Monday, March 21, 2011

Financial Market Utilities, Dodd-Frank, and JPMorgan

Cate Long and FinanceObserver have asked me to do a post on Title VIII of Dodd-Frank, so here goes. Title VIII is something of a wildcard in financial reform. It establishes a regulatory and supervisory regime for what it calls “financial market utilities” (FMUs), which are basically entities that clear and settle payments, securities, or other financial transactions between financial institutions. This is the critical infrastructure of the financial system. However, Title VIII doesn’t apply to every single electronic payments system that fits the definition of an FMU; it only applies to “systemically important” FMUs.

Naturally, the Financial Stability Oversight Council (FSOC) determines which FMUs are systemically important. The Fed, however, is the one ultimately charged with developing and enforcing the prudential standards for systemically important FMUs. Title VIII also gives systemically important FMUs access to the discount window, which is a no-brainer — but which I’m sure the usual suspects, who like to appear to be “savvy commentators” by feigning outrage over everything, will object to nonetheless (bailouts!).

There are two main issues in Title VIII. First, which FMUs will be deemed “systemically important”? Second, what will the prudential standards for systemically important FMUs be?

Financial Market Utilities and “Systemic Importance”

In the context of FMUs, Title VIII defines “systemically important” and “systemic importance” as:

[A] situation where the failure of or a disruption to the functioning of a financial market utility ... could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system of the United States.
That’s obviously a very broad definition (as are the criteria Title VIII requires the FSOC to consider), so the reality is that the FSOC will have broad authority to designate pretty much any FMU it wants “systemically important.”

Based on the proposed rule they released last week, the FSOC seems inclined to limit the “systemically important” label to the major institutional and interbank players — CHIPS, the DTCC entities, etc. That means the FSOC will probably not designate retail payment systems as systemically important (save possibly for Visa), or at least not initially.

I hate how in discussions like these (and especially in comment letters), no one is willing to talk about specific entities — to name names, as it were. Everyone just talks in generalities about broad types of entities, even though we all know exactly which entities we’re debating. Screw that. If I had to guess, gun-to-my-head-style, I’d say the FSOC’s list of systemically important FMUs will be (or, more accurately, will include):



CLS Bank

The Depository Trust Company (DTC)

National Securities Clearing Corporation (NSCC)

Fixed Income Clearing Corporation (FICC)


Bank of New York


CME Clearing

ICE Clear and ICE Trust

The Options Clearing Corporation (OCC)

State Street (maybe)
New York Portfolio Clearing (NYPC), which clears interest-rate futures and was just launched recently, will probably also get the “systemically important” designation once it gets going, since I understand it has the support of the dealers.

Yes, I do think that JPM and BNY (the two clearing banks) will be deemed systemically important FMUs. They clearly meet the definition of an FMU — they both operate a “multilateral system for the purpose of transferring, clearing, or settling” financial transactions — and they can’t squeeze their way into any of the § 803(6)(B) exclusions. And they’re both obviously systemically important: together, they clear over $1.6 trillion in tri-party repos. For a long time, the big fear didn’t involve one of the big investment banks like Lehman failing, it involved one of the two clearing banks failing (since that would affect all of the dealers that use the bank as their clearing bank).

Moreover, JPM’s margining practices with Lehman were almost comically inadequate. For example, for 3 months JPM allowed Lehman to post about $8bn worth of CDOs, valued at par, as margin. And when JPM later “discovered” that these CDOs were worth significantly less, they hit Lehman with a $5bn margin call. Essentially, JPM had been carrying $5bn of uncollateralized exposure to an obviously faltering investment bank in the Summer of 2008. Given JPM’s obvious systemic importance, there’s no way that kind of thing should be allowed to happen. And that’s why the two clearing banks need to be subject to minimum prudential standards specifically for their clearing functions.

What Will the Prudential Standards for FMUs Be?

What makes Title VIII such a wildcard is that it completely outsources the development of the actual prudential standards for FMUs to the regulators. Section 805(a)(1) says that the Fed “shall prescribe risk management standards, taking into consideration relevant international standards and existing prudential requirements, governing ... the operations related to the payment, clearing, and settlement activities of” systemically important FMUs.

So what will kind of prudential standards will the Fed impose? For that, I direct you to the BIS Committee on Payment and Settlement Systems’ recent report, “Principles for Financial Market Infrastructure.” It’s highly likely that this will be a blueprint for the prudential standards under Title VIII. Not only does Title VIII explicitly require the Fed to consider “international standards,” but the Chair of the Committee on Payment and Settlement Systems just so happens to be NY Fed president William Dudley. So the report most likely represents the current Fed thinking on FMUs.

I won’t even try to summarize the entire 153-page report, but I will pull the most important proposal for you:

“A payment system, [central securities depository], or [securities settlement system] ... should have sufficient liquid resources to effect, at a minimum, timely completion of daily settlement in the event of the inability of the [one/two] participant[s] and [its/their] affiliates with the largest aggregate payment obligation[s] to settle those obligations. A CCP should have sufficient liquid resources to meet required margin payments and effect the same-day close out or hedging of the [one/two] participant[s] and [its/their] affiliates with the largest potential liquidity need[s] in extreme but plausible market conditions.”
Clearly, national regulators differ on whether FMUs should be required to be able to withstand the failure of one or two of their biggest counterparties/members. Whether the Fed goes with a “one failure” or “two failures” test will be extremely important for FMUs like JPM/BNY and the clearinghouses, because a “two failures” test would require them to hold significantly higher capital and liquidity buffers. And since I’m making predictions in this post, I’m guessing the Fed will go with a “two failures” test.

In any event, Title VIII definitely bears watching. It’s one of the big remaining wildcards in financial reform.

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