reduced. An important component of evaluating risk is a clearing house's ability to evaluate the market exposure of its customers. Transparency of market exposure is greatly enhanced when related market positions of individual customers can be captured in one place. A regulatory interest is served in being able to measure quickly and easily the market risk and other exposure of, for example, ABC Company, be it a customer or an FCM, in crude oil and related products by going to the NYMEX Clearing house, rather than by attempting to piece together positions and exposures at multiple clearing houses.
In addition, separating the long and short contracts of the same customers across multiple clearing houses (as could be the case with spread transactions) enhances systemic risk by assuring that a clearing firm (or underlying customer) which defaults on a debt to one clearing organization will still have positive equity at the other clearing organization which is out of reach to cure the default. Independent clearing houses holding opposite legs of market spreads are placed at risk when assets can be protected at one clearing organization while shortfalls at another - which would not be shortfalls if all assets resided at the same clearing house - cause a default and a concomitant loss of market integrity.
- Capital costs are reduced. Capital costs are reduced when customers carry related positions in related markets at the same clearing house. Since, at present, the NYMEX clearing house holds the assets (margin) associated with crude oil contracts and its related petroleum products, gasoline and heating oil, the risk of price movement can be significantly reduced from a situation where NYMEX just held one of those positions. A refiner would naturally be "short" crude oil at NYMEX (because it needs to buy the oil in the cash market) and "long" petroleum products on NYMEX (because it is producing an inventory of gasoline and heating oil through its refinery operations.) The refiner's margin requirements, which reflect risk, would be lower given the offsetting nature of the crude oil and petroleum products positions, and its capital can be employed elsewhere. This capital efficiency ultimately accrues to the benefit of the consumer. It is hard to imagine a market user, or customer, as opposed to a market professional or broker, benefiting from the inefficient distribution and use of the customer's capital, resulting from positions being placed in different clearing houses.
- Economic incentives are preserved. If an exchange can only be assured of transaction revenue, but not clearing revenue, it can rebalance customer fees onto the exchange side of the ledger, thus foregoing clearing revenue. Thus, the economic incentive is diminished to preserve and to protect the financial integrity of their clearing houses in the same way as when the clearing houses were producing revenue. The statutory purpose of preserving financial integrity would thus also be undercut by the proposed vision of "customer choice."
Section 5b(f) of the Act, which is included below, authorizes the CFTC to review situations where the foregoing policy arguments might not apply, and to oversee the mechanics and rules for enabling such coordination to occur. These circumstances for determining exceptions to the established mechanism are quite limited:
"LINKING OF REGULATED CLEARING FACILITIES-
(1) IN GENERAL. --The Commission shall facilitate the linking or coordination of derivatives clearing organizations registered under this Act with other regulated clearance facilities for the coordinated settlement of cleared transactions.
(2) COORDINATION. --In carrying out paragraph (1), the Commission shall coordinate with the Federal banking agencies and the Securities and Exchange Commission."
Two points should be made about this statutory language: First, the language requires the CFTC merely to "facilitate" linking or coordination. Under the plain reading of the statute's language, the CFTC's role is triggered in the context of linking between clearance facilities that is voluntarily undertaken by such facilities. The language of this subsection is limited to facilitation of linking or coordination of DCOs with a more generic reference to "other regulated clearance facilities" (emphasis added). In other words, this subsection only addresses CFTC facilitation in connection with the linking of DCOs with clearance facilities subject to a separate regulatory scheme and does not address in any way any linking between DCOs.
Second, and equally significant is subsection (2), which may be read to provide in essence that in all such instances of CFTC facilitation, the CFTC must coordinate with the SEC and the Fed and other banking agencies. This provision supports the notion that this section is intended to address not the linking of clearing for purposes of transactions regulated only by the CFTC (i.e., futures), but rather the voluntary linking of clearing for transactions regulated under other regulatory regimes, e.g., linking of clearing of security futures with the clearing of securities.
It should be noted that the issues raised by coordinating margin policies for example, across clearing houses are complex, and infinitely so when different national jurisdictions are involved. As two examples of such difficulties, U.K. and U.S. law differ on bankruptcy and segregation of funds, and any rules for coordination would need to bridge these major differences. Facilitation also faces daunting tasks of integrating various systems and long-established procedures, which should not be underestimated.
The concept of "customer choice" in the selection of a clearing house for futures transactions is absent from the Act. Moreover, in considering the plain language of the Act, it is very clear that Congress continues to maintain its focus upon the core needs to be met by this scheme of regulation, i.e., providing for liquidity, integrity and transparency in price formation.
In conclusion, the concept of "customer choice" in the selection of a clearing house for futures transactions is simply absent from the Act. Moreover, in considering the plain language of the Act, it is very clear that Congress continues to maintain its focus upon the core needs to be met by this scheme of regulation, i.e., providing for liquidity, integrity and transparency in price formation.
1With respect to clearing, the term "customer choice" is something of a misnomer: from the customer's perspective he or she is not a counterparty with any clearinghouse. Instead, the customer's relationship is with the futures commission merchant (FCM) carrying the customer's account. Each FCM aggregates all U.S. futures business for each customer executed across all exchanges and residing in all clearinghouses on a consolidated brokerage statement to that customer. In the vast majority of instances, the customer has little interest or concern about the identity of the ultimate clearinghouse, as the customer's funds are segregated and separately accounted for by the FCM.
2Part 35 of the CFTC's regulations, which governed swaps transactions prior to the adoption of the CFMA, established a swap exemption from most sections of the Act and the CFTC's regulations for certain eligible swap transactions. However, this swap exemption by its terms did not extend to transactions subject to a clearing system in which counterparty risk was effectively eliminated. By comparison, the CFTC indicated that an entity seeking to establish a clearing system for swaps might apply for a further exemption from the Act. Exemption for Certain Swap Agreements, 58 Fed. Reg. 5587, at 5591 n. 30 (Jan. 22, 1993). In other words, swap transactions were prohibited from being cleared with the exception of individually issued exceptions from the CFTC. However, with the exception of the London Clearing House's SwapClear programs, other clearing organizations did not undertake this approach.
3See Board of Trade Clearing Corp. v. CFTC, 1978 U.S. Dist. LEXIS 20220 (DDC), aff'd w/out opinion, Appeal No. 78-1263 (D.C. Cir. 1978), where the court upheld the CFTC's regulatory authority over the rules of such organizations. |
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