December 5, 2011
Today, we have before us two final rules and a further notice of proposed rulemaking. I greatly appreciate the cooperation of Commission staff in accommodating many of the requests for changes to these rules. I also appreciate that we have chosen to slow down the break-neck pace of finalizing rules under the Dodd-Frank Act, even though I continue to struggle with the fact that it is becoming increasingly clear that the rules we are putting out are less than clear. I hope that we can take the time to develop rules that are done right, rather than done quickly.
It is that time of year again when I start to fill out my Christmas list. This year I have some new requests and I am going to ask again for things I didn’t get last year. Last Christmas, my first wish was for the Commission to take the opportunity to organize the rulemaking process in a manner that would build derivatives regulation from a strong foundation as opposed to the regulatory jumble of our earliest attempts to put out the 50+ Dodd-Frank proposals. I reiterated that request many times over this year, and I am pleased that Congress took notice and retained language in the Commission’s annual appropriations bill directing the Commission “to develop and publish, with a 60-day comment period, a schedule for implementation and sequencing of all rules and regulations” under title VII of the Dodd-Frank Act.1 While the Commission has outlined two critical rules around trading, clearing, and margining,2 a more comprehensive and definitive schedule must be produced. Not only will it help U.S. markets, but a desire for such a schedule was a common refrain from fellow regulators in Asia, who are attempting to coordinate their respective rules with U.S. and European reform efforts.
These rules have not come out in any particular order, and do not make any attempt to create a solid foundation for the new regulatory landscape. Our current process is creating pools of legal and regulatory uncertainty that through interconnection, are rapidly forming seas of ambiguity detrimental to market structure and confidence.
For example, in light of ongoing discussions regarding the challenges of complying with the new large swaps trader reporting requirements that became effective on September 20th, the Division of Market Oversight recently issued temporary and conditional relief from certain requirements to provide a safe harbor for market participants making a good faith effort to comply with the new rules. While I believe such relief is entirely appropriate, I question whether we could have avoided this action had we designed and followed an implementation and sequencing plan.
My second wish is that the Commission continues its early efforts to reorganize itself around technology. It is essential that the Commission discontinue the practice of overseeing a 21st century market with 20th century tools. This year, the Congress appropriated $55 million for technology alone. This funding will allow the Commission’s new Office of Data and Technology to facilitate a comprehensive approach to developing advanced technology aimed at automating regulatory functions and improving the Commission’s data analysis in support of mission-critical functions under the Commodity Exchange Act (“CEA”) (as amended by the Dodd-Frank Act). I feel that it would be a missed opportunity if the Commission doesn’t capitalize on this targeted investment to focus on developing a strategic plan for technology investment for the next several years.
My next Christmas request is for the Commission to schedule a series of roundtables to provide market participants an opportunity to fully vet their concerns with staff before they are in that sea of uncertainty between effective dates and implementation dates. Earlier this year, the Commission hosted a number of roundtables on new topics that I believe have been informative and worthwhile.
First, I would like to reiterate my request for a roundtable on client clearing documentation. Since the Commission approved a proposal to ban the FIA-ISDA Cleared Derivatives Execution Agreement – particularly the Tri-Party Annex – market participants from all sectors have continued to discuss the best technological solution for executing swap transactions.
I support the development of a technological solution that will minimize the chance that an intermediary or a DCO would reject a swap transaction for credit reasons. However, market participants differ on how fast the swaps market could evolve to implement such technology. They also differ on where the technology could be deployed most effectively – namely, at the intermediary, the execution platform, the DCO, or a centralized credit “hub”. I believe that a roundtable would permit market participants to explore the tension between documentation and various technological solutions in greater depth. Thus far the Commission’s proposal will ban the Tri-Party Annex, but it does nothing to provide the critical technological solution that the swaps market desperately needs. Our next step should be to schedule a roundtable so that market participants from all sectors could discuss the most effective solution available.
Second, I had asked for a roundtable to clarify how the Commission should make a mandatory clearing determination. Such determination is inextricably tied to the mandatory trading requirement, which is the subject of a proposal today. Whereas I would have preferred for the roundtable to have been held before today’s proposal, I would like to reiterate my roundtable request. Since the Commission has not finalized the scope of the end-user exemption, the mandatory clearing determination has the potential to affect each and every entity currently executing swaps in the bilateral market. Therefore, the Commission should ensure that each category of affected participants has an opportunity to openly and publicly discuss how various interpretations of the clearing determination affect them.
