November 12, 2014
I was invited to speak at the SEFCON V conference being hosted today by the Wholesale Markets Brokers’ Association, Americas (WMBAA). However, under Executive Order 13490, also known as President Obama’s Ethics Pledge, I am prohibited from speaking at SEFCON because of my past association with the WMBAA and because a fee is charged to attend the conference. I applied to the White House for a waiver to speak, but was denied, and I respect that decision. However, given the importance of the subject matter being discussed at SEFCON to the U.S. swaps market, if I had been permitted to speak at the conference, this is the speech I would have delivered.
Before I begin, let me say that the views I express are my own and do not necessarily reflect the views of the Commodity Futures Trading Commission (CFTC or Commission), the Commission staff or my fellow Commissioners.
I also wish to make clear that my criticism of the CFTC’s swaps trading regulatory framework is not directed in any way at the dedicated CFTC staff, particularly staff of the Division of Market Oversight, who continue to work diligently to apply the CFTC’s ill-fitting rule set to the unique characteristics of global swaps markets. Unfortunately, they are engaged in a Sisyphean task to make swaps trading succeed in an unsuitable, futures-style regime.
I would like to discuss the CFTC’s implementation of the swaps trading regulatory framework under Title VII of the Dodd-Frank Act.1 I would like to address some of the flaws in the CFTC’s swaps trading rules, describe some of the adverse consequences that are occurring, and suggest some improvements.
Let me start, however, with an event that took place in New York two months ago. That is, the largest U.S.-listed initial public offering (IPO) of all time. Alibaba, the Chinese e-commerce giant, raised over $25 billion in an IPO that took place on the New York Stock Exchange.2
Global Capital Flocks to U.S. IPO Market. In fact, the entire third quarter this year has been great for IPOs with over $40 billion raised in the U.S. compared to $8.6 billion raised in Europe and $14.3 billion in Asia.3 U.S. markets overall accounted for 52 percent of cross-border IPOs during the quarter.4 The U.S. ranks as the top country for new equity fundraisings for the fourth straight year.
Why did Alibaba choose New York to offer its shares rather than major exchanges in Asia and Europe? Certainly, Alibaba was drawn by the depth of U.S. equity liquidity necessary for a blockbuster offering. Yet, companies big and small from around the world flock to the U.S. IPO market. Is it only trading liquidity or does it also have to do with the balance of favorable market characteristics and a proven and well-respected U.S. regulatory framework?
Flexibility around governance provisions and the reputation for U.S. capital markets as a whole make the U.S. a premier place to list. Certainly, flexibility in corporate governance provisions was important to Alibaba. U.S. listing rules permitted Alibaba’s unique board structure that was prohibited by the Hong Kong Stock Exchange.
Yet, no one can assert that the flexibility afforded Alibaba makes the U.S. a lax and lenient jurisdiction in which to list shares. The Securities and Exchange Commission’s (SEC’s) public company disclosure regime and registration process is likely the world’s most rigorous. However, what is globally recognized is that the U.S. IPO market has a highly optimal balance of robust regulation, fulsome corporate disclosure, and flexible corporate compliance compared to its peer market places. As a result, the world and its capital flocks to the U.S. IPO market bringing jobs and economic growth along with it.
Global Capital Shuns CFTC Swaps Trading Regime. Compared to the recently resurgent global interest in the U.S. IPO market, however, the world’s response to the CFTC’s newly implemented regulation of the U.S. swaps markets has been swift and stark. The world is voting with its trading book to transact in other markets. According to several studies, global swaps trading has fragmented into U.S. person markets and non-U.S. person markets. Non-U.S. person market participants are curtailing transactions with U.S. counterparties to avoid getting caught up in the CFTC’s ill-designed swaps trading rules.
So, why does the world’s capital flow to the U.S. IPO market and yet shun the CFTC’s swaps trading regime? What is wrong with the CFTC’s swaps regulations?
CFTC Swaps Trading Rules are Mismatched to Global Swaps Markets. I believe the CFTC’s swaps regime is fundamentally mismatched to the natural commercial workings of the swaps markets. It is ill-suited to its stated goals of market stability, enhanced transparency, and regulatory supervision. It is a square peg being forced into a round hole. The misalignment of the regulatory framework with the underlying market characteristics results from a CFTC implementation process that was misconceived from the start. This misalignment with the true nature of global swaps trading causes the CFTC’s regulatory structure to dampen market activity and repel global capital rather than welcome and reward it. Failing to address this misalignment will have adverse consequences for U.S. economic growth and job creation.
