October 18, 2011
Today, the Commission is voting on final rulemakings on position limits and the operation of derivatives clearing organizations (“DCOs”). Further, the Commission is voting on a proposed order that would extend needed exemptive relief to market participants during the pendency of Commission rulemaking. Before we begin, I would like to join my colleagues in thanking the three teams responsible for the final rulemakings and the proposed order. Their hard work has resulted in comprehensive documents totaling nearly 800 pages. Their perseverance over the one-and-a-half-year rulemaking process has been truly inspiring.
The position limits rulemaking will form the foundation for Commission surveillance of the physical commodity markets, whereas the DCO rulemaking will form the foundation for Commission oversight of the financial integrity of market transactions. That is why I am particularly disappointed with both rulemakings. Both rulemakings rely on one fundamentally flawed assumption – namely, that the Commission, in nearly all circumstances, knows best and can substitute its judgment for that of exchanges and DCOs, despite the complexities of the futures - and now swaps - markets. As I will further explain, such assumption leads to regulations with substantial costs and little corresponding benefits. Such assumption is also difficult to justify from an evidentiary and statutory perspective.
First, both rulemakings will have a substantial economic impact on market participants, who for legitimate commercial reasons, use futures and swaps markets for hedging purposes. Both rulemakings have been confirmed by the Office of Management and Budget (“OMB”) to be “major rules” under the Congressional Review Act. This means that OMB has determined that each rule will have an annual effect on the economy of more than $100 million. This determination is unsurprising given that the position limits rulemaking alone will force commercial hedgers to invest multiple millions of dollars in developing compliance systems to justify and account for their legitimate hedging strategies.
Despite the above, neither the position limits rulemaking nor the DCO rulemaking fully describes its costs, even qualitatively, in its cost-benefit analysis. Further, neither rulemaking attempts meaningful quantification of its costs. Thus, both rulemakings deprive the public of transparency into their impact, in direct contradiction of two Executive Orders.1 Finally, both rulemakings again render themselves vulnerable to legal challenge.2
The two quotes that best capture my views on cost-benefit analyses come from President Barack Obama himself. They are:
“Wise regulatory decisions depend on public participation and on careful analysis of the likely consequences of regulation. Such decisions are informed and improved by allowing interested members of the public to have a meaningful opportunity to participate in rulemaking. To the extent permitted by law, such decisions should be made only after consideration of their costs and benefits (both quantitative and qualitative).” 3
“I have continued to underscore the importance of reducing regulatory burdens and regulatory uncertainty, particularly as our economy continues to recover.” 4
Obviously, it is a challenge to balance the regulatory objectives of the Dodd-Frank Act with economic growth, but as President Obama has urged in these two quotes, the Commission has an obligation to not lose sight of the impact our rulemakings will have on our economy. By not providing meaningful quantification – especially when we can easily do so – our cost-benefit analyses are inadequate by President Obama’s own standards.
Second, in addition to failing to detail costs, the two final rulemakings fail to articulate a convincing rationale for eliminating our current regime of principles-based regulation and substituting in its stead a prescriptive “government-knows-best” regime. After all, our current regime has served the Commission well both prior to and during the 2008 financial crisis. Specifically, the two final rulemakings fail to root their prescriptive requirements in fact-based evidence. As a result, both rulemakings contain multiple provisions that appear arbitrary. Consequently, the two final rulemakings again render themselves vulnerable to legal challenge.5 Whereas Congress may have mandated that the Commission promulgate certain rulemakings under the Dodd-Frank Act, the Commission retains the discretion to determine the best manner to meet such mandate.
I believe that both of the abovementioned points highlight themes that will be replicated in forthcoming rulemakings. Therefore, it is important to emphasize the deficiencies with these themes now. I recently celebrated my second anniversary serving as a Commissioner at the Commodity Futures Trading Commission. Like my colleagues, I take this responsibility very seriously and am honored to serve. I recognize there are passionate views on both sides, especially with regard to position limits, but our role is to make decisions on policy in a dispassionate manner that is rooted in facts. I hope that we continue to examine the facts and ask tough questions as to the implications of each and every rulemaking.
