United States: House Subcommittee Considers Impact Of Capital And Margin Requirements On End Users (With Delta Strategy Group Summary)

Last Updated: May 5 2016
Article by Steven D. Lofchie and Nihal S. Patel

Most Read Contributor in United States, September 2017

The Subcommittee on Commodity Exchanges, Energy and Credit ("Subcommittee") of the House Committee on Agriculture reviewed the impact of capital and margin requirements on end users.

The Delta Strategy Group highlighted the following key takeaways from the hearing:

  • Three of the four witnesses argued that because Basel III leverage ratios do not recognize margin posted to a clearinghouse as segregated funds, they would have an adverse impact on access to derivatives markets.
  • All four witnesses agreed that futures commission merchants ("FCMs") underwent a period of consolidation that resulted in fewer FCMs being made available to customers.

Subcommittee Chair Austin Scott asserted that although Congress has been "explicit in its efforts to exempt end users from much of the regulatory burdens associated with Dodd-Frank, these rules could have impacts on end users if they drive intermediaries, like FCMs and swap dealers ("SDs"), from the markets."

ISDA CEO Scott O'Malia asked regulators to conduct a comprehensive cumulative-impact assessment that would encompass all elements of the bank capital and liquidity reforms. He also asked the CFTC to reconcile its cross-border guidance and cross-border margin proposal with U.S. prudential rules.

Futures Industry Association ("FIA") CEO Walter Lukken criticized the Basel III leverage ratio and the failure to recognize that client margin posted to a bank-affiliated clearing member belongs to the customer, and is provided by that customer in order to offset the clearing member's exposure to the clearinghouse.

National Association of Corporate Treasurers Chair Thomas C. Deas remarked that end users comprise less than ten percent of the volume in derivatives markets and use derivatives to hedge and offset business risks. The cumulative effect of capital and liquidity requirements will be to reduce the number of counterparties available to end users, he argued.

Myrtle Makena, LLC Founder Tyler Gellasch maintained that regulatory reforms cannot impact end users negatively because they do not apply to them.

For a further description of the hearing and of witness testimonies, please click here.

Commentary / Steven Lofchie

Mr. Deas, the representative of a large coalition of end users of derivatives, argues that capital and margin regulations raise end users' costs. His statement provides a clear description of how costs imposed on "Wall Street" (financial market intermediaries) affect "Main Street" (commercial entities).

By contrast, Mr. Gellasch, a lawyer and executive director at a public interest advocacy group, asserts that the end users have not been injured. Mr. Gellasch's position is that because a rule does not affect "how" a firm does business, but only the business's "profitability," it has no material impact. This conclusion seems to be based on a common misunderstanding of how markets work: that because regulation does not affect end users directly, but only affects them indirectly through the dealers with whom they do business, they cannot be injured.

Mr. Gellasch's strongest supporting argument is that liquidity in the bond market has not diminished, and that he "has seen no evidence of margin and capital requirements . . . increasing costs for end users." He backs up this position citing a Report by the IMF, titled "IMF Global Financial Stability Report." Unfortunately, a thorough reading of this Report actually shows that it does not support his argument. The Report states: "Weak systemic market liquidity – this poses a challenge to equilibria in markets and the wider economy" (page 9). "Markets for some assets, including U.S. Treasury securities, are exhibiting episodes of volatility, marked by a disappearance of liquidity and depth" (page 23). In short, Mr. Gellasch cites a Report that stands for the opposite of his position.

Advocates for the benefits of Dodd-Frank must raise real commercial facts if there is to be a real debate about economics and policy. A genuine discussion requires that all sides bring to the table knowledge and a sincere desire for open inquiry.

Commentary / Nihal Patel

The hearing focused primarily on bank leverage ratio requirements and their impact on bank-affiliated FCMs. As market participants know well, this is an issue that is controlled by bank regulators, which suggests that the hearing itself likely was held by the wrong congressional committee. Even the Chair of the CFTC (whose agency is directly overseen by this subcommittee) entreated banking regulators to effect change regarding this issue.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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