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May 19, 2011

Jennifer J. Johnson

Secretary

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue, NW

Washington, DC 20551

Re:       Notice of Proposed Rulemaking – Financial Market Utilities    (RIN 7100-AD71)

On behalf of Americans for Financial Reform, thank you for the opportunity to comment on the proposed rule promulgating risk-management standards for certain financial market utilities  that are designated as “systemically important” by the Financial Stability Oversight Council under the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Americans for Financial Reform is an unprecedented coalition of over 250 national, state and local groups who have come together to reform the financial industry. Members of our coalition include consumer, civil rights, investor, retiree, community, labor, religious and business groups as well as prominent economists.

The proper regulation of financial market utilities (FMUs), particularly Central Counterparties (CCPs), is absolutely central to the success of financial reform and the maintenance of financial stability. The new derivatives framework will move the credit exposure for trillions of dollars in currently over-the-counter (OTC) derivatives off banking books to CCPs. The run on clearing banks for tri-party repo, another major CCP, played a signifcant role in creating the 2008 financial crisis. The lack of regulation for the multi-trillion dollar repo market was cited by the Financial Crisis Inquiry Commission as a major contributor to the financial crisis.

Title VIII of the Dodd-Frank Act gave the Federal Reserve an important backstop role in oversight of systemic risk created by FMUs, as well as risk management by FMUs. It also permitted designated FMUs access to Federal Reserve funding in certain cases. In light of the importance of CCPs to the stability of the financial system proper oversight of this risk management is essential.

Comments

In general, the standards and principles laid out in this regulation are sensible and prudent. However, they are also very broad and general, and they appear to be drawn from recommendations and standards that were established well before the financial crisis of 2008. To take one example, the CPSS-IOSCO standards referenced in the proposed rule were promulgated in 2001 and 2004.[1] It would be useful to see more specificity in these standards, especially given the fact that FMUs are private sector entities who may face conflicts of interest in their interpretation of broad and general standards. It would also be useful and appropriate to see a discussion of the lessons learned in the financial crisis regarding systemic risk management and whether and how such lessons have influenced these rules. This is true generally, but is particularly important in the case of repo clearing banks.

Several specific recommendations are given below that would strengthen these standards to provide sufficient protection against systemic risk.

Standards Should Reflect Issues Related to Tri-Party Repo Clearing Banks

The Financial Stability Oversight Commission (FSOC), not the Federal Reserve, is given the responsibility for designating systemically important FMUs, and it is as yet unclear whether repo clearing banks will be so designated. However, they certainly fit the criteria of systemic significance and do serve a key utility function, so they are appropriate for designation. This is particularly true in light of the fact that the potential failure of these entities clearly created a systemic risk in 2008 and motivated the Federal Reserve to establish a number of special credit facilities during the crisis.

The Payments Risk Committee sponsored by the Federal Reserve Bank of New York has issued an extensive report with multiple detailed recommendations that would reduce systemic risk at clearing banks.[2] It is surprising that some of these lessons drawn specifically from the financial crisis were not incorporated into the risk management directives for FMUs, and indeed were not referenced at all in the proposed rule. Should repo clearing banks – or other future entities that perform a similar function – be designated as FMUs the Federal Reserve should incorporate specific risk management directives (such as the elimination of intraday credit risk) aimed at lessening systemic risks at these banks.

FMUs Should At Minimum Be Required to Hold Sufficient Capital To Meet A “Cover Two” Requirement, or, Better, A Percentage of Risk Requirement

Section 234.4 (a) (18) of the proposed rules requires the FMU to withstand a default of its single largest counterparty (a “cover one”) requirement. The Board requests comments on the choice between a “cover one” requirement and a “cover two” requirement (which would require the FMU to hold sufficient resources to cover simultaneous defaults by its two largest counterparties). Given the choice between these options, AFR favors the “cover two” requirement. During a period of extreme market stress it cannot be guaranteed that there will be only a single default. Given the potential access of private, for-profit FMUs to public financial support through the Federal Reserve, it is important that rules require key financial market entities to internalize the costs of protecting against systemic risk.

However, basing this key capital decision on simply the number of counterparties seems highly arbitrary. Systemic risk can be generated by the failure of an FMU which has many counterparties, no one of which is particularly large, if the various counterparties are highly interconnected. In such a case, the failure of multiple interconnected counterparties could occur at once. AFR agrees with the proposal in the comment by Better Markets that the resource requirements for FMUs should be based on a percentage of aggregate exposures, not simply the number of counterparties. The test should be based on the larger of (a) the member representing the largest exposure to the CCP, or (b) members constituting at least 33 percent of the exposures in aggregate to the CCP.  This approach captures the risk of a diverse, but interconnected, membership.

Model Validation Must Be Performed By A Truly Independent Third Party

The margining requirements are the key protection against failure of a CCP and the need for public financial assistance or the creation of systemic risk. However, private FMUs may face competitive pressures to lower their margins in order to attract business and increase profits. In light of this conflict of interest, the models setting margin requirements should be validated by a genuinely independent third party. The proposal in this rule, which simply requires the validation by an individual who has not been involved in creating the model, is inadequate. No employee of the FMU is fully independent of the profit pressures at the FMU.

The independent third party should be qualified and must have no financial stake in the outcome of the validation. Another possibility is to set up a procedure by which the models could be validated by the regulators themselves.

We appreciate the opportunity to comment on the proposed rule. If you have any questions, please contact Marcus Stanley, the Policy Director at Americans for Financial Reform, at Marcus@ourfinancialsecurity.org or (202) 466-3672

Sincerely,

Americans for Financial Reform