December 9, 2010
The holidays are right around the corner, and as many of you know, I have three daughters, and therefore, three wish lists. My youngest daughter, Macey, spent the weekend scouring the various catalogs that haven’t made it to the recycling bin in search of the perfect gift to top her list. And you know what she came up with? A towel warming rack. She had no idea why she wanted it, but it was in the catalogue, and thus had equal opportunity with a lot of other items to make it to the list.
I didn’t think much of the towel rack until I read today’s proposal relating to swap execution facilities (“SEFs”), namely, the parts that aim to further define what a SEF is. And I thought to myself that this SEF rule is very similar to the towel rack episode: no reason, just because.
I’m not buying a seven year-old a towel warming rack, and I’m not supporting this proposed rulemaking today.
The Commission had a lot of options and opinions before it with regard to interpreting the statutory language and the goal of providing greater pre-trade price transparency. Without much reason, the Commission chose a limited two-tier approach that relies upon a narrow reading of the statute and a broad reading of an aspiration that, if adopted, will actually diminish the overarching goal of promoting the trading of swaps on SEFs.
The rulemaking mandates that a SEF either take the form of a central limit order book for any product that trades more than 10 times a day, or that of a transparent request for quote or “RFQ” approach. The so-called transparent RFQ proposal will require all bids and offers to be firm and provide a first-in bid, first-in fill approach. That is it. Staff has interpreted the minimal statutory requirements in a manner that entirely strips away the unique characteristics of swaps that have been bandied about the Commission for at least 20 years, and requires swaps to trade like futures. Looking over the history of the Commission’s treatment of swaps, it remains abundantly clear that while swaps may contain some features similar to those of futures, they remain sufficiently different in their purpose, function, and design. To limit swap trading to a traditional central limit order book-type exchange may be unnecessary to mitigate systemic risk, protect the public interest, and may, in fact, inappropriately burden commerce. That is, if swaps possessed the same characteristics as futures, than Congress would not have needed to create a SEF definition to accommodate them.
End users and buy-side participants are understandably wary about being forced into unfamiliar and inhospitable environments where high frequency traders can undermine their ability to trade sizeable positions and nascent, illiquid markets threaten to divulge their positions through bidding alone. Like a seven year-old wanting a towel warming rack, it just can’t be right. But at least buying a towel rack helps commerce. I can’t say the same of this proposal.
I want to be clear: I am in favor of increasing pre-trade price transparency, bringing more swaps to execution facilities, and relying less on block trades. To achieve this, we must permit a broader range of venues to inspire market innovation and competition and improve transparent market pricing. Congress’s open ended language is clearly intended to permit for flexibility across trading venues. I ask that we interpret the statute broadly to permit the various RFQ and transparent voice broker systems already serving the industry to continue operating with, at most, minor alterations. This, I believe, will allow the market participants to ultimately determine what levels of pre-trade transparency and liquidity they require to manage risks and maximize profitability for themselves and their clients.
I checked back with Macey about that list of hers, and she admitted that it might be a little too long. She’s being reasonable and is cutting the towel rack; I hope we get the comments and input necessary to cut ours.
From my experience working in the Senate, I do know how it feels to be in that hot seat, and I would like to thank Riva Adriance and her team for their efforts on this proposal. I’d like to thank all the other teams presenting today headed by Phyllis Cela, Nancy Schnabel, and George Wilder and Susan Nathan. I appreciate your unwavering commitment to responding to my questions, comments, and criticism with thoughtful consideration.
End User Exemption
I commend the end-user exemption team for drafting what overall is a very thoughtful and well written proposal. However, I am flummoxed as to why we are failing to fully address the issue of excluding small banks, farm credit institutions and credit unions from the definition of financial entity. This is unreasonable. Section 2(h)(7(C))(ii) directs the Commission with that ever important word “shall” to consider whether to exempt these entities, and as pointed out by House Ag. Committee Chairman Collin Peterson, “The regulators will have maximum flexibility when evaluating the risk portfolio of these institutions for consideration of an exemption.”1 All we are going to do today, after almost five months with this language, is punt it. While I can appreciate the staff’s decision to pose a series of questions aimed at further informing their consideration of the appropriate criteria for such an exception, we are too far into these rulemakings to begin from square one.
As we move forward on this rulemaking, I encourage staff to keep in mind that many of the effected institutions play a critical role in the economic development of our small communities and rural areas. It is my hope that a final rule will ultimately permit the bulk of these institutions to avail themselves of the end-user exemption.
Business Conduct Standards
As for the proposal for business conduct standards for swap dealers and major swap participants in their dealings with counterparties and especially counterparties who are Special Entities, I believe that staff has demonstrated an extraordinary ability to effectuate the statutory mandates through consideration of congressional intent and the manner in which market participants actually conduct their business. This proposal is especially timely as Bank of America has just agreed to pay a more than $137 million in restitution to federal and state agencies for its participation in a conspiracy to rig bids in the municipal bond derivatives market. That being said, I am not entirely convinced that these layers of protections are necessary in every relationship scenario. However, because they strive ultimately to ensure that counterparties dealing with sophisticated swap dealers and major swap participants are fully informed (and have clear recourse if they are not) prior to entering incredibly complex instruments, I support this proposal.
I will say that I am not entirely sold on the broader proposal to apply execution standards to all Commission registrants transacting swaps available for trading on designated contract markets (DCMs) and SEFs. These standards are designed to ensure fair dealing and further protections against fraud and abusive practices, and these are good things, don’t get me wrong. However, the proposal, in part, requires that execution ultimately be on terms that have a “reasonable relationship” to the “best terms available” for such a swap on a DCM or SEF. While this is better than requiring absolute “best execution,” the requirements of this proposal are somewhat vague and may ultimately become just another rule in the book only relied upon in the most egregious of circumstances. I am keeping my mind open, however, and look forward to reviewing comments from a diverse population of Commission registrants who may ultimately be affected by this proposal.
In closing, I’d like to again thank the dedicated staff throughout the Commission as they continue to persevere through this time of great change. And, by all means, do not interpret my views to mean that you should never request the “towel warming rack.” However, in making your wish lists, please continue to consider whether the items you choose are reasonable for the markets.
1 156 Cong. Rec. 100, 5246 (daily ed. June 30, 2010)(statement of Rep. Peterson).
. (“The language says that institutions to be considered for the exemption shall include those with $10 billion or less in assets. It is not a firm standard. Some firms with larger assets could qualify, while some with smaller assets may not. The regulators will have maximum flexibility when looking at the risk portfolio of these institutions for consideration of an exemption.”)
Last Updated: January 19, 2011