May 16, 2013
Mr. Chairman, thank you for calling this meeting to finalize the critical suite of rules regarding swap execution. Adoption of these rules will bring the Commission in compliance with three of the four principles agreed to by the G-20 nations who finalized the Pittsburgh Communique on September 25, 2009.1
These three principles are 1) reporting of all trades to a trade repository; 2) requiring that “all standardized OTC derivatives should be traded on exchanges or electronic trading platform, where appropriate”; and 3) “clearing through central counterparties.”
The fourth directive calls for higher collateral charges for all non-cleared OTC contracts. To comply with this remaining directive, the Commission has published a proposed rule to address this issue and is working with international regulators to establish harmonized rules that would apply internationally.
Notably, the data rules were one of the first set of rules implemented by the Commission. While the rules are not without flaws, data is a foundational element of our regulatory oversight because it shines a light on the true makeup of the market, including trading and risk relationships that were previously opaque. From this point forward, the excuse of “we don’t have the data” simply doesn’t hold water, because it is not true. We have three SDRs all collecting and reporting real time, historic and regulatory trade data.
The big question in my mind is will we use the data to support decisions by this Commission or will we selectively ignore the facts when it doesn’t suit our outcomes?
Commission Staff Deserves Credit for Hard Work
Of course, this achievement wouldn’t be possible without the hard work and dedication of the Commission staff who have labored endlessly to develop rules, seek and review comments, conduct public roundtables and endure countless meetings on these issues. I am grateful for all the hard work and the patience of the staff to bring the Commission to this point.
In particular, I would like to recognize the rule teams here today including John Dunfee, Esen Onur, Nhan Nguyen, George Pullen, Rick Shilts, David Van Wagner, Sayee Srinivasan, Amir Zaidi, Jonathan Marcus, Adrianne Joves, Michael Penick, David Meister and Bob Pease.
I would like to also recognize Bella Rozenberg who had responsibility for both the SEF and Made Available to Trade rules prior to coming to my office. She has done marvelous work in service to the Commission.
Swap Execution Facility.
Today, the big rule everyone is waiting for is the Swap Execution Facility (SEF) final rule. It has been over 2 years since the draft rule was first voted back in January of 2011. That initial meeting was not without controversy as it was cancelled and the draft proposal was rewritten to include a request for quote (RFQ) execution methodology. Since that date, the product has evolved, but it has always remained more prescriptive and limiting than what was required by the statute.
From the beginning, the vision of SEF platforms varied with respect to the products offered, the methods of execution and technical functionality. In 2010, I hosted an all-day meeting known as the SEF Showcase (aka SEF-a palooza) where over 15 potential SEFs presented their platforms.
I am very excited about the opportunity SEFs will provide in bringing transparency to the swaps market. I support a flexible framework to ensure that all participants have the opportunity to – or frankly don’t have an excuse not to – trade on a SEF.
Victory on Temporary Registration of SEFs
I also encouraged the Commission to adopt a temporary registration process for SEFs that was better than the procedure we established for the Swap Data Repositories. In that respect, I believe we have succeeded. This rule provides that a complete application that makes a good faith effort to comply with all the Form SEF questions will be provided a temporary registration license before the new 60-day effective date. I believe a streamlined temporary registration process will not create a disadvantage for SEF applications reviewed later in the queue.
I know that approximately 18 SEFs have registered with the National Futures Association to support their market surveillance activities. These SEFs have undergone a rigorous testing procedure and completed their rulebooks. I am confident that we should have a good competitive market starting 60 days after publication of this rule.
But the Commission should have done a better job at implementing the Dodd-Frank directives to create flexible trading platforms for sophisticated traders, such as Eligible Contract Participants. Instead, the Commission has come up with a number of prescriptive rules, especially in the rule enforcement area, that are almost identical to the Designated Contract Markets rules. Also, in the spirit of promoting trading on SEFs, the Commission should have expressly permitted other methods of execution, including voice. At a minimum, the rule text should have included voice as the third method of execution.
Ignoring the Data Available to the Commission
More importantly, I am concerned with the process the Commission is using to shift the minimum number of traders on an RFQ from two to three participants. It is incredible to me that the Commission rushed to implement the data rules to ensure that it can make informed decisions, and yet has chosen to pick an unsubstantiated number without relying on any transaction data. A transparent rulemaking process would utilize available data to make fact based decisions. However, both the SEF rule and the Swap Block Rule suffer from a willful refusal to utilize available and useful data.