Adverse Consequences of Flawed Swaps Trading Rules. The CFTC’s flawed SEF framework is causing a range of unintended adverse consequences. For one, it is ensuring that big platforms get bigger and small platforms get squeezed out because of the sharply increased legal and compliance costs of registering and operating a SEF. The CFTC’s restrictive approach to methods of execution is thwarting technological innovation that promises to better serve market participants. It is causing non-U.S. persons to stop using the services of U.S.-based support personnel and thereby harming American financial service jobs. Conversely, the CFTC’s overly complex SEF rules, while a bureaucratic delight, are an unnecessary waste of taxpayer dollars. It is also harming relations between the CFTC and foreign regulators. Most seriously, the CFTC’s swaps trading framework is the cause of abrupt fragmentation of global swaps markets between U.S. persons and non-U.S. persons. This has led to smaller, disconnected liquidity pools and less efficient and more volatile pricing and shallower liquidity, posing a significant risk of failure in times of economic stress or crisis. This market fragmentation is increasing the systemic risk that the Dodd-Frank regulatory reform was predicated on reducing.
There are some who will argue that the problem is simply one of regulatory arbitrage. They contend that trading will naturally flow away from the U.S. to Europe and other jurisdictions that have yet to adopt swaps transaction level rules. They argue that the European Commission and others are just taking too long to adopt transaction levels rules and that, once they do, the fragmentation of global swaps markets will reverse itself. They argue that the problem is just temporary.
This argument is far too forgiving of the CFTC’s flawed rule set and ignores the long-term harm to U.S. financial markets. The argument is built on the assumption that, if the Europeans and others could just be hurried along in their rule writing, they will adopt the same flawed rule set as the CFTC has done. Unfortunately for this argument, the Europeans are not looking to make the same mistakes. It has been clear for a long time that European swaps trading rules will not limit methods of swaps execution, or impose many of the other peculiar CFTC trading restrictions. The Europeans also do not intend to be hurried. They have been clear in their approach from the outset that the transaction level swaps rules are tertiary in importance to swaps clearing and trade reporting and would be addressed with that level of priority. The defense of CFTC rules further assumes that, once swaps markets leave the U.S., they can easily be brought back. Sadly, the history of trading markets, such as the Euro-Dollar market, shows that even when fundamental flaws are eventually addressed, it is hard to bring departed markets back to U.S. shores, along with the jobs they support.
Need for Reform. So, how did we get to this unfortunate state of affairs? Let’s start where it all began. In September 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. Its failure was a consequence of the bursting of a double bubble of housing prices and consumer credit as lenders became concerned about a fall in property values and repayment of mortgages. A typical “run on the bank” ensued with rapidly falling asset values, preventing U.S. and foreign lenders from meeting their cash obligations. This marked the beginning of a financial crisis that was devastating for far too many American businesses and families.
Without question, counterparty exposures related to bilaterally executed over-the-counter (OTC) swaps helped amplify and spread the financial crisis. Many exposures were inadequately collateralized, causing swaps users to record huge losses, as counterparty defaults appeared likely. With little public information about bilateral exposures among swaps users, third parties became less willing to provide credit to institutions that might face such losses. Fear for the stability of the U.S. banking system forced the federal government to inject emergency capital into the largest U.S. banks and insurance companies at great expense to American taxpayers.
Unwavering Support for Swaps Reform. I found myself in the middle of that crisis as a senior executive of a U.S. wholesale brokerage firm that operates global trading platforms for bank-to-bank swaps transactions. I remember the panic in the eyes of bank executives and the tremor in the voices of bank regulators. I saw that the crisis was driven by fear – fear of counterparty failure among the major dealing banks. Fear by regulators into their lack of visibility into counterparty credit exposure. I remember the crisis very well. I was there.
That experience confirmed my support, which has not wavered, for central counterparty (CCP) clearing of swaps and reporting trades to centralized data repositories. I also support sensible regulation of swaps intermediaries to raise trading standards and bring swaps markets in line with regulation of intermediaries in other capital markets like equities and futures.