I have several concerns with both the position limits rulemaking and the DCO rulemaking. I have articulated my concerns in comprehensive separate dissents, which will be available on the Commission website after our vote and which will be published in the Federal Register. I will briefly describe herein my concerns with each rulemaking in turn.
Position Limits – CFTC Checks A Box
Today’s rule represents the Commission’s desire to “check the box” as to position limits. Unfortunately, in its exuberance and attempt to justify doing so, the Commission has overreached in interpreting its statutory mandate to set position limits. While I do not disagree that the Commission has been directed to impose position limits, as appropriate, the Commission cannot provide a legally sound, comprehensible rationale based on empirical evidence for the final rule we will likely pass today.
For commercial hedgers this rule puts them on the defense immediately and will keep them scrambling to (i) justify, and perhaps to alter, their hedging strategies and (ii) comply with the extraordinarily complex aggregation and hedging limitations.
If the commercial entities who use futures and swaps markets for hedging commercial risk feel like we are waging war on them, I don’t blame them. According to the Commission’s cost-benefit analysis, legitimate hedgers will pay close to 1/3 of the total annual $100 million cost of this proposal for reporting alone. These are the market participants to which Congress extended specific protection, yet this rulemaking will increase the cost of hedging and managing risk.
Now there are some market players that will probably find the new regulatory regime challenging, but full of gaps. I don’t believe this will diminish their ability to find exposure in commodity markets, but it may change the way they access these markets. I have no doubt that index investors and other passive long investors will continue to be able to secure their commodity exposure through new regulatory loopholes, including possibly expanding their investments in physical stocks, which are assets outside the Commission’s regulatory authority. This result is not what Congress intended.
DCO Core Principles
The DCO final rulemaking6 is among the most important Dodd-Frank rulemakings that the Commission has undertaken. I have been a strong proponent of clearing ever since the Enron crisis, when I witnessed the effectiveness of ClearPort in ameliorating counterparty credit fears and restoring liquidity to the energy merchant markets. I am certain that clearing will similarly benefit the swaps market,7 particularly by significantly expanding execution on electronic platforms and by ensuring that swaps counterparties – and not the hardworking American taxpayer – post collateral to support their exposures.
The main goal of this final rulemaking is to ensure that clearing contributes to the integrity of the United States financial system. I fully support this goal. However, I disagree with the prescriptive approach of this final rulemaking, because it leaves DCOs with insufficient discretion to take legitimate actions to manage the risks that they confront. Moreover, such an approach may result in substantial costs to the futures and swaps market, which are not detailed or explored. If the costs of this final rulemaking discourage market participants from prudently hedging their risks or from clearing on a voluntary basis, then such rulemaking may undermine the Dodd-Frank Act, which seeks to move risk from our financial and commercial entities into a regulated framework.
Two provisions in particular best highlight my concerns.
$50 Million Capital Requirement
This final rulemaking prohibits a DCO from requiring more than $50 million in capital from any entity seeking to become a swaps clearing member. This number makes a great headline. Unfortunately, it appears to lack an evidentiary basis. Moreover, whereas the $50 million threshold may prevent a DCO from engaging in anticompetitive behavior, it may also prohibit a DCO from taking a range of legitimate, risk-reducing actions (e.g., increasing capital requirements in proportion to risk). This final rulemaking provides little to no insight on the manner in which the Commission intends to distinguish between the former and the latter. Finally, this final rulemaking may impose costs on DCOs, which are likely to be passed on to commercial and financial end-users. Such costs may include: (i) the costs that a DCO would incur to ensure access to entities that have no ability to clear any significant volume of transactions in certain asset classes, for themselves or for customers; (ii) increased margin requirements; and (iii) increased guaranty fund contributions. Given the magnitude of such potential costs, it is at least likely that they would deter market participants from hedging or voluntarily clearing. The cost-benefit analysis of the final rulemaking, however, neither qualitatively nor quantitatively explores such costs.