In July, I issued a letter to market participants regarding the mandatory clearing determination. I received 11 replies, all of which are available on my website.3 To give a sense of the questions that participants are asking, the Agricultural Retailers Association, the American Gas Association, the American Public Power Association, the Commodity Markets Council, Edison Electric Institute, Electric Power Supply Association, National Corn Growers Association, National Rural Electric Cooperative Association, Natural Gas Supply Association, and the Fertilizer Institute filed a joint letter asking the Commission to clarify the manner in which it would take into account “trading liquidity” in making a mandatory clearing determination.4 They state that such clarification would enable market participants to “make certain long-term investment decisions” because it would increase “confidence in the availability and cost of risk management tools.”5 The Business Council for Sustainable Energy makes similar points.6 In this environment of increasing economic uncertainty, the Commission should do its best to clarify its processes in a way that would encourage businesses to invest the capital necessary for our economy’s revitalization.
Finally, I would also like to reiterate my request for a roundtable on the mandatory trading requirement.7 This requirement – like the mandatory clearing requirement – has the potential to affect each and every entity currently executing bilateral swaps. As I will explain later, I have deep reservations about the process that the Commission is proposing for “making a swap available to trade” under CEA section 2(h)(8). Moreover, the Commission must give guidance on how much liquidity it believes is necessary to sustain a requirement that all entities – other than commercial end-users – execute swaps on an electronic trading platform. A number of commenters to our swap execution facility proposal observed that a swap may be liquid enough to be cleared but not traded electronically.8 Other commenters noted that a swap may be liquid in the bilateral, over-the-counter environment, but not in an electronic trading environment.9 The Commission needs to find a way to encourage swaps trading on electronic trading platforms while enhancing – rather than disrupting – liquidity. A good way for the Commission to start is by engaging market participants in an open and public discussion.
Getting back to today’s final rules, I would like to thank Bella Rozenberg, Duane Andresen, and Jon DeBord, and their team members for their work and dedication to these rulemakings.
Foreign Boards of Trade
I intend to support the final rule on registration of foreign boards of trade (“FBOT”). The rule sets forth a new requirement that links the approval of an FBOT with its clearing organization. I have two primary concerns with this final rule. First, does this rule provide adequate clarity regarding the new requirement that links FBOT approval to a Commission determination regarding its clearing organization? This is a new standard, which is tied to the second concern. The rule relies on international principles and standards that are currently, but may not be in the future, comparable to our own regulatory regime.
I have just returned from a trip to Asia where I met with international regulators. Uniformly, the first question that they asked me was: what standard will the U.S. apply in permitting mutual recognition for regulation of clearing organizations? Foreign regulators are concerned that the U.S. would demand that clearing organizations – and their regulators – comport with standards that are not strictly necessary under the principles set forth by the Bank for International Settlements’ (“BIS”) Committee on Payment and Settlement Systems (“CPSS”) and the Technical Committee of the International Organization of Securities Commissions (“IOSCO”). I am looking forward to hearing staff’s response to this question.
Investment of Customer Funds
I also intend to support the final rule on investment of customer funds. As recent events have highlighted, the protection and preservation of customer funds is fundamental to our markets. By limiting investments of customer funds to a subset of instruments that currently have minimal risk, this final rule is a step towards enhancing customer protection. However, as I emphasized in a statement on MF Global, the Commission must not become complacent. It must take additional action to bolster public confidence in our customer protection regime, including enhancing transparency into the risks that our intermediaries assume.10 I hope that the Commission can develop a notice of proposed rulemaking in the near future to improve transparency into intermediaries on behalf of customers.
Preliminarily, I would like to note that this final rule is markedly more sophisticated than the proposal in the way that it (i) clarifies the scope of prohibitions (e.g., in-house transactions), (ii) evaluates the risks posed by certain instruments (e.g., securities from government-sponsored enterprises and money-market mutual funds), and (iii) adjusts the asset-based and issuer-based concentration limits accordingly. I am pleased that this rule permits greater utilization of money market mutual funds, which would enable intermediaries and DCOs to more easily diversify investments of customer funds. Further, I am pleased that this rule restricts investments in two failed government- sponsored enterprises that remain eligible entirely as a result of federal protection.
My support of the final rule on investment of customer funds is not without reservation. With regard to sovereign debt limitations, I am reminded of my recent discussions in Asia with regulators and market participants. Market participants in both Singapore and Australia had exposure to MF Global and are fighting to secure lost customer funds, just like market participants in the U.S. This fact highlighted the interconnection of our economies and markets. I recognize that foreign sovereign debt can no longer be considered “riskless” investments. But the truth of the matter is – we are all in a global economy together. The coordinated action by the Federal Reserve and five other central banks last week evidences this truth. I am pleased that the final rule states that market participants may petition for exemption, and that the Commission would consider such exemption on a case-by-case basis. While the rule provides no standards for acceptable holdings – even those hedging currency exposure or foreign operational risk in jurisdictions that the greater financial market has deemed safe – I hope that the Commission will act in a timely manner to clarify acceptable practices and debt holdings to minimize disruption to the market.