But, I am also a firm believer that vibrant, open, and competitive markets are an essential element to a strong U.S. economy. Proper regulatory oversight can go hand-in-hand with open and competitive markets. However, if excessive regulation artificially increases the cost of risk management and stymies the legitimate use of derivatives, the overall economy will suffer.
It is because I am a committed supporter of the core tenants of Title VII of the Dodd-Frank Act that I am opposed to the unnecessary and burdensome elements of the CFTC’s swaps trading regulatory framework, which is Balkanizing global markets. Those include limits on technological innovation in methods of execution, the artificial distinction between Required Transactions and Permitted Transactions, pushing block transactions off regulated platforms, creating an unworkable “made available for trading” process, inconsistent transparency objectives, and promulgating highly prescriptive rules under the guise of core principles. The CFTC’s framework has led to a range of adverse consequences that I mentioned above, including an abrupt fragmentation of global swaps markets that is increasing the systemic risk that the Dodd-Frank regulatory reform was predicated on reducing.
Swaps Trading Regulation White Paper. I will soon issue a formal “White Paper” analyzing the mismatch between the CFTC’s swaps regulatory framework and the trading and market structure characteristics of the underlying swaps markets. It will review the global swaps market structure that evolved in the decades before the Dodd-Frank Act. It will analyze Congress’s comprehensive swaps regulatory framework set out in Title VII of the Dodd-Frank Act. Thereafter, the White Paper will consider in detail the CFTC’s peculiar swaps trading regulations. It will then review the adverse consequences of the CFTC’s flawed swaps trading framework. Finally, the White Paper will propose an alternative to the CFTC’s swaps trading regulatory framework that is more comprehensive in its regulatory scope, more flexible in application, better aligned with swaps market dynamics, and, critically, more true to Congressional intent. Most importantly, the alternative presented will promote swaps trading in CFTC-regulated markets and attract, rather than repel, global capital to U.S. trading markets. I will use the rest of the statement below to summarize additional conclusions of the coming White Paper.
Understanding Swaps Liquidity
Implementing a sensible swaps regulatory framework starts with an appreciation of the unique nature of swaps trading liquidity. Liquidity in the swaps markets is fundamentally different than liquidity in the futures and equities markets. The unique “episodic” nature of swaps liquidity drives most other characteristics of the structure, support infrastructure, methods of execution and clearing, and roles of trading participants in the global swaps markets. The distinct nature of swaps liquidity has been the subject of several well-researched studies and comment letters presented to the CFTC and the SEC.5 A thorough understanding of the episodic nature of swaps liquidity must be at the heart of any effective rulemaking under Title VII of the Dodd-Frank Act.
Swaps markets are best understood by contrasting them to exchange-traded and other highly liquid markets that exist for more commoditized instruments, such as U.S. treasury securities, equities, and certain commodity derivatives. Exchange-traded markets provide a trading venue for the most commoditized instruments that are based on standard characteristics and single key measures or parameters. Exchange-traded markets with CCP clearing rely on relatively active order submission by buyers and sellers and generally high transaction flow. While exchange-traded markets offer no guarantee of high trading liquidity, for those products that do become liquid, exchange marketplaces allow a broad range of trading customers (including retail customers), meeting relatively modest margin requirements, to transact highly standardized contracts in relatively small amounts. As a result of the high number of market participants, the relatively small number of standardized instruments traded, and the credit of a CCP clearer, liquidity in exchange-traded markets is relatively continuous in nature. This allows for efficient all-to-all execution with substantial price competition.
In comparison, many swaps markets and other less commoditized cash markets feature a broader array of less-standardized products and larger-sized orders that are traded by fewer counterparties, almost all of which are institutional and not retail. Trading in these markets is characterized by variable or non-continuous liquidity. To offer one simple example, of the over 4,500 corporate reference entities in the credit default swaps market, 80 percent trade less than five contracts per day.6 Such thin liquidity can often be episodic, with liquidity peaks and troughs that can be seasonal (e.g., certain energy products) or more volatile and tied to external market and economic conditions (e.g., many credit, energy, and interest rate products). These markets thus have less price competition, wider bid-offer spreads, and negotiated intermediation.
