Plumbing of the Financial System in GOP Sights

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WASHINGTON — With the GOP set to begin its rollback of the Dodd-Frank Act early next year, some observers are questioning whether plans to strip away regulators' powers to designate nonbanks as systemically risky might be going too far.

One big concern is what happens to financial market utilities, the first firms to be targeted as systemically important financial institutions, which are now directly supervised by the Federal Reserve Board.

"This is a critical question for the stability for the U.S. and global financial system, but no one has really thought about it," said Karen Shaw Petrou, managing partner with Federal Financial Analytics.

Marcus Stanley, head of regulatory affairs at Americans for Financial Reform, said such a move would put the financial system at risk with no obvious benefit to markets, the public or even the utilities themselves.

"This is one of the areas of Dodd-Frank where it's somewhat accepted that the regulatory steps that were taken were sensible and needed," Stanley said. "They're core to actual systemic risk."

At issue is Title VIII of Dodd-Frank, which gives the Financial Stability Oversight Council the authority to designate nonbank firms as systemically risky, and thereby subjects them to heightened prudential supervision. The title also establishes the FSOC's authority to designate certain firms involved in the "transferring, clearing, and settling payments, securities, and other financial transactions" as financial market utilities. Those firms are then subject to supervision by the Fed in addition to their primary regulators, but may also borrow money directly from the central bank's discount window in certain emergency situations.

To date, eight firms have been designated as financial market utilities: The Clearing House Payments Co. LLC; CLS Bank International; the Chicago Mercantile Exchange Inc.; ICE Clear Credit LLC (a subsidiary of Intercontinental Exchange); the Options Clearing Corp.; and three subsidiaries of DTCC (Depository Trust Co., Fixed Income Clearing Corp. and National Securities Clearing Corp.) All eight firms were designated by FSOC in July 2012, and none objected to the designation.

Most of the firms are involved in "clearing" — a transaction meant to limit the risks of market contagion in a crisis. In the case of derivatives, a central counterparty, or CCP, nominally assumes both sides of a transaction. If one side of a deal fails to meet the terms of the transaction — either because of bankruptcy, insolvency, or any reason — the transaction will still be executed, and thus the other side of the contract can carry on as though there was no disruption. The CCP collects margin on each trade to cover that contingency.

Title VII of Dodd-Frank mandated that most swaps transactions should be cleared. But mandatory clearing had the secondary effect of concentrating risk into those clearinghouses, leading many in the industry to fear what might happen if those clearinghouses were to fail.

Mark Wetjen, former member of the Commodity Futures Trading Commission and current managing director of DTCC's global public policy office, said that the firm is not pushing for a repeal of Title VIII. In an interview, he said the designation makes sense and its responsibilities as a SIFI are appropriately balanced.

“DTCC has worked with the regulatory community since the passage of Dodd-Frank, including its supervisors, the SEC and the Fed, and is supportive of the … framework,” he said. “The standards that apply to [SIFMUs] are rigorous, but [we’re] comfortable in the sense that we think the standards are appropriate, and therefore we don’t have any issue with what’s expected of us as a [SIFMU] in terms of compliance.”

But a source familiar with the Financial Choice Act — a bill proposed by House Financial Services Committee Chair Jeb Hensarling, R-Texas — said that the elimination of the FMU designation is a critical step toward ending "too big to fail." That bill is likely to be the starting point for President-elect Donald Trump's expected rollback of Dodd-Frank.

Title VIII was included in Dodd-Frank without the benefit of a formal hearing, the source said, and its conferment of privileged status on only a few firms — some private companies, some publicly traded — is precisely the sort of "too big to fail" status that Republicans want to end.

"Anytime entities that didn't have access to the Federal Reserve and that didn't have access to emergency lending and the discount window get it, that's controversial," the source said. "Republicans want to end the bailout regime; we want to end bailout authorities. Title VIII is yet another bailout authority."

Norbert Michel, research fellow at the Heritage Foundation, agreed that repealing Title VIII makes sense. It creates utilities by giving certain market actors advantages over any other firm that may attempt to provide a similar service, he said.

But the companies are not utilities in the economic sense — they do not have a proprietary monopoly on payments, settlement and clearing, and are for-profit enterprises in most cases.

"There's no anticompetitive mandate to set these things up as monopolies — there's no reason that somebody else can't come in and serve that function," Michel said. "The fact that it may have economies of scale is not a justification for doing this."

Wetjen said that concerns about the creation of moral hazard are well-founded, but that they simply don't apply in the case of FMUs, at least in the case of DTCC. The firm's interactions with the SEC and Fed have been beneficial and rather than leaving the company with a sense of security, it leaves them with an abundant awareness of the risks they assume that concern the entire financial system.

“I understand the policy goal around trying to minimize or even eliminate moral hazard. But the reality is, it’s not as though any of the authorities that were given to the SEC or the Fed under Dodd-Frank encourage moral hazard,” Wetjen said. “In fact, just the opposite -- we’re reminded every day of the importance of our duty as a financial market utility, and that’s to manage risk according to the very highest of standards.”

Michel went on to say that, ideally, both Titles VII and VIII of Dodd-Frank would be repealed, thus eliminating both mandatory clearing and the special treatment of FMUs.

"Title VII and Title VIII combined, all they do is concentrate risk into a bunch of special financial entities and hook the Fed directly into it," Michel said. "It facilitates moral hazard, it facilitates bailouts. This is not the way you go if you want to end bailouts."

The source familiar with the Choice Act said that future iterations of a Dodd-Frank rollback may well include reconsiderations of various aspects of Title VII, noting that since its passage there have already been several modifications to that section of the law — notably with respect to end user protections and the elimination of the swaps pushout rule.

"As it relates to the Choice Act, the goal was to address the most immediate problems throughout Dodd-Frank," the source said. "There are some provisions in Title VII that still are on our list to examine and address. [Mandatory clearing] is one of the provisions that has been raised as a linkage to Title VIII."

But Stanley said eliminating mandatory clearing is a major step backward, especially since the markets were moving toward central clearing even before the crisis. Eliminating the Fed's oversight role into FMUs will do little to spur competition in the clearing and payments business, and instead will simply make an already complicated market even less visible to regulators.

"The irony here is that by de-designating them as systemic FMUs, they're going to make risk management at and oversight at the clearinghouses harder to do," he said. "They're putting themselves in a little bit of a self-fulfilling prophecy: They de-designate the clearinghouses, and then say 'We can't do mandatory clearing because clearinghouses are too risky.' "

Petrou agreed, saying the risks that FMUs pose to the financial system go beyond the fallout that might occur if they were to go out of business. If payment transactions were to be disrupted long enough and by enough parties, it could cause a liquidity crisis and could even spur an avalanche of defaults. And such a disruption isn't merely theoretical, she said; BNY Mellon, the only bank currently in the business of selling Treasury securities, experienced a 19-hour payment processing blackout earlier this month.

"When you have a central market infrastructure entity — whether it's in payments, settlement of clearing — it might liver to clear another day, but the counterparty deprived of an essential payment that then defaults may not," Petrou said. "You create a cascading contagion risk across the financial system in which the only ultimate survivor may be a central payment or clearing institution. That's a pretty perverse result."

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