The Commodity Futures Trading Commission (“CFTC”) has proposed new governance requirements (“Governance Proposal”) for derivatives clearing organizations (“DCOs”). Under the Governance Proposal, DCOs would need to create forums to consult with their clearing members and the customers of clearing members on matters that could materially affect the risk profile of the DCO and respond to some feedback.
While the focus of the Governance Proposal is DCOs, clearing members and customers of clearing members should consider the ramifications of codifying this industry practice as a regulatory requirement. Among other issues, clearing members and customers of clearing members will need to consider carefully how they interact with and manage the representatives who are selected to review DCO risk matters and provide feedback.
The Governance Proposal is based on recommendations from the CFTC’s Market Risk Advisory Committee (“MRAC”). MRAC is an advisory committee that is composed of DCOs, clearing members, end-users, and other stakeholders. It assessed the existing DCO governance requirements to identify opportunities to enhance their effectiveness. Its recommendations were that the CFTC should codify the existing risk governance practices of some DCOs to enhance transparency and ensure the consideration of the views of owners and participants in risk management matters.
There are two key elements to the Governance Proposal.
Risk Management Committees
First, each DCO would be required to establish and consult with one or more risk management committees (“RMCs”) on matters that could materially affect the risk profile of the DCO.
The RMCs would be composed of representatives of clearing members and customers of clearing members who are selected by the DCO. The RMC would need to contain at least two representatives of clearing members and two representatives of customers of clearing members, although a DCO would have flexibility to set the maximum size of the RMC based on its structure. The DCO would be required to rotate the membership of the RMC on a regular basis, and the CFTC is considering if it should add a minimum frequency for rotations to the final rule.
As with other affiliated individuals, the DCO would need to consider the fitness of individual members for RMC participation and develop appropriate fitness standards. The individual members of an RMC would be expected to serve as independent experts that are “neither beholden to their employers’ particular interests nor acting as fiduciaries of the DCO.”
The board of the DCO would be required to consult with, and consider and respond to input from, an RMC on all matters that could materially affect the risk profile of the DCO. This would include any material change to the DCO’s margin model, default procedures, participation requirements, and risk monitoring practices, as well as the clearing of new products. While the board would retain the ultimate responsibility to make major decisions with respect to the DCO, it would be required to respond to the substance of the input it receives from an RMC and could not merely acknowledge that the input was received.
The CFTC requests comment on whether members of an RMC should be permitted to share certain types of information they learn in their capacity as an RMC member with fellow employees of their clearing member or customer firm in order to obtain additional expert opinion. It also asks if there should be criteria for the types of information that may be shared and what measures should be taken to ensure the confidentiality of DCO information.
The DCO would be required to maintain written policies and procedures to make certain that the RMC consultation process is described in detail and includes requirements for the DCO to document the board’s consideration of and response to RMC input. A DCO also would be required to maintain policies that are designed to enable its RMC members to provide independent, expert opinions in the form of risk-based input on all matters presented to the RMC for consideration and perform their duties in a manner that supports the safety and efficiency of the DCO and the stability of the broader financial system.
Risk Advisory Working Groups
Second, each DCO would be required to establish one or more risk advisory working groups (“RWGs”) from which the DCO may seek risk-based input. The membership of RWGs generally would be larger than an RMC, for example, including a diverse cross-section of the DCO’s clearing members and customers of its clearing members.
A DCO would be required to convene an RWG at least quarterly and solicit input regarding all matters that could materially affect the risk profile of the DCO. The CFTC is considering whether to require DCOs to document RWG meetings.
The Governance Proposal also asks if a DCO should be required to consult with a broad spectrum of market participants prior to submitting any rule change to the CFTC. It also requests comment on how DCOs should be expected to describe and respond to opposing views.
It appears from comments made by Commissioner Summer K. Mersinger that 12 DCOs already have some form of an RMC and six already have RWGs. This may indicate that RMCs and RWGs are widely accepted best practices. However, imposing them as regulatory requirements may create new concerns and crystalize existing issues.
First, it is unclear how a DCO, clearing member, or customer of a clearing member would be expected to ensure that members of an RMC act as independent experts. The Governance Proposal notes that there may be a tension between RMC members’ corporate law duties to their employer and regulatory obligations to the DCO. Moreover, members of an RMC presumably will be compensated by their employer and, therefore, may have an implicit bias for their employers’ particular interests. While the Governance Proposal requests comment on whether a DCO should be required to have policies for managing conflicts of interest involving RMC members, it is not clear whether or how a DCO policy would be able to alter RMC members’ duties to their employees.
Separately, the Governance Proposal does not address how clearing members and customers of clearing members may interact with and manage RMC members. For example, must a clearing member or customer firm consider the ability of a prospective RMC member to act independently of their commercial interests? May a clearing member or customer firm ask an RMC member to consider or understand commercial interests that affect a DCO risk matter, or must the RMC member be walled off from all commercial information? It seems that the CFTC may be seeking a level of independence in RMC members that is more consistent with a public accountant or, at least, a second or third line of defense. This may be difficult to achieve in practice.
With respect to the RMC member’s status as a representative and employee of the clearing member and customer firm, under what circumstances may a clearing member or customer firm terminate all or part of the relationship? For example, if an RMC member makes a recommendation to a DCO that a clearing member disagrees with, may the clearing member replace the RMC member or terminate their employment?1 Similarly, if an RMC member is investigated or sued for their actions on the RMC (e.g., leaking information, harassment), who is responsible/liable for their conduct and to whom may they look for indemnification?2
Second, it would seem preferable for the CFTC to define and impose a duty of confidentiality on RMC and RWG members instead of relying on DCO rules or contractual terms. This is particularly true with respect to the contemplated information sharing practices, which may vary among DCOs and among clearing members and customer firms. A CFTC-imposed duty also may mitigate questions regarding who is liable for an improper disclosure (e.g., the RMC member as an individual, the RMC member as an employee, or the RMC member’s employer).
More broadly, however, the CFTC’s recognition that highly confidential material would be shared with the RMC members raises questions with how that information should be stored and managed by the RMC members. For example, may they retain confidential DCO information in an employer-monitored email account? What if the confidential DCO information discloses an impending peril for their employer? Must the RMC member “sit” on this information until the clearing member or customer firm becomes aware of it? Could they disclose the risk to their employer without disclosing the source of the information?
Third, the Governance Proposal’s discussion of RWGs is vague and somewhat confusing. On one hand, it states that RWGs would need to be convened at least once each quarter. On the other hand, it implies that RWGs would have the opportunity to provide input on all matters that could materially affect the risk profile of the DCO. It is unclear how a DCO would be expected to seek input from RWGs on time-sensitive matters that might not be able to wait until the next quarterly meeting. It also is unclear if DCOs would be required to provide RWGs with the same level of detail on risk-related matters as is provided to RMCs.
Comments on the Governance Proposal are due to the CFTC by October 11, 2022. If you have any questions or comments, we look forward to hearing from you.
1 Presumably, an RMC member’s participation in an RMC would end if the individual’s employment with the clearing member or customer firm is terminated, but this is not stated in the Governance Proposal.