It is because of the limited liquidity in many of the swaps markets that they have evolved into “dealer” marketplaces for institutional market participants. That is, many corporate end-users of swaps and other “buy-side” traders recognize the risk that, at any given time, a particular swaps marketplace will not have sufficient liquidity to satisfy their need to acquire or dispose of swaps positions. As a result, these counterparties turn to sell-side dealers with large balance sheets that are willing to take on the “liquidity risk” for a fee. These dealers have access to secondary trading of their swaps exposure through the marketplaces operated by wholesale and inter-dealer brokers. These wholesale marketplaces allow dealers to hedge the market risk of their swaps inventory by trading with other primary dealers and large, sophisticated market participants. Without access to wholesale markets, the risk inherent in holding swaps inventory would cause dealers to have to charge much higher prices to their buy-side customers for taking on their liquidity risk, assuming they remain willing to do so.
The episodic liquidity of swaps and the swaps market’s sell-side and buy-side market structure has led to a broad range of venues with multiple methods of trade execution for a wide variety of financial products.
Along the continuum of swaps markets liquidity from low-to-high, intermediation methods and techniques vary widely according to product trading characteristics. In markets for less commoditized products where liquidity is not continuous, trading platforms provide a range of liquidity fostering methodologies and technologies. These include hybrid modes of broker work-up, methods of broadcasting completed trades and attracting others to “join the trade,” and auction-based methods, such as matching and fixing sessions. In other swaps markets, intermediaries conduct operations that are similar to traditional “open outcry” trading pits where qualified brokers communicate bids and offers to counterparties in real time through a combination of electronic display screens and hundreds of installed, always-open phone lines, as well as through other email and texting technologies. In every case, the technology and methodology used is calibrated to the particular liquidity characteristics of the instruments traded, and carefully designed to disseminate customer bids and offers to the widest extent possible to foster the greatest degree of trading liquidity.
The Dodd-Frank Swaps Trading Regulatory Framework
In crafting Title VII of the Dodd-Frank Act, Congress got it mostly right. Congress laid out a fairly simple and flexible SEF regulatory framework suited to the episodic nature of swaps liquidity trading through a wide range of regulated venues featuring multiple methods of execution. In essence, Title VII requires that most cleared swaps be executed on designated contract markets (DCMs) or SEFs. Congress expressly permitted SEFs to execute swaps transactions using “any means of interstate commerce.” Additionally, Congress articulated goals, not requirements, for this SEF framework to maintain its flexibility. Congress did not create confusing artificial distinctions for swaps trading, nor did it create a detailed regulatory mandate around which swaps must be executed on SEFs. Congress did, however, provide for a core principles-based framework and gave SEFs reasonable discretion to comply with them.
Flexible Execution Methods. In Title VII, Congress expressly permitted SEFs to offer various flexible execution methods for swaps trading. The law defines a SEF as a “trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that – (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.”7
The Dodd-Frank Act’s broad language essentially provides for “multiple participant-to-multiple participant” swaps execution through any means of interstate commerce. Congress could have required swaps to trade exclusively on a DCM, which must be a trading facility,8 but it chose not to do that. Congress could have left in the final bill earlier draft references to electronic execution, but it did not do that either. Instead, it deleted those restrictions in favor of the final construct that trade execution could take place through “any means of interstate commerce.” Thus, Congress spoke quite clearly in the Dodd-Frank Act on the subject of methods of swaps trading. It used precise language with rich Constitutional context. “Interstate commerce” has long been interpreted by U.S. Federal Courts to cover almost an unlimited range of commercial and technological enterprise. Congress certainly knew the implications of using these particular words.
Goal to Balance Price Transparency with Promotion of Regulated Trading. Congress expressly set two goals for Title VII of the Dodd-Frank Act: promoting the trading of swaps on SEFs and promoting pre-trade price transparency in the swaps market.9 Interestingly, Congress defined these as “goals,” not requirements. In doing this, Congress provided added flexibility to the SEF framework. Given the liquidity characteristics of swaps and the unique swaps market structure, Congress appreciated the need for such flexibility allowing the two goals to be balanced against each other as necessary. This approach is consistent with the flexible SEF definition and the core principles-based framework for SEFs.
