Unfortunately, risk management programs usually make news only when they fail. For example, a bank takes on too much risky debt and/or uninsured deposits. The bank’s risk management program fails to stop the buildup of unsustainable risks. The bank’s regulator intervenes only when it’s too late, shutting down the bank and forcing the sale of its assets and liabilities. The Federal Deposit Insurance Corporation (FDIC) admitted in September that it had not supervised First Republic Bank’s operations adequately before it closed the bank in May, allowing JP Morgan Chase to buy most of those $200 billion in assets and liabilities.
IATP referenced the First Republic Bank financial failure and the FDIC regulatory failure at the outset of our September 18 letter to the Commodity Futures Trading Commission (CFTC). We responded to questions posed in an Advanced Notice of Proposed Rulemaking (ANPRM) to revise two risk management program rules. The CFTC is not a bank regulator, but it does regulate two kinds of commodity trading intermediaries that are often owned by very large banks. Futures Commission Merchants (FCM) trade standardized contracts, e.g., wheat futures, on regulated exchanges, such as the Chicago Mercantile Exchange. Swaps Dealers (SDs) trade customized contracts off exchange (known as Over the Counter) on Swaps Execution Facilities. FCM and SDs’ clients seek to manage price risks and take profits by buying and selling future-dated contracts according to a trading strategy.
According to the National Futures Association, a self-regulatory organization, as of August 31, 2023, there were 105 SDs and 61 FCMs. CFTC staff review quarterly reports from the SDs and FCMs to evaluate their exposure to different risks, e.g., the credit risks of their clients. However, the ANPRM stated there was “significant variance” in how different risk areas were defined and what was reported, so it was difficult for the staff to understand the extent of risk and how well it was managed. The CFTC asked several questions about whether the agency should develop a template for reporting quantitative risk data and for narrating risk management issues. IATP’s letter answered in the affirmative. Making data reporting more consistent and comparable increases the likelihood that the CFTC can aggregate risks and determine which SDs or FCMs might have to increase their capitalization and/or collateral requirements for trading to prevent risk management problems in one FCM or SD from resulting a wider pattern of defaults among counterparties to one or more contracts.
Under the current risk management program regulations, each SD and FCM has a Risk Management Unit (RMU) independent from the business unit. The RMU is responsible for the daily implementation of the Risk Management Program (RMP) developed by senior management and overseen by the board or “similar governing body.” IATP urged the CFTC to amend the definitions of “senior management” and “governing body” to clarify the accountability structure for managing risks. IATP advocated for the inclusion of "Chief Technology Officer” in “senior management,” given the SDs and FCMs’ nearly ubiquitous use of automated trading systems. We recommended that the RMU director report to the Chief Compliance Officer, who would be designated in the definition of “senior management.” We concluded, “Reporting lines are a means to accountability. A definition of ‘senior management’ that confuses accountability likely will weaken risk management operations.”
The ANPRM asked whether a revised risk management program regulation should include new enumerated risks, in addition to the traditional reporting of credit risk, operational risk and liquidity risk. We recommended that the revised rule include reporting on two new kinds of financial risk: technology-related risk and climate change-related risk.
Although there are many types of technology risk, e.g., cyber security risk, IATP recommended that the CFTC focus on the risks of generative Artificial Intelligence (AI) risk controls. The CFTC has been studying AI at least since 2019. A subcommittee of the CFTC’s Technology Advisory Committee (IATP is a member) is preparing a short study of how AI is used in trading and risk management. Without prejudging what the TAC might recommend to the CFTC about AI, we recommended that current rules regarding Third Party Service (TPS) providers of automated trading technology might be applied to AI-directed trading or risk control programs.
As a National Institute for Standards and Technology study pointed out, the TPS developers of AI models purchased and adapted by SDs and FCMs might not be transparent about the data parameters used to train the AI models. The autonomy of an AI model could become out of sync with the SD or FCM trading or risk management objectives. Although computer engineers are developing methods for training AI models to behave ethically, it is not clear what the TPS developer’s responsibility is to the FCM or SD employing a SD or FCM specific AI model. Nor is it clear where accountability lies if an AI system “hallucinates” (tech jargon for not responding truthfully or accurately) with a customer’s money.
The CFTC Chair is a member of the Financial Stability Oversight Council (FSOC), an interagency group of federal financial regulators. FSOC has characterized climate change as a systemic financial risk that affects a very wide array of financial instruments, markets and actors. How should SD and FCM risk management programs incorporate climate-related financial risk into their risk models, which should guide their own trading and trades transacted on behalf of their clients?
Climate scenario modeling is a tool used by central banks and very large banks, including those that own SDs and FCMs, to quantitatively estimate Climate Value at Risk (CVAR) under various climate shocks and financial stresses. However, a recent study by British actuaries characterized many current climate scenario models as the “emperor’s new climate scenarios,” alluding to a fable about an emperor who donned imaginary clothes, but whose subjects dared not to say that he was naked. These authors write, “Tipping points must be included if scenarios are to be realistic. They are no longer high-impact, low-likelihood events but are now high impact, high likelihood, and we need to mitigate and plan for them. Ignoring them in scenarios and modelling significantly understates risk.” We advocated that a revised risk management program rule require SDs and FCMs to include negative tipping points, such as the ongoing and perhaps irreversible depletion of major U.S. aquifers, in scenarios and computer modeling about agricultural futures and swaps trading. We also recommended that the revised RMP rule require best case scenario modeling.
IATP anticipates that inclusion of climate-related risk management requirements in a proposed RMP rule will be resisted by industry groups who prefer that the CFTC allow industry to innovate and market products, such as carbon dioxide emissions offset futures contracts, to manage climate risk.
Our letter cited the response of the CME Group in October 2022 to the CFTC’s “Request for Information on Climate-Relate Financial Risks.” The CME group claimed that “The Commission’s principles-based regulatory foundation enables market stakeholders to create and innovate and should not be compromised by the temptation to reach into policy areas best addressed by regulators with different competencies, history, and expertise.” (p. 2) This warning against regulating climate-related financial risk likely will be repeated in face-to-face meetings with CFTC Commissioners and with sympathetic members of Congress, particularly those on the agriculture committees who oversee the CFTC’s budget and staffing levels.
In sum, it likely will be difficult to persuade SDs and FCMs, who trade on CME Group exchanges, to include climate-related financial risk in their quarterly Risk Exposure Reports (RERs) to the CFTC. Perhaps only the financial costs for SD and FCM customers of increasingly severe and frequent extreme weather events exacerbated by climate change will change their minds about the imperative to include climate risk in RERs. SDs and FCMs that fail to internalize those costs by increasing their capital reserves and margin collateral to trade will be failing their customers by advising them to trade contracts with no strategy to hedge against climate risk