April 27, 2011
Thank you Mr. Chairman, and let me thank the teams, which have spent many long hours negotiating and developing the rule proposals before us today.
Let me begin by making a comment on the rulemaking process going forward. After the May 2nd and 3rd staff roundtable on the implementation process, it is my hope that the Commission will release a comprehensive schedule of the sequencing of final rulemakings and a proposed implementation plan in the Federal Register and allow the public to comment on it before we finalize any rules under Dodd-Frank. Like you Mr. Chairman, I believe transparency will benefit this process. By allowing the public to comment on both the sequencing of the final rules and the proposed implementation plan, those affected by the rules will have the transparency and certainty they need to make budget, investment, and hiring decisions.
After almost ten months, the rule that will define the definition of a swap is finally before us.
I think the public will be surprised that this rulemaking is over 300 pages in length and by the number of differences that still exist between the two Commissions with respect to insurance products, foreign sovereign debt instruments, and swap indexes. I have a particular concern about the anti-evasion proposal, and how the Commission will conduct its analysis and implement this provision going forward.
I am also particularly interested to learn what pension funds and ERISA plans that use total return and mixed swaps think about this rulemaking. While I believe our interpretation of the forward exclusion is consistent with years of Commission precedent, I would like to hear from the public whether it will allow the forward market to continue to operate under Dodd-Frank in the same manner that it does today. With regard to financial transmission rights in electricity markets, this proposal recommends the Commission use its public interest waiver authority provided under Section 722 (f) of the Dodd-Frank Act. I believe that is the appropriate process.
Portfolio Margining – the Missing Link
As I was reviewing the treatment of single name CDS and index credit default swaps in the proposal, it struck me that market participants who purchase these products will not be able margin them on a portfolio basis. Congress gave the SEC and the CFTC a mandate under Section 713 of the Dodd-Frank Act to propose a joint rule on portfolio margining. Unfortunately, we are now at the end of the rule proposal process and we still have not proposed a portfolio margining rule. Portfolio margining is non-controversial, the entire market wants it, and it is one of the few, if not the only, cost saving tools in Title VII.
Let me first say that I strongly believe that swap dealers must be adequately capitalized. A swap dealer with enough regulatory capital to stand behind a trade gives comfort to its counterparties. While I realize that undercapitalized financial institutions were at the heart of the financial crisis, I want to point out that commercial entities that use swaps were not the root of the problem, and this proposal seems to ignore the flexibility of the statute and Congressional direction as it relates to the application of capital charges on end-users.
With that said, I want to read the language of Section 731 in the Dodd-Frank Act, which states that “[t]o offset the greater risk to swap dealer and the financial system” capital requirements for uncleared swaps shall “be appropriate for the risk associated with the non-cleared swaps held as a swap dealer or major swap participant”.1 I cite this language because I don’t feel that our proposal gives enough consideration to the phrase “appropriate for the risk”. In particular, non-bank, non-FCM swap dealers will be required to calculate and hold capital for each and every swap they enter into with a commercial end-user beginning with the first dollar of exposure. This regulation provides no thresholds, no exemptions, and certainly no consideration of the statutory flexibility provided in Section 731 (e)(3)(ii) to accommodate end-users.
Just so we are clear, commercial end-users are cooperatives, captive finance companies, farmers, municipalities, and other non-financial non-systemically risky counterparties. If a commercial swap dealer does not collect margin from a commercial end-user, then it must take a capital charge equal to its credit risk exposure to the end-user and the market risk of the swap. Two outcomes result from this regulation: either the dealer will require commercial end-users to post margin to avoid taking a capital charge for the transaction or the dealer will point to this regulation as a reason to increase the bid/ask spread of swaps for end-users to cover the capital charge mandated by this rule. Either way, the cost of hedging commercial risk for end-users will increase.
What I have just described is contrary to the intent of Congress. I quoted the Lincoln-Dodd letter in our last meeting, but I feel compelled to do it again. It says that “Congress clearly stated in this bill that the margin and capital requirements are not to be imposed on end-users...”2 The letter also goes on to say that “Capital and margin standards should be set to mitigate risk in our financial system, not punish those who are trying to hedge their own commercial risk.”3 Our proposed capital rule does just that. As a result, I will not support this proposal.
The other concern I have is the impact this rule will have on non-bank, non-FCM commercial firms that are likely to be captured by the overly broad definition of a swap dealer proposed by the Commission. To be clear, a non-bank, non-FCM swap dealer is an entity that generates the overwhelming majority of its income from commercial activity and engages in a de minimis amount of “swap dealing.” I predict this capital rule, combined with the broad swap dealer definition, will drive commercial firms that pose little, if any, systemic risk to the financial system out of the market-making business and concentrate the entire swap dealing business in Wall Street banks. Higher costs and less competition for commercial end-users is not proposition I favor, especially when I consider the source of the financial contagion in 2008.
Because the Commission put forward the swap dealer rulemaking on December 1, 2010, long before the capital and margin rules were completed, the swap dealer team did not have the benefit of comparing the cost impact of a broad swap dealer definition along with the cost of margin and capital rules on the affected entities. With that said, I also believe the recently released CFTC Inspector General’s Report on Cost-Benefit Analysis has appropriately highlighted the lack of attention that was paid to assessing the true cost of the swap dealer rule in the first place. This agency needs to take that report very seriously. I am in favor of a complete re-proposal of the swap dealer definition rule. The re-proposal must narrow the definition of swap dealer, propose reasonable exceptions, and perform a more rigorous analysis of the actual costs of the rulemaking to both the market and the Commission.
Individual Segregation of Collateral Rule
The complicated issue of how cleared swaps customer collateral should be segregated came before this Commission back in December in the form of an advanced notice of proposed rulemaking (ANPRM).4 After receiving several comments on that proposal, the Commission has narrowed its options by eliminating the complete physical segregation model from consideration. The proposal leans towards adopting a complete legal segregation model. To get this issue right, though, I believe we need to continue to consider other options that are viable alternatives and let the market decide which model best balances higher operational costs against the benefits of increased levels of customer collateral protection. As a result, I’ve asked the team to continue to consider the current futures model. The proposal signals in its preamble that the Commission is still considering this alternative. I recognize, though, that the futures model presents certain challenges to fellow customers of an FCM who don’t currently have the benefit of knowing enough about the risk profile of an FCM’s other customers. I am particularly interested in comments regarding how we might address that challenge, including requiring certain disclosures by FCMs. I am also pleased to see that the preamble reflects the strong debate inside the Commission on the effect of each option under the bankruptcy code. Finally, I am pleased that the preamble of this proposal includes language that will allow the Commission to adopt a final rule which lets a DCO choose what model is right for its business. I believe this flexibility allows the market to determine which option is the best way to move forward into the cleared swaps world.
I would like to thank the team for their efforts and for posting a red-line of the affected regulations on our website. The team worked very cooperatively with my staff, and accepted a number of my suggestions, I am very appreciative of that and I will support this proposal.
1 Section 731 of the Dodd-Frank Act adds 4s(e)(3) to the Commodity Exchange Act.
2 Letter from Chairman Christopher Dodd, Committee on Banking, Housing, and Urban Affairs, U.S. Senate, and Chairman Blanche Lincoln, Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, to Chairman Barney Frank, Financial Services Committee, United States House of Representatives, and Chairman Collin Peterson, Committee on Agriculture, United States House of Representatives (June 30, 2010); see also 156 Cong. Rec. S5904 (daily ed. July 15, 2010) (statement of Sen. Lincoln).
4 75 FR 75162 (Dec. 2, 2011).
Last Updated: April 27, 2011