No Artificial Distinctions for Swaps Trading. Congress did not require the artificial distinction between Required Transactions10 and Permitted Transactions,11 or that block transactions be executed “off-SEF” as opposed to “on-SEF.”12 Congress simply required that certain swaps be executed on SEFs through flexible execution methods. The Dodd-Frank Act did not then slice and dice these swaps into further categories and require specific and different execution methods for these categories. With respect to block transactions, Congress only intended to provide blocks with delayed reporting.13 The Dodd-Frank Act did not require these transactions to be executed “off-SEF.”
No Regulatory Mandate for Made Available to Trade. A plain reading of the trade execution requirement demonstrates that Congress did not intend to create an entire regulatory mandate around the phrase “made available to trade” (MAT).14 Congress expressly added a trade execution requirement to the Dodd-Frank Act requiring SEF execution for swaps subject to the clearing mandate.15 In an exception to this requirement, Congress stated that this trade execution requirement does not apply if no SEF “makes the swap available to trade.”16 It is plain that Congress intended the phrase to express simple logic that, if any given product is not available to execute on a SEF, then the trade execution requirement does not apply. Drafters of Title VII were aware that, unlike futures, newly developed swaps products are initially traded bilaterally and not intermediated until later in their development cycle. The statutory language evidences Congress’s appreciation that, until trading reaches a critical stage, early stage swaps products generally will not trade on an intermediary platform. Congress knew how to institute a regulatory mandate. It chose to do so for the clearing mandate.17 It chose not to do so for trade execution.
Core Principles-Based Framework. Congress envisioned a core principles-based framework for SEFs and provided them with reasonable discretion to comply with these principles. This was in keeping with the Commission’s historical core principles-based regulatory regime for DCMs. While Congress provided the Commission with some rule writing authority, Congress did not envision a highly prescriptive rules-based approach to SEFs. Such an approach is a big departure from the Commission’s historical regulatory framework. It is also inconsistent with the simple, flexible SEF framework Congress created in the Dodd-Frank Act.
The Current CFTC Swaps Trading Regulatory Framework
Limits on Methods of Execution. The CFTC’s SEF rules require a SEF to offer an order book18 (Order Book) for all transactions and limit the methods of execution on a SEF to Order Book or Order Book plus Request for Quote System to three participants19 (RFQ System) for those transactions that meet the trade execution requirement.20 There is no statutory support for the CFTC’s construct. Rather, as explained above, the Dodd-Frank Act’s SEF definition is broad and flexible and contemplates execution methods beyond an Order Book or RFQ System. The SEF definition does not contain an all-to-all requirement as required by the Commission’s Order Book obligation. And, while the SEF rules acknowledge the phrase “through any means of interstate commerce,21 the CFTC reads it narrowly to allow for voice and other “means” of execution or communication, but still prohibits SEF execution methods beyond the Order Book and RFQ System.
It also important to note that while a DCM’s execution methods are limited by DCM Core Principle 9,22 there is no similar core principle for SEFs. DCM Core Principle 9 requires a DCM to provide a competitive, open, and efficient market that protects the price discovery process of trading in the centralized market.23 The lack of a similar core principle for SEFs reflects Congress’s understanding that swaps trade through a variety of execution methods given their episodic liquidity. The Commission, while acknowledging this difference, uses it to justify its limited execution approach, instead of following Congressional intent.24
Throughout the preamble to the SEF final rule, the Commission again and again relies on the SEF definition and SEF goals to support its positions.25 However, the Commission’s general reliance on the goals of promoting pre-trade price transparency and the trading of swaps on SEFs does not justify limited execution methods. Assuming, for the sake of argument, that both SEF goals must be met for each SEF execution method, there are certainly other swap execution methods that would meet the SEF definition and these goals. It is hard to believe, for example, that only an RFQ System that operates in conjunction with an Order Book, where a market participant must obtain quotes from three participants who are not affiliates of each other, among other peculiar requirements, is the only RFQ System that satisfies the SEF definition and SEF goals.26 By prohibiting various execution methods, the CFTC is discouraging rather than promoting trading on SEFs in contravention of the express goal of the Dodd-Frank Act.