Made Available for Trading
Finally, I intend to support the proposed rulemaking on the process for making a swap “available to trade.” My main purpose is to focus public comment on the mandatory trading requirement. Pursuant to this proposed rulemaking, an execution platform would determine that a swap is “available to trade” after considering a minimum of one of eight liquidity-related factors. The execution platform would then notify the Commission of its determination by either requesting a rule approval or by self-certifying the rule.
My concern with this proposal is that the Commission is fostering an inherent conflict of interest that could negatively impact the swaps market. This proposal is permitting those that have the greatest financial incentives to force all trading onto a platform to determine which swaps must be executed on such platform. This is like asking the fox to guard the chicken coop. Who are the chickens in this situation? Most likely the buy-side participants (e.g., pension funds). Fearing this exact situation, many on the buy-side have already urged the Commission to play a more active role in the mandatory trading requirement. For example, the American Benefits Council and the Committee on Investment of Employee Benefit Assets stated that the Commission – and not platforms with “pecuniary interests” – should determine whether a swap has been “made available for trading.” They further stated that the Commission should base its determination on empirical data on swap liquidity.11 Managed Funds Association,12 as well as MetLife Insurance Company, made similar comments.13 I recognize this issue is not easy, particularly due to the linkage between the mandatory trading requirement and the mandatory clearing determination – unless, of course, the Commission applies the lowest standard of simply listing a product as sufficient. As mentioned above, I believe that the Commission should engage market participants in an open and public discussion of the mandatory trading requirement, through a roundtable.
The Dodd-Frank Act has placed the Commission in the position to preside over a significant portion of the most sweeping financial regulatory legislation ever. Though we often attach a numeric label to mark our progress in terms of rules proposed and finalized, pages published, and comments received, it all comes down to making sure that we ultimately create a regulatory structure that will promote the successful transition of the over-the-counter markets, decrease systemic risk, and create stability. We must make sure we get it done right, not just done quickly. I hope the Commission will focus on the rulemaking schedule as requested by Congress and conduct the roundtables so we can benefit from market input.
Thank you, Mr. Chairman.
1 See H.R. Rep. No. 112-101, at 54 (2011), available at http://www.gpo.gov/fdsys/pkg/CRPT-112hrpt101/pdf/CRPT-112hrpt101.pdf.
2 See Swap Transaction Compliance and Implementation Schedule: Trading Documentation and Margining Requirements Under Section 4s of the CEA, 76 FR 58176 (Sept. 20, 2011); Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011).
3 Available at http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.
4 Section 2(h)(2)(D) of the CEA requires the Commission to consider “[t]he existence of significant...trading liquidity” in making a mandatory clearing determination.
5 See letter from the Agricultural Retailers Association, et al., dated September 14, 2011, available at http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps
6 See letter from the Business Council for Sustainable Energy, dated September 26, 2011, available at http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps
7 See, e.g., Jobs on Main Street vs. Wall Street: The Choice Should Be Clear, dated September 14, 2011, Keynote Address by Commissioner Scott D. O’Malia, U.S. Commodity Futures Trading Commission, for the 2011 Futures Industry Association Energy Forum, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-8
8 See, e.g., comment letter from the Coalition for Derivatives End-Users, dated March 8, 2011, to Core Principles and Other Requirements for Swap Execution Facilities, 76 FR 1214 (Jan. 7, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=955 (stating that “[s]ome less liquid trades could be suitable for clearing but not for trade execution, yet the proposed rule does not recognize such a distinction.”)
9 E.g., Evolution Markets, a specialist in facilitating transactions in green markets (e.g., carbon or emissions), states in its comment letter: “…certain contracts, including many in emerging environmental and energy markets, find sufficient liquidity in over-the-counter markets…But, just because a contract finds liquidity in an over-the-counter market does not mean listing for trading on a DCM or SEF will provide similar liquidity.” Comment letter from Evolution Markets, dated March 8, 2011, to Core Principles and Other Requirements for Swap Execution Facilities, 76 FR 1214 (Jan. 7, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=955
10 See Statement of Commissioner Scott D. O’Malia on MF Global: Next Steps, dated November 16, 2011, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement111611
11 See comment letter from the American Benefits Council and the Committee on Investment of Employee Benefit Assets, dated March 8, 2011, to Core Principles and Other Requirements for Swap Execution Facilities, 76 FR 1214 (Jan. 7, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=955.
12 See comment letter from the Managed Funds Association, dated March 8, 2011, to Core Principles and Other Requirements for Swap Execution Facilities, 76 FR 1214 (Jan. 7, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=955.
13 See comment letter from MetLife Insurance Company, dated March 8, 2011, to Core Principles and Other Requirements for Swap Execution Facilities, 76 FR 1214 (Jan. 7, 2011), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=955
Last Updated: December 5, 2011