Let me be plain. I am against anticompetitive behavior. However, an entity with $50 million in capitalization may not be an appropriate clearing member for every DCO. Rather than setting forth a prescriptive requirement that may scourge both the guilty and the innocent alike, the Commission should have provided principles-based guidance to DCOs on the other components of fair and open access, such as the standard for less restrictive participation requirements.8 By taking such an approach, the Commission would have been in greater accord with international regulators (one of which explicitly cautioned against the $50 million threshold),9 current international standards,10 and proposed revisions of such standards.11
Minimum Liquidation Time
This final rulemaking requires a DCO to calculate margin using different minimum liquidation times for different products. Specifically, a DCO must calculate margin for (i) futures based on a one-day minimum liquidation time, (ii) agricultural, energy, and metals swaps based on a one-day minimum liquidation time, and (iii) all other swaps based on a five-day minimum liquidation time.12
As a preliminary matter, such minimum liquidation times appear to lack an evidentiary basis. More importantly, when these requirements are juxtaposed against our proposal interpreting core principle 9 for designated contract markets (“DCMs”),13 it becomes clear that these requirements have the potential to severely disrupt already established futures markets. In the proposal, which is entitled Core Principles and Other Requirements for Designated Contract Markets, the Commission proposed, in a departure from previous interpretations of DCM core principle 9, to prohibit a DCM from listing any contract for trading unless an average of 85 percent or greater of the total volume of such contract is traded on the centralized market, as calculated over a twelve (12) month period.14 If the Commission finalizes such proposal, then DCMs may need to delist hundreds of futures contracts.15 Financial contracts may be affected, along with contracts in agricultural commodities, energy commodities, and metals.
According to the proposal, DCMs may convert delisted futures contracts to swap contracts.16 However, if the futures contracts reference financial commodities, then this final rulemaking would require that a DCO margin such swap contracts using a minimum liquidation time of five days instead of one day for futures. If nothing substantive about the contracts change other than their characterization (i.e., futures to swaps), then how can the Commission justify such a substantial increase in minimum liquidation time and margin? An increase of this magnitude may well result in a chilling of activity in the affected contracts. Such chilling would be an example of the type of market disruption that the Commodity Exchange Act (“CEA”) was intended to avoid.
I believe this has severe implications for competition. As commenters to the DCM proposal noted, market participants generally execute new futures contracts outside the DCM centralized market until the contracts attract sufficient liquidity. Attracting such liquidity may take years.17 Let us assume that an established DCM already lists a commercially viable futures contract on a financial commodity that meets the 85 percent threshold. Even without the DCM proposal and this final rulemaking, a DCM seeking to compete by listing a futures contract with the same terms and conditions already faces an uphill battle. Now with the DCM proposal, the competitor DCM would have to also face the constant threat of being required to convert the futures contract into a swap contract. With this final rulemaking, the competitor DCM (or a competitor swap execution facility (SEF)) faces the additional threat that, by virtue of such conversion, the contract would be margined using a five-day minimum liquidation time. It is difficult to imagine a DCM (or a competitor SEF) willing to compete given the twin Swords of Damocles that it would need to confront. By dissuading such competition, this final rulemaking and the DCM proposal undermine the “responsible innovation and fair competition among boards of trade” that the CEA was intended to promote.18
What should the Commission have done to avoid market disruption and a curtailment in competition? Again, the Commission should have retained a principles-based regime, and should have permitted each DCO to determine the appropriate minimum liquidation time for its products. Determining appropriate margin requirements involves quantitative and qualitative expertise. Such expertise resides in the DCOs and not in the Commission. In its cost-benefit analysis, the final rulemaking admits as much.19 Returning to a principles-based regime would have also better aligned with current international standards on CCP regulation,20 as well as the revisions to such standards.21
Amendment to the Effective Date Order
As Yogi Berra famously proclaimed: “It is déjà vu all over again.” Yogi perfectly encapsulates my feelings today.
I support the proposal, as I did last time, because it is important for the Commission to provide market participants and the public with the form of relief the exemptive order is contemplating, but I would have preferred that this rule, like its predecessor, not select an arbitrary end date.
Mr. Chairman, I again renew my call for a comprehensive rulemaking schedule and implementation plan, that provides greater insight on reporting requirements to swap data repositories as well as separate rulemaking on real-time and block rules. The Commission must also provide some certainty on the clearing and trading mandate including clarification of “made available for trading” and guidance on swap clearing.
Thank you, Mr. Chairman.
1 See Exec. Order No. 13,563, 76 Fed. Reg. 3821 (Jan. 21, 2011); Exec. Order No. 13,579, 76 Fed. Reg. 41,587 (July 14, 2011).