The Commission’s misguided approach to SEF execution is starting to show its shortcomings. Package transactions are a perfect example. The Commission has required participants to execute package transactions through the SEF’s limited execution methods. However, many of these transactions are not suitable for Order Book or RFQ System execution given their limited liquidity and complex characteristics. As a result, the Commission staff is engaged in a detailed no-action relief process for different categories of package transactions to avoid the harm that its MAT determination will cause to swaps package trading. It is contemplating a new “SEF Permitted-Lite” set of execution methods.27 So now, in addition to “Required” and “Permitted” Transactions, we will have a new catchall set called “Permitted-Lite.” The CFTC could have avoided this complex situation and saved many hours of Commission resources if it followed Congressional intent. This intent allows SEFs the flexibility to follow existing market practice and use methods of execution that best accommodate the way in which swaps actually trade in global markets.
Artificial Distinction between Required and Permitted Transactions. As noted, the SEF rules create two categories of transactions: Required Transactions28 (i.e., any transaction involving a swap that is subject to the trade execution requirement), and Permitted Transactions29 (i.e., any transaction not involving a swap that is subject to the trade execution requirement), and prescribes execution methods for each category.30 In a footnote to the preamble of the SEF final rules, the Commission justifies this distinction pointing to the trade execution requirement in Commodity Exchange Act (CEA) section 2(h)(8).31
The Commission’s explanation for this distinction, however, is not supported by the statute. The trade execution requirement only requires that certain swaps must be executed on a SEF; it does not prescribe the specific execution methods for these swaps. Additionally, as previously noted, the SEF definition allows for flexible execution methods for all swaps, not just certain “Permitted Transactions.” By creating such an artificial distinction between swaps on SEFs and their corresponding execution methods, the CFTC is forcing swaps to trade through limited execution methods before the appropriate liquidity is available to support these execution methods. This execution regime has disrupted swaps trading as demonstrated by the Commission’s ongoing package transactions struggle.
Block Transactions “Off-SEF” or “On-SEF”? In another example of CFTC artificial distinctions, the Commission’s block trade definition, specifically, the “occurs away” requirement, has created challenges for SEFs, FCMs, and market participants. The CFTC defines a block trade as a publicly reportable swap transaction that involves a swap that is listed on a registered SEF or DCM, “occurs away” from the SEF’s or DCM’s trading platform and is executed pursuant to the SEF’s or DCM’s rules and procedures, has a notional amount at or above the appropriate minimum block size, and is reported subject to the rules.32
It is unclear what the CFTC is trying to achieve by requiring that block trades be executed away from the SEF’s trading platform. The “occurs away” requirement creates an arbitrary and confusing distinction between “on-SEF” and “off-SEF” especially given that a SEF may offer any method of execution for Permitted Transactions. What is the real difference between “on-SEF” and “off-SEF?” How does an “off-SEF” requirement help the Commission promote the SEF goal of encouraging swap trading on SEFs?
The Commission should rethink the “occurs away” requirement for swaps trading. The requirement is a holdover from the futures model. It has no relevance in the swaps markets, where blocks and non-blocks trade through a variety of execution methods depending on liquidity and other characteristics. The CFTC should not impose the futures model on swaps trading. Congress recognized these differences by not imposing on SEFs an open and competitive centralized market requirement, with corresponding exceptions for certain non-competitive trades as contained in DCM Core Principle 9.33 Given these statutory and market differences between swaps and futures, the Commission should revisit the block trade definition for swaps and remove the “occurs away” requirement.
Division of Market Oversight staff provided relief from the “occurs away” requirement given the technological challenges that SEFs and FCMs have faced in facilitating pre-execution credit checks of block trades pursuant to this requirement.34 It is my understanding that the no-action relief has helped SEFs and FCMs with their pre-execution credit check obligations. While this is a good result, I believe that the Commission should focus on the bigger policy issue of requiring block trades to “occur away” from the SEF’s trading platform.
Unworkable Made Available to Trade Process. The CFTC’s swaps rules have also created an unnecessary tension between the clearing mandate and trading requirement. This tension arises from the CFTC’s limited execution methods and creation of an entire regulatory mandate around the phrase “makes the swap available to trade” in the trade execution requirement in CEA section 2(h)(8).35 Under this SEF-controlled MAT process, clearing mandated swaps are subject to the trade execution requirement if a SEF certifies that it has made the swap available to trade.36 Once made available to trade, these swaps must be executed on a SEF pursuant to the limited execution methods allowed by the CFTC’s rules.37
The current non-deliverable forward (NDF) clearing mandate debate highlights the tension between clearing and trading and the Commission’s flawed regime. At the October 9, 2014 Global Markets Advisory Committee meeting, participants voiced their concern over an NDF clearing mandate because such swaps are not ready to trade pursuant to a SEF’s limited execution methods.38 These participants noted that once NDFs are subject to the clearing mandate, the trade execution requirement is a certainty due to the SEF-controlled MAT process.39 While some participants stated that NDFs might be ready for a clearing mandate, they urged the Commission to think carefully about how this mandate would affect NDF trading.40
The Commission could have avoided the tension between the clearing mandate and trading requirement if it allowed flexible execution methods for all swaps on SEFs. Participant resistance to NDF clearing would likely fall away with flexible execution methods.