Data Amendments to SEF Rule and Swap Block Rule
To remedy this shortsighted policy, I have prepared amendments to both the SEF rule and Swap Block Rules that require the Commission to conduct a timely analysis of the liquidity on the SEF and in the relevant assets classes in setting block levels.
The SEF amendment requires the Commission to collect the data to identify the depth and quality of the liquidity and its interaction with the order book and voice systems. The Commission will then make a decision whether to change the minimum RFQ requirements.
Swap Block Rule
My frustration with the swap block final rule lies in the process. The goals of promoting pre-trade price transparency and trading on a SEF require the Commission to encourage on-screen trading, while the block rule should be reserved for those trades that are sufficiently large to be disruptive in the market.
Today’s Block Rule suffers from a similar shortcoming as the SEF rule. The foundation of any block size, whether it is a swap or future, is good data. Again, the Commission developed a rule with meager data in financial products and no swaps data in the case of foreign exchange and commodities. Making matters worse, the rule does not require consideration of transaction data to increase the blocks for any swap category, but instead simply imposes the arbitrary and automatic increase.
Again, I believe the Commission should utilize the facts and data and make an informed decision about the appropriate block levels. Therefore, I am prepared to offer an amendment to this rule to require the Commission to set block levels based on a study using trade data.
Made Available to Trade
I recognize the challenge that the Commission is facing in interpreting the “make available to trade” provision. Unfortunately, Congress did not provide the Commission with any guidance as to how and under what conditions the trade execution mandate must be triggered. Nevertheless, a lack of direction from Congress should not be an excuse for the Commission to come up with an unworkable rule.
The rule provides illusory comfort that the Commission will have a legal authority to review and, if necessary, challenge a mandatory trading determination made by a SEF or DCM. In fact, the only authority that the Commission has is to “rubber stamp” a SEF or DCM’s initial determination. Moreover, the lack of specific objective criteria for determining trading liquidity introduces uncertainty into the market and makes it unfeasible for the Commission to have any meaningful regulatory oversight over the made available-to-trade determination process. Finally, the process for removing a made available-to-trade determination lacks any logical or legal basis and is the exact opposite of what is required to make the initial available-to-trade determination.
Disruptive Trade Practices
This has been a long process from the initial Advance Notice of Proposed Rule Making (ANPR) in October of 2010, to the Proposed Guidance published in February of 2011, and finally to the Final Guidance we are voting on today. The team has made significant progress in giving meaning to CEA §4c(a)(5), which prohibits disruptive trading practices. The team has worked hard to define a broad statutory requirement and explain how to comply with the prohibition on violating the best bid or offer. Reflecting the concerns expressed in the comments, the Guidance draws the proper line between requiring market participants to trade in an economically efficient manner, and allowing them to take into consideration other factors that are also important when executing a transaction.
By allowing market participants to factor in such variables as clearing options and counterparty risk, the staff has established a prudent standard that respects both the trading process as well as the financial interest of market participants. I think this is an example of the Commission working with the industry to find the best solution from both a regulatory and economic standpoint.
While the final document is a significant improvement over the proposed guidance, I still have concerns with the guidance provided with respect to interpretation of disruptive trading and spoofing. In the ANPR, the Commission asked the industry to provide comment on what areas of the disruptive trading prohibition needed clarification. The ANPR asked 18 questions on topics ranging from general clarification of issues to more specific issues, such as rules for algorithmic or automated trading and what constitutes spoofing. Unfortunately, we failed to provide guidance in equal measure on the 18 questions listed in the ANPR.
For example, the Guidance has clarified what constitutes the closing period and made clear that orders, and not just trades, can contribute to disruptive trading. The document does not, however, provided clear guidance on how algorithmic or automated trading should be viewed in the context of disruptive trading. When the Guidance we provide says, “it’s always a facts and circumstances test,” then we aren’t really providing guidance. I would like to see the Commission work closely with market participants to develop a better understanding of the trading strategies used by algorithmic and high frequency traders, and then identify strategies that could lead to disruptive trading. We must also work to enhance the technological infrastructure required at the Commission in order to conduct proper market analysis that allows us to identify disruptive trading when it occurs in our markets. The Guidance issued today is a step in the right direction, but I think we still have more to do to provide market participants with the certainty they need.
I want to close by again thanking the staff for all their hard work in developing these rules. I look forward to finalizing these important rules so that the market can move forward with greater certainty surrounding development of the swaps market.
1 http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf Page 9
Last Updated: May 16, 2013