2 See, e.g., Business Roundtable and the United States Chamber of Commerce vs. SEC, No. 10-1305, 2011 U.S. App. LEXIS 14988 (July 22, 2011).
3 Exec. Order No. 13,579, 76 Fed. Reg. 41,587 (July 14, 2011).
4 See Statement by President Obama on Ozone National Ambient Air Quality Standards (September 02, 2011) http://www.whitehouse.gov/the-press-office/2011/09/02/statement-president-ozone-national-ambient-air-quality-standards.
5 See supra note 2.
6 Derivatives Clearing Organizations, 76 Fed. Reg. [___] ([__________]) (to be codified at 17 C.F.R. pts. 1, 21, 39, and 140).
7 See Kathryn Chen et al., An Analysis of CDS Transactions: Implications for Public Reporting, Federal Reserve Bank of New York Staff Report no. 517 (September 2011), available at: http://www.newyorkfed.org/research/staff_reports/sr517.pdf (stating that “[c]learing-eligible products within our sample traded on more days and had more intraday transactions than non-clearing eligible products”).
8 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.12(a)(1)).
9 See letter, dated March 21, 2011, from the United Kingdom Financial Services Authority, available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=957 (stating that “whilst capital thresholds or other participation eligibility threshold limitations may be a potential tool to help ensure fair and open access to [central counterparties (“CCPs”)], to impose them on clearing arrangements for products that have complex or unique characteristics could lead to increased risk to the system in the short to medium term.”)
10 See Bank for International Settlements’ Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions (“CPSS-IOSCO”), “Recommendations for Central Counterparties,” CPSS Publ’n No. 64 (November 2004), available at: http://www.bis.org/publ/cpss64.pdf (the “CPSS-IOSCO Recommendations”). See specifically Section 4.2.2 of the CPSS-IOSCO Recommendations.
11 See CPSS-IOSCO, “Principles for financial market infrastructures: Consultative report,” CPSS Publ’n No. 94 (March 2011), available at: http://www.bis.org/publ/cpss94.pdf (the “CPSS-IOSCO Consultation”). See specifically Section 3.16.6 of the CPSS-IOSCO Consultation.
12 See 76 Fed. Reg. at [___] (to be codified at 17 C.F.R. § 39.13(g)(2)(ii)).
13 See Core Principles and Other Requirements for Designated Contract Markets, 75 Fed. Reg. 80572 (Dec. 22, 2010).
14 Id. at 80616.
15 According to information that I have received from one DCM, the proposal would force conversion of 628 futures and options contracts to swap contracts. Moreover, according to the Off-Market Volume Study (May-2010 through July-2010) prepared by Commission staff, the proposal would force conversion of approximately 493 futures and options contracts. See Off-Market Volume Study, available at: http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_12_DCMRules/index.htm.
16 See 75 Fed. Reg. at 80589-90.
17 See letter, dated February 22, 2011, from NYSE Liffe U.S., available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27910&SearchText=. See also letter, dated February 22, 2011, from ELX Futures, L.P., available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27873&SearchText=. See further letter, dated February 22, 2011, from Eris Exchange, LLC, available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27853&SearchText=.
18 See section 3(b) of the CEA, 7 U.S.C. § 5(b).
19 See 76 Fed. Reg. at [___] (stating that “[i]n addition to the liquidation time frame, the margin requirements for a particular instrument depend upon a variety of characteristics of the instrument and the markets in which it is traded, including the risk characteristics of the instrument, its historical price volatility, and liquidity in the relevant market. Determining such margin requirements does not solely depend upon such quantitative factors, but also requires expert judgment as to the extent to which such characteristics and data may be an accurate predictor of future market behavior with respect to such instruments, and applying such judgment to the quantitative results…Determining the risk characteristics, price volatility, and market liquidity of even a sample for purposes of determining a liquidation time specifically for such instrument would be a formidable task for the Commission to undertake and any results would be subject to a range of uncertainty.”).
20 See supra note 22. See specifically Section 4.4.3 of the CPSS-IOSCO Recommendations.
21 See also supra note 23. See specifically Section 3.6.7 of the CPSS-IOSCO Consultation.
Last Updated: October 18, 2011