Inconsistent Transparency Objectives. The Commission spent much time focusing on the SEF goal of pre-trade price transparency when promulgating the SEF rules, but in other transparency initiatives the CFTC appears to be supporting inconsistent objectives. That is especially the case with the “embargo rule.”
Under the embargo rule, a SEF may not disclose swap transaction and pricing data to its market participants until it transmits such data to a swap data repository (SDR) for public dissemination.41 This rule causes delays in flashing swaps transaction data to a SEF’s market participants because, for example, the data must be enriched and converted as required by the SDR before transmittal or the SEF chooses to use a third-party provider to transmit data to an SDR. These delays disrupt the work-up process, where counterparties may wish to buy or sell additional quantities of a swap after its execution on the SEF.42 This outcome reduces market liquidity. The effect of this rule is to prioritize one type of transparency – public transparency – at the expense of another type of transparency – market transparency. This prioritization is being done, notwithstanding that the swaps market is an “eligible contract participant” (ECP)43 market that is closed to the general public. It is hard to know what public good is being served by the CFTC putting non-market participants on the same priority level as market participants.
Prescriptive Rules Disguised as Core Principles. My White Paper will cover in greater detail the CFTC’s one-size-fits-all approach to SEF core principles and cost prohibitive obligations placed on SEFs. For purposes of this discussion, I assert that the CFTC must approach the swaps core principles as true principles and not as rigid rule sets. The CFTC must rethink its prescriptive rules-based approach to SEFs modeled on futures exchange practices that are unsuitable for the way swaps actually trade. Congress has permitted SEFs to operate through “any means of interstate commerce.” SEFs should not be punished by having to comply with unworkable rules more suitable for single silo, all-to-all futures trading platforms. I encourage the Commission and the CFTC staff to consider a flexible core principles-based approach for SEFs based on the range of execution methods utilized, the ECP status of market participants, and the competing, multi-polar structure of the swaps market. Without a more flexible and true principles-based approach to the SEF core principles, the CFTC is ensuring that Congress’s Title VII regulatory framework will be unsuccessful.
Conclusion: Re-Balance by Returning to Congressional Intent
So, how can we at the CFTC fix our flawed swaps trading regime so that the world is attracted to U.S. markets the same way Alibaba and other international firms flock to participate in the U.S. IPO market? How can we achieve Congress’s goals of promoting trading on CFTC registered SEFs with proper transparency and supervision? How can we undo the fragmentation in global markets and increased systemic risk that our flawed rules have caused?
Much of the current problem would be resolved if the CFTC’s swaps rules were redesigned in a much simpler and effective manner in the clear spirit of Title VII of the Dodd-Frank Act. Of course, the central premise must remain that that if swaps under CFTC jurisdiction are intermediated, they generally must be transacted on CFTC registered, regulated, and supervised platforms. However, there should be no separation between Required and Permitted Transactions. There should also be no separation between block trades transacted off-SEF and non-blocks on-SEF. There should be no MAT determinations. Most of the CFTC’s complex slicing and dicing of transaction categories should be replaced with a clear mandate that swaps can be executed through flexible execution methods as Congress mandated, provided they are executed on registered platforms. And, provided the Commission approaches the core principles in Title VII as true principles and not as rigid rule sets.
Let customers and the market, not the CFTC, determine optimal trading methodologies and innovative technology. Let customers, not the CFTC, determine market structure and trading relationships. Let customers and the market, not the CFTC, pick winners and losers. The CFTC should encourage, not discourage, the development of many types of platforms serving as many different customer sets as there is commercial demand. This simplified approach is soundly in line with Congressional intent.
A return to the clear framework of Title VII of the Dodd-Frank Act would yield enormous benefits. It would promote healthy global markets by regulating swaps execution in a manner well matched to the underlying market dynamics. It would reduce the enormous legal and compliance costs of registering and operating a SEF that is closing the doors of smaller platforms. It would encourage technological innovation to better serve market participants and preserve the jobs of U.S. based support personnel. It would free up agency resources and save taxpayer money at a time of Federal budget deficits. As importantly, it would undo much of the global fragmentation in global swaps trading and the resulting increased systemic risk. Instead of the global trading community rejecting the CFTC’s swaps regime, the world might be drawn to it.
A smarter and more flexible swaps regulatory framework would enable the U.S. to lead the world in swaps trading, just as it does with IPOs. It would stimulate American jobs. It would allow American businesses to more efficiently hedge commercial risks, promoting economic growth. The U.S. has a persistent global reputation for being at the forefront of innovation in the marketplace, from finance and technology to agriculture and manufacturing. Behind all of those advances, risk management has been a critical component of success. It is time for the federal government to realize that it must enable and encourage American excellence in regulating risk-hedging markets. Without that realization, we will continue to drive markets overseas to jurisdictions gladly waiting to take them from us. We cannot and must not allow that to happen. We must get these rules right.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010).
2 Includes the overallotment exercise.
3 IPO Markets Don’t Need Alibaba for Best Quarter Since 2010, Bloomberg, September 30, 2014, available at, http://www.bloomberg.com/news/2014-09-30/ipo-markets-don-t-need-alibaba-for-best-third-quarter-since-2010.html.
5 ISDA and SIFMA, Block trade reporting for over-the-counter derivatives markets, January 18, 2011, (“ISDA/SIFMA Block Trade Study”), available at, http://www.isda.org/speeches/pdf/Block-Trade-Reporting.pdf; J.P. Morgan Comment Letter to Real-Time Public Reporting of Swap Transaction Data proposed rule (January 12, 2011), available at, http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27106&SearchText=j.p.%20morgan.
6 See ISDA/SIFMA Block Trade Study.
7 CEA section 1a(50); 7 U.S.C. 1a(50).
8 CEA section 1a(51); 7 U.S.C. 1a(51).
9 CEA section 5h(e); 7 U.S.C. 7b-3(e).
10 17 C.F.R. 37.9(a)(1).
11 17 C.F.R. 37.9(c)(1).
12 17 C.F.R. 43.2.
13 CEA section 2(a)(13)(C); 7 U.S.C. 2(a)(13)(C).
14 CEA section 2(h)(8); 7 U.S.C. 2(h)(8).
17 CEA section 2(h)(1); 7 U.S.C. 2(h)(1).
18 17 C.F.R. 37.3(a)(2) and 37.3(a)(3).
19 17. C.F.R. 37.9(a)(3).
20 17 C.F.R. 37.9(a)(2).
21 17 C.F.R. 37.9(a)(2)(ii).
22 17 C.F.R. 38.500.
24 Core Principles and Other Requirements for Swap Execution Facilities, 78 FR 33,476, 33,484 (Jun. 4, 2013).
25 See, e.g., 78 FR 33,484, 33,496, 33,497, 33,498, 33,499, and 33,501.
26 17 C.F.R. 37.9(a)(3).
27 No-Action Letters 14-12 (Feb. 10, 2014), 14-62 (May 1, 2014), and 14-137 (Nov. 10, 2014).
28 17 C.F.R. 37.9(a)(1).
29 17 C.F.R. 37.9(c)(1).
30 17 C.F.R. 37.9(a)(2) and 37.9(c)(2).
31 78 FR 33,493 n. 216.
32 17 C.F.R. 43.2.
33 17 C.F.R. 38.500.
34 No-Action Letter 14-118 (Sep. 19, 2014).
35 CEA section 2(h)(8); 7 U.S.C. 2(h)(8). Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 FR 33,606 (Jun. 4, 2013).
38 See webcast of the October 9, 2014 Global Markets Advisory Committee meeting, available at, http://www.cftc.gov/PressRoom/Events/opaevent_gmac100914.
41 17 C.F.R. 43.3(b)(3).
42 See 78 FR 33,500 for additional information about the work-up process.
43 CEA section 1a(18); 7 U.S.C. 1a(18).
Last Updated: November 